CHAPTER 6

MEASURING AND EVALUATING THE PERFORMANCE OF BANKS AND THEIR

PRINCIPAL COMPETITORS

Goal of This Chapter: The purpose of this chapter is to discover what analytical tools can be
applied to a bank’s financial statements so that management and the public can identify the most
critical problems inside each bank and develop ways to deal with those problems
Key Topics in This Chapter

 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

Chapter Outline

I. Introduction:
II. Evaluating a Bank's Performance
A. Determining Long-Range Objectives
B. Maximizing The Value of the Firm: A Key Objective for Nearly All Financial-
Service Institutions
C. Profitability Ratios: A Surrogate for Stock Values
1. Key Profitability Ratios
2. Interpreting Profitability Ratios
D. Useful Profitability Formulas for Banks and Other Financial Service Companies
E. Breaking Down Equity Returns for Closer Analysis
F. Break-Down Analysis of the Return on Assets
G. What a Breakdown of Profitability Measures Can Tell Us
H. Measuring Risk in Banking and Financial Services
1. Credit Risk
2. Liquidity Risk
3. Market Risk
4. Interest-Rate Risk
5. Operational Risk
6. Legal and Compliance Risk
7. Reputation Risk
8. Strategic Risk
9. Capital Risk
I. Other Goals in Banking and Financial Services Management

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III. Performance Indicators among Banking’s Key Competitors
IV. The Impact of Size on Performance
A. Size, Location and Regulatory Bias in Analyzing The Performance of Banks and
Competing Financial Institutions
B. Using Financial Ratios and Other Analytical Tools to Track Bank Performance--
The UBPR.
V. Summary of the Chapter

Appendix to the Chapter - Improving the Performance of Financial Firms Through Knowledge:
Sources of Information on the Financial-Services Industry

Concept Checks

6-1. Why should banks and other corporate financial firms be concerned about their level of
profitability and exposure to risk?

Banks in the U.S. and most other countries are private businesses that must attract capital from
the public to fund their operations. If profits are inadequate or if risk is excessive, they will have
greater difficulty in obtaining capital and their funding costs will grow, eroding profitability.
Bank stockholders, depositors, and bank examiners representing the regulatory community are
all interested in the quality of bank performance. The stockholders are primarily concerned with
profitability as a key factor in determining their total return from holding bank stock, while
depositors (especially large corporate depositors) and examiners typically focus on bank risk
exposure.

6-2. What individuals or groups are likely to be interested in these dimensions of performance
for a bank or other financial institution?

The individuals or groups likely to be interested in bank profitability and risk include other banks
lending to a particular bank, borrowers, large depositors, holders of long-term debt capital issued
by banks, bank stockholders, and the regulatory community.

6-3. What factors influence the stock price of a financial-services corporation?

A bank's stock price is affected by all those factors affecting its profitability and risk exposure,
particularly its rate of return on equity capital and risk to shareholder earnings. A bank can raise
its stock price by creating an expectation in the minds of investors of greater earnings in the
future, by lowering the bank's perceived risk exposure, or by a combination of increases in
expected earnings and reduced risk.

6-4. Suppose that a bank is expected to pay an annual dividend of $4 per share on its stock in
the current period and dividends are expected to grow 5 percent a year every year, and the
minimum required return to equity capital based on the bank's perceived level of risk is 10
percent. Can you estimate the current value of the bank's stock?

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In this constant dividend growth rate problem the current value of the bank's stock would be:

Po = D1 / (k – g) = $4 / (0.10 – 0.05) = $80.

6-5. What is return on equity capital and what aspect of performance is it supposed to
measure? Can you see how this performance measure might be useful to the managers of
financial firms?

Return on equity capital is the ratio of Net Income/Total Equity Capital. It represents the rate of
return earned on the funds invested in the bank by its stockholders. Financial firms have
stockholders, too who are interested in the return on the funds that they invested.

6-6 Suppose a bank reports that its net income for the current year is $51 million, its assets
totally $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?

The bank's return on equity capital should be:

ROE = Net Income = $51 million = .098 or 9.8 percent

Equity Capital $1,444 mill.-$926 mill.

In order to evaluate the performance of the bank, you have to compare the ROE to the ROE of
some major competitors or some industry average.

6-7 What is the return on assets (ROA), and why is it important? Might the ROA measure be
important to banking’s key competitors?

Return on assets is the ratio of Net Income/Total Assets. The rate of return secured on a bank's
total assets indicates the efficiency of its management in generating net income from all of the
resources (assets) committed to the institution. This would be important to banks and their major
competitors.

6-8. 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?

The bank's return on assets would be:

ROA = Net Income = $155 mill. - $107 mill. = 0.0096 or 0.96 percent
Total Assets $4,960 mill. + $52 mill.

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The size of this bank's ROA should be compared with the ROA's of other banks similar in size
and location to determine if this bank's ROA is high or low relative to the average for
comparable banks.

