💾 Archived View for gmi.noulin.net › mobileNews › 3854.gmi captured on 2021-12-05 at 23:47:19. Gemini links have been rewritten to link to archived content
⬅️ Previous capture (2021-12-03)
-=-=-=-=-=-=-
January 04 2007 | Filed Under Banking , Stocks
Financial statements for banks present a different analytical problem than
manufacturing and service companies. As a result, analysis of a bank's
financial statements requires a distinct approach that recognizes a bank's
somewhat unique risks. (To learn more about reading financial statements, see
What You Need To Know About Financial Statements and our Advanced Financial
Statement Analysis tutorials.)
Banks take deposits from savers, paying interest on some of these accounts.
They pass these funds on to borrowers, receiving interest on the loans. Their
profits are derived from the spread between the rate they pay for funds and the
rate they receive from borrowers. This ability to pool deposits from many
sources that can be lent to many different borrowers creates the flow of funds
inherent in the banking system. By managing this flow of funds, banks generate
profits, acting as the intermediary of interest paid and interest received and
taking on the risks of offering credit.
Leverage and Risk
Banking is a highly leveraged business requiring regulators to dictate minimal
capital levels to help ensure the solvency of each bank and the banking system.
In the U.S., a bank's primary regulator could be the Federal Reserve Board, the
Office of the Comptroller of the Currency, the Office of Thrift Supervision or
any one of 50 state regulatory bodies, depending on the charter of the bank.
Within the Federal Reserve Board, there are 12 districts with 12 different
regulatory staffing groups. These regulators focus on compliance with certain
requirements, restrictions and guidelines, aiming to uphold the soundness and
integrity of the banking system. (To read more about leverage, see When
Companies Borrow Money.)
Looking for penny stocks that skyrocket?
As one of the most highly regulated banking industries in the world, investors
have some level of assurance in the soundness of the banking system. As a
result, investors can focus most of their efforts on how a bank will perform in
different economic environments.
Below is a sample income statement and balance sheet for a large bank. The
first thing to notice is that the line items in the statements are not the same
as your typical manufacturing or service firm. Instead, there are entries that
represent interest earned or expensed as well as deposits and loans. (To find
out more about balance sheets and income statements, see Find Investment
Quality In The Income Statement, Understanding The Income Statement, Reading
The Balance Sheet and Breaking Down The Balance Sheet.)
Figure 1: The Income Statement
Figure 2: The Balance Sheet
As financial intermediaries, banks assume two primary types of risk as they
manage the flow of money through their business. Interest rate risk is the
management of the spread between interest paid on deposits and received on
loans over time. Credit risk is the likelihood that a borrower will default on
its loan or lease, causing the bank to lose any potential interest earned as
well as the principal that was loaned to the borrower. As investors, these are
the primary elements that need to be understood when analyzing a bank's
financial statement.
Advertisement - Article continues below.
Interest Rate Risk
The primary business of a bank is managing the spread between deposits
(liabilities, loans and assets). Basically, when the interest that a bank earns
from loans is greater than the interest it must pay on deposits, it generates a
positive interest spread or net interest income. The size of this spread is a
major determinant of the profit generated by a bank. This interest rate risk is
primarily determined by the shape of the yield curve. (For more insight, see
The Impact Of An Inverted Yield Curve and Trying To Predict Interest Rates.)
As a result, net interest income will vary, due to differences in the timing of
accrual changes and changing rate and yield curve relationships. Changes in the
general level of market interest rates also may cause changes in the volume and
mix of a bank's balance sheet products. For example, when economic activity
continues to expand while interest rates are rising, commercial loan demand may
increase while residential mortgage loan growth and prepayments slow.
Banks, in the normal course of business, assume financial risk by making loans
at interest rates that differ from rates paid on deposits. Deposits often have
shorter maturities than loans and adjust to current market rates faster than
loans. The result is a balance sheet mismatch between assets (loans) and
liabilities (deposits). An upward sloping yield curve is favorable to a bank as
the bulk of its deposits are short term and their loans are longer term. This
mismatch of maturities generates the net interest revenue banks enjoy. When the
yield curve flattens, this mismatch causes net interest revenue to diminish.
A Banking Balance Sheet
The table below ties together the bank's balance sheet with the income
statement and displays the yield generated from earning assets and interest
bearing deposits. Most banks provide this type of table in their annual
reports. The following table represents the same bank as in the previous
examples:
Figure 3: Average Balance and Interest Rates
First of all, the balance sheet is an average balance for the line item, rather
than the balance at the end of the period. Average balances provide a better
analytical framework to help understand the bank's financial performance.
Notice that for each average balance item there is a corresponding
interest-related income, or expense item, and the average yield for the time
period. It also demonstrates the impact a flattening yield curve can have on a
bank's net interest income.
