6-2

Key topics Banks’ key objectives

MEASURING & 1. Stock values and profitability ratios

EVALUATING THE 2. Measuring credit, liquidity, and other risks

1. Maximizing the bank value
PERFORMANCE OF BANKS 3. Measuring operating efficiency

4. Performance of competing financial firms 2. Controlling wide-range risks

Chapter 5 5. Size and location effects

6. The UBPR and comparing performance

William Chittenden edited and updated the PowerPoint slides for this edition.

1 2 3

6-4 6-5 6-6

Value of bank’s stock
Value of the bank’s stock Value of a bank’s stock rises when: if earnings growth is constant

 Expected dividends increase

 Risk of the bank falls D1

P0 
 Market interest rates decrease
r -g
 Combination of expected dividend increase

and risk decline

4 5 6

6-7 6-8 6-9

Key profitability ratios in banking Key profitability ratios in banking (cont.) Breaking down ROE

Net Income Total Operating Revenues -

Return on Equity Capital (ROE) =
Total Equity Capital Total Operating Expenses ROE = Net Income/ Total Equity Capital
Net Bank Operating Margin 
Net Income Total Assets
Return on Assets (ROA) =
Total Assets Net Income After Taxes
Earnings Per Share (EPS) 
(Interest income Common Equity Shares Outstanding ROA = Equity Multiplier =
Net Interest Margin 
- Interest expense)

Net Interest Income Net Income/Total Assets x Total Assets/Equity Capital
Total Assets Total Assets Total Interest Income __ Total Interest Expense
Earnings Spread = Total Earning Assets Total Interest Bearing Liability

Noninterest revenue
- PLLL Net Profit Margin = x Asset Utilization =
Earning Assets
Net Noninterest Margin 
- Noninterest expenses Net Noninterest Income

Earning Base  Net Income/Total Operating Revenue Total Operating Revenue/Total Assets
Total Assets Total Assets Total Assets

7 8 9
 Return on equity (ROE = NI / TE)
… the basic measure of stockholders’ returns Return on assets (ROA = NI / TA) ROA is driven by the bank’s ability to:
…can be decomposed into two parts: …generate income (AU) and control expenses (ER)
 ROE is composed of two parts:  Asset Utilization (AU) → income generation
 Return on Assets (ROA = NI / TA),  Expense Ratio (ER) → expense control  Income generation (AU) can be found on the UBPR
(page 1) as:
 represents the returns to the assets the bank has  ROA = AU - ER Int. Inc. Non. int. Inc. Sec gains (losses)
invested in = (TR / TA) - (TE / TA) AU   
Where: TA TA TA
 Equity Multiplier (EM = TA / TE),  Expense control (ER) can be found on the UBPR
TR = total revenue or total operating income (page 1) as:
 the degree of financial leverage employed by the = Int. inc. + Non-int. inc. + SG and
Int . Exp . Non  int . Exp . PLL
bank TE = total expenses ER *   
= Int. exp. + Non-int. exp. + PLL + Taxes TA TA TA
Note, ER* does not include taxes.

10 11 12

6-13
Bank Performance Model Rate
Expense ratio (ER = Exp / TA)
ROE depends on: Returns to
Interest
Composition (mix)
… the ability to control expenses
Shareholders Volume
 Equity multiplier=Total assets/Total equity capital ROE = NI / TE INCOME  Interest expense / TA
Fees and Serv Charge
 Cost per liability (avg. rate paid)
 Leverage or financing policies: the choice of sources of Non Interest Trust  Int. exp. liab. (j) / $ amt. liab. (j)
funds (debt or equity)
Other  Composition of liabilities
Return to the Bank
ROA = NI / TA  $ amt. of liab. (j) / TA
Rate
 Net profit margin=Net income/Total operating revenue  Volume of int. bearing debt and equity
Interest
Composition (mix)  Non-interest expense / TA
 Effectiveness of expense management (cost control)
Volume
 Salaries and employee benefits / TA
EXPENSES
Salaries and Benefits  Occupancy expense / TA
 Asset utilization=Total operating revenue/Total assets Overhead
Occupancy  Other operating expense / TA
 Portfolio management policies (the mix and yield on assets)
Degree of Leverage
Other  Provisions for loan losses / TA
EM =1 / (TE / TA) Prov. for LL
 Taxes / TA
Taxes

