Course structure

1

A. Bank as financial intermediary

B. Banking products and services

C. Banks' Financial Reporting

Course 6-8 - Banks‘ Balance Sheet

Course 9-10 - Banks‘ Income Statement

D. Risk management issues

Part C. Banks' Financial Reporting

Lectures 6&7. Banks‘ Balance

Sheet (I)

Lecture 6

Outline

6.1. Banks' Assets

6.2. Banks' Liabilities

3

Introduction

A commercial bank balance sheet shows :

the level and structure of financial resources that the

bank attracts (debt and equity);

how these resources are directed to the lending

activity, or financial investments (bank assets) .

4

Introduction

Through a simple analysis of the evolution of the most

significant balance positions (as a ratio to total assets)

we can answer questions such as:

What is the lending strategy of the bank?

What is the investment strategy of the bank?

What is the policy on liquidity risk management?

What are the favorite bank funding sources and how

these choices reflect the cost of capital?

5

Introduction

The basic balance sheet idendity valid for all

type of banks:

Assets = Liabilities + Equity Capital (1)

6

Introduction

C + S + L + MA = D + NDB + EC (2)

Cash assets (C) in the vault and held at different depository

institutions

Government and private interest-bearing securities (S)

Loans made available to customers (L)

Mixed assets – tangible, intangible and financial (MA)

7

Introduction

C + S + L + MA = D + NDB + EC (2)

Deposits made by and owed to customers (D)

Non-deposit borrowings of funds in the money

and capital markets (NDB)

Equity capital (EC)

8

Introduction

Equation (2) is useful because it expresses a structure

of resources and investments globally valid, even in

the presence of differences in accounting and

regulation.

Depending on how banks place resources in the four

asset classes, their performance will vary

(profitability and risk indicators), but also the

minimum level of equity they have to provide (risk

adjusted capital).

9

Introduction

in periods of economic expansion, banks are targeting a share

of loans to total assets (L) because they generate the highest

yields, as long as the credit risk is considered acceptable (due

to good business conditions)

during periods of economic recession, the risk aversion of

banks leads them to direct their available resources to

investments with reduced level of risk like government bonds

(Inv)

10

Introduction

At the board level of banks, the management of

assets and liabilities is under the supervision of

ALCO Committee (Assets and Liabilities

Committee) which monitors:

the risk and return characteristics of loans and

investments portfolio;

the structure and cost of financing resources.

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Introduction

The financial position (balance sheet) for banks

For banks, asset ordering is opposite to non-financial

corporations), starting from the most liquid assets.

For bank liabilities, the ranking positions is also reversed

compared to non-financial firms: first are nominated debts and

subsequently equity capital.

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6.1. Banks' Assets

Cash and cash equivalents includes:

cash held in bank’s vault across the territorial network;

current accounts placed with other depository institutions

including correspondent accounts;

bank’s reserve account held with the National Bank of

Romania/Federal Reserve Bank (USA)/European Central

Bank (Euro zone)

! Example: Mandatory reserve requirements

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6.1. Banks' Assets

Characteristics:

It is the most liquid component of a bank and is usually

known as the primary reserve (or immediate liquidity).

Thus, if during moments of panic customers withdraw

significant cash (or transfer money through accounts to other

banks), these liquidities represent the first and main line of

defense for the bank.

the first source of which new cash loans are given to

customers.

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6.1. Banks' Assets

Characteristics:

banks avoid unreasonably high sums of immobilizations in

this class of assets as:

the return is very low (for mandatory reserve requirements

the interest rates paid by the NBR are far below normal

market rates);

significant costs of providing security, transport and storage

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6.1. Banks' Assets

Deposits placed with other depository institutions

includes:

Sight and time deposits placed with other banks;

banks place their resources on short-term maturities,

frequently overnight (ON) and tomorrow next (TN)

Short-term loans granted by the bank to other credit

institutions: direct loans and loans related to reverse repo

transactions

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6.1. Banks' Assets

Available for sale securities

Most assets from this class are government securities -

financial instruments whereby sates (government, ministry of

finance) finance their debt :

Treasury bills

Short-term government securities

Short-term municipal securities (local governments)

Usually government securities addressing internal market (commercial

banks and their customers ) are issued in RON and those issued to foreign

markets, in EUR or USD.

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6.1. Banks' Assets

Treasury bills - represent short-term government securities

with a maturity of less than 1 year, typically bonds of “zero

coupon”. Thus , they do not offer interests/coupon to

investors, their gain coming from an issue price lower than the

face value repaid at maturity.

!!! This type of treasury bills are known in the US as the Bills or

T – bills: the generic term for government securities with very

short maturity (3 or 6 months).

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6.1. Banks' Assets

Government bonds/notes

As a convention for government securities issued for longer

than 1 year practitioners use the term bonds. In Romania, the

Ministry of Finance issue bonds mainly with maturities of 3, 5

and 10 years.

In the case of bonds, the issue price and amount to be repaid at

maturity are usually equal to the nominal value, which is also

the basis for calculating the interest owed to the bond buyer

(investor).

Globally, two terms are used to designate liabilities:

notes (for maturities of 2, 3, 5 and 10 years)

bonds (for maturities over 10 years ) .

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6.1. Banks' Assets

Characteristics:

Low risk and high liquidity. If needed, notes/bonds can be sold

easily on the interbank market for cash.

Also, holdings of government securities allow banks to obtain

loans from other banks in the system through repo operations

(repurchase agreement).

