Description
to analyze bank's performance. What are the bank's assets and what are its liabilities. What are the investments for the banks, balance sheet of the commercial banks, off balance sheet items, banks earnings. What are the objectives of creative accounting.
1
? The purpose of this chapter is
? to acquaint with the content ? structure and purpose of bank financial statements ? how information from bank financial statements can be used as tools to reveal how well the banks are performing
2
?
Commercial banks facilitate the flow of funds from surplus spending units (savers) to deficit spending units (borrowers) Their financial characteristics largely reflect government-imposed operating restrictions and peculiar features of the specific markets served
?
3
The characteristics that stand out.
? ?
Most banks own few fixed assets They have few fixed costs, and thus low operating leverage Most liabilities are payable on demand or have short-term maturities - depositors can renegotiate deposit rates as market interest rates change Interest expense changes with short-run changes in market interest rates
4
?
?
?
Corporate
? ? ? ? Liquidity Asset Utilization Leverage Profitability
?
Banks
? Profitability ? Capital/Risks ? Liquidity
?
Concentration on use of assets to provide return and continuation
?
Concentration on risks to provide return, stability and continuation
5
? Report
Sheet ? Report of Income – Income Statement ? Sources and Uses of Funds Statement ? Statement of Stockholders’ Equity
6
of Condition – Balance
?
?
?
Assets = Liabilities + Equity. Balance sheet figures are calculated at a particular point in time and thus represent stock values. The Balance Sheet of a Bank Showing its Assets, Liabilities and Net Worth
7
C = Cash Assets S = Security Holdings L = Loans MA = Miscellaneous Assets
D = Deposits NDB = Non-deposit Borrowings CA = Capital Accounts
8
?
Assets: Uses of Funds
? Cash Items
? reserves ? cash items in process of collection ? vault cash
? Securities
? secondary reserves
? Loans
9
?
Noninterest Cash and due from banks
? vault cash, deposits held at the RBI and other financial institutions, and cash items in the process of collection. Held to
customer withdrawal needs, meet legal reserve requirements, assist in check clearing and wire transfers, or effect the purchase and sale of Treasury securities
?
Investment Securities
? assets held to earn interest, speculate on interest rate movements and help meet liquidity needs.
?
Loans
? the major asset, generate the greatest amount of income, exhibit the highest default risk and are relatively illiquid.
?
Other assets
? bank premises and equipment, interest receivable, prepaid expenses, other real estate owned, and customers' liability to the bank 10
?
A bank negotiates loan terms with each borrower that vary with the use of proceeds, source of repayment, and type of
collateral.
?
Maturities range from call loans payable on demand to residential mortgages amortized over 30 years. The interest rate may be fixed over the life of the loan or vary with changes in market interest rates. Similarly, the loan principal may be repaid periodically or as a lump sum. Loans into six categories according to the use of proceeds: real estate, commercial, individuals, agricultural, other loans in domestic offices, and loans in foreign offices.
11
?
?
?
? ?
The adjustments are made to obtain a net loan figure
The amount of outstanding leases is included in gross loans. Unearned income is deducted from gross interest received. Unearned income is income that has accrued but not yet been paid. Gross loans are reduced by the magnitude of a bank's loanloss reserve, which exists in recognition that some loans will not be repaid. A bank is permitted a tax deduction for net additions to the loss reserve, denoted as the provision for loan losses on the income statement.
? ?
?
?
12
? Gross
Loans – Sum of All Loans ? Allowance for Possible Loan Losses
? Net
Loans ? Nonperforming Loans
? Contra Asset Account ? For Potential Future Loan Losses
13
? ?
?
? ? ? ? ?
Commercial and Industrial Loans Consumer Loans Real Estate Loans Financial Institution Loans Foreign Loans Agriculture Production Loans Security Loans Leases
14
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Real estate loans - loans secured by real estate and generally consist either of property loans secured by first mortgages or interim construction loans Commercial loans - commercial and industrial loans, loans to financial institutions, and obligations (other than securities) to states- typically finance
?
firm’s working capital needs, equipment purchases, and plant expansions. This
includes credit extended to other financial institutions, security brokers, and dealers.
?
Loans to individuals - individuals for household, family, and other personal expenditures, etc. Loans made for the purchase of credit card items and durable goods comprise the greatest volume of this consumer credit.
?
Agricultural loans appear in many forms but typically finance agricultural production and include other loans to farmers. Other loans in domestic offices include all other loans and all lease-financing
?
receivables in domestic offices.
?
International loans, are essentially business loans and lease receivables made to foreign enterprises or loans guaranteed by foreign governments. Amount of outstanding leases is included in gross loans because lease financing is an alternative to direct loans.
15
?
? Experience
Method ? Specific Charge-Off Method
16
?
?