13 14 15

6-17 6-18

Asset utilization (AU = TR / TA): Components of ROE for all insured U.S.
… the ability to generate income. Banks (1992-2007)
 Interest Income / TA
 Asset yields (avg. rate earned) Determinants
of ROE in a
 Interest income asset (i) / $ amount of asset (i) financial firm
 Composition of assets (mix)
 $ amount asset (i) / TA
 Volume of Earning Assets
 Earning assets / TA
 Noninterest income / TA
 Fees and service charges
 Securities gains (losses)
 Other income

16 17 18
 6-20 6-21

Quick quiz A variation on ROE Breakdown of ROA

 Table 6.1 – p 177

Net Income Pre-Tax Net Operating Income
ROE =  
 What is the trend of ROE? Which Pre-Tax Net Operating Income Total Operating Revenue
factors strongly affect this trend of
ROE? Total Operating Revenue Total Assets

Total Assets Total Equity Capital
ROE = Tax Management Efficiency 
Expense Control Efficiency 
Asset Management Efficiency 
Funds Management Efficiency

19 20 21

Financial ratios UBPR for PNC Interest expense Interest income

…PNC and Community National Bank …composition, rate and volume effects for PNC and …composition, rate and volume effects for
Community National Bank PNC and Community National Bank
PNC BANK, NATIONAL ASSOCIATION COMMUNITY NATIONAL BANK
Dec-03 Dec-04 Dec-03 Dec-04 PNC BANK, NATIONAL ASSOCIATION COMMUNITY NATIONAL BANK
RISK RATIOS Pg # CALC BANK PG 1 CALC BANK PG 1 CALC BANK PG 4 CALC BANK PG 4 PNC BANK, NATIONAL ASSOCIATION COMMUNITY NATIONAL BANK
Dec-03 Dec-04 Dec-03 Dec-04
ROE: Net Income / Average total equity 11 16.90% 16.56% 14.41% 15.59% 15.26% 14.55% 5.48% 5.56% 11.56% 8.63% 8.67% 11.72% RISK RATIOS Pg # CALC BANK PG 1 CALC BANK PG 1 CALC BANK PG 4 CALC BANK PG 4 Dec-03 Dec-04 Dec-03 Dec-04
ROA: Net Income / aTA 1 1.59% 1.59% 1.28% 1.31% 1.31% 1.31% 0.41% 0.41% 1.07% 0.63% 0.63% 1.09%
AU: Total Revenue / aTA 1 calc 7.59% 7.59% 6.45% 7.02% 7.02% 6.21% 6.10% 6.10% 6.50% 5.90% 5.91% 6.23% Interest Expense: Composition, Rate and Volume Effects RISK RATIOS Pg # CALC BANK PG 1 CALC BANK PG 1 CALC BANK PG 4 CALC BANK PG 4
ER: Total expenses (less Taxes) / aTA 1 calc 5.18% 5.17% 4.51% 5.15% 5.14% 4.23% 5.47% 5.48% 5.01% 4.93% 4.94% 4.73% Rate: Avg, interest cost of interest bearing l 3 1.24% 1.27% 1.62% 1.50% 1.44% 1.51% 1.51% 1.48% 1.98% 1.39% 1.34% 1.74%
10.59x 10.48x 11.20x 11.59x 11.47x 10.65x 13.37x 13.76x 10.85x 13.78x 13.97x 10.67x
EM: aTA / Avg, Total Equity
EB: Earning Assets / aTA
6 calc
6 82.86% 82.60% 89.84% 82.85% 82.92% 90.08% 85.43% 86.74% 91.45% 86.83% 86.98% 91.76%
Memo: Interest expense / Earning assets 1 1.09% 1.07% 1.41% 1.34% 1.28% 1.31% 0.95% 0.92% 1.61% 0.87% 0.85% 1.41% Interest Income: Composition, Rate and Volume Effects
