1 Bank Fund Management [EFIN 519]

Lecture 02: Evaluating Bank Performance

A bank’s financial statements are quite different from those of a firm in any other industry. In their
roles as financial intermediaries, banks have to take considerable financial risks and their financial
statements merely reflect these risks. After examining the financial statements of a commercial bank
and compare the components with a manufacturing or a trading company.

Characteristics of Bank’s Financial Statements:

 The sources of funds are primarily short-term in nature, payable on demand or with short-term
maturities. (depositors can renegotiate the term deposit rates as market interest rate changes)
 The financial leverage is very high and the equity base is very low. (this is risky and can lead to
earnings volatility)
 The proportion of fixed assets is very low and so is the operating leverage. ( operating leverage
is the ratio of fixed costs to total costs)
 A high proportion of the bank funds are invested in loans and advances or investments, all of
which are subject to interest rate volatility.

Furthermore, when deposit rates change, the cost of funds also changes, which in turn would impact
the pricing of bank’s assets. Thus, there seem to be considerable risks embedded in banking operations;
high financial risk due to the high leverage, high interest rate risk, which would affect profitability, and
high liquidity risk which might endanger the solvency of the bank.

The Balance Sheet:

A bank’s balance sheet presents financial information comparing what a bank owns with what it owes
and the ownership interest of stockholders. Assets indicate what the bank owns; liabilities represent
what the bank owes and equity refers to the owners’ interest.

 Bank Assets:

Bank assets fall into one of four general categories: loans, investment securities, noninterest cash and
due from banks, and other assets.

1. Loans are the major assets in most banks’ portfolios and generate the greatest amount of income
before expenses and taxes. They also exhibit the highest default risk and some are relatively
illiquid.
2. Investment Securities are held to earn interest, help to meet liquidity needs, speculate on
interest rate movements and serve as part of bank’s dealer functions.
3. Noninterest Cash and Due from Banks consist of vault cash, deposit held in central bank,
deposits held at other financial institutions and cash items in the process of collection. These
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assets are held to meet customer withdrawal needs and legal reserve requirements, assist in
check clearing and wire transfer, and affect the purchase and sale of Treasury securities.
4. Other Assets are residual assets of relatively small magnitudes such as bankers’ acceptance,
premises and equipment, other real estate owned etc.

 Bank Liabilities and Stockholders’ Equity:

Bank funding sources are classified according to the type of the debt instrument and equity
component. The characteristics of various debt instruments differ in terms of check-writing
capabilities, interest paid, maturity, and whether they can be traded in the secondary market. The
components of equity (common and preferred capital) also have different characteristics.

1. Bank Liabilities are composed of transaction accounts, savings and time deposits, and other
borrowings.
2. All Common and Preferred Capital represents stockholders’ equity or ownership interest in the
bank. Common and preferred stocks are listed at their par values while the surplus account
represents the amount of proceeds received by the bank in excess of par when the stock was
issued. Retained earnings represent the bank’s cumulative net income since the firm started
operations minus all cash dividends paid to the stockholders.

The Income Statement:

A bank’s income statement reflects the financial nature of banking, as interest on loans and investments
represents the bulk of revenue. The income statement format starts with Interest Income, and then
subtracts Interest Expense to produce Net Interest Income (NII). The other major source of bank
revenue is Non-interest Income like fiduciary activities; deposit service charges; trading revenue,
venture capital revenue and securitization income; investment banking, advisory, brokerage, and
underwriting fees and commissions; net gains (losses) on sales of loans etc. After adding non-interest
income, bank subtracts Non-interest Expense or overhead expense.

Although banks constantly try to increase their non-interest income and reduce non-interest expense,
the non-interest expense generally exceeds non-interest income such that the difference is labeled the
bank’s Burden. The next step is to subtract Provisions for Loan and Lease Losses. The resulting figure
essentially represents operating income before securities transactions and taxes. Next, Realized Gains
and Losses from the sale of securities are added to produce pretax net operating income. Subtracting
applicable income taxes, tax-equivalent adjustments, and any extraordinary items yields Net Income.
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Analyzing Bank’s Financial Statements:

How do we compare bank? The answer depends on what matrix we used to measure size. Traditional
models of bank performance are based on the return on assets (ROA) approach. Some others such as
CAMELS rating model follows a rating approach based on various parameters. Besides, a list of key
performance indicators (KPIs) are used that help to measure bank performance on various parameters.
There are also more sophisticated models based on risk rating criteria.

