MONASH
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Lecture 2
ANALYSIS OF BANK PERFORMANCE
BFF2401 Commercial banking and finance
LEARNING MAP
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LEARNING OBJECTIVES
1. Identify internal & external aspects of bank performance
2. Outline the main components of bank financial statements
3. Generate key return and risk measures from bank
financial statements
4. Put it all together to evaluate bank financial performance
using the Dupont (Return on Equity) model as a
foundation
5. Explain the importance of supplementary data in addition
to financial analysis
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REFERENCES
▪ Text:
– Saunders et al. (2021) Chapter 2
– Gup et al. (2007), Commercial Banking: The Management of Risk, Milton,
John Wiley & Sons, Chapter 3 (Optional)
▪ Other references
– ANZ Annual Report 2022
– KPMG (2022) Major Australian banks: Full-year 2022 results analysis
https://kpmg.com/au/en/home/insights/2022/11/major-australian-banksfull-year-analysis-2022.html
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LECTURE OUTLINE
▪ Introduction (LO1)
– A performance framework
– Types of assessment
▪ Data
▪ Financial ratio analysis
▪ Conclusions
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BANK PERFORMANCE – A FRAMEWORK
Why do we need to evaluate bank performance?
Bank management
Competitor financial institutions
▪ Policy setting and strategy
▪ Merger and acquisition decisions,
strategy
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BANK PERFORMANCE – A FRAMEWORK
Why do we need to evaluate bank performance?
Shareholders/investors
Regulators and the community
▪ Investment decisions
▪ Supervisory assessments
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BANK PERFORMANCE – A FRAMEWORK
Objective: maximise shareholder wealth
Optimise risks and expected returns
Economic and political environment
Internal performance
External performance
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INTERNAL PERFORMANCE
▪ Bank planning
– Setting objectives and planning to achieve them,
effective management
▪ Technology
– Contributes to improved service and lower costs
▪ Personnel development
– Needs a skilled highly motivated workforce
▪ Bank’s financial condition
– Reflected by financial accounts
– Measures of profitability and risk
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EXTERNAL PERFORMANCE
▪ Market share
– Can the bank respond to changing demand as it moves
through the business cycle?
– Is the bank growing its share of its chosen markets?
▪ Regulatory compliance
– Is the bank comfortably satisfying laws and regulations?
– Is it able to respond to changes in requirements?
▪ Public and investor confidence
‐ Does the market perceive the bank as safe and reliable?
‐ A bank cannot operate without public confidence.
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QUANTITATIVE ASSESSMENT
▪ Financial analysis
– Profitability & performance ratios, risk measures
• From financial reports e.g. ROE, ROA, Capital adequacy
▪ Share market data and ratings
▪ Purpose for bank management
– Provides measures of past performance
– Enables modeling for future planning periods
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QUALITATIVE ASSESSMENT
▪ Non-financial analysis
–
–
–
–
Market perception
Range of products & services
Corporate citizenship or quality of management
Staff morale
▪ Purpose for bank management
– Indicates non-financial performance
– Validates financial analysis of performance
– Contributes to modeling for future planning
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LECTURE OUTLINE
▪ Introduction
▪ Data (LO2,3)
– Sources of data
– Absolute data and ratios
– Supplementary data and non-financial information
▪ Financial ratio analysis
▪ Conclusions
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SOURCES OF BANKING INFORMATION
▪
▪
▪
▪
▪
▪
▪
▪
▪
▪
Bank annual reports and half-yearly reports
Australian Bureau of Statistics (ABS)
RBA and APRA
Stockbrokers and large accounting firms e.g. KPMG
Ratings agencies – e.g. Standard and Poor’s, Moody’s,
Fitch
Australian Bankers’ Association (ABA)
Financial Services Institute of Australasia (FINSIA)
Financial press e.g. Australian Financial Review
Australian Payments Clearing Association (APCA)
Data services e.g. CANSTAR CANNEX
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BANK ANNUAL REPORT DATA
1. Balance sheet (statement of financial position)
–
–
Shows the bank’s financial state at a point in time,
E.g. Assets, liabilities and net worth
2. Income statement (statement of financial performance)
–
Shows a bank’s major categories of revenue and expenses over
a period of time
3. Statement of changes in equity
–
–
Shows items which impact on the bank’s equity
E.g. Share transactions, changes in reserves, retained profits and
dividend payments
4. Cash flow statement
–
All cash inflows and outflows for a given period
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BANK ANNUAL REPORT DATA
Simplified Balance Sheet
Assets
Liquidity
=
Liabilities + Equity
Buffer against
run on deposits
Loans
Deposits
Funding
Buffer against
loan losses
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Capital
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BANK ANNUAL REPORT DATA
Profit & Loss (Income statement)
Interest revenue
=
=
=
=
Interest expense
Net interest income
Non-interest revenue
Non-interest expense
Net non-interest cost
Net operating income
Tax (30%)
Net income
Dividends
Retained Earnings
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ANZ Annual Report (2022), page 108
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WHICH BANK IS MORE PROFITABLE?
