CHAPTER 5
ACCOUNTING AND ECONOMIC MODELS
OF BANK PERFORMANCE AND VALUATION
Chapter 5
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LEARNING OBJECTIVES
TO UNDERSTAND ...
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The Return-On-Equity Model and its
Decomposition Analysis
Variability of Return as a Measure of Risk
Modern Finance in the Real World
Accounting and Economic Models of Bank
Valuation
The Notion of “Hidden Capital” in Banks
Chapter 5
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CHAPTER THEME
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Stamp bank financial statements:
“Once upon a time”
Why? Because they are “fairy tales” of
the risks embodies in them!
For many banks, however, only these
statements are available for
performance analysis
ROE Model and Decomposition Analysis
Chapter 5
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FDCI QUARTERLY BANKING
PROFILE: BULLET POINTS
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Third Quarter, 2000
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1. Industry earnings rebound
2. Net income of $19.3 billion (3rd highest)
3. Troubled commercial loans continue to
rise
4. PLL absorbs a growing share of
revenues
5. Assets surpass $6-trillion level
Chapter 5
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ROA by Bank Size
(third quarter, 2000)
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Asset size
ROA (%, annualized)
< $100 million
1.16
$100-$1,000
1.30
$1B-$10B
1.36
> $10B
1.16
All banks
1.20
ROE (all banks) = 14.25% = 1.2% x 11.87
Chapter 5
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BANKING STRUCTURE
(September 30, 2000)
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Asset size
Number of banks
< $100 million
4,922
$100-$1,000
3,070
“Community banks”
7,992 (95%)
$1B-$10B
301
> $10B
82
“Large banks”
383 (5%)
Chapter 5
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Banking Structure: A More
Detailed View(Box 5-1, p. 137)
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Description based on 25 asset-size groups
Number of banking offices (1, 2, 3+)
Location (SMA or non-SMA)
Number of banks in peer group
Example: As of 12-31-00, there 830 banks
with two or fewer banking offices and total
assets between $50-$100 million located in
non-SMAs
Chapter 5
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More Banking Structure
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521 FDIC-insured savings banks
57 credit-card specialty banks
5,109 BHCs across four size groups
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> $10 billion
$1B-$10B
$150M-$1B
< $150 million
64
246
1,407
3,392
Chapter 5
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Overall Bank Performance
EM
ROE<
NonControllable Factors
ROA<
Overall Bank
Performance <
Controllable Factors
Risk Variability
Credit Risk
Balance Sheet Risk < Interest-Rate Risk
Regulatory Risk
Liquidity Risk
Technological Risk
Exchange-Rate Risk
Affiliation Risk
Operating-Efficiency Risk
Strategic Risk
Chapter 5
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The ROE Model
ROE
ROA x EM
ROA
Net Income / Assets or PM x AU
Profit Margin (PM)
Net Income / Revenue
Asset Utilization (AU)
Revenue / Average Total Assets
Chapter 5
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ROE DECOMPOSITION
ANALYSIS
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Stage One: ROE = ROA x EM
Stage Two: ROA = PM x AU
Substituting:ROE = PM x AU x EM
Stage Three: Figure 5-2, p. 135
Conduct a Sherlock-Holmes-type
investigation to determine strengths
and weaknesses
Chapter 5
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MEANINGFUL COMPARISONS
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Trend or time-series analysis
Peer-group or cross-sectional analysis
Potential “control variables” include:
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Bank size
Location
Type of business
Organizational structure
Chapter 5
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Bank Profitability
Factors Contributing to Improved
Bank Profitability Since 1992
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Improved Loan Quality
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Lower and More Stable Interest Rates
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Enhanced Generation of Fees and Other
NonInterest Income
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Improved Operating Efficiency
Chapter 5
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Catastrophic Risk
11 September 2001
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The bad news of over 6,000 innocent
deaths overwhelmed the following good
news
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The banks and securities firms affected
had secondary and tertiary backup systems
The Fed provided ample liquidity to ease
the financial aftermath of the market crash
in the week that followed and continued its
policy of “easy money” to attempt to
stimulate the economy
Chapter 5
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Measures of Dispersion
Standard Deviation
The Square Root of the Sum of Squared
Deviations from the Mean
Coefficient of Variation
The Ratio of the Standard Deviation to
the Mean
Chapter 5
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Risk Index for Banks
RI = [E(ROA) + CAP] / sROA
Where
E(ROA) = Expected Return on Assets
CAP = The Inverse of the EM, or the
bank’s ratio of equity capital to
total assets
SROA = The Standard Deviation of ROA
Chapter 5
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PROBABILITY OF BOOKVALUE INSOLVENCY
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The risk index (RI) is a distance
measure in terms of the number of
standard deviations that a bank is away
from book-value insolvency
Given an RI, we can compute (an upper
bound) probability of book-value
insolvency as Pr(BV<0) = 1/2[(RI)2]
Chapter 5
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RI and Pr(BV<0)
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Component
E(ROA)
CAP
sROA
RI
Pr(BV<0)
Strong bank
0.02
0.10
0.001
120.0
0.0035%
Chapter 5
Weak bank
-0.02
0.03
0.007
1.43
24.5%
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The Critical Role of Credit Risk
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When a bank has too many bad loans
what happens?