Volume: All Interest bearing debt (avg.) / aTA 1 72.73% 70.78% 80.81% 73.70% 74.97% 80.65% 53.76% 55.17% 75.51% 54.29% 56.69% 74.88%
NIM: Net interest margin (te) 1 3.89% 3.82% 3.51% 3.32% 3.18% 3.52% 4.95% 4.80% 4.33% 4.82% 4.74% 4.36%
Mix and Cost of Individual Liabilities:* Rate: Avg, yield on aTA
Spread (te) 3 calc 3.74% 3.62% 3.36% 3.15% 3.02% 3.37% 4.39% 4.25% 3.97% 4.30% 4.25% 4.04%
Efficiency Ratio 3 60.93% 60.86% 57.73% 68.01% 67.97% 57.92% 82.72% 82.75% 66.06% 75.35% 75.34% 65.99% Total deposits (avg.) / aTA: 6 73.72% 73.84% 67.79% 72.45% 72.30% 68.32% 91.72% 91.94% 85.07% 92.02% 91.96% 84.46% Memo: Avg. yield on earn. assets (rate) 1 4.98% 4.89% 4.98% 4.66% 4.46% 4.88% 5.91% 5.73% 5.95% 5.69% 5.59% 5.78%
Burden / aTA 1 calc 0.67% 0.66% 1.12% 0.81% 0.81% 1.16% 3.37% 3.37% 2.33% 2.94% 2.94% 2.39% Cost (rate): Int bearing Total deposits 3 1.20% 1.22% 1.39% 1.18% 1.14% 1.25% 1.52% 1.49% 1.90% 1.38% 1.33% 1.66%
Non Interest Income / Noninterest exp. 1 calc 83.24% 83.42% 62.03% 79.79% 79.70% 59.86% 21.08% 21.08% 29.18% 24.18% 24.23% 26.23% Core deposits (avg.) / aTA 6 67.41% 68.16% 53.90% 64.84% 64.29% 54.64% 84.26% 84.50% 72.07% 85.00% 84.90% 71.52% Volume: Earn assets (avg.) / aTA 6 82.86% 82.60% 89.84% 82.85% 82.92% 90.08% 85.43% 86.74% 91.45% 86.83% 86.98% 91.76%
EXPENSES:
ER*: Expense ratio (Expense components) 5.18% 5.17% 4.51% 5.15% 5.14% 4.23% 5.47% 5.48% 5.01% 4.93% 4.94% 4.73%
All other deposits (avg.) / aTA 6-calc 55.93% 55.41% 42.13% 53.38% 53.19% 43.03% 45.73% 45.52% 54.88% 46.77% 47.73% 53.88% Non earning assets (avg.) / aTA 6-calc 17.14% 17.39% 9.75% 17.15% 17.07% 9.64% 14.57% 13.27% 8.25% 13.17% 13.03% 7.93%
Trans (NOW&ATS) Accts (avg.) / aTA 6 2.40% 2.23% 1.81% 2.35% 2.15% 1.92% 6.55% 6.58% 10.37% 7.43% 7.02% 10.60%
Total Interest expense / aTA 1 0.90% 0.90% 1.29% 1.08% 1.08% 1.20% 0.82% 0.82% 1.50% 0.76% 0.76% 1.31% Cost (rate): Trans (NOW&ATS) Acts 3 #N/A 0.90% 0.60% #N/A 0.86% 0.62% #N/A 0.29% 0.63% #N/A 0.28% 0.59% Mix and Yield on Individual Assets:*
Memo: Interest expense / Avg. Earn as 1 1.09% 1.07% 1.41% 1.34% 1.28% 1.31% 0.95% 0.92% 1.61% 0.87% 0.85% 1.41%
Noninterest Expenses / aTA 1 3.98% 3.98% 2.95% 3.99% 3.99% 2.89% 4.27% 4.27% 3.29% 3.88% 3.88% 3.24%
MMDA's and other sav. Accts (avg) / aTA 6-calc 42.29% 42.15% 30.73% 41.23% 41.28% 32.75% 25.67% 25.71% 22.70% 28.07% 29.57% 22.85% Total Loans (Gross loans - unearn inc.) (avg 6 57.55% 57.17% 57.69% 57.13% 57.25% 58.22% 65.76% 64.10% 66.45% 62.05% 61.33% 67.80%
Personnel expense 3 1.83% 1.83% 1.37% 2.04% 2.04% 1.38% 2.38% 2.38% 1.79% 2.16% 2.16% 1.78% Cost (rate): Other savs deposits* 3 #N/A 0.57% 0.70% #N/A 0.60% 0.69% #N/A 0.90% 1.08% #N/A 0.98% 1.00%