Large bank
Small bank
Net Income
$200 million
$20 million
Total assets
$10 billion
$500 million
ROA
2%
4%
If based on
absolute dollar
values of net
income, then
large bank
performs better
since $200m >
$20m BUT…
In fact, small bank is
more profitable than
large bank since its
return on assets
(ROA) is higher
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SUPPLEMENTARY INFORMATION
Other items that can be calculated, or may be provided
in Notes to the Accounts
–
–
–
–
–
Earning assets (those earning an explicit interest income)
Risk weighted capital adequacy (Basel 3)
Maturities of investment securities
Net write-offs (loan write-offs less recoveries)
Past-due loans (late or delinquent loans)
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OFF BALANCE SHEET INFORMATION
▪ OBS transactions are significant.
▪ They affect bank revenues, expenses and risks.
▪ Important to look at the level and breakdown of different
types of OBS.
– Financial guarantees
• Direct credit substitutes – e.g. standby letters of credit
• Trade and performance-related items
– Commitments
• E.g. liquidity facilities
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SUPPLEMENTARY INFORMATION OUTSIDE THE ACCOUNTS
▪ Share market data
– share prices
– dividend payments
▪ Credit ratings
▪ Analysts’recommendations
▪ Market shares
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NON-FINANCIAL INFORMATION
Non-financial information may indicate bank performance
(or risk):
– Significant management changes?
▪ Maybe there was bad management and hence management was
dismissed…?
– Recent change of auditors?
– Approach to corporate governance?
– Conservative method (low estimates) for defining nonperforming loans?
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Interactive Activities 1 & 2
▪ https://h5p.org/node/981219
▪ https://h5p.org/node/981225
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LECTURE OUTLINE
▪ Introduction
▪ Data
▪ Financial ratio analysis
– Financial ratios, benefits and problems
– DuPont model (breakdown of ROE)
LO4
– Example
– Other key ratios and supplementary data
▪ Conclusions
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FINANCIAL RATIOS
▪ Common size ratios
–
Balance sheet items as a percentage of total assets or
income items as a percentage of total revenue
▪ Profitability ratios based on revenue and cost indicators
▪ Risk measures
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FINANCIAL RATIOS
▪ Benefits of Financial Ratios
– Allow valid comparisons (reduced impact of differences in size of
institutions)
▪ Effective performance measurement relies on
– Accurate data
– Intelligent interpretation
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FINANCIAL RATIOS
Financial ratio analysis relies on intelligent interpretation
based on comparisons with
▪ Trends
– Comparison relative to a bank’s own past performance
▪ Targets
– Comparison with the bank’s stated targets/objectives
▪ Peers
– Comparison with other similar banks
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PROBLEMS WITH RAW DATA
▪ Inaccurate data can give false inputs.
▪ Creative accounting can distort measures.
▪ Accounting data does not always accurately reflect
true market values.
▪ Changing accounting standards make trend analysis
difficult.
– Example: under the new International Financial Reporting
Standards (IFRS) of 2005, banks report higher levels of
return on equity (ROE) because some items are no longer
counted as equity. So reported equity tended to fall and
reported ROE tended to rise.
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PROBLEMS WITH RATIOS
▪ Averages/aggregates hide the details.
▪ Ratios are backward looking, reflect past
performance.
▪ Ratios tend to compartmentalize financial analysis,
so it is important to consider linkages, e.g. increase in
net interest income may reflect increase in credit risk.
▪ Omissions
– Off-balance sheet transactions may be omitted or not
comparable.
– Share market data are not considered
– Qualitative factors are omitted.
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EFFECTIVE FINANCIAL ANALYSIS
Effective analysis of bank performance includes:
–
–
–
–
–
–
Financial ratio analysis
Other key indicators
Off-balance sheet indicators
Share market data
Indicators of qualitative performance
Indicators of business unit performance
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ROE (DUPONT) MODEL
▪ Financial analysis using the ROE model
▪ Uses return to shareholders as the starting point
– Based on ratios
– Plus detailed data to explain observed changes in financial
ratios and their linkages
– Structured discussion
– Starts with ROE (Return on Equity)….
