Chapter Twelve

Commercial Banks’
Financial Statements and
Analysis

MCGRAW-HILL/IRWIN 8-1
CAMELS Rating: is a Composite
rating
Regulators
Regulatorsuse
useCAMELS
CAMELSratings
ratingsto
toevaluate
evaluatethe
thesafety
safetyand
and
soundness
soundnessofofbanks
banks
CAMELS
CAMELSratings
ratingsrely
relyheavily
heavilyon
onfinancial
financialstatement
statementdata
data
Components
Components
◦◦ Capital
Capitaladequacy
adequacy
◦◦ Asset
Assetquality
quality
◦◦ Management
Managementquality
quality
◦◦ Earnings
Earningsquality
quality
◦◦ Liquidity
Liquidity
◦◦ Sensitivity
Sensitivityto
tomarket
marketrisk
risk

MCGRAW-HILL/IRWIN 12-2
component description rating weight Weighted
rating
1. Capital Does the bank have enough capital to absorb 1 1 1
adequacy losses; is evaluation in relation to risk-weighted
assets
2. Asset quality Quality of assets based on credit quality and 2.5 2 5
diversification
3. Management Ability to exploit profitable opportunities while 2 1 2
capabilities managing risk

4. Earnings Return on capital and quality of earnings 3 2 6

5. Liquidity Ability to honor current liabilities 1 1 1

6. Sensitivity to Exposure to changes in interest rates, FX rates, 1 1 1
market risk security prices and commodity prices

Total score 10.5 8 16

CAMELS rating 2

Calculating the CAMELS rating:

•Assign rating 1 to 5 to each component (1 is best, 5 is worst)
•Assign weight to each component and compute weighted rating
•Add weighted ratings to compute total score
•Divide total score by total weight for CAMELS rating

MCGRAW-HILL/IRWIN 9-3
CAMELS Ratings
CAMELS
CAMELSratings
ratingsrange
rangefrom
from11to
to55
◦◦ Composite
Composite“1”—banks
“1”—banksare arebasically
basicallysound
soundininevery
everyrespect
respect
◦◦ Composite
Composite“2”—banks
“2”—banksare arefundamentally
fundamentallysound,
sound,but butmay
mayhave
have
modest
modestweaknesses
weaknessescorrectable
correctableininthe
thenormal
normalcourse
courseofofbusiness
business
◦◦ Composite
Composite“3”—banks
“3”—banksexhibit
exhibitfinancial,
financial,operational,
operational,or orcompliance
compliance
weaknesses
weaknessesranging
rangingfrom
frommoderately
moderatelysevere
severeto tounsatisfactory
unsatisfactory
◦◦ Composite
Composite“4”—banks
“4”—bankshave haveananimmoderate
immoderatevolume
volumeof ofserious
serious
financial
financialweaknesses
weaknessesor oraacombination
combinationof ofother
otherconditions
conditionsthat
thatare
are
unsatisfactory
unsatisfactory
◦◦ Composite
Composite“5”—banks
“5”—bankshave haveananextremely
extremelyhigh
highimmediate
immediateor ornear
near
term
termprobability
probabilityof
offailure
failure

MCGRAW-HILL/IRWIN 12-4
Financial Statements
The
TheFederal
FederalFinancial
FinancialInstitutions
InstitutionsExamination
ExaminationCouncil
Council(FFIEC)
(FFIEC)
prescribes
prescribesuniform
uniformprinciples,
principles,standards,
standards,and
andreport
reportforms
formsfor
for
depository
depositoryinstitutions
institutions
◦◦ balance
balancesheets
sheetsare
arereported
reportedononreport
reportof
ofcondition
conditionforms
forms
◦◦ income
incomestatements
statementsare
arereported
reportedon
onreport
reportof
ofincome
incomeforms
forms
◦◦ commercial
commercialbanks
banksreport
reportcontingent
contingentassets
assetsand
andliabilities
liabilitieson
onoff-balance-
off-balance-
sheet reports
sheet reports
Retail
Retailbanks
banksfocus
focusbusiness
businessactivities
activitieson
onconsumer
consumerbanking
banking
relationships
relationships
Wholesale
Wholesalebanks
banksfocus
focusbusiness
businessactivities
activitieson
oncommercial
commercialbanking
banking
relationships
relationships
◦◦ most
mostwholesale
wholesalebanks
banksalso
alsoengage
engageininretail
retailbanking
banking

