This is a continuation from the previous post of How to Analyse Banking Stocks (Part 1). We have covered very briefly on the background context of how the banking system works and the individual line items in the P/L statement. In this series, we would go on to the balance sheet to get a deeper dive into what kind of assets and liabilities a bank usually owns or owes.
These are the line items found under DBS’s assets of the balance sheet.
Cash & Balances with Central Banks
The first item would be cash and balances with central banks. The total amount of cash DBS has is $22.1 billion. But the important thing to highlight is that NOT ALL the $22.1 billion is available for use. $7.9 billion are restricted balances with central banks. This tie in with the concept we have discussed in part 1 on Minimum Cash Balance (MCB).
Recall that a bank has the legal right to lend out a big portion of your money as long as it keeps a minimum cash reserve? Under MAS regulatory guidelines, that figure is 3% and 3% of total deposits from customers get stored separately with MAS. This is otherwise known as the “reserve money” in the quantity-based monetary economy. Hence, you can see that the highlighted wordings are “restricted mandatory balances with central banks”. It is money that can’t be touched under any circumstances and it is reserve money that is stored in the accounts of MAS.
Government Securities & Treasury Bills
The second item up the list is government securities and treasury bills. These are the Singapore Government Bonds (SGSs) issued by MAS. A government bond is nothing but an IOU promising to pay you back the principal + interest. It is backed by NOTHING except the full credit faith of the government. They would use the proceeds to engage in deficit spending on public works and infrastructure projects. This is to stimulate spending and spur the economic growth of a nation. Remember from part 1 that a person’s spending is equivalent to a person’s income and the cycle goes on. Government bonds are a nation’s debt and it is paid back through the next generation of taxpayer’s money.
Fortunately, Singapore doesn’t issue bonds to fund deficit spending. This is because they are in a net budget surplus position. The original intent of government bonds is to provide liquidity for banks so as to meet their minimum liquid asset requirements. A highly liquid bond market provides stability for our financial system and this allows Singapore to flourish as an international debt centre.
Liquidity Risk Management: LCR & NSFR
What does it mean by using SGS to provide financial stability for our banking system? Due to the banking failures in 2008/2009, the Basel lll committee has introduced 2 liquidity measures known as the:
- Liquidity Coverage Ratio (LCR)
- Net Stable Funding Ratio (NSFR)
LCR is implemented to promote short-term resilience of banks to survive a short-term stress scenario of 30 days. The formula for LCR is as shown above. It means that banks MUST have sufficient liquid assets that can be converted immediately into cash to meet the estimated demands of total net withdrawals within the next 30 days.
A period of 30 days is chosen because it gives sufficient buffer time for the government and central banks to step in and rectify the issue. The worst case last resort solution is a bank bailout; saving the banks using taxpayer’s hard-earned money. Singapore government bonds are qualified as liquid assets and thus the action of commercial banks buying up SGSs is to meet the LCR regulatory requirements. Another reason is simply to earn a risk-free interest income on government bonds.
NSFR is more complicated and I still do not have a clear understanding of how it works yet. While LCR protects the liquidity risks from a short-term outlook, NSFR is implemented to promote the resilience of banks over a longer-term horizon. My take is that NSFR is used to balance and match the maturity of funding with the maturity of assets. Short-term liability to fund short-term assets and long-term liability to fund long-term assets. Not too sure about that. If you have read and understood what NSFR is, do comment and share your thoughts below!
Due From Banks, Reverse Repurchase Agreements (Reverse Repos)
The third item is the amount due from banks. This is a reverse purchase agreement or Reverse Repo. A reverse repo is likened to a forward agreement. As mentioned in part 1, some banks have more deposits while other banks have more withdrawals. Banks that have more deposits would have a surplus of cash buildup and banks that have more withdrawals would have a lack of cash in its account. To meet the regulatory reserve requirements or MCB, banks with surplus money would lend their excess money to banks with a lack of money. A repurchase agreement is another form of method to facilitate this transaction.
To be more precise, banks with a lack of money SELLS their government securities to banks that have excess money. Additionally, there would be a contractual agreement from the seller to BUY back the government securities at a premium. This mark-up premium is equivalent to the principal + interest rate of the government securities. In this way, the bank with a lack of cash can meet its regulatory liquidity requirement and the bank with the excess cash can make a risk-free return on its surpluses.
DBS has $40.1 billion on “Due From Bank”. This simply means that other banks who need short-term capital have sold their government securities to DBS with the contractual promise to repurchase them back at a higher price. The fair value amount of these government securities is $40.1 billion and this is computed using the effective interest rate model. Unlike other businesses where there might be a risk of account receivables turning delinquent, banks face less risk as these receivables are backed by collaterals. If the counterparty banks failed to repurchase the government securities, the bank can simply sell off the government bonds to the market at its fair value.
Loans & Advances to Customers
Moving down the line, we have derivatives, bank & corporate securities and loans and advances to customers. I would probably skip derivatives as there are all sorts of derivative instruments that would take more than one post to fully explain them. Bank & corporate securities are simply debt securities such as bonds that are being issued out by the company.
