RH (Ch. 5); Handout and Notes Theory and Concepts:

Concept Check: 5.4, 5.5, 5.7, 5.10, 5.11, 5.16 Answers:
5-4. What are the essential differences among demand deposits, savings deposits, and time deposits? Demand deposits are regular checking accounts against which a customer can write checks or make any number of personal withdrawals. Regular checking accounts do not bear interest under current U.S. law and regulation. Savings deposits bear interest (normally, they carry the lowest rate paid on bank deposits) but may be withdrawn at will (though a bank usually will reserve the right to require advance notice of a planned withdrawal). Time deposits carry a fixed maturity and the bank may impose a penalty if the customer withdraws funds before the maturity date is reached. The interest rate posted on time deposits is negotiated between the bank and its deposit customer and may be either fixed or floating. A NOW account combines features of a savings account and a checking account, while a money market deposit account encompasses transactional powers similar to a regular checking account (though usually with limitations on the number of checks or drafts that may be written against the account) but also resembles a time deposit with an interest rate fixed for a brief period (such as weekly) but then becomes changeable over longer periods to reflect current market conditions.

5-5. What are primary reserves and secondary reserves, and what are they supposed to do? Primary reserves consist of cash, including a bank's vault cash and checkable deposits held with other banks or any other funds such as reserves with the Federal Reserve that are accessible immediately to meet demands for liquidity made against the bank. Secondary reserves consist of assets that pay some interest (though usually pay returns that are much lower than earned on other assets, such as loans) but their principal feature is ready marketability. Most Secondary reserves are marketable securities such as short term government securities and private securities such as commercial paper. Both primary and secondary reserves are held to keep the bank in readiness to meet demands for cash (liquidity) from whatever source those demands may arise.
5-7. What are off-balance-sheet items and why are they important to some financial firms? Off-balance-sheet items are usually transactions that generate fee income for a bank (such as standby credit guarantees) or help hedge against risk (such as financial futures contracts). They are important as a supplement to income from loans and to help a bank reduce its exposure to interest-rate and other types of risk.

5-10. In rank order, what are the most important revenue and expense items on a Report of Income? By dollar volume in most recent years the rank order of the revenue and expense items on a bank's Report of Income is:

Rank Order Revenue Items Expense Items 1 Loan Income Deposit Interest 2 Security Income Interest on Nondeposit Borrowings 3 Service Charges on Deposits Salaries, Wages, and and Other Deposit Fees Employee Benefits 4 Other Operating Revenues Miscellaneous Expenses

5-11. What is the relationship between the provision for loan losses on a bank's Report of Income and the allowance for loan losses on its Report of Condition? Gross loans equal the total of all loans currently outstanding that are recorded on the bank's books. Net loans are equal to gross loans less any interest income on loans already collected by the bank but not yet earned and also less the allowance for loan-loss account (or bad-debt reserve).

The allowance for loan losses is built up gradually over time by an annual noncash expense item that is charged against the bank's current income, known as the Provision for Loan Losses. The dollar amount of the annual loan-loss provision plus the amount of recovered funds from any loans previously declared worthless (charged off) less any loans charged off as worthless in the current period is added to the allowance-for-loan-losses account.

If current charge-offs of worthless loans exceed the annual loan-loss provision plus any recoveries on previously charged-off loans the annual net figure becomes negative and is subtracted from the allowance-for-loan-losses account.

5-16. What are the key features or characteristics of the financial statements of banks and similar financial firms? What are the consequences of these statement features for managers of financial-service providers and for the public? The financial statements of financial-service firms exhibit three main characteristics that have important consequences for managers of these firms and the public.

The first characteristic of these firms is that they have lower operating leverage. They have small amounts of buildings, equipment and other fixed assets. Operating leverage adds risk to the firm and firms with large amount of operating leverage can face large fluctuations in net income and earnings per share for small changes in revenues.

Financial-service firms do not have this problem. However, financial service firms have large amounts of financial leverage. Financial leverage comes from how the firm finances their assets. If a firm borrows a lot, they face have larger financial leverage and have a larger amount of risk as a result. Financial service firms finance approximately 90% of their assets with debt and therefore face significant financial leverage.

Small changes in revenues can lead to large changes in net income and earnings per share as a result. In addition, changes in interest rates can have significant effects on the net income and capital position of financial firms. Finally, most of the liabilities of financial firms are short term. This means that financial firms can face significant liquidity problems. A sudden demand by depositors for funds can lead to large problems for financial firms.

