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Chapter Six
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Chapter Six

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  1. Chapter Six Measuring and Evaluating the Performance of Banks and Their Principal Competitors

  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 • The UBPR and Comparing Performance

  3. Why should banks be concerned about profitability and risk? • Profitability and risk are the most important dimensions of performance. Banks are private businesses that must attract capital from the public to fund their operations. • Bank stockholders, depositors, and bank examiners representing the regulatory community are all interested in the quality of bank performance.

  4. Who is likely to be interested in these dimensions of performance? • The individuals or groups likely to be interested in bank profitability and risk are: • Other banks lending to a particular bank, • large depositors, • holders of long-term debt capital issued by banks, • bank stockholders, and the regulatory community.

  5. Value of the Bank’s Stock

  6. Value of a Bank’s Stock Rises When: • Expected Dividends Increase • Risk of the Bank Falls • Market Interest Rates Decrease • Combination of Expected Dividend Increase and Risk Decline

  7. Value of Bank’s Stock if Earnings Growth is Constant

  8. Value of Bank’s Stock if Earnings Growth is Constant • If D1 = 4 • r = 10% • g = 5% • Calculate Po

  9. Key Profitability Ratios in Banking

  10. Key Profitability Ratios in Banking (cont.) Total Interest Income __ Total Interest Expense Earnings Spread = Total Earning Assets Total Interest Bearing Liability

  11. ROE • 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?

  12. ROA – indicates efficiency in generating income from its assets • 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 its equity capital amounts to $52 million. What is the bank's return on assets? Is this ROA high or low? How could you find out?

  13. Net interest and non-interest margins • 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 • 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 and overhead expenses).

  14. Net interest and non – interest margins • 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 expense of $5 million, while interest income from earning assets totaled $16 million and noninterest revenues added to a total of $2 million. Suppose further that assets amounted to $480 million. See if you can determine this bank's net interest and noninterest margins.

  15. Breaking Down ROE x x

  16. ROE Depends On: • Equity Multiplier = Assets/Equity • Leverage or Financing Policies • Net Profit Margin= Net Income/Total Operating revenue • Effectiveness of Expense Management • Asset Utilization = Total operating revenue/Total Assets • Portfolio Management Policies

  17. Components of ROE for All Insured U.S. Banks (1996-2005)

  18. ROE/ROA Problem • 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?

  19. Breakdown of ROA

  20. Credit Risk Liquidity Risk Market Risk Interest Rate Risk Operational Risk Legal and Compliance Risk Reputation Risk Strategic Risk Capital Risk Bank Risks

  21. Credit Risk The Probability that Some of the Financial Firm’s Assets Will Decline in Value and Perhaps Become Worthless

  22. 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

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

  24. Liquidity Risk Measures • Purchased Funds/Total Assets • Net Loans/Total Assets • Cash and Due from Banks/Total Assets • Cash and Government Securities/Total Assets

  25. Market Risk Probability of the Market Value of the Financial Firm’s Investment Portfolio Declining in Value Due to a Change in Interest Rates

  26. 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

  27. Interest Rate Risk The Danger that Shifting Interest Rates May Adversely Affect a Bank’s Net Income, the Value of its Assets or Equity

  28. Interest Rate Risk Measures • Interest Sensitive Assets/Interest Sensitive Liabilities • Uninsured Deposits/Total Deposits

  29. Operational Risk Uncertainty Regarding a Financial Firm’s 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

  30. 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

  31. 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.

  32. Capital Risk Probability of the Value of the Bank’s Assets Declining Below the Level of its Total Liabilities. The Probability of the Bank’s Long Run Survival

  33. Capital Risk Measures • Stock Price/Earnings Per Share • Equity Capital/Total Assets • Purchased Funds/Total Liabilities • Equity Capital/Risk Assets

  34. Other Goals in Banking

  35. Calculate as many risk measures as you can from the following data • Net loans and leases book value = $936 • Total assets = $1324 mill • Equity capital book value =$ 110 mill • Deposits book value = $1150 mill • Market value assets = $1443 mill • Market value of equity cap = $130 mill • Current stock price = $60 with annual per share earnings of $2.50 • Uninsured deposits = $243 mill • Money market borrowings = $132 mill • Non performing loans = $43 mill • Loans charged off = $21 mill

  36. solution • Net loans and leases/total assets = 936/1324 • Equity capital/total assets = 130/1443 • Uninsured deposits/total deposits = 243/1150 • Stock price/EPS = 60/250 • Non performing assets/net loans and leases 43/936 • Charge offs of loans/total loans and leases= 21/936 • Purchased funds /total liabilities = 243 +132/1324-110 • Book value of assets/market value of assets = 1324/1443

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