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Provision for loan losses is an expense item that adds to a bank’s loan loss reserve (a contra-asset account). Banks provide for loan losses in anticipation of credit quality problems in the loan portfolio. Loans are written off against the loan loss reserve
17
Recoveries
Provisions for loan losses
Reserve for Loan Losses
Charge offs
18
? ?
Money Market Securities – Secondary Reserves Investment Securities
? Taxable Securities(HTM, AFS, HFT) ? Nontaxable Securities
?
Trading Account Securities
? Held for Resale Only ? Valued at Market Value
19
? ? ? ? ? ? ?
?
?
Earn interest - the administration and transaction costs are extremely low Concentrate on higher quality instruments When interest rates fall, securities increase in value Banks - earn very attractive yields or sell the securities at a gain Liquidity - large amount of short-term securities that can be easily sold to obtain cash Lower risk - earn less interest than longer-term securities The short-term investments include interest-bearing bank balances (deposits due from other banks), Govt. bonds sold, securities purchased under agreement to resell (repurchase agreements or REPOs), Treasury bills They have maturities ranging from overnight to one year and carry returns that vary quickly with changes in money market conditions. They are extremely liquid as they can be easily sold at a price close to that initially paid by the bank.
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?
?
? ? ?
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Long-term investment securities consist of notes and bonds that generate taxable or tax-exempt interest. Treasury securities and obligations of Govt. agencies, Banks also purchase mortgage-backed securities and small amounts of foreign and corporate bonds. Most of these carry fixed-rate interest rates with maturities up to 20 years. The government securities are classified as general obligation or revenue bonds and pay interest that is exempt from income taxes. Banks can generally purchase corporate stock as an investment (there’s a limit) and if it is acquired as collateral on a loan
21
?
Bank, at purchase, must designate the objective behind buying investment securities as either:
? held-to-maturity securities are recorded on the balance sheet at amortized cost. The expected income is interest income with a return of principal at maturity. ? trading account securities are actively bought and sold, so the bank marks the securities to market (reports them at current market value) on the balance sheet and reports unrealized gains and losses on the income statement. ? available-for-sale, all other investment securities, are recorded at market value on the balance sheet with a corresponding change to stockholders’ equity as unrealized gains and losses on securities holdings.
22
?
Vault cash - coin & currency held to meet customer withdrawals. Deposits held at RBI - banks are demand balances used to
? meet legal reserve requirements ? assist in check clearing and wire transfers, or ? effect the purchase and sale of Treasury securities. ? Banks hold balances at other financial institutions primarily to purchase services - corresponding bank
?
?
Cash items in the process of collection (CIPC) represents
checks written against other institutions and presented to
the bank for payment for which credit has not been given.
?
To verify that actual balances support each check, the
bank delays credit until the check clears or a reasonable
23
?
Liabilities: Sources of Funds
? Checkable Deposits ? Non-transactions Deposits ? Borrowings
? discount loans ? Money market funds
24
?
?
Bank funding sources are classified according to the type of debt instrument and equity component. The characteristics of various debt instruments differ in terms of
? ? ? ? ? check-writing capabilities, interest paid, maturity, whether they carry Deposit insurance, and whether they can be traded in the secondary market.
25
?
Demand deposits
? transactions accounts that pay no interest
?
Negotiable orders of withdrawal and automatic transfers from savings accounts
? pay interest set by each bank
?
Time deposit accounts
? pay market rates
?
Savings and time deposits represent the bulk of interest-bearing liabilities at banks.
26
?
Two general time deposits categories exist:
? Time deposits in excess of Rs. 100,000, labeled jumbo certificates of deposit (CDs). ? Small CDs, considered core deposits which tend to be stable deposits that are typically not withdrawn over short periods of time.
?
Deposits held in foreign offices
? balances issued by a bank subsidiary located outside the country
?
Rate-sensitive borrowings:
? Govt. Bonds purchased and ? Repos
?
Commercial paper represents short-term, unsecured corporate promissory notes
27
?
Core deposits are stable deposits that are not highly interest
rate-sensitive.
? Core deposits are more sensitive to the fees charged, services rendered, and location of the bank. ? Core deposits include: demand deposits, ATS accounts, MMDAs, and small time deposits.
?
Large, or volatile, borrowings are liabilities that are highly
rate-sensitive.
? Normally issued in uninsured denominations. ? Their ability to borrow is sensitive to the market's perception of their asset quality. ? Volatile liabilities or net non-core liabilities include: large CDs (over 100,000), deposits in foreign offices, Govt. bonds purchased, repurchase agreements, and other borrowings with maturities less than one year.
28
?
Subordinated notes and debentures:
? notes and bonds with maturities in excess of one year.
?
Stockholders' equity
? Ownership interest in the bank. ? Common and preferred stock are listed at par ? Surplus account represents the amount of proceeds received by the bank in excess of par when it issued the stock.
