Measuring and

Evaluating the
Performance of
Banks
and Their Principal
Competitors

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 Overview
▪ In today's world, bankers and their competitors are under great pressure to
perform well all the time.
▪ In this case performance refers to how adequately a financial firm meets the
needs of its stockholders (owners), employees, depositors and other creditors, and
borrowing customers.
▪ At the same time, financial firms must find a way to keep government regulators
satisfied that their operating policies, loans, and investments are sound,
protecting the public interest.
▪ In this chapter we take a detailed look at the most widely used indicators of the
quality and quantity of bank performance. The chapter centers on the most
important dimensions of performance-profitability and risk.

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Evaluating Performance
Determining Long-Range Objectives:
Performance must be directed toward specific objectives. A fair evaluation of any
financial firm’s performance should start by evaluating whether it has been able to
achieve the objectives its management and stockholders have chosen.
➢Maximizing the Value of the Firm: A Key Objective for Nearly All Financial-Service
Institutions
▪ The basic principles of financial management strongly suggest maximizing a
corporation's stock value as the firm’s key objective. Otherwise, current investors
may seek to unload their shares and the financial institution will have difficulty
raising new capital to support its future growth.

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Maximizing the Value of the Firm (Cont’d)
The value of the financial firm's stock will tend to rise in any of the following
situations:
▪ The value of the stream of future stockholder dividends is expected to increase.
▪ The financial organization's perceived level of risk falls
▪ Market interest rates decrease, reducing shareholders' acceptable rates of return
via the risk-free rate of interest component of all market interest rates.
▪ Expected dividend increases are combined with declining risk, as perceived by
investors.
Stock values of financial institutions to be especially sensitive to changes in market
interest rates, currency exchange rates, and the strength or weakness of the
economy that each serves.

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Maximizing the Value of the Firm (Cont’d)
▪ If the dividends paid to stockholders are expected to grow at a constant rate over
time, perhaps reflecting steady growth in earnings, the stock price equation can be
greatly simplified into

▪ Most capital-market investors have a limited time horizon, however, and plan to sell
the stock at the end of their planned investment horizon. In this case the current
value of a corporation's stock is determined from

where we assume an investor will hold the stock for n periods, receiving the stream of
dividends D1 D2, ••• , D n, and sell the stock for price P n at the end of the planned
investment horizon.

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Profitability Ratios:
A Surrogate for Stock Values
• While the behavior of a stock's price is, in
theory, the best indicator of a financial firm’s
performance because it reflects the market's
evaluation of that firm, this indicator is often
not available for smaller banks and other
relatively small financial-service corporations
because the stock issued by smaller
institutions is frequently not actively traded
in international or national markets.
• This fact forces the financial analyst to fall
back on surrogates for market-value
indicators in the form of various profitability
ratios.

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Interpreting Profitability Ratios
▪ Return on assets (ROA) is primarily an indicator of managerial efficiency; it
indicates how capable management has been in converting assets into net
earnings.
▪ Return on equity (ROE}, on the other hand, is a measure of the rate of return
flowing to shareholders.
▪ The net operating margin, net interest margin, and net noninterest margin are
efficiency measures as well as profitability measures, indicating how well
management and staff have been able to keep the growth of revenues ( which
come primarily from loans, investments, and service fees) ahead of rising costs
(principally the interest on deposits and other borrowings and employee salaries
and benefits).
▪ Another traditional measure of earnings efficiency is the earnings spread, or
simply the spread, calculated as follows:

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 Useful Profitability Formulas for Banks and
Other Financial-Service Companies
• In analyzing how well any given financial-service firm is performing, it is often
useful to break down some of these profitability ratios into their key components.
• ROE and ROA, two of the most popular profitability measures, are closely related.
Both use the same numerator: net income. Therefore, these two profit indicators
can be linked directly:

• Return to a financial firm's shareholders is highly sensitive to how its assets are
financed-whether more debt or more owners' capital is used.
• ROE-ROA relationship illustrates quite clearly the fundamental trade-off the
managers of financial-service firms face between risk and return. 8
Risk-Return Trade-Offs for Return on Assets (ROA) and Return on
Equity (ROE)

▪ As earnings efficiency represented by ROA declines, the firm must take on

more risk in the form of higher leverage to have any chance of achieving its
desired rate of return to its shareholders (ROE).

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 Return on Equity and Its Principal Components
Another highly useful profitability formula focusing upon ROE is this one:

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Elements That Determine the Rate of Return Earned on the
Stockholders' Investment (ROE) in a Financial Firm

