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Part 2: Bank Financial Statements, Risks, and Valuation. Chapter 4: Sources and Uses of Bank Funds and the Risks of Banking Chapter 5: Accounting and Economic Models of Bank Performance and Valuation Chapter 6: Case Studies in Bank Valuation and Performance. CHAPTER 4. - PowerPoint PPT Presentation
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Chapter 4 1
Part 2:Bank Financial Statements, Risks, and Valuation
Chapter 4: Sources and Uses of Bank Funds
and the Risks of Banking
Chapter 5: Accounting and Economic Models
of Bank Performance and Valuation
Chapter 6: Case Studies in Bank Valuation
and Performance
Chapter 4 2
CHAPTER 4
Sources and Uses of Bank Funds and the Risks of
Banking
Chapter 4 3
LEARNING OBJECTIVES
Three Views of a Bank: As a Portfolio or Balance Sheet, as an Information Processor, and as a Regulated Firm
A Bank’s Sources and Uses of Funds The Components of a Bank’s Income-Expense
Statement The Linkage Between Bank Financial Statements
and the Risks of Banking
TO UNDERSTAND...
Chapter 4 4
CHAPTER THEME The traditional business of banking is
funding loans (use of funds) with deposits (source of funds). This function generates the “bread-and-butter cash flow” of a bank – net interest income. Netting out the provision for loan loss and net noninterest income gets to a bank’s pre-tax net income. Measuring and managing the risks associated with this business represents the hear of bank financial management, which is risk management.
Chapter 4 5
Bank’s Evolution from Money Changers to Dealer-Makers, Information Processors, and Regulated Firms
Functions that a Bank Performs
1. Chest: the safekeeping or risk-control function
2. Bench: the transactions function
Cash, Check, Credit/Debit Card
Chapter 4 6
Banks As Portfolios: Two-Way Funds Rental and Risk Control
Risks Credit Risk Interest-Rate Risk Liquidity Risk Prepayment Risk Foreign-Exchange Risk
Chapter 4 7
Bank Financial Statements
Balance Sheet: A = L + NW Income-Expense Statement:
P = R - C - T
Book Values Market Value of Equity
Chapter 4 8
Bank Balance Sheets Sources of Funds: Core Deposits
CORE DEPOSITSGathered in Local Markets andTypically have Lower InterestCosts than Purchased Fund
Demand Deposit Accounts Other Checkable Balances Savings Accounts Small Time Deposits
Chapter 4 9
Bank Balance Sheets Sources of Funds: Managed Liabilities
Managed Liabilities As the antithesis of core deposits,
managed liabilities are more volatile and more rate-sensitive funds that are gathered in national and international money markets rather than local markets
Examples: Foreign deposits, large CDs, FF purchases, repos, demand notes, subordinated notes and debentures, and other borrowed money
Chapter 4 10
Bank Balance Sheets Uses of Funds Interest-Earning Assets
Loans and leases C&I, real estate, and consumer
Investment securities Investment account
Held to Maturity (historical cost or book value) Available for Sale (market value)
Trading account (recorded at market value under “trading assets”)
Fee-Based Assets (e.g., trust services) Nonearning Assets (e.g., cash and due
and premises)
Chapter 4 11
Bank Balance Sheets Sources and Uses of Funds
Federal Funds
and
Repurchase Agreements
Chapter 4 12
CREDIT RISK, PLL, AND LLR OR ALLL (see Box 4-1, p. 112) Credit or default risk results in loan losses
– an accepted part of the business of lending
Banks set aside funds for such purpose, called the provision for loan loss (PLL) – a noncash outlay that runs through the income-expense statement to a contra-asset account on the balance sheet called the loan-loss reserve (LLR) or the allowance for loan and lease loss (ALLL)
“Bathtub Analogy” in Box 4-1, p. 112
Chapter 4 13
Bank Equity Capital Equity Capital = Net Worth =
Book Value of Equity = Assets - Liabilities
Regulatory capital Market value of equity
Chapter 4 14
COMPONENTS OF BANK EQUITY CAPITAL Common stock ($32.4 billion, par value) Surplus ($238 billion) Undivided profits ($203.3 billion) Book values for all insured commercial
banks at the beginning of 2000 are in parentheses
External equity: issue equity or hybrid securities (e.g., trust preferred stock, TPS)
Internal equity: retained earnings or undivided profits
Chapter 4 15
Sources of Bank Revenue (“Sales” and “Cross-Selling”)
Total revenue or “sales” for a bank:
Interest IncomeFrom Loans, Securities, Federal Funds Sold
Non-Interest IncomeFrom Fees and Service Charges
Chapter 4 16
Bank Costs Interest Expenses
On Deposits and other Interest-Bearing Liabilities
Non-Interest ExpensesAdministrative and Operating Expenses
PLL is so important that it is treated separately
Chapter 4 17
A Bank’s Income-Expense Statement
Net Interest Income = Interest Income - Interest Expense
Net Interest Margin = Net Interest Income / Total Assets
PLL = Provision for loan loss Net Noninterest Income: “Burden”
Noninterest Income - Noninterest Expense Taxes Net income
Chapter 4 18
A BANK’S “BURDEN” For almost all banks, net interest income
is negative (< 0) because noninterest expense exceeds noninterest income
For this reason, it can be described as a bank’s “burden”
Since NII has the tremendous job of having to cover a bank’s PLL, its burden, and its taxes, it is the “bread and butter” of the business of traditional banking
Chapter 4 19
A Bank’s Income-Expense Statement
Return on Assets (ROA)Net Income / Total Assets
Return on Equity (ROE)Net Income / Total Equity
orROA x Equity Multiplier (EM)
Chapter 4 20
A Bank’s Income-Expense Statement
Dividends and Additions to Retained Earnings
Internal Capital Generation Rate
Chapter 4 21
RECAP OF BANK INCOME AND EXPENSES Four key components:
1. Net interest income 2. PLL 3. Net noninterest income (”burden”) 4. Taxes
Net income is the bottom line ROA is the key accounting
measure of bank performance
Chapter 4 22
CHAPTER SUMMARY Three alternative ways of viewing
a bank are: 1. Portfolio or balance sheet 2. Information processor 3. Regulated firm
This chapter has focused on the first view and the income and expenses that flow from a bank’s portfolio or balance sheet
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