6-9. Why do the managers of financial firms often pay close attention today to the net interest
margin and noninterest margin? To the earnings spread?

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. If the NIM rises, loan and security
income must be rising or the average cost of funds must be falling or both. A declining NIM is
undesirable because the bank's interest spread is being squeezed, usually because of rising
interest costs on deposits and other borrowings and because of increased competition today.

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). For most banks the noninterest margin is negative. Management will
usually attempt to expand fee income, while controlling closely the growth of noninterest
expenses in order to make a negative noninterest margin less negative.

The earnings spread measures the effectiveness of the bank's intermediation function of
borrowing and lending money, which, of course, is the bank's primary way of generating
earnings. As competition increases, the spread between the average yields on assets and the
average cost of liabilities will be squeezed, forcing the bank's management to search for
alternative sources of income, such as fees from various services the bank offers.

6-10. 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 of which earning assets
represented 85 percent of total assets, while total interest-bearing liabilities amounted to 75
percent of total assets. See if you can determine this bank's net interest and noninterest margins
and its earnings base and earnings spread for the most recent year.

The bank's net interest and noninterest margins must be:

Net Interest = $16 mill. - $12 mill. Noninterest = $2 mill. - $5 mill.

Margin $480 mill. Margin $480 mill.
=.00833 = -.00625

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 The bank's earnings spread and earnings base are:

Earnings = $16 mill. - $12 mill.

Spread $480 mill * 0.85 $480 mill. * 0.75
= .0392 =.0333

Earnings Base = $480 mill. - $480 mill. * 0.15 = 0.85 or 85 percent

$480 mill.

6-11. What are the principal components of ROE and what do each of these components
measure?

The principal components of ROE are:

a. The net profit margin or net after-tax income to operating revenues which reflects the
effectiveness of a bank's expense control program;

b. The degree of asset utilization or ratio of operating revenues to total assets which
measures the effectiveness of managing the bank's assets, especially the loan portfolio; and,

c. The equity multiplier or ratio of total assets to total equity capital which measures a
bank's use of leverage in funding its operations.

6-12. 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?

The bank's ROE is:

ROE = 0.80 percent *12 = 9.60 percent.

If ROA falls to 0.60 percent, the bank's ROE and equity multiplier can be determined from:

ROE = 9.60% = 0.60 percent * Equity Multiplier

Equity Multiplier = 9.60 percent = 16x.

0.60 percent

6-13. Suppose a bank reports net income of $12, before-tax net income of $15, operating
revenues of $100, assets of $600, and $50 in equity capital. What is the bank's ROE? Tax-
management efficiency indicator? Expense control efficiency indicator? Asset management
efficiency indicator? Funds management efficiency indicator?

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 The bank's ROE must be:

$12
ROE = = 0.24 or 24 percent
$50

Its tax-management, expense control, asset management, and funds management efficiency
indicators are:

Tax Management = $12 Expense Control = $15

Efficiency indicator $15 Efficiency Indicator $100

= .8 or 80 percent =.15 or 15 percent

Asset Management = $100 Funds Management = $600

Efficiency Indicator $600 Efficiency Indicator $50

= 0.1666 or 16.67 percent = 12 x

6-14. What are the most important components of ROA and what aspects of a financial
institution’s performance do they reflect?

The principal components of ROA are:

a. Total Interest Income Less Total Interest Expense divided by Total Assets, measuring a bank's
success at intermediating funds between borrowers and lenders;

b. Provision for Loan Losses divided by Total Assets which measures management's ability to
control loan losses and manage a bank's tax exposure;

c. Noninterest Income less Noninterest Expenses divided by Total Assets, which indicates the
ability of management to control salaries and wages and other noninterest costs and generate tee
income;

d. Net Income Before Taxes divided by Total Assets, which measures operating efficiency and
expense control; and

e. Applicable Taxes divided by Total Assets, which is an index of tax management effectiveness.

6-15. If a bank has a net interest margin of 2.50%, a noninterest margin of -1.85%, and a ratio
of provision for loan losses, taxes, security gains, and extraordinary items of -0.47%, what is its
ROA?

The bank's ROA must be:

ROA = 2.50 percent - 1.85 percent - 0.47 percent = 0.18 percent

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6-16. To what different kinds of risk are banks and their financial-service competitors subjected
today?

a. Credit Risk -- the probability that loans and securities the bank holds will not pay out as
promised.

b. Liquidity Risk -- the probability the bank will not have sufficient cash on hand in the volume
needed precisely when cash demands arise.

c. Market Risk -- the probability that the value of assets held by the bank will decline due to
falling market prices.

d. Interest-Rate Risk - the possibility or probability interest rates will change, subjecting the bank
to lower profits or a lower value for the firm’s capital.

e. Operational Risk – the uncertainly regarding a financial firm’s earnings due to failures in
computer systems, employee misconduct, floods, lightening strikes and other similar events.

f. Legal and Compliance Risk – the uncertainty regarding a financial firm’s earnings due to
actions taken by our legal system or due to a violation of rules and regulations

g. Reputation Risk – the uncertainty due to public opinion or the variability in earnings due to
positive or negative publicity about the financial firm

h. Strategic Risk – the uncertainty in earnings due to adverse business decisions, lack or
responsiveness to changes and other poor decisions by management

i. 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.

