Financial Soundness of Commercial Banks
Financial Soundness of Commercial Banks
commercial banks
Dr. Tu Le
Institute for Development and Research in Banking
Technology
University of Economics & Law
Leaning objectives
• Understanding the bank’s assets, liabilities
and bank’s income
• Understanding some bank’s off-balance
sheet activities
• Introducing some models to assess bank’s
financial soundness
Bank’s assets
• Liquid assets and quasi-liquid assets
– Cash and cash equivalent
– Due from banks (interbank Assets)
– Government securities
– Marketable securities
– Unquoted securities
Banks’ Assets (Cont’d)
• Illiquid assets
– Loans and advances
– Investments in and assets in respects of
subsidiaries and affiliated companies
– Fixed assets
– Other assets: prepayment and goodwill
The breakdown of
ACB’s assets
Bank’s liabilities
• Funding liabilities
– Often but not always interest bearing
– Customer and interbank deposits
– Long-term liabilities
– Other liabilities
Customer and interbank liabilities
• Customer Deposits
– Retail-core deposits
• USA: NOW and Super Now Accounts: interest bearing checking accounts and money market
accounts
– Demand deposits:
• current or checking account deposits
• Traditionally, bearing no interest
– Saving deposits
• Paying interest but no fixed term
– Time deposits
• For a certain time
• Paying higher interest rate than saving deposits
• Interbank deposits (due to other banks)
– Large denomination certificates of deposits
– Short-term borrowing: purchased funds or hot money
Long-term liabilities
• Borrowing for a term (> year)
• Loan capital
• Subordinated debt
Other liabilities
• Checks and demand draft outstanding
• Accrued taxes, interest, and other
expenses
• Dividends payable
• Liabilities in respect of subsidiaries and
affiliates
• Miscellaneous liabilities
ACB’s liabilities
Bank’s capital
• Share Capital: share capital or paid-in capital refers to the value of the
assets contributed by the shareholders. It is comprised of the par value of
the bank’s shares
• Common Shares: represents the equity ownership of the banks
• Preferred Shares: have limited voting and ownership rights but are
guaranteed a specified dividend
• Retained Earnings- undivided profits: represents the earnings of the bank
that have been plowed back into its business- so called the source of
internally generated capital
• Equity Reserves: are reserves designated for special purposes. Watch out
don’t confuse it with Loan-Loss Reserves
• Minority Interest in Subsidiaries: In consolidated reporting for a bank that
has subsidiaries, the investment of outside shareholders as minority owners
in the bank’s subsidiaries will be counted as part of the consolidated group’s
capital
ACB’s equity capital
Bank’s OBS activities
• Do not appear on the balance sheet,
• May appear in notes to the financial statements.
• Loan commitments: the promise that a bank will
make a loan if the bank customer so opts
• Letter of credit,
• Guarantees: the bank’s promise, in exchange for a
fee, to pay if a customer defaults
• A various types of financial derivatives (interest rate
swap, income swaps), and foreign exchange
contracts
Interest rate swap
• Assume A offers B a fixed rate of 5% in
exchange for receiving a floating rate of
the LIBOR rate plus 1% (assume LIBOR is
4%). Therefore, A has 5 % fixed rate and B
has 5% (LIBOR rate of 4% + 1%)
• What if LIBOR rate of 5.25% and LIBOR
rate of 3.75%, what happens to A and
B???
Credit default swap
• How total returns swap works?
Letter of credit
Bank’s income statement
• Interest income (gross interest income)
• Interest expenses (cost of funding)
• Non-interest income
• Operating income
• Non-interest expenses
• Loan loss provisions (non-cash expense)
• Minority interest
Interest income
• Income from loans- advances to customers
and securities (investments in fixed income
securities such as treasury bills and bonds, and
comprises the bulk of income from most banks
• The mere increase in general interest rates will
cause a bank’s interest income to rise even
though net interest income remains the same.
Note that a rise in either interest income or net
interest income does not necessarily imply a
rise in profitability
Interest expenses
• Interest the bank must pay to its depositors
and creditors from whom it has borrowed
funds to on-lend to bank customers
• Customer deposits, interbank borrowing,
medium- and long –term borrowing.
• Commercial banks obtain the bulk of their
funding from deposits
• Wholesale banks tend to rely to a great
extent on commercial borrowing for funding
Non-interest income
• Fees and commissions(providing
guarantees, letter of credit, trust services,
arranging financing, rental of safe, deposit
boxes, checking clearing fees and
automatic teller machine fees
• Gains on securities and foreign exchange
trading
Non-Interest Expenses