MEASURING &
EVALUATING THE
PERFORMANCE OF BANKS
Chapter 5
William Chittenden edited and updated the PowerPoint slides for this edition.
6-2
Key topics
1.
Stock values and profitability ratios
2.
Measuring credit, liquidity, and other risks
3.
Measuring operating efficiency
4.
Performance of competing financial firms
5.
Size and location effects
6.
The UBPR and comparing performance
Banks’ key objectives
1.
Maximizing the bank value
2.
Controlling wide-range risks
6-4
Value of the bank’s stock
6-5
Value of a bank’s stock rises when:
 Expected dividends increase
 Risk of the bank falls
 Market interest rates decrease
 Combination of expected dividend increase
and risk decline
Value of bank’s stock
if earnings growth is constant
D1
P0 
r-g
6-6
6-7
Key profitability ratios in banking
Net Income
Return on Equity Capital (ROE) =
Total Equity Capital
Net Income
Return on Assets (ROA) =
Total Assets
(Int erestincome
Net Int erestMargin 
- Int erestexpense) Net Int erestIncome

T ot alAsset s
T ot alAsset s
Noninterest revenue
- PLLL
Net Noninterest Margin 
- Noninterest expenses Net Noninterest Income

T otalAssets
T otalAssets
6-8
Key profitability ratios in banking (cont.)
Total Operating Revenues Total Operating Expenses
Net Bank Operating Margin 
Total Assets
Net IncomeAfterT axes
EarningsPer Share (EPS) 
CommonEquity Shares Outstanding
Total Interest Income __ Total Interest Expense
Earnings Spread = Total Earning Assets
Total Interest Bearing Liability
Earning Assets
Earning Base 
Total Assets
6-9
Breaking down ROE
ROE = Net Income/ Total Equity Capital
ROA =
Net Income/Total Assets
x
Equity Multiplier =
Total Assets/Equity Capital
x
Net Profit Margin =
Asset Utilization =
Net Income/Total Operating Revenue Total Operating Revenue/Total Assets
Return on equity (ROE = NI / TE)
… the basic measure of stockholders’ returns
 ROE is composed of two parts:

Return on Assets (ROA = NI / TA),
 represents
the returns to the assets the bank has
invested in
 Equity
 the
Multiplier (EM = TA / TE),
degree of financial leverage employed by the
bank
Return on assets (ROA = NI / TA)
…can be decomposed into two parts:
 Asset Utilization (AU) → income generation
 Expense Ratio (ER) → expense control
 ROA
=
=
AU (TR / TA)
ER
- (TE / TA)
Where:
TR = total revenue or total operating income
= Int. inc. + Non-int. inc. + SG and
TE = total expenses
= Int. exp. + Non-int. exp. + PLL + Taxes
ROA is driven by the bank’s ability to:
…generate income (AU) and control expenses (ER)
 Income generation (AU) can be found on the UBPR
(page 1) as:
Int. Inc. Non. int. Inc. Sec gains (losses)
AU 


TA
TA
TA
 Expense control (ER) can be found on the UBPR
(page 1) as:
Int . Exp . Non  int . Exp . PLL
ER 


TA
TA
TA
*
Note, ER* does not include taxes.
6-13
ROE depends on:
 Equity multiplier=Total assets/Total equity capital

Leverage or financing policies: the choice of sources of
funds (debt or equity)
 Net profit margin=Net income/Total operating revenue

Effectiveness of expense management (cost control)
 Asset utilization=Total operating revenue/Total assets

Portfolio management policies (the mix and yield on assets)
Bank Performance Model
Returns to
Shareholders
ROE = NI / TE
Interest
Rate
Composition (mix)
Volume
INCOME
Fees and Serv Charge
Non Interest
Trust
Other
Return to the Bank
ROA = NI / TA
Rate
Interest
Composition (mix)
Volume
EXPENSES
Overhead
Salaries and Benefits
Occupancy
Degree of Leverage
EM =1 / (TE / TA)
Prov. for LL
Taxes
Other
Expense ratio (ER = Exp / TA)
… the ability to control expenses
 Interest expense / TA
 Cost per liability (avg. rate paid)
 Int. exp. liab. (j) / $ amt. liab. (j)
 Composition of liabilities
 $ amt. of liab. (j) / TA
 Volume of int. bearing debt and equity
 Non-interest expense / TA
 Salaries and employee benefits / TA
 Occupancy expense / TA
 Other operating expense / TA
 Provisions for loan losses / TA
 Taxes / TA
Asset utilization (AU = TR / TA):
… the ability to generate income.
 Interest Income / TA
 Asset yields (avg. rate earned)
 Interest income asset (i) / $ amount of asset (i)
 Composition of assets (mix)
 $ amount asset (i) / TA
 Volume of Earning Assets
 Earning assets / TA
 Noninterest income / TA
Fees and service charges
 Securities gains (losses)
 Other income