Loans and advances to customers are the core essence of fractional reserve banking. This is where the main bulk of interest income comes from, this is where credit money is being created out of thin air and this is what drove our economy to flourish and bubbles up. Using the above diagram, you can see how the initial $10,000 deposit has sprung into a gross loan of $24,390 ($9,000 + $8,100 + $7,290) that is being circulated in the economy.
DBS’s Gross Loans to Customers is $349 billion. But we also have to make an allowance on the credit loss based on the ECL model. Net loan after accounting for non-performing loans is $345 billion. There is also a breakdown of all the different types of loans by product category. (Long-term, Short-term, Housing, Trade)
Is Credit Money Good or Bad?
Gross loans can be an indicator of whether the economy is expanding or contracting. If gross loans are increasing, more people are taking up loans, businesses are expanding, and more spending = more income. On the contrary, if you see gross loans decreasing, it is probably due to the effect of monetary policy to cool down the economy. The 3 methods include increasing interest rates, increasing MCB or selling government bonds. Either of these monetary policy tools would reduce the money supply and gross loans would fall as banks have less money.
Loans are good, provided that it leads to increased productivity and income. Without credit money, businesses wouldn’t expand that fast, development of infrastructure would be slower, the standard of living drops, there are lesser jobs going around, economic growth slows down and we wouldn’t be able to enjoy the material things in life. Imagine having to buy a car with $150,000 in your bank account, or property with $500,000 in your bank account. It would definitely take decades for you to earn that sum of money before enjoying the wealth. However, loans become bad when it turns into greed. When too much debt is being taken up and the rise in income can’t keep up with the rise in debt servicing costs, that is when shit happens. Like a domino effect.
The following line items such as other assets, associates, subsidiaries, PPEs, Goodwill & Intangibles are beyond the scope of this post. The reason is to keep this article focused on banking related terminologies and concepts.
These are the line items found in DBS’s Liabilities of the balance sheet.
Due To Banks, Repurchase Agreements (Repos)
First up on the list, Due to Banks. This is familiar isn’t it? We see a similar item like this under the assets of the balance sheet. As mentioned earlier, the purpose of repurchase agreements or Repos is to raise short-term capital either for lending or to meet liquidity requirements.
If we see a “Due to Banks” line item under the liability section, it means that DBS sold some form of collaterals (government securities) to some other banks for some short-term capital WITH the contractual promise to repurchase them back at a higher price at a later date.
Repurchase Agreements between Central Banks
Do take note that Repos and Reverse Repos do not just occur between banks to banks. It can also occur between banks and MAS to control the money supply. As mentioned in part 1, MAS can control the money supply of the economy by buying up government bonds (injecting liquidity) or selling government bonds (withdrawing liquidity). Below is a diagram of how it works.
If the economy is heating up, credit bubbles are going up, MAS will sell its government bonds (SGS) to banks WITH the promise to buy them back at a later date. The money supply would flow from Banks to MAS and less paper money would be circulating in the economy. That is why you see “SGS holdings” with the down arrow and “Loan of SGS under repo” with the up arrow under the asset column of MAS.
In a Repo agreement, MAS would repay the banks on a future maturity date after the economy has cooled off and stabilised. At repayment date, it would buy back SGS bonds, thus injecting money into the banks and increase the money supply circulating in the economy. That’s how repo works and it’s one of the monetary tools that the central bank use to control the money supply.
Deposits & Balances from Customers
The 2nd item up the list is deposits and balances from customers. This is the sum total of ALL the deposits that you and I have deposited in the accounts of DBS. It is a liability because every fiat money we hold in our wallet is just an IOU. When our bank statement shows that we have $20,000, it simply means that the bank owes you $20,000. When you make a withdrawal from the ATM, the bank has to return you the money with no questions asked.
It is also a liability because the bank has to pay you interest when you deposit money with them. Depending on whether you deposited money on the current accounts, savings account, fixed deposits or whatever savings programme such as DBS Multiplier, the bank has to pay you interest expense. It’s just that they pay you at a different interest rate. Usually the more money you deposit with them, the higher the interest rate they will pay you. This is because the more money you deposit, the more money they can lend out and the more interest income they can earn.
We can actually calculate the average interest rate that the bank pays by taking interest expense divided by total deposits and balances from customers. Interest expense is found on the P/L statement and it is $4,843. Total deposits and balances from customers are $393,785. 4,843 divided by 393,785 is = 1.23%. This is just a simple rough estimate.
Different Types of Debt Securities (CDs & MTNs)
Moving down the line, we have derivatives, other liabilities and other debt securities. Again, we will skip derivatives as these are the forwards, swaps, futures and options. Other liabilities are accrued interest payables, deferred tax liabilities etc. We shall skip all these minor details. Other debt securities include things like certificate of deposits and medium-term notes.