Occupancy expense 3 0.58% 0.58% 0.38% 0.50% 0.50% 0.36% 0.71% 0.71% 0.48% 0.64% 0.64% 0.47% Time deposits under $100M (avg.) / aTA 6 11.24% 11.03% 9.59% 9.80% 9.76% 8.36% 13.51% 13.23% 21.81% 11.27% 11.14% 20.43% Yield (rate): Total Loans & Leases (te) 3 5.48% 5.48% 5.66% 5.04% 5.04% 5.47% 6.89% 6.89% 6.91% 6.90% 6.90% 6.58%
Cost (rate): All oth time dep. (CD<100 3
Other Oper Exp (Incl intangibles)
Provision: Loan & Lease Losses / aTA 1
3 1.57%
0.29%
1.58%
0.29%
1.13%
0.27%
1.43%
0.07%
1.44%
0.07%
1.08%
0.14%
1.17%
0.39%
1.18%
0.39%
1.00%
0.22%
1.07%
0.30%
1.07%
0.30%
0.98%
0.18%
#N/A 3.12% 2.41% #N/A 2.78% 2.03% #N/A 2.51% 2.80% #N/A 2.01% 2.43% Total Investments (avg.) / aTA: 6-calc 26.33% 26.46% 26.43% 26.60% 26.52% 26.50% 20.36% 23.28% 21.82% 25.50% 26.35% 20.98%
Volatile (S.T non core) liab (avg.) / aTA 10 9.85% 11.47% 23.24% 13.08% 12.11% 23.42% 8.03% 4.10% 11.90% 7.52% 4.84% 12.21%
Income Taxes / aTA #N/A 0.82% 0.83% 0.66% 0.56% 0.57% 0.67% 0.21% 0.21% 0.42% 0.34% 0.34% 0.41% Large CDs (inc. brokered) (avg.) / aTA 6 3.23% 3.14% 9.02% 3.67% 3.76% 8.99% 7.46% 7.44% 12.41% 7.02% 7.06% 12.39% Total investment securities (avg.) / aTA 6-calc 21.41% 21.90% 22.56% 22.12% 22.03% 23.03% 16.43% 14.97% 17.89% 20.83% 20.78% 17.81%
INCOME: Cost (rate): CD's over $100M
AU: Asset Utilization (Income components): 7.59% 7.59% 6.45% 7.02% 7.02% 6.21% 6.10% 6.10% 6.50% 5.90% 5.91% 6.23%
3 3.44% 3.66% 2.38% 2.89% 2.81% 2.17% 2.83% 2.79% 2.72% 2.82% 2.78% 2.40% Yield (rate): Total invest secs. (TE) 3 3.99% 3.81% 4.18% 3.54% 3.51% 3.98% 2.94% 3.32% 4.08% 3.00% 2.92% 3.91%
Fed funds purchased & resale (avg.)/ aTA 6 0.74% 0.99% 8.16% 1.55% 3.18% 8.00% 0.56% 0.55% 1.05% 0.50% 0.55% 1.07%
Interest income / aTA
Memo: Avg, yield on earning assets
1
1
4.12%
4.98%
4.12%
4.89%
4.57%
4.98%
3.77%
4.66%
3.77%
4.46%
4.46%
4.88%
5.08%
5.91%
5.08%
5.73%
5.52%
5.95%
4.97%
5.69%
4.97%
5.59%
5.37%
5.78% Cost (rate): Fed funds pur & resale 3 2.95% 1.10% 1.15% 3.84% 1.37% 1.41% 1.10% 1.10% 0.82% 2.10% 1.75% 0.98% Yield (rate): Total invest secs. (Book) 3 3.99% 3.81% 4.00% 3.52% 3.48% 3.84% 2.86% 3.24% 3.75% 2.91% 2.83% 3.61%
Memo: All brokered deposits (avg.) / aTA 6 2.36% 2.19% 2.29% 2.81% 3.00% 2.81% 0.00% 0.00% 0.51% 0.00% 0.11% 0.84%
Noninterest income / aTA 1 3.32%
0.15%
3.32%
0.15%
1.83%
0.05%
3.18%
0.07%
3.18%
0.07%
1.73%
0.02%
0.90%
0.12%
0.90%
0.12%
0.96%
0.02%
0.94%
0.00%
0.94%
0.00%
0.85%
0.01% All common and preferred capital (avg.) / aTA 6 9.44% 9.54% 8.93% 8.63% 8.72% 9.39% 7.48% 7.27% 9.22% 7.26% 7.16% 9.37%
Trading account assets (avg.) / aTA 6 1.61% 1.63% 0.39% 1.92% 2.09% 0.34% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Realized security gains (losses) / aTA 1

