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CHAPTER 6MEASURING AND EVALUATING THE PERFORMANCE OF BANKS AND THEIR PRINCIPAL COMPETITORSGoal of This Chapter: The purpose of this chapter is to discover what analytical tools can be applied to a banks financial statements so that management and the public can identify the most critical problems inside each bank and develop ways to deal with those problems Key Topics in this Chapter 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 BHCPRChapter OutlineI. Introduction:II Evaluating PerformanceA. Determining Long-Range ObjectivesB. Maximizing the Value of the Firm: A Key Objective for Nearly All Financial-Service InstitutionsC. Profitability Ratios: A Surrogate for Stock Values1. Key Profitability Ratios2. Interpreting Profitability RatiosD. Useful Profitability Formulas for Banks and Other Financial-Service CompaniesE. Return on Equity and Its Principal ComponentsF. The Return on Assets and Its Principal Components G. What a Breakdown of Profitability Measures Can Tell UsH. Measuring Risk in Banking and Financial Services1. Credit Risk2. Liquidity Risk3. Market Risk4. Price Risk5. Interest Rate Risk6. Foreign Exchange and Sovereign Risk7. Off-Balance-Sheet Risk8. Operational (Transactional) Risk9. Legal and Compliance Risks10 Reputation Risk11. Strategic Risk12. Capital RiskI. Other Goals in Banking and Financial-Services ManagementIII. Performance Indicators among Bankings Key CompetitorsIV.The Impact of Size on PerformanceA. Size, Location and Regulatory Bias in Analyzing the Performance of Banks and Competing Financial InstitutionsV. Summary of the ChapterAppendix to the Chapter - Using Financial Ratios and Other Analytical Tools to Track Financial-Firm Performance-The UBPR and BHCPRConcept Checks6-1.Why should banks and other corporate financial firms be concerned about their level of profitability and exposure to risk?Banks in the U.S. and most other countries are private businesses that must attract capital from the public to fund their operations. If profits are inadequate or if risk is excessive, they will have greater difficulty in obtaining capital and their funding costs will grow, eroding profitability. Bank stockholders, depositors, and bank examiners representing the regulatory community are all interested in the quality of bank performance. The stockholders are primarily concerned with profitability as a key factor in determining their total return from holding bank stock, while depositors (especially large corporate depositors) and examiners typically focus on bank risk exposure.6-2.What individuals or groups are likely to be interested in these dimensions of performance for a financial institution?The individuals or groups likely to be interested in the dimensions i.e., Bank profitability and Risk are Other banks lending to a particular bank, borrowers, large depositors, holders of long-term debt capital issued by banks, bank stockholders, and the regulatory community.6-3.What factors influence the stock price of a financial-services corporation?A banks stock price is affected by all those factors affecting its profitability and risk exposure, particularly its rate of return on equity capital and risk to shareholder earnings. Research evidence over the years has found that the stock prices of financial institutions is sensitive to changes in market interest rates, currency exchange rates, and the strength or weakness of the economy. A bank can raise its stock price by creating an expectation in the minds of investors of greater earnings in the future, by lowering the banks perceived risk exposure, or by a combination of increases in expected earnings and reduced risk.6-4.Suppose that a bank is expected to pay an annual dividend of $4 per share on its stock in the current period and dividends are expected to grow 5 percent a year every year, and the minimum required return-to-equity capital based on the banks perceived level of risk is 10 percent. Can you estimate the current value of the banks stock?In this constant dividend growth rate problem the current value of the banks stock would be:Po = D1 / (r g) = $4 / (0.10 0.05) = $80.6-5.What is return on equity capital, and what aspect of performance is it supposed to measure? Can you see how this performance measure might be useful to the managers of financial firms?Return on equity capital is the ratio of Net Income/Total Equity Capital. It represents the rate of return earned on the funds invested in the bank by its stockholders. Financial firms have stockholders, who too are interested in the return on the funds that they invested.6-6 Suppose a bank reports that its net income for the current year is $51 million, its assets total $1,144 million, and its liabilities amount to $926 million. What is its return on equity capital? Is the ROE you have calculated good or bad? What information do you need to answer this last question?The banks return on equity capital should be:ROE =Net Income =$51 million= 0.234 or 23.39 percentTotal equity Capital$1,144 mill.