6-17. What items on a bank's balance sheet and income statement can be used to measure its
risk exposure? To what other financial institutions do these risk measures apply?

There are several alternative measures of risk in banking and financial service firms. Capital risk
is often measured by bank capital ratios, such as the ratio of total capital to total assets or total
capital to risk assets. Credit risk can be tracked by such ratios as net loan losses to total loans or
relative to total capital. Liquidity risk can be followed by using such ratios as cash assets to total
assets or by total loans to total assets. Interest-rate risk may be indicated by such ratios as
interest-sensitive liabilities to interest-sensitive assets or the ratio of money-market borrowings
to money-market assets.

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6-18. 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 bank's risk measures as you can from the foregoing
data.

Net Loans and Leases = $936 mill. Uninsured Deposits $243 mill.
Total Assets $1,324 mill. Total Deposits $1,150 mill.

0.7069 or 70.69 percent 0.2113 or 21.13 percent

Equity Capital = $130 mill. Stock Price $60

Total Assets $1,443 mill. Earnings Per Share $2.50

= 0.0901 or 9.01 percent = 24 X

Nonperforming Assets = $43 mill. =0.0459 or 4.59 percent

Net Loans and Leases $936 mill.

Charge-offs of loans = $21 Purchased Funds = $243 mill. + $132 mill.

Total Loans and Leases $936 Total Liabilities $1,324 mill. - $110 mill.

=.0224 or 2.24 percent .3089 or 30.89 percent

Book Value of Assets = $1324 =0.9175 or 91.75 percent

Market Value of Assets $1443

Problems

6-1. An investor holds the stock of First National Bank of Imoh and expects to receive a
dividend of $12 per share at the end of the year. Stock analysts have recently predicted that the
bank’s dividends will grow at approximately 3 percent 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 15
percent, what should be the current stock price per share of Imoh’s stock?

D1 $12
P0    $100
r-g .15  .03

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6-2. Suppose that stockbrokers have projected that Poquoson Bank and Trust Company will
pay a dividend of $3 per share on its common stock at the end of the year; a dividend of $4.50
per share is expected for the next year and $6 per share in the following year. The risk-adjusted
cost of capital for banks in Poquoson’s risk class is 17 percent. If an investor holding
Poquoson’s stock plans to hold that stock for only three years and hopes to sell it at a price of
$55 per share, what should the value of the bank’s stock be in today’s market?

$3.00 $4.50 $6.00 $55

P0      $43.94
(1  .17) (1  .17) (1  .17) (1  .17) 3
2 3

P0 = $43.94 per share.

6-3 Depositors Savings Association has a ratio of equity capital to total assets of 7.5 percent.
In contrast, Newton Savings reports an equity capital to asset ratio of 6 percent. What is the
value of the equity multiplier for each of these institutions? Suppose that both institutions have
an ROA of 0.85 percent. What must each institution’s return on equity capital be? What do your
calculations tell you about the benefits of having as little equity capital as regulations or the
marketplace will allow?

Depositors Savings Association has an equity-to-asset ratio of 7.5 percent which means its equity
multiplier must be:

Assets
1/ (Equity Capital / Assets) = = 1 / 0.075 = 13.33x
EquityCapital

In contrast, Newton Savings has an equity multiplier of:

1
1/ (Equity Capital / Assets) = = 16.67x
0.06

With an ROA of 0.85 percent Depositors Savings Association would have an ROE of:

ROE = 0.85 x 13.33x = 11.33 percent.

With an ROA of .85 percent Newton Savings would have an ROE of:

ROE = 0.85 x 16.67x = 14.17 percent

In this case Newton Savings is making greater use of financial leverage and is generating a
higher return on equity capital.

