Chap006

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Chapter Six

Measuring and Evaluating the Performance of Banks and Their

Principal Competitors

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Key Topics

•Stock Values and Profitability Ratios •Measuring Credit, Liquidity, and Other Risks •Measuring Operating Efficiency •Performance of Competing Financial Firms •Size and Location Effects •Appendix: Using Financial Ratios and Other

Analytical Tools to Track Financial Firm Performance – The UBPR and BHCPR

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Introduction

• This chapter focuses on the most widely used indicators of the quality and quantity of bank performance and their principal competitors

• Focus on the most important dimensions of performance – profitability and risk

• Financial institutions are simply businesses organized to maximize the value of the shareholders’ wealth invested in the firm at an acceptable level of risk

• Must continually be on the lookout for new opportunities for revenue growth, greater efficiency, and more effective planning and control

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Evaluating Performance

• Performance must be directed toward specific objectives

• A fair evaluation of any financial firm’s performance should start by evaluating whether it has been able to achieve the objectives its management and stockholders have chosen

• A key objective is to maximize the value of the firm

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Evaluating Performance (continued)

• The minimum acceptable rate of return, r, is sometimes referred to as an institution’s cost of capital▫ Two main components▫ The risk-free rate of interest ▫ The equity risk premium

• The value of the financial firm’s stock will tend to rise in any of the following situations1. The value of the stream of future stockholder dividends is expected to

increase2. The financial organization’s perceived level of risk falls3. Market interest rates decrease, reducing shareholders’ acceptable rates

of return via the risk-free rate of interest component of all market interest rates

4. Expected dividend increases are combined with declining risk, as perceived by investors

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Evaluating Performance (continued)

• The stock values of financial institutions are sensitive to changes in market interest rates, currency exchange rates, and the strength or weakness of the economy

• Equation (6–1) assumes that the stock may pay dividends of varying amounts over time

• If the dividends paid to stockholders are expected to grow at a constant rate over time, perhaps reflecting steady growth in earnings, the stock price equation can be greatly simplified into

▫ D1 is the expected dividend in period 1

▫ r is the rate of discount reflecting the perceived level of risk▫ g is the expected constant growth rate at which all future stock

dividends will grow each year

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Evaluating Performance (continued)

• The previous two stock price formulas assume the financial firm will pay dividends indefinitely into the future

• Most capital market investors have a limited time horizon

▫ where we assume an investor will hold the stock for n periods, receiving the stream of dividends D1, D2, . . . , Dn and sell the

stock for price Pn at the end of the planned investment horizon

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Evaluating Performance (continued)

• The behavior of a stock’s price is, in theory, the best indicator of a financial firm’s performance because it reflects the market’s evaluation of that firm

• This indicator is often not available for smaller banks and other relatively small financial-service corporations

• Key Profitability Ratios

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Evaluating Performance (continued)

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Evaluating Performance (continued)

• Return on assets (ROA) is primarily an indicator of managerial efficiency▫ Indicates how capable management has been in converting assets into

net earnings• Return on equity (ROE) is a measure of the rate of return flowing to

shareholders• Approximates the net benefit that the stockholders have received from investing

their capital in the financial firm

• The net operating margin, net interest margin, and net noninterest margin are efficiency measures as well as profitability measures▫ The net interest margin measures how large a spread between interest

revenues and interest costs management has been able to achieve▫ The net noninterest margin measures the amount of noninterest

revenues stemming from service fees the financial firm has been able to collect relative to the amount of noninterest costs incurred▫ Typically, the net noninterest margin is negative

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Evaluating Performance (continued)

• Another traditional measure of earnings efficiency is the earnings spread

▫ Measures the effectiveness of a financial firm’s intermediation function in borrowing and lending money and also the intensity of competition in the firm’s market area

▫ Greater competition tends to squeeze the difference between average asset yields and average liability costs

▫ If other factors are held constant, the spread will decline as competition increases

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Evaluating Performance (continued)

• Useful Profitability Formulas for Banks and Other Financial-Service Companies

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Evaluating Performance (continued)

or

where

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EXHIBIT 6–1 Elements That Determine the Rate of Return Earned on the Stockholders’ Investment (ROE) in a Financial Firm

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TABLE 6–1 Components of Return on Equity (ROE) for All FDIC-Insured Institutions (1992-2009)

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Evaluating Performance (continued)

