Bank Balance Sheets and Income Statements

Unit Agenda
FDIC Website: UBPR, SDI, CTR Overview of Bank Balance Sheets Overview of The Income Statement
1. Components of Profits 2. Profitability Analysis

Unit Objectives
Students will be able to obtain information on bank profitability from publicly available records. Students will be able to calculate measures of bank profitability and explain the significance. Students will be able to use 6 steps of profitability analysis for trend and peer comparisons.

FDIC Data
In USA, bank deposits are insured by government owned Federal Deposit Insurance Corporation are required to submit quarterly data on income and balance sheets to regulator which is available on-line in easy to use form. UBPR Comprehensive set of quarterly data for every bank in the US collected by Federal Financial Instituting Examination Council. Link.

Additional Data
Additional macro or industry level data from FDIC & Fed linkable from the site. Call and Thrift Reports Detailed Balance Sheet and Income Statement for each bank. Link Statistics on Depositary Institutions Create reports with customized peer groups. Link

Analyzing Bank Performance in HK

Data less easily available in consistent comparable form. Main source of bank data will be bank annual reports. Most information is available in annual and interim reports on the web. Less useful, because the data is not as consistent across banks and not reported as frequently.

Analysis
Peer Analysis - Compare with others in same business situation Trend Analysis Compare performance with previous periods. Learn About Bank Balance Sheets at HSBC Subsidiary HSBC National Association, USA

Balance Sheets
Assets
1. Loans

Liabilities
1. Transactions Accounts

2. Investment Securities
3. Noninterest Cash & Due from Banks 4. Other

2. Savings and Time Deposits

3. Other Borrowings

Equity

Peer Comparison: Assets

HSBC National Association 3 Total assets A. Loans 8 Net loans & leases 9 Loan loss allowance B. Investments 5 Interest-bearing balances 6 Securities 7 Federal funds sold & reverse repos 10 Trading account assets C. Non-Interest Cash and Due from Banks 4 Cash and due from depository institutions 5 Interest-bearing balances D. Other 11 Bank premises and fixed assets 12 Other real estate owned 13 Goodwill and other intangibles 14 All other assets 15 Life insurance assets 8743

166,631,767
89,014,289 89,014,289 883,837 65,056,873 2,599,612 22,529,121 14,677,257 25,250,883 3,672,570 6,272,182 2,599,612 8,888,035 525,791 46,294 2,597,390 5,718,560 200,894 53.4%

11,757,683,470
7,091,356,071 7,091,356,071 77,947,959 3,323,577,178 156,842,309 1,991,937,101 578,081,565 596,716,203 586,967,795 430,125,486 156,842,309 1,069,467,043 109,358,467 6,684,378 387,892,082 565,532,116 102,375,796 60.3%

39.0%

28.3%

2.2%

5.0%

5.3%

9.1%

Source: SDI

Cert. 57890

Types of Bank Assets Show Website on Screen

Cash and Funds Due:
Vault Cash Deposits at Central Bank Cash items in process of Collection

Types of Bank Assets cont.

Investments
Deposits at other banks Lending of central bank reserves (to other banks) Securities:

Maturity 1. Short-term (<1 year) 2. Long-term (>1 year)

Accounting 1. Held-to-Maturity (valued at cost) 2. Trading Account Securities (marked-to-market) 3. Available-for-sale (marked-tomarket)

Composition of Securities
HSBC USA
Held to m aturity (book value) 6%

All Institutions

Held to m aturity (book value) 7%

Trading account assets 23%

Trading account assets 53% Available for sale (fair m arket value) 41%

Available for sale (fair m arket value) 70%

Types of Bank Assets, cont.

Net Loans and Leases, Loans to customers less the allowances for loan losses. Loan loss accounts are contra-assets, deductions from value of loans which are chosen subjectively (subject to regulatory approval).
HSBC All USA Institutions 55.50% 60.44% 0.06% 0.43% 18.25% 16.41% 21.91% 14.59% 4.28% 8.13%

All real estate loans Farm loans Commercial and industrial loans Loans to individuals Total other loans and leases *

Liabilities
HSBC USA Total liabilities Transaction accounts Nontransaction accounts Other Liabilities 154,571,824 6,429,631 67,942,235 80,199,958 Federally Chartered Institutions 7,399,096,294 4.2% 443,810,074 6.0% 44.0% 3,655,825,585 49.4% 51.9% 3,299,514,125 44.6%

Types of Liabilities
Deposits: Main source of funding for commercial banks. Volatile Liabilities in Red Transactions Non Transactions Non Interest Paying Interest Paying Other Volatile Demand Deposits MMDA NOW Small Savings Deposits

Savings Time Deposits < 100K Time Deposits > 100K Fed Funds, Brokered Deposits, Foreign Office Deposits, Short-term Borrowings

Types of Liabilities, cont.

