Banks and nonfinancial entities have similar financial statements, but a few key differences due to the nature of their businesses. Banks operate on storing customer deposits and lending money out from those deposits. As such, they earn income from the difference between the interest they earn on lending and the cost of storing customer deposits. This fundamental difference in operations results in the difference of a bank's financial statements from those of nonfinancial entities.
Balance Sheet Basics
One of the fundamentals of accounting is that assets equal liabilities plus equity. Banks and nonfinancial entities have these items in common, but they start to differ from there. A nonfinancial company may have working capital, intangible assets, accounts payable, research and design, whereas a bank would not have these items but instead have deposits, loans, and property.
Furthermore, banks are held to many regulatory requirements, which alter the nature of their balance sheet. Banks are meant to keep reserve requirements; a percentage of their deposits that are unencumbered overnight. The Federal Reserve sets the amount of reserve requirements. Banks with deposits over $127.5 million have to maintain a reserve of 10% while banks with reserves between $16.9 million and $127.5 million have to maintain reserves of 3%.
After the financial recession of 2008, the Basel Committee enacted the Basel III accords, an update to certain regulatory capital requirements that banks must meet to protect against shocks in the economy and reduce the amount of risk that banks take on. The accords stipulate minimum capital requirements, leverage ratios, and liquidity requirements that banks must meet.
Given these items, a simplified bank's balance sheet may look something like this:
|Bank Balance Sheet|
|- Purchased Securities|
|- Customer Loans|
|- Central Bank Deposits|
|- Customer Deposits|
|- Securities Sold|
|- Stockholder's Equity|
Assets and Liabilities
Loans to customers are considered assets because this is the core method in which a bank earns money. They store customer deposits, sometimes paying out a small interest rate, and then lend out a percentage of those deposits to other customers in the form of loans, charging a higher interest rate. The spread on the interest rates is where a bank earns revenue. Conversely, under liabilities, the customer deposits are not owned by the bank and have to be paid out to the customers upon request.
Purchased securities refer to the securities banks acquire in their trading business. These securities are assets and expected to increase in value, if they decrease in value, they may become trading liabilities.
The central bank deposits line item shows the amount banks store in extra funds and/or the capital that is required by law for reserve requirements. These deposits are the bank's property.
A bank's income statement contains two general categories: interest income and non-interest income. Interest income, as discussed prior, is the money earned from lending out customer deposits and the interest earned on the financing. Non-interest income encompasses all the other business activities that a bank engages in. These may include credit card fees, underwriting fees, fees from overdrawn accounts, transaction fees, and any other non-interest income that a bank earns.
A bank's income statement will also include interest expense, which is the expense related to storing customer deposits, which would be deducted from interest related revenue. Another important item on a bank's income statement is the "provisions" line item. Provisions relate to loans that have defaulted and will not be paid. This will be found in the income statement usually as "loan loss provision."
Risks to Banks
Every company has to deal with risks in its operations. Depending on the type of business, the industry, and the economic environment, risks will be different for each company. For a bank, two of the most important risks it has to deal with are interest rate risk and credit risk.
Interest Rate Risk
As mentioned, banks earn interest on the deposits they lend out as loans. The amount a bank earns as revenue depends on how much interest it can charge. Depending on the current economic environment, the interest rate environment can be beneficial or detrimental to a bank's profits. In high-interest rate environments, banks earn more on their loans whereas in low-interest rate environments, they will earn less.
The interest rate environment can also impact non-interest earning areas of a bank's business. In a high-interest rate environment, consumers may not wish to purchase homes as they would be paying higher rates of interest on their mortgage. As such, demands for mortgages will decrease and any non-interest income, such as mortgage-related fees, will decrease as well.
Credit risk arises when a bank makes a loan to an individual or company. The risk is that the borrower may default and not be able to pay the loan back. Banks perform a thorough analysis of a borrower before making a loan to mitigate credit risk, yet, unforeseen defaults still occur. A default results in losses for a bank, though they do set aside reserves to meet these losses.
The Bottom Line
Banks operate differently than nonfinancial companies. They have contrasting business models, goals, revenue sources, and risks. These differences are reflected on their financial statements, mainly on their balance sheet and income statement. Understanding these line items is important in analyzing the performance of a bank and its risk management capabilities.