CHAPTER 6MEASURING AND EVALUATING THE PERFORMANCE OF BANKS AND THEIRPRINCIPAL COMPETITORSGoal of This Chapter: The purpose of this chapter is to discover what analytical tools can be applied to a bank’s financial statements so that management and th e 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 AllFinancial-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 ComponentsG. What a Breakdown of Profitability Measures Can Tell UsH. Measuring Risk in Banking and Financial Services1. Credit Risk2. Liquidity Risk3. Market Riska. Price Riskb. Interest Rate Risk4. Foreign Exchange and Sovereign Risk5. Off-Balance-Sheet Risk6. Operational (Transactional) Risk7. Legal and Compliance Risks8. Reputation Risk9. Strategic Risk10. Capital RiskI. Other Goals in Banking and Financial-Services ManagementIII. Performance Indicators among Banking’s Key CompetitorsIV. The Impact of Size on PerformanceA.Size, Location, and Regulatory Bias in Analyzing the Performance of Banks andCompeting 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 like 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., 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 bank examiners representing the regulatory community.6-3. What factors influence the stock price of a financial-service corporation?A bank's 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 working to achieve policies that increase future earnings, reduce risk, or pursue a combination of both actions.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 theminimum required return-to-equity capital based on the bank's perceived level of risk is 10 percent. Can you estimate the current value of the bank's stock?In this constant dividend growth rate problem, the current value of the bank's stock would be:1o D 4 (1+0.05) 4.2P ====$84(r-g)(0.10-0.05)0.05⨯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 over total equity capital. It represents the rate of return earned on the funds invested in the bank by its stockholders. They expect to earn a suitable profit over the risk of their investment.Return on equity capital can also be calculated using the return on assets as follows:Total assets ROE = ROA Total equity capital⨯This ROE –ROA relationship illustrates the fundamental trade-off between risk and return. This equation reminds us that the return to a financial firm’s shareholders is highly sensitive to how i ts assets are financed —the proportion of debt and owner’s capital used. Constructing a risk -return trade-off table can help the managers understand how much leverage (debt relative to equity) must be used to achieve a financial institution’s desired rate o f return to its stockholders.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 bank's return on equity capital should be:Net income ROE Total equity capital=$51 million = 0.2339 or 23.39 percent $1,144 million $926 million=-In order to evaluate the performance of the bank, you have to compare its ROE to the ROE of some major competitors or the industry average.6-7 What is the return on assets (ROA), and why is it important? Might the ROA measure be important to banking’s key competitors?Return on assets is the ratio of net income over total assets. The rate of return secured on a bank's 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 itsequity capital amounts to $52 million. What is the bank's return on assets? Is this ROA high or low? How could you find out?The bank's return on assets would be:Net income ROA Total Assets=$155 million $107 million = 0.0096 or 0.96 percent $4,960 million $52 million-=+The size of this bank's ROA should be compared with the ROA's of other banks similar in size and location to determine whether this bank's 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 bank's 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 andoverhead 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 bank's intermediation function of borrowing and lending money, which, of course, is the bank's 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 bank's 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 expenses 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 bank's net interest and noninterest margins and its earnings base and earnings spread for the most recent year.The bank's net interest and noninterest margins must be:()Interest income-Interest expense Net interest margin = Totalassets$16million - $12million = = 0.00833$480millionNoninterest revenues -Provision for loan and leaselosses -Noninterest expenses Net noninterest margin = Totalassets⎛⎫ ⎪⎝⎭$2million - $5million = = -0.00625$480millionThe bank's earnings spread and earnings base are:Totalinterest income Total interestexpense Earningsspread = - Totalearning assets Total