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3_ lecture 3 - Lecture 1

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3_ lecture 3 - Lecture 1 Powered By Docstoc
					Introduction to banking
       Lecture 3


  Banks financial statements
     Prof. Franco Fiordelisi
Aims of the lecture
  demonstrate an understanding of banks’
   sources and uses of funds
  distinguish between balance sheet and income
   statement of banks
  identify the fundamental importance of capital
   in banking
  understand banks’ key financial ratios


                                                    2
Table of contents

1.   Recall from lecture 1
2.   Modern bank is a firm
3.   Banks financial statements
       a)   Banks simplified balance sheet
       b)   Banks simplified income statement
4.   How to calculate bank performance?
5.   Financial ratio analysis
6.   Other important issues




                                                3
1) Recall: Direct financing

                  Financial claim


Surplus Units        Financial      Deficit Units
 (Savers, S>0 )       Markets       (Borrowers, S<0)


                      Money




                                                       4
 1) Recall: Intermediated financing

                   Financial          Financial
                     claim              claim

   Surplus Units            Financial         Deficit Units
  (Savers, S>0 )         Intermediaries     (Borrowers, S<0)


               Money                  Money

Brokerage                       Asset Transformation
Assess information about        Financial Intermediaries are
lenders and borrowers and       engaged in transforming the
bring suitable transactors      assets because of the different
together for mutual benefit     requirements of lenders and
                                borrowers.                    5
1) Recall: Lenders and borrowers requirements (1)

 LENDER REQUIREMENTS

    The minimisation of risk or certainty. This includes the
     risk of default, the risk of the assets dropping in value,
     risk of an undiversified asset.
    Convenience, the lender aims to minimise search
     costs, including gathering and analysing information.
     The lender will probably not have the expertise to
     analyse the expected potential of the borrower.
    Liquidity, the lender gains a higher utility from holding
     assets that are more easily converted into cash. One
     reason for this is the lack of knowledge of future
     events, which results in lenders preferring short term
     lending to long term.
                                                                  6
1) Recall: Lenders and borrowers requirements (2)
BORROWER REQUIREMENTS
  Funds at a particular specified date.
  Funds for a specific time period.
  Funds at the lowest possible cost.
  Funds that are relatively long term

Summary:
  the majority of lenders want to lend their assets for short
   periods of time and for the highest possible return. In
   contrast, the majority of borrowers demand liabilities that
   are cheap and for long periods.
  Therefore, intermediaries liaise between lenders and
   borrowers.
                                                                 7
1) Recall: what do banks do?

 INTERMEDIATE (hence financial intermediaries)

 They obtain funds from X (surplus units) and intermediate it to Y

  (deficit units)

 They link depositors with borrowers

 They also provide LIQUIDITY SERVICES, POOL RISK and

  undertake DELEGATED MONITORING




                                                                      8
1) Recall: Forces of change in the banking industry


  Deregulation
  Liberalisation
  Financial innovation
  Technology
  Competition                  Banks as firms!...
  Consolidation
  Privatisations




                                                      9
            2) Banks as firms (1)

OBJECTIVE OF A COMPANY:
 Maximisation of Shareholders’ Wealth

ROLE OF FINANCIAL MANAGEMENT
 Investment decisions (allocating finance)
 Financing decisions (acquiring finance)
 Controlling resources (conserving finance)




Investment & financing decisions are vital elements
of planning to achieve the objectives of any
organisation including banks!
                                                      10
                 2) Banks as firms (2)

HOW TO QUANTIFY THESE OBJECTIVES?
Sales ( for a bank will be the level of intermediation activity)
and profit goals over a planned period supported by financial
targets (e.g., reserves)

ROLE OF FINANCIAL MANAMAGEMENT
Monitor actual performance against planned goals and targets


Financial Management will rely on the information
revealed by periodic financial reports produced by
the accounting system...
What are these reports??
                                                               11
      3) Bank’s Financial Statements (1)

Balall costs from all income
ance sheet
 Financial statement of the wealth of a firm on a given
  date. This is usually at the end of the financial year

Income statement (or P/L)
 financial statement that reports a firm’s profitability
  over some time period by subtracting



                                                            12
3a) Banks simplified Balance Sheet:
     the liability-side (1)
 Where do bank funds come from?
 General Public – retail deposits
 Companies – (small, medium, large) corporate deposits
 Other Banks – interbank deposits, typically wholesale deposits >£1
  million
 Debt Issues – bond issues and loans
 Equity Issues – share issues (conferring ownership rights on holders)
 Retained Earnings

 A bank’s liabilities comprise:
 Deposits - Retail and Wholesale
 Debt, Equity, and Reserves - often referred to as Capital

                                                                          13
3a) Banks simplified Balance Sheet:
     the liability-side (2)