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 Elements That Determine the Rate of Return Earned on the
Stockholders' Investment (ROE) in a Financial Firm
▪ If any of these ratios begins to decline, management needs to pay close attention
and assess the reasons behind that change.
▪ The multiplier is a direct measure of financial leverage-how many dollars of
assets must be supported by each dollar of equity (owners') capital and how much
of the financial firm’s resources, therefore, must rest on debt. Because equity
must absorb losses on assets, the larger the multiplier, the more exposed to
failure risk the financial institution is. However, the larger the multiplier, the
greater the potential for high returns for the stockholders.
▪ The net profit margin (NPM), or the ratio of net income to total revenues, is also
subject to some degree of management control and direction. It reminds us that
financial service corporations can increase their earnings and the returns to their
stockholders by successfully controlling expenses and maximizing revenues.
▪ Similarly, by carefully allocating assets to the highest-yielding loans and
investments while avoiding excessive risk, management can raise the average
yield on assets (AU, or asset utilization).
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 What a Breakdown of Profitability Measures
Can Tell Us
Clearly, breaking down profitability measures into their respective components
tells us much about the causes of earnings difficulties and suggests where
management needs to look for possible cures for any earnings problems that
surface. The foregoing analysis reminds us that achieving superior profitability for
a financial institution depends upon several crucial factors:
1. Careful use of financial leverage ( or the proportion of assets financed by debt as
opposed to equity capital).
2. Careful use of operating leverage from fixed assets ( or the proportion of fixed-
cost inputs used to boost operating earnings as output grows).
3. Careful control of operating expenses so that more dollars of sales revenue
become net income.
4. Careful management of the asset portfolio to meet liquidity needs while seeking
the highest returns from any assets acquired.
5. Careful control of exposure to risk so that losses don't overwhelm income and
equity capital. 13
Measuring Risk in Banking and Financial Services

▪ Risk to the manager of a financial institution or to a regulator supervising financial

institutions means the perceived uncertainty associated with a particular event.
▪ Earnings may decline unexpectedly due to factors inside or outside the financial firm,
such as changes in economic conditions, competition, or laws and regulations.
▪ For example, recent increases in the competition have tended to narrow the spread
between earnings on assets and the cost of raising funds.
▪ Thus, stockholders always face the possibility of a decline in their earnings per share
of stock, which could cause the bank’s stock price to fall, eroding its resources for
future growth.

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Measuring Risk in Banking and Financial Services
▪ Among the more popular measures of overall risk for a financial firm are the
following:
✓Standard deviation ( ) or variance ( < 2) of stock prices.
✓Standard deviation or variance of net income.
✓Standard deviation or variance of return on equity (ROE) and return on assets
(ROA).
The higher the standard deviation or variance of the above measures, the greater
the overall risk.
Let's examine several of the most important types of risk encountered daily by
financial institutions.

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Credit Risk
▪ The probability that some of a financial institution's assets, especially its loans, will
decline in value and perhaps become worthless is known as credit risk.
▪ The following are five of the most widely used ratio indicators of credit risk:
• Nonperforming assets / • Net charge-offs of loans / • Annual provision for loan
Total loans and leases. Total loans and leases. losses / Total loans and leases
or relative to equity capital.
• Allowance for loan losses • Nonperforming assets / • Total loans/total deposits.
/ Total loans and leases or Equity capital.
relative to equity capital.

▪ Nonperforming assets are income-generating assets, including loans, that are past
due for 90 days or more.
▪ Charge-offs, on the other hand, are loans that have been declared worthless and
written off the lender's books.
▪ As these ratios rise, exposure to credit risk grows, and failure of a lending institution
may be just around the corner.
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Liquidity Risk
▪ Financial-service managers are also concerned about the danger of not having
sufficient cash and borrowing capacity to meet customer withdrawals, loan
demand, and other cash needs.
▪ Faced with liquidity risk a financial institution may be forced to borrow
emergency funds at excessive cost to cover its immediate cash needs, reducing its
earnings.
▪ One useful measure of liquidity risk exposure is the ratio of
• Purchased funds (including Eurodollars, federal funds, security RPs, large CDs,
and commercial paper)/Total assets.
• Cash and due from balances held at other depository institutions/Total assets.
• Cash assets and government securities/Total assets.

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Liquidity Risk
▪ Cash assets include vault cash held on the financial firm's premises, deposits
held with the central bank in the region, deposits held with other depository
institutions to compensate them for clearing checks and other interbank
services, and cash items in the process of collection (mainly uncollected
checks).
▪ Standard remedies for reducing a financial institution's exposure to liquidity
risk include increasing the proportion of funds committed to cash and readily
marketable assets, such as government securities, or using longer-term
liabilities to fund the institution's operations.

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Market Risk
• The market values of assets, liabilities, and net worth of financial service
providers are constantly in a state of flux due to uncertainties concerning market
rates or prices.
• Market risk is composed of both price risk and interest rate risk.
Price Risk:
Especially sensitive to these market-value movements are bond portfolios and
stockholders’ equity (net worth), which can dive suddenly as market prices move
against a financial firm. Among the most important indicators of price risk in
financial institutions’ management are:
➢ Book-value assets/Estimated market value of those same assets.
➢Market value of common and preferred stock per share, reflecting investor
perceptions of a financial institution’s risk exposure and earnings potential. Etc.

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Market Risk
▪ Interest Rate Risk:
• The impact of changing interest rates on a financial institution’s margin of profit
is called interest rate risk. Among the most widely used measures of interest-rate
risk exposure are the ratios:
➢Interest-sensitive assets/Interest-sensitive liabilities
➢Uninsured deposits/Total deposits
• With more volatile market interest rates in recent years, bankers and their
competitors have developed several new ways to defend their earnings margins
against interest-rate changes, including interest-rate swaps, options, and
financial futures contracts.