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6-4. The latest report of condition and income and expense statement for Galloping Merchants
National Bank are as shown in the following tables:

Galloping Merchants National Bank

Interest Fees on Loans $65

Interest Dividends on Securities 12
Total Interest Income 77

Interest Paid on Deposits 49

Interest on Nondeposit Borrowings 6
Total Interest Expense 55

Net Interest Income 22

Provision for Loan Losses 2
Noninterest Income and Fees 7
Noninterest Expenses:
Salaries and Employee Benefits 12
Overhead Expenses 5
Other Noninterest Expenses 3
Total Noninterest Expenses 20
Net Noninterest Income -13

Pre Tax Operating Income 7

Securities Gains (or Losses) 1
Pre Tax Net Operating Income 8
Taxes 1
Net Operating Income 7
Net Extraordinary Income -1
Net Income $6

FTE 40

Galloping Merchants National Bank

Report of Condition

Cash and Due From Banks $100 Demand Deposits $190

Investment Securities $150 Savings Deposts $180
Federal Funds Sold $10 Time Deposits $470
Net Loans $670 Federal Funds Purch $69
(ALL 25) Total Liabilities $900
(Unearned Income 5) Common Stock $20
Plant and Equipment $50 Surplus $25
Retained Earnings $35
Total Assets $980 Total Ca $80

Interest Bearing
Total Earnings Assets $830 Deposits $650

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Fill in the missing items on the income and expense statement. Using these statements, calculate the
following performance measures:

Net Income $6
ROE =   .075 or 7.5%
Total Equity Capital $80

Net Income $6
ROA =   .00612 or .612%
Total Assets $980

Net Interest Income $22

Net Interest Margin =   .0224 or 2.24%
Total Assets $980

-$13
Net Noninterest Margin =  .0133 or -1.33 percent
$980

Total Operating Revenues - Total Operating Expenses $84  $77

Net Operating Margin =   .00714 or .714%
Total Assets $980
Total Interest Income Total Interest Expenses $77 $55
Earnings Spread =     .01531 or 1.53 %
Total Earnings Assets Total Interest Bearing Liabilities $830 $710

Net Income $6
Net Profit Margin =   .0714 or 7.14 percent
Total Operating Revenues $84

Total Operating Revenues $84

Asset Utilization =   .0857 or 8.57%
Total Assets $980

Total Assets $980

Equity Multiplier =   12.25 x
Total Equity Capital $80

Net Income $6
Tax ManagementEfficiency    .857 or 85.7%
Pre Tax Net Operating Income $7

Pre Tax Net Operating Income $7

Expense Control Efficiency    .0833 or 8.33%
Total Operating Revenue $84

Total Operating Revenues $84

Asset Management Efficiency Ratio =   .0857 or 8.57%
Total Assets $980

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 Total Assets $980
Funds Management Efficiency Ratio =   12.25 x
Total Equity Capital $80

Total Operating Expenses $78 (including taxes)

Operating EfficiencyRatio    .9176 or 91.76%
Total Operating Revenues $85 (includingsecuritiesgains)

6-5. The following information is for Shallow National Bank

Interest Income $2,100

Interest Expense $1,400
Total Assets $30,000
Securities Gains (losses) $21
Earning Assets $25,000
Total Liabilities $27,000
Taxes Paid $16
Shares of Common
Stock 5,000
Noninterest income $700
Noninterest Expense $900
Provision for Loan
Losses $100

ROE = $405 ROA = $405

$30,000 - $27,000 $30,000

0.135 or 13.5 percent 0.0135 or 1.35 percent

Earnings = $405 = $.081 per share

Per Share 5000

Net Interest = $2100 - $1400 = $700 = 0.028 or 2.8 percent

Margin $25,000 $25,000

Net Noninterest = $700 - $900 = -$200 = 0.008or .8 percent

Margin $25,000 $25,000

Net Operating = ($2100 + $700) – ($1,400 + $900 + $100) = $400 =0.0133 or 1.33 percent
Margin $30,000 $30,000

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Alternative Scenario 1:

Suppose interest income, interest expenses, noninterest income, and noninterest expenses each
increase by 5 percent, with all other items remaining unchanged.

Interest Income $2,205

Interest Expense $1,470
Total Assets $30,000
Securities Gains (losses) $21
Earning Assets $25,000
Total Liabilities $27,000
Taxes Paid $16
Shares of Common
Stock 5,000
Noninterest income $735
Noninterest Expense $945
Provision for Loan
Losses $100

ROE = $430 ROA = $430

$30,000 - $27,000 $30,000

0.1433 or 14.33 percent 0.0143 or 1.43 percent

Earnings = $430 = $.086 per share
Per Share 5000

Net Interest = $2205 - $1470 = $735 = 0.0294 or 2.94 percent

Margin $25,000 $25,000

Net Noninterest = $735 - $945 = -$210 = 0.0084 or .84 percent

Margin $25,000 $25,000

Net Operating = ($2205 + $735) – ($1,470 + $945 + $100) = $425 =0.0142 or 1.42 percent
Margin $30,000 $30,000

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Alternative Scenario 2:

On the other hand, suppose Shallow’s interest income, interest expenses, noninterest income,
and noninterest expenses decline by 5 percent, again with all other factors held equal. How
would the bank’s ROE, ROA and per share earnings change?