MCGRAW-HILL/IRWIN 12-5
Commercial Bank Assets
Cash
Cashand
andbalances
balancesdueduefrom
fromother
otherdepository
depositoryinstitutions
institutions
◦◦ Consist of vault cash, currency in the process of collection (CIPC), correspondent balances and
Consist of vault cash, currency in the process of collection (CIPC), correspondent balances and
reserves
reservesatatthe
theFed.
Fed. Also
Alsocalled
calledprimary
primaryreserves.
reserves.
Investment
Investmentsecurities
securities
◦◦ short-term securities (e.g, Treasury bills and fed funds sold, Interest bearing deposits at other FIs,
short-term securities (e.g, Treasury bills and fed funds sold, Interest bearing deposits at other FIs,
Fed
Fedfunds
fundssold,
sold,Reverse
ReverseRepos,
Repos,U.S.
[Link]
Treasuryand
andagency
agencysecurities
securities
◦◦ long-term securities (e.g., Treasury bonds, munis, MBSs)
long-term securities (e.g., Treasury bonds, munis, MBSs)
Loans
Loans
◦◦ commercial and industrial
commercial and industrial
◦◦ real estate
real estate
◦◦ consumer
consumer
◦◦ other loans
other loans
Unearned
Unearnedincome
incomeand
andallowance
allowancefor
forloan
loanand
andlease
leaselosses
losses
◦◦ Are contra-asset accounts that are deducted from gross loans and leases on the balance sheet to
Are contra-asset accounts that are deducted from gross loans and leases on the balance sheet to
create
createNet
NetLoans
Loansand
andLeases
Leases
Other
Otherassets
assets(e.g.,
(e.g.,fixed
fixedassets,
assets,goodwill,
goodwill,etc.),
etc.),recorded
recordedininnet,
net,net
netofofdepreciation
depreciationand
andamortization.
amortization.

MCGRAW-HILL/IRWIN 12-6
Commercial Bank Liabilities

MCGRAW-HILL/IRWIN 12-7
Commercial Bank
Liabilities and Equity
Non-deposit
Non-depositliabilities
liabilities
◦◦Borrowed
Borrowed(purchased)
(purchased)funds:
funds:rate-sensitive
rate-sensitivefunding
fundingsources
sources
(highly volatile source of funding)
(highly volatile source of funding)
◦◦ fed
fedfunds
fundspurchased
purchasedand
andrepos
repos
◦◦ other
otherborrowed
borrowedfunds
funds(e.g.,
(e.g.,banker’s
banker’sacceptances,
acceptances,commercial
commercial
paper, discount window loans)
paper, discount window loans)
◦◦Subordinated
Subordinatednotes
notesand
anddebentures
debentures
◦◦other
otherliabilities
liabilities--non-interest
non-interestbearing
bearing
◦◦ accrued
accruedinterest,
interest,deferred
deferredtaxes,
taxes,dividends
dividendspayable,
payable,etc.
etc.
Equity
Equity
◦◦preferred
preferredand
andcommon
commonstock
stock
◦◦surplus
surplusor
oradditional
additionalpaid
paidinincapital
capital
◦◦retained
retainedearnings
earnings