-$926 mill.In order to evaluate the performance of the bank, you have to compare the ROE to the ROE of some major competitors or some industry average.6-7What is the return on assets (ROA), and why is it important? Might the ROA measure be important to bankings key competitors?Return on assets is the ratio of Net Income/Total Assets. The rate of return secured on a banks total assets indicates the efficiency of its management in generating net income from all of the resources (assets) committed to the institution. This would be important to banks and their major competitors.6-8.A bank estimates that its total revenues will amount to $155 million and its total expenses (including taxes) will equal $107 million this year. Its liabilities total $4,960 million while its equity capital amounts to $52 million. What is the banks return on assets? Is this ROA high or low? How could you find out?The banks return on assets would be:ROA =Net Income=$155 mill. - $107 mill.= 0.0096 or 0.96 percentTotal Assets$4,960 mill. + $52 mill.The size of this banks ROA should be compared with the ROAs of other banks similar in size and location to determine if this banks ROA is high or low.6-9.Why do the managers of financial firms often pay close attention today to the net interest margin and noninterest margin? To the earnings spread?The net interest margin (NIM) indicates how successful the bank has been in borrowing funds from the cheapest sources and in maintaining an adequate spread between its returns on loans and security investments and the cost of its borrowed funds. If the NIM rises, loan and security income must be rising or the average cost of funds must be falling or both. A declining NIM is undesirable because the banks interest spread is being squeezed, usually because of rising interest costs on deposits and other borrowings and increased competition today.In contrast, the noninterest margin reflects the banks spread between its noninterest income (such as service fees on deposits) and its noninterest expenses (especially salaries and wages and overhead expenses). For most banks the noninterest margin is negative. Management will usually attempt to expand fee income, while controlling closely the growth of noninterest expenses in order to make a negative noninterest margin less negative.The earnings spread measures the effectiveness of the banks intermediation function of borrowing and lending money, which, of course, is the banks primary way of generating earnings. As competition increases, the spread between the average yields on assets and the average cost of liabilities will be squeezed, forcing the banks management to search for alternative sources of income, such as fees from various services the bank offers.6-10. Suppose a banker tells you that his bank in the year just completed had total interest expenses on all borrowings of $12 million and noninterest expense of $5 million, while interest income from earning assets totaled $16 million and noninterest revenues totaled $2 million. Suppose further that assets amounted to $480 million, of which earning assets represented 85 percent of that total while total interest-bearing liabilities amounted to 75 percent of total assets. See if you can determine this banks net interest and noninterest margins and its earnings base and earnings spread for the most recent year.The banks net interest and noninterest margins must be:Net Interest =$16 mill. - $12 mill.Noninterest=$2 mill. - $5 mill.Margin$480 mill.Margin$480 mill.= 0.00833= -0.00625The banks earnings spread and earnings base are:Earnings=$16 mill.