Chapter 4
Measuring and Evaluating the
Performance of Banks and Their
Principal Competitors
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Key Topics
• Stock Values and Profitability Ratios
• Measuring Credit, Liquidity, and Other
Risks
• Measuring Operating Efficiency
• Performance of Competing Financial
Firms
• Size and Location Effects
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Introduction
• This chapter focuses on the most
widely used indicators of the quality
and quantity of bank performance
and their principal competitors
• Focus on the most important
dimensions of performance –
profitability and risk
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Introduction
• Financial institutions are businesses
organized to maximize the value of
the shareholders’ wealth invested in
the firm at an acceptable level of risk
• Must always be looking for new
opportunities for revenue growth,
greater efficiency, and more effective
planning and control
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Introduction
• Individuals or groups that are interested in
how well a bank performs includes the:
stockholders (owners)
employees
depositors and creditors
borrowing customers
bank examiners representing the
laws and regulations
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Evaluating Performance
p. 89
1. Performance must be directed toward specific
objectives, such as:
Growing faster
Longer term growth (growing over time)
Minimizing risk and being a safe bank
2. 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
3. A key objective is to maximize the value of the firm
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Evaluating Performance (continued)
p. 89
• The minimum acceptable rate of return, r, is referred to as an
bank’s cost of capital
▫ Risk-free rate of interest
▫ Equity risk premium (return to investors for risk)
• The value of the financial firm’s stock will tend to rise in any
of the following situations
1. Stockholder dividends is expected to increase
2. The level of risk falls
3. Market interest rates decrease, reducing shareholders’
acceptable rates of return with the risk-free rate of interest
component of all market interest rates
4. Dividend increases combined with declining risk, as seen
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Evaluating Performance (continued)
p. 89
• The stock values of banks are sensitive to changes in market
interest rates and the strength or weakness of the economy
• Stocks may pay dividends of varying amounts over time
• If the dividends paid to stockholders are expected to grow at a
constant rate over time, the stock price equation can be greatly
simplified into
▫ D1 is the expected dividend in period 1
▫ r is the rate of discount reflecting the perceived level of risk
▫ g is the expected constant growth rate at which all future
stock dividends will grow each year
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Concept Check
p. 90
• What factors influence the stock price of a financial
firm?
• What individuals or groups are likely to be interested
in the banks’ level of profitability and exposure to
risk?
• A bank is expected to pay an annual dividend of $4
per share and the dividends are expected to grow at
5% by the end of year and the return-to-equity capital
based on the level of risk is 10%. Estimate the current
value of the bank’s stock?
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Evaluating Performance (continued)
p. 90
• The previous price formula assumes the financial
firm will pay dividends ongoing into the future
• Most capital market investors have a limited time
horizon
▫ where we assume an investor will hold the stock
for n periods, receiving the stream of dividends D1,
D2, . . . , Dn and sell the stock for price Pn at the end
of the planned investment horizon
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Evaluating Performance (continued)
p. 91
• The behavior of a stock’s price is the best indicator 指针
(zhǐzhēn) of a financial firm’s performance because it
reflects the market’s evaluation of that firm
• The stock price indicator is often not available for smaller
banks and other relatively small financial firms
• KEY PROFITABILITY RATIOS (in simple form):
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Evaluating Performance (continued)
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Evaluating Performance (continued) P. 91-92
• Return on assets (ROA) is primarily an indicator of
managerial efficiency
• Indicates how capable能 (néng) management has
been in converting 兑换 (duìhuàn) assets into net
earnings
• Return on equity (ROE) is a measure of the rate of
return flowing to shareholders
• The net benefit that the stockholders have received
from investing their capital in the financial firm
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Evaluating Performance (continued) P. 91-92
• The net operating margin (difference), net interest margin, and
net noninterest margin are efficiency measures as well as
profitability measures
▫ The net interest margin measures how large a difference
between interest revenues and interest costs
▫ The net noninterest margin measures the noninterest
revenues from service fees the firm has been able to collect
relative to the amount of noninterest costs
▫ Typically, the net noninterest margin is negative
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Evaluating Performance (continued) p. 92
• Another measure of earnings efficiency is the earnings spread
▫ Measures the effectiveness of a financial firm’s function in
borrowing and lending money and also the amount of
competition in the firm’s market area
▫ Greater competition tends to make the difference between
average asset yields and average liability costs lower
▫ If other factors are held constant, the spread will decline as
competition increases
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Concept Check
P. 92
4-5 What is Return on Equity (REO) capital and what
is it supposed to measure? How is this helpful to
managers of financial firms?
4-6 A bank reports that its net income for the year is
$51 million, its asset total is &1,144 million and
liabilities are $926 million. What is its return on equity
capital? Is the ROE good or bad? What information do
you need to answer this question?
4-7 What is the return on assets (ROA) and why is it
important?
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Concept Check
P. 92, 99
4-8 A bank estimates that its total revenues will amount
to $155 million and its total expenses (including taxes)
will equal $107 million this year.