22 23 24

6-25
Bank risk Bank risks
6-27

Quick quiz …Popular measures of overall risk … most important types of risk
1. What individuals or groups are likely to be interested
in the banks’ level of profitability and exposure to risk? 1. Standard deviation (σ) or variance (σ2) of 1. Credit risk 6. Legal and compliance
2. What are the principal components of ROE, and what
stock price 2. Liquidity risk risk
does each of these components measure?
3. Suppose a bank has an ROA of 0.80% and an equity
2. Standard deviation or variance of net income 3. Market risk 7. Reputation risk
multiplier of 12x. What is its ROE? Suppose this
bank’s ROA falls to 0.60%. What size equity multiplier
3. Standard deviation or variance of ROE & ROA 4. Interest rate risk 8. Strategic risk
must it have to hold its ROE unchanged?
4. What are the most important components of ROA and The higher σ and σ2 the greater the overall risk
, 5. Operational risk 9. Capital risk
what aspects of a financial institution’s performance
do they reflect?

25 26 27
 6-28 6-29

Credit risk Credit risk measures Credit risk: more ratios to consider

1. Nonperforming loans/Total loans

 Three Questions need to be addressed:
The probability that some of the financial firm’s 2. Net charge-offs/Total loan

3. Provision for loan losses/Total loan 1. What has been the loss experience?
assets will decline in value and perhaps become
4. Provision for loan losses/Equity capital 2. What amount of losses do we expect?
worthless resulting from nonpayment or delayed
5. Allowance for loan losses/Total loan
payment on loans and securities. 3. How prepared is the bank?
6. Allowance for loan losses/Equity capital

7. Nonperforming loans/Equity capital

28 29 30

Credit risk ratios :

Credit ratios to consider Credit ratios to consider (cont.)
PNC and Community National
PNC BANK, NATIONAL ASSOCIATION COMMUNITY NATIONAL BANK
 What has been the loss experience?  How prepared are we? Dec-03 Dec-04 Dec-03 Dec-04
1. Net loss to average total Loan & Lease (LN&LS) RISK RATIOS Pg # CALC BANK PG 1 CALC BANK PG 1 CALC BANK PG 4 CALC BANK PG 4
1. Provision for loan loss to: average assets
2. Gross losses to average total LN&LS Credit Risk
Gross loss / Avg. tot LN&LS 7 0.73% 0.73% 0.53% 0.40% 0.40% 0.36% 0.54% 0.54% 0.26% 0.21% 0.21% 0.20%
3. Recoveries to avg. total LN&LS and average total LN&LS Net loss / Avg. tot LN&LS 7 0.59% 0.59% 0.41% 0.28% 0.28% 0.25% 0.53% 0.53% 0.21% 0.20% 0.20% 0.16%
4. Recoveries to prior period losses Recoveries / Avg. tot LN&LS 7 0.13% 0.13% 0.12% 0.12% 0.12% 0.11% 0.01% 0.01% 0.06% 0.02% 0.02% 0.05%

5. Net losses by type of LN&LS

2. LN&LS Allowance to: net losses and total Recoveries to prior credit loss 7 19.0% 19.03% 22.26% 19.5% 19.52% 23.76% 6.7% 6.75% 29.21% 3.1% 3.08% 24.53%
90 days past due / EOP LN&LS 8A 0.21% 0.21% 0.13% 0.13% 0.13% 0.10% 0.16% 0.16% 0.13% 0.00% 0.00% 0.10%
 What amount of losses do we expect? LN&LS total Nonaccrual LN&LS / EOP LN&LS 8A 0.79% 0.79% 0.66% 0.33% 0.33% 0.46% 0.19% 0.19% 0.47% 0.16% 0.16% 0.41%
total Noncurrent / EOP LN&LS 8A 1.00% 1.00% 0.83% 0.46% 0.46% 0.59% 0.35% 0.35% 0.66% 0.16% 0.16% 0.55%
1. Non-current LN&LS to total loans
2. Total Past/Due LN&LS - including nonaccrual 3. Earnings coverage of net loss LN&LS Allowance to total LN&LS 7 1.77% 1.78% 1.44% 1.34% 1.35% 1.27% 1.07% 1.07% 1.25% 1.23% 1.23% 1.20%
LN&LS Allowance / Net losses 7 2.9x 2.92x 4.18x 5.2x 5.23x 7.51x 2.1x 2.08x 11.89x 6.7x 6.71x 14.52x
3. Non-current & restruc LN&LS / Gross LN&LS LN&LS Allowance / total nonaccural LN& 7 1.77x 2.24x 2.73x 2.92x 4.12x 3.73x 3.05x 5.49x 4.35x 7.77x 7.77x 5.63x
Earn Coverage of net losses 7 7.44x 7.44x 10.92x 11.61x 11.61x 19.94x 2.57x 2.57x 23.89x 10.38x 10.38x 30.80x
4. Current - Non-current & restruc/ Gr LN&LS Net Loan and lease growth rate 1 -4.55% -4.55% 10.14% 27.51% 27.51% 17.96% 2.16% 2.16% 11.61% 11.49% 11.49% 14.24%
0.00% 0.00% 0.00% 0.00%
5. Past due loans by loan type

