ECON3610

Money and Banking

Lecture Topic 9

Measuring and Evaluating Bank

Performance
Readings: Rose and Hudgins: Ch. 6

Summary
Evaluating a Banks Performance
Measuring Risk in Banking
Bank Size and Performance
Examples

Value of the Banks Stock

Value of a Banks Stock Rises

When:
Expected Dividends Increase
Risk of the Bank Falls
Market Interest Rates Decrease
Combination of Expected Dividend
Increase and Risk Decline

Value of Banks Stock if Earnings

Growth is Constant

D1
P0
r -g

Key Profitability Ratios in Banking

Net Income
Return on Equity Capital (ROE) =
Total Equity Capital

Net Income
Return on Assets (ROA) =
Total Assets
Net Interest Income
Net Interest Margin
Total Assets

Net Noninterest Income

Net Noninterest Margin
Total Assets

Key Profitability Ratios in Banking

(cont.)
Total Operating Revenues Total Operating Expenses
Net Bank Operating Margin
Total Assets
Earnings Per Share (EPS)

Net Income After Taxes

Common Equity Shares Outstanding

Total Interest Income __ Total Interest Expense

Earnings Spread = Total Earning Assets
Total Interest Bearing Liability

6-9

Evaluating Performance (continued)

Return on assets (ROA) is primarily an indicator of managerial efficiency
Indicates how capable management has been in converting assets into
net earnings
Return on equity (ROE) is a measure of the rate of return flowing to
shareholders
Approximates the net benefit that the stockholders have received from investing
their capital in the financial firm

The net operating margin, net interest margin, and net noninterest margin
are efficiency measures as well as profitability measures
The net interest margin measures how large a spread between interest
revenues and interest costs management has been able to achieve
The net noninterest margin 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
Typically, the net noninterest margin is negative

6-10

Evaluating Performance (continued)

Earning Spread:
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

Breaking Down ROE

ROE = Net Income/ Total Equity Capital

ROA =
Net Income/Total Assets

Net Profit Margin =

Net Income/Total Operating Revenue

Equity Multiplier =
Total Assets/Equity Capital

Asset Utilization =
x Total Operating Revenue/Total Assets

ROE Depends On:

Equity Multiplier
Leverage or Financing Policies

Net Profit Margin

Effectiveness of Expense Management

Asset Utilization
Portfolio Management Policies

6-13

Evaluating Performance (continued)

Useful Profitability Formulas for Banks and Other FinancialService Companies

6-14

Evaluating Performance (continued)

or

where

6-15

EXHIBIT 61 Elements That Determine the Rate of Return

Earned on the Stockholders Investment (ROE) in a Financial
Firm

6-16

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

FDIC-Insured Institutions (1992-2009)

Copyright 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

A Variation on ROE

Breakdown of ROA
Net Interest Income Net Noninterest Income
ROA =

Total Assets
Total Assets
PLL-Security Gain(Losses)+Taxes-Extraordinary Gains
Total Assets

ROA = Net Interest Margin +

Net Noninterest Margin +
Special Transactions Affecting Net Income

Components of ROA for All Insured U.S. Banks (1990-2000)

Incoem Statement Items

2000

1999

1998

1996

1994

1992

1990

Interest income/Total assets

- Interest expense/Total assets
= Net Interest income/Total assets
+Noninterest income/Total assets
-Noninterest expense/Total assets
=Net noninterest income/Total assets
- Provision for loan losses/Total assets
= Pretax operating income/Total assets
- Taxes paid/Total assets
+ security gains or losses/Total assets
= Net after tax income/Total assets

6.98%
-3.51
3.38
2.47
-3.58
-1.11
-0.43
1.84
-0.64
-0.06
1.14

6.41%
-3.05
3.35
2.52
-3.56
-1.04
-0.38
1.25
-0.69
0
1.25

6.65%
-3.29
2.37
2.27
-3.57
-1.3
-0.41
1.09
-0.59
0.06
1.14

6.83%
-3.28
3.55
2.04
-3.51
-1.47
-0.36
1.73
-0.61
0.02
1.14

6.29%
-2.67
3.62
1.88
-3.52
-1.64
-0.27
1.71
-0.59
1.01
1.13

7.47%
-3.57
3.9
1.95
-3.87
-1.92
-0.77
1.21
-0.42
0.13
0.92

9.60%
-6.44
3.46
1.67
-3.49
-1.82
-0.96
0.68
-0.24
0.03
0.47

6-20

Breakdown of ROA

6-21

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

FDIC-Insured Depository Institutions (19922009)

6-22

Evaluating Performance (continued)

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

6-23

Evaluating Performance (continued)

Risk to the manager of a financial institution or to a
regulator supervising financial institutions means the
perceived uncertainty associated with a particular
event
Among the more popular measures of overall risk for
a financial firm are the following
Standard deviation () or variance (2) of stock prices
Standard deviation or variance of net income
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

Bank Risks
Credit Risk
Liquidity Risk
Market Risk
Interest Rate Risk
Operational Risk

Legal and
Compliance Risk
Reputation Risk
Strategic Risk
Capital Risk

Credit Risk
The Probability that Some of the
Financial Firms Assets Will Decline
in Value and Perhaps Become
Worthless

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

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

Liquidity Risk Measures

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

Market Risk
Probability of the Market Value of the
Financial Firms Investment Portfolio
Declining in Value Due to a Change in
Interest Rates

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

Interest Rate Risk

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

Interest Rate Risk Measures

Interest Sensitive Assets/Interest
Sensitive Liabilities
Uninsured Deposits/Total Deposits

Operational Risk
Uncertainty Regarding a Financial
Firms 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

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

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.

Capital Risk
Probability of the Value of the Banks
Assets Declining Below the Level of
its Total Liabilities. The Probability of
the Banks Long Run Survival

Capital Risk Measures

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

6-38

Evaluating Performance (continued)

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
In contrast, 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

6-39

TABLE 64 Important Performance Indicators Related to the Size

and Location of FDIC-Insured Depository Institutions (2009)

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