 Profitability Analysis: Return on Equity Model

In 1972, David Cole introduced a procedure for evaluating bank performance via ratio analysis. It
enables an analyst to evaluate the source and magnitude of bank profits relative to selective risk taken.

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡

Expense Ratio 𝑁𝑜𝑛 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

𝑇𝑜𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡

Tax Ratio 𝑃𝑟𝑜𝑣𝑖𝑠𝑖𝑜𝑛𝑠 𝑓𝑜𝑟 𝐿𝑜𝑎𝑛 𝐿𝑜𝑠𝑠𝑒𝑠

𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥𝑒𝑠
Return on Assets 𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
Retun on Equity
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
Equity Multiplier 𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
Asset Utilization
𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑁𝑜𝑛 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑣𝑔. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡

Figure: decomposition of Return on Equity (ROE): the nature of bank profit

Return on Equity (ROE) or Return on Assets (ROA) is a performance measure, where higher these
measures than peers indicate high-performance bank. Essentially, for a firm to report higher return, it
must either take on more risk, price assets and liabilities better, or realize cost advantages compared
with peers.

Aggregate bank profitability is measured and compared in terms of ROE and ROA. The ROE model
simply relates ROE to ROA and financial leverage, then decomposes ROA into its contributing
elements. By definition:

ROE =
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ROE measures the percentage return on each dollar of stockholders’ equity. It is the aggregate return to
stockholders before dividends. The higher the return the better, as banks can add more to retained
earnings and pay more in cash dividends when profits are higher.

ROE is linked to ROA by the equity multiplier (EM) via the following accounting identity:

ROE =

= ROA × EM

A bank’s equity multiplier compares assets with equity such that large value indicates a large amount
of debt financing relative to stockholders’ equity. Thus, EM measures financial leverage and represents
both a profit and risk measure. EM affects a bank’s profits because it has a multiplier impact on ROA to
determine a bank’s ROE. EM represents a risk measure too as it reflects how many assets can go into
default before a bank becomes insolvent.

The basic return on total assets, ROA, is composed of two principal parts: income generation and
expense control (including taxes). As net income is the difference between total revenue and total
operating expense and taxes, ROA can also decomposed into its components:

ROA = − −
. . .

Hence, a bank’s ROA is composed of asset utilization (AU), the expense ratio (ER) and tax ratio. The
greater is AU and the lower are ER and tax, the higher ROA.

As a bank’s expenses are comprised of interest expense, non-interest expense and provisions for loan
losses, the lower is the ER, the more efficient is a bank will be in controlling expenses. In other words,
all other factors being equal, the lower is each ratio, the profitable is the bank. The sum of these ratios
equals the expense ratio:

ER =
. . . .

In addition, asset utilization is a measure of the bank’s ability to generate total revenue (interest
income, non-interest income and realized security gains or losses). The greater is AU, the greater is the
bank’s ability to generate income from the assets it owns.

AU =
. . . .
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 CAMELS Ratings:

Regulators, analysts and investors have to periodically assess the financial condition of each bank.
Banks are rated on various parameters, based on financial and non-financial performance. One of the
popularly used assessments is CAMELS, where each letter refers to a specific category of performance.

1. C – Capital Adequacy:

This indicates the bank’s capacity to maintain capital proportionate with the nature and extent of all
types of risks, as also the ability of bank’s managers to identify, measure, monitor and control these
risks. Some components are as follows:

 Size of the bank

 Volume of inferior quality assets
 Bank’s growth experience, plans and prospects
 Quality of capital
 Retained earnings
 Access to capital markets etc.

2. A – Asset Quality:

This measure reflects the magnitude of credit risk prevailing in the bank due to its composition and
quality of loans, advances, investments and off-balance sheet activities.

 Volume of classification
 Special mention loans
 Volume of concentrations
 Volume and character of insider transactions etc.