Certificate of Deposits (CDs) simply means that when you deposit money with the bank, you are restricted from withdrawing them until a certain maturity date. Between this period till maturity, the bank pays you interest for depositing money with them. Unlike normal deposits where you can withdraw at any point in time, CDs provide banks with the assurance that the money doesn’t flow out. Because the depositor is restricted from withdrawing money out from the bank over a period of time, the interest rate for CDs is usually higher than ordinary deposits.
Medium-term notes are just medium-term bonds, with a slight difference. Bonds are usually repaid one lump sum at the maturity date. Medium-term notes on the other can be issued from time to time with the added flexibility to tailor the amount and maturity term. Let’s use one recent example to have a clearer understanding of how MTN works. This news came out on 19 April 2019.
DBS has a global medium-term note programme that is US$30 billion in size. This US$30 billion is split out into different tranches of different amount and different maturity date. This provides investors with the option to invest in MTNs that suit their time-frame. The recent news announced that DBS priced a US$750 (which is part of this US$30 billion programme) due 2022 at 2.85%. The proceeds would be used for some general purposes and financing activities for DBS. The time frame is around 3-4 years. That’s why its called medium-term note.
The advantage of medium-term notes is that DBS does not have to repay the full principal of US$30 billion at one go. It can decide to issue $500 million, $750 million, $1 billion at different periods and it can choose the maturity time frame as well as the currency of the MTNs. It provides a lot more flexibility and it is less of a hassle when compared to issuing a bond.
You can actually see the breakdown of ALL the Certificate of Deposits and Medium-Term Notes. They fall under liabilities because the bank has to pay interest for getting the money from depositors and investors.
Subordinated Term Debts
The last item on the list is subordinated term debts. Subordinated term debt is a junior debt that receives a lower priority in comparison to senior debt holders. Usually, when a company goes bankrupt, it would undergo a liquidation process by selling off its assets. All the proceeds would be used to repay all senior debt holders FIRST followed by junior debt holders and finally common shareholders. In return for a lower priority ranking with regards to claim on assets and earnings, subordinated term debts usually pay a higher interest rate as compared to senior debt securities. Subordinated term debts are classified as tier-2 capital in calculating the CAR ratio.
Alright, that’s just some examples of debt securities that a bank has in its balance sheet. You might have realised by now that banks do not solely rely on customer deposits as their primary source of capital funding. They have a whole lot of regulatory requirements to comply with and it is important that banks have sufficient liquidity to absorb temporarily losses. As a result, banks usually tap into the capital markets and issue a whole lot of different debt securities as shown above.
I would probably just combine all the line items into 1 discussion since equity is fairly short. Share cap is just money raised from shareholders in exchange for the issuance of DBS shares. It is made up of ordinary shares and treasury shares. Treasury shares are share buybacks from the open market by the issuer. The effect of this would reduce the share cap as the number of outstanding shares in the market would be reduced.
Other equity instruments are perpetual securities that are classified as additional tier-1 capital. This is relevant when we are calculating CAR ratio. Perpetual securities receive a higher priority over common shareholders but they still rank below debt holders, be it subordinated junior or senior debt. The lower the priority ranking, the higher the interest rate banks would pay you. This is to compensate for the additional risk that is being undertaken.
Lastly, there are many categories of reserves. It can be retained earnings, revaluation of bonds and equities that goes into revaluation reserves, capital reserves or general reserves. Most of the line items in equity are classified as tier-1 capital because they are derived from the core earnings.
We have covered quite a bit of stuff going through the entire balance sheet. Under assets, we know that a portion of cash is restricted and they have to be kept with MAS under the regulatory MCB requirement. Next, banks buy government bonds to provide safe buffer liquidity which is measured using the LCR & NSFR. We also touched on Repos and Reverse Repos and how they work. Lastly, we get to see where interest income is derived from which is the gross loans to customers. Loans are good when the borrowed money translates to increased productivity income. Loans become bad when greed overtakes human nature and the rise of income fails to keep up with the rise of debt servicing costs.
Under liabilities, we see how Repos doesn’t just occur between banks but also between the banks and central bank (MAS) to control the money supply in our economy. Next, we covered why total deposits and balances from customers is a liability to the bank because money is just an IOU. We also know that banks do not just rely on customer deposits but also a whole string of other debt instruments in the capital market. We touched on how Certificate of Deposits (CDs) and Medium-Term Notes work with the most recent news by DBS. Lastly, we have a better understanding of what subordinated debts are. Equities are just equities. The only thing we know of is most tier-1 capital comes from Equities.
In closing, we have gone through the line items of the income statement as well as the individual line items of the balance sheet. This is definitely not a complete guide to everything about banks. I am sure there are a whole lot of other metrics and banking concepts out there. But this series on analysing banking stocks is just to provide a brief background overview, context, and familiarity when reading a bank’s financial statement. I am not a banker by profession and the things I wrote are based on my own research and readings. It might not be entirely accurate, but it is my hope that this series of analysing banking stocks have benefited you in understanding how the banking system works.