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

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Introduction
Financial institutions
Maximize the value of the shareholders wealth 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

What individuals or groups are likely to be interested in the

banks level of profitability and risk exposure?

Lenders (other banks)

Borrowers
Large depositors
Long-term debt holders
Stockholders
Bank examiners - regulators

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Evaluating Performance
Performance must be directed toward specific objectives
A key objective is to maximize the value of the firm

Equation (61) assumes that the stock may pay dividends of

varying amounts over time
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Evaluating Performance (continued)

The minimum acceptable rate of return (r) or the cost of capital
Two main components
The risk-free rate of interest
The equity risk premium

The value of the financial firms stock will tend to rise in any of the
following situations
1.

2.
3.

4.

The value of the stream of future stockholder dividends is expected to

increase
The financial organizations perceived level of risk falls
Market interest rates decrease, reducing shareholders acceptable
rates of return via the risk-free rate of interest component of all
market interest rates
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
Market interest rates
Currency exchange rates
The strength or weakness of the economy
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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Example 1
An investor holds the stock of RGV Bank and expects to receive
a dividend of $4.75 per share at the end of the year. Stock
analysts recently predicted that the banks dividends will grow
at approximately 3% 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%, what should be the current
price per share of RGV Banks stock?

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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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Example 2
Suppose that stockbrokers have projected that RGV Bank 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 is expected for the next year,
and $4.00 per share in the following two years. The risk-adjusted
cost of capital for banks in RGV Banks risk class is 15%. If an
investor holding RGV Banks stock plans to hold that stock for
only 4 years and hopes to sell it at a price of $50 per share, what
should the value of the banks stock be in todays market?

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Key Profitability Ratios

The behavior of a stocks price is, in theory, the best
indicator of a financial firms performance
Reflects the markets evaluation of that firm
However, this indicator is often not available for smaller banks and
other relatively small financial-service corporations

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Key Profitability Ratios

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Key Profitability Ratios

Return on assets (ROA): an indicator of managerial efficiency
Management capability in converting assets into net earnings
Return on equity (ROE): a measure of shareholders rate of return
The stockholders net benefit from investing their capital
The net operating margin, net interest margin, and net noninterest
margin are efficiency measures as well as profitability measures
The net interest margin: measures the spread between interest
revenues and interest costs management
The net noninterest margin: measures the amount of noninterest
revenues stemming from service fees relative to the amount of
noninterest costs incurred
Typically, the net noninterest margin is negative

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Earnings Spread
Another traditional measure of earnings efficiency

Measures the effectiveness of a financial firms intermediation

function in borrowing and lending money and also the intensity of
competition in the firms 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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Example 3
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 return on assets? What is return on equity
capital?

ROA?
ROE?

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Example 4
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% of that total while total
interest-bearing liabilities amounted to 75% of total assets.

Net interest & Net noninterest margins?

Earnings spread for the most recent year?

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ROE ROA
Useful Profitability Formulas for Banks and Other FinancialService Companies

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ROE DuPont Formula

or

where

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TABLE 61 Components of Return on Equity (ROE) for All

FDIC-Insured Institutions (1992-2009)

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ROE Efficiency Equation

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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Components of ROA
We can also divide a financial firms return on assets into its
component parts

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TABLE 63 Components of Return on Assets (ROA) for All

FDIC-Insured Depository Institutions (19922009)

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Superior Profitability
Achieving superior profitability for a financial institution
depends upon several crucial factors:
1.
2.

3.
4.

5.

Careful use of financial leverage (or the proportion of assets

financed by debt as opposed to equity capital)
Careful use of operating leverage from fixed assets (or the
proportion of fixed-cost inputs used to boost operating earnings as
output grows)
Careful control of operating expenses so that more dollars of sales
revenue become net income
Careful management of the asset portfolio to meet liquidity needs
while seeking the highest returns from any assets acquired
Careful control of exposure to risk so that losses dont overwhelm
income and equity capital

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

Popular measures of overall risk for a financial firm

Standard deviation () or variance (2) of stock prices
Standard deviation or variance of net income (NI)
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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Types of Bank Risks

Credit Risk: the probability that the loans and securities the bank holds will
not pay out as promised.
Liquidity Risk: the probability that the bank will not have sufficient cash on
hand in the volume needed precisely when cash demands arise.
Market Risk: the probability that the market value of assets held by the bank
will decline due to falling market prices:

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.
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 firms capital.

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.
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Types of Bank Risks

Off-Balance-Sheet Risk: the probability that the volume of off-balance-sheet commitments far
exceeds the volume of conventional assets.
Operational (Transactional) Risk: the uncertainty regarding a financial firms earnings due to
failures in computer systems, employee misconduct, floods, lightening strikes and other similar
events.
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.
Reputation Risk: the uncertainty due to public opinion or the variability in earnings due to
positive or negative publicity about the financial firm.
Strategic Risk: the uncertainty in earnings due to adverse business decisions, lack of
responsiveness to industry changes, and other poor decisions by management.
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.

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Measuring Risk
1. Credit Risk

Total Loans/ Total Deposits

Nonperforming Assets / Net Loans and Leases
Charge-offs of Loan / Total Loans and Leases

2. Liquidity Risk:

Net Loans and Leases/ Total Assets

3. Interest Rate Risk:

Uninsured Deposits/ Total Deposits

4. Price Risk:

Book Value of Assets / Market Value of Assets

5. Capital Risk:

Equity Capital / Risky Assets

Stock Price / Earnings per Share

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Example 5
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.
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Other Goals
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
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
Medium-size and larger banks tend to be most efficient
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Performance Indicators among Bankings

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 assets (ROA)
Net interest margin
Asset utilization ratio
Nonperforming assets to equity capital
ratio
Book-value assets to market-value assets
Interest-rate spread between yields on
the financial firms debt and market
yields on government securities

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Return on equity capital (ROE)

Net operating margin
Equity multiplier
Cash accounts to total assets
Interest-sensitive assets to interestsensitive liabilities
Equity capital to risk-exposed assets
Earnings per share of stock

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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 64 Important Performance Indicators Related to the Size

and Location of FDIC-Insured Depository Institutions (2009)

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Recap Q&As
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 institutions 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 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?
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