29
? Standby ? Interest
Credit Agreements (Bank Guarantees) Rate Swaps
? Financial ? Loan
Futures and Options Interest-Rate Contracts Commitments
Exchange Rate Contracts
30
? Foreign
? The
Statement of Revenues, Expenses and Profits for a Bank
31
? ?
Interest income (II) Interest expense (IE)
? Interest income less interest expense is net interest income (NII) must be large enough to cover a bank’s expenses and taxes such that changes in net interest income dramatically affect aggregate profitability
?
Noninterest income (OI) - deposit service charges and fee income Noninterest expense (OE) - overhead costs
? noninterest expense usually exceeds noninterest income such that the difference is labeled the bank's burden
?
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Loan-loss provisions (PL)
? represent management's estimate of potential lost revenue from bad loans.
? ?
Realized gains or losses from the sale of securities Taxes
32
?
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A bank’s income statement reflects the financial nature of banking, as interest on loans and investments comprises the bulk of revenue. Interest income - approximately 74-93 percent of total income at a bank The trend away from interest income toward noninterest income has played a major role in changing bank management. Interest payments on borrowings similarly represent the primary expense.
33
Interest Income
?
Interest Expenses
? Deposit
?
?
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Interest and Fees on Loans Taxable Securities Revenue Tax-Exempt Securities Revenue Other Interest Income
Costs ? Interest on Short-Term Debt ? Interest on Long-Term Debt
Interest
34
?
Loan interest and fees represent the main source of bank revenue, followed by interest on investment securities.
?
Interest paid on deposits is the largest
expense, followed by interest on other
borrowings.
?
Net interest income is the difference between
gross interest income and gross interest
expense.
?
This margin is relatively stable because the
35
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?
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The composition of assets and liabilities and the relationships between different interest rates determine net interest income. The mix of deposits between consumer and commercial customers affects the services provided and thus the magnitude of noninterest income and noninterest expense. The ownership of nonbank subsidiaries increases fee income but often raises noninterest expense.
36
?
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The sum of interest and fees earned on all of a bank's assets. Interest income includes interest from:
? ? ? ? ? Loans Deposits held at other institutions, Municipal and taxable securities, and Investment and trading account securities. rental receipts from lease financing
37
Noninterest Income
?
Noninterest Expenses
? ?
?
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Service Charges on Customers Deposits Trust Department Income Other Operating Income
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Wages and Salaries Other Personnel Expenses Net Occupancy Expenses Other Operating Expenses
38
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Noninterest income includes fees and service charges. This has grown significantly in importance. Noninterest expense includes personnel, occupancy, technology, and administration. These expenses have also grown in recent years.
39
?
Personnel expense:
? salaries and fringe benefits paid to bank employees,
?
Occupancy expense :
? rent and depreciation on equipment and premises, and
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Other operating expenses:
? utilities and ? deposit insurance premiums.
?
Most banks today face great pressure to keep net interest income from shrinking, they have aggressively tried to raise fee income and cut expenses to support profit growth.
40
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Expenses and loan losses directly effect the balance sheet. The greater the size of loan portfolio, the greater is operating overhead and PLL. Consumer loans are usually smaller and hence more expensive (non-interest) per Rupee of loans.
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41
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A deduction from income representing a bank’s periodic allocation to its loan and lease loss allowance (loan loss reserve) on the balance sheet. Conceptually, management is allocating a portion of income to a reserve to protect against potential loan losses. It is a noncash expense but indicates management’s perception of the quality of the bank’s loans. It is subtracted from net interest income in recognition that some of the reported interest income overstates what will actually be received when some of the loans go into default.
42
Classification of Loan
Provision Requirements A general provision of a minimum of 0.25% of total outstandings is required to be made (w.e.f. 31/03/2000) A general provision of 10% of total outstanding is required to be made. While calculating provisions, DICGC / ECGC cover is not to be deducted from the outstanding balance.
Standard Assets
Sub-Standard
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Classification of Loan i)
Provision Requirements 100 percent of the extent to which the advance is not covered by the realizable value of the security to which the bank has a valid recourse and the realizable value is estimated on a realistic basis. ii) In regard to the secured portion, provision may be made on the following basis, at the rates ranging from 20 percent to 50 percent of the secured portion depending upon the period for which the asset has remained doubtful:44
Doubtful Assets
Classification of Loan Period for which the advance has been considered as doubtful Upto one year one to three years More than three years
Provision Requirements Provision requirement (%) 20% 30% 50% The entire asset should be written off. If the assets are permitted to remain in the books for any reason, 100 percent of the outstanding should be provided for.
Loss Assets
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Net Interest Income - Provision for Loan Loss Net Income After PLL +/- Net Noninterest Income Net Income Before Taxes Taxes Net Income - Dividends Undistributed Profits
46
? ?
Also Known as the Funds-Flows Statement It asks Two Questions
? Where Do Funds Come From? ? How Were Those Funds Utilized?
47
Sources
? ? ? ?
Uses
? ? ? ?
?
