Chapter 5: Financial Statements of Banks

Question 1

How does a banks capital structure, revenue and expenses differ to that of a company?

Answer 1

Capital Structure: A bank has a small amount of equity capital and takes on larger amounts of debt (customer deposits). This debt is treated more as a raw material to lend to others than a source of finance

Revenue: This is often the interest coming in from borrowers, so profit = the interest rate spread between borrowers and depositors
Other revenue is from fees and trading activities

Expenses: Overheads connected to business operations e.g. staffing

Question 2

Explain how the features of the following areas of the SOFP are for banks?
Assets
Liabilities

Answer 2

Total assets are mainly made up:
  Loans and advances to customers
  Loans to other banks
  Cash
  Trading assets connected to market making and proprietary trading activities

Total liabilities are made up of:
Deposits from customers
Loans from banks
Debt securities in issue

Question 3

Banks SOFP isn’t categorised by current and non-current. How are they categorised and why?

Answer 3

They are categorised by liquidity. Anything receivable/payable within and after is disclosed in the notes.

Non-current and current isn’t the most useful or informative presentation for a bank

Question 4

What are some significant issues of the bank’s statement of financial position

Answer 4

1. Leverage
2. Liquidity
3. Capital
4. Money Creation

Question 5

Define leverage ratio and its formula?

What does a low leverage ratio mean?

Answer 5

Definition: The percentage of total funding represented by equity

Formula: Equity/Total Assets

Low leverage ratio = the higher the company’s leverage

Question 6

How is the leverage of a bank different to that of a non-financial company?

Answer 6

A non-financial FTSE 100 company’s leverage is around 35-40%
For a bank it is usually single figures, meaning they have higher leverage because a large proportion of their assets are interest bearing loans

Question 7

What was impact of leverage and the Global Financial Crash?

Answer 7

Excessive leverage was one of the factors implicated in the Financial Crisis. Therefore the Basel III states that the leverage ratio should be at least 3%

Question 8

What does the minimum regulatory capital represent

Answer 8

It’s a buffer of equity capital to absorb losses to prevent losses being sustained by depositors and other creditors

Question 9

Banks don’t lend money directly from depositors to borrowers. How instead does it give money to the borrower?

Answer 9

The bank in essence ‘creates money’ to give to the borrower.

To give them a loan the bank credits the amount to the borrower’s current account and then debits the obligation to repay as an asset

Dr Asset - Borrower’s loan account
Cr Liability - Borrower’s current account

Question 10

Where do banks hold their bank account?

Answer 10

Banks hold their reserve account with the Bank of England, which acts as their current account. They use these accounts when they are settling with other bank

Question 11

How can banks vary their resources with the Bank of England

Answer 11

If a bank needs to increase their reserve account they can exchange other assets with the Bank of England under its QE or repo facilities

There are no limits on the overall level of reserves

Question 12

What happens under Quantitative Easing in terms of reserve accounts?

Answer 12

The Bank of England creates money to buy bonds from banks which increases the liquid resources available for the bank to continue lending to businesses and customers

Question 13

What are some of the commercial an regulatory constraints on the amount of lending a bank can do

Answer 13

1. Banks need to operate profitably and there are a limit of attractive profitable lending opportunities
2. Monetary policy will influence the demand for lending through interest rates
3. Banks need to manage their liquidity risk to make sure they have enough liquidity (cash) to meet customer withdrawal needs
4. Need to meet minimum capital requirements
5. Banks need robust operational and risk management controls which needs resources and expertise

Question 14

What are the main sources of income for a bank?

Answer 14

Net interest income
Net fee income
Trading income
Income from financial instruments

Question 15

What are the main expenses for a bank?

Answer 15

Impairment losses
Overheads - mainly personnel
Depreciation - but not much as banks typically have low levels of tangible assets
Amortisation

Question 16

What does impairment losses indicate and why are they so important now?

Answer 16

They indicate the quality of the bank’s financial assets

Impairment losses were a big factor in the losses sustained by many banks in the immediate aftermath of the financial crises 2007/08
They are recognised earlier under IFRS 9 to prevent such huge unforeseen losses in the future

Question 17

Define net interest income

What are the three things that impact this type of income?

Answer 17

Bank’s interest Income - interest paid
So the difference between the interest paid by borrowers and that paid to depositors and other liabilities. It’s like gross profit

a) Maturity transformation - funding long term lending from short term deposits and borrowing
b) Asset and liability mismatches - creates liquidity risk
c) General level of interest rates - if they fall so does this income

Question 18

1. Give some examples of fee generating income?
2. How is fee generating income difference to NII?
3. How is commission generated?

Answer 18

1. Private banking, wealth management, corporate finance
2. Not interest rate sensitive and doesn’t need the bank to increase its regulatory capital
3. Generated from the execution of customer transactions e.g. sale/purchase of securities/derivatives

Question 19

What does net trading income normally arise from?

Answer 19

It arises from proprietary trading and market making activities. It includes both realised gains/losses on disposal of financial instruments as well as unrealised gains/losses when open positions are market to fair value

Question 20

What does the net impairment loss on financial assets represent?

Answer 20

The charge in relation to expected credit losses on financial assets not classified as fair value through profit or loss

Question 21

What is included in overheads?

Answer 21

This is the expense of the of running the bank

Mainly made up of personnel-related costs

Question 22

What are the main purposes of key performance indicators and ratios?

Answer 22

1) Allow the bank to measure past performance in absolute and relative terms with ratios
2) Provide transparency and clarity of disclosure
3) Allows banks to sets strategic financial targets
4) Summaries bank’s performance and allows them to be assessed against peers, past targets
5) Helps users gauge potential future performance - provides useful info to base future forecasts
6) Can assess dimensions of profitability, growth and risk

Question 23

What are the main profit or loss measures?

Answer 23

1. Profit or loss attributable to common shareholders after distribution to non-controlling interests and preferred dividends
2. Earnings per hare
3. Adjusted or recurring profit or loss - not really used as banks often record recurring exceptional costs
4. Pre-tax profit or loss
5. Profit before impairment charges

Question 24

What are the main revenue measures?

Answer 24

1. Net interest income
   Since the banks make a spread between borrowing and lending, gross interest income is not relevant
2. Gross banking revenues
   Net interest income + Net fees and commission income + Net trading income

Question 25

Banks are balance sheet driven. What are three important items that need a key performance indicator

Answer 25

1. Customer loans and customer deposits
2. Total assets or risk-weighted assets
3. The capital invested in the bank

Question 26

The measurement of capital invested in the bank can be done by measuring three closely related items. These items summarise how much has been invested and how much activity the bank engages in. What are these three items?

Answer 26

a) Common shareholders’ equity = the best quality of capital a bank needs in order to take risk
b) Tangible equity = common shareholders’ equity - goodwill - intangibles
c) Regulatory measures of capital e.g. Common Equity Tier 1 or Total Capital

Question 27

What are three other items on the balance sheet that are relevant in a risk assessment context?

Answer 27

1) Non-performing loans - loans with evidence of a deteriorating performance needing loan loss provisions
2) Short-term wholesale funding - excessive reliance wholesale funding
3) Liquidity Pool = if insufficient bank may not withstand liquidity stresses and funding pressures

Question 28

What are the four main profitability performance ratios?

Answer 28

Return on equity
Return on assets
Net interest margin
Cost income ratio

Question 29

Define ‘Return on Equity’ and its ratio

Answer 29

The most relevant profitability indicator