Because of their ability to turn relatively easy to cash,

government securities are known as secondary reserves. In

terms of liquidity, it takes an intermediate class between the cash

and loans to customers.

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6.1. Banks' Assets

Financial assets at fair value through profit or loss

In addition to government securities, banks' investment portfolio

includes:

Other fixed income instruments (bonds)

Other variable income instruments (shares)

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6.1. Banks' Assets

Other fixed income instruments (bonds)

Bonds issued by financial institutions or non-financial companies

directly purchased in the primary market or through private

placements , and, respectively, in the secondary market of bonds

issued previously.

The risk associated with holding these investments is higher compared

to the government securities but also the interest (yield) is higher.

Banks buy such bonds to ensure a regular flow of interest income

when real lending opportunities are lacking.

Typically, these bonds are not accepted as collateral for repos or

refinancing operations with the central bank because of the higher

risk.

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6.1. Banks' Assets

Other fixed income instruments (bonds)

In case of marketable bonds (for which exists an active secondary

market), there is an acceptable liquidity of these investments. Thus, if

the bank needs cash they may sell bonds before they reach maturity.

There is the risk that the market price is lower than the nominal value

(or than the purchase price) as a result of interest rate dynamics; in

this case, when selling, the bank will incur a loss.

But if the bank has the intention to hold the bonds until maturity,

price risk disappears because the loan will be repaid at least at

nominal value.

Depending on how the investments are classified by the bank

("available for trade" versus "held to maturity") the riskiness of

the assets and capital requirements vary.

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6.1. Banks' Assets

Other variable income instruments (shares)

In Romania, the regulations allow commercial banks to hold shares in

non-financial companies up to a maximum of 20 % of bank’s equity and

not exceed a threshold of 50 % share in the non-financial firm.

In the US, the US Congress passed the Glass-Steagall Act in 1933 with a

series of restrictions related to the activity of banks , including the holding

of shares of non-financial companies .

!!! In this way it drew a dividing line between commercial banks (taking

deposits and granting loans) and investment banks.

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6.1. Banks' Assets

Loans and advances to customers

Depending on the purpose and the beneficiary:

Loans to companies (legal entities, manufacturing, trade, construction,

services , transport, energy mining, chemical, etc.)

Loans to households (individuals, PFA - freelancers )

Loans to financial institutions (banks, insurance companies )

Loans to governments, institutions or foreign companies

Real estate loans

Loans for farmers

Loans to investors and brokerage houses (investment banks )

Finance leases

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6.1. Banks' Assets

Each category may be detailed further by:

(1) maturity (short, medium, long);

(2) currency (lei, euro and other currencies);

(3) interest rate (fixed or variable relative to a reference type

ROBOR or EURIBOR)

(4) quality of the debtor (creditworthiness);

(5) debt service (the extent of delays in payment of installments

etc.)

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6.1. Banks' Assets

Characteristics

In case of commercial banks, this position represents the core of

bank investments.

It represents the amount of money that the bank will collect from

loans landed to customers.

The position is recorded at amortized cost, i.e. the value at which

the asset is recognized initially (when signing the contract and

giving credit) minus principal payments already made.

From a technical perspective, this item includes current loans,

overdue loans and debit balances on current account generated

by credit cards or overdrafts for debit cards . Globally, these

individual loans come together under the concept of the bank's loan

portfolio.

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6.1. Banks' Assets

Characteristics

For this post in the balance sheet appears the net amount of

credit obtained by subtracting the impairment losses from

gross (total) loans: the lower is the credit quality, the higher is

the size of the adjustment that reduces the net (recoverable)

loans.

Net loans = Gross loans – Impairment losses

Technically, this adjustment (known as allowance for loan

losses) functions as a reserve designed to offset the negative

effects of doubtful loans (non performing loans).

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6.1. Banks' Assets

Characteristics

The purpose of the reserve is to convey a more complete

picture of the actual recoverable debts of the bank, ignoring

those existing elements only "on paper".

The main source used to build this reserve are the recorded

provisions for loan losses (which are noncash expenses).

When credit quality decreases with time, banks must record these

expenditures with provisioning for supplying the reserve.

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6.1. Banks' Assets

Characteristics

Although banks are bound by the BNR norms to classify loans

by risk categories and record provisions for credit risk, this

may result in tax savings as provisioning expenses are tax

deductible (reduce the level of gross profit).

Provisioning expenses are non-cash expenses , i.e. not

involving cash outflows (payments) of the firm but gross profit

decrease.

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6.1. Banks' Assets

Tangible and intangible assets

Tangible assets include land, buildings, capital goods and

equipment necessary to conduct banking activity;

they are reported at revalued amount less accumulated

depreciation and any provision for impairment.

Usually, intangible assets have a lower weight in the balance

sheet containing predominantly licenses for various

applications and any goodwill.

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6.1. Banks' Assets

Financial assets

Investments which do not necessarily aim to make a profit on

short-term trading activity, being rather associated with long

term holdings.

Examples:

holdings of banks in support institutions such as Transfond, Central

Credit Risk and Credit Bureau;

the network of subsidiaries or related companies that are developed

by a bank to internalize a wider range of financial services

(Assurance, Leasing, Asset management).

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6.1. Banks' Assets

Other assets

This item includes position not provided before:

Accounts receivables (Income earned but not collected

on loans)

Inventories

Net differed taxes

Prepayments

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