Net Income Noncash Expenses Decrease in Assets Increase in Liabilities Increase in Capital Accounts
?
Net Loss Dividends Increase in Assets Decrease in Liabilities Decrease in Capital Accounts
48
Beginning Capital Account Balance +/- Net Income for Period - Preferred Stock Dividends - Common Stock Dividends + New Shares of Stock Issued - Repurchases of Stock Ending Capital Account Balance
49
?
“Window Dressing” or “Creative Accounting”
? Manipulation of Financial Statements to Look Stronger and More Successful
?
Creative accounting is widely understood to mean the grey area between bookkeeping and accounting that comply with legal or normative requirements and those that clearly do not. Creative accounting is thus not an infringement of the law, but it is on the fringes of legality Creative accounting is a phenomenon that can be observed throughout the world
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?
50
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The most frequent effects of creative accounting are:
? increasing operating profit to the detriment of non-operating profit
? increasing the annual profit ? transforming an annual loss into a break-even result or even a profit ? increasing shareholders’ equity
? transforming over-indebtedness (more debts than assets)into positive shareholders’ equity
? increasing liquid funds (liquidity) ? increasing operating cash flow
51
?
The reason may be associated with the following factors:
? Directors or a group of shareholders may want to impress a “prospective” group of shareholders with the company’s past performance. ? Following a takeover bid, management may wish to impress existing shareholders of their strategic decision. ? Earning fixation. – Earnings-per-share indicator as the top market news. ? Directors remuneration may be fixed to profit performance of the business (e.g. profit related pay). ? Income smoothing to show a low variability in income, thus give the impression of low risk operation. ? Information Asymmetry – managers are privy to internal information than most outsiders inclusive of analysts.
52
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There are at least 12 methods that can be used to produce profit. Capitalization of Operating Costs Off-Balance Sheet Financing Deferred purchase consideration Use of Brand Accounting Apply contingent liabilities
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.
Use of Profits on disposal of a business
Treat Extra-ordinary & exceptional items of income & expenditure Changes in depreciation policy on fixed assets Use of Pension Fund Accounting Use of Convertible Securities
Treatment of Foreign Exchange Currency Items
Write down of pre-acquisition costs or potential future costs
53
What about the Enron, Worldcom Scandals?
(1)Use of high-risk Accounting Principles (2)Conflict of Interests in Boardroom (3)Too Much Off-Balance Sheet Transactions (4)Executives Were Paid High Compensations (5)Lack of Proper Corporate Governance (6)Failure of Board of Directors’ Corporate Responsibilities
These signs are common occurrence associated with Corporate Scandals
54
1.
The Emergence of Sarbanes-Oxley Act 2002.
2.
New Emphasis on Corporate Governance
More Power & Responsibilities to the External & Internal Auditors Strengthening Risk Management Practices Accountability by All Executives More Power to the Shareholders
3.
4.
5.
6.
7.
New Accounting & Auditing Standards inclusive of Disclosure Requirements.
55
One way for a bank to increase expected profits is to take on more risk. However, this can
jeopardize bank safety.
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For a bank to survive, it must balance the demands of three constituencies: shareholders depositors
regulators
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Each with their own interest in profitability and safety.
56
?
Solvency: Maintaining the momentum of a
going concern, attracting customers and financing.
? A firm is insolvent when the value of its liabilities exceeds the value of its assets. ? Banks have relatively low capital/asset ratios but generally high-quality assets.
?
Liquidity: the ability to fund deposit
withdrawals, loan requests, and other promised disbursements when due.
? A bank can be profitable and still fail because of
57
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A bank must balance profitability, liquidity, and solvency.
?
Bank failure can result from excessive losses on
loans or securities - from over-aggressive profit seeking.
?
But a bank that only invests in high-quality assets may not be profitable. Failure can also occur if a bank cannot meet liquidity demands. If assets are profitable but illiquid, the bank also has a problem.
58
?
59
?
Tier I capital or “core” capital includes
common stock, common surplus, retained earnings, non-cumulative perpetual preferred stock, minority
interest in consolidated subsidiaries,
minus goodwill and other intangible assets.
?
Tier II capital or “supplemental” capital
includes cumulative perpetual preferred stock, loan loss reserves, mandatory
60
?
Absorb losses on assets (loans) and limit the risk of insolvency. Maintain confidence in the banking system. Provide protection to uninsured depositors and creditors. Ultimate source of funds and leverage base to raise depositor funds.
? ?
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61
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As capital requirements have increased, regulators have also implemented riskbased capital standards. Capital is measured against riskweighted assets.
?
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Risk-weighting is a measure of total
assets that weighs high-risk assets more heavily.
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The purpose is to require high-risk banks to hold more capital than low-risk banks.
62
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Ratio of Tier 1 capital to risk-weighted assets must be at least 4% Ratio of Total Capital (Tier 1 plus Tier 2) to
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risk-weighted assets must be at least 9%.