Fed Funds Purchased: Short-term loans from one bank to another with securities as collateral. Trading liabilities: Obligations of banks securities dealers. Other Borrowed Money: Short-term borrowings and commercial paper. Subordinated Debt: Debt w/ maturity > 1 yr. and junior to deposits. Foreign Office Deposits: Deposits at Foreign Subsidiaries.

Income Statement
NII
Net Interest Income: Interest Income-Interest Expense

- Burden Non-interest Income-Non-interest Expense

- PLL
+ SG -T + XG = NI

Provision for Loan Losses and Leases

Securities Gains Applicable Taxes Extraordinary Gain Net Income

Statistics For Depository Institutions

HSBC National Association Income and Expense Total interest income Total interest expense (Year-to-date) 9/30/2007 6,674,815 4,020,472 9/30/2006 5,824,761 3,398,247

NII Net interest income PII Provision for loan and lease losses
Total noninterest income
Fiduciary activities Service charges on deposit accounts Trading account gains & fees Additional noninterest income

2,654,343 873,134
1,629,423
72,706 166,128 439,937 950,652

2,426,514 585,895
1,643,787
65,232 159,063 421,671 997,821

Total noninterest expense

Salaries and employee benefits Premises and equipment expense Additional noninterest expense

2,484,787
958,909 176,689 1,349,189

2,282,546
888,797 179,919 1,213,830

BURDEN
Pre-tax net operating income

855,364
925,845 31,465

638,759
1,201,860 16,965

SG Securities gains (losses) T Applicable income taxes

Income before extraordinary items

292,169
665,141

414,089
804,736

XG Extraordinary gains - net Net income

-3,814

665,141

800,922

Net Interest: Key Source of Profits

Main business of commercial banks is taking deposits at interest and making loans or buying interest paying assets. Net Interest Income (NII) = Interest Revenue Interest Expenses
HSBC USA N.A., 12/31/2005
Foreign office loans Lease financing receivables Balances due from depository institutions Securities Trading accounts Federal funds sold Other interest income Total 82,145 4,264 116,643 870,114 275,011 190,678 32,005 6,098,094

Statistics For Depository Institutions

Sources of Interest Income HSBC USA N.A., 12/31/2005 CTR

Domestic Office Loans Loans secured by real estate Loans to finance agricultural production and other loans to farmers Commercial and industrial loans (1) Credit cards (2) Other individual loans Loans to foreign governments and official institutions. All other loans in domestic offices Securities U.S. Treasury securities and U.S. Government agency obligations Mortgage-backed securities All other securities (includes state and municipal) 2,861,663 63.21% 2,050 0.05% 530,230 11.71% 812,798 17.95% 236,419 5.22% 168 0.00% 83,906 1.85% 4,527,234 100.00% 56,485 6.49% 682,616 78.45% 131,013 15.06% 870,114 100.00%

Statistics For Depository Institutions U.S. Banks heavily dependent on income from property sector like Hong Kong!

Sources of Interest Expense HSBC USA N.A., 12/31/05 SDI & CTR
Domestic office deposits Foreign office deposits Federal funds purchased Trading liabilities and other borrowed money Subordinated notes and debentures 1,106,807 733,802 52,635 768,982 217,237

Transaction accounts (NOW accounts, ATS accounts, etc.) (1) Savings deposits (includes MMDAs) (2) Time deposits of $100,000 or more (3) Time deposits of less than $100,000

685 321,392 578,695 206,035

Other sources of profits

Banks face other expenses (salaries, rent, etc.) and have other sources of income such as fees and services. Banks have an increasing role in providing services to financial markets. In HK, banks have many financial businesses including credit cards, insurance, etc. Burden = Noninterest Expenses Noninterest Revenues

