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An Introduction to Banks: The Balance Sheet

Warren Buffett (Trades, Portfolio) has been bullish on U.S. banks recently. Should you share his optimism? Well, that depends on whether you are able to effectively analyze bank stocks, and this in turn requires knowledge of how banks report their finances. Over the course of the next few articles, I will provide readers with an introduction to banks, starting with the balance sheet.

Assets

Like any company, a bank has assets and liabilities on its balance sheet. However, unlike most other companies, banks typically don't have items like inventories or receivables. Let's first look at what typically comprises the assets held by a bank.

Loans. Traditionally, a bank's primary function is to loan out money to borrowers and to charge interest. In most cases, loans will represent the majority of a bank's assets. Investors generally want to see sustained loan growth, particularly in the case of a smaller bank. Lending money is by definition a risky business. Inevitably, some borrowers will default on their loans. For this reason, investors like to look at the percentage of non-performing loans (NPLs) on the balance sheet. These are usually defined as loans that have been in default for more than 90 days.

Securities. Most banks like to make money by issuing loans, but in instances when they deem it impossible or unprofitable to do so they like to purchase income-generating securities. Typically, U.S. banks will purchase U.S. government debt in the form of Treasury bills, notes and bonds. These investments are extremely low risk, so the bank can be assured of a constant stream of payments. However, banks may also hold riskier securities on their books, either for their clients, or for themselves.

Reserves. This is cash that the bank currently holds. Unlike loans or securities, cash does not generate any interest. Banks need to hold reserves, either at their own locations, or at the relevant central bank -- they need to fulfill "reserve requirements." A bank needs adequate reserves to prevent a "run" -- a situation where depositors rush to withdraw their money all at once because they are worried about liquidity.

Liabilities and net worth

Deposits. When a customer deposits cash into their bank account, the bank must record it as a liability, since they have an obligation to return the money to the customer.

Debt. Although they are in the business of lending money, banks themselves often require loans to function. Accordingly, they must record any loans they have taken out as liabilities, similarly to any other business.

Net worth. Net worth is defined as a bank's total assets minus its total liabilities; in other words, it is the equity of the bank. It is also often called the "bank capital." You may have heard about "capital requirements" and wondered about how they differ from the "reserve requirements" we talked about above. Capital requirements exist to cover losses, whereas reserve requirements exist to protect the banks from runs. If a bank loses money on a securities investment, or on a bad loan, that non-performing asset needs to be covered by something. It can't be covered by existing deposits or debt (as they fund existing assets) -- it can only come from the existing equity. In other words, equity is loss-absorbing. Banks need to have adequate capital in order to stay solvent in tough times.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.