Measuring and Evaluating Bank Performance

6 July 2009

Ms. Kashmirr C. Ibanez

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

What is performance?

How adequately a financial firm meets the needs of its stockholders, employees, depositors and other creditors and borrowing customersKeep regulators satisfied that operating policies, loans and investments are soundMust be directed towards specific objectives

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Value of the Bank’s Stock

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FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Value of a Bank’s Stock Rises When:

Expected dividends increaseRisk of the bank fallsMarket interest rates decreaseCombination of expected dividend increase and risk decline

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Value of Bank’s Stock if Earnings Growth is Constant

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FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Key Profitability Ratios in Banking

CapitalEquity Total

TaxesAfter IncomeNet (ROE) CapitalEquity on Return

Assets Total

TaxesAfter IncomeNet (ROA) Assetson Return

Assets Total

IncomeInterest Net Margin Interest Net

Assets Total

Incomet NoninteresNet Margin t NoninteresNet

** use total earning assets for NIM and NNM

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Key Profitability Ratios in Banking

Assets Total

Expenses Operating Total

- Revenues Operating Total

Margin OperatingBank Net

gOutstandin SharesEquity Common

TaxesAfter IncomeNet (EPS) SharePer Earnings

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Interpreting the key profitability ratios

Return on Equity (ROE)

•Measure of rate of return flowing to shareholders

Return on Assets (ROA)

•Managerial efficiency

•How capable management has been in converting assets into net earnings

Net Interest Margin •How large a spread between interest revenues and interest costs management has been able to achieve

Net Non-interest Margin

•Amount of non-interest revenues stemming from service fees relative to the amount of non-interest costs incurred

•Usually negative

sLiabilitie bearing-Interest Total

ExpenseInterest Total

Assets Earning Total

IncomeInterest Total Spread Earnings

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Zoom in on ROE

capitalequity Total

assets TotalROA x ROE

capitalequity Total

assets Total

assets Total

IncomeNet

capitalequity Total

IncomeNet x

capitalequity Total

assets Total

assets Total

Taxes - expenses operating

Total - Revenues Total

xROE

•Return to shareholder is sensitive to how its assets are financed•Financial institutions with low ROA can achieve a relatively high ROE through heavy use of debt (leverage) and minimal use of owner’s capital•As earnings efficiency (ROA) declines, the firm must take on more risk in the form of higher leverage to have any chance of achieving its desired ROE

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Zoom in on ROE

MultiplierEquity x

Ration utilizatioAsset Margin x Profit Net ROE

Net Profit Margin Net Income

Total operating revenue

Degree of Asset Utilization

Total operating revenue

Total assets

Equity Multiplier Total assets

Total equity capital

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Zoom in on ROE

MultiplierEquity x

Ration utilizatioAsset Margin x Profit Net ROE

Net Profit Margin

Effectiveness of expense management (cost control) and service pricing policies

Degree of Asset Utilization

Portfolio management policies, especially the mix and yield on assets

Equity Multiplier

Leverage of financing policies (debt or equity)

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Achieving profitability depends on several crucial factors

Careful use of financial leverageProportion of assets financed by debt as opposed to equity capital

Careful use of operating leverageProportion of fixed cost inputs used to boost operating earnings as output grows

Careful control of operating expenses

Careful management of asset portfolio

Careful control of exposure to risk

Other measures of bank performance

revenues operating total

expenses operating total ratio efficiency Operating

FTEs ofnumber

income operatingNet ratioty productivi Employee

All about risk

Riskperceived uncertainty associated with a particular event

Deviation from expectations

Popular measures for overall risk for a financial firm

Standard deviation or variance of stock prices, net income, ROE or ROA

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Measuring Bank RisksCredit Risk

The probability that some of the bank’s assets will decline in value and perhaps become worthless

Liquidity RiskProbability the bank will not have sufficient cash and borrowing capacity to meet deposit withdrawals and other cash needs

Market RiskProbability of the market value of the bank’s investment portfolio declining in value due to a rise in interest rates

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Bank RisksInterest Rate Risk

The danger that shifting interest rates may adversely affect a bank’s net income, the value of its assets or equity

Earnings RiskThe risk to the bank’s bottom line – its net income after all expenses

Capital RiskProbability of the value of the bank’s assets declining below the level of its total liabilities. The probability of the bank’s long run survival

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Bank RisksLegal risk

Creates variability in earnings resulting from actions taken by leval system (e.g. unenforceable contracts, lawsuits, adverse judgments

Compliance riskReaches beyond violation of the legal system and includes violations of rules and regulations.

Reputational riskUncertainty associated with public opinion

Strategic riskVariations in earnings due to adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Credit Risk Measures

Nonperforming Loans/Total LoansNet Charge-Offs/Total LoansProvision for Loan Losses/Total LoansProvision for Loan Losses/Equity CapitalAllowance for Loan Losses/Total LoansAllowance for Loan Losses/Equity CapitalTotal Loans/Total Deposits

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Liquidity Risk Measures

Purchased Funds/Total Assets

Net Loans/Total Assets

Cash and Due from Banks/Total Assets

Cash and Government Securities/Total Assets

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Market Risk Measures

BV of Assets/ MV of Assets

BV of Equity/ MV of Equity

BV of Bonds/MV of Bonds

MV of Preferred Stock and Common Stock

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Interest Rate Risk Measures

Interest Sensitive Assets/Interest Sensitive Liabilities

Uninsured Deposits/Total Deposits

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Earnings Risk Measures

Standard Deviation of Net Income

Standard Deviation of ROE

Standard Deviation of ROA

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Capital Risk Measures

Interest rate spread between market yields on debt issues and market yields on GS with the same maturity

Stock Price/ Annual EPSRatio falls if investors believe that a financial firm is undercapitalized relative to the risk it is taking on

Equity Capital/Total Assets

Purchased Funds/Total Liabilities

Equity Capital/Risk Assets

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Other Forms of Risk in Banking

Inflation Risk

Currency or Exchange Rate Risk

Political Risk

Crime Risk

FINBANK SY 08-09 Term 2Ms. Kashmirr C. Ibañez

Don’t Forget to be FAIR!

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