Sources of Non-Interest Income HSBC USA N.A., 12/31/2005 SDI

Fiduciary activities 87,341 Service charges on deposit accounts 208,434 Trading account gains & fees 364,824 Investment banking, advisory, brokerage, and underwriting fees and commissi 10,983 Venture capital revenue 0 Net servicing fees 48,015 Net securitization income 113,718 Insurance commission fees and income 32,761 Net gains(losses) on sales of loans 10,120 Net gains (losses) on sales of other real estate owned 2,056 Net gains (losses) on sales of other assets (excluding securities) 77,956 Other 709,765
US$, 000, CTR

Sources of Non-Interest Expense HSBC USA N.A., 12/31/05 SDI

Salaries and employee benefits 956,378 Premises and equipment expense 237,058 Amortization expense and impairment losses for other intangible losses 4,390 Goodwill impairment losses 0 Other noninterest expense 1,435,531

CTR

Loan Provisions
When loans are not repaid, these losses occur they will have a negative impact on profits. To prevent unexpected losses from leading to fluctuations in profits, banks create a loan reserve account. Loan reserves are a contra-asset account, i.e. an account of deductions from stock of loans. Net Loans = Gross Loans Loan Reserves When loans are not repaid, their amount is deducted from Gross Loans & Loan Reserves When bank makes Provisions for Loan Losses this amount is added to Loan Reserves & deducted from profits.

Etc.
Securities Gains: Changes in Mark-toMarket value of financial assets. Extraordinary Items: One time gains and losses on asset sales. Taxes

Evaluating Bank Performance

ROE Analysis

Measures of Performance
Benchmark measure of a banks profitability is the return on equity which is profits per unit of dollars invested by the banks owners. i.e. dollars of income divided by equity in the bank. Corresponds with a rate of return on investment. Items on the Income Statement are generated over a period of time while items on the Balance sheet are at a point in time.

Averaging Stock Variables

Example: Consider equity value of HSBC USA, N.A., at ends of 2004 and 2005 compared with income earned over 2005.
NI[2005] Equity NI/Equity 1,016,372 Dec. 31, 2004 11,372,560 8.9% Jun. 30, 2004 12,142,210 8.4%

Most appropriate to average balance sheet variables over the year.

NI Return on Equity ROE Average Equity

Averages
Average of available balance sheets. Quarterly (and semi-annual) income statements report on a year-to-date basis. [e.g. income on 9/30 is the income earned from January through September]. To get appropriate denominator, start with end of previous year and take average of end of period balance sheets over the year. Annualize.

HSBC USA Return on Equity

Year to Date Averages, Check against UBPR

Dec. 31, 2005 Sep. 30, 2005 Jun. 30, 2005 Mar. 31, 2005 Dec. 31, 2004

Equity Assets 11,888,099 1,016,372 12,375,281 792,829 12,142,210 525,347 11,402,758 319,197 11,372,560

Average Equity 11,836,182 11,823,202 11,639,176 11,387,659

NI/ Annualized AvgeEq ROE 0.08587 8.59% 0.067057 8.94% 0.045136 9.03% 0.02803 11.21%

Last Year HSBC National Assoc. Qtr by Qtr Averages SDI

Assets Equity HSBC National Association 12/31/2006 9/30/2006 6/30/2006 165,673,017 166,631,767 168,899,000 12,257,932 12,059,943 12,259,680 3/31/2006 158,753,889 12,102,159 12/31/2005 150,679,481 11,888,099 0.08347 0.00624 13.38396 Income 1,011,140 ROE Averrage Assets 162,127,431 ROA Average Equity 12,113,563 EM

Compare Q-by-Q ROE with UBPR

PERCENT OF AVERAGE TOTAL EQUITY: NET INCOME DIVIDENDS RETAINED EARNINGS
BANK

PG 1 PCT 8.35 12.89 7.06 6.26 1.29 5.65

22 58 23

Quarterly Averages
For some balance sheet variables, such as assets, banking firms construct day-byday or week-by-week averages and report these on a quarterly basis. Averages (across quarters) of these daily/weekly averages are used to most accurately calculate yields for UBPR.

Determinants of ROE
The first step in analyzing profits is to decompose returns into the profitability of assets and the leverage of the bank.

