06-05-2014, 11:56 AM
Analyzing A Bank's Financial Statements
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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.
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.
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.
Credit Risk
Credit risk is most simply defined as the potential of a bank borrower or counterparty to fail in meeting 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 shows how this calculation is performed for the bank being analyzed.
The Bottom Line
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.