Balance Sheet of a Bank
The balance sheet of the bank is different from the balance sheet of the company and it is prepared only by the banks according to the mandate by the Bank’s Regulatory Authorities in order to reflect the tradeoff between the profit of the bank and its risk and its financial health.
Balance Sheet for banks is different from other sectors and companies. There are several characteristics of the bank’s financial statement that highlight how banks balance sheets and income statements are created. Sales are not measured by ratios like sales turnover and receivables turnover. Once investors are comfortable with the terminology and can grasp the statements, it becomes elementary for them to analyze the trends and understand the statements.
Banks Balance Sheet Example
Below is the example of Consolidated balance sheet of Goldman Sachs for the year 2017 and 2016 from their Annual 10K
Balance Sheet Assets
source: Goldman Sachs SEC Filings
- We note that the bank’s balance sheet assets are different from what we usually see in other sectors like Manufacturing etc. The classification is not based on current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc., long term assets, inventory, payables, etc.
- The key highlight is that bank assets include securities purchased, loans, financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes., etc.
Balance Sheet Liabilities
- The Bank’s balance sheet liability section looks very different from the ordinary liabilities (current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc., long term liabilities, etc.).
- Here the key terms to note are Deposits, Securities under repurchase agreementsRepurchase AgreementsA repurchase agreement or repo is a short-term borrowing for individuals who deal in government securities. Such an agreement can happen between multiple parties into three types- specialized delivery, held-in-custody repo and third-party repo., short term and long term borrowings, etc.
Components of Banks Balance Sheet
The main components of the above bank’s balance sheet are
#1 – Cash
- For other sectors, holding a large amount of cash is considered a loss in opportunity cost. But in the case of Banks Balance Sheet, cash is a source of income and is held on deposit. Sometimes banks also hold cash for other banks, and one of the significant services which banks provide is to provide cash on demand.
- Due to the nature of its business and also as per regulatory norms, banks must have a minimum amount of liquid cash. Most often, banks keep excess reservesExcess ReservesExcess reserves are kept or deposited with the central regulatory authority over and above the statutory requirements. If reserves are positive, the bank has held the amount in reserves more than the statutory requirement. In the case of zero value, there is no deficit or surplus reserves balance kept. for higher safety Goldman Sachs has a considerable amount of cash balance.
- In 2017 it had ~12% of its balance in cash and equivalentsCash And EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. . This is an essential focus for the investors, since the chances of receiving a higher amount of dividend or share buyback increasesShare Buyback IncreasesShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.
#2 – Securities
- These instruments are typically short-term in nature, and banks generate a yield from these kinds of investments. Banks own US Treasuries and municipal bondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports..
- These securities are liquid and can be easily sold in the secondary marketSecondary MarketA secondary market is where securities are offered to the general public after being offered in the primary market. Such securities are usually listed on the stock exchange. A significant portion of trading happens in such a market and are of two types – equities and debt markets. and hence are termed as secondary reserves. Goldman has increased its investment in securities in 2017.
#3 – Loans
Lending money and earning interest is the primary business of the bank. It can be termed as bread and butter of the bank.
- From an investor’s perspective, the increase in loans is an essential factor for the growth of the bank. Along with the increase in loans, bank deposits should also be observed. An increase in loans is alone not sufficient. The quality of creditors should be noted. Poor quality of creditors may lead to a rise in default rates and, in turn, a loss for the banks.
- On a broad level, banks provide Personal and mortgage loans. Personal loans are given without any security, and hence interest for these loans remains high. In the case of mortgage loans, the loan is given against a mortgage, and the interest is lower. But if the loan taker defaults on its loan, the mortgage is claimed by the bank as per agreement.
- Banks also provide loans for business, real estate loans, which include but not limited to residential loans, home equity loans and commercial mortgages, consumer loansConsumer LoansA consumer loan is a type of credit given to a consumer to finance specified set of expenditures. The borrower must pledge a specific asset as collateral for the loan, or it may be unsecured depending on the loan's monetary value., and interbank loans.
#4 – Deposits
- Deposits fall under the liability portion of the banks’ balance sheet and are also mainly the most substantial liability for the bank. It includes money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders., savings, and current account and has both interest and non-interest bearing accounts.
- Deposits are considered liabilities, but they are also crucial in determining a bank’s ability to lend. If the bank does not have sufficient deposits, it will not be able to lend, and the loan growth will also be hampered. Banks may have to take on debt to meet the loan growth, which would cost them more than the rate they might receive on loans.
- Also, this is not a sustainable way for banks to grow their loans. After a certain point, the debt amount will reach an extent where the bank will not get any credit, and if the bank fails to pay on its payments, it will lead to a crash.
- Banks use these liabilities to generate more income, which earns them additional income. By using these deposits to finance loans for individuals etc. Banks will be able to leverage this additional capital to make the extra income that they might have otherwise earned through the capital.
- Banks also have an allowance in the balance sheet for covering losses, and the changes in this amount are based on the economic conditions.
Accounting Rules for Valuing Assets in a Bank
Capital is determined by Total Assets, less total liabilities (also known as net worth). However, the recent changes have changed this definition and have made it complex to determine the true value of the bank’s net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus..
Post-2009 crisis, the government took specific initiatives to restore faith in the banking system. Financial Accounting Standards Board has allowed Banks to value their assets at a Fair Value. Banks are now also allowed to record income on the income statement if the market value of the debt decreases. This change is because the bank could buy its debt in the market and reduce the debt amount.
Important Indicators in Banks Balance Sheet Analysis
The word “Default” means failure to meet interest or payment obligations. Usually, banks use a Non-performance ratio, which is a percentage indicating the number of loans given on credit is expected to fail. This comparison helps us in understanding if the bank has sufficient funds to meet the future contingencies
Widely used ratios include –
- Non-performing loans / Customer loans
- Non performing loans / Customer loans + collateral
- Non-performing loans / Average total assets
- Own Resources / Average total assets
Non-performing assets or loans to loans ratio is used as a measure of the overall quality of the bank’s entire loan book. Not performing loans are the ones for which interest is overdue for more than 3 months
The third ratio is especially significant for institutions that are already in a bad place. When this ratio crosses a benchmark, it is considered as a strong sign of insolvencySign Of InsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.
The higher fourth the ratio indicates that the bank is highly leveraged and there is lower protection against defaults on the loans mentioned above on the asset side
This article has been a guide to Banks Balance Sheet. Here we discuss the main components of the banks’ balance sheet in detail and its analysis along with practical examples, important indicators, and the widely used Ratios. You may learn more about accounting from the following articles –