Interest Income $1995

Interest Expense $1,330
Total Assets $30,000
Securities Gains (losses) $21
Earning Assets $25,000
Total Liabnilities $27,000
Taxes Paid $16
Shares of Common
Stock 5,000
Noninterest income $665
Noninterest Expense $855
Provision for Loan
Losses $100

ROE = $380 ROA = $380

$30,000 - $27,000 $30,000

0.1267 or 12.67 percent 0.0127 or 1.27 percent

Earnings = $380 = $.076 per share

Per Share 5000

Net Interest = $1995 - $1330 = $665 = 0.0266 or 2.66 percent

Margin $25,000 $25,000

Net Noninterest = $665 - $855 = -$190 = 0.0076 or .76 percent

Margin $25,000 $25,000

Net Operating = ($1995 + $665) – ($1,330 + $855 + $100) = $375 =0.0125 or 1.25 percent
Margin $30,000 $30,000

6-6. Blue and White National Bank holds total assets of $1.69 billion and equity capital of $139
million and has just posted an ROA of 1.1 percent. What is this bank’s ROE?:

Total Assets $1,690

ROE = ROA * Equity Capital = 0.011 * = 0.1337 or 13.37%
$139

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Alternative Scenario 1:

R0A increases by 50%, with no change in assets or equity capital.

Therefore, the new ROA = 0.011 * 1.5 = 0.0165 or 1.65%.

New ROE = 1.65% * 12.16 = 20.06%

This represents a 50% increase in ROE. With no changes in assets or equity, the investors' funds
are more effectively utilized, generating additional income and making the bank more profitable.

Alternative Scenario 2:

ROA decreases by 50%, with no change in equity or assets.

Therefore, the new ROA = 0.011 * 0.5 = 0.0055 or 0.55%.

New ROE = 0.55% * 12.16 = 6.69%

This represents a 50% decrease in ROE. The bank's management has been less efficient, in this
case, in managing their lending and/or investing functions or their operating costs.

Alternative Scenario 3:

ROA = 0.011 or 1.1% (as in the original problem)

Total assets double in size to $3.38 billion and equity capital doubles in size to $278 million.
Therefore, the equity multiplier (i.e. total assets/equity capital) remains the same (E.M. =
$3,380/$278 = 12.16). As a result, there is no change in ROE from the original situation (i.e.),
1.1% * 12.16 = 13.38%).

Alternative Scenario 4:

This, of course, is just the reverse of scenario 3. Since the changes in both assets and equity
capital are the same, the ratio of the two (i.e., the equity multiplier) remains constant. As a result,
there is again no change in ROE.

E.M. = Total Assets/Equity Capital = $845/$69.5 = 12.16.

Therefore, ROE = 1.1% * 12.16 = 13.38%.

6-7. Monarch State Bank reports total operating revenues of $135 million, with total operating
expenses of $121 million, and owes taxes of $2 million. It has total assets of $1.00 billion and
total liabilities of $900 million and has just posed an ROA of 1.1o percent. What is the bank’s
ROE?

Net Income after Taxes = $135 million -$121 million -$2 million = $12 million
Equity Capital = $1.00 billion - $900 million = $100 million

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 Net Income after Taxes
ROE = = $12 million / $100 million = 0.12 or 12%.
Equity Capital

Alternative Scenario 1: How will the ROE for Monarch State Bank change if total operating
expenses, taxes and total operating revenues each grow by 10 percent while assets and liabilities
stay fixed.

Total revenues = $135 million * 1.10 = $148.5 million

Total expenses = $121 million * 1.10 = $133.1 million
Tax liability = $2 million * 1.10 = $2.2 million

Net Income after Taxes = $148.5 - $133.1 - $2.2 = $13.2 million

ROE = $13.2 million/$100 million = 0.132 or 13.2%

Change in ROE = (13.2%-12%)/12% = 10%

Alternative Scenario 2: Suppose Monarch State’s total assets and total liabilities increase by 10
percent, but its revenues and expenses (including taxes) are unchanged. How will the bank’s
ROE change?

Total assets increase by 10% (Total assets = $ 1.0 * 1.10 = $1.1 billion)
Total liabilities increase by 10% (Total liabilities = $900 million * 1.10 = $990
Revenues and expenses (including taxes) remain unchanged.

Solution: Equity Capital = $1.1 billion - $990 million = $110 million

ROE = $12 = .1091

$110 10.91 percent

Therefore change in ROE = 10.91% - 12% = -1.09% = -.0908%

12% 12% (ROE decreases by 9.08%)

Alternative Scenario 3: Can you determine what will happen to ROE if both operating revenues
and expenses (including taxes) decline by 10 percent, with the bank’s total assets and liabilities
held constant?