31 32 33

6-34 6-35
Liquidity risk ratios :
Liquidity risk Liquidity risk measures PNC and Community National
PNC BANK, NATIONAL ASSOCIATION COMMUNITY NATIONAL BANK
Dec-03 Dec-04 Dec-03 Dec-04
1. Purchased funds/Total assets RISK RATIOS Pg # CALC
0.00% BANK PG 1 CALC 0.00% BANK PG 1 CALC
0.00% BANK PG 4 CALC
0.00% BANK PG 4
Probability the financial firm will not have Liquidity Risk
2. Net loans/Total assets %Total (EOP) Assets (except where noted)
sufficient cash and borrowing capacity to meet Total equity 11 9.07% 9.07% 8.95% 8.26% 8.26% 9.74% 7.29% 7.29% 9.28% 7.23% 7.23% 9.42%
Core deposits 10 67.41% 66.75% 53.75% 64.84% 63.23% 54.19% 84.26% 84.95% 71.85% 85.00% 85.04% 71.10%
3. Cash and due from banks/Total assets
deposit withdrawals and other cash needs. S.T Non-core funding 10 #N/A 11.47% 23.24% #N/A 12.11% 23.42% #N/A 4.10% 11.90% #N/A 4.84% 12.21%
Net loans & leases / Total Deposits 10 73.73% 73.73% 87.72% 81.00% 81.00% 88.28% 65.90% 65.90% 78.94% 67.35% 67.35% 81.42%
4. Cash and government securities/Total sssets Net loans & leases / Core Deposits 10 81.11% 81.11% 115.16% 91.76% 91.76% 116.10% 71.36% 71.36% 93.85% 72.89% 72.89% 97.58%
Avg. Available for sale securities / aTA 6 21.41% 21.90% 21.11% 22.12% 22.03% 21.00% 14.44% 13.39% 15.88% 19.38% 19.04% 15.80%
Short-term investments 10 #N/A 2.73% 6.25% #N/A 3.02% 5.23% #N/A 5.99% 5.41% #N/A 5.72% 5.26%
Pledged securities 10 #N/A
0.00% 46.50% 49.08% #N/A
0.00% 51.76% 54.78% #N/A
0.00% 29.25% 40.34% #N/A
0.00% 28.49% 41.20%

34 35 36
 6-37 6-38 6-39

Market risk: comprises price risk and

Market risk measures Interest rate risk
interest rate risk

1. Book-value of assets/ Market value of assets

Probability of the market value of the financial The danger that shifting interest rates may
2. Book-value of equity/ Market value of equity
firm’s investment portfolio declining in value
adversely affect a bank’s net income, the value
3. Book-value of bonds/Market value of bonds
due to a change in interest rates.
of its assets or equity.
4. Market value of preferred stock and common

stock

37 38 39

6-40 6-42

Interest rate risk measures Foreign exchange risk Off-balance-sheet risk

… the risk to a financial institution’s condition resulting
from adverse movements in foreign exchange rates
The volatility in income and market value of bank
1. Interest sensitive assets/Interest sensitive
 Foreign exchange risk arises from changes in foreign equity that may arise from unanticipated losses
liabilities exchange rates that affect the values of assets,
liabilities, and off-balance sheet activities denominated due to OBS activities (activities that do not have
2. Uninsured deposits/Total deposits in currencies different from the bank’s domestic
a balance sheet reporting impact until a
(home) currency.
 This risk is also often found in off-balance sheet loan transaction is affected).
commitments and guarantees denominated in foreign
currencies; foreign currency translation risk

40 41 42

Ethics in banking and finance

6-43 6-45

Operational risk Legal and compliance risk

services
 Box – p.187 – France’s Societe
Uncertainty regarding a financial firm’s earnings General Risk of earnings resulting from actions taken by
 What is the operational risk here?
due to failures in computer systems, errors, Why? the legal system. This can include unenforceable
 How big is the problem? contracts, lawsuits or adverse judgments.
misconduct by employees, floods, lightening

strikes and similar events or risk of loss due to Compliance risk includes violations of rules and

unexpected operating expenses. regulations.