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MAJOR AUSTRALIAN BANKS - ROE
Return on Equity (ROE) =
Operating profit after taxes
Shareholders’funds
Source: Banks’ annual reports and KPMG analysis reports
Is this cash?
Is ROE related to the share price on the stock exchange?
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DUPONT MODEL
▪ Breaks down ROE performance into component
parts
▪ An increase in any ratio contributes to an increase
in ROE
▪ It is important to investigate risks too i.e. how has a
higher ROE been achieved?
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REDUCED DUPONT MODEL
▪ It is called the “reduced Dupont Model” or “reduced
ROE model” as we will only look at the first 5 ratios
Leverage
Multiplier
ROE
Net Income
Equity
Measures return to
shareholders
=
Measures leverage and dividend
policies (financing effectiveness)
Total Assets
Equity
Asset
Utilisation
x
Revenue
Total Assets
ROA
Net Income
Total Assets
=
x
Net (Profit)
Margin
Measures overall
operating efficiency
Net Income
Revenue
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Measures
asset portfolio
management (mix
and yield)
Measures
effectiveness of
cost controls
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EXAMPLE OF DUPONT MODEL
Bank A Bank B
Assets
Total Assets
10
10
10
10
Bank A
Bank B
Liabilities
7
3
Equities
3
7
Total Liabilities &
Equities
10
10
▪ Which bank is riskier and why?
– Leverage multiplier:
• Bank A = 10/3 = 3.33x
• Bank B = 10/7 = 1.33x
• Bank A is riskier as it has more debt.
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Source: Eisenbeis, R.A. (2008) The Sub Prime Debacle and Financial Turmoil
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FINANCIAL ANALYSIS – DUPONT MODEL
▪ Risk versus return:
𝑅𝑂𝐸
= 𝑅𝑂𝐴
×
= 𝑅𝑂𝐴
×
𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦
×
𝐷𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦
= 𝑅𝑂𝐴
Return
𝐴𝑠𝑠𝑒𝑡𝑠
𝐸𝑞𝑢𝑖𝑡𝑦
Credit Risk?
1+
Capital Risk?
▪ Important to investigate risks too
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FINANCIAL ANALYSIS: PROCESS
1.
2.
3.
4.
Collect the absolute data
Calculate the ratios
Identify the initial meaning of each ratio
Look for the linkages and consider other key ratios
Then to complete performance assessment:
▪ Look at share market data, credit ratings, non-financial indicators
and other measures of performance
▪ Calculate growth rates and market share
See hypothetical example of financial analysis...
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1. COLLECT ABSOLUTE DATA
Sample balance sheet $
Assets
2021
Cash/liquidity
Loans etc
Premises etc
Total
2022
8,000,000
10,000,000
120,000,000
121,500,000
2,000,000
2,000,000
130,000,000
133,500,000
Liabilities
2021
2022
Current debt
63,000,000
65,000,000
Long term debt
57,000,000
58,000,000
Equity
10,000,000
10,500,000
130,000,000
133,500,000
Total
Sample Income Statement $
2021
2022
Interest revenue
4,000,000
4,200,000
Interest expense
(1,500,000)
(1,677,419)
Net interest income
2,500,000
2,522,581
Non-interest income
1,000,000
1,100,000
Non-interest expense
(1,500,000)
(1,500,000)
Net non-interest cost
(500,000)
(400,000)
Net operating income
2,000,000
2,122,581
Tax (30%)
(600,000)
(636,774)
Net income
1,400,000
1,485,806
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2. CALCULATE RATIOS
▪ Dupont model: Data required ▪ Using 2021 data from
example, calculate:
– Revenue = (Interest revenue) +
(Non-interest income)
– Net income = (Revenue) (Interest expense) – (Noninterest expense) – Taxes
– Total assets (average*)
– Equity (average*)
– Revenue
– Net Income
– Assets
– Equity
* Assets for 2020 not provided, so
use year end
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3. IDENTIFY INITIAL MEANING OF RATIOS
Peer comparison for 2021
▪ ROE
▪ Leverage multiplier
▪ ROA
▪ Asset utilisation
▪ Net margin
2021
14%
13.0x
1.08%
3.85%
28%
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Majors
13.83%
13.97x
0.99%
3.50%
28.40%
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3. IDENTIFY INITIAL MEANING OF RATIOS
Peer comparison for 2021:
Ratios compared with other peer banks (or industry average)
Leverage
Multiplier
13x
Higher/Lower than
Majors: Why?