3. M – Management Quality:

Signaling the ability of the board of directors and senior managers to identify, measure, monitor and
control risks associated with banking, this qualitative measure uses risk management policies and
processes as indicators of sound management.

 Technical competence, leadership of middle and senior management

 Compliance with banking laws and regulations
 Adequacy and compliance with internal policies
 Ability to plan and respond to changing circumstances etc.
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4. E – Earnings:

This indicator not only shows the amount of and the trend of earnings but also analyses the strength of
expected earnings growth in future.

 ROA compared to peer group averages and bank’s own trends

 Adequacy of provisions for loan losses
 Quality of earnings
 Dividend payout ratio in relation to the adequacy of bank capital etc.

5. L – Liquidity:

This measure takes into account the adequacy of the bank’s current and potential sources of liquidity,
including the strength of its fund management practices.

 Adequacy of liquidity sources compared present and future needs

 Access to money market
 Level of diversification of funding sources
 Trend and stability of deposits
 Ability to securitize and sell certain pool of assets
 Management competence to identify, measure, monitors and control liquidity position
etc.

6. S – Sensitivity to Market Risk:

This is a recent addition to the ratings parameters and reflects the degree to which changes in interest
rates, exchange rates, commodity prices and equity prices can affect earnings and also the bank’s
capital.

 Sensitivity of bank’s net earnings to changes in interest rates under various scenarios
and stress environment
 Volume, composition and volatility of any foreign exchange or other trading position
 Actual or potential volatility of earnings or capital because of any changes in market
valuation of trading portfolios etc.
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The rating analysis and interpretation are typically done along the following lines:

Rating Analysis Interpretation

1.0 – 1.4 Strong: sound in every respect. No supervisory responses required
1.6 – 2.4 Satisfactory: fundamentally sound with modest correctable weakness
2.6 – 3.4 Fair (watch category): combination of weakness if not rectified will
become sever. Watch category requires more than normal supervision.
3.6 – 4.4 Marginal (some risk of failure): immoderate weakness unless
properly addressed could impair future viability of the bank. Needs
close supervision.
4.6 – 5.0 Unsatisfactory (high degree of failure evident): high risk of failure in
the near term. Under constant supervision terminate and discontinue
order.

 Key Performance Indicators (KPIs) Approach:

External factors that affect the performance of financial institutions include:

1. Technology changes
2. Competition
3. Regulation
4. Government policies (monetary and fiscal policy)

Bank management cannot control these factors. The best they can do is to try to anticipate future
changes and position the institution to take advantage of these changes. However they can control
many internal factors, some of which are:

1. Operating efficiency
2. Expense control
3. Tax management
4. Liquidity
5. Risk

1. Efficiency and Expense Control Ratios

Description Numerator Denominator Interpretation

Operating Total operating Total assets The lower this ratio, the more efficient the
efficiency expense bank

Cost of funds Total interest Total deposit and The lower this ratio, the lower the variable
expenses non-deposit cost for the bank
borrowing

Efficiency Non-interest Net total income The higher the ratio, the more profitable the
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ratio income bank since most of this income comprises

fees-based services, though such services are
not without risks to banks

Overhead Non-interest Non-interest expense

efficiency income
ratio
Tax ratio Total income Income before taxes
tax payments

These ratios describe how well the bank controls expenses relative to producing revenues and how
productive employees are in terms of generating income, managing assets and handling accounts.

2. Liquidity

Description Numerator Denominator Interpretation

Demand-to- Total demand Total time deposits The higher this ratio, the more the need for
time deposit deposits liquidity for the bank

Demand Total demand Total assets The higher the ratio, the more the need to
deposits ratio deposits invest in liquid assets for the bank

Non-deposit Non-deposit Total assets The higher the ratio, the higher the
borrowing borrowings probability of default risk or reputation risk
ratio for the bank

Net loans-to- Total credit Total assets When comparing the preceding ratio with
asset ratio minus this, the larger the difference between the
provisions two ratios, the less healthy the bank’s credit
made portfolio

Cash-to- Cash and bank Demand deposits The higher the ratio, the higher the liquidity
demand balance of the bank. Hence, the probability that the
deposit ratio including call bank defaults on its payment obligations is
money low