ROE ROA EM
NI ROA average Total Assets
Profitability of Banks Assets

average Total Assets EM average Total Equity

Leverage

Equity Multiplier
Banks owners earn profits on the spread between interest on lending and the interest on deposits. When the leverage (EM) is high, banks are accepting a lot of deposits and can earn high income levels. A high multiplier multiplies profits when profits are positive. But in periods with negative profits, negative profits may also be multiplied. A high EM is a risk factor since it reduces the amount of assets that can go bad without the bank itself going bankrupt.
Capitalization is a key pillar of bank regulation

Dupont Analysis
ROA

Asset Utilization Income Management

Expense Ratio Cost Management

Tax ROA AU ER average Total Assets

Dupont Analysis (Bank Version)

ROA for all types of firms can be decomposed into revenue and cost management. AU = Asset Utilization (Revenue Management) Revenues AU average Total Assets

ER = Expense Ratio (Cost Management)

Total Operating Expense ER average Total Assets

II. Earnings and Profitability Analysis

The Dupont Analysis can decompose owners returns into cost management and revenue management. Profitability Analysis decomposes cost management and revenue management into narrower categories of cost and revenue to evaluate the source of profits.

Asset Utilization
Securities Gains Asset Utilization (UA)

= Non Interest Revenue/ Assets Interest Revenue/ Assets

1. Rate 2. Composition 3. Volume Effects

Non Interest Income is growing as a share of operating income

Non Interest Income as % of Income

45.00% 40.00% 35.00% 30.00% 25.00% % 20.00% 15.00% 10.00% 5.00% 0.00% 1991 USA 1996 Japan 2001

Source: Hoshi and Kashyap, 2002

Determinants of Net Interest Income

Interest Earning assets as a share of assets 1. Volume Effects Earning Assets
Total Assets

2. Rate Effects: Level of interest earned on assets of a given type. 3. Composition/Mix Effects: Types of interest earning assets.

Yield Analysis Banks with Assets > US$50 billion

TOTAL LOANS & LEASES (TE) LOANS IN DOMESTIC OFFICES REAL ESTATE COMMERCIAL & INDUSTRIAL INDIVIDUAL CREDIT CARD AGRICULTURAL LOANS IN FOREIGN OFFICES TOTAL INVESTMENT SECURITIES(TE) INTEREST-BEARING BANK BALANCES FEDERAL FUNDS SOLD & RESALES 2004 5.74 5.72 4.61 5.36 5.99 6.28 3.63 3.09 3.94 2.12 1.53 2003 5.81 5.76 4.51 5.55 6.02 4.11 3.19 3.23 3.96 1.85 1.55 2002 6.52 6.51 5.31 5.69 7.41 4.91 3.56 2.53 5.09 2.48 1.99

Source: UBPR Custom Peer Group Reports

Expense Ratio and Cost Management

ER
Interest Expenses aTA
NonInterest Expenses aTA
PLL aTA

1. Rate 2. Composition 3. Volume Effects

Efficiency Ratio
One measure of the ability to manage costs is the ratio of expenses to revenue EFF = Efficiency Ratio

Noninterest Expense EFF NII Noninterest Income

Analysis of Non Interest Expense

We may also want to look carefully at the sources of efficiency with which banks deliver services % of Assets Personnel Expenses Total Expenses Burden Productivity Measures Efficiency Ratio Personnel Expense/Employee Assets/Employee

Decomposition of Expenses Banks with Assets > US$50 billion

PERSONNEL EXPENSE OCCUPANCY EXPENSE OTHER OPER EXP(INCL INTANGIBLES) TOTAL OVERHEAD EXPENSE OVERHEAD LESS NONINT INC OTHER INCOME & EXPENSE RATIOS EFFICIENCY RATIO AVG PERSONNEL EXP PER EMPL($000) ASSETS PER EMPLOYEE ($MILLION) 2004 1.44 0.38 1.5 3.54 0.65 56.87 76.12 6.62 2003 1.51 0.43 1.6 3.74 0.35 56.09 70.82 6.04 2002 1.54 0.42 1.61 3.71 0.34 53.97 67.08 4.69

Determinants of Net Interest Expense

A. Interest Paying liabilities as a share of assets Volume Effects B. The interest paid on interest earning liabilities: 1. Rate Effects: Level of interest paid on liabilities of a given type. (TREND Analysis) 2. Composition/Mix Effects: Types of interest bearing liabilities