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Foreign Exchange and Sovereign Risk
▪ Fluctuating currency prices generate foreign exchange risk as the value of a
financial institution’s assets denominated in foreign currencies may fall, forcing a
write-down of those assets on its balance sheet.
▪ Under what is often called sovereign risk foreign governments may face domestic
instability and even armed conflict, which may damage their ability to repay
debts owed to international lending institutions.
▪ Management must learn how to assess and monitor these risks and how to hedge
their financial firm’s assets when market conditions deteriorate.

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Off-Balance-Sheet Risk
▪ One of the newest forms of risk faced by leading financial institutions is
associated with the rapid build-up of financial contracts that obligate a
financial firm to perform in various ways but are not recorded on its balance
sheet.
▪ Examples include standby credit agreements, in which a financial firm
guarantees repayment of a customer’s loans owed to other businesses; loan
commitments, in which a financial institution pledges to extend credit over a
set period of time as needed by its customers; and financial futures and
options, in which prices and interest rates are hedged against adverse market
movements.
▪ These off-balance-sheet instruments are often highly complex and volatile in
their market values, creating substantial off-balance-sheet risk for
management to deal with.

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Operational (Transactional) Risk
▪ Operational risk refers to uncertainty regarding a financial firm’s earnings due to
failures in computer systems, errors, misconduct by employees, floods, lightning
strikes, and similar events.
▪ Some analysts say that operational risk is therisk of loss due to anything other than
credit or market risk. Others say it includes legal and compliance risk, but not
reputation or strategic risk.

Legal and Compliance Risks

▪ Legal risk creates variability in earnings resulting from actions taken by our
legal system. Unenforceable contracts, lawsuits, or adverse judgments may
reduce a financial firm’s revenues and increase its expenses. Lawyers are never
cheap and fines can be expensive!
▪ In a broader sense compliance risk reaches beyond violations of the legal system
and includes violations of rules and regulations. For example, if a depository
institution fails to hold adequate capital, costly corrective actions must be taken
to avoid its closure.
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Reputation Risk
▪ Reputation risk is the uncertainty associated with public opinion. The very
nature of a financial firm’s business requires maintaining the confidence of its
customers and creditors.

Strategic Risk
▪ Variations in earnings due to adverse business decisions, improper
implementation of decisions, or lack of responsiveness to industry changes are
parts of what is called strategic risk.
▪ This risk category can be characterized as the human element in making bad
long range management decisions that reflect poor timing, lack of foresight,
lack of persistence, and lack of determination to be successful.

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Capital Risk
• The impact of all the risks examined above can affect a financial firm’s long-run
survival, often referred to as its capital risk.
• For example, if a bank takes on an excessive number of bad loans or if a large
portion of its security portfolio declines in market value, generating serious
capital losses when sold, then its equity capital, which is designed to absorb such
losses, may be overwhelmed. If investors and depositors become aware of the
problem and begin to withdraw their funds, regulators may have no choice but to
declare the institution insolvent and close its doors.
• When investors believe that a financial firm has an increased chance of failing,
the market value of its capital stock usually begins to fall and it must post
higher interest rates on its borrowings in order to attract needed funds.

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Capital Risk
▪ Economists call this phenomenon market discipline: interest rates and
security prices in the financial marketplace move against the troubled firm,
forcing it to make crucial adjustments in policies and performance in order to
calm investors’ worst fears.
▪ This suggests that capital risk can be measured approximately by:
➢The interest rate spread between market yields on debt issues (such as
capital notes and CDs issued by depository institutions) and the market
yields on government securities of the same maturity.
➢Stock price per share/Annual earnings per share
➢Equity capital (net worth)/Total assets
➢Equity capital/Risk assets

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Capital Risk
▪ Risk assets consist mainly of loans and securities and exclude cash, plant and
equipment, and miscellaneous assets.
▪ Some authorities also exclude holdings of short-term government securities from
risk assets because the market values of these securities tend to be stable and
there is always a ready resale market for them.
▪ Concern in the regulatory community over the risk exposure of depository
institutions has resulted in heavy pressure on their management to increase
capital.

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The Impact of Size on Performance
• When the performance of one financial firm is compared to that of another, size —often
measured by total assets or, in the case of a depository institution, total deposits—
becomes a critical factor.
• The largest banks also generally report the highest (least negative) noninterest
margins because they charge fees for so many of their services. In contrast, smaller and
medium size banks frequently display larger net interest margins and, therefore,
greater spreads between interest revenue and interest costs because most of their
deposits are small denomination accounts with lower average interest costs.
• the smallest banks usually report higher ratios of equity capital to assets. Some bank
analysts argue that larger banks can get by with lower capitalto-asset cushions because
they are more diversified across many different markets and have more risk-hedging
tools at their disposal.
• Smaller banks appear to be more liquid, as reflected in their lower ratios of net loans to
deposits, because loans are often among a bank’s least liquid assets.
• The biggest banks may carry greater credit risk at times as revealed by their higher
loan loss
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Thank you!

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