Ch04

ALTERNATIVE MODELS OF BANK PERFORMANCE

Chapter 4

Bank ManagementBank Management, 5th edition.5th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2003 by South-Western, a division of Thomson Learning

Traditional bank performance analysis carries three basic flaws

1. It ignores the wide diversity in strategies pursued by different institutions

2. A bank’s total assets no longer serve as a meaningful yardstick when banks engage in off-balance sheet activities

3. The analysis provides no directinformation concerning how or which of the bank’s activities contribute to the creation of shareholder value

Wide diversity in strategies pursued by different institutions

When UBPRs were introduced, most banks did similar things, which were reflected in their balance sheet They accepted deposits and made loans, and

many interest rates were regulated The primary differentiation of performance

was balance sheet composition Today, banks may pursue sharply different

strategies

Bank’s total assets no longer serve as a meaningful yardstick when banks engage in off-balance sheet activities

Consider the situation where two banks report the same asset size, but one also has an extensive mortgage-servicing operation that generates servicing income

If the bank with mortgage-servicing makes a profit on this activity, it will report a higher ROA, ceteris paribus, due to the higher noninterest income for mortgage-servicing fees

The analysis provides no direct information concerning how or which of the bank’s activities contribute to the creation of shareholder value

It similarly ignores other performance benchmarks that customer-focused managers must consider to identify the best strategies going forward

Although ROA might be a biased indicator of performance, return on equity (ROE) doesn’t suffer from the same weaknesses.

When considering the entire bank, stockholders’ equity must support all activities, whether on- or off-balance sheet.

Thus, a comparison of net income to equity captures the returns to owners’ contributions.

The appropriate peer group…as long as banks have a similar strategic focus and offer similar products and services, asset size and UBPR ratios can provide meaningful comparisons.

To identify the appropriate peer institutions, management should consider the following:

1. What is the bank’s strategic focus?2. What are the traditional balance sheet and off-

balance sheet characteristics of firms with this focus?

3. How do the bank’s activities affect its operating revenue?

A common starting point is to determine whether the bank’s strategy is more loan-driven or deposit-driven.

A loan-driven bank’s profitability is generally a function of net interest income (the margin) with loan volume a major factor.

A deposit-driven bank’s profitability is generally a function of noninterest income with franchise value and deposit volume a major factor.

A loan driven bank finds that:

asset size is determined by loan demand profitability is determined by loan

economics; i.e., loan yields versus cost of fund

loan margin is high as well as noninterest expense

the culture is typically “our bank underwrites loans better than other banks”

value is typically some multiple of core earnings

A deposit driven bank typically finds that:

asset size is determine by the growth in core deposits

value is determined by the bank’s franchise value -- measured by the market share of low-cost core deposits

lower interest income, interest margins and noninterest expenses

lower loan losses

Evaluating performance using GAAP-based data and UBPR ratios…a bank should compare its ratios with those from a select sample of peer institutions that are similarly loan-driven or deposit-driven.

Peers should operate the same approximate number of offices in the same metropolitan or non-metropolitan markets and have the same product and service mix.

Asset-based ratios are thus directly comparable. Analysts can easily construct peer bank averages by

direct comparison to other similar bank’s UBPR’s or by using the FDIC’s Statistics on Depository Institutions (SDI) system at:

http://www3.fdic.gov/sdi/

One way to construct ratios that avoid the problems of off-balance sheet activities is to calculate ratios tied to a bank’s total operating revenue (net interest income plus noninterest income)-- (David Cates (1996))

Fundamentally this means calculate performance measures using total operating revenue as the denominator rather than assets. Here, total operating revenue equals the sum

of net interest income and noninterest income.

The efficiency ratio…measured as noninterest expense divided by total operating revenue, is a popular measure used by stock analysis based on operating revenue rather than assets.

Analysts strongly encourage banks, regardless of size, to meet fairly specific targets in this ratio.

Because operating revenue includes both interest income and noninterest (fee-based) income, it captures all activities.

Efficiency Ratio= noninterest expense / net operating revenuewhere net operating revenue = the sum of net interest income + noninterest income.