6-17
Determinants
of ROE in a
financial firm
Components of ROE for all insured U.S.
Banks (1992-2007)
6-18
Quick quiz
 Table 6.1 – p 177
 What is the trend of ROE? Which
factors strongly affect this trend of
ROE?
6-20
A variation on ROE
Net Income
Pre-Tax Net Operating Income
ROE =


Pre-Tax Net Operating Income
Total Operating Revenue
Total Operating Revenue
Total Assets

Total Assets
Total Equity Capital
ROE = Tax Management Efficiency 
Expense Control Efficiency 
Asset Management Efficiency 
Funds Management Efficiency
6-21
Breakdown of ROA
UBPR for PNC
Financial ratios
…PNC and Community National Bank
PNC BANK, NATIONAL ASSOCIATION
RISK RATIOS
Pg #
ROE: Net Income / Average total equity
11
ROA: Net Income / aTA
1
AU: Total Revenue / aTA
1 calc
ER: Total expenses (less Taxes) / aTA 1 calc
EM: aTA / Avg, Total Equity
6 calc
EB: Earning Assets / aTA
6
NIM: Net interest margin (te)
1
Spread (te)
3 calc
Efficiency Ratio
3
Burden / aTA
1 calc
Non Interest Income / Noninterest exp.
1 calc
EXPENSES:
ER*: Expense ratio (Expense components)
Total Interest expense / aTA
1
Memo: Interest expense / Avg. Earn assets1
Noninterest Expenses / aTA
1
Personnel expense
3
Occupancy expense
3
Other Oper Exp (Incl intangibles)
3
Provision: Loan & Lease Losses / aTA 1
Income Taxes / aTA
#N/A
INCOME:
AU: Asset Utilization (Income components):
Interest income / aTA
1
Memo: Avg, yield on earning assets
1
Noninterest income / aTA
1
Realized security gains (losses) / aTA
1
Dec-03
CALC BANK PG 1
Dec-04
CALC BANK PG 1
16.90% 16.56% 14.41% 15.59% 15.26%
1.59% 1.59% 1.28% 1.31% 1.31%
7.59% 7.59% 6.45% 7.02% 7.02%
5.18% 5.17% 4.51% 5.15% 5.14%
10.59x 10.48x 11.20x 11.59x 11.47x
82.86% 82.60% 89.84% 82.85% 82.92%
3.89% 3.82% 3.51% 3.32% 3.18%
3.74% 3.62% 3.36% 3.15% 3.02%
60.93% 60.86% 57.73% 68.01% 67.97%
0.67% 0.66% 1.12% 0.81% 0.81%
83.24% 83.42% 62.03% 79.79% 79.70%
COMMUNITY NATIONAL BANK
Dec-03
CALC BANK PG 4
14.55% 5.48% 5.56%
1.31% 0.41% 0.41%
6.21% 6.10% 6.10%
4.23% 5.47% 5.48%
10.65x 13.37x 13.76x
90.08% 85.43% 86.74%
3.52% 4.95% 4.80%
3.37% 4.39% 4.25%
57.92% 82.72% 82.75%
1.16% 3.37% 3.37%
59.86% 21.08% 21.08%
Dec-04
CALC BANK PG 4
11.56% 8.63% 8.67% 11.72%
1.07% 0.63% 0.63% 1.09%
6.50% 5.90% 5.91% 6.23%
5.01% 4.93% 4.94% 4.73%
10.85x 13.78x 13.97x 10.67x
91.45% 86.83% 86.98% 91.76%
4.33% 4.82% 4.74% 4.36%
3.97% 4.30% 4.25% 4.04%
66.06% 75.35% 75.34% 65.99%
2.33% 2.94% 2.94% 2.39%