Total revenues decline by 10% (Total revenues = $135 million * 0.90 = $121.5 million)
Total expenses decline by 10% (Total expenses = $121 million * 0.9 = $108.9 million)
Tax liability declines by 10% (Tax liability = $2 * 0.9 = $1.8 million)
Assets and liabilities remain unchanged (Therefore, equity remains unchanged)

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Solution: Net Income after Tax = $121.5 million - 108.9 million - $1.8 million = $10.8

ROE = $10.8 million = 0.108 = 10.8%

$100 million

Therefore change in ROE = 10.8% - 12% = -1.2% = -.10

12% 12% (ROE decreases by 10%)

Alternative Scenario 4: What does ROE become if Monarch State’s assets and liabilities
decrease by 10 percent, while its operating revenues, taxes and operating expenses do not
change?

Total assets = $1.0 billion * 0.9 = $900 million

Total liabilities = $900 million * 0.9 =$810 million
Equity capital = $900 million - $810 million = $90 million

ROE = $12 = .1333

$90 13.33 percent

6-8. Suppose a stockholder owned thrift institution is projected to achieve a 1.25 percent ROA
during the coming year. What must its ratio of total assets to total equity capital be if it is to
achieve its target ROE of 12 percent? If ROA unexpectedly falls to .75 percent, what assets-to-
capital ratio must it then have to reach a 12 percent ROE?

ROE = ROA * (Total Assets/Equity Capital)

Total Assets = ROE = 12% = 9.6 x

Equity Capital ROA 1.25%

If ROA unexpectedly falls to 0.75% and target ROE remains 12%:

12% = .75% * Total Assets

Equity Capital

Total Assets = 12% =16 x

Equity Capital .75%

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6-9. Saylor County National Bank presents us with these figures for the year just concluded.
Please determine the net profit margin, equity multiplier, asset utilization ratio, and ROE:

Net Income = $18

Total Operating Revenues = $125
Total Assets = $1,500
Total Equity Capital Accounts = $155

a. Net Profit Margin = Net Income = $18 mill. = 0.144 or 14.4%

Total Operating Revenue $125 mill.

b. Asset Utilization = Total Operating Revenues = $125 mill. = 0.083 or 8.3%

Total Assets $1500 mill.

c. Equity Multiplier = Total Assets = $1500 mill. = 9.68 times

Total Equity Capital $155 mill.

d. ROE = Net Income = $18 mill. = 0.1161 or 11.61%

Total Equity Capital $155 mill.

6-10. Lochiel Commonwealth Bank and Trust Company has experienced the following trends over
the past five years (all figures in millions of dollars):

Net Income Total Total Total Equity

Year Operating Assets Capital
Revenues
1 2.7 26.5 293 18
2 3.5 30.1 382 20
3 4.1 39.8 474 22
4 4.8 47.5 508 25
5 5.7 55.9 599 28

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Determine the figures for ROE, profit margin, asset utilization, and equity multiplier for this
bank. Are any adverse trends evident? Where would you recommend that management look to
deal with the bank’s emerging problem(s)?

Profit Asset Equity

Year Margin Utilization Multiplier ROA ROE
1 10.2% 0.0904 16.28x 0.92% 15.0%
2 11.6% 0.0788 19.10X 0.92% 17.5%
3 10.3% 0.0840 21.55X 0.86% 18.6%
4 10.1% 0.0935 20.32X 0.94% 19.2%
5 10.2% 0.0933 21.39X 0.95% 20.4%

If we look at the entire 5-year period, Lochiel's profit margin has remained relatively constant.
However, from year 2 through year 5, there has been a significant decline (from 11.6% to
10.2%). This can be viewed as troublesome when we note that net income, total operating
revenues, and total assets have more than doubled during the five-year period. Two potential
areas that management should investigate are (1) the mix of funding sources and (2) non-interest
expenses.

Since ROE has grown much more rapidly than ROA (ROE grew at an average annual rate of 8%
compared to only a 0.8% average annual growth rate in ROA), we should be concerned that
Lochiel is increasing its liability sources of funding, thereby increasing its leverage to keep its
ROE growing. This can cause serious problems with its income as interest rates rise, driving up
its cost of funds.

With regard to its noninterest expenses, if these are growing faster than the bank's noninterest
income, then there is greater pressure on the bank's net interest margin to offset the increasing
negative spread between noninterest income and noninterest expenses.

Since bank regulators place a great deal of emphasis on capital adequacy, these two areas,
leverage and noninterest margin, could be moving Lochiel to a precarious capital adequacy
position

6-11. Wilmington Hills State Bank has just submitted its Report of Condition and Report of
Income to its principal supervisory agency. The bank reported net income before taxes and
securities transactions of $27 million and taxes $6 million. If its total operating revenues were
$780 million, its total assets $2.1 billion, and its equity capital $125 million, determine the
following for Wilmington:

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a. Tax Management = Net Income
Efficiency Ratio Net Income Before Taxes and Securities
Transactions

= $27 million - $6 million - $21 million

$27 million $27 million

= 0.778 or 77.8 percent.

b. Expense Control = Net Income Before Taxes and Securities Gains

Efficency Ratio Total Operating Revenues

= $ 27 million = 0.035 or 3.5 percent.

