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FSU FIN 4324 - Financial Statements of Commercial Banks

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FIN 4324 Final Exam Study GuideCommercial Bank AdministrationDr. Jeffrey A. Clark1. Financial Statements of Commercial Banksa. Importance of Financial Statement Datai. Most banks are not publicly traded and therefore have no observable stock or bond pricesii. Heavily utilized by Regulators in evaluating the safety and soundness of a bankiii. Used by industry analysts and by ownership and management to evaluate bank performance1. Report of condition (aka Balance Sheet)a. Balance sheet of a commercial bank reporting information at a single point in time b. We will focus on a wholesale bank (a bank that focuses its business activities on commercial banking relationships) financial statementsc. Unlike manufacturing corporations, the majority of a commercial bank’s assets are financial assets rather than physical or fixed assets (such as buildings or machines)d. In general, banks have higher leverage than manufacturing corporations doe. Assets are the first item listed on a bank’s balance sheet. And they are grouped into four major subcategories: (1) cash and balances due from other depository institutions, (2) investment securities, (3) loans and leases, and (4) other assets.i. (1) Cash and balances due from other depository institutions : (item 1) the first item usually listed is vault cash, which is composed of currency and coin needed to meet customers daily withdrawals. (item 2) Deposits at the Federal Reserve are used primarily to meet legal reserve requirements, which assist in check clearing, wire transfers, and the purchase or sale oftreasury securities. (item 3) Deposits at other financial institutions are primarily used to purchase services from those institutions. These banks generally purchase services such as check collection, check processing, fed funds trading, and investment advice from correspondent banks (a bank that provides services to another commercial bank). (item 4) Cash items in the process of collection are checks written against accounts at other institutions that have been deposited at the bank. Credit is given to the depositor of these checks only after they clear. ii. (2) Investment Securities : Consist of items such as interest-bearing deposits at other Financial Institutions, federal funds sold, repurchase agreements (RPs or repos), U.S. Treasury and agency securities, securities issued by states and political subdivisions (municipals), mortgage-backed securities, and other debt and equity securities. These securities generate some income for the bank and are used for liquidity risk management purposes. Investment securities are highly liquid, have low default risk, and can usually be traded in secondary markets. Banks usually maintain a significant amount of these securities, so they can easily meet liquidity needs that arise unexpectedly. iii. (3) Loans and Leases : Loans are the major items on a bank’s balance sheet and generate the largest flow of revenue income. However, loans are also the least liquid asset item and the major source of credit and liquidity risk for most banks. Leases are used as alternatives to loans when the bank, as owner of a physical asset, allows a customer to use an asset in return for periodic lease payments. Loans are categorized as commercial and industrial (C&I) loans, loans secured by real estate, individual or consumer loans, and other loans. 1. Commercial and industrial loans (roughly 11.88% of banks total assets): These loans are used to finance a firm’s capital needs, equipment purchases, and plant expansion. 2. Real estate loans (roughly 31.49% of banks total assets): Primarily mortgage loans and some revolving home equity loans. 3. Consumer loans (roughly 8.28% of TA): Mainly personal or auto loans.4. Other loans (roughly 2.28% of TA): Consists of a variety of uncommon loans.iv. (part of Loans and Leases) Unearned income and allowance for loan and lease losses: these two items are contra-asset accounts that are deducted from gross loans and leases on the balance sheet to create net loans and leases. Unearned income is the amount of income that the bank has received on a loan from a customer but has not yet recorded as income on the income statement. The allowances for loans and lease losses is an estimate by the bank’s management of the amount of the gross loans (and leases) that will not be repaid to the bank.1. Net write-offs: actual loan losses less loan recoveriesv. Investment securities plus net loans and leases are the earning assets of a depository institution. It is these items on the balance sheet that generate interest income and some of the noninterest income. vi. (4) Other assets : consist of items such as premises and fixed assets, other real estate owned (OREO, collateral seized on defaulted loans), intangible assets, etc. Usually make up a small portion of total assets. f. Liabilities : A bank’s liabilities consist of various types of deposit accounts and other borrowings used to fund the investments and loans on the asset side of the balance sheet. Liabilities vary in terms of their maturity, interest payments, check-writing privileges, and deposit insurance coverage. i. Demand deposits : are transactions accounts held by individuals, corporations, partnerships, and governments that pay no explicit interest.1. Corporations are prohibited from using deposits other than demand deposits for transaction account purposes, therefore this group consists of the majority of the demand deposit holders. ii. NOW (negotiable order of withdrawal) account : these accounts are similar to a demand deposit but pays interest when a minimum balance is maintained iii. MMDAs (Money Market deposit accounts) : these accounts are checkable but are subject to restrictions on the number of checks written on each account per month, the number of preauthorized automatic transfers per month, and the minimum denomination of the amount of each check. In addition, MMDAs impose minimum balance requirements on depositors. iv. Other savings deposits : All savings accounts other than MMDAsv. Retail CDs : Time deposits with a face value below $100,000.vi. Core Deposits : The bank liabilities listed in above, in red, make up a bank’s core deposits. The core deposits are, deposits of the bank that are stable over short periods of time and thus provide a long-term funding source to a bank. vii. Wholesale CDs : Time deposits with a face value of $100,000 or more. They


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