3 Balance Sheets of Banks and Insurance Companies

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1 3 Balance Sheets of Banks and Insurance Companies As was shown in Chapter 2, banks and insurance companies have quite different business models. What they have in common is that they both fulfil very important social functions and the business they do with customers is reflected at the liability side of their balance sheets. This contrasts with regular (non-financial) business models, which are purely asset driven. This means that customers want to do business with nonfinancial companies because of their abilities and (value added) outputs that are reflected at the asset side of their balance sheets. As an example, Philips produces light bulbs which are held in stock and appear at the asset side of the balance sheet. When a customer buys a light bulb, this reduces the balance sheet item light bulbs in stock and increases the item cash or debtors. Light bulbs in stock, cash, or debtors are all items that show up at the asset side of Philips balance sheet. The above shows that client activity of non-financial companies takes place at the asset side of the balance sheet, whereas client activity for financial companies occurs, at least for a substantial part, at the liability side of the balance sheet. In other words, customers of non-financial companies are typically debtors (i.e. the customer owes the non-financial company money), whereas a substantial part of the customer base of a financial company has a creditor relationship (i.e. the financial company owes the customer money). This means that a customer puts significant faith in a financial company as he is willing to store money with the expectation of receiving it back at a later stage. The way this works out in the balance sheet of a bank or insurance company is discussed in sections 3.1 and 3.2 respectively. 3.1 BANK BALANCE SHEET It has already been mentioned that, generally, the balance sheet of a bank is either liability driven or asset driven. An asset-driven balance

2 16 Bank and Insurance Capital Management sheet is less common for retail banks, but more common for investment banks. When a balance sheet is liability driven, client activity at the liability side drives the structure and size of the balance sheet. For example, the balance sheet of a savings bank is liability driven. For asset-driven balance sheets the opposite holds. In other words, client activity at the asset side determines the structure and size of the balance sheet. A consumer finance bank and an investment bank have both an asset-driven balance sheet. However, almost all banks, even investment banks and consumer finance banks, have some client activity taking place at the liability side of the balance sheet. There are several different bank business models with either asset-driven or liability-driven balance sheets. Nevertheless, the general balance sheet structure is similar, because banks have sought to diversify themselves at both the asset and liability sides of the balance sheet. A general bank balance sheet structure is displayed in Figure 3.1, and almost every bank has its balance sheet components displayed in this manner. Even an investment bank will typically have some deposits. Indeed, investment banks tend to sell structured products (e.g. reverse convertibles) to high-net-worth individuals. However, Figure 3.1 gives only a high-level impression of a bank balance sheet. If one looks at the balance sheet of a specific bank company one can provide a deeper level of granularity. For example, one can split up lending into corporate lending, mortgage lending, consumer lending; with respect to deposits, one can distinguish between term deposits, savings and checking accounts. Figure 3.1 only displays the high-level structure of the balance sheet of a bank. Generally, it helps to segment the balance sheet, which will be discussed in section At a bank, client activity either takes place at the liability side, in which case it is a type of deposit, or at the asset side, in which case it will be related to lending. There are some exceptions, however, such as derivatives. Investment banks sell or buy derivatives from their clients. This is not directly related to either lending or deposits, as derivatives can best be compared with insurance. A long derivative position is accounted for on the asset side of a balance sheet, while a short derivative position is reflected on the liability side. It has been mentioned above that one of the functions of a bank is maturity transformation. This means that money with a short duration (e.g. savings that can be withdrawn on demand) is transformed into money with a long duration through lending (e.g. mortgages). By doing

3 Balance Sheets of Banks and Insurance Companies 17 Shareholder s equity Intangible assets Subordinated debt Investments Wholesale funding Lending Deposits = client activity = Focus of capital management Figure 3.1 Bank balance sheet structure. this, banks have an unfavourable liquidity position in the sense that they cannot access the money they have lent to customers (mortgages cannot be repaid on demand), but, at the same time, the money that they owe to customers (e.g. savings) can be withdrawn by the customers on demand. Banks have to manage this inherent liquidity mismatch. Intangible assets can comprise a significant component of a bank s balance sheet and can easily be overlooked. Goodwill is one of the main examples of an intangible asset. Furthermore, although not officially

4 18 Bank and Insurance Capital Management an intangible asset, the item deferred tax assets is an asset whose realization depends on future profitability. 1 Since goodwill is crucial in determining the capital position of a financial institution and plays an important role in takeovers, it will be elaborated on in section 3.3. If a financial institution has deferred tax assets on its balance sheet, it is in a loss carry forward position. This means that the financial institution has suffered losses in previous years and is allowed to deduct these losses from potential future gains; in this respect, the financial institution is compensated from a tax perspective. In other words, deferred tax assets allow a company to subdue its future tax burden. It is important to emphasize that, in order to decrease its tax burden, deferred tax assets can only (partially) be released if the financial institution posts a profit. The focus of this book is on capital. Capital comprises both shareholders equity as well as different qualities of subordinated debt. This also holds true for an insurance company. Contrary to a non-financial company, a bank s capital position cannot be seen as a means of acquiring the necessary assets to do business. A bank s capital position serves as a buffer to absorb losses that might materialize as a result of the risks that a bank runs. How this works exactly is discussed from Part II onwards. There is an easy link between the profit and loss (P&L) statement and the balance sheet of a company. Profits and losses are reflected on the balance sheet as retained earnings and are part of shareholders equity. In other words, if a financial institution posts a profit of $1 billion, its shareholders equity increases by the same amount. This is quite logical as shareholders equity should represent the value that shareholders have a claim on. As a rule of thumb, one can say that the change in shareholders equity is a result of profits. However, there are exceptions that can become quite material and make the management of capital more difficult. These exceptions are discussed throughout the book and are mainly related to asymmetries in IFRS accounting legislation. 3.2 INSURANCE BALANCE SHEET The balance sheet structure of an insurance company shows similarities with that of a bank. The biggest difference is that the balance sheet of an insurance company is completely liability driven; in other words, client activity of an insurance company does not take place at the asset side of 1 Deferred tax assets are deferred claims on tax authorities instead of intangibles.