Bank stock analysts follow a standard procedure when evaluating firm performance

Initially use GAAP-based financial information to calculate performance measures adjust the data to omit the impact of nonrecurring items, such as one-

time asset sales and restructuring charges compare these historical ratios with a carefully selected group of peer

institutions, matching each bank’s primary strategic focus Based on his or her own analysis and conversations with

specialists within the bank, the analyst then assesses the quality of earnings based on: their sustainability the bank’s market power in specific product or service areas the bank’s franchise value

The next step is to forecast earnings, cash flow, and market value of equity over a three- to five-year time horizon

Finally, the analyst makes a stock recommendation: accumulate (buy) neutral (hold) below-market performance (sell)

It is extremely rare, however, to see an outright sell recommendation because analysts want to remain in the good graces of the banks that they follow

Thus, they do not formally recommend selling the stock, but rather label it as likely to exhibit below-market performance.

A hold recommendation thus actually means “sell the stock” for most analysts.

The recent failure of Enron is potentially an example of the conflict of interest “buy-side” and “sell-side” analysts have.

Investors in bank stocks are primarily concerned with whether the bank’s management is creating value for stockholders.

When analysts compare performance over some historical period, they are less concerned with ROE, ROA, and efficiency ratios – rather the overall total return from investing in the bank’s stock.

Total return equals dividends received plus stock price appreciation/depreciation relative to the initial investment.

Return to stockholders = (price + dividends) / pricet-1

Earnings per share

Price to earnings (P/E) = stock price / EPS

Price to book value= stock price / book value per share

Market value (MV) of equity= MV of assets - MV of liabilities or= # share of common stock x stock price

goutstandintock s common of shares of number

stock preferred on dividends and taxes after ΔNI

Key stock market-based performance measures include

Example: buy 100 shares of PNC Financial at the beginning of 2001 for $73.06. The bank paid $1.92 per share in dividends that generated reinvestment income of $.09. At the end of 2001, the price of stock was $56.20.

Return to stockholders in 2001 was -20.3%.

0.203 = [$56.20 - $73.06 + $2.01] ÷ $73.06

Balanced scorecard…performance measures that look beyond just financial measures The balanced scorecard is an attempt to balance

management decisions based on financial measures with decisions based on a firm’s relationships with its customers and the effectiveness of support processes in designing and delivering products and services

The result is that line of business managers use indicators such as: market share, customer retention and attrition, customer profitability, and service quality to evaluate performance

Internally, they also track productivity and employee satisfaction

Such nonfinancial indicators provide information regarding whether a bank is truly customer-focused and whether its systems are appropriate

Operationalize the balanced scorecard

…divide the bank into a Customer Bank and a House Bank Income derived from balance sheet

and income statement items that are derived from bank customers determines

The Customer Bank Items that arise when the bank is its

own customer determines The House Bank

Two banks in one house Traditional or Customer Bank, activities include:

most loans, core deposits, payment services, credit enhancements, asset management, and financial advisory.

Investment or House Bank, activities include: the investment portfolio, noncore, purchased

liabilities, loan participations, asset sales, servicing, and bank-sponsored mutual funds.

Items are assigned based on whether the underlying activities pertain to bank customers (Customer Bank) or the bank itself (Investment Bank).

Evaluate the returns on each Bank relative to the risks and relevant benchmarks.

Line of business profitability analysis…By allocate operating expenses to activities that support bank customers and bank management, banks can obtain at least a rough estimate of segment net income.

Leads to the reporting and use of both financial and nonfinancial performance data, based on specific customers.

Many banks attempt to measure profitability by: type of loan customer (small business, middle market,

consumer installment, etc.) type of depositor; by characteristics of the relationship

(account longevity, cross-sell patterns, profitability, etc.) and delivery system (branch, ATM, tele-phone, home banking,

etc.).

RAROC/RORAC analysis…RAROC refers to risk-adjusted return on capital, while RORAC refers to return on risk-adjusted capital.

In order to analyze profitability and risk precisely, each line of business must have its own balance sheet and income statement. These statements are difficult to construct because many

nontraditional activities, such as trust and mortgage-servicing, do not explicitly require any direct equity support.

Even traditional activities, such as commercial lending and consumer banking, complicate the issue because these business units do not have equal amounts of assets and liabilities generated by customers.

The critical issue is to determine how much equity capital to assign each unit.