ROE
14%
=
Majors, 2021: 13.83%
Higher/Lower: Why?
Majors, 2021: 13.97
Asset
Utilisation
3.85%
x
ROA
1.08%
=
Higher/Lower: Why?
Majors, 2021: 3.50%
x
Net margin Higher/Lower: Why?
Majors, 2021: 28.40%
28%
Higher/Lower : Why?
Majors, 2021: 0.99%
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3. IDENTIFY INITIAL MEANING OF RATIOS
Trend comparison 2021 to 2022
▪
▪
▪
▪
▪
ROE
Leverage multiplier
ROA
Asset utilisation
Net margin
2021
14.0%
13.0x
1.08%
3.85%
28.0%
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2022
14.2%
12.7x
1.11%
3.97%
28.03%
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4. LOOK FOR LINKAGES
Trend comparison 2021 to 2022:
Leverage
multiplier
Fall of 0.3 points
(Slightly lower capital risk)
13.0->12.7
ROE
14.0->14.2%
=
x
3.85->3.97%
ROA
Increase of 0.2
percentage points
Asset
Utilisation
1.08->1.11%
=
x
Net margin
Increase of 0.03
percentage points
28.0->28.03%
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Increase of 0.12 percentage
points.
• Have asset interest rates
risen?
• Has mix of assets moved
to higher credit risk?
• Has non-interest income
increased?
Increase of 0.03
percentage points.
• Have costs decreased?
• Have non-interest costs
fallen?
• Lower taxes?
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Interactive Activity 3
▪ https://h5p.org/node/981229
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LECTURE OUTLINE
▪ Introduction
▪ Data
▪ Financial ratio analysis
– Financial ratios, benefits and problems
– DuPont model (breakdown of ROE)
– Example
– Other key ratios and supplementary data (LO5)
▪ Conclusions
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OTHER KEY FINANCIAL RATIOS
▪ Other key ratios such as:
– Bank efficiency
– Interest differentials
– Risk measures – interest rate risk, credit risk, liquidity risk,
capital risk (will be covered in subsequent topics)
▪ These ratios can
– Help answer some of the questions raised during the ROE
analysis
– Give additional information
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OTHER KEY EFFICIENCY RATIOS
▪ Operating income per employee
Net operating income
Number of employees (FTE)
▪ Cost to assets ratio:
Operating expenses
Total Assets
▪ Efficiency ratio, or cost to income ratio
Operating expenses
Operating income
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MAJOR BANKS’ COST TO INCOME
KPMG (2022), Major Australian banks: Full year 2022 results analysis, p.19
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KEY INTEREST DIFFERENTIAL RATIOS
▪ Net interest income (dollar interest margin)
Interest earned - Interest expense
▪ Percentage interest spread
– average interest earned on interest earning assets less average
interest paid on interest bearing liabilities
Interest earnings
Interest expense
Interest earning assets
Interest bearing liabilities
▪ Percentage interest margin (net interest margin)
Interest earned - Interest expense
Earning assets
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INTEREST DIFFERENTIALS EXAMPLE
Interest margin ratios:
Interest income
$500 million
Interest expense
$280 million
Total earning assets at 1 July 2019
$8.1 billion
Total earning assets at 30 June 2020
$9.5 billion
Interest-bearing liabilities at 1 July 2019
$6.5 billion
Interest-bearing liabilities at 30 June 2020
$7.5 billion
What are its interest differentials?
Solution:
Net interest income/margin = $500m - $280m = $220m
% net interest margin = $220m/[($8.1b+$9.5b)/2] = 2.5%
% interest spread = $500m/[($8.1b+$9.5b)/2] - $280m/[($6.5b+$7.5b)/2]
= 5.68% - 4% = 1.68%
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MAJOR BANKS’ INTEREST MARGINS
KPMG (2022), Major Australian banks: Full year 2022 results analysis, p.7
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KEY RISK RATIOS
Risk Measurement - Interest rate risk
▪ Interest sensitivity ratio - a sample measure
Interest sensitive assets ($RSA)
Interest sensitive liabilities ($RSL)
▪ Interpretation:
• If ratio = 1 i.e. RSA = RSL
– Change in interest rates will affect both income and
expense.
– Two effects will tend to offset each other.
– NET interest income will remain largely unchanged.
