How to read a bank’s balance sheet (2024)

The three crucial elements in all financial analyses include:

• Liquidity: ability to meet the obligations of liquid funds.
• Solvency: credit quality and adequacy of the bank’s own resources (indebtedness).
• Profitability: ability to generate income/profit from allocated capital.

These elements have some peculiarities when applied to a financial institution given the uniqueness of the banking business.

Liquidity is usually measured as a company’s ability to pay off debts as they come due, but this does not make sense for a credit institutions as the banking business is illiquid by definition (liabilities coming due and long-term assets).

The special characteristics of banking assets and liabilities, largely financial instruments, and the large impact of default alter the traditional approach to solvency. The regulator sets solvency ratios mainly based on the quality of the bank’s own funds and also on leverage to a lesser degree.

Profitability in a credit institution is directly related to “time” and “risk”, factors that significantly affect liquidity and solvency. The risk-return trade-off is key in the banking business.

The information included in a credit institution’s balance sheet makes it possible to analyze its investment and financing structure, in both absolute values and percentages. This allows us to compare different items relevant to the assets (trading portfolio, lending, etc.) with the total assets; selected items from the liabilities (deposits, securities issued, interbank loans received) and their evolution over time or in comparison with another institution or sector average.

However, unlike non-financial companies, using traditional accounting analysis techniques for a bank balance sheet has the limitation of not being able to calculate the ratios used by the regulator to monitor a bank’s solvency, leverage, indebtedness, etc. from outside the bank using the information contained in the annual accounts. The nominator and denominator of these ratios include adjustments on items in the financial statements that can only be made with internal information.

A bank's activity is in its balance sheet

In a non-financial company, the sale of merchandise, billing for the provision of services or purchases made represent the volume of business in the year covered by the income statement. A bank’s activity, on the other hand, is included in its balance sheet as a variation in the volume of lending, in the assets, and comparing this with the variation of customer deposits or other financing instruments on the liabilities side. In retail banks, these two items represent the vast majority of their total assets and of the sum of equity and liabilities

By analyzing a balance sheet, conclusions can be drawn regarding a bank’s increase or decrease in activity and the resources employed to finance lending.

The income statement shows the financial margin or net interest margin. This margin is the derivative of activity from using funds from spending units that are capable of financing to grant loans to those in need of financing. Its value is equivalent to the difference between the products and financial costs, and institutions’ strategy is to obtain the lowest cost for others’ money and the highest income from funds lent to third parties.

The sum of the net interest margin plus the commissions for services provided is called core revenue. The fundamental difference between income from the banking business and those from providing services to clientele is that the latter do not directly affect the institution’s equity, as they are carried out by others, while the bank takes on risks (for its capital and others’ capital) for financial intermediation. Some authors feel it is appropriate to introduce loan loss provisions in the net interest margin, as provisions for non-performing or questionable loans means lower returns from lending.

It remains to be seen how the enormous changes taking place in the banking industry, and those that are yet to come, will impact the importance of these two items on the balance sheet (lending and customer deposits).

On September 13, 2016, at the presentation of the Financial Studies Foundation’s (FEF) study “Banks’ changing business model”, BBVA Research’s Ana Rubio González affirmed that credit will no longer be the driver of banks’ income, meaning that institutions “should no longer be so focused on growing and expanding their balance sheets, but on providing services that use little capital - more in line with what U.S. institutions have been doing.”

And who will take on the role of intermediation between savings and productive investment? It is now a reality that the largest European companies are replacing traditional financing from bank loans by issuing debt securities in capital markets.

Market share

We analyze the market share controlled by the analyzed institution, as well as its development over time, the degree of relative concentration in the sector and the eventual dominant positions.