• A slight variation of the simple ROE model produces an efficiency equation useful for diagnosing problems in four different areas in the management of financial-service firms

or

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Evaluating Performance (continued)

• We can also divide a financial firm’s return on assets into its component parts

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TABLE 6–2 Calculating Return on Assets (ROA)

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TABLE 6–3 Components of Return on Assets (ROA) for All FDIC-Insured Depository Institutions (1992–2009)

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Evaluating Performance (continued)

• Achieving superior profitability for a financial institution depends upon several crucial factors

1. Careful use of financial leverage (or the proportion of assets financed by debt as opposed to equity capital)

2. Careful use of operating leverage from fixed assets (or the proportion of fixed-cost inputs used to boost operating earnings as output grows)

3. Careful control of operating expenses so that more dollars of sales revenue become net income

4. Careful management of the asset portfolio to meet liquidity needs while seeking the highest returns from any assets acquired

5. Careful control of exposure to risk so that losses don’t overwhelm income and equity capital

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Evaluating Performance (continued)

•Risk to the manager of a financial institution or to a regulator supervising financial institutions means the perceived uncertainty associated with a particular event

•Among the more popular measures of overall risk for a financial firm are the following▫ Standard deviation (σ) or variance (σ2) of stock prices▫ Standard deviation or variance of net income▫ Standard deviation or variance of return on equity (ROE)

and return on assets (ROA)

•The higher the standard deviation or variance of the above measures, the greater the overall risk

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Evaluating Performance (continued)

• Bank Risks▫Credit Risk▫ Liquidity Risk▫Market Risk▫ Interest Rate Risk▫Operational Risk▫ Legal and Compliance Risk▫Reputation Risk▫ Strategic Risk▫Capital Risk

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Evaluating Performance (continued)

• Other Goals in Banking and Financial-Services Management

▫ A rise in the value of the operating efficiency ratio often indicates an expense control problem or a falloff in revenues, perhaps due to declining market demand

▫ In contrast, a rise in the employee productivity ratio suggests management and staff are generating more operating revenue and/or reducing operating expenses per employee, helping to squeeze out more product with a given employee base

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Performance Indicators among Banking’s Key Competitors• Among the key bank performance indicators that often are equally

applicable to privately owned, profit-making nonbank financial firms are

Prices on common and preferred stock Return on equity capital (ROE)Return on assets (ROA) Net operating marginNet interest margin Equity multiplierAsset utilization ratio Cash accounts to total assetsNonperforming assets to equity capital Interest-sensitive assets to interest-ratio sensitive liabilitiesBook-value assets to market-value assets Equity capital to risk-exposed assetsInterest-rate spread between yields on Earnings per share of stockthe financial firm’s debt and market yields on government securities

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The Impact of Size on Performance

• When the performance of one financial firm is compared to that of another, size becomes a critical factor▫ Size is often measured by total assets or, in the case of a

depository institution, total deposits

• Most performance ratios are highly sensitive to the size group in which a financial institution finds itself

• The best performance comparison is to choose institutions of similar size serving the same market area

• Also, compare financial institutions subject to similar regulations and regulatory agencies

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TABLE 6–4 Important Performance Indicators Related to the Size and Location of FDIC-Insured Depository Institutions (2009)

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Quick Quiz

• What individuals or groups are likely to be interested in the banks’ level of profitability and exposure to risk?

• What are the principal components of ROE, and what does each of the these components measure?

• What are the most important components of ROA and what aspects of a financial institution’s performance do they reflect?

• Why do the managers of financial firms often pay close attention today to the net interest margin and noninterest margin? To the earnings spread?

• To what different kinds of risk are banks and their financial-service competitors subjected today?

• What items on a bank’s balance sheet and income statement can be used to measure its risk exposure? To what other financial institutions do these risk measures seem to apply?

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Appendix: Using Financial Ratios and Other Analytical Tools to Track Financial-Firm Performance – The UBPR and BHCPR • Compared to other financial institutions, more information is

available about banks than any other type of financial firm• Through the cooperative effort of four federal banking agencies –

the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the Office of the Comptroller of the Currency – the Uniform Bank Performance Report (UBPR) and the Bank Holding Company Performance Report (BHCPR) provide key information for financial analysts

• The UBPR, which is sent quarterly to all federally supervised banks, reports each bank’s assets, liabilities, capital, revenues, and expenses, and the BHCPR is similar for BHCs

• Web link for UBPR and BHCPR: www.ffiec.gov