interest-bearing liablities$16million $12million = - = 0.0059$480million ?0.85$480million ?0.75Totalearning assets Earnings base = Totalassets()$480million - $480 million 0.15= = 0.85 or 85 percent $480million⨯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 the Net after-tax income to Total operating revenues which reflects the effectiveness of a bank's expense control program and service pricing policies;b. The degree of asset utilization or the ratio of Total operating revenues to Total assets which measures the effectiveness of the bank's portfolio management policies, especially the mix and yield on assets; and,c. The equity multiplier or the ratio of Total assets to Total equity capital which measures a bank's use of leverage in funding its operations: the 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 bank's ROA falls to 0.60 percent. What size equity multiplier must it have to hold its ROE unchanged?The bank's ROE is:ROE = 0.80 percent ×12 = 9.60 percent.If ROA falls to 0.60 percent, the bank's ROE and equity multiplier can be determined from: ROE = 9.60 percent = 0.60 percent × Equity multiplier9.60 percent==Equity Multiplier 16X0.60 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 bank's ROE? Tax-management efficiency indicator? Expense control efficiency indicator? Asset management efficiency indicator? Funds management efficiency indicator?The bank's ROE must be:$12ROE = = 0.24or24percent$50Its tax-management, expense control, asset management, and funds management efficiency indicators are:$12Tax Management Effeciency Indicator = = 0.8or80percent$15$15ExpenseControl Effeciency Indicator = = 0.15or15percent$100$100Asset Management Effeciency Indicator = = 0.1667or16.67percent$600$600Fund Management Effeciency Indicator = = 12x$50Alternative calculation for ROE:= 0.8 ?0.15 ?0.1667 ?12= 0.24or24percent6-14. What are the most important components of ROA, and what aspects of a financial institution’s performance do they reflect?The principal components of ROA are:a. Total Interest Income less Total Interest Expense divided by Total Assets, measuring a bank's success at intermediating funds between borrowers and lenders.b. Provision for Loan Losses divided by Total Assets, which measures management's ability to control loan losses and manage a bank's accrual expense.c. Noninterest Income less Noninterest Expenses divided by Total Assets, which indicates the ability of management to control salaries and wages, other noninterest costs of operations and generate income from handling customer transactions.d. Applicable Taxes divided by Total Assets, which is an index of tax management effectiveness, measures the financial firm’s share of the cost of government securities.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 its ROA?The bank's ROA must be:ROA = Net interest margin + Noninterest margin – Ratio of provision for loanlosses, taxes, security gains, and extraordinary itemsROA = 2.5 percent + (−1.85 percent) –(−0.47 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. Market risk is composed of both price risk and interest rate risk.Price Risk: the probability or possibility that the value of bond port folios and stockholders’ equity may decline due to market prices movement against the financial firm.Interest-Rate Risk: the possibility or probability that the interest rates will change,subjecting the bank to incur a lower margin of profit or a lower value for the firm’s capital.d. Foreign Exchange and Sovereign Risk: the uncertainty that due to fluctuation in currency prices, assets denominated in foreign currencies may fall, forcing the write-down of these assets on its Balance Sheet.e. Off-Balance-Sheet Risk: the probability that the volume of off-balance-sheet commitments far exceeds the volume of conventional assets.f. Operational (Transactional) Risk: the uncertainty regarding a financial firm’s earnings due to failures in computer systems, employee misconduct, floods, lightening strikes and other similar events.g. Legal and Compliance Risk: the uncertainty regarding a financial firm’s earnings due to actions taken by our legal system or due to a violation of rules and regulations.h. Reputation Risk: the uncertainty due to public opinion or the variability in earnings due to positive or negative publicity about the financial firm.i. Strategic Risk: the uncertainty in earnings due to adverse business decisions, lack of responsiveness to industry changes, and other poor decisions by management.j. 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 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?