43 44 45
 6-46 6-47 6-48

Reputation risk Strategic risk Capital risk

The variations in earnings due to adverse

This is risk due to negative publicity that can Probability of the value of the bank’s assets
business decisions, improper implementation of
dissuade customers from using the services of declining below the level of its total liabilities.
decisions, or lack of responsiveness to industry
the financial firm. It is the risk associated with The probability of the bank’s long run survival.
changes.
public opinion.

46 47 48

6-49 6-51

Capital risk measures Quick quiz Other goals in banking

 Reading: Ebanking & E-commerce
(Insights and Issues - p.182)
1. Stock price/Earnings per share
 What is the story of Netbank? Total Operating Expenses
Operating Efficiency Ratio =
2. Equity capital/Total assets  What are the implications for profit Total Operating Revenues
management?
3. Purchased funds/Total liabilities
Net Operating Income
Employee Productivity Ratio =
Number of Full Time-Equivalent Employees
4. Equity capital/Risk assets

49 50 51

Average performance characteristics of

banks by business concentration and size Bank performance measure by size Bank risk measures by size
All All
 ROE and ROA (up to $10 billion in assets) $100M - $1B - Trend Commercial $100M - $1B - Trend Commercial
Assets Size
increases with bank size Number of institutions reporting
< $100M
3,655
$1B
3,530
$10B
360
> $10B
85
with Size

Banks
7,630
Assets Size < $100M $1B $10B > $10B with Size Banks
Asset Quality 
 Employees per dollar of assets decreases with % of unprofitable institutions 9.80 2.00 1.90 1.20  5.70
Net charge-offs to LN&LS 0.27 0.31 0.43 0.73  0.63
% of institutions with earn gains 59.30 70.70 71.90 68.20  then  65.30
bank size Performance ratios (%)  Loss allow to Noncurr LN&LS 151.5 196.2 206.0 168.0  then  174.6
Return on equity 8.46 12.88 13.48 14.24 generally 13.82 LN&LS provision to net charge-offs 134.2 125.7 125.5 83.0  89.9
 Larger banks have lower efficiency ratios than Return on assets 0.99 1.28 1.46 1.30 then  1.31 Loss allowance to LN&LS 1.44 1.39 1.47 1.53  1.50
smaller banks Pretax ROA
Equity capital ratio
1.24
11.52
1.73
10.00
2.21
10.90
1.93
9.95
then 

1.92
10.10
Net LN&LS to deposits 72.67 82.11 92.82 86.68  then  86.38
Capital Ratios 
 Smaller banks: Net interest margin
Yield on earning assets
4.18
5.65
4.22
5.73
4.00
5.39
3.43
4.83


3.61
5.02
Core capital (leverage) ratio 11.31 9.47 9.36 7.23  7.83
Tier 1 risk-based capital ratio 16.83 12.85 12.34 9.11  10.04
 have proportionately more core deposits and Cost of funding earn assets 1.47 1.51 1.39 1.40  1.41
Total risk-based capital ratio 17.93 14.06 13.92 12.07  12.62
Earning assets to total assets 91.86 91.93 91.01 84.39  86.18
fewer volatile liabilities than larger banks Efficiency ratio 69.54 62.22 55.54 57.42  57.96 Structural Changes
 have a proportionately larger earnings base Burden ratio 2.60 2.07 1.21 0.82  1.06 New Charters 118 2 1 1  122
Noninterest inc to earn assets 1.03 1.54 2.46 2.93  2.66 Banks absorbed by mergers 102 125 30 7  264
than larger banks Noninterest exp to earn assets 3.63 3.61 3.67 3.75  3.72 Failed banks 3 0 0 0  3
Net charge-offs to LN&LS 0.27 0.31 0.43 0.73  0.63 
 have proportionately lower charge-offs than LN&LS loss provision to assets 0.22 0.26 0.34 0.34  0.33
larger banks