Problems:
Question 1, 2, 5, 8

Question 1:
5-1. Norfolk National Bank has just submitted its Report of Condition to the FDIC. Please fill in the missing items from its statement shown below (all figures in millions of dollars):

Report of Condition
Total assets $4,000
Cash and due from Depository Institutions 90
Securities 535
Federal Funds Sold and Reverse Repurch. 45
Gross Loans and Leases 2900 2,900 * Gross Loans and Leases = Net Loans and Leases+ Loan Loss Allowance 200 Loan Loss Allowance
Net Loans and Leases 2700
Trading Account Assets 20
Bank Premises and Fixed Assets $220 220 *This is the only asset missing and so is total assets less all of the rest of the assets listed here
Other Real Estate Owned 15
Goodwill and Other Intangibles 200
All Other Assets 175
Total Liabilities and Capital 4000 4,000 *Total Liabilities and Capital = Total assets
Total Liabilities 3580 3,580 * Total Liabilities = Total Liabilities and Capital-Total Equity Capital
Total Deposits 2920 2,920 *Total Deposits = Total Liabilities Less All of the Other Liabilities
Federal Funds Purchased and Repurchase Agreements. 80
Trading Liabilities 10
Other Borrowed Funds 50
Subordinated Debt 480
All Other Liabilities 40
Total Equity Capital 420 420 Total Equity Capital = Perpetual Preferred Stock +Common Stock+Surplus+Undivided Profit
Perpetual Preferred Stock 5
Common Stock 25
Surplus 320
Undivided Profit 70

Question 2:
5-2. Along with the Report of Condition submitted above, Norfolk has also prepared a Report of Income for the FDIC. Please fill in the missing items from its statement shown below (all figures in millions of dollars): Report of Income Total Interest Income $200
Total Interest Expense $140 $140 * Total Interest Expense = Total Interest Income - Net Interest Income
Net Interest Income 60
Provision for Loan and Lease Losses 20 20 * Provision for Loan and Lease Losses = Net Interest Income + Total Noninterest Income - Total Noninterest Expense - Pretax Net Operating Income
Total Noninterest Income 100 Fiduciary Activities 20 Service Charges on Deposit Accounts 25 Trading Account Gains and Fees 25 25 * There are four areas of Total Noninterest Income and only one is missing and the total is given Additional Noninterest Income 30
Total Noninterest Expense 125 Salaries and Benefits 95 95 *There are three areas of Total Noninterest Expense and only one is missing and the total is given Premises and Equipment Expense 10 Additional Noninterest Expense 20
Pretax Net Operating Income 15
Securities Gains (Losses) 5
Applicable Income Taxes 3
Income Before Extraordinary Income 17 17 *Pretax Income Plus Security Gains Less Taxes is income before extraordinary income
Extraordinary Gains – Net 2
Net Income 19 19 * Net Income = Income Before Extraordinary Income + Extraordinary Gains – Net

Question 5:
The Sea Level Bank has Gross Loans of $800 million with an ALL account of $45 million. Two years ago the bank made a loan for $12 million to finance the Sunset Hotel. Two million dollars in principal was repaid before the borrowers defaulted on the loan. The Loan Committee at Sea Level Bank believes the hotel will sell at auction for $7 million and they want to charge off the remainder immediately. a. The dollar figure for Net Loans before the charge-off is ?

Net Loans = Gross Loans –ALL = $800 - $45 = $755

b. After the charge-off, what are the dollar figures for Gross Loans, ALL and Net Loans assuming no other transactions.

Gross Loans = $800 - $1 = $799 The gross loans now reflect the realizable value. ALL = $45 - $1 = $44 *The amount of the loan that is bad
Net Loans = $799 -$44 = $755

c. If the Mountain View Hotel sells at auction for $8 million, the bank recovers full principal on the loan.

Gross Loans = $750 - $10 = $790
ALL = $45 ALL is restored to original amount

Net Loans = $790 -$45 = $745 Question 8:
The John Wayne Bank is developing a list of off-balance-sheet items for its call report. Please fill in the missing items from its statement shown below. Using Table 5–5, describe how John Wayne compares with other banks in the same size category regarding its off-balance sheet activities.