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 and government securities to total assets or by purchased funds to total assets. Interest-rate risk may be indicated by such ratios as interest-sensitive assets to interest-sensitive liabilities or the ratio of money-market assets to money-market borrowings.These risk measures also apply 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, mutual funds, and hedge 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 bank's total assets and equity capital are $1,443 million and $130 million, respectively. The bank's 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.1. Liquidity Risk:Net Loans and Leases$936million= = 0.706949or70.69percentTotal Assets$1,324 million2. Interest Rate Risk:Uninsured Deposits$243million= = 0.211304or21.13percentTotal Deposits$1,150 million3. Capital Risk:Equity Capital$130million= = 0.09009or9.01percentRisk Assets$1,443 millionStock Price$6024==Earnings per Share$2.50Book Value of Assets$1,324million= = 0.917533or91.75percentMarket Valueof Assets$1,443 million4. Credit Risk:Nonperforming Assets$43million= = 0.04594or4.59percentNet Loans and Leases$936 millionCharge-offs of Loans$21million= = 0.022436or2.24percentTotal Loans and Leases$936 million5. Price Risk:Book Value of Assets $1,324million = = 0.917533or 91.75percent Market Valueof Assets $1,443 millionProblems and Projects6-1. An investor holds the stock of Last-But-Not-Least Financials and expects to receive a dividend of $4.75 per share at the end of the year. Stock analysts recently predicted that the bank’s 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 14 percent, what should be the current price per share of Last-But-Not-Least Financials’ stock?()()10 4.75$43.180.140.03D P r g ===--6-2. Suppose that stockbrokers have projected that Jamestown Savings will pay a dividend of $2.50 per share on its common stock at the end of the year; a dividend of $3.25 per share isexpected for the next year, and $4.00 per share in the following two years. The risk-adjusted cost of capital for banks in Jamestown ’s risk class is 15 percent. If an investor holding Jamestown ’s stock plans to hold that stock for only four years and hopes to sell it at a price of $50 per share, what should the value of the bank’s stock be in today’s market?()()()()()023442.50 3.25445010.1510.1510.1510.1510.15P =+++++++++0P = $38.14 per share.6-3 Oriole 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 0.67 percent. What must each institution’s 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?Oriole Savings Association has an equity-to-asset ratio of 9 percent which means its equity multiplier must be:11 = = 11.11X Equity Capital 0.09Assets ⎛⎫ ⎪⎝⎭In contrast, Cardinal Savings has an equity-to-asset ratio of 7 percent which means it has an equity multiplier of:11 = = 14.29X Equity Capital 0.07Assets ⎛⎫ ⎪⎝⎭With an ROA of 0.67 percent Oriole Savings Association would have an ROE of:ROE = 0.67 × 11.11x = 7.44 percent.With an ROA of 0.67 percent Cardinal Savings would have an ROE of:ROE = 0.67 × 14.29x = 9.57 percentIn this case Cardinal Savings is making greater use of financial leverage and is generating a higher return on equity capital as compared to Oriole Savings Association.6-4. The latest report of condition and income and expense statement for Smiling Merchants National Bank are as shown in the following tables:Smiling Merchants National Bank (complete)Income and Expense Statement (Report of Income)Interest and fees on loans $50Interest and dividends on securities 6Total interest income 56Interest paid on deposits 40Interest on nondeposit borrowings 6Total interest expense 46Net interest income 10Provision for loan losses 5Noninterest income and fees 20Noninterest expenses:Salaries and employee benefits 10*Overhead expenses 5Other noninterest expenses 2Total noninterest expenses 17Net noninterest income -2Pretax operating income 8Securities gains (or losses) 2Pretax net operating income 10Taxes 2Net operating income 8Net extraordinary income -1Net income 7*Note: the bank currently has 40 FTE employees.Smiling Merchants National BankReport of ConditionAssets LiabilitiesCash and deposits due from banks $100 Demand deposits $190Investment securities 150 Savings deposits 180Federal funds sold 10 Time deposits 470Net loans 700 Federal funds purchased 80(Allowance for loan losses = 25) Total liabilities 920(Unearned income on loans = 5) Equity capitalNet Fixed Assets 50 Common stock 20Surplus 35 Total assets 980 Retained earnings 35Total Capital 80 Total earnings assets 860 Interest-bearing deposits 650Fill in the missing items on the income and expense statement. Using these statements, calculate the following performance measures:ROE Asset utilizationROA Equity multiplierNet interest margin Tax management efficiencyNet noninterest margin Expense control efficiencyNet operating