Banks - Financial Reporting and Analysis

Banks operate under either a federal or state charter. National banks are required to submit uniform accounting statements to the Comptroller of the Currency. State banks are controlled by their state banking departments. In addition, the Federal Deposit Insurance Corporation and theBoard of Governors of the Federal Reserve System receive financial and operating statements from all members of the Federal Reserve System. Member banks are required to keep reserves with their district Federal Reserve bank. State banking laws also dictate the geographical area within which a bank may function. The range runs from within one county to interstate.

Banking systems usually involve two types of structures: individual banks and bankholding companies. Bank holding companies consist of a parent that owns one or many banks. Additionally, the holding company may own bank - related financial services and nonfinancial subsidiaries. In financial report analysis, we must determine the extent of the business generated by banking services. In order for the specific industry ratios to be meaningful, a large proportion of the services should be bank related.

Figure presents part of the 1998 annual report of National City. Located in Cleveland, Ohio, National City owns and operates seven commercial banks with offices in Ohio, Kentucky, Illinois, Indiana, Michigan, and Pennsylvania.

Balance Sheet

The balance sheet of a commercial bank is sometimes termed the report of condition. Two significant differences exist between the traditional balance sheet and that of a bank. First, the accounts of banks may seem the opposite of those of other types of firms. Checking accounts or demand deposits are liabilities to a bank, since it owes the customers money in these cases. Similarly, loans to customers are assets - receivables. Further, the balance sheet accounts are not subdivided into current and noncurrent accounts.

Some banks provide a very detailed disclosure of their assets and liabilities. Other banks provide only general disclosure. The quality of review that can be performed can be no better than the disclosure.

Representative assets of a bank may include cash on hand or due from other banks, investment securities, loans, bank premises, and equipment. Closely review the disclosure of a bank’s assets. This review may indicate risk or opportunity. For example, a review of the assets may indicate that the bank has a substantial risk if interest rates increase. The general rule is that for 20 - year fixed obligations, a gain or loss of 8% of principal arises when interest rates change by 1%. Thus, an investment of $100,000,000 in 20 - year bonds would lose approximately $32,000,000 in principal if interest rates increased by 4%.

A similar example would be a bank that holds long - term fixed - rate mortgages. The value of these mortgages could decline substantially if interest rates increased. Many bank annual reports do not disclose the amount of fixed - rate mortgages.

Review the stockholders’ equity section of the balance sheet to determine if significant accumulated comprehensive income (losses) exist. For National City, accumulated comprehensive income was $345,787,000 and $272,078,000 at the end of 1997 and 1998, respectively. The decline came from selling securities and realizing the gain.

In recent years, Less Developed Country (LDC) loans have become a national issue. In general, LDC loans are perceived as being more risky than domestic loans. National City had $40 million in international loans at the end of both 1998 and 1997. It is not disclosed if there were LDC loans. These loans represent a small percentage of the loan portfolio.

As part of the review of assets, review the disclosure that describes related - party loans. Observe the materiality and the trend of these loans. National City apparently did not have related party loans at the end of 1998 or 1997.





Review the disclosure of allowance for loan losses. It may indicate a significant change and / or significant losses charged. National City disclosed net charge - offs of $200.5 million in 1998 and $222.7 million in 1997, respectively.

Review the footnotes and Management’s Discussion and Analysis for disclosure of nonperforming assets. In general, nonperforming assetsare those for which the bank is not receiving income or is receiving reduced income. The categories of nonperforming assets are nonaccrual loans, renegotiated loans, and other real estate. Nonaccrual loans are loans for which payments have fallen significantly behind, so that the bank has stopped accruing interest income on these loans. Renegotiated loans are loans that the bank has renegotiated with a customer because the customer has had trouble meeting the terms of the original loan. For example, a loan in the amount of $10,000,000 and 10% interest may come due.

The customer who cannot pay may be allowed to renegotiate the loan with the bank, reducing the principal to $8,000,000 and the interest rate to 6% and gaining a five-year extension. Under current GAAP, no immediate loss will be taken by the bank on the renegotiated loan if the projected cash flow under the renegotiated loan will cover the current book value of the loan. In the example, the projected cash flow comes to $10,400,000 ($8,000,000 in principal and $480,000 in interest each year for five years). Since this covers the current book figure of $10,000,000, no immediate loss will be recognized. In addition to other factors, banks should consider renegotiated loans when they adjust the loan loss reserve.

Other real estate usually consists of real estate the bank has taken when it foreclosed ona loan. For example, the bank may have made a loan to a company for a hotel and accepted a mortgage on the hotel as collateral. If the bank must foreclose on the loan, it may take possession of the hotel. The bank would want to sell the hotel, but it may be necessary to hold and operate the hotel for a relatively long period of time before a buyer can be found.

The amount and trend of nonperforming assets should be observed closely. This can bean early indication of troubles to come. For example, a significant increase in nonperforming assets late in the year may have had an in significant effect on the past year’s profits, but it could indicate a significant negative influence on the future year’s profits.

National City discloses nonperforming assets at the end of 1998 and 1997 of $248.5 million and $273.3 million, respectively. This is a positive trend.

Typical liabilities of a bank include savings, time and demand deposits, loan obligations, and long - term debt. Closely review the disclosure of liabilities for favorable or unfavorable trends. For example, a decreasing amount in savings deposits would indicate that the bank is losing one of its cheapest sources of funds. There was not a significant change in core deposits at National City between 1997 and 1998.