Assigning equity capital to each unit

Alternative capital allocation methods include: using regulatory risk-based capital

standards assignment based on the size of assets benchmarking each unit to “pure-play”

peers that are stand-alone, publicly held firms; and

measures of each line of business’s riskiness.

RAROC/RORAC…often used interchangeably, but are formally defined as follows:

Risk adjust return on capital (RAROC) RAROC = Risk-adjusted income / Allocated capital

Using this method, income is adjust for risk. Typically, income is adjusted for expected losses.

Return on risk adjusted capital (RORAC) RORAC = Net income / Allocated risk capital

Using this method, capital is adjusted for risk. Typically, capital is adjusted for a maximum

potential loss based on the probability of future returns or volatility of earnings.

Example: PNC reported results for seven distinct lines of business Banking Businesses

1. Regional Community Banking

2. Corporate Banking

3. PNC Real Estate Finance

4. PNC Business Credit

Asset Management and Processing

5. PNC Advisors

6. BlackRock

7. PFPC.

The data were obtained from PNC’s management accounting system based on internal assumptions about revenue and expense allocations and assignment of equity to each line of business.

PNC’s profitability analysis for 2000-2001

Two lines of business for PNC are detailed

1. Corporate Banking …represents products and services provided nationally in the areas of credit, equipment leasing, treasury management, and capital markets products to large and mid-sized corporations and government entities.

2. Community Banking…encompasses the bank’s traditional deposit, branch-based brokerage, electronic banking and credit products to retail customers along with products to small businesses such that it is primarily a deposit-generating unit.

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Transfer pricing…the interest rate at which a firm could buy or sell funds in the external capital markets.

When management creates balance sheets for each line of business, it must allocate capital as well as assets or liabilities to make the balance sheet balance.

It must then assign a cost or yield to each of these components to produce income statement for each line of business.

Transfer pricing systems

Banks use internal funds transfer pricing systems to assign asset yields and cost of funds to different lines of business and products.

Most systems use a matched maturity framework that assigns rates by identifying the effective maturity of the underlying assets or liabilities and assigning a rate obtained from a money or capital market instrument of the same maturity.

Bank Asset Liability Loan: 2 year Time deposit: 3 month $1,000,000 @8.50% $1,000,000 @ 4.5%

Margin = 4.00% Interest Rate Risk: Liability sensitive Embedded Option: Prepayment risk on loan

Lending Division Asset Liability Loan: 2 year Transfer from Treasury: 2

year $1,000,000 @8.50% $1,000,000 @6.00%

Margin = 2.50% Interest Rate Risk: None Option: Sold prepayment option to loan customer on balance sheet; buy an option from Treasury for 0.20%. NIM after option cost = 2.50% - 0.20% = 2.30%

Deposit-Gathering Division Asset Liability Receivable from Treasury Time dposit 3-month 3-month $1,000,000 @5.20% $1,000,000 @ 4.5%

Margin = 0.70% Interest Rate Risk: None Option: None

Treasury Division Asset Liability Receivable from Lending: Transfer to Deposit-Gathering: 2-year 3-month $1,000,000 @6.00% $1,000,000 @5.20%

Margin = 0.80% Interest Rate Risk: Liability sensitive Option: Sell option to lending division for 0.20%; NIM after option sale = 0.80% + 0.20% = 1.00%. Treasury has interest rate and loan prepayment risk.

Example: Internal funds transfer pricing2-year loan financed by a 3-month deposit

Risk-adjusted income and economic income Two adjustments are frequently made to

income in line of business profitability analysis:

1. The return is adjusted for risk by subtracting expected losses

2. The return nets out required returns expected by stockholders.

This minimum required return, or cost of equity, represents a hurdle rate, or stockholders’ minimum required rate of return.

The specific concern is whether RAROC is greater than the firm’s cost of equity.

Allocated risk capital…The objective of RAROC analysis is to assist in risk management and the evaluation of line of business performance. As part of this, it is necessary to assign capital to each line of business.

Banks allocate risk capital by:

1. Regulatory risk-based capital standards

2. Asset size

3. Benchmarking versus “pure-play” stand-alone businesses

4. Perceived riskiness of the business unit

Unfortunately, most lines of business do not have market value balance sheets. Hence, many banks focus on the volatility in

economic earnings (earnings-at-risk) or estimate a value-at-risk figure.