The best place to start is with the net interest income line item. The bank
experienced lower net interest income even though it had grown average
balances. To help understand how this occurred, look at the yield achieved on
total earning assets. For the current period, it is actually higher than the
prior period. Then examine the yield on the interest-bearing assets. It is
substantially higher in the current period, causing higher interest-generating
expenses. This discrepancy in the performance of the bank is due to the
flattening of the yield curve.
As the yield curve flattens, the interest rate the bank pays on shorter term
deposits tends to increase faster than the rates it can earn from its loans.
This causes the net interest income line to narrow, as shown above. One way
banks try to overcome the impact of the flattening of the yield curve is to
increase the fees they charge for services. As these fees become a larger
portion of the bank's income, it becomes less dependent on net interest income
to drive earnings.
Changes in the general level of interest rates may affect the volume of certain
types of banking activities that generate fee-related income. For example, the
volume of residential mortgage loan originations typically declines as interest
rates rise, resulting in lower originating fees. In contrast, mortgage
servicing pools often face slower prepayments when rates are rising, since
borrowers are less likely to refinance. As a result, fee income and associated
economic value arising from mortgage servicing-related businesses may increase
or remain stable in periods of moderately rising interest rates.
When analyzing a bank you should also consider how interest rate risk may act
jointly with other risks facing the bank. For example, in a rising rate
environment, loan customers may not be able to meet interest payments because
of the increase in the size of the payment or a reduction in earnings. The
result will be a higher level of problem loans. An increase in interest rates
exposes a bank with a significant concentration in adjustable rate loans to
credit risk. For a bank that is predominately funded with short-term
liabilities, a rise in rates may decrease net interest income at the same time
credit quality problems are on the increase. Credit Risk
Credit risk is most simply defined as the potential that a bank borrower or
counterparty will fail to meet its obligations in accordance with agreed terms.
When this happens, the bank will experience a loss of some or all of the credit
it provided to its customer. To absorb these losses, banks maintain an
allowance for loan and lease losses.
In essence, this allowance can be viewed as a pool of capital specifically set
aside to absorb estimated loan losses. This allowance should be maintained at a
level that is adequate to absorb the estimated amount of probable losses in the
institution's loan portfolio.
Actual losses are written off from the balance sheet account "allowance" for
loan and lease losses. The allowance for loan and lease losses is replenished
through the income statement line item "provision" for loan losses. Figure 4,
below, shows how this calculation is performed for the bank being analyzed.
Figure 4: Loan Losses
There are a couple of points an investor should consider from Figure 4. First,
the actual write-offs were more than the amount management included in the
provision for loan losses. While this in itself isn't necessarily a problem, it
is suspect because the flattening of the yield curve has likely caused a
slow-down in the economy and put pressure on marginal borrowers.
Arriving at the provision for loan losses involves a high degree of judgment,
representing management's best evaluation of the appropriate loss to reserve.
Because it is a management judgment, the provision for loan losses can be used
to manage a bank's earnings. Looking at the income statement for this bank
shows that it had lower net income due primarily to the higher interest paid on
interest-bearing liabilities. The increase in the provision for loan losses was
a 1.8% increase, while actual loan losses were significantly higher. Had the
bank's management just matched its actual losses, it would have had a net
income that was $983 less (or $1,772).
An investor should be concerned that this bank is not reserving sufficient
capital to cover its future loan and lease losses. It also seems that this bank
is trying to manage its net income. Substantially higher loan and lease losses
would decrease its loan and lease reserve account to the point where this bank
would have to increase the future provision for loan losses on the income
statement. This could cause the bank to report a loss in income. In addition,
regulators could place the bank on a watch list and possibly require that it
take further corrective action, such as issuing additional capital. Neither of
these situations benefits investors.
Conclusion
A careful review of a bank's financial statements can highlight the key factors
that should be considered before making a trading or investing decision.
Investors need to have a good understanding of the business cycle and the yield
curve - both have a major impact on the economic performance of banks. Interest
rate risk and credit risk are the primary factors to consider as a bank's
financial performance follows the yield curve. When it flattens or becomes
inverted a bank's net interest revenue is put under greater pressure. When the
yield curve returns to a more traditional shape, a bank's net interest revenue
usually improves. Credit risk can be the largest contributor to the negative
performance of a bank, even causing it to lose money. In addition, management
of credit risk is a subjective process that can be manipulated in the short
term. Investors in banks need to be aware of these factors before they commit
their capital.
by Hans Wagner
As a long time investor, Hans Wagner was able to retire at 55 by following a
disciplined process using sound investment principles. After his children and
their friends graduated from college, Hans began helping them to invest in the
stock market. Soon, friends and acquaintances also began to seek advice, so
Hans created a website, Trading Online Markets, which provides information on
investing topics, along with sample portfolios.