Cost Analysis Banks with Assets > US$50 billion

TOTAL-INT BEARING DEPOSITS TRANSACTION ACCOUNTS OTHER SAVINGS DEPOSITS TIME DEPS OVER $100M ALL OTHER TIME DEPOSITS FOREIGN OFFICE DEPOSITS FEDERAL FUNDS PURCHASED & REPOS OTHER BORROWED MONEY SUBORD NOTES & DEBENTURES ALL INTEREST-BEARING FUNDS 2004 1.22 0.61 0.72 2.14 2.56 1.4 1.47 2.79 3.9 1.52 2003 1.2 0.58 0.67 2.25 2.63 1.12 1.24 3.05 3.84 1.52 2002 1.82 0.85 1.1 3 3.44 1.75 1.82 3.68 4.19 2.19

Source: UBPR Custom Peer Group Reports

Net Interest Margin & Spread

Concentrates on Rate & Composition Effects
NII NIM average Earning Assets

Spread

Interest Income Interest Expenses average Earning Assets average Paying Liabilities

Increasing Competition?
Net Interest Margin (NII/Earning Assets) 4.40% 4.20% 4.00% 3.80% 3.60% 3.40% 3.20% 3.00%

20 04 20 02 20 00 19 98 19 96 19 94 19 92 19 90 19 88 19 86 19 84 19 82 19 80 19 78

Profits vs. Risk

Earning high profits in good or even normal times will be easier if the bank is willing to take on some risk. But this risk may be more problematic in bad times. Important to measure the risk of the banking system as well as the profits.

Types of Risk
1. Credit Risk 2. Liquidity Risk 3. Market Risk
Interest Rate Risk Foreign Exchange Risk Stock market risk Business Risk Legal Risk

4. Operational Risk

5. Off-Balance Sheet Risk

Credit Risk: the risk that a borrower will not pay back interest or principal on a loan.
Evaluating Bank Credit Risk History of Credit Performance (Chargeoffs) Future expected losses (non-performing loans, types of lending, diversification) Strength of bank preparation (reserves, earnings coverage).

Liquidity Risk Variation in Net income caused by banks difficulty in obtaining immediately available funds.
1. Short-term obligations to shareholders 2. Liquid Assets 3. Other sources of liquidity

Interest Rate Risk Variation in income and market value due to effects of interest rate changes on profits & present value of assets and liabilities.
Gap between interest sensitivity of assets and liabilities at different maturities. Duration of assets and liabilities of bank.

Off-balance Sheet Items

Commercial Letters of Credit Banks guarantee payment on trade related items. Standby Letters of Credit Banks make loans triggered by default on s-t borrowing or commercial paper. Loan Commitments Banks commit to lending on borrowers demand. Securitization w/ Recourse Credit Derivatives Credit Guarantees Financial Derivatives Interest Rate, Forex, etc. Swaps, Futures & Options.

Comprehensive Risk Management

Modern banks use computer models to measure market risk. Based on historical data on correlations between asset prices and assumptions about the distribution of shocks (i.e. assume shocks are normally distributed) the models will generate a distribution of returns over any horizon. Value at Risk models will predict some possible loss which will be the maximum possible loss with some percentage chance over some forecast horizon.

Problems with VARs

Normal distributions assess a very low likelihood of extreme, crisis events.
HKMA recommends balance sheets should be stress-tested against some

Historical time series models are subject to unexpected structural change. Less good at evaluating losses from infrequently traded assets like loans.

Other Risks
Operational Risk Risk that operating expenses may vary significantly.
Crime & terrorism Employee error or fraud

Legal Risk Risk that lawsuits or unenforcable contracts might affect profitability or solvency Reputation Risk Risk that negative publicity may affect customer base or business opportunities.

Market Measures of Bank Performance

Financial markets may be a measure of bank performance. Equity Markets: Common stock Book-to-Market ratio measures markets perception of growth potential and risk of assets. Preferred stock and subordinated debt holders are exposed to downside risk but not upside gains from risky activities. Price of these assets may help measure riskiness of activities.

Reading List
J.A. Lopez, Methods for Evaluating Valueat-risk Estimates SF FRB Economic Review, 1999 Clark, Dick, Hirtle, Stiroh, and William The Role of Retail Banking in the U.S. Banking Industry: Risk, Return, and Industry Structure NY FRB Economic Review 2007