I often try to provide alternate ways of looking at issues as a way of adding to the dialogue. Two weeks ago earnings season began and in my first article I looked at the income statement of some banks and in a subsequent article I examined the balance sheet of a bank. This week I link the income statement to the balance sheet statement using First Abu Dhabi Bank’s Q3 financials.

Banking Sector Review

Two weeks ago I looked at the first banks to report their Q3 financial performance. The main thing that I was looking at was source and quality of profits and the increase in profits. If profits came from core business, which is lending, then I considered this better quality profits. If the source of profits was due to sources that were difficult to repeat or maintain, such as operating expense efficiencies, large increases in investment or fee income, or a large decrease in the impairment charge, then I considered this lower quality profits, even though they might be important.

Last week I took a look at another bank but this time examining it from my long running worry that banks might be increasing profits by increasing their loans at a time when the return on assets for some was deteriorating. I was concerned about why some banks might be lending more in a more challenging market. Looking at the balance sheet of the bank that I reviewed, ADCB, it was clear that there was a conscious de-risking of the balance sheet by management followed by a balance sheet optimisation strategy that looked like deploying their balance sheet into stable markets.

This week I look at First Abu Dhabi Bank’s Q3 performance. I’m not trying to make an absolute judgment about performance but rather to explore ways in which to study the performance. Also, keep in mind that FAB completed its merger earlier this year and this will have one-off effects. All numbers are quarterly year on year, i.e. comparing Q3 2017 to Q3 2016.

Linking FAB’s Income Statement to the Balance Sheet

The income statement stands out with a 5% drop in net interest income. To understand this I look at the components and see that interest revenue dropped slightly by 0.8% but interest expense increased 9.85%.

What could cause such a big increase in the interest expense? Look at what generates an interest expense and we do that by going to the balance sheet. The main component of this is customer deposits, which is about flat. Looking at the other entries there are three large movements of note. Due to banks dropped 34.8%, repurchase agreements (repos) increased 16.3% and commercial paper (CP) increased 56.1%.

FAB’s Funding Structure

Let me explain what repos and CPs are. A repo is when you sell a security, usually bonds, to another party with an agreement to buy them back for a specified price at a specified time. It is a form of borrowing that is relatively low risk as the collateral is transferred to the ownership of the lender and furthermore the collateral is liquid.

Commercial paper you can think of as similar to a bond with a short tenor, so another form of borrowing. The interbank borrowing (due to banks line item) is usually low cost and extremely short tenor.

The 34.8% drop in cheap, short-term interbank funding was replaced partially with cheap repos but mostly with longer-term CPs. In absolute terms CPs increased AED 7.7 billion. Can this explain the interest expense increase of AED 130 million?

FAB’s Risk / Return Decisions

It can if CPs are more expensive than the interbank borrowings by about 1.7%. Not everything is about revenue and expense. Because commercial paper usually has a far longer tenor than interbank borrowings the bank’s funding risk has decreased. This needs to be weighed against the expense. And in this market, decreasing risk should be the priority.

Let’s look at what is happening to interest revenue. Remember, just because a number doesn’t change this doesn’t mean that nothing worthwhile is happening. The first place to look at is again the balance sheet and the loans and advances line item which shows a drop of 1.84%.

FAB’s Quality of Income

In expansionary economic times this might be considered a bad thing. But in an economy that is adjusting to the change in oil price, I would argue that this is the smart thing to do. The more important conclusion is that loans and advances, the highest interest earning asset, went down 1.84% but interest income went down only 0.80%.

This indicates that FAB increased the rates it charges, but there might be other explanations. The last step is to understand whether the interest increase is due to a risk increase or better marketing. Given the conservative heritage of FAB, I’m leaning towards the latter explanation.

There is much more to FAB’s financials and using some of the ideas you should be able to improve your understanding even more. I have not covered the important cash flow statement but this is simply because I have run out of space. Perhaps in a future article.

This article was originally published in The National.