Cash to total Cash and bank Total assets The higher the ratio, the higher the liquidity
assets balances of the asset portfolio. However, this may
including call lead to low profitability.
money

Although it is mandatory for the banks to meet the depositors’ demands for liquidity, there is a trade-
off since more liquid assets generally yield lower returns.
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3. Risk

Description Numerator Denominator Interpretation

Equity Total assets Total equity Measures financial leverage position

multiplier

Equity ratio Total equity Total assets Inverse of EM. Shows how many assets can
default before the equity eroded. The higher
the ratio, the less risky the bank

Capital Total capital Risk-weighted assets

adequacy
ratio

Provisions Loan loss Total assets

ratio provisions

Financial institutions face many risks including losses on loans and losses on investments. Therefore,
manager must limit these risks in order to avoid failure of the bank.

4. Profitability

Description Numerator Denominator Interpretation

ROE Net income Total equity Measures the returns to

shareholders

ROA Net income Total assets How well bank is using

its assets to generate
income

Profit margin Net income Total income

Asset utilization Total income Total assets

Earnings per share Net income Number of equity shares

P/E ratio Share price Earnings per share

Net operating margin Net operating income Total assets Represent bank’s
minus net operating operation efficiency.
expense What portion of the
bank’s revenues flow
through to net income
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Net interest margin Total interest income Total assets

minus total interest
expense

 Alternative Models for Bank Financial Statement Analysis

1. Measure based on Total Operating Revenues:

In using ‘Total Assets’ as the denominator for calculating performance measure, we have ignored the
fact that off-balance sheet items – contingent liabilities – have the potential of turning into ‘unsolicited
assets for banks’. Further, they also have the potential to generate substantial income for banks. To
avoid such omission, it has been suggested that performance measures may be calculated using ‘Total
Operating Revenue’ as the denominator rather than ‘Total Assets’. Total operating revenues represent
both interest and non-interest income. However, non-recurring revenues, such as securities gains or
losses are to be excluded in computing total operating revenues.

2. Stock-Market based Performance Measure:

Investors are less concerned about historical ratios such as ROA or ROE, since these indicators do no
convey the extent of cash flows to investors in the form of dividends and stock market prices. Investor
can assess how profitable their investments in the bank were through this simple ratio:

Market return to stockholders =

Other common ratios used by investors and analysts are:

 EPS = Net Income after Tax / No. of Outstanding Shares

 Price to Earnings (P /E ratio) = Stock Price / EPS
 Price to Book Value = Stock Price / Book Value per Share
 Market Value of Equity (MVE)

3. Consumer Centric Performance Measure:

Besides financial measures, banks use indicators such as market share, customer profitability, customer
relation, customer satisfaction etc. many banks also measure profitability in terms of business segments
(e.g. corporate, retail), customer segments (small and medium enterprise, personal segments, corporate
and institutional borrowers) by types of depositors or by delivery system (ATMs, brunch, internet
banking.
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 Line-of-Business Profitability Analysis:

Many large banks evaluate line-of-business profitability and risk via Risk-adjusted Returns on Capital
(RAROC) or Return on Risk-adjusted Capital (RORAC) systems.

RAROC =

RORAC =

‘Risk-adjusted Income’ implies that net revenues have been arrived at after deducting expenses and
expected losses. While ‘Risk-adjusted Capital’ represents capital necessary to compensate earnings
volatility.

4. A ‘Risk Index’- based Approach:

Generally ROA is one of the most widely accepted measures of overall bank performance. However,
the ROA is not static- it varies with credit risk, interest rate risk, liquidity risk and other risks inherent
in banking business. The variability in the ROA is typically measured by the standard deviation. A
combination of three important factors- ROA, EM and Standard Deviation of the ROA is called ‘Risk
Index’ (RI). It follows that higher values of RI indicate lower risk of insolvency – implying a higher
level of book value of equity – relative to the potential stocks to the earnings of a bank. Thus, banks
with risky assets portfolios can remain solvent as long as they are well capitalized.

RI = (Expected value of ROA + Capital to Asset ratio) / Standard Deviation (σ) of ROA