Bank balance sheets are substantially different from company balance sheets, which summarize the net assets of a company by subtracting total liabilities from total assets to arrive at total equity. Many of the differences between the assets and liabilities of banks and those of other companies lie in the ways they are recorded on balance sheets. Bank balance sheet values more generally approximate fair values and are used by bank management largely to manage interest rate risk. This is done by matching the duration of assets and liabilities, also known as Gap analysis.
A wide variety of companies collectively exhibit a great disparity in industry-specific accounting methods for preparing balance sheets. One of the main components of the asset side of a bank balance sheet is its loans. As of Dec. 31, 2012, the national average balance of net loans was 52.1 percent of total assets. Loans are critical to the growth and risk profile of the banking industry. Loan growth may also provide a strong indication of the health of the bank and the local economy.
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Real estate financing includes loans for the purpose of land development, construction, and the purchase of a home or a commercial property. There are also farm loans, automobile loans and personal loans. Bank management adjusts loan composition based on economic expectations.
Note the balances of each loan type. Certain types of loans may be more risky than others based on prevailing economic conditions. Bank management adjusts loan composition based on economic expectations.
Note the balance of the provision made for loan losses, which is generally lower than 3 percent for healthy banks. As of the end of 2012, the national average loan loss allowance was 1.12 percent.
A value-at-risk analysis on the loan portfolio may also be performed. It consists of the calculation of potential total losses generated by the loan portfolio under worst-case scenario interest rate movement.
Cash and Securities
As bank executives strive to manage interest rate risk while producing Gap reports, cash and short-term investments are used to lower total asset duration and exposure to loan default risk while increasing liquidity. Short-term investments typically consist of holdings of Treasury securities. As of Dec. 31, 2012, the national average balance of Treasury securities was 20.8 percent of total assets. Companies may also invest excess cash in Treasury securities and other instruments, but banks are generally limited to low-risk government bonds. A higher balance of cash and Treasury security investments may indicate that management is concerned about the quality of the lending environment.
Deposits and other borrowed funds form a large portion of the liability side of bank balance sheets. Other companies generally hold higher balances of accounts payable and long-term borrowings from banks. Banks compete with each other for customer deposits from individuals and businesses, and hold very little other interest-bearing debt. The net interest spread on investment income less interest paid on deposits is an important gauge of how well a bank is investing funds provided by its borrowing activities.