$780 million

c. Asset Management Efficiency Ratio = Total Operating Revenues

(Asset Utilization) Total Assets

= $ 780 million = 0.371 or 37.1 percent.

$2,100 million

d. Funds Management = Total Assets = $ 2,100 million = 16.80 x.

Efficiency Ratio Equity Capital $125 million

e. ROE = Net Income after Taxes = $ 21 million = 0.168 or 16.8%

Equity Capital $125 million

Alternative Scenario 1: Suppose Wilmington Hills State Bank experienced a 20 percent rise in
net before-tax income, with its tax obligation, operating revenues, assets, and equity unchanged.
What would happen to ROE and its components?

ROE = ROA * Total Assets = Net Income * Total Assets

Total Equity Total Assets Total Equity

= [($27 x 1.20) - $6 * $2,100 = $32.4 - $6 * $2,100

$2,100 $125 $2,100 $125

= 0.0126 * 16.8 = 0.2112 or 21.12 %

This represents a 26% increase in ROE, from 16.8% to 21.17%. Since the equity multiplier did
not change, this increase in ROE is due to the increase in ROA, from 1% to 1.26%.

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Alternative Scenario 2: If total assets climb by 20 percent, what will happen to Wilmington’s
efficiency ratio and ROE

$780 $780
Asset Management Efficiency Ratio = = = .31
$2100 * 1.2 $2520

This represents a decrease of 16.4%.

$2520
Funds Management Efficiency Ratio = = 20.16 times
$125
This represents an increase of 20%.

ROE would not change since the decrease in the asset management efficiency ratio is offset by
the increase in the funds management efficiency ratio.

Alternative Scenario 3: What effect would a 20 percent higher level of equity capital have upon
Wilmington’s ROE and its components?

Funds Management = Total Assets = $2,100 = $2,100 = 14 times

Efficiency Ratio Equity Capital $125 x 1.20 $150

ROE = Tax Management Efficiency Ratio * Expense Control Efficiency Ratio * Asset
Management Efficiency Ratio *Funds Management Efficiency Ratio

= 0.778 * 0.035 * 0.371 * 14 = 0.1414 or 14.14%

Change in ROE = 14.14% - 16.8% = -0.158 or a 15.8% decrease

16.8%

6-12. Using this information for Lochness International Bank and Trust Company (all figures
in millions); calculate the bank's net interest margin, noninterest margin, and ROA.

Interest Income = $65 Noninterest Expense = $8

Interest Expense = $48 Noninterest Income = $5
Provision for Loan Loss = $3 Extraordinary Net Gains = $1
Security Gain (Losses) = $2 Total Assets = $986

a. Net Interest Margin = Interest Income – Interest Expenses

Total Assets

= $65 - $48 = $17 = 0.0172 or 1.72 %

$986 $986

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 b. Noninterest Margin = Noninterest Income – Noninterest Expenses
Total Assets

= $5 - $8 = -$3 = -0.0030 or -.3%

$986 $986

c. ROA = Net Income = [($65+$5+$2+$1) – ($48+$8+$3)] = $14 = 0.0142 or 1.42%

Total Assets $986 $986

6-13. Valley Savings reported these figures (in millions) on its income statement for the past
five years. Calculate this institution’s ROA in each year. Are there any adverse trends? Any
favorable trends? What seems to be happening to this institution?

One Two Three Four

Current Year Years Years Years
Year Ago Ago Ago Ago

Gross Interest Income $40 $41 $38 $35 $33

Interest Expenses 24 23 20 18 15
Net Interest Income 16 18 18 17 18
Provision for Loan Losses 2 1 1 0 0
Net Interest Income after 14 17 17 17 18
Loan Loss Provision
Noninterest Income 4 4 3 2 1
Noninterest Expense 8 7 7 6 5
Net Noninterest Income (4) (3) (4) (4) (4)
Income before Taxes 10 14 13 13 14
Income Taxes 1 1 0 1 0
Net Income after Taxes 9 13 13 12 14
but Before Gains (Losses)
Net Securities Gains (Losses) (2) (1) 0 1 2
Net Income 7 12 13 13 16
Total Assets 385 360 331 319 293
ROA 1.8% 3.33% 3.93% 4.08% 5.46%

Valley's ROA has gone from an exceptional level, at almost 5.5%, progressively down to a
reasonably good level, at 1.8%, over the last four years.

Growth in interest and noninterest income has been outstripped by the growth in interest and
noninterest expense, as well as the increase in the allowance for loan losses, resulting in a
significant decline in net income from operations. Needless to say, the shift from gains in
securities trading to losses has not been helpful either.

