Understanding a bank financial statements and its operations

Analyzing and understanding a bank's financial statement can be a daunting task. I have taken the past few months to learn more on the basics of banking operation. Bank's financial statements are vastly different from that of manufacturing or service companies. As a result, analyzing a bank's financial statement requires a different approach to decipher its unique risk.

HOW BANKS MAKE MONEY?

Primarily, banks acts as an intermediary between savers and borrowers by taking in deposits from savers and making out loans to borrowers. The bank makes a "spread" between the interest paid out to the depositors and interest received from the borrowers. This spread is known as the Net Interest Income (NII). As a result, banks as financial intermediaries, has inherently two kinds of risks: 1) interest rate risk - managing the spread between the interest paid on deposits and the interest received from loans; 2) credit risk - the probability that a borrower will default on its loan or lease. So, banks have to provide for a provision for loans and credit losses, which take a portion off the net interest income. Banks also makes a constellation of fees from services like credit cards fees, asset management and insurance business - known as Non-Interest Income. Banks also need to pay for employees salaries and benefits, rentals, office equipments, operating cost, etc. - these are non-interest related expenses and known as Non-Interest Expense. In summary, the following table depicts how a typical bank makes its money.

+ Interest income	Bank makes loans
- Interest expense	Bank receive deposits, debt financing and commercial papers
= net interest income	The spread between interest received and interest paid
- Provision for loan and credit losses	Bank takes risk for lending out
+ Non interest income	Sell investments, insurance, and other services
- Interest expense	Bank needs people, system, space and equipments
= Net operating income	Bank keeps what is left
- Tax expense	The country takes her share
= Net income	Bank's goal

INTEREST RATE

One of the avenue banks can grow its revenue is by widening the net interest margin. The size of this spread or margin determines the profit generated by a bank. Consider, a difference in 1% of net interest margin on $100 billion is $1 billion. Interest rates are important to banks because it determines the rate at which money is bought (garnering of deposits) and sold (extension of loans). But interest rates present its own risk. Interest rate risk is affected by the shape of the yield curve. Net interest income varies due to the changing of rates, the timing of accrual changes and also the yield curve relationship. Banks assume financial risk by making loans at an interest rate that differ from rates paid on deposit. Because deposit often have shorter maturities than loans and adjust to market rates changes faster than loans, it causes a mismatch in the balance sheet between assets (loans) and liabilities (deposits). An upward sloping yield curve - the steeper it is, the wider the spread - is favorable to a bank as the bulk of its deposits are short term while its loans are longer in term. This mismatch of maturities generates the net interest income banks enjoy. When the yield curve reverse or flattens, this mismatch causes the spread to diminish.

BALANCE SHEET

A bank's balance sheet is unlike that of a typical company. There's no inventory, account receivable, or account payable. Instead, you will find securities, investments and loans on the asset side and deposits, and borrowings on the liability side. On all bank's financial reports, you can find two kinds of balance sheet: 1) the ending period balance sheet and; 2) the average balances with the yield rates indicated. For a better understanding, it is better to use the "average balances" to explain. Below is an example.

AVERAGE BALANCES, YIELDS & RATES PAID
(In millions)	2008			2009
	Average balance	Yields/rates	Interest income/expense	Average balance	Yields/rates	Interest income/expense
EARNING ASSETS
Federal funds sold & securities	5293	1.70%	90	4468	4.99%	223
Trading assets	4971	3.80%	189	4291	4.38%	188
Debt securities available for sale	86345	6.46%	5577	57023	6.28%	3582
Mortgages held for sale	25656	6.13%	1573	33066	6.50%	2150
Loans held for sale	837	5.73%	48	896	7.81%	70
Loans	398460	6.94%	27651	344775	8.43%	29057
Other	1920	4.74%	91	1402	5.06%	71
Total earning assets	523482	6.73%	35219	445921	7.93%	35341
NONINTEREST EARNING ASSETS
Cash & due from banks	11175			11806
Goodwill	13353			11957
Other	56386			51068
Total noninterest earning assets	80914			74831
TOTAL ASSETS	604396			520752
INTEREST BEARING LIABILITIES
Deposits	266056	1.70%	4521	239178	3.41%	8152
Short term borrowings	65826	2.25%	1478	25854	4.82%	1245
Long term debt	102283	3.70%	3789	93193	5.18%	4824
Total interest bearing liabilities	434165	2.25%	9788	358225	3.97%	14221
NONINTEREST BEARING LIABILITIES & SOURCES
Deposits	87820			88907
Other liabilities	28939			26557
Preferred stockholders equity	4051			0
Common stockholders equity	49421			47063
Total noninterest bearing sources	170231			162527
TOTAL LIABILITIES AND EQUITY	604396			520752
NET INTEREST INCOME			25431			21120
GROSS INTEREST MARGIN		4.47%			3.96%
As percentage of earning assets:
Interest income		6.73%			7.93%
Interest expense		1.87%			3.19%
Net interest income		4.86%			4.74%

