Commercial Bank Accounting Flashcards
What’s the purpose of the Allowance for Loan Losses and Provision for Credit Losses? Where do they show up on a bank’s financial statements?
The Allowance for Loan Losses is a contra-Asset netted against Gross Loans on the Balance Sheet to get Net Loans; it represents how much the bank expects to lose on its current Gross Loans balance because of defaults. The Provision for Credit Losses is a non-cash expense on the Income Statement that gets added back on the Cash Flow Statement. It represents how much the bank expects to lose on its Gross Loans in the current period above and beyond the Allowance for Loan Losses. Net Charge-Offs increase the Allowance (it is a contra-Asset, so it becomes less negative), and additional Provisions reduce the Allowance by making it more negative on the Balance Sheet.
A bank’s Interest Income increases by $100, and its Interest Expense increases by $50. Nothing else changes. Assuming a 40% tax rate, walk me through the statements, and explain how the Regulatory Capital Ratios change.
IS: Pre-Tax Income is up by $50, so Net Income is up by $30 at a 40% tax rate. CFS: Net Income is up by $30, and nothing else changes, so Cash at the bottom is up by $30. BS: Cash is up by $30, so the Assets side is up by $30. The L&E side is also up by $30 because Retained Earnings increases due to the $30 of Net Income, so both sides balance. Regulatory Capital: All the ratios increase because this additional Net Income increases the bank’s Common Shareholders’ Equity, the bank has not increased its Risk-Weighted Assets, and its Tangible Assets are only up by $30 (and they’re much bigger than the bank’s CSE). Intuition: We get additional Net Interest Income and Net Income, but we don’t need additional Assets or funding sources. It’s a free lunch! This scenario is not realistic.
A bank records a $10 Provision for Credit Losses. Walk me through the statements.
IS: Pre-Tax Income is down by $10, and Net Income is down by $6 at a 40% tax rate. CFS: Net Income is down by $6, but you add back the $10 of Provisions, so Cash is up by $4 at the bottom. BS: Cash is up by $4, but Net Loans is down by $10, so the Assets side is down by $6. The L&E side is also down by $6 because Retained Earnings is down by $6 from the reduced Net Income. Regulatory Capital: All the ratios decrease because CSE decreases, but Risk-Weighted Assets do not change, and the bank’s Tangible Assets decrease by the same amount as its CSE. Intuition: This bank expects to charge off more of its Loans, so its “buffer capital” decreases to reflect this expected loss. Cash increases due to the tax savings from this non-cash Provision expense.
A bank’s beginning Allowance for Loan Losses is $50. It records Gross Charge-Offs of $10, Recoveries of $5, and Provisions for Credit Losses of $10 to reflect higher expected losses. What is its ending Allowance?
Ending Allowance = Beginning Allowance – Gross Charge-Offs + Recoveries + Provision for CLs = $50 – $10 + $5 + $10 = $55. “Recoveries” refer to previously charged-off Loans from which the bank can now recover some money due to collateral or other factors.
Walk me through what happens on the financial statements with these changes (Gross Charge- Offs of $10, Recoveries of $5, and Provisions for Credit Losses of $10).
IS: Only the $10 Provision for CLs shows up here; Pre-Tax Income falls by $10, and Net Income falls by $6 at a 40% tax rate. CFS: Net Income is down by $6, but you add back the $10 of Provisions, so Cash is up by $4 at the bottom. Gross Charge-Offs and Recoveries do not show up on the Cash Flow Statement. BS: Cash is up by $4, but the Gross Loans balance is down by $5 because of the $10 in Gross Charge-Offs and $5 in Recoveries. The Allowance for Loan Losses also declines by $5, becoming more negative, because of the $10 in Provisions and $5 in Net Charge-Offs. The Assets side is down by $6. The L&E side is also down by $6 because of the $6 in reduced Retained Earnings. Regulatory Capital: The ratios will fall because CSE has declined by $6, but Gross Loans have declined by $5, and the denominators of the ratios (Tangible Assets or Risk-Weighted Assets) are much bigger than the numerators. Net Charge-Offs cancel out because they affect both Gross Loans and the Allowance for Loan Losses, so they make no impact on Net Loans. Only Loan Additions and the Provision for Credit Losses affect Net Loans. Intuition: This bank charged off some Loans and expects to charge off more Loans in the future. As a result, its “buffer capital” falls, but its Cash increases because it had already expected to charge off the now-charged-off Loans, and the new Provisions provide tax savings.
A bank issues new Loans, and its Loans and Deposits both increase by $100. Its Net Interest Income then increases by $10, and its Provision for Credit Losses increases by $5. Walk me through the statements.