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Undercapitalized banks receive extra
regulatory scrutiny; regulators may limit activities, intervene in management, or even revoke charter.
63
doc_828241245.pptx
to analyze bank's performance. What are the bank's assets and what are its liabilities. What are the investments for the banks, balance sheet of the commercial banks, off balance sheet items, banks earnings. What are the objectives of creative accounting.
1
? The purpose of this chapter is
? to acquaint with the content ? structure and purpose of bank financial statements ? how information from bank financial statements can be used as tools to reveal how well the banks are performing
2
?
Commercial banks facilitate the flow of funds from surplus spending units (savers) to deficit spending units (borrowers) Their financial characteristics largely reflect government-imposed operating restrictions and peculiar features of the specific markets served
?
3
The characteristics that stand out.
? ?
Most banks own few fixed assets They have few fixed costs, and thus low operating leverage Most liabilities are payable on demand or have short-term maturities - depositors can renegotiate deposit rates as market interest rates change Interest expense changes with short-run changes in market interest rates
4
?
?
?
Corporate
? ? ? ? Liquidity Asset Utilization Leverage Profitability
?
Banks
? Profitability ? Capital/Risks ? Liquidity
?
Concentration on use of assets to provide return and continuation
?
Concentration on risks to provide return, stability and continuation
5
? Report
Sheet ? Report of Income – Income Statement ? Sources and Uses of Funds Statement ? Statement of Stockholders’ Equity
6
of Condition – Balance
?
?
?
Assets = Liabilities + Equity. Balance sheet figures are calculated at a particular point in time and thus represent stock values. The Balance Sheet of a Bank Showing its Assets, Liabilities and Net Worth
7
C = Cash Assets S = Security Holdings L = Loans MA = Miscellaneous Assets
D = Deposits NDB = Non-deposit Borrowings CA = Capital Accounts
8
?
Assets: Uses of Funds
? Cash Items
? reserves ? cash items in process of collection ? vault cash
? Securities
? secondary reserves
? Loans
9
?
Noninterest Cash and due from banks
? vault cash, deposits held at the RBI and other financial institutions, and cash items in the process of collection. Held to
customer withdrawal needs, meet legal reserve requirements, assist in check clearing and wire transfers, or effect the purchase and sale of Treasury securities
?
Investment Securities
? assets held to earn interest, speculate on interest rate movements and help meet liquidity needs.
?
Loans
? the major asset, generate the greatest amount of income, exhibit the highest default risk and are relatively illiquid.
?
Other assets
? bank premises and equipment, interest receivable, prepaid expenses, other real estate owned, and customers' liability to the bank 10
?
A bank negotiates loan terms with each borrower that vary with the use of proceeds, source of repayment, and type of
collateral.
?
Maturities range from call loans payable on demand to residential mortgages amortized over 30 years. The interest rate may be fixed over the life of the loan or vary with changes in market interest rates. Similarly, the loan principal may be repaid periodically or as a lump sum. Loans into six categories according to the use of proceeds: real estate, commercial, individuals, agricultural, other loans in domestic offices, and loans in foreign offices.
11
?
?
?
? ?
The adjustments are made to obtain a net loan figure
The amount of outstanding leases is included in gross loans. Unearned income is deducted from gross interest received. Unearned income is income that has accrued but not yet been paid. Gross loans are reduced by the magnitude of a bank's loanloss reserve, which exists in recognition that some loans will not be repaid. A bank is permitted a tax deduction for net additions to the loss reserve, denoted as the provision for loan losses on the income statement.
? ?
?
?
12
? Gross
Loans – Sum of All Loans ? Allowance for Possible Loan Losses
? Net
Loans ? Nonperforming Loans
? Contra Asset Account ? For Potential Future Loan Losses
13
? ?
?
? ? ? ? ?
Commercial and Industrial Loans Consumer Loans Real Estate Loans Financial Institution Loans Foreign Loans Agriculture Production Loans Security Loans Leases
14
?
Real estate loans - loans secured by real estate and generally consist either of property loans secured by first mortgages or interim construction loans Commercial loans - commercial and industrial loans, loans to financial institutions, and obligations (other than securities) to states- typically finance
?
firm’s working capital needs, equipment purchases, and plant expansions. This
includes credit extended to other financial institutions, security brokers, and dealers.
?
Loans to individuals - individuals for household, family, and other personal expenditures, etc. Loans made for the purchase of credit card items and durable goods comprise the greatest volume of this consumer credit.
?
Agricultural loans appear in many forms but typically finance agricultural production and include other loans to farmers. Other loans in domestic offices include all other loans and all lease-financing
?
receivables in domestic offices.
?
International loans, are essentially business loans and lease receivables made to foreign enterprises or loans guaranteed by foreign governments. Amount of outstanding leases is included in gross loans because lease financing is an alternative to direct loans.
15
?
? Experience
Method ? Specific Charge-Off Method
16
?