– Interest rate risk (repricing risk) will be minimised.
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KEY RISK RATIOS
Risk Measurement - Credit risk (asset quality)
▪ Ratios reflecting losses - a sample measure:
Net write-offs
Total assets
OR
Past due loans
Total loans
▪ Ratios reflecting the level of diversification
–
Exposure ratios - example: Loans to farmers (or other
industry segment) as a percentage of total assets
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KEY RISK RATIOS
Risk Measurement - Liquidity risk
– Liquidity ratios - sample measures:
Liquid assets
Total assets
Liquid assets
Deposits
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KEY RISK RATIOS
Risk Measurement - Capital risk
– Simple capital ratio
Shareholders’ funds
Total assets
– Capital adequacy ratio (CAR)
Total regulatory capital
Total risk-adjusted assets
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MAJOR BANKS’ PROVISIONING FOR CREDIT RISK
KPMG (2022), Major Australian banks: Full year 2022 results analysis, p.15
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MAJOR BANKS’ CAPITAL RATIOS
KPMG (2022), Major Australian banks: Full year 2022 results analysis, p.13
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OFF-BALANCE SHEET INDICATORS
▪ Ratios such as:
Off-balance sheet business (nominal values)
Total balance sheet assets
Off-balance sheet credit risk exposures
Total risk-weighted assets
▪ Value-at-Risk of off-balance sheet items
–
–
Modern statistical measure of risk
VaR = how much a bank might lose over a given time with a
given probability
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SHARE MARKET DATA
Share value
– Price/earning ratio (P/E ratio) is the share price
divided by bank earnings per share.
– If the P/E ratio is higher than average, the market
expects that the bank will perform better in the
future.
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SHAREHOLDERS’ RETURNS
Single period shareholder returns:
𝐷𝑖𝑣1
𝑃0
𝑃 −𝑃
rate = 1 0
𝑃0
– Dividend yield =
– Capital gain
– Shareholders’ total return = dividend yield + capital
gain rate
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EXAMPLE OF SHAREHOLDERS’ RETURNS
Single period shareholder returns:
Example:
▪ Share price at beginning of period = $21
▪ Share price at end of period = $25
▪ Dividend paid during period = $1.20
Solution:
▪ Dividend yield = ($1.20/$21) x 100 = 5.7%
▪ Capital gain rate = [($25 - $21)/$21] x 100 = 19.0%
▪ Shareholders’total return
= {[$1.20 + ($25 - $21)]/$21} x 100 = 24.8%
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MAJOR BANKS’ DIVIDEND YIELD VS PAYOUT RATIO
KPMG (2022), Major Australian banks: Full year 2022 results analysis, p.21
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GROWTH RATES & MARKET SHARE
Asset growth rate e.g. for 2020-2021:
$133.5𝑏 − $130𝑏 100
×
= 2.7%
130
1
–
–
–
–
How does this compare to GDP growth (economy)?
How does this compare to previous years?
How does this compare to other peer banks’growth rates?
If high (low) growth: does this reflect more (less) risk taking?
Does it reflect more (less) market share?
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GROWTH RATES & MARKET SHARE
Market-share movements e.g. in 2021:
$133.5𝑏
100
×
= 𝑋%
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑜𝑓 𝑎𝑙𝑙 𝑏𝑎𝑛𝑘𝑠
1
– If gained or lost market share, why? If gain, has the bank
‘bought’ market share (sacrificed margins)?
– Can do similar assessments of the bank’s share of the loan
market, the deposit market, etc.
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LECTURE OUTLINE
▪
▪
▪
▪
Introduction (LO1)
Data (LO2,3)
Financial ratio analysis (LO4,5)
Conclusions
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PERFORMANCE ANALYSIS - CONCLUSION
Fundamental question is whether shareholder value has
been maximized.
Good financial analysis requires:
(1) Quality inputs (data)
–
–
–
–
–
–
Verify the data quality – e.g. look at notes to accounts
Ratio analysis focused on ROE
Share market indicators of performance
Other measures of returns and risks
Off-balance sheet indicators
Qualitative indicators and external economic and political factors
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PERFORMANCE ANALYSIS - CONCLUSION
Good financial analysis requires:
(2) Comparative analysis i.e. comparisons
– Between planning periods (to identify trends)
– With competitors/peers
– With forecasts/objectives/targets
(3) An understanding of the strategic context
– Current business/economic climate
(4) ‘Drilling down’ to discover WHY ratios change
– Look at linkages
– Look at risk-adjusted analysis of business units
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