It has to take such a large PLL that
E(ROA) < 0 and it wipes out CAP such
that NW < 0. In terms of RI, the
numerator < 0.
Chapter 5
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Market Values, Book Values, and
Transparency
Itemization Principles
Procedures that Govern what Entries do or do
not Need to be Recognized in the Body of
Each Financial Statement
Valuation Principles
Procedures that Determine the Worth or Value
Assigned to Itemized Entries
Chapter 5
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Economic Values vs.
Accounting Numbers
ECONOMICS
Market-Value Analysis
ACCOUNTING
Book-Value Analysis
Chapter 5
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A Comparative-Statics
Experiment: Initial Conditions
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Balance sheet:
$100,000 = $90,000 + $10,000
Income-expense statement:
100,000 x .075 – 90,000 x 0.6 = 2,100
Asset is a five-year, fixed-rate bond with
an annual coupon of 7.5% funded by a
one-year CD at 6%
Chapter 5
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A Comparative-Statics
Experiment: Interest-Rate Shock
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Assume interest rates double
immediately after the balance sheet is
set
Net income in the second year is:
7,500 – 90,000 x 0.12 = -3,300
Immediately after the shock, MVE =
PV(A) – PV(L) = 74,859 – 85,178 =
-10,319
Chapter 5
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THE ROLE OF GOVERNMENT
GUARANTEES
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A + G = L + NW
G, the government guarantee, is an
unbooked intangible asset
As a bank’s NW => 0, G becomes more
important
Since an unbooked intangible asset
must have an offsetting entry, what is it
and where is it booked?
Chapter 5
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Modern Finance in the Real
World
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Acquisition and Funding of Assets
Risks: Credit, Liquidity, Prepayment,
Interest Rate, Sovereign, and Foreign
Exchange
Stock Price = EPS x P/E
Chapter 5
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Discounted Cash Flow
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Economic, Real, and Market Value
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PV = CF1/(1+r)+CF2/(1+r)2+...+CFn/(1+r)n
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Risk/Return Tradeoffs
Chapter 5
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Compromise Model
P = EPS* x P/E x K
Where:
EPS* = current economic or real earnings
and
K = an adjustment factor that marks the industry P/E
ratio either up or down to reflect the firm’s unique
risk profile
Chapter 5
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Pricing Capital Assets and
BETA
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Capital Asset Pricing Model (CAPM) =
provides a method for determining
asset prices based on the asset’s
contribution to portfolio risk
r = rf + beta(rM + rf )
Beta = index of systematic risk
Chapter 5
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Market Measures of Financial
Performance
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Market-To-Book Ratio
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Price-Earnings Ratio
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Constant-Growth Model
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Dividend-Payout Ratio
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Dividend Yield
Chapter 5
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Hidden Capital
Two Sources of Hidden Capital
1. Differences Between the Market Values (MV) and
Book Values (BV) of on-balance-sheet items
2. Neglect off-balance-sheet items that Generally
Accepted Accounting Principles do not Permit to be
Formally Booked
Chapter 5
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SMVAM
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Statistical Market Value Accounting
Model (SMVAM)
MVE = a + b (BVE) + e
Joint hypothesis: [a = 0, b = 1]
If so, MVE = BE
Do we expect this to hold?
How do we interpret the rejection of the
null hypothesis?
Chapter 5
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SMVAM Results (2000)
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Sample
28 BHCs
9 largest
19 large
Intercept (a)
- 2.60
-24.1
1.0
Slope (b)
3.03*
3.66*
2.91*
*Significantly different from 1.0 at the
1% level of significance
Chapter 5
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CHAPTER SUMMARY
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Accounting and economic models can
be used to measure bank performance
Economic models are more realistic but
accounting frameworks are the only
game in town for many banks
ROE = PM x AU x EM
Credit risk has caused the greatest
fluctuations in bank earnings
Chapter 5
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