MEASURING AND EVALUATING

THE PERFORMANCE OF BANKS

AND THEIR PRINCIPAL
COMPETITORS
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INTRODUCTION
 What do we mean by the word perform when it comes to
banks and other financial firms?
 In this case performance refers to how adequately a
financial firm meets the needs of its stockholders
(owners), employees, depositors and other creditors, and
borrowing customers.
 At the same time, financial firms must find a way to keep
government regulators satisfied that their operating
policies, loans, and investments are sound, protecting the
public interest. The success or lack of success of these
institutions in meeting the expectations of others is usually
revealed by a careful study of their financial statements. 2
EVALUATING PERFORMANCE
 Determining Long-Range 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.
 Maximizing the Value of the Firm
 The basic principles of financial management, as that science
is practiced today, suggest strongly that attempting to
maximize a corporation's stock value is the key objective that
should have priority over all others. If the stock fails to rise in
value commensurate with stockholder expectations, current
investors may seek to unload their shares and the financial
institution will have difficulty raising new capital to support
its future growth. 3
WHAT WILL CAUSE A FINANCIAL FIRM'S
STOCK TO RISE IN VALUE?

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WHAT WILL CAUSE A FINANCIAL FIRM'S
STOCK TO RISE IN VALUE?
 The minimum acceptable rate of return, r, is sometimes
referred to as an institution's cost of capital and has two
main components:
 The risk-free rate of interest (often proxied by the current
yield on government bonds) and
 The equity risk premium (which is designed to compensate
an investor for accepting the risk of investing in a financial
firm's stock rather than in risk-free securities).

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WHAT WILL CAUSE A FINANCIAL FIRM'S
STOCK TO RISE IN VALUE?
 The value of the stream of future stockholder dividends is
expected to increase.
 The financial organization's perceived level of risk falls.

 Market interest rates decrease.

 Expected dividend increases are combined with declining

risk.
 The stock values of financial institutions to be especially
sensitive to changes in market interest rates, currency
exchange rates, and the strength or weakness of the economy
that each serve.
 Clearly, management can work to achieve policies that
increase future earnings, reduce risk, or pursue a combination 6
of both actions in order to raise its company's stock price
WHAT WILL CAUSE A FINANCIAL FIRM'S
STOCK TO RISE IN VALUE?

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WHAT WILL CAUSE A FINANCIAL FIRM'S
STOCK TO RISE IN VALUE?
 Suppose a bank is expected to pay a dividend of $5 per
share in period 1, dividends are expected to grow 6
percent a year for all future years, and the appropriate
discount rate to reflect shareholder risk is 10 percent.
Then the bank's stock price must be valued at:

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WHAT WILL CAUSE A FINANCIAL FIRM'S
STOCK TO RISE IN VALUE?

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WHAT WILL CAUSE A FINANCIAL FIRM'S
STOCK TO RISE IN VALUE?
 Suppose investors expect a bank to pay a $5 dividend at
the end of period 1, $10 at the end of period 2, and then
plan to sell the stock for a price of $150 per share. If the
relevant discount rate to capture risk is 10 percent, the
current value of the bank's stock should approach:

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PROFITABILITY RATIOS

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PROFITABILITY RATIOS

 Many authorities prefer to use total earning assets in the denominator of the net interest margin and
noninterest margin. Earning assets are those generating interest or fee income, principally loans and
security investments. The reasoning is that net interest income as well as net noninterest income 12
should be compared, not to all assets, but rather to those assets that account for the majority of
income.
PROFITABILITY RATIOS

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INTERPRETING PROFITABILITY RATIOS
 Return on assets (ROA) is primarily an indicator of
managerial efficiency; it indicates how capable
management has been in converting assets into net
earnings.
 Return on equity (ROE}, on the other hand, is a measure
of the rate of return flowing to shareholders. It
approximates the net benefit that the stockholders have
received from investing their capital in the financial
firm.

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INTERPRETING PROFITABILITY RATIOS
 The net operating margin, net interest margin, and net noninterest margin
are efficiency measures as well as profitability measures, indicating how
well management and staff have been able to keep the growth of revenues
( which come primarily from loans, investments, and service fees) ahead
of rising costs (principally the interest on deposits and other borrowings
and employee salaries and benefits).
 The net interest margin measures how large a spread between interest
revenues and interest costs management has been able to achieve by close
control over earning assets and pursuit of the cheapest sources of funding.
 The net non interest margin, in contrast, 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
(including salaries and wages, repair and maintenance of facilities, and
loan loss expenses). Typically, the net noninterest margin is negative:
Noninterest costs generally outstrip fee income, though fee income has 15
been rising rapidly in recent years as a percentage of all revenues.
INTERPRETING PROFITABILITY RATIOS

