Commercial Bank 3-Statement Modeling Flashcards
How do you project the financial statements for a commercial bank?
You start by projecting the bank’s Balance Sheet, usually beginning with its Loans, Deposits, and other
Interest-Earning Assets and Interest-Bearing Liabilities.
Then, you project the interest rates for all these items and link them to a prevailing rate like the Federal Funds rate or interbank rate of the country.
Use that information to calculate the Interest Income and Interest Expense on the Income Statement. Estimate the Non-Interest Income and Expenses with simple percentage growth, percentage-of- revenue, or percentage-of-Balance-Sheet-line-item estimates.
Project the bank’s Dividends based on the “capital” (roughly, Tangible Common Equity) it’s targeting vs. how much it currently has. You can complete the full Cash Flow Statement by linking to the relevant IS and BS line items and projecting a few items, such as CapEx and D&A, separately on the CFS.
How do you use the Balance Sheet of a bank to create its Income Statement?
First, determine the Assets that earn interest – the Interest-Earning Assets – and the Liabilities that bear interest – the Interest-Bearing Liabilities.
Then, assign interest rates to these items based on historical rates or spreads against benchmark rates, and use those rates to calculate Interest Income and Interest Expense.
Subtract the Interest Expense from Interest Income to calculate the bank’s Net Interest Income, which
appears on the Income Statement.
Then, base the Non-Interest items on percentage growth rates or percentages of other on- or off- Balance Sheet items. For example, Credit Card Fees might be a percentage of Credit Card Loans.
How do you project a bank’s Loans and Deposits?
You almost always start with the bank’s Loans and then make Deposits a percentage of those Loans,
based on the historical trends.
To project the bank’s Loans, you could assume simple percentage growth rates.
Or, you could link the Loans to GDP Growth and assume that Total National Loans are a percentage of
GDP and that the bank’s market share changes in a certain direction over time.
You’re building Base, Upside, and Downside scenarios in a 3-statement model for a commercial bank. What might be different about the assumptions in each scenario?
Loan Growth and Interest Rates tend to be highest in the Upside scenario and lower in the others (the same applies to related assumptions such as GDP Growth and Market Share).
Net Charge-Offs and the Provision for Credit Losses are the opposite: They’ll be highest in the Downside scenario and lowest in the Upside scenario.
Additionally, the bank’s margins, Non-Interest Income Growth Rate, and other figures may be highest in the Upside scenario and lower in the others.
How do you balance a bank’s Balance Sheet?
Unlike the approach used for normal companies, where Cash and Shareholders’ Equity act as “plugs,” you use Federal Funds Sold (AKA Funds with Central Banks or similar names outside of the U.S.) on the Assets side and Federal Funds Purchased on the L&E side to balance the Balance Sheet.
If Total Assets are below Total L&E, you assume that the bank sells its excess funding to the central bank or other banks in the country, which boosts its Federal Funds Sold.
And if Total L&E are below Total Assets, you assume that the bank borrows from the central bank or other banks, which boosts its Federal Funds Purchased.
These items are interest-earning and interest-bearing, so it’s not “free money” for the bank – if the bank borrows more, it has to pay to additional Interest, and if it sells excess funding, it earns interest on that.
How can you tell if a bank is over-provisioning or under-provisioning for Loan Charge-Offs?
You could look at figures such as Net Charge-Offs / Reserves, the Reserve Ratio, and Net Charge-Offs / Prior Year Provision for CLs to determine this.
For example, if the bank’s Net Charge-Offs / Reserves and Net Charge-Offs / Prior Year Provision for CLs keep decreasing, but its Reserve Ratio keeps increasing, the bank may be over-provisioning.
If the opposite happens, the bank may be under-provisioning because it’s setting aside less of an
Allowance each year to cover Charge-Offs.
You’re the CEO of a large bank, and you’re looking at the firm’s Income Statement. Would you prefer to see a higher percentage of Non-Interest Income or Net Interest Income?
It is often seen as positive if a higher percentage of the bank’s revenue comes from Non-Interest Income because banks have more control over the fees and commissions they charge than they do over prevailing interest rates.
But it also depends on the bank’s business model: If it’s more of a pure-play commercial bank, it might want to earn a higher percentage of revenue from Net Interest Income (and vice versa if it is aiming to diversify).
How do you calculate Dividends for a bank?
First, you check the bank’s Available CET 1 by taking its Common Shareholders’ Equity + Net Income to Common + Other Items That Affect CSE – Goodwill and Other Intangibles, and then you compare that to the Minimum CET 1 Required, which equals the bank’s Risk-Weighted Assets * Targeted CET 1 Ratio.
Subtract the Minimum CET 1 from the Available CET 1 to determine the capital available for Dividends. For example, if the bank’s Available CET 1 is $100, and its Minimum CET is $80, then it can issue $20 in Dividends.
Most banks target specific Payout Ratios, so you might multiply this bank’s targeted ratio by its Net Income to Common to determine the Dividends it plans to issue (e.g., 50% Payout Ratio * $30 in Net Income to Common = $15 in Dividends).
If the capital available for Dividends ($20 in this example) exceeds that figure, the bank can issue the full $15 in Dividends. If not, it can only issue Dividends up to the capital available to do so.
You review a bank’s 3-statement model and find that the firm’s ROE and ROTCE increase each year
as its ROA decreases. How could that happen?
Most likely, this happens because the bank’s Non-Interest-Earning Assets are growing more quickly than its Interest-Earning Assets (IEAs).
ROE, ROTCE, and ROA all use Net Income or Net Income to Common in the numerator, but the denominators differ. ROE uses Equity, ROTCE uses Tangible Common Equity, and ROA uses Total Assets.
So, if Net Income (to Common) keeps increasing, but ROA keeps decreasing, then the firm’s Total
Assets must be growing at a faster rate than its Net Income.
But if ROE and ROTCE keep increasing, then its Equity and Tangible Common Equity must be growing at a slower rate than its Net Income.
That probably means that the bank’s Non-Interest-Earning Assets are growing more quickly than its Interest-Earning Assets. Since IEAs correspond to Risk-Weighted Assets, the bank needs more Tangible Common Equity to support them as it grows.
But since TCE and Equity grow at a slower rate than Total Assets, it seems like the bank’s Risk- Weighted Assets and, therefore, its IEAs, are growing more slowly than the other Assets.
You finish a 3-statement model for a bank and find that its CET 1 Ratio in Year 5 is highest in the Downside case and lowest in the Upside case. How is that possible?
You could easily get this result if you target the same CET 1 Ratio in the Upside and Downside cases,
but the bank’s Loan Growth is highest in the Upside case.
Higher Loan Growth means the bank will have more Risk-Weighted Assets, which means that the bank will need more CET 1 to support those RWAs.
So, in the Upside case, the bank might be at or near its targeted CET 1 Ratio in most years.
But in the Downside case, with much lower Loan Growth, the bank won’t need as much CET 1, so it
could easily exceed its targeted CET 1 Ratio.