Banks get the bulk of their funds from:
 Issuing shares
 Issuing bonds (long-term debt paying fixed dividend)
 Saving past profits (retained earnings) which they put in
  reserves

But mainly from…
 Deposits



 Why is this so important ?
                                                              14
  3a) Banks simplified Balance Sheet:
       the assets-side (1)
 Liabilities are used to fund the banks activities (its Assets)
 In other words… where does the money go?
   Cash
   Liquid Assets - short-term money market instruments such as T-bills,
    which they can sell (liquidate quickly) if they have a cash shortage
  Loans
  Other Investments
  Fixed Assets (branch network,computers etc)
 Assets become less liquid as we move down balance sheet



                                                                           15
3a) Banks simplified Balance Sheet (1)


 ASSETS                 LIABIILITIES
   Cash                   Deposits:
   Liquid Assets              Retail
   Loans                      Wholesale

   Other                  Equity
    Investments            Other Capital Items
   Fixed Assets
   TOTAL                  TOTAL

                                                  16
3a) Banks simplified Balance Sheet (2)


Note that the Liabilities side tends to be more liquid
 than the Assets side of the Balance Sheet
Liabilities tend to have short maturities
Assets (loans) tend to have longer maturities
Recall: asset transformation of banks
Capital is particularly important in banking.




                    Why?
                                                          17
3a) Banks simplified Balance Sheet (4)

 Let’s assume a bank has the following B/S structure

       ASSETS                    LIABIILITIES

    Loans         100%       Deposits      80%

                             Capital       20%


    Total         100%       Total         100%
                                                       18
 3a) Banks simplified Balance Sheet (5)

 Assume bank lends to borrowers and 30% of loans go bad (Non-
  Performing Loans = NPL) The bank never gets repaid…
 What should the bank do?
   Use its capital, but this will only cover 20% of the bad loans;
   Use up capital and tell depositors that their deposits are only worth 7/8th of
    previous value
 What happens next?
   Bank goes bust, i.e. bank becomes technically insolvent, depositors cannot be
    repaid in full.
   Other banks engage in a rescue package to pump new capital into the troubled
    bank. Depositors get cash back and confidence is restored.
   Government rescues the troubled bank using taxpayers money.




                                                                                     19
3a) Banks simplified Balance Sheet (6)

 A simple Reclassified balance sheet


           Interest-bearing
                                    Financial costive
           Financial Assets
                                        Liabilities




                                  Financial non-costive
         Other financial Assets
                                        Liabilities




          Non-financial Assets           Equity



                                                          20
   3b) Banks simplified Income Statement (1)
The profitability of a bank can be derived from its income
 statement that measures bank performance between two-year end
 balance sheets.
What is the relationship between balance sheet and income
 statement?
 Balance            sheet        represents        stock       values
    (eg. a 20-year mortgage loans),
 Income statement represents cash flow values for a particular
    year (eg, the interest received in 2004 on the mortgage loan).



                                                                    21
    3b) Banks simplified Income Statement (2)

How do banks make profits?
 Liabilities - incur a cost, e.g. banks have to pay interest on
  deposits, dividends to shareholders, interest on debt (Interest Cost),
  provisions for loan losses, taxes etc.
 Assets - generate revenue e.g. interest earned on loans and
  investments; fees and commissions (Interest & Non-Interest Revenue)
 Banks also incur staffing and other operating costs



              BANK PROFITS = INCOME – COSTS
   Where:
   • Income = Interest and Non-Interest Income
   • Costs = Interest Costs + Staffing Costs + Other Operating Costs       22
3b) Banks simplified Income Statement (3)
          a       Interest income
          b       Interest expense
      c (=a-b)    Net interest income (or “spread” or “interest margin”)

          d       Provision for loan losses (PLL)
      e (=c-d)    Net interest income after PLL
          f       Non-interest income
         G        Non-interest expense
      h (=f-g)    Net non-interest income
      i (=e+h)    Pre-tax net operating income
           L      Securities gains (losses)
      m (=i±l)    Income before taxes
           n      Taxes
           O      Extraordinary items
     p (=m-n-o)   Net income
           q      Cash dividends
       r (=p-q)   Retained profit
                                                                           23
    4) How to calculate bank performance?
  Bank performance can be calculated and assessed with:
   the aim of looking at past and current trends and
   the objective of determining future estimates of bank
    performance.
                   Credit
                   rating      Shareholders
                   companies                    Bondholders
Who is
interested in
bank
performance?    Depositors          Bank
                                                    Direct competitors
                                performance

                  Regulators                  Other market
                               Financial      participants         24
                               markets
5) Financial ratio analysis (1)
  In terms of the information they give, financial ratio analysis
   investigates different areas of bank performance.
 Abbreviation                   Ratio                              Brief Explanation