Earnings-at-risk…the volatility of earnings from a line of business.

Securities underwriting and letters of credit (guarantees) against customer exposures at a large bank do not require much capital to support day-to-day operations. But before a bank can actively engage in this

business, it must have a strong credit and bond rating, which requires a substantial amount of risk capital.

One way to measure the required risk capital is to relate it to the volatility of earnings from this line of business; i.e., earnings-at-risk.

Earnings-at-risk applied to loans

1. Using historical data for each of the past 30 months, estimate revenues obtained directly from these loans.

2. Using historical data for each of the past 30 months, estimate direct expenses from offering these services and expected losses.

3. Using the 60 observations for revenues minus expenses and losses, estimate one standard deviation of earnings. This is earnings-at-risk.

4. Estimate risk capital as one (or two) standard deviation of earnings, divided by the risk-free interest rate.

Allocating risk capital based on earnings volatility: Securities underwriting and letters of credit division

A. Monthly Revenue Less Expenses (in millions of $)1. Most Recent 30 Months Observations:

4, 3, 4.5, 5, 5.2, 4.6, 3.9, 4.3, 5, 4.7, 5.1, 5.4, 5, 4.5, 4.4, 4.8, 5, 5.5, 5.3, 5.1, 5, 5.4, 5.7, 6.3, 6, 5.8, 5.5, 5.9, 5.5, 6.4

2. Mean: $5.06 millionStandard Deviation: $0.735 million

B. Allocated Risk Capital Assuming a risk-free rate of 5.5% (annual):

(0.055 / 12) x Risk Capital = $ 0.735 million Risk Capital = $160.364 million

C. RORAC for the Most Recent Month1. Revenue minus expense of $6.4 million

RORAC = 6.4 / 160.364 = 0.0399 monthly, or 47.89% annually

1. Economic IncomeAssuming a hurdle rate of 12% annually, economic income net of the capital charge:

$6.4 - (.12/12) $160.364 = $4.796 million

Management of market risk…market risk is the risk of loss to earnings and capital related to changes in the market values of bank assets, liabilities, and off-balance sheet positions. In January 1998, bank regulators imposed capital

requirements against the market risk associated with large banks’ trading positions. The requirements apply to any U.S. bank or bank holding

company that has a trading account in excess of $1 billion or accounts for 10 percent or more of bank assets.

Typically, market risk arises from taking positions and dealing in foreign exchange, equity, interest rate, and commodity markets, and the items affected are the securities trading account, derivatives positions, and foreign exchange positions.

The new capital requirements address market risk associated with a bank’s trading activities.

Value-at-risk estimate for foreign exchangeIdentify the maximum expected loss given the bank’s recent history of daily returns on the trading portfolio.

Empirical distribution approach to value-at-risk involves:1. Identify the lowest 1 % of daily price moves. 2. Assuming that the value of the 1% lowest price move is 7.54 percent, 99 percent of the daily returns exceed this figure.

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Some analysts criticize traditional earnings measures such as ROE, ROA, and EPS because they provide no information about how a bank’s management is adding to shareholder value.

If the objective of the firm is to maximize stockholders’ wealth, such measures do not indicate whether stockholder wealth has increased over time, let alone whether it has been maximized.

Stern, Stewart & Company has introduced the concepts of market value added (MVA) and its associated economic value added (EVA) in an attempt to directly link performance to shareholder wealth creation.

Economic value added (EVA)…an approach to measuring performance that compares a bank’s (or line of business) net operating profit after-tax (NOPAT) with a capital charge.

Economic Value Added (EVA) is the capital charge which represents the required return to stockholders assuming a specific allocated risk capital amount.

Market and economic value added

MVA represents the increment to market value and is determined by the present value of current and expected economic profit:

Stern Stewart and Company measures economic profit with EVA, which is equal to a firm's operating profit minus the charge for the cost of capital:

where the capital charge equals the product of the firm’s value of capital and the associated cost of capital.

