Chapter Six Measuring and Evaluating the Performance of Banks and Their Principal Competitors Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights.

Chapter Six

Measuring and Evaluating the Performance of Banks and Their Principal Competitors

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

McGraw-Hill/IrwinBank Management and Financial Services, 7/e

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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 •The UBPR and Comparing Performance

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Value of the Bank’s Stock

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Value of a Bank’s Stock Rises When:

•Expected Dividends Increase•Risk of the Bank Falls•Market Interest Rates Decrease•Combination of Expected Dividend

Increase and Risk Decline

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Value of Bank’s Stock if Earnings Growth is Constant

g -r

D P

1

0

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Key Profitability Ratios in Banking

Assets Total

IncomeInterest Net

Assets Total

expense)Interest -

income(Interest

Margin Interest Net

Assets Total

Incomet NoninteresNet

Assets Total

expensest Noninteres-

PLLL-

revenuet Noninteres

Margin t NoninteresNet

Net IncomeReturn on Equity Capital (ROE) =

Total Equity Capital

Net IncomeReturn on Assets (ROA) =

Total Assets

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Key Profitability Ratios in Banking (cont.)

Assets Total

Expenses Operating Total

- Revenues Operating Total

Margin OperatingBank Net

gOutstandin SharesEquity Common

TaxesAfter IncomeNet (EPS) SharePer Earnings

Total Interest Income __ Total Interest ExpenseEarnings Spread = Total Earning Assets Total Interest Bearing Liability

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Breaking Down ROE

N et P ro fit M arg in =N et In com e/To ta l O p era tin g R even u e

A sse t U tiliza tion =To ta l O p era tin g R even u e /To ta l A sse ts

R O A =N et In com e/To ta l A sse ts

E q u ity M u lt ip lie r =To ta l A sse ts /E q u ity C ap ita l

R O E = N e t In com e/ To ta l E q u ity C ap ita l

x

x

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ROE Depends On:

• Equity Multiplier=Total assets/Total equity capital▫Leverage or Financing Policies: the choice of

sources of funds (debt or equity)

• Net Profit Margin=Net income/Total operating revenue▫Effectiveness of Expense Management (cost

control)

• Asset Utilization=Total operating revenue/Total assets▫Portfolio Management Policies (the mix and

yield on assets)

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Determinants of ROE in a Financial Firm

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Components of ROE for All Insured U.S. Banks (1992-2007)

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A Variation on ROE

Net Income Pre-Tax Net Operating IncomeROE =

Pre-Tax Net Operating Income Total Operating Revenue

Total Operating Revenue Total Assets

Total Assets Total Equity Capital

ROE = Tax Management Efficiency

Expense Control Efficiency

Asset Management Efficiency

Funds Management Efficiency

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Breakdown of ROA

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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?

•Suppose a bank has an ROA of 0.80% and an equity multiplier of 12x. What is its ROE? Suppose this bank’s ROA falls to 0.60%. What size equity multiplier must it have to hold its ROE unchanged?

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

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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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Credit Risk

The Probability that Some of the Financial Firm’s Assets Will Decline in Value and Perhaps Become Worthless

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Credit Risk Measures

•Nonperforming Loans/Total Loans•Net Charge-Offs/Total Loans•Provision for Loan Losses/Total Loans•Provision for Loan Losses/Equity Capital•Allowance for Loan Losses/Total Loans•Allowance for Loan Losses/Equity Capital•Nonperforming Loans/Equity Capital

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Liquidity Risk

Probability the Financial Firm Will Not Have Sufficient Cash and Borrowing Capacity to Meet Deposit Withdrawals and Other Cash Needs

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Liquidity Risk Measures

•Purchased Funds/Total Assets•Net Loans/Total Assets•Cash and Due from Banks/Total Assets•Cash and Government Securities/Total Assets

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Market Risk: Comprises Price Risk and Interest Rate Risk

Probability of the Market Value of the Financial Firm’s Investment Portfolio Declining in Value Due to a Change in Interest Rates

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Market Risk Measures

•Book-Value of Assets/ Market Value of Assets

•Book-Value of Equity/ Market Value of Equity

•Book-Value of Bonds/Market Value of Bonds

•Market Value of Preferred Stock and Common Stock

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Interest Rate Risk

The Danger that Shifting Interest Rates May Adversely Affect a Bank’s Net Income, the Value of its Assets or Equity

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Interest Rate Risk Measures

•Interest Sensitive Assets/Interest Sensitive Liabilities

•Uninsured Deposits/Total Deposits

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Off-Balance-Sheet Risk

The Volatility in Income and Market Value of Bank Equity that May Arise from Unanticipated Losses due to OBS Activities (activities that do not have a balance sheet reporting impact until a transaction is affected)

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Operational Risk

Uncertainty Regarding a Financial Firm’s Earnings Due to Failures in Computer Systems, Errors, Misconduct by Employees, Floods, Lightening Strikes and Similar Events or Risk of Loss Due to Unexpected Operating Expenses

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Legal and Compliance Risk

Risk of Earnings Resulting from Actions Taken by the Legal System. This can Include Unenforceable Contracts, Lawsuits or Adverse Judgments. Compliance Risk Includes Violations of Rules and Regulations

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Reputation Risk

This is Risk Due to Negative Publicity that can Dissuade Customers from Using the Services of the Financial Firm. It is the Risk Associated with Public Opinion.

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Capital Risk

Probability of the Value of the Bank’s Assets Declining Below the Level of its Total Liabilities. The Probability of the Bank’s Long Run Survival

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Capital Risk Measures

•Stock Price/Earnings Per Share•Equity Capital/Total Assets•Purchased Funds/Total Liabilities•Equity Capital/Risk Assets

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Other Goals in Banking

Total Operating ExpensesOperating Efficiency Ratio =

Total Operating Revenues

Net Operating IncomeEmployee Productivity Ratio =

Number of Full Time-Equivalent Employees

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Performance Indicators Related to the Size of a Firm, 2007

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Appendix: UBPR

The Uniform Bank Performance Report Provided by U.S. Federal Regulators so that Analysts Can Compare the Performance of One Bank Against Another

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

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