?
?
Provision for loan losses is an expense item that adds to a bank’s loan loss reserve (a contra-asset account). Banks provide for loan losses in anticipation of credit quality problems in the loan portfolio. Loans are written off against the loan loss reserve
17
Recoveries
Provisions for loan losses
Reserve for Loan Losses
Charge offs
18
? ?
Money Market Securities – Secondary Reserves Investment Securities
? Taxable Securities(HTM, AFS, HFT) ? Nontaxable Securities
?
Trading Account Securities
? Held for Resale Only ? Valued at Market Value
19
? ? ? ? ? ? ?
?
?
Earn interest - the administration and transaction costs are extremely low Concentrate on higher quality instruments When interest rates fall, securities increase in value Banks - earn very attractive yields or sell the securities at a gain Liquidity - large amount of short-term securities that can be easily sold to obtain cash Lower risk - earn less interest than longer-term securities The short-term investments include interest-bearing bank balances (deposits due from other banks), Govt. bonds sold, securities purchased under agreement to resell (repurchase agreements or REPOs), Treasury bills They have maturities ranging from overnight to one year and carry returns that vary quickly with changes in money market conditions. They are extremely liquid as they can be easily sold at a price close to that initially paid by the bank.
20
?
?
? ? ?
?
Long-term investment securities consist of notes and bonds that generate taxable or tax-exempt interest. Treasury securities and obligations of Govt. agencies, Banks also purchase mortgage-backed securities and small amounts of foreign and corporate bonds. Most of these carry fixed-rate interest rates with maturities up to 20 years. The government securities are classified as general obligation or revenue bonds and pay interest that is exempt from income taxes. Banks can generally purchase corporate stock as an investment (there’s a limit) and if it is acquired as collateral on a loan
21
?
Bank, at purchase, must designate the objective behind buying investment securities as either:
? held-to-maturity securities are recorded on the balance sheet at amortized cost. The expected income is interest income with a return of principal at maturity. ? trading account securities are actively bought and sold, so the bank marks the securities to market (reports them at current market value) on the balance sheet and reports unrealized gains and losses on the income statement. ? available-for-sale, all other investment securities, are recorded at market value on the balance sheet with a corresponding change to stockholders’ equity as unrealized gains and losses on securities holdings.
22
?
Vault cash - coin & currency held to meet customer withdrawals. Deposits held at RBI - banks are demand balances used to
? meet legal reserve requirements ? assist in check clearing and wire transfers, or ? effect the purchase and sale of Treasury securities. ? Banks hold balances at other financial institutions primarily to purchase services - corresponding bank
?
?
Cash items in the process of collection (CIPC) represents
checks written against other institutions and presented to
the bank for payment for which credit has not been given.
?
To verify that actual balances support each check, the
bank delays credit until the check clears or a reasonable
23
?
Liabilities: Sources of Funds
? Checkable Deposits ? Non-transactions Deposits ? Borrowings
? discount loans ? Money market funds
24
?
?
Bank funding sources are classified according to the type of debt instrument and equity component. The characteristics of various debt instruments differ in terms of
? ? ? ? ? check-writing capabilities, interest paid, maturity, whether they carry Deposit insurance, and whether they can be traded in the secondary market.
25
?
Demand deposits
? transactions accounts that pay no interest
?
Negotiable orders of withdrawal and automatic transfers from savings accounts
? pay interest set by each bank
?
Time deposit accounts
? pay market rates
?
Savings and time deposits represent the bulk of interest-bearing liabilities at banks.
26
?
Two general time deposits categories exist:
? Time deposits in excess of Rs. 100,000, labeled jumbo certificates of deposit (CDs). ? Small CDs, considered core deposits which tend to be stable deposits that are typically not withdrawn over short periods of time.
?
Deposits held in foreign offices
? balances issued by a bank subsidiary located outside the country
?
Rate-sensitive borrowings:
? Govt. Bonds purchased and ? Repos
?
Commercial paper represents short-term, unsecured corporate promissory notes
27
?
Core deposits are stable deposits that are not highly interest
rate-sensitive.
? Core deposits are more sensitive to the fees charged, services rendered, and location of the bank. ? Core deposits include: demand deposits, ATS accounts, MMDAs, and small time deposits.
?
Large, or volatile, borrowings are liabilities that are highly
rate-sensitive.
? Normally issued in uninsured denominations. ? Their ability to borrow is sensitive to the market's perception of their asset quality. ? Volatile liabilities or net non-core liabilities include: large CDs (over 100,000), deposits in foreign offices, Govt. bonds purchased, repurchase agreements, and other borrowings with maturities less than one year.
28
?
Subordinated notes and debentures:
? notes and bonds with maturities in excess of one year.
?
Stockholders' equity
? Ownership interest in the bank. ? Common and preferred stock are listed at par ? Surplus account represents the amount of proceeds received by the bank in excess of par when it issued the stock.