52 53 54
 Average performance characteristics of Profitability measures of banks by Risk measures of banks by business
banks by business concentration and size business concentration concentration
Asset Concentration Groups Asset Concentration Groups
 Wholesale Banks All
Institu
Credit Inter - Ag.
Comm-
ercial
Mort -
Con – Other All All
summer spec. < Other Other
All
Credit Inter - Ag.
Comm-
Mort -
Con – Other All All
Card national Lending gage Institu ercial summer spec. < Other Other
Lending Lending $1B <$1B > $1B Card national Lending gage
Lending Lending $1B <$1B > $1B
 Focus on loans for the largest commercial # of institutions reporting 8,975 34 5 1,730 4,424 990 132 465 1,120 75
Asset Quality
Commercial banks 7,630 30 5 1,725 4,019 250 101 414 1,026 60
Savings institutions 1,345 4 0 5 405 740 31 51 94 15 Net charge-offs to LN&LS 0.56 4.67 0.91 0.21 0.30 0.12 1.57 0.59 0.31 0.25
customers and purchase substantial funds from Performance ratios (%) Loss allow to Noncurr LN&LS 167.8 215.8 135.3 156.7 206.3 97.1 259.4 168.4 155.3 156.3
Return on equity 13.28 22.16 10.35 11.45 13.48 11.61 16.81 10.03 10.18 13.69 LN&LS provs. to net charge-offs 90.6 108.8 63.1 118.3 105.2 100.2 85.5 67.3 99.4 52.0
Return on assets 1.29 4.01 0.76 1.23 1.30 1.18 1.66 1.66 1.10 1.35
corporate and government depositors Pretax ROA 1.90 6.21 1.09 1.51 1.89 1.81 2.56 2.43 1.41 1.98
Loss allowance to LN&LS
Net LN&LS to deposits
1.34 4.27 1.74
91.69 239.79 69.91 76.64
1.43 1.30 0.53
93.90 120.82
1.66
135.96
1.66
33.54
1.34
67.56
1.16
80.51
Equity capital ratio 10.28 20.52 8.05 10.79 10.09 10.55 11.36 16.94 10.79 10.25
Net interest margin 3.53 9.05 2.50 4.07 3.86 3.05 4.71 3.20 3.86 3.27
Capital Ratios
 Retail Banks Yield on earning assets 5.02 11.25 4.02 5.68 5.26 4.80 6.88 4.54 5.40 4.54 Core capital (leverage) ratio 8.12 16.64 6.05 10.37 8.29 9.10 8.82 15.17 10.38 7.20
Cost of funding earn assets 1.49 2.20 1.52 1.61 1.40 1.75 2.17 1.33 1.53 1.27 Tier 1 risk-based capital ratio 10.76 14.59 8.38 14.71 10.14 15.36 13.07 34.70 17.32 9.45
Earning assets to total assets 87.13 82.95 81.47 91.91 90.18 92.17 90.73 88.93 92.11 84.36 Total risk-based capital ratio 13.19 17.34 12.03 15.82 12.18 16.86 14.62 35.95 18.55 12.12
 Focus on consumer, small business, mortgage, Efficiency ratio 58.03 45.29 70.16 62.07 57.10 56.46 45.53 72.42 66.92 57.71 Structural Changes
Burden 0.97 -2.15 0.75 2.08 1.40 1.07 0.78 0.34 2.01 0.84 New Charters 128 0 0 5 35 4 1 77 5 1
Noninterest inc to earn assets 2.13 11.18 2.51 0.69 1.51 1.20 2.26 6.55 1.16 1.96
and agriculture loans and obtain deposits form Noninterest exp to earn assets 3.10 9.03 3.26 2.77 2.91 2.27 3.04 6.89 3.17 2.80
Banks absorbed by mergers 322 1 2 24 210 26 13 6 20 20
Failed institutions 4 0 0 0 3 0 0 0 1 0
LN&LS loss provision to assets 0.30 3.96 0.25 0.16 0.22 0.08 1.05 0.11 0.17 0.07
SOURCE: FDIC Quarterly Banking Profile, http://www.fdic.gov/, http://www2.fdic.gov/qbp.
individuals and small businesses

55 56 57

Performance indicators related to the size 6-58

of a firm, 2007 Questions & Problems

1. Why should banks and other corporate financial firms be
concerned about their level of profitability and exposure to MEASURING &
risk?
2. Why do the managers of financial firms often pay close
EVALUATING THE
attention today to the net interest margin and noninterest PERFORMANCE OF BANKS
margin? To the earnings spread?
3. 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 Chapter 5
seem to apply?
4. Problem 4, 10 and 11 (page 193-6)

William Chittenden edited and updated the PowerPoint slides for this edition.

58 59 60