It’s liabilities total $4,960 million while it’s equity
capital amounts to $52 million. What is the bank’s
return on assets? Is this ROA high or low? How could
you find out?
4-9 Why do the managers of financial firms often pay
close attention today to the net interest margin and
noninterest margin? To the© 2008
earnings
spread?
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Evaluating Performance (continued) p. 92-93
• Useful Profitability Formulas for Banks and Other Financial-Service
Companies. Both ROE and ROA use the same numerator of net
income, so they can be linked directly, as such,
or in other words:
In a more detailed form, we note that net income is equal to total
revenues minus total operating expenses and taxes, thus
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Evaluating Performance (continued) p. 93, 94
or
where
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EXHIBIT 4–1 Elements That Determine the Rate of Return Earned on
the Stockholders’ Investment (ROE) in a Financial Firm p. 94
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TABLE 4–1 Components of Return on Equity (ROE) for All
FDIC-Insured Institutions (1992-2009) p. 95
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Evaluating Performance (continued) p. 96, 97
• A slight variation of the simple ROE model produces an efficiency
equation useful for diagnosing problems in four different areas in
the management of financial-service firms
or
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Evaluating Performance (continued) p. 98
• We can also divide a financial firm’s return on assets into its
component parts
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TABLE 4–2 Calculating Return on Assets (ROA) p. 98
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TABLE 6–3 Components of Return on Assets (ROA) for All
FDIC-Insured Depository Institutions (1992–2009) p. 99
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Evaluating Performance (continued) p. 100
• Achieving superior profitability for a financial institution
depends upon several crucial factors
• Careful use of financial leverage 杠杆作用
(Gànggǎn
zuòyòng) (or the proportion of assets financed by debt as opposed to
•
•
•
•
equity capital)
Careful use of operating leverage from fixed assets (or the proportion
of fixed-cost inputs used to boost operating earnings as output grows)
Careful control of operating expenses so that more dollars of sales
revenue become net income
Careful management of the asset portfolio to meet liquidity needs
while seeking the highest returns from any assets acquired
Careful control of exposure to risk so that losses don’t overwhelm
income and equity capital
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Evaluating Performance (cont) p. 101-106
• Bank Risks
▫ Credit Risk – loans might be bad or decline in value
▫ Liquidity Risk – danger of bank not having enough cash to meet
customers ned for cash or loan demand.
▫ Market Risk includes price risk and interest rate risk
▫ Price risk – price goes up or down on assets like stock.
▫ Interest Rate Risk – interest rate changes.
▫ Operational Risk – computer failure, employee errors or
mistakes.
▫ Legal and Compliance Risk
▫ Reputation Risk
▫ Strategic Risk
▫ Capital Risk
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Evaluating Performance (continued) p. 107
• Other Goals in Banking and Financial-Services Management
2 Other Key Operating Efficiency Ratios
1. A rise in the value of the operating efficiency ratio often indicates an
expense control problem or a falloff in revenues, perhaps due to
declining market demand
2. In contrast, a rise in the employee productivity ratio suggests
management and staff are generating more operating revenue and/or
reducing operating expenses per employee, helping to squeeze out
more product with a given employee base
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The Impact of Size on Performance p. 108,109
• When the performance of one financial firm is compared to
that of another, size becomes a critical factor
▫ Size is often measured by total assets or, in the case of a depository
institution, total deposits
• Most performance ratios are highly sensitive to the size group
in which a financial institution finds itself
• The best performance comparison is to choose institutions of
similar size serving the same market area
• Also, compare financial institutions subject to similar
regulations and regulatory agencies
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TABLE 4–4 Important Performance Indicators Related to the Size
and Location of FDIC-Insured Depository Institutions (2009) p.109
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Concept Check
• To what different kinds of risk are
banks and their financial-service
competitors subjected today?
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Chapter Summary
• The focus of this chapter shows how well
banks perform in serving their customers and
providing a good rate of return to their owners.
• We have also looked at the many ways banks
measure their own performance and that of
other banks.
• The 2 key ways of looking at performance are
profitability and risk. Good profits and
controlling risk insure growth for a bank.
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Chapter Summary
• Return on Assets (ROA) – measures how
efficient is management.
• Return on Equity (ROE) – measures rate of
return to shareholders.
• Net operating margin 差额 (chā'é), net
interest and net non-interest margin measure
how management is keeping growth ahead of
costs.
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Chapter Summary
• There are other ratios to measure operating
efficiency of a bank such as the Operating
efficiency ratio and employee productivity
ratio.
• Making a profit must always be balanced
against risk. There are several types of risk.
These risks are shown on a previous slide.
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Chapter Summary
• There are other ratios to measure operating
efficiency of a bank such as the Operating
efficiency ratio and employee productivity
ratio.
• Making a profit must always be balanced
against risk. There are several types of risk.
These risks are shown on a previous slide.
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