-$12 mill.Spread$480 mill * 0.85$480 mill. * 0.75= 0.0392= 0.0333=0.0059Earnings Base=$480 mill. ($480 mill. * 0.15)=0.85 or 85 percent$480 mill.6-11. What are the principal components of ROE, and what does each of these components measure?The principal components of ROE are:a. The net profit margin or net after-tax income to Total operating revenues which reflects the effectiveness of a banks expense control program and service pricing policies;b. The degree of asset utilization or ratio of Total operating revenues to Total assets which measures the effectiveness of managing the banks portfolio management policies, especially the mix and yield on assets; and,c. The equity multiplier or ratio of Total assets to Total equity capital which measures a banks use of leverage in funding its operations: sources chosen to fund the financial institution (debt or equity).6-12.Suppose a bank has an ROA of 0.80 percent and an equity multiplier of 12X. What is its ROE? Suppose this banks ROA falls to 0.60 percent. What size equity multiplier must it have to hold its ROE unchanged?The banks ROE is:ROE = 0.80 percent *12 = 9.60 percent.If ROA falls to 0.60 percent, the banks ROE and equity multiplier can be determined from:ROE = 9.60% = 0.60 percent * Equity Multiplier Equity Multiplier = 9.60 percent = 16X. 0.60 percent6-13.Suppose a bank reports net income of $12, pre-tax net income of $15, operating revenues of $100, assets of $600, and $50 in equity capital. What is the banks ROE? Tax-management efficiency indicator? Expense control efficiency indicator? Asset management efficiency indicator? Funds management efficiency indicator?The banks ROE must be:ROE = = 0.24 or 24 percent Its tax-management, expense control, asset management, and funds management efficiency indicators are:Tax Management=$12Expense Control=$15Efficiency indicator$15Efficiency Indicator$100= 0.8 or 80 percent= 0.15 or 15 percentAsset Management=$100Funds Management=$600Efficiency Indicator$600Efficiency Indicator$50= 0.1667 or 16.67 percent= 12 xAlternative Calculation for ROE = 0.8 0.15 0.1667 12 = 0.24 or 24%6-14.What are the most important components of ROA, and what aspects of a financial institutions performance do they reflect?The principal components of ROA are:a. Total Interest Income Less Total Interest Expense divided by Total Assets, measuring a banks success at intermediating funds between borrowers and lenders;b. Provision for Loan Losses divided by Total Assets which measures managements ability to control loan losses and manage a banks tax exposure;c. Noninterest Income less Noninterest Expenses divided by Total Assets, which indicates the ability of management to control salaries and wages, other noninterest costs and generate the income;d. Net Income Before Taxes divided by Total Assets, which measures operating efficiency and expense control; ande. Applicable Taxes divided by Total Assets, which is an index of tax management effectiveness.6-15.If a bank has a net interest margin of 2.50%, a noninterest margin of -1.85%, and a ratio of provision for loan losses, taxes, security gains, and extraordinary items of -0.47%, what is itsROA?The banks ROA must be:ROA = Net interest margin + Noninterest margin Ratio of provision for loan losses, taxes, security gains, and extraordinary itemsROA = 2.5 percent + (-1.85 percent) (-.47 percent) = 1.12 percent6-16.To what different kinds of risk are banks and their financial-service competitors subjected today?a. Credit Risk - the probability that the loans and securities the bank holds will not pay out as promised.b. Liquidity Risk - the probability that the bank will not have sufficient cash on hand in the volume needed precisely when cash demands arise.c. Market Risk - the probability that the market value of assets held by the bank will decline due to falling market prices.d. Price Risk the probability or possibility that the value of bond portfolios and stockholders equity may decline due to market prices movement against the financial firm.e. Interest-Rate Risk - the possibility or probability that the interest rates will change, subjecting the bank to lower profits or a lower value for the firms capital.f. Foreign Exchange and Sovereign Risk the uncertainty that due to fluctuation in currency prices, assets denominated in foreign currencies may fall, forcing the written down of these assets on its Balance Sheet.g. Off-Balance-Sheet Risk the probability that the volume of off-balance-sheet commitments far exceeds the volume of conventional assets.h. Operational Risk the uncertainly regarding a financial firms earnings due to failures in computer systems, employee misconduct, floods, lightening strikes and other similar events.i. Legal and Compliance Risk the uncertainty regarding a financial firms earnings due to actions taken by our legal system or due to a violation of rules and regulations.j. Reputation Risk the uncertainty due to public opinion or the variability in earnings due to positive or negative publicity about the financial firm.k. Strategic Risk the uncertainty in earnings due to adverse business decisions, lack of responsiveness to industry changes and other poor decisions by management.k. Capital Risk the risk that the value of the assets will decline below the value of the liabilities. All of the other risks