MVA = Mkt Value of Capital - Hist. Amt of Invested Capital

EVA = Net Operating Profit After Tax (NOPAT) - Capital Charge

Difficulties in measuring EVA for the entire bank It is often difficult to obtain an accurate measure of a

firm's cost of capital. The amount of bank capital includes not just

stockholders' equity, but also includes loan loss reserves, deferred (net) tax credits, non-recurring items such as restructuring charges and unamortized securities gains.

NOPAT should reflect operating profit associated with the current economics of the firm. Thus, traditional GAAP-based accounting data, which distort true profits, must be modified to obtain estimates of economic profit.

A. Balance Sheet Assets $Millions Rate Liabilities & Equity $Millions Rate Cash $150 0 Demand deposits $800 Securities $800 6.5% MMDAs $1800 3% Commercial loans $2000 9.0% CDs $1300 5.5% Credit card loans $1900 10.0% Small time deposits $680 4.5% -Loss reserve -$100 Deferred tax credits $100 Other assets -$250 Equity - $320 Total assets $5,000 Liabilities + equity $5,000 Risk-weighted assets: .50($800) + 1($2,000) + 1($1,900) + 1($250) = $4,550 Tier 1 capital = $320 Tier I ratio: $320/$4,550 = 7.03% Total capital = $420 Total capital ratio: $420/$4,550 = 9.23% B. Income Statement Interest income: .065($800) + .090($2,000) + .10($1,900) = $422 Interest expense: .03($1,800) + .055($1,300) + .045($680) = -$156.1 Net interest income $265.9 Provision for loan losses -$25 Noninterest income $60 Noninterest expense -$190 Pre tax Income $110.90 Taxes @ 40% $44.36 Net income $66.54 C. Profit Measures ROE = (66.54 / 320 ) = 20.8% ROA = (66.54 / 5,000) = 1.33% Assuming that net charge-offs $22, cash taxes pai, = $39, and allocated risk capital $550 with a capital charge of 12%: NOPAT = $110.90 + $25 - $22 - $39 = $74.9 EVA = $74.9 - 0.12($550) = $8.9 E

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A. Change In Balance Sheet items Assets Amount Liablilties Amount Credit card loans -$1,000 CDs -$940 Loan loss reserve +$30 Equity -$30 Total assets -$970 Total -$970

B. Income Statement Change Interest income: .065($800) + .09($2,000) + .10($900) $322 -$100 Interest expense: .03($1,800) + .055($460) + .045($680) -$109.9 -$46.2 Net interest income: $212.1 -$53.8 Provision for loan losses: +$5 +$30.0 Noninterest income: $72 +$12 Noninterest expense: -$195 -$5 Pre tax income: $94.1 -$16.8 Taxes @ 40%: $37.64 -6.72 Net income: $56.46 -10.08 C. Profit Measures: Actual net charge-oft $14, cash taxes paid = $31,

and risk capital falls to $500. ROE = $56.46/$290 = 19.47% ROA = $56.46/$4,030 = 1.40% EVA = [$94.1 - $5 - $14 - $31] - $60 = -$15.9 Risk-weighted assets: .50($800) + 1($2,000) + 1($900) + 1($250) = $3,550 Tier 1 capital = $290 Tier I ratio: $290/$3,550 = 8.17% Tier 2 capital = $420 Total capital ratio: $420/$3,550 = 11.83% E

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Balanced scorecard One of the recent dramatic shifts in strategic thinking by management

has recently produced a new approach to performance measurement at many firms, both financial and nonfinancial. The primary catalyst is an appreciation that financial measures alone do

not provide sufficient information regarding a firm’s overall performance. In addition to profit and risk measures, managers need benchmarks and

targets for efforts and activities related to: customer satisfaction, employee satisfaction, organizational innovation, and the development of business processes.

This is particularly true if a bank is customer-focused. Should management target and measure performance along the lines of:

market share, service quality, customer profitability, sales performance, and customer satisfaction?

Balanced scorecard framework with four blocks1. Financial Performance:

How Do Stockholders View Our Risk and Return Profile?

2. Customer Performance: How Do Customers See Us?

3. Internal Process Management: At What Must We Excel?

4. Innovation and Learning: How Can We Continue to Improve and

Create Value?

Scorecard measures

ALTERNATIVE MODELS OF BANK PERFORMANCE

Chapter 4

Bank ManagementBank Management, 5th edition.5th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2003 by South-Western, a division of Thomson Learning