IS: Pre-Tax Income is up by $5, so Net Income is up by $3 at a 40% tax rate. CFS: Net Income is up by $3, but you add back the $5 in Provision for CLs as a non-cash expense. The Changes in Loans and Deposits cancel out, so Cash is up by $8 at the bottom. BS: Cash is up by $8, and Net Loans is up by $95, so the Assets side is up by $103. On the L&E side, Deposits is up by $100, and Retained Earnings is up by $3 due to the increased Net Income, so both sides are up by $103 and balance. Regulatory Capital: Most likely, the ratios will decrease because Gross Loans is up by $100, but CSE is only up by $3, and $100 is probably a greater percentage of the bank’s RWAs than $3 is of the bank’s CET 1, Tier 1, and Total Capital. Intuition: This bank issues some new, high-yielding Loans, but its capital ratios decline because its CSE doesn’t increase by much relative to these new Assets. If it keeps doing this, it will need additional Equity in the future.
A bank’s Allowance for Loan Losses is $60, but it experiences a sudden, unexpected loss, and it must record $100 in Gross Charge-Offs. What happens on the financial statements?
In this scenario, the bank must increase its Allowance by allocating more Provisions to cover these unexpected losses. For simplicity, we’ll assume that its Provisions for Credit Losses increases by $40 so that its Allowance can cover these Charge-Offs: IS: Pre-Tax Income is down by $40 due to the $40 in new Provisions, so Net Income falls by $24 at a 40% tax rate. CFS: Net Income is down by $24, but you add back the $40 in Provisions for CLs, so Cash at the bottom is up by $16. Gross Charge-Offs do not appear on the CFS. BS: Cash is up by $16, and the Allowance for Loan Losses decreases from negative $60 to negative $100, so the Assets side is down by $24. Then, Gross Loans decreases by $100, and the Allowance for Loan Losses increases by $100, reaching $0, but those changes cancel out, and the Assets side is still down by $24. The L&E side is also down by $24 due to the reduced Net Income that flows into Retained Earnings. Regulatory Capital: All the ratios will decline because the $24 decrease in CSE represents a greater percentage of the numerator in each ratio than the $100 decrease in Gross Loans represents of the denominator. This scenario is the point of Regulatory Capital: To provide a cushion for unexpected losses. Intuition: This bank experiences a large, unexpected loss, so its Net Loans and Equity both fall. Cash increases because of the tax savings on the additional Provisions the bank sets aside to cover this unexpected loss.
A bank wants to issue $100 in additional Loans, and it needs additional funding to do it. What are the trade-offs of raising this funding with Deposits vs. Subordinated Notes vs. Preferred Stock vs. Common Equity?
If the bank has sufficient Regulatory Capital, it will almost always raise this funding via additional Deposits because they are the cheapest funding source: Interest rates on Deposits are lower than the rates on anything else, and they’re certainly below the Cost of Equity. However, additional Deposits will not increase the Regulatory Capital Ratios, such as the CET 1, Tier 1, and Total Capital Ratios (though they might improve the Net Stable Funding Ratio). So, if the bank needs more Total Capital, it might prefer to raise Subordinated Notes since they count toward Tier 2 Capital, which is a component of Total Capital. If the bank needs additional Tier 1 Capital, Preferred Stock might make sense. And if the bank needs additional CET 1 or TCE, it must raise Common Equity – the most expensive funding source, but also the only one that boosts all the ratios.
A bank wants to return capital to its shareholders, and it is considering both Dividends and Stock Repurchases. How do these methods affect the financial statements and Regulatory Capital Ratios differently?
The financial statement impact is nearly the same: Both items appear in Cash Flow from Financing on the CFS, and they both reduce the bank’s Cash on the Assets side and Equity on the L&E side. The main difference is that Stock Repurchases also reduce the bank’s share count, but Dividends do not (also, they affect different line items within Equity), so Stock Repurchases will boost the bank’s EPS. The impact on the bank’s Regulatory Capital Ratios is also the same: Everything falls because the bank’s Common Shareholders’ Equity falls, but its Risk-Weighted Assets stay the same.
Which ratios can you use to analyze a bank’s Charge-Offs and Provisions for Credit Losses?
A few of the most common ones include: Net Charge-Off Ratio: Net Charge-Offs / Average Gross Loans Meaning: How bad are the defaults? Net Charge-Offs / Reserves: Net Charge-Offs / Allowance for Loan Losses Meaning: Have we set aside enough to cover defaults in a given period? Reserve Ratio: Allowance for Loan Losses / Gross Loans Meaning: What % of our Loans do we expect borrowers to default on? Net Charge-Offs / Prior Year Provisions for Credit Losses Meaning: Were our predictions for Charge-Offs in-line with the real Charge-Offs? NPLs / Gross Loans: Non-Performing Loans / Gross Loans Meaning: What % of our Loans have borrowers that are late making payments and likely to default? NPL Coverage Ratio: Allowance for Loan Losses / Non-Performing Loans Meaning: How well does the Allowance for Loan Losses cover Loans that are past due and likely to go into default? “Non-Performing Loans” typically refer to Loans where the borrowers are more than 90 days late paying the required interest and principal.
