ALEXANDRIA, VA (April 1, 1998) -- Yesterday, we discussed some more income statement terms with a longer detour into charge-offs. Providing for loan losses is a multi-financial statement affair. That's true for any set of events for any industry, but loan loss accounting can be especially daunting for those who are new to looking at financial services companies. On to more income statement terms.
(Interest Income on) Federal Funds Sold
These are essentially short-term and overnight loans made in the money markets. A bank sells excess reserves when it has more cash than it needs to satisfy its reserve requirements and when another bank does not have enough cash to meet its reserve requirements. A reserve requirement is a percentage of deposits, varying from 3% of certain deposits to 12% of transaction, or checkable, deposits. Below a certain level of deposits, reserve requirements can vary.
These requirements are set by the Federal Reserve (http://www.bog.frb.fed.us/), and cash used to meet the requirements does not earn interest as it is kept in the bank's own vault, at a Federal Reserve bank, or on deposit in a special checking account at another qualifying bank. Reserve requirements are a tool of monetary policy used by the Fed, and they are not changed very often. The term "reserve system" comes from the requirement that a fraction of deposits be kept on hand in cash to satisfy normal customer transaction needs and to quell potential panic-induced runs on the bank.
(Interest Income on or Interest Expense on) Repurchase Agreements
A repurchase agreement is another money market instrument that a bank has at its disposal. A repurchase agreement is an agreement from the borrower to buy back a note at its face value. The note is sold to the lender at a discount. The difference between the discounted purchase price and the price at which the note is sold back to the issuer represents the interest earned on the agreement. Banks and financial services companies operate extensively in the money markets because there is so much cash passing through these businesses on a regular basis.
Interest and Fees on Loans and Leases
Usually, this is the major component of interest income for commercial banks and savings & loans. It represents interest payments on loans and leases that a bank makes.
A bank's revenue for the purposes of calculating its efficiency ratio is comprised of interest income minus interest expense plus noninterest income.
Net revenue is comprised of the above minus its provision for loan losses or provision for credit losses.
Efficiency Ratio or Overhead Efficiency Ratio
A bank's efficiency ratio is the percentage of revenue that goes to all noninterest expenses. The ratio is calculated as noninterest expense divided into revenue. The calculation -- 1 minus the efficiency ratio -- is analogous to operating margin for manufacturing or services companies.
Cash Efficiency Ratio
Some banks identify amortization of goodwill expense and pull it out of their noninterest expense to calculate their efficiency ratio. Cash efficiency ratio is noninterest expense minus goodwill amortization expense divided into revenue.