29
? Standby ? Interest
Credit Agreements (Bank Guarantees) Rate Swaps
? Financial ? Loan
Futures and Options Interest-Rate Contracts Commitments
Exchange Rate Contracts
30
? Foreign
? The
Statement of Revenues, Expenses and Profits for a Bank
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? ?
Interest income (II) Interest expense (IE)
? Interest income less interest expense is net interest income (NII) must be large enough to cover a bank’s expenses and taxes such that changes in net interest income dramatically affect aggregate profitability
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Noninterest income (OI) - deposit service charges and fee income Noninterest expense (OE) - overhead costs
? noninterest expense usually exceeds noninterest income such that the difference is labeled the bank's burden
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Loan-loss provisions (PL)
? represent management's estimate of potential lost revenue from bad loans.
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Realized gains or losses from the sale of securities Taxes
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A bank’s income statement reflects the financial nature of banking, as interest on loans and investments comprises the bulk of revenue. Interest income - approximately 74-93 percent of total income at a bank The trend away from interest income toward noninterest income has played a major role in changing bank management. Interest payments on borrowings similarly represent the primary expense.
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Interest Income
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Interest Expenses
? Deposit
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Interest and Fees on Loans Taxable Securities Revenue Tax-Exempt Securities Revenue Other Interest Income
Costs ? Interest on Short-Term Debt ? Interest on Long-Term Debt
Interest
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Loan interest and fees represent the main source of bank revenue, followed by interest on investment securities.
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Interest paid on deposits is the largest
expense, followed by interest on other
borrowings.
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Net interest income is the difference between
gross interest income and gross interest
expense.
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This margin is relatively stable because the
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The composition of assets and liabilities and the relationships between different interest rates determine net interest income. The mix of deposits between consumer and commercial customers affects the services provided and thus the magnitude of noninterest income and noninterest expense. The ownership of nonbank subsidiaries increases fee income but often raises noninterest expense.
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The sum of interest and fees earned on all of a bank's assets. Interest income includes interest from:
? ? ? ? ? Loans Deposits held at other institutions, Municipal and taxable securities, and Investment and trading account securities. rental receipts from lease financing
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Noninterest Income
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Noninterest Expenses
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Service Charges on Customers Deposits Trust Department Income Other Operating Income
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Wages and Salaries Other Personnel Expenses Net Occupancy Expenses Other Operating Expenses
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Noninterest income includes fees and service charges. This has grown significantly in importance. Noninterest expense includes personnel, occupancy, technology, and administration. These expenses have also grown in recent years.
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Personnel expense:
? salaries and fringe benefits paid to bank employees,
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Occupancy expense :
? rent and depreciation on equipment and premises, and
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Other operating expenses:
? utilities and ? deposit insurance premiums.
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Most banks today face great pressure to keep net interest income from shrinking, they have aggressively tried to raise fee income and cut expenses to support profit growth.
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Expenses and loan losses directly effect the balance sheet. The greater the size of loan portfolio, the greater is operating overhead and PLL. Consumer loans are usually smaller and hence more expensive (non-interest) per Rupee of loans.
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A deduction from income representing a bank’s periodic allocation to its loan and lease loss allowance (loan loss reserve) on the balance sheet. Conceptually, management is allocating a portion of income to a reserve to protect against potential loan losses. It is a noncash expense but indicates management’s perception of the quality of the bank’s loans. It is subtracted from net interest income in recognition that some of the reported interest income overstates what will actually be received when some of the loans go into default.
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Classification of Loan
Provision Requirements A general provision of a minimum of 0.25% of total outstandings is required to be made (w.e.f. 31/03/2000) A general provision of 10% of total outstanding is required to be made. While calculating provisions, DICGC / ECGC cover is not to be deducted from the outstanding balance.
Standard Assets
Sub-Standard
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Classification of Loan i)
Provision Requirements 100 percent of the extent to which the advance is not covered by the realizable value of the security to which the bank has a valid recourse and the realizable value is estimated on a realistic basis. ii) In regard to the secured portion, provision may be made on the following basis, at the rates ranging from 20 percent to 50 percent of the secured portion depending upon the period for which the asset has remained doubtful:44
Doubtful Assets
Classification of Loan Period for which the advance has been considered as doubtful Upto one year one to three years More than three years
Provision Requirements Provision requirement (%) 20% 30% 50% The entire asset should be written off. If the assets are permitted to remain in the books for any reason, 100 percent of the outstanding should be provided for.
Loss Assets
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Net Interest Income - Provision for Loan Loss Net Income After PLL +/- Net Noninterest Income Net Income Before Taxes Taxes Net Income - Dividends Undistributed Profits
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Also Known as the Funds-Flows Statement It asks Two Questions
? Where Do Funds Come From? ? How Were Those Funds Utilized?
