The first half of 2023 brought a challenging financial environment. UMB continues to have strong financials despite this, but the media coverage and perception of the industry might cause some to wonder, “Is my money safe?” and, maybe more importantly, “How do I know if my bank is doing well?”
There is one document that can help answer this question and that is a balance sheet. You likely keep track of your money, noting how it comes and goes and how much you own and owe to keep a total picture of your financial health. All banks do this, too, as it is one cornerstone of banking.
Similar to how you manage your own finances, a bank keeps track of all its assets, as well as the money it is owed. But do you know how to access and analyze this information? As a customer, it is important to understand a bank’s balance sheet and how it might affect you – or provide you peace of mind about your banking partner.
How banks work
Banks are where you keep your money, receive credit opportunities or invest, but that is just scratching the surface of how banks operate and thrive. Banking is built on four pillars:
- Prudential supervision
- Access to lender of last resort
In this article, we focus on the first three pillars.
You may be surprised to learn that your money doesn’t actually sit in the bank vault once you deposit it. Instead, banks use that money to provide credit to other people and businesses that are looking to borrow money. Banks then make money by charging interest on those loans, at a higher rate than what is paid on customer deposits.
In the U.S., banks are required to keep adequate liquidity to fund loan originations and deposit withdrawals, but the majority of their assets are typically held in loans. This is the business of banking and covers the lending pillar mentioned above.
To ensure the offered loans will be paid back and earn the bank its interest –critical to the stability of the bank – bankers typically have checkpoints and requirements in place before making a loan.
Lenders look for:
- Safety – Has this person or institution proven they are capable of paying back a loan?
- Liquidity – Does the bank have enough liquid funds available to provide this loan?
- Diversification – Are loans being made to different types of companies and organizations to spread out money and risk amongst different industries?
- Profit potential – Can this potential loan provide an acceptable profit to the bank?
Once loans are made, it’s time to track, monitor and report on these transactions to ensure the coming and going of money is balanced and profitable. Prudential supervision includes the legal guidelines a bank must follow to help ensure the financial safety and stability of the bank and the broader financial system. This is where a bank’s balance sheet comes into play. The assets and liabilities on a balance sheet help drive the level of a bank’s income.
A bank is overseen and regulated by one or more regulatory organizations, including the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC) or the Federal Reserve – all of which work to protect depositors. These agencies examine banks regularly to make sure they are operating in a safe and sound manner.
Balance sheet breakdown
A balance sheet is made up of three main components: assets, liabilities and shareholder equity.
- Assets include everything the bank owns or is owed. This includes physical cash in the bank’s vaults, government bonds, and various financial products, but also items like bank buildings and computers. This category includes the loans that people owe to the bank.
This is a key difference between banks and other industries. For corporations, a loan would be considered a liability, something they owe to a bank or other entity. For a bank, a loan is an asset, because it is a contractual obligation or a promise by a company to pay the loan back to the bank. In short, loans you owe to someone else are considered liabilities, and loans someone owes to you are considered assets.
- Liabilities are what the banks owe to others, including the money consumers and businesses deposit into their accounts.
- Shareholder equity is the difference between the assets and liabilities. Essentially, this is what is left for the shareholders –or owners – of the bank if all assets were sold and used to pay off the bank’s liabilities. Equity also provides a type of safety net for depositors in the event loans are not repaid as agreed.
The second pillar is a bank’s deposit accounts. Deposits held by a bank may be insured or uninsured. And some uninsured deposits are collateralized, which we’ll explain in a moment.
An insured deposit is the amount of funds in an account under the FDIC limit ($250,000) and is thus insured by the FDIC. This covers most typical consumer deposit accounts. Banks that work with larger companies, institutions or municipalities often deal with balances above that limit, as these organizations are holding much larger sums of money than an individual or family would. In the case of deposits belonging to municipalities, which are generally local and state governments, and certain trust deposits, banks must pledge high-quality bonds as collateral to secure these funds.
For UMB, there are robust internal processes, people and systems dedicated to daily collateral management, monitoring and reporting. It is a very tightly controlled process.
Positive equity (otherwise known as capital) for a bank indicates that its assets are worth more than its liabilities and capital is above the required levels. Banks are required by regulation to maintain minimum levels of capital, which we cover below. Almost all banks hold enough capital to ensure they meet the definition of “well-capitalized”.
Reading a bank’s balance sheet
You can typically find your bank’s balance sheet on its website, usually in the investor relations section for a publicly-traded bank like UMB. You can also visit the FDIC website and find a quarterly report for any bank. These are known as call reports, and the analysis section is accessible to anyone.
The call report is the most consumer-friendly piece of information from a bank, but keep in mind this report does not have the context or detail of some other documents banks prepare.
If there is something specific you are looking for, you can always call your bank and ask for it. If a bank is publicly traded, you can look at their Forms 10Q or 10K, which are filed with the Securities and Exchange Commission, or the “SEC”.
Publicly traded banks may also create a quarterly earnings presentation for investors. All public and private banks should have a financial audit once a year with an outside auditor.
A few things you may want to look for on your bank’s financial statements to ensure stability include:
- Capital ratios – These are measures of a bank’s capital to certain assets, called risk-weighted assets. These ratios exist to ensure banks don’t take on excess leverage and are able to gather capital when needed. These ratios are heavily impacted by the liability side of the balance sheet and are a good indicator of a bank’s safety and stability. Banks must meet regulations related to capital levels and being above those required levels is a good sign.
According to the Federal Reserve, to be well-capitalized a bank must have:
- A tier 1 leverage ratio‡ (tier 1 capital/total assets) of 5%OR
- A tier 1 risk-based ratio (tier 1 capital/risk-weighted assets) of 6%OR
- A total risk-based capital ratio (tier 1 + tier 2 capital/risk-weighted assets) of 10%.1
- Non-performing assets and historical charge offs – This is the list of loans or accounts that are no longer performing because payments have been missed for an extended period or have been charged off as a loss to the bank. You want these to be low, as they are a good indicator of a bank’s quality of lending.
- Credit loss history – Check out your bank’s credit loss history, which is made available in their financial information listed above. This lets you see how the bank collects unpaid debts. It can also cover things like non-conventional loans or other riskier offerings.
While you check your bank’s balance sheet, be sure to regularly review your bank’s income statement as well to see how much money it is making.
As for how often you should be looking into your bank, financial information is made available on a quarterly basis. However, if you are a depositor with under $250,000 in your accounts, an annual review is a good rule of thumb.
Simplifying the complex: business of banking explained
While this may seem complicated, a simple way to look at the business of banking is that banks were created to serve their communities by offering credit. This credit helps communities and the people in them thrive. Properly managing how money comes and goes in this way is what makes the modern world function. All banks function together as parts of the larger banking system. So, the next time you go to the bank to withdraw or deposit money, realize that your transaction is simply one piece of the health of your bank and the financial system as a whole.
Understanding the larger picture of the role your money plays in the banking system is one step toward protecting yourself and your financial future.
To view UMB’s latest balance sheet, click here.
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This material is provided for informational purposes only and contains no investment advice or recommendations to buy or sell any specific securities or engage in any specific investment strategy. Statements in the presentation are based on the opinions of the author and are subject to change at any time without notice. You should not use this presentation as a substitute for your own judgment, and you should consult the appropriate financial professional before making any tax, legal, financial planning or investment decisions.