The numbers in the balance sheet is an average balance for each line item, rather than the balance at the end of the period. At the side of each line item, you will find there is a corresponding interest-related income or expense item, and the average yield or rate for the period. In this case, you can also see the slight steepening of the yield curve - caution: provided the bank reflects the market which may not be all the time because some banks manage interest rates better than others.

Let's start with the net interest income. The bank generated a higher net interest income even though its interest revenue was flat and interest rate was lower. This is because correspondingly, the bank managed to reduce its interest expense at a slightly higher rate and reducing its interest rate paid out. The reason for this could be either: 1) the yield curve had steepened or; 2) the bank manage its interest margin more efficiently. If the yield curve had steepened, the interest rate the bank pays on shorter term deposits tends to decrease faster than the rates it can earn from its loan during a period when interest rates are falling. This causes the net interest margin to widen, as you can draw from the table.

The bulk of a bank's assets are loans. Loans are the life blood because it can typically earn a higher interest rate. However, loans have its danger. If a bank makes bad loans, the bank can face credit problems when borrowers default on their loans. So it is also important to know the composition of the loans and also who the bank lends out to.

CREDIT RISK

When banks make loans, there's always a risk of defaults. The key is to manage the credit risk of the bank's loan portfolio. Credit risk is the potential that a borrower or counterparty will fail to meet its obligations in accordance with the agreed terms. When this happens, the bank will experience a loss of some or all of the credit it provided to the customer. An allowance for loan and lease losses is maintained by the banks to absorb such losses. In order for the allowance to be accurate to absorb actual losses, banks have to estimate the amount of probable losses in its loan portfolio.

Actual losses will be written off from the allowance for loan losses account in the balance sheet. As it is written off, banks need to replenish it. It is replenished via the income statement through the item "provision for loan and lease or credit losses." Some times banks replenish more than it write loans off. This happens when banks anticipate credit quality or probable loan losses is likely to increase in the coming quarters. In such cases when provision is more than write-offs, banks are building its loan-loss allowance. At other times, provision for loan losses could be lower than actual write-offs which in turn reduces the amount in the allowance for loan losses account. While this by itself may not necessarily means a problem, but if it is coupled with a flattening of the yield curve (long term rate converging with short term rate), then it may be suspect because it indicates there is a slow-down in economy or economy is in uncertainty and thus push marginal borrowers to the blink of default.

Providing a provision for loan losses is an art as well as a science. It involves a high degree of judgment and evaluation on the part of the management for approximating a loss reserve probability. Since it is a management judgment, the provision is a good source to manage a bank's earnings. In a given quarter where banks need to meet market's expectation and if its earnings fall short, banks can opt to under-provide for that quarter to hit the expectation. On the other hand, banks can also over-provide - not that it is a bad thing - but by overproviding, it ties up capital which otherwise can be deployed to generate more revenue.

The most concerning factor an investor should worry of is when banks isn't reserving sufficient allowance to cover its probably future loan and credit losses. If a bank under-reserves, they will have to face up to reality when more borrowers default on the loans. When the time comes, such banks must provide for loan and credit losses that not only covers actual write-offs but also build on the allowance. Thus the provision for loan losses will spike tremendously which often cause the bank to report a loss in income. When that happens, it depletes shareholder equity and if equity falls below and fails to meet regulatory requirements, regulators will take corrective action such as issuing additional capital, and in worst case, seize the bank, thus wiping out all shareholders' equity. Neither of these situations benefit investors.

WRAP UP

Analyzing banks are one of the most convoluted among other businesses. Moreover, banks are highly leveraged in order to generate the higher return on equity, and thus, a loss on any assets, also magnify the loss on shareholder's equity. So a real careful review and understanding of a bank financial statements is required because it can highlight the key factors that must be considered before making an investing decision. The yield curve as well as the business cycle have a major impact on the economic performance of banks. Credit risk must always be the most important factor when banks manage its loans portfolio because that is the life-blood of a bank. Running a stress-test for adverse economic conditions to evaluate how much losses banks can absorb before eating into capital is one way to evaluate the strength of the bank. Lastly, if you were to hand over money to others, you'd want a honest and trustworthy fellow to be the steward of your money. Same here, you want a good and honest banker who do not manipulate earnings for the short term.