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Bank Earnings 103: Reading Bank Balance Sheets


Changes in bank balance sheet composition are much better predictors of future earnings than current period income statements.

Minyan Peter, who has become quite popular around the 'Ville with readers and professors alike, here continues his informative series on banks. Previous entries were Bank Earnings 101 and Bank Earnings 102.

While I anticipate that most of Wall Street's attention at the end of the third quarter will be on bank earnings, for reasons I outlined in Banking 102, I strongly recommend that you focus on bank balance sheets. From experience, changes in bank balance sheet composition are much better predictors of future earnings than current period income statements.

So where do you start?

First, I would look at changes across the four different major investment/loan categories.

In investments "held for trading", I would look for a significant overall balance reduction and an upgrading in quality. Both would be indications of a reduction in overall market risk appetite and a willingness to allocate capital to "volatile" capital markets and related businesses.

In investments "held for sale", I would also look for a reduction in balances. As I mentioned in "Whispers from the Confessional", I expect that you will see many financial institutions reducing their "available for sale" assets given the decline in secondary market liquidity. Watch as to where the assets went. There should be associated disclosure if the assets were moved into portfolio. And remember that once in portfolio, the accountants make it very difficult to move them back out to "held for sale." So these moved assets will have to be funded through to maturity.

For investments "held to maturity" I would go right to the footnotes. These investments require fair market value determinations (many times subjective forecasts of future performance). Particularly for capitalized assets associated with previously securitized assets there may be changes in assumptions that drive upward or downward revisions in valuation. This quarter I would be focused on any downward valuation changes due to higher loss rates and as well as upward valuations due to lower payment rates. Both would be warning signs.

Finally, I would look at changes in the general loan category. And here, while changes in composition may be telling, the more important factor to me is how overall loan growth compares to deposit growth. If loan growth is outpacing deposit growth the institution must fill the gap through borrowings. As a general rule, borrowed money is more expensive and less "stable" than core deposits.

Associated with the loan portfolio, I would also review the loan loss allowance. Material changes in the allowance ratios (provision to charge-offs and provision to loan balances) are warning signs. So too are increases in loan portfolio delinquency statistics. Remember, credit cycles play out over a long period of time.

The final asset category I would look at is "goodwill and other intangibles". Accounting rules require writedowns of these assets when the associated earnings/cashflow no longer support the balance sheet value. When you see this, you should immediately ask "Why?"

Once I have reviewed the asset side of the balance sheet I turn to capital. And this quarter, I am focused on a couple of things.

First, what happened vis-à-vis stock buy-backs? Many banks provided buy-back projections at the end of the second quarter. Check to see if they followed through. If not, why?

Second, did the bank issue subordinated debt/preferred stock? Both are capital items. As I wrote earlier, in this market environment you wouldn't issue them unless you really needed to.

Finally, I would look at all of the capital related leverage ratios. Is leverage increasing or decreasing? And has management changed its targets for capital up or down? Rising capital targets (reduced leverage) are indicative of defensive management concerned about the future.
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