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Chap IV Analyzing Commercial Bank Performance

Analyzing financial ratios is an important way for bank managers to evaluate a bank's performance. Key ratios include return on equity (ROE), return on assets (ROA), and efficiency ratios. ROE can be decomposed into ROA multiplied by the equity multiplier, and further decompositions of ROA and its components can provide insight into a bank's profitability, costs, and risks. Market measures like stock prices and returns can also provide an external perspective on a bank's performance.

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41 views29 pages

Chap IV Analyzing Commercial Bank Performance

Analyzing financial ratios is an important way for bank managers to evaluate a bank's performance. Key ratios include return on equity (ROE), return on assets (ROA), and efficiency ratios. ROE can be decomposed into ROA multiplied by the equity multiplier, and further decompositions of ROA and its components can provide insight into a bank's profitability, costs, and risks. Market measures like stock prices and returns can also provide an external perspective on a bank's performance.

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MANAGEMENT OF FINANCIAL

INSTITUTIONS

ANALYZING COMMERCIAL
BANKS PERFORMANCE

Professor: Amira Guermazi


JUNIOR FINANCE
 One way to identify performance, weaknesses and
problem areas of a bank is by analyzing financial
statements.

 In particular an analysis of selected accounting ratio-ratio


analysis , allows a bank manager to evaluate the bank’s
current performance, the change in its performance over
time and its performance compared to that of competitor
banks
• Peer Analysis: cross sectional analysis of ratios across a group
of firms. Compare with others in same business situation

• Trend Analysis: time series analysis of ratios over a period of


time. Compare performance with previous periods
THE RETURN ON EQUITY
ROE
• Return on equity is defined as:

ROE=NET INCOME / TOTAL EQUITY CAPITAL

• The amount of net income returned as a percentage of shareholders equity.

• Return on equity measures a bank’s profitability by revealing how much


profit the bank generates with the money shareholders have invested.

• ROE is the basic measure of stockholder’s returns.

• Generally, bank stockholders prefer ROE to be high. It is possible, however


that an increase in ROE indicates increased risk
• ROE increases if total equity capital decreases to net income

ROE=NET INCOME / TOTAL EQUITY CAPITAL

• A large drop in equity capital may result in a violation of


minimum regulatory capital standards and an increased risk of
insolvency for the bank

• An increase in ROE may simply result from an increase in a


bank’s leverage, an increase in its debt to equity ratio
• To identify potential problems, ROE can be decomposed into 2
components parts as follows:

ROE=NET INCOME / TOTAL EQUITY CAPITAL

ROE = (NET INCOME/TOTAL ASSETS)*(TOTALASSETS/EQUITY CAPITAL)

ROE = ROA * EM
ROE = ROA * EM

• ROA is a measure of profitability linked to the asset size of


the bank. It determines the net income produced per one unit
of assets.

• EM equity multiplier, a measure of the degree of financial


leverage employed by the bank

• It measures the value of assets funded with each unit of


equity capital.
• Since EM measures financial leverage, it represents both
profit and risk measure:

ROE = ROA * EM
EM = (TOTAL ASSETS/EQUITY CAPITAL)

– 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 because it reflects how
many assets can go into default before a bank becomes
insolvent

• Large value of EM indicates a large amount of debt financing


relative to stockholders’ equity
• When the leverage (EM) is high, banks are accepting a lot of
deposits and can earn high income levels

• A high EM mutliplies profits when profits are positive, but also


does with losses.

ROE = ROA * EM

• An increase in ROE due to an increase in the EM means that


the bank’s leverage increased but also indicates high
insolvency risk
• Consider 2 competing banks, each holding 100 million in
assets with identical composition and same asset quality.

• One bank is financed with 90 million in debt and 10 million in


total equity, while the other one is financed with 95 million in
debt and just 5 million in total equity.