listed above can affect earnings and the value of the assets and liabilities and therefore can have an effect on the capital position of the firm.6-17.What items on a banks 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?There are several alternative measures of risk in banking and financial service firms. Capital risk is often measured by bank capital ratios, such as the ratio of total capital to total assets or total capital to risk assets. Credit risk can be tracked by such ratios as net loan losses to total loans or relative to total capital. Liquidity risk can be followed by using such ratios as cash assets to total assets or by total loans to total assets. Interest-rate risk may be indicated by such ratios as interest-sensitive liabilities to interest-sensitive assets or the ratio of money-market borrowings to money-market assets.These risk measures also applies to those nonbank financial institutions that are private, profit making corporations, including stockholder-owned thrift institutions, insurance companies, finance and credit-card companies, security broker and dealer firms, and mutual funds. 6-18.A bank reports that the total amount of its net loans and leases outstanding is $936 million, its assets total $1,324 million, its equity capital amounts to $110 million, and it holds $1,150 million in deposits, all expressed in book value. The estimated market values of the banks total assets and equity capital are $1,443 million and $130 million, respectively. The banks stock is currently valued at $60 per share with annual per-share earnings of $2.50. Uninsured deposits amount to $243 million and money - market borrowings total $132 million, while nonperforming loans currently amount to $43 million and the bank just charged off $21 million in loans. Calculate as many of the risk measures as you can from the foregoing data.Net Loans and Leases=$936 mill.Uninsured Deposits=$243 mill.Total Assets$1,324 mill.Total Deposits$1,150 mill.= 0.7069 or 70.69 percent= 0.2113 or 21.13 percentEquity Capital=$130 mill.Stock Price=$60Total Assets$1,443 mill.Earnings Per Share$2.50= 0.0901 or 9.01 percent= 24 XNonperforming Assets=$43 mill.= 0.0459 or 4.59 percentNet Loans and Leases$936 mill.Charge-offs of loans=$21Purchased Funds=$243 mill. + $132 mill.Total Loans and Leases$936Total Liabilities$1,324 mill. - $110 mill.= 0.0224 or 2.24 percent= 0.3089 or 30.89 percentBook Value of Assets=$1324= 0.9175 or 91.75 percentMarket Value of Assets$1443Problems and Projects6-1.An investor holds the stock of Foremost Financials and expects to receive a dividend of $5.75 per share at the end of the year. Stock analysts recently predicted that the banks dividends will grow at approximately 3 percent a year indefinitely into the future. If this is true, and if the appropriate risk-adjusted cost of capital (discount rate) for the bank is 12.25 percent, what should be the current price per share of Foremost Financials stock?6-2.Suppose that stockbrokers have projected that Yorktown Savings will pay a dividend of $3 per share on its common stock at the end of the year; a dividend of $4.50 per share is expected for the next year, and $ 5.50 per share in the following two year. The risk-adjusted cost of capital for banks in Yorktowns risk class is 15 percent. If an investor holding Yorktowns stock plans to hold that stock for only four years and hopes to sell it at a price of $60 per share, what should the value of the banks stock be in todays market?P0 = $47.08 per share.6-3Bluebird Savings Association has a ratio of equity capital to total assets of 9 percent. In contrast, Cardinal Savings reports an equity-capital-to- asset ratio of 7 percent. What is the value of the equity multiplier for each of these institutions? Suppose that both institutions have an ROA of 0.85 percent. What must each institutions return on equity capital be? What do your calculations tell you about the benefits of having as little equity capital as regulations or the marketplace will allow?Bluebird Savings Association has an equity-to-asset ratio of 9 percent which means its equity multiplier must be:1/ (Equity Capital / Assets) = = 1 / 0.09 = 11.11xIn contrast, Cardinal Savings has an equity multiplier of:1/ (Equity Capital / Assets) = = 14.29xWith an ROA of 0.85 percent Bluebird Savings Association would have an ROE of:ROE = 0.85 x 11.11x = 9.44 percent.With an ROA of .85 percent Cardinal Savings would have an ROE of:ROE = 0.85 x 14.29x = 12.14 percentIn this case Cardinal Savings is making greater use of financial leverage and is generating a higher return on equity capital.
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