MCGRAW-HILL/IRWIN 12-8
Off-Balance-Sheet Items
Off-balance-sheet
Off-balance-sheet(OBS)
(OBS)items
itemsare
arecontingent
contingentassets
assetsand
andliabilities
liabilitiesthat
that
may affect a commercial bank’s balance sheet and/or income statement
may affect a commercial bank’s balance sheet and/or income statement
Loan
Loancommitments
commitments
◦◦ up-front fees are charged for making funds available
up-front fees are charged for making funds available
◦◦ commitments fees are charged on unused portion of commitments
commitments fees are charged on unused portion of commitments
Letters
Lettersof
ofcredit
credit
◦◦ commercial
commercialletters
lettersofofcredit:
credit:trade-related
trade-relatedcommercial
commercialletter
letterofofcredit
credit
◦◦ standby letters of credit: to cover contingencies that are potentially more sever,
standby
less letters of credit: to cover contingencies that are potentially more sever,
lesspredictable
predictableororfrequent.
frequent.
Loans
Loanssold
sold
◦
◦ loans
loanscan
canbe
besold
soldwith
withor
orwithout
withoutrecourse
recourse
Derivative
Derivative contracts
contracts
◦
◦ futures,
futures,forwards,
forwards,swaps,
swaps,and
andoptions
options

MCGRAW-HILL/IRWIN 12-9
Other Fee Generating Activities
Correspondent banking
◦ Is the provision of banking services to other banks,
usually overseas
Trust services
◦ Holding and managing assets for individuals or
corporations
Processing Services
◦ include management consulting, data processing, and
information systems or other technological services

MCGRAW-HILL/IRWIN 9-10
Income Statement
Interest
Interestincome
income
––interest
interestexpense
expense
==net
netinterest
interestincome
income
Noninterest
Noninterestincome
income
––noninterest
noninterestexpense
expense
==net
netnoninterest
noninterestincome
income
––provision
provisionfor
forloan
loanlosses
losses
==income
incomebefore
beforetaxes
taxesand
andextraordinary
extraordinaryitems
items(EBTEI)
(EBTEI)
––income
incometaxes
taxes
––/+
/+extraordinary
extraordinaryitems
items
==net
netincome
income

MCGRAW-HILL/IRWIN 12-11
Income Statement
There
Thereisisaadirect
directrelationship
relationshipbetween
betweenthe
theincome
incomestatement
statementand
and
the balance sheet of commercial banks
the balance sheet of commercial banks
N M
NI   rn An  rm Lm  P  NII  NIE  T
n 1 m

NINI==netnetincome
income
AAn ==dollar
dollarvalue
valueofofthe
thebank’s
bank’snth
nthasset
asset
n
LmL ==dollar value of the bank’s mth liability
dollar value of the bank’s mth liability
m
rnr ==rate
rateearned
earnedon onthe
thebank’s
bank’snth
nthasset
asset
n
rmr ==rate paid on the bank’s mth liability
rate paid on the bank’s mth liability
PP=m=provision
provisionfor forloan
loanlosses
losses
NII
NII = non-interest incomeearned,
= non-interest income earned,including
includingincome
incomefrom
fromOBS
OBSactivities
activities
NIE = non-interest expenses
NIE = non-interest expenses
TT ==taxes
taxesandandextraordinary
extraordinaryitems
items
NN ==number
number of assets the bankholds
of assets the bank holds
MM==number of liabilities the bank
number of liabilities the bank holdsholds

MCGRAW-HILL/IRWIN 12-12
Finding the required dollar interest
spread
Suppose that a bank has equity of $200, interest expense of
$90, PLL = $20, net noninterest income of -$15 and a tax
rate of 34%. What is the minimum total interest revenue
required to give a ROE of 15%?
Required NI = NI/$200 = 0.15 or NI = $30
NI = [Interest revenue– Interest expense – PLL + (NII – NIE)]
X (1 – Tax rate) or
$30 = [Interest revenue – $90 – $20 + –$15]  (1 – 0.34)
Required interest revenue = $170.45

MCGRAW-HILL/IRWIN 9-13
Illustrative loan pricing
If securities are $500 and are earning an average
rate of return of 5% and the bank has $1500 in
loans, what must be the average loan rate to
generate interest revenue of $170.45?
$170.45 = ($500 x 0.05) + ($1500 x Avg. Loan Rate)
Avg. Loan Rate required = 9.7%