    ROA             Net income / Total assets                   Measures profit generated
                                                            relative to the bank’s total assets

    ROE         Net income / Total equity capital Rate of return to shareholders or
                                                   the % return on each $ or £ of
                                                                equity


     NIM          Net interest income/ Earning               Net interest return on income
                             assets                                producing assets
    C/I or        {Interest expense + Provision for loan      Quick test of efficiency and
  “Efficiency   losses (PLL) + fee &commission payable       currently much used – reflects
                       + employment costs + other
     ratio”     administrative expenses + deprecetiation           input over output
                 & amortisation} / {Interest income + fee
                    & commission receivable + trading
                    income + other operating income}
5) Financial ratio analysis (2)
  The amount of capital affects the returns to equity holders and ROE is a
   good measure for shareholders to know how much profit the bank is
   generating on their equity investments.
  ROE is related directly with ROA that is a typical measure of bank
   profitability. In particular:


                                                          1
      ROE = ROA  EM                          EM  ROE 
                                                         ROA

                             TOTAL ASSETS
                       EM 
                            TOTAL CAPITAL
                                                                         26
 5) Financial ratio analysis (3)

Equity multiplier (EM) and bank safety

Bank          Total        Total          EM         ROA       ROE
            Assets (a)   Capital (b)   = (a) / (b)          = EM  ROA
Bank Alfa   £50,000,000 £5,000,000         10        1.5%      15%
Bank Beta   £50,000,000 £2,500,000         20        1.5%      30%

 There is a trade-off between capital and ROE
 oThe lower the bank capital the higher the return for the owners
 of the bank
 But remember:
 There is a trade-off between the return for the owners of the bank
 and the level of safety
                                                                     27
5) Financial ratio analysis (4)

Limitations:
(1) Generally one year’s figures are insufficient; trends are
    calculated from a comparison of at least 5 years;
(2) Comparisons with other firms can only be made with
    firms of the same size and activity;
(3) The ratios discussed in this lecture are not exhaustive:
    there is a number of other useful ratios that can be
    used;
(4) Ratios don’t stand in isolation: they are interrelated;
(5) Ratios relate to a particular point in time. Seasonal
    factors can distort them;
(6) Figures may be “window-dressed”; that is, made to
    look better than they really are!
                                                               28
        5) Financial ratio analysis (5)
                                                             Income statement
                                                                            Interest income               A
                                                                           Interest expense               B
   The ROE decomposition                                                     Interest margin         C=A-B
                                                      (or “net interest income” or “spread”)
          Balance sheet                                    Fee and commission receivable                  D
                                                             Fee and commission payable                   E
                                                                     Intermediation margin        F=C+(D-E)
Interest bearing
                   Financial costive                                 Trading income/losses                G
Financial Assets
                      Liabilities                                  Other operating income                 H
     (FAI)               (CL)
                                                                         Employment Costs                  I
                                                           Other administrative expenses                  L
                                                   (eg property and equipment expenses)
                      Financial                              Depreciation and amortisation                M
Other financial
                     non-costive                         Operating profit before provisions      N=F+(H-I-L-
    Assets
                      Liabilities                                                                     M±G)
    (OFA)
                        (NCL)          Provisions for loan losses, contingent liabilities and             O
                                                                             commitments
                                                                            Operating profit         P=N-O

 Non-financial                                                            Exceptional items               Q

    Assets            Equity (EQ)                      Profit on ordinary activity before tax        R=P-Q
    (NFA)                                                Tax on profit on ordinary activities             S
                                                         Profit on ordinary activity after tax
                                                                                                       29
                                                                                                     T=R-Q
5) Financial ratio analysis (6)

           T  T R P N F C
    ROE      x x x x x
          EQ R P N F C EQ

                    A       B
 C  A  B  FAI        CL
                   FAI      CL


              A
                  iA
             FAI
 Consider…                       C  (iA  iB )CL  iA ( FAI  CL)
             B
                 iL
             CL

                                                                     30
6) Other important issues

 Finally, another important issue relates to the increased
  relative importance of off-balance sheet (OBS) items
  (eg, derivative products)
 They generally refer to promises or commitments of
  the bank to undertake certain types of business in the
  future (eg., an unused overdraft facility will be recorded
  as an OBS item). Other items include derivatives
  transactions, underwriting business & various other
  commitments and guarantees.
 For the bank, the earnings generated from these
  operations are fee-related and not shown on the
  balance sheet.
 We will focus on these issues in lecture 5

                                                               31
Learning outcomes

Now, you should:
    demonstrate an understanding of banks’ sources
    and uses of funds
    distinguish between balance sheet and income
    statement of banks
    identify the fundamental importance of capital in
    banking
    understand banks’ key financial ratios


Questions?

                                                        32

				
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