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6-14. An analysis of the UBPR reports on NCB was presented in this chapter. We examined a
wide variety of profitability measures for that bank including ROA, ROE, net profit margin, net
interest and operating margins, and asset utilization. However, the various measures of earnings
risk, credit risk, liquidity risk, market risk (price and interest rate risk), and capital risk were not
discussed in detail. Using the data in Tables 6-5 through 6-9, calculate each of these dimensions
of risk for NCB for the most recent two years and discuss how the bank’s risk exposure appears
to be changing over time. What steps would you recommend to management to deal with any
risk exposure problems you observe?

Note to instructors: The Uniform Bank Performance Report (UBPR) is provided to each bank by
the Federal Financial Institutions Examination Council. The UBPR is prepared from the call
reports of condition and income that are filed quarterly by all banks. It (the UBPR) is for the use
of regulators and management to assess how well the bank is performing relative to its internal
goals and its peer group.

The user's guide to the UBPR is available from the FFIEC for a nominal fee and details the
various ratios and comparative data contained in the UBPR. The actual UBPR is much more
detailed than the example provided in the text as Tables 6-5 through 6-9. These exhibits are for
illustrative purposes and do not contain all the information that is necessary to calculate all the
risk measures described in the text. The instructor may find it helpful to use UBPRs provided by
a few local banks in class discussions. Those actual UBPRs allow the students to calculate the
full range of risk and return measures and expand discussion of the concepts and ratios
considerably.

For those instructors who do not want this much detail, this problem can be reduced to a smaller
number of ratios that can be readily calculated from the simple UBPR provided. The following
ratios can be calculated for National City Bank:

Capital Risk Measures:

Equity Capital to Total Assets (Current Year) = $3,783,712/$52,974,916 = 0.0714 or 7.14%

Equity Capital to Total Assets (Past Year) = $2,902,903/$46,276,022 = 0.0627 or 6.27%

Ratio of purchased funds to total liabilities (current year) =$16,373,005/$47,777,598 = 0.343 or

34.3%
Ratio of purchased funds to total liabilities (past year) = $15,778,220/$41,938,534 = 0.373 or
37.3%

(Purchased Funds = Large Time Deposits + Deposits Held in Foreign Offices +

Federal Funds Purchased and repossessions + Other borrowings with maturities less than 1
year)

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Ratio of equity capital to risk assets (current year) = $3,783,712/$46,902,819 = 0.0807 or 8.07%
Ratio of equity capital to risk assets (past year) = $2,902,903/$39,641,025= 0.0732 or 7.32%

(Risk Assets = Total Assets - Cash and Due From Banks - U.S. Treasury Securities
- Premises, Fixed Assets, and Capital Leases – Acceptances and Other Assets)

Ratio of primary capital to total assets (current year) = $5,711,636/$52,974,916 = 0.1078 or

10.78%
Ratio of primary capital to total assets (past year) = $4,929,882/$46,276,022 = 0.1065 or 10.65%

(Primary Capital = Equity Capital + Allowance for Loan Losses + Minority Interests in
Subsidiaries + Subordinated Debentures - Intangible Assets)

Liquidity Risk Measures:

Ratio of purchased funds to total assets (current year) =$16,373,005/$52,974,916 = 0.3091 or

30.91%
Ratio of purchased funds to total assets (past year) = $15,778,220/$46,276,022 = 0.3410 or
34.10%

Ratio of net loans to total assets (current year) =$41,717,733/$52,974,916 = 0.7875 or 78.75%
Ratio of net loans to total assets (past year) =$37,694,152/$46,276,022 = 0.8146 or 81.46%

Ratio of cash and due from to total assets (current year) = $1,792,763/$52,974,916 = 0.0338 or
3.38%
Ratio of cash and due from to total assets (past year) = $1,646,705/$46,276,022 = 0.0356 or
3.56%

Ratio of cash, due from, and Treasury securities to total assets (current year)
= $2,880,126/$52,974,916
= 0.0544 or 5.44%
Ratio of cash, due from, and Treasury securities to total assets (past year)
= $2,970,977/$46,276,022
= 0.0642 or 6.42%

Interest-Rate Risk Measures:

Note: In order to calculate the Gap ratios, that is, interest-sensitive assets/interest-sensitive
liabilities, we must classify the asset and liability accounts as rate sensitive or non-rate sensitive.
Since banks are no longer required to provide this specific information in their call reports, the
classification based on the UBPR may be somewhat arbitrary.

Although we do not have complete information for National City Bank and realizing that two
years do not really provide a reliable estimate of a trend, there are some changes in the risk
measures that can serve as indicators of potential problems.

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The relatively heavy dependence on purchased funds to total liabilities and total assets places the
bank at some risk if interest rates increase dramatically. Additionally, the dollar volume of rate--
sensitive liabilities subjects the bank to additional costs if rates rise dramatically. Additionally,
its liquidity position has declined during the year. Finally, it also decreased its proportion of net
loans relative to total assets which lowered its earnings during the past year. On the other hand,
National City Bank increased its capital adequacy during the year.

87