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Sources
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Uses
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Net Income Noncash Expenses Decrease in Assets Increase in Liabilities Increase in Capital Accounts
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Net Loss Dividends Increase in Assets Decrease in Liabilities Decrease in Capital Accounts
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Beginning Capital Account Balance +/- Net Income for Period - Preferred Stock Dividends - Common Stock Dividends + New Shares of Stock Issued - Repurchases of Stock Ending Capital Account Balance
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“Window Dressing” or “Creative Accounting”
? Manipulation of Financial Statements to Look Stronger and More Successful
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Creative accounting is widely understood to mean the grey area between bookkeeping and accounting that comply with legal or normative requirements and those that clearly do not. Creative accounting is thus not an infringement of the law, but it is on the fringes of legality Creative accounting is a phenomenon that can be observed throughout the world
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The most frequent effects of creative accounting are:
? increasing operating profit to the detriment of non-operating profit
? increasing the annual profit ? transforming an annual loss into a break-even result or even a profit ? increasing shareholders’ equity
? transforming over-indebtedness (more debts than assets)into positive shareholders’ equity
? increasing liquid funds (liquidity) ? increasing operating cash flow
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The reason may be associated with the following factors:
? Directors or a group of shareholders may want to impress a “prospective” group of shareholders with the company’s past performance. ? Following a takeover bid, management may wish to impress existing shareholders of their strategic decision. ? Earning fixation. – Earnings-per-share indicator as the top market news. ? Directors remuneration may be fixed to profit performance of the business (e.g. profit related pay). ? Income smoothing to show a low variability in income, thus give the impression of low risk operation. ? Information Asymmetry – managers are privy to internal information than most outsiders inclusive of analysts.
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There are at least 12 methods that can be used to produce profit. Capitalization of Operating Costs Off-Balance Sheet Financing Deferred purchase consideration Use of Brand Accounting Apply contingent liabilities
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.
Use of Profits on disposal of a business
Treat Extra-ordinary & exceptional items of income & expenditure Changes in depreciation policy on fixed assets Use of Pension Fund Accounting Use of Convertible Securities
Treatment of Foreign Exchange Currency Items
Write down of pre-acquisition costs or potential future costs
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What about the Enron, Worldcom Scandals?
(1)Use of high-risk Accounting Principles (2)Conflict of Interests in Boardroom (3)Too Much Off-Balance Sheet Transactions (4)Executives Were Paid High Compensations (5)Lack of Proper Corporate Governance (6)Failure of Board of Directors’ Corporate Responsibilities
These signs are common occurrence associated with Corporate Scandals
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1.
The Emergence of Sarbanes-Oxley Act 2002.
2.
New Emphasis on Corporate Governance
More Power & Responsibilities to the External & Internal Auditors Strengthening Risk Management Practices Accountability by All Executives More Power to the Shareholders
3.
4.
5.
6.
7.
New Accounting & Auditing Standards inclusive of Disclosure Requirements.
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One way for a bank to increase expected profits is to take on more risk. However, this can
jeopardize bank safety.
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For a bank to survive, it must balance the demands of three constituencies: shareholders depositors
regulators
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Each with their own interest in profitability and safety.
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Solvency: Maintaining the momentum of a
going concern, attracting customers and financing.
? A firm is insolvent when the value of its liabilities exceeds the value of its assets. ? Banks have relatively low capital/asset ratios but generally high-quality assets.
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Liquidity: the ability to fund deposit
withdrawals, loan requests, and other promised disbursements when due.
? A bank can be profitable and still fail because of
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A bank must balance profitability, liquidity, and solvency.
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Bank failure can result from excessive losses on
loans or securities - from over-aggressive profit seeking.
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But a bank that only invests in high-quality assets may not be profitable. Failure can also occur if a bank cannot meet liquidity demands. If assets are profitable but illiquid, the bank also has a problem.
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Tier I capital or “core” capital includes
common stock, common surplus, retained earnings, non-cumulative perpetual preferred stock, minority
interest in consolidated subsidiaries,
minus goodwill and other intangible assets.
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Tier II capital or “supplemental” capital
includes cumulative perpetual preferred stock, loan loss reserves, mandatory
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Absorb losses on assets (loans) and limit the risk of insolvency. Maintain confidence in the banking system. Provide protection to uninsured depositors and creditors. Ultimate source of funds and leverage base to raise depositor funds.
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As capital requirements have increased, regulators have also implemented riskbased capital standards. Capital is measured against riskweighted assets.
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Risk-weighting is a measure of total
assets that weighs high-risk assets more heavily.
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The purpose is to require high-risk banks to hold more capital than low-risk banks.
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Ratio of Tier 1 capital to risk-weighted assets must be at least 4% Ratio of Total Capital (Tier 1 plus Tier 2) to
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risk-weighted assets must be at least 9%.
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Undercapitalized banks receive extra
regulatory scrutiny; regulators may limit activities, intervene in management, or even revoke charter.
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