margin Asset management efficiencyEarnings spread Funds management efficiencyNet profit margin Operating efficiency ratioWhat strengths and weaknesses are you able to detect in Smiling Merchants’ performance?1.Net income$7ROE = = = 0.0778 or 7.78 percent Totalequity capital$902.Net income$7ROA = = = 0.00714 or 0.71 percent Totalassets$9803.Net interest income$10Net interest margin = = = 0.0120 or 1.02 percentTotalassets$9804.Net noninterest income-$2Net noninterest margin = = = -0.00204 or -0.20 percentTotalassets$9805.Totaloperating revenues - Totaloperating expenses Net operating margin =Totalassets$8= = 0.008163 or 0.82 percent$9806.Totalinterest income Totalinterest expenses Earningsspread= -Totalearnings assets Totalinterest-bearing liabilities$56$46= - = 0.002103 or 0.21 percent$860$6507.Net income$7Net profit margin = = = 0.092105 or 9.21 percentTotaloperating revenues$548.Totaloperating revenues$76Asset utilization = = = 0.077551 or 7.76 percentTotalassets$9809.Totalassets$980Equity multiplier== = 10.89xTotalequity capital$9010.Net income$7Tax Management = = = 0.7 or 70 percentPretax net operating income$1011.Pretax net operating income$10 Expensecontroleffeciency = = = 0.131579 or 13.16 percentTotaloperating revenue$7612.Totaloperating revenues Asset managment effeciency ratio =Totalassets$76= = 0.07755 or 7.76 percent$98013.Totalassets$980Funds Managment Effeciency Ratio= = = 10.89xTotalequity capital$9014.Totaloperating expenses$68Operating effeciency ratio= = = 0.894737 or 89.47 percentTotaloperating revenues$76Strengths:ROE: Positive value reflects a high rate of return flowing to shareholders.Net profit margin: Positive value reflects effectiveness of management in controlling cost and service pricing policies.Asset utilization: Positive value reflects a good portfolio management policies and yield on assets. Equity multiplier: Positive value reflects efficient financial policies.Expense control efficiency, asset management efficiency ratio, funds management efficiency ratio, operating efficiency ratio also reflects a high operating efficiency and expense control.Tax-management efficiency ratio: Positive ratio reflecting the use of security gains or losses and other tax-management tools (such as buying tax-exempt bonds) to minimize tax exposure etc. Weaknesses:ROA: Positive value (0.714%) reflects managerial efficiency and how successful management has been in converting assets into net earnings. Since the positive value is only 0.714% it acts as a weakness for Smiling Merchants National Bank.Net noninterest margin: Negative value (−0.2%) reflects that net noninterest income is inline with noninterest cost.Net interest margin: Positive value (1.02%) reflects that management is not successful in achieving close control over earning assets and in utilizing the cheapest sources of funding. Since the positive value is only 1.02% it acts as a weakness for Smiling Merchants National Bank.Earnings spread: Positive value (0.21%) reflects a high competition, forcing management to try and find other ways to make up for an eroding earnings spread.6-5. The following information is for Rainbow National Bank:Interest income $2,250.00Interest expense 1,500.00Total assets 45,000.00Securities losses or gains 21.00Earning assets 40,000.00Total liabilities 38,000.00Taxes paid 16.00Shares of common stock outstanding 5,000Noninterest income $800.00Noninterest expense 900.00Provision for loan losses 250.00Please calculate:ROEROANet interest marginEarnings per shareNet noninterest marginNet operating marginNet income$405ROE= = = 0.058or5.8percentTotalequity capital$45,000 - $38,000Net income$405ROA= = = 0.009or0.90percentTotalassets$45,000Net interest income$750Net interest margin= = = 0.01667or1.67percentTotalassets$45,000Net income$405Earnings per share= = = $0.081per shareCommon equityshares outstanding5,000Net noninterest income-$350Net noninterest margin = = = -0.0078or-0.78percentTotalassets$45,000Totaloperating revenues-Totaloperating expenses$400Net operating margin= =Totalassets$45,000= 0.00889 or 0.89percentAlternative Scenarios:a. Suppose interest income, interest expenses, noninterest income, and noninterest expenses each increase by 3 percent while all other revenue and expense items shown in the preceding table remain unchanged. What will happen to Rainbow ROE, ROA, and earnings per share?Interest income $2,317.50Interest expense $1,545.00Total assets $45,000.00Securities losses or gains $21.00Earning assets $40,000.00Total liabilities $38,000.00Taxes paid $16.00Shares of Common Stock outstanding 5,000Noninterest income $824.00Noninterest expense $927.00Provision for loan losses $250.00Net income$425ROE= = = 0.06064or6.06percentTotalequity capital$45,000 - $38,000。