MCGRAW-HILL/IRWIN 9-14
Financial Statement Analysis
Financial
Financialstatement
statementanalysis
analysisisisbased
basedon
onaccounting
accounting
ratios
ratios
Time
Timeseries
seriesanalysis
analysisisisthe
theanalysis
analysisof
offinancial
financial
statements
statementsover
overaaperiod
periodof oftime
time
Cross-sectional
Cross-sectionalanalysis
analysisisisthe
theanalysis
analysisof
offinancial
financial
statements
statementscomparing
comparingone onefirm
firmwith
withothers
others
◦◦the
theUniform
UniformBank
BankPerformance
PerformanceReport
Report(UBPR)
(UBPR)maintained
maintainedby
by
the FFIEC allows banks to observe competitor financial
the FFIEC allows banks to observe competitor financial
statements
statements
Most
Mostfinancial
financialstatement
statementanalyses
analysesisisaacombination
combinationof
of
time
timeseries
seriesanalysis
analysisand
andcross-sectional
cross-sectionalanalysis
analysis

MCGRAW-HILL/IRWIN 12-15
 RETURN ON EQUITY AND ITS COMPONENTS
Figure 12-3 p. 402 Interest Expense
37.46%
Operating Income
Profit Margin
Net Income
Operating Income PLL
6.95%
11.89% Operating Income
ROA
Net Income Noninterest expense
38.20%
Total Assets Operating Income
0.93%
ROE Income Taxes
5.21%
Net Income Operating Income
Total Equity Capital

9.13% Asset Utilization Interest Income

Operating Income Total Assets 5.47%

Total Assets
Equity Multiplier 7.15% Noninterest income
1.89%
Total Assets Total Assets
Total Equity Capital
9.65x
MCGRAW-HILL/IRWIN 9-16
Return on Equity (ROE) Framework
Return
Returnon onEquity
Equity(ROE)
(ROE)analysis
analysisbegins
beginswith
withROE
ROEand
andthen
then
breaks
breaksititdown
downinto
intoits
itscomponents
components
ROE
ROEmeasures
measuresthetheoverall
overallprofitability
profitabilityof
ofthe
thebank
bankper
perdollar
dollar
of
ofequity
equity
net income
ROE 
total equity capital

ROE
ROEcan
canbe
bebroken
brokendown
downinto
intoits
itscomponents
components
net income total assets
ROE    ROA  EM
total assets total equity capital

MCGRAW-HILL/IRWIN 12-17
Return on Equity (ROE) Framework
Return
Returnon
onAssets
Assets(ROA)
(ROA)measures
measuresprofit
profitgenerated
generatedrelative
relative
the
thebanks
banksassets
assets
Equity
EquityMultiplier
Multiplier(EM)
(EM)measures
measuresthe theextent
extentto towhich
whichassets
assets
are
arefunded
fundedwith
withequity
equityrelative
relativeto
todebt
debt(i.e.,
(i.e.,ititisisaameasure
measureof of
leverage)
leverage)
ROA
ROAcan
canalso
alsobe
bebroken
brokendown
downinto
intoits
itscomponents
components
net income total operating income
ROA  
total operating income total assets
 PM  AU

MCGRAW-HILL/IRWIN 12-18
Return on Equity (ROE) Framework
Profit
ProfitMargin
Margin(PM)
(PM)measures
measuresthe
theability
abilityto
topay
payexpenses
expensesand
and
generate
generatenet
netincome
incomefrom
frominterest
interestand
andnoninterest
noninterestincome
incomeand
andisis
composed
composedofof
◦◦ interest
interestexpense
expenseratio
ratio
◦◦ provision
provisionfor
forloan
loanloss
lossratio
ratio
◦◦ noninterest
noninterestexpense
expenseratio
ratio
◦◦ tax
taxratio
ratio
Asset
AssetUtilization
Utilization(AU)
(AU)measures
measuresthe
theamount
amountof ofinterest
interestand
and
noninterest
noninterest income generated per dollar of total assets andisis
income generated per dollar of total assets and
composed
composedof of
◦◦ interest
interestincome
incomeratio
ratio
◦◦ noninterest
noninterestincome
incomeratio
ratio

MCGRAW-HILL/IRWIN 12-19
Other Ratios
The
Thenet
netinterest
interestmargin
margin(NIM)
(NIM)measures
measuresthe
thenet
netreturn
returnon
onaa
bank’s
bank’searning
earningassets
assets
net interest income interest income  interest expense
NIM  
earning assets investment securities  net loans and leases