As part of the review of liabilities, look for a footnote that describes commitments and contingent liabilities. This footnote may reveal significant additional commitments and contingent liabilities. National City discloses significant commitments at the end of 1998 and 1997. There apparently were not significant changes except for the commitment to sell mortgages and mortgage - backed securities totaling $5.2 billion and $1.9 billion, respectively, at the end of 1998 and 1997.

The stockholders’ equity of a bank resembles that of other types of firms, except that the total stockholders’ equity is usually very low in relation to total assets. A general guide formany years was that a bank’s stockholders’ equity should be approximately 10% of total assets, but very few banks in recent years have had that much stockholders’ equity. Currently, stockholders’ equity of 6% – 7%, would probably be considered favorable.

National City had approximately 8% stockholders’ equity at the end of 1998. In general, the lower the proportion of stockholders’ equity in relation to total assets, the greater the risk of failure. A higher stockholders’ equity in relation to total assets would probably improve safety, but the bankwould perhaps be less profitable because of the additional capital requirement.

As part of the analysis of stockholders’ equity, review the statement of stockholders’ equity and the related footnotes for any significant changes. National City had significant changes from a purchase of common shares and an issuance of shares pursuant to an acquisition.

The current approach by bank regulators is not only to view the adequacy of stockholders’ equity in relation to total assets, but also to view capital in relation to risk - adjusted assets. National City discloses that it has consistently maintained regulatory capital rates ator above the “well capitalized” standards.

Income Statement

A bank’s principal revenue source is usually interest income from loans and investment securities. The principal expense is usually interest expense on deposits and other debt. The difference between interest income and interest expense is termed net interest income or net interest margin.

The net interest margin is important to the profitability of a bank. Usually, falling interest rates are positive for a bank’s interest margin because the bank will be able to reduce the interest rate that it pays for deposits before the average rate of return earned on loans and investments declines. Increasing interest rates are usually negative for a bank’s interest margin because the bank will need to increase the interest rate on deposits, which is usually done before rates on loans and investments are adjusted.

Bank income statements include a separate section for other income. Typical other income includes trust department fees, service charges on deposit accounts, trading account profits (losses), and securities transactions.

The importance of other income has substantially increased for banks. For example, service charges have increased in importance in recent years since many banks have set service charges at a level to make the service profitable. This has frequently been the result of improved cost analysis. In addition, banks have been adding non traditional sources of income, such as mortgage banking, sales of mutual funds, sales of annuities, and computer services for other banks and financial institutions.

National City had net interest income after provision for loan losses of $2,710,248,000 and $2,584,971,000, respectively, for 1998 and 1997. Total noninterest income increased from $1,847,632,000 to $2,314,142,000, respectively. Total noninterest expense increased from $2,792,570,000 to $3,377,113,000. A substantial part of this increase in expense came from merger and restructuring expense.

Ratios for Banks

Because of the vastly different accounts and statement formats, few of the traditional ratios are appropriate for banks. Exceptions include return on assets, return on equity, and most of the investment - related ratios. The following sections present meaningful ratios for bank analysis, but this is not a comprehensive treatment. The Bank Administration Institute, in its annual Index of Bank Performance, includes 43 ratios and growth statistics. The investment firm of Keefe, Bruyette & Woods, Inc., in its Bank book Report on Performance, lists 21financial ratios. Both are excellent sources of industry averages for banks.

Earning Assets to Total Assets

Earning assets includes loans, leases, investment securities, and money market assets. It excludes cash and nonearning deposits plus fixed assets. This ratio shows how well bank management puts bank assets to work. High - performance banks have a high ratio. Banks typically present asset data on an average annual basis. National City provides a schedule of average balances in its annual report. This schedule is used for the average total assets in computing earning assets to total assets. Figure presents National City’s earning assets to total assets ratio, which has decreased slightly between 1997 and 1998.



Interest Margin to Average Earning Assets

This is a key determinant of bank profitability, for it provides an indication of management’s ability to control the spread between interest income and interest expense. Figure presents this ratio for National City and indicates a decline in profitability.



Loan Loss Coverage Ratio

The loan loss coverage ratio, computed by dividing pretax income plus provision for loan losses by net charge - offs, helps determine the asset quality and the level of protection of loans. Figure presents this ratio for National City. This ratio increased moderately in 1998.



Equity Capital to Total Assets

This ratio, also called funds to total assets, measures the extent of equity ownership in the bank. This ownership provides the cushion against the risk of using debt and leverage. Figure presents this ratio, computed by using average figures, for National City. This ratio increased in 1998 to 8.70% from 8.57% in 1997. Both of these ratios appear to be very good.

Deposits Times Capital

The ratio of deposits times capital concerns both depositors and stockholders. To some extent, it is a type of debt / equity ratio, indicating a bank’s debt position. More capital implies a greater margin of safety, while a larger deposit base gives a prospect of higher



return to stockholders, since more money is available for investment purposes. Figure presents this ratio for National City, based on average figures. Deposits times capital decreased in 1998 to 7.15 from 7.96 in 1997.



Loans to Deposits

Average total loans to average deposits is a type of asset to liability ratio. Loans make up a large portion of the bank’s assets, and its principal obligations are the deposits that can be withdrawn on request - within time limitations. This is a type of debt coverage ratio, and it measures the position of the bank with regard to taking risks. Figure shows this ratio for National City. Loans to deposits increased moderately in 1998, indicating an increase in risk from a debt standpoint.



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Financial Reporting and Analysis Topics