5 Balance Sheets of Banks and Insurance Companies 19 Shareholder s equity Subordinated debt Intangible assets Wholesale funding Investments Technical provisions = client activity = Focus of capital management Figure 3.2 Balance sheet structure of an insurance company. the balance sheet. The balance sheet structure of an insurance company is laid out in Figure 3.2. When comparing the balance sheet structure of an insurance company (Figure 3.2) to that of a bank (Figure 3.1), there are two striking differences. 1. Contrary to a bank, an insurance company does not lend money to customers and therefore has almost no client activity at the asset side of the balance sheet.

6 20 Bank and Insurance Capital Management 2. An insurance company has technical provisions as a balance sheet item, where a bank has deposits. What deposits are for banks is what technical provisions are for insurance companies. They both show up at the liability side of the balance sheet, and they both represent the amounts that a bank, respectively insurance company, are indebted to customers. Deposits are a bit more straightforward than technical provisions, as they are nothing more than the nominal amount that a customer has deposited at a bank, and a customer is at any time entitled to this nominal amount. Technical provisions however, are a best estimate of the net present value of future claims minus the net present value of future premiums. Intangible assets might even play a larger role in the insurance industry than in banking. The reason being that, aside from goodwill and deferred tax assets, 2 there is a significant insurance-specific balance sheet item, namely deferred acquisition costs (DACs). 3 This intangible asset arises because an insurance company tends to make considerable up front costs (e.g. marketing, administration) when it sells an insurance product, especially for life insurance. Instead of charging these costs to the customer at inception of the insurance contract, an insurance company can spread these costs over the life of the product by taking them into account in the premium. Hence, accounting allows for the booking of an asset, deferred acquisition costs, so that the up-front costs do not have to be taken as a loss at once, but can be amortized over the life of the product. This works well, as long as future premiums flow in as expected. However, if premiums appear to be lower than expected, the up-front costs will not be fully recovered and the insurance company needs to make a direct charge as a result. This is called DAC unlocking. It can, for example, occur if the premium of an insurance product is a fixed percentage of an equity index that has dropped in value significantly. 3.3 GOODWILL Goodwill is an asset that is activated if the takeover price exceeds the net asset book value of the company. The net asset book value is nothing more than the value of assets minus the value of liabilities of 2 Deferred tax assets (DTAs) are officially not intangible assets as they represent a deferred claim. 3 Like deferred tax assets, DACs are not officially intangible assets as they are a deferred claim on the future premiums.

7 Balance Sheets of Banks and Insurance Companies 21 the company, which should be equivalent to shareholders equity. This increment between takeover price and net asset book value is called goodwill. Goodwill shows up as an asset on the balance sheet and is typically subject to an impairment test. An impairment test means that one tests whether it is still realistic to assume that goodwill will be earned back in the future. Indeed, before goodwill can be booked as an asset, the company has to justify this by showing it can earn back the goodwill by means of synergies, economies of scale, or any other means. If this is no longer realistic, the company has to take an impairment loss, which is equal to that part of goodwill that the company is no longer able to recoup. Since goodwill can be a substantial portion of the balance sheet of a financial institution, it is important to understand how goodwill occurs in practice, and it is particularly relevant to understand the accounting bookings that result in goodwill. Goodwill is discussed in this section Bank A ($100 billion) Net asset book value ($10 billion) ($90 billion) ($108.5 billion) Bank A Net asset book value ($10 billion) ($10 billion) Bank B Net asset book value ($1 billion) Goodwill ($0.5 billion) ($99 billion) ($9 billion) = subject of takeover Figure 3.3 Goodwill accounting.

8 22 Bank and Insurance Capital Management and is explained by means of an example as it is a determinant for the capital position and valuation of a financial institution. Consider bank A with a total balance sheet of $100 billion and a net asset book value of $10 billion. Bank B has a total balance sheet of $10 billion and a net asset book value $1 billion. Suppose bank A acquires bank B for $1.5 billion in cash. In this case, goodwill amounts to $0.5 billion. The question is, how is goodwill accounted for on the balance sheet of the combination of banks A and B, bank A? First of all, it is important to note that bank A acquires all the assets and liabilities of bank B. Because bank B has a net asset book value of $1 billion, the acquisition involves $10 billion worth of assets, but only $9billion worth of liabilities. The compensation for shareholders of bank B is $1.5 billion. Hence, a $0.5 billion premium is paid over and above the $1 billion net asset book value. The balance sheets of banks A and B and of the combination, bank A, are displayed in Figure 3.3. As one can see from the figure, the changes in the liability side, as a result of the takeover, are quite straightforward. The total amount of capital remains at $10 billion. This is quite obvious as the only way that the capital position can change is through profits or by means of an outside capital injection (e.g. rights issue). The liabilities increase by $9 billion, which is equal to the total amount of liabilities of bank B. The total value of the liability side of the balance sheet of bank A is thus equal to $109 billion. The changes to the asset side of bank A, as a result of the takeover, are a bit more complex. First of all, assets decrease by $1.5 billion as this is what bank A has to payout in cash to finance the takeover. Then, under the terms of the takeover, bank A receives ownership of the $10 billion assets of bank B. Hence, the assets of bank A, as a result of the takeover of bank B, increase to $108.5 billion. Since the liability side and asset side of bank A need to match, the incremental $0.5 billion is booked as goodwill.