• EM = 100/10 = 10 for the first bank and 100/5 = 20 for the


second bank

• If both banks earned 1% on assets (ROA = 1%), the first bank


would report a ROE of 10% while the second bank’s ROE
would equal 20%
• If each bank reported an ROA equal to -1%, the second
bank’s ROE would equal to -20% or twice the loss of the
first bank

• Consider the ratio (total equity /total assets) or 1/EM. This


ratio equals 10% (1/10) for the first bank and 5% (1/20) for
the second bank. Although both banks hold identical assets,
the first one is in less risky position because twice as many
assets can default (and, thus, be reduced in value to zero on
the balance sheet) compared to the second bank before
insolvency.
• From its first-level decomposition, it is seen that in order for a
banking firm to report high ROE at least one of the following
must be true:

– The bank is taking one more risk


– The bank is pricing assets and liabilities better
– the bank is realizing cost advantages compared to peers
ROE = NI/E = NI/TA * TA/E = ROA * EM

ROA can be broken into 2 component parts as follows:

ROA = NI/TA
ROA =(NI/Total Operating Income )* (Total Operating Income/TA)

ROA = PM*AU

PM: Profit margin, net income generated per unit of total operating
income ( interest and non interest income). It measures the
bank’s ability to control expenses.

AU: Asset utilization ratio measures the extent to which the bank’s
assets generate revenue
• A breakdown of PM can isolate the various expense items
listed on the income statement as follows:

PM = NI/Total Operating Income


PM = (TOI - IE - NIE – P - T)/TOI
PM = 1- (IE/TOI + NIE/TOI + P/TOI + T/TOI )

• The lower any of these expenses ratio the higher the bank’s
profitability
• Other decomposition of ROA:

ROE = NI/E = NI/TA * TA/E = ROA * EM


ROA = NI/TA = (TOI –Total expenses)/TA
ROA = AU – ER
ER: Expense Ratio

• The lower is the ER , the more efficient a bank will be in


controlling expenses
• The ROA analysis can decompose owner’s returns into cost
management and revenue management
• The break down of AU asset utilization ratio into interest
income and non interest income ratios:

AU = TOI/TA = (II + NOII)/TA = II/TA + NOII/TA

AU = interest income ratio + non interest income ratio


OTHER PROFITABILITY
MEASURES
• Net Interest Margin (NIM) measures the net return on the
bank’s earning assets:

NIM = NII/Earning Assets


NIM = (II - IE)/(Inv. Securities + Net Loans and Leases)

• Generally, the higher this ratio is, the better is. But it cannot
measure the risk for the bank.

• Assume that we replace the earning assets with higher


earning ones but riskier, the NIM will increase but it also
increases the risk for the bank
• The spread: this ratio measures the difference between the
average yield on earning assets and average cost of interest
bearing liabilities:

Spread = (II/earning assets) – (funding cost/ interest bearing liabilities)

• Generally the higher the spread, the more profitable the bank but
again the source of high spread can involve a higher risk for the
bank
• Overhead Efficiency: this ratio measures the bank’s ability to
generate non interest income to cover non interest expenses

Overhead efficiency = NOII/NIE

• The higher this ratio, the better.


• Generally NIE >NOII, therefore this ratio is <1.
• Low NOII can also indicate increased risk if the bank is not
investing in the most efficient technology
• Efficiency ratio : measures the bank’s ability to manage costs

Efficiency ratio = NIE/TOI

• It indicates how much the bank pays for its non interest
expenses for 1 unit of Total Operating Income

• The bank uses this ratio to measure the success of recent


efforts to control non interest expenses while supplementing
earnings from increasing fees

• The smaller is the efficiency ratio the more profitable is the


bank
• Burden ratio: measures the amount of non interest expense
covered by fees, service charges and other income as a
fraction of average total assets

Burden ratio= (NIE – NOII)/TA

• The greater is this ratio the greater non interest expense


exceeds non interest income for the bank’s balance sheet size.
The bank is thus better off with a low burden ratio
MARKET MEASURES OF
BANK PERFORMANCE
• Financial markets may be a measure of bank performance

• Equity markets: common stock book-to-market ratio measures


market perception of growth potential and risk assets

Earning per share:


EPS= NI/Number of stocks
Price to Earnings
P/E = Stock price/EPS

Market Value of equity


MV of Equity = MV of assets – MV of Liabilities
MV of Equity = number of common stock *stock price
Return to stockholders :
(stock price t- stock price t-1+dividends) /stock price t-1

• Example: you buy 100 shares of LOKA Bank at the beginning of


2015 for 45.06, the bank paid 2 per share in dividends. At the
beginning of 2016, the stock price was 33.02

• Return to stockholder in 2014:


(33.02-45.06+2)/45.06 = -22.28%
• Many banks attempt to measure profitability by:

– Type of loan customer (small business, middle market,


consumer installment, etc…)
– Type of depositor by characteristics of the relationship
(account longevity, cross sell patterns, etc…)
– Delivery system(branch, ATM, telephone, home banking,
etc…)

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