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USEFUL PROFITABILITY FORMULAS FOR BANKS
AND OTHER FINANCIAL-SERVICE COMPANIES

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USEFUL PROFITABILITY FORMULAS FOR BANKS
AND OTHER FINANCIAL-SERVICE COMPANIES
 A bank whose ROA is projected to be 1 percent this year will need
$10 in assets for each $1 in capital to achieve a 10 percent ROE.
 If, however, the bank's ROA is expected to fall to 0.5 percent, a 10
percent ROE is attainable only if each $1 of capital supports $20 in
assets.
 Indeed, we could construct a risk-return trade-off table like the one
following that will tell us how much leverage (debt relative to
equity) must be used to achieve a financial institution's desired rate
of return to its stockholders.
 For example, the trade-off table indicates that a financial firm with a
5-to-l assets-to-capital ratio can expect
 (a) a 2.5 percent ROE if ROA is 0.5 percent and
 (b) a 10 percent ROE if ROA is 2 percent.
 In contrast, with a 20 to 1 assets-to-capital ratio a financial firm can 18
achieve a 10 percent ROE simply by earning a modest 0.5 percent ROA.
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RETURN ON EQUITY AND ITS
PRINCIPAL COMPONENTS

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RETURN ON EQUITY AND ITS
PRINCIPAL COMPONENTS

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RETURN ON EQUITY AND ITS
PRINCIPAL COMPONENTS

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RETURN ON EQUITY AND ITS
PRINCIPAL COMPONENTS

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RETURN ON EQUITY AND ITS
PRINCIPAL COMPONENTS
 Suppose a bank's Report of Condition and Report of
Income show the following figures:

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 Its ROE must be,
THE RETURN ON ASSETS AND ITS
PRINCIPAL COMPONENTS

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THE RETURN ON ASSETS AND ITS
PRINCIPAL COMPONENTS

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Risk to the manager of a financial institution or to a
regulator supervising financial institutions means the
perceived uncertainty associated with a particular event.
 For example, will the customer renew his or her loan?

 Will deposits and other sources of funds grow next

month?
 Will the financial firm's stock price rise and its earnings
increase?
 Are interest rates going to rise or fall next week, and will
a financial institution lose income or value if they do?
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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Among the more popular measures of overall risk for a
financial firm are the following:
 Standard deviation or variance of stock prices.
 Standard deviation or variance of net income.
 Standard deviation or variance of return on equity (ROE) and
return on assets (ROA).

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Credit Risk
 The probability that some of a financial institution's assets,
especially its loans, will decline in value and perhaps become
worthless is known as credit risk.
 The following are the most widely used ratio indicators of
credit risk:
 Nonperforming assets / Total loans and leases.
 Net charge-offs of loans / Total loans and leases.
 Annual provision for loan losses / Total loans and leases or
relative to equity capital.
 Allowance for loan losses / Total loans and leases or relative to
equity capital.
 Nonperforming assets / Equity capital.
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 Total loans/total deposits.
MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Liquidity Risk
 Financial-service managers are also concerned about the
danger of not having sufficient cash and borrowing capacity
to meet customer withdrawals, loan demand, and other cash
needs. Faced with liquidity risk a financial institution may
be forced to borrow emergency funds at excessive cost to
cover its immediate cash needs, reducing its earnings.
 Cash and due from balances held at other depository
institutions/Total assets.
 Cash assets and government securities/Total assets.

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Market Risk
 Market risk is composed of both price risk and interest rate
risk.
 Price Risk Especially sensitive to these market-value
movements are bond portfolios and stockholders' equity (net
worth), which can dive suddenly as market prices move against
a financial firm. Among the most important indicators of price
risk in financial institutions' management are:
 Book-value assets/Estimated market value of those same
assets.
 Book-value equity capital/Market value of equity capital.

 Market value of bonds and other fixed-income assets/Their

value as recorded on a financial institution's books. 33
MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 The impact of changing interest rates on a financial
institution's margin of profit is called interest rate risk.
Among the most widely used measures of interest-rate
risk exposure are the ratios:
 Interest-sensitive assets/Interest-sensitive liabilities

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Foreign Exchange and Sovereign Risk
 Fluctuating currency prices generate foreign exchange risk
as the value of a financial institution's assets denominated in
foreign currencies may fall, forcing a write-down of those
assets on its balance sheet.
 Under what is often called sovereign risk foreign
governments may face domestic instability and even armed
conflict, which may damage their ability to repay debts owed
to international lending institutions.

