Measuring and Evaluating the

Performance of Banks

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6-2

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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6-3

Value of the Banks Stock

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6-4

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

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6-5

Value of Banks Stock if Earnings Growth is

Constant

D1
P0
r-g
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6-6

Key Profitability Ratios in Banking

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

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

Total Assets
Total Assets
Noninterest revenue
- PLLL
- Noninterest expenses Net Noninterest Income
Net Noninterest Margin

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Total Assets
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6-7

Key Profitability Ratios in Banking (cont.)

Total Operating Revenues Total Operating Expenses
Net Bank Operating Margin
Total Assets
Net Income After Taxes
Earnings Per Share (EPS)
Common Equity Shares Outstanding
Total Interest Income
Earnings Spread = Total Earning Assets

__ Total Interest Expense

Total Interest Bearing Liability

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6-8

Breaking Down ROE

R O E = N e t In c o m e / T o ta l E q u ity C a p ita l
ROA =
N e t In c o m e /T o ta l A s s e ts

E q u ity M u ltip lie r =

T o ta l A s s e ts /E q u ity C a p ita l

N e t P ro fit M a rg in =
A s s e t U tiliz a tio n =
x
N e t In c o m e /T o ta l O p e ra tin g R e v e n u e T o ta l O p e ra tin g R e v e n u e /T o ta l A s s e ts
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6-9

ROE Depends On:

Equity Multiplier=Total assets/Total equity capital
Leverage or Financing Policies: the choice of sources
of funds (debt or equity)
Net Profit Margin=Net income/Total operating revenue
Effectiveness of Expense Management (cost control)
Asset Utilization=Total operating revenue/Total assets
Portfolio Management Policies (the mix and yield on
assets)
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6-10

Determinants of
ROE in a
Financial Firm

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6-11

Components of ROE

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6-12

A Variation on ROE
Net Income
Pre-Tax Net Operating Income
ROE =

Pre-Tax Net Operating Income

Total Operating Revenue

Total Operating Revenue

Total Assets

Total Assets
Total Equity Capital

ROE = Tax Management Efficiency

Expense Control Efficiency
Asset Management Efficiency
Funds Management Efficiency
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CAMELS Analysis

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6-14

Breakdown of ROA

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6-15

Rapid Fire
What are the principal components of ROE, and what
does each of the these components measure?
Suppose a bank has an ROA of 0.80% and an equity
multiplier of 12x. What is its ROE? Suppose this
banks ROA falls to 0.60%. What size equity
multiplier must it have to hold its ROE unchanged?
What are the most important components of ROA and
what aspects of a financial institutions performance
do they reflect?
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6-16

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

Legal and
Compliance Risk
Reputation Risk
Strategic Risk
Capital Risk

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6-17

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

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6-18

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

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6-19

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

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6-20

Liquidity Risk Measures

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

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6-21

Market Risk: Comprises Price Risk and

Interest Rate Risk

Probability of the Market Value of the

Financial Firms
Investment Portfolio
Declining in Value Due to a Change in Interest
Rates

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6-22

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

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6-23

Interest Rate Risk

The Danger that Shifting Interest Rates

May Adversely Affect a Banks Net Income,
the Value of its Assets or Equity

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6-24

Interest Rate Risk Measures

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

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6-25

Off-Balance-Sheet Risk
The Volatility in Income and Market Value of Bank
Equity that May Arise from Unanticipated Losses due
to OBS Activities (activities that do not have a
balance sheet reporting impact until a transaction is
affected)

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6-26

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

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6-27

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

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6-28

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.

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6-29

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

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6-30

Capital Risk Measures

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

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6-31

Other Goals in Banking

Total Operating Expenses
Operating Efficiency Ratio =
Total Operating Revenues

Net Operating Income

Employee Productivity Ratio =
Number of Full Time-Equivalent Employees

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6-32

Performance Indicators-Issue of Size Bias

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