The
Thespread
spreadmeasures
measuresthethedifference
differencebetween
betweenthe
the
average
averageyield
yieldon
onearning
earningassets
assetsand
andaverage
averagecost
coston
on
interest-bearing
interest-bearingliabilities
liabilities
interest income interest expense
Spread  
earning assets interest - bearing liabilities

MCGRAW-HILL/IRWIN 12-20
Other Ratios
Overhead
Overheadefficiency
efficiencymeasures
measuresaabank’s
bank’sability
abilityto
togenerate
generate
noninterest
noninterestincome
incometo tocover
covernoninterest
noninterestexpenses
expenses
noninterest income
Overhead efficiency 
noninterest expense

Many
Manyadditional
additionalratios
ratiosare
arecommonly
commonlyused
usedto
toanalyze
analyze
commercial
commercialbanks
banksbybybreaking
breakingdown
downthe
thecomponents
componentsofof
ROE
ROEeven
evenfurther
further(see
(seeTables
Tables12-6
12-6and
and12-7)
12-7)

MCGRAW-HILL/IRWIN 12-21
The Impact of Market Niche and Size
Retail
Retailand
andwholesale
wholesalecommercial
commercialbanks
banksoperate
operatein
in
different
differentmarket
marketniches
nichesthat
thatshould
shouldbe
benoted
notedwhen
when
performing
performingfinancial
financialstatement
statementanalysis
analysis
Webster
WebsterFinancial
FinancialBancorp
Bancorp(WBS)
(WBS)
◦◦WBS
WBSisisaaprofitable
profitableand
andefficient
efficientretail
retailbank
bank
◦◦invests
investsmainly
mainlyininreal
realestate
estateloans
loans
◦◦uses
useslow
lowcost
costretail
retaildeposits
depositsto tofund
fundits
itsassets
assets
◦◦holds
holdsrelatively
relativelymore
moreequity
equitycapital
capitalthan
thanBank
BankofofAmerica
America

MCGRAW-HILL/IRWIN 12-22
The Impact of Market Niche and Size
Bank
Bankof
ofAmerica
America(BOA)
(BOA)
◦◦BOA
BOAisisboth
bothaaretail
retailand
andaawholesale
wholesalebank
bank
◦◦has
hasaarelatively
relativelymore
morediversified
diversifiedportfolio
portfoliothan
thanWBS
WBS
◦◦uses
usesaabroader
broaderarray
arrayof
ofdeposits
depositsand
andmore
morepurchased
purchased
funds
funds(i.e.,
(i.e.,fewer
fewercore
coredeposits)
deposits)than
thanWBS
WBS
◦◦offers
offersaabroad
broadspectrum
spectrumofoffinancial
financialservices
services
BOA
BOAisisthe
themore
moreprofitable
profitablebank
bank
◦◦uses
usesless
lessequity,
equity,which
whichcontributes
contributesto
toaahigher
higherROE
ROE
◦◦generates
generatesmuch
muchmore
morenoninterest
noninterestincome
income

MCGRAW-HILL/IRWIN 12-23
 Comparison of WFS and BOA
Interest Expense WFS = 38.40%
Operating Income BOA = 37.16%
Profit Margin
Net Income
Operating Income PLL WFS = 1.14%
WFS = 14.02% Operating Income BOA = 5.33%
ROA BOA = 18.18%
Net Income Noninterest expense WFS = 38.50%

Total Assets Operating Income BOA = 30.25%

WFS = 0.99%
ROE BOA = 1.43% Income Taxes WFS = 6.94%
Net Income Operating Income BOA = 9.15%
Total Equity Capital

WFS = 8.45% Asset Utilization Interest Income WFS = 5.95%

BOA = 13.36% Operating Income Total Assets BOA = 5.57%
Total Assets
Equity Multiplier WFS = 7.08% Noninterest income WFS = 1.13%
Total Assets BOA = 7.91% Total Assets BOA = 2.34%
Total Equity Capital
WFS = 8.51
BOA = 9.33
MCGRAW-HILL/IRWIN 9-24