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Off-Balance-Sheet Risk
 One of the newest forms of risk faced by leading financial
institutions is associated with the rapid build-up of financial
contracts that obligate a financial firm to perform in various
ways but are not recorded on its balance sheet.
 Examples include standby credit agreements, in which a
financial firm guarantees repayment of a customer's loans
owed to other businesses; loan commitments, in which a
financial institution pledges to extend credit over a set period
of time as needed by its customers; and financial futures and
options, in which prices and interest rates are hedged against
adverse market movements.
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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Operational (Transactional) Risk
 Operational risk refers to uncertainty regarding a financial
firm's earnings due to failures in computer systems, errors,
misconduct by employees, floods, lightning strikes, and similar
events. The broad group of actions included in this risk
definition often decrease earnings due to unexpected operating
expenses.
 Today, acts of terrorism such as 9/11 and natural disasters such
as hurricanes, earthquakes, and tsunamis can lead to great loss
for any financial firm. These natural and not so-natural
disasters may close financial institutions for extended periods
and interrupt their service to customers. Foregone income from
such disasters is unpredictable, resulting in unexpected
operating expenses and greater variability in earnings. 37
 Legal and Compliance Risks
 Legal risk creates variability in earnings resulting from
actions taken by our legal system. Unenforceable contracts,
lawsuits, or adverse judgments may reduce a financial firm's
revenues and increase its expenses. Lawyers are never cheap,
and fines can be expensive!
 For example, if a depository institution fails to hold adequate
capital, costly corrective actions must be taken to avoid its
closure.

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Reputation Risk
 Negative publicity, whether true or not, can affect a financial
firm's earnings by dissuading customers from using the
services of the institution, just as positive publicity may serve
to promote a financial firm's services and products.
 Reputation risk is the uncertainty associated with public
opinion. The very nature of a financial firm's business
requires maintaining the confidence of its customers and
creditors.

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Strategic Risk
 Variations in earnings due to adverse business decisions,
improper implementation of decisions, or lack of
responsiveness to industry changes are parts of what is called
strategic risk.
 This risk category can be characterized as the human element
in making bad long-range management decisions that reflect
poor timing, lack of foresight, lack of persistence, and lack of
determination to be successful.

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MEASURING RISK IN BANKING AND
FINANCIAL SERVICES
 Capital Risk
 The impact of all the risks examined above can affect a
financial firm's long-run survival, often referred to as its
capital risk. Because variability in capital stems from other
types of risk it is often not considered separately by
government regulatory agencies.

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CAPITAL RISK
 Capital risk can be measured approximately by:
 The interest rate spread between market yields on debt issues (such as capital
notes and CDs issued by depository institutions) and the market yields on
government securities of the same maturity. An increase in that spread indicates
that investors in the market expect increased risk of loss from purchasing and
holding a financial institution's debt.
 Stock price per share/Annual earnings per share. This ratio often falls if investors
come to believe that a financial firm is undercapitalized relative to the risks it has
taken on.
 Equity capital (net worth)/Total assets, where a decline in equity funding relative
to assets may indicate increased risk exposure for shareholders and debtholders.
 Purchased funds/Total liabilities. Purchased funds usually include uninsured
deposits and borrowings in the money market from banks, nonbank corporations,
and governmental units that fall due within one year.
 Equity capital/Risk assets, reflecting how well the current level of a financial
institution's capital covers potential losses from those assets most likely to
decline in value. 42
OTHER GOALS IN BANKING AND
FINANCIAL-SERVICES MANAGEMENT

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PERFORMANCE INDICATORS AMONG
BANKING'S KEY COMPETITORS

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THE IMPACT OF SIZE ON
PERFORMANCE
 When the performance of one financial firm is compared
to that of another, size-often measured by total assets or,
in the case of a depository institution, total deposits-
becomes a critical factor.
 Most of the performance ratios presented in this chapter
are highly sensitive to the size group in which a financial
institution finds itself.
 Thus, "size bias" is especially evident in the banking
industry.

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SIZE, LOCATION, AND REGULATORY BIAS IN
ANALYZING THE PERFORMANCE OF BANKS AND
COMPETING FINANCIAL INSTITUTIONS

 To conduct even more valid performance comparisons,

we should also compare financial firms serving the same
or similar market areas.
 The best performance comparison of all is to choose
institutions of similar size serving the same market area.
 Finally, where possible, it's a good idea to compare
financial institutions subject to similar regulations and
regulatory agencies. For example, in the banking
community each regulator has a somewhat different set
of rules banks must follow, and these government-
imposed rules can have a profound impact on
performance. 46