29.18% 24.18% 24.23% 26.23%
5.18%
0.00%
0.90%
1.09%
3.98%
1.83%
0.58%
1.57%
0.29%
0.82%
5.17%
0.90%
1.07%
3.98%
1.83%
0.58%
1.58%
0.29%
0.83%
4.51%
1.29%
1.41%
2.95%
1.37%
0.38%
1.13%
0.27%
0.66%
5.15%
0.00%
1.08%
1.34%
3.99%
2.04%
0.50%
1.43%
0.07%
0.56%
5.14%
1.08%
1.28%
3.99%
2.04%
0.50%
1.44%
0.07%
0.57%
4.23%
1.20%
1.31%
2.89%
1.38%
0.36%
1.08%
0.14%
0.67%
5.47%
0.00%
0.82%
0.95%
4.27%
2.38%
0.71%
1.17%
0.39%
0.21%
5.48%
0.82%
0.92%
4.27%
2.38%
0.71%
1.18%
0.39%
0.21%
5.01%
1.50%
1.61%
3.29%
1.79%
0.48%
1.00%
0.22%
0.42%
4.93%
0.00%
0.76%
0.87%
3.88%
2.16%
0.64%
1.07%
0.30%
0.34%
4.94%
0.76%
0.85%
3.88%
2.16%
0.64%
1.07%
0.30%
0.34%
4.73%
1.31%
1.41%
3.24%
1.78%
0.47%
0.98%
0.18%
0.41%
7.59%
4.12%
4.98%
3.32%
0.15%
7.59%
4.12%
4.89%
3.32%
0.15%
6.45%
4.57%
4.98%
1.83%
0.05%
7.02%
3.77%
4.66%
3.18%
0.07%
7.02%
3.77%
4.46%
3.18%
0.07%
6.21%
4.46%
4.88%
1.73%
0.02%
6.10%
5.08%
5.91%
0.90%
0.12%
6.10%
5.08%
5.73%
0.90%
0.12%
6.50%
5.52%
5.95%
0.96%
0.02%
5.90%
4.97%
5.69%
0.94%
0.00%
5.91%
4.97%
5.59%
0.94%
0.00%
6.23%
5.37%
5.78%
0.85%
0.01%
Interest expense
…composition, rate and volume effects for PNC and
Community National Bank
PNC BANK, NATIONAL ASSOCIATION
RISK RATIOS
COMMUNITY NATIONAL BANK
Dec-03
Dec-04
Dec-03
Dec-04
Pg # CALC BANK PG 1 CALC BANK PG 1 CALC BANK PG 4 CALC BANK PG 4
Interest Expense: Composition, Rate and Volume Effects
Rate: Avg, interest cost of interest bearing liabilities
3
1.24%
Memo: Interest expense / Earning assets
1
1.09%
Volume: All Interest bearing debt (avg.) / aTA 1 72.73%
Mix and Cost of Individual Liabilities:*
Total deposits (avg.) / aTA:
6 73.72%
Cost (rate): Int bearing Total deposits
3
1.20%
Core deposits (avg.) / aTA
6 67.41%
All other deposits (avg.) / aTA
6-calc 55.93%
Trans (NOW&ATS) Accts (avg.) / aTA
6
2.40%
Cost (rate): Trans (NOW&ATS) Acts 3
#N/A
MMDA's and other sav. Accts (avg) / aTA 6-calc 42.29%
Cost (rate): Other savs deposits*
3
#N/A
Time deposits under $100M (avg.) / aTA 6 11.24%
Cost (rate): All oth time dep. (CD<100M) 3
#N/A
Volatile (S.T non core) liab (avg.) / aTA
10
9.85%
Large CDs (inc. brokered) (avg.) / aTA
6
3.23%
Cost (rate): CD's over $100M
3
3.44%
Fed funds purchased & resale (avg.)/ aTA 6
0.74%
Cost (rate): Fed funds pur & resale
3
2.95%
Memo: All brokered deposits (avg.) / aTA
6
2.36%
All common and preferred capital (avg.) / aTA 6
9.44%
1.27% 1.62% 1.50% 1.44% 1.51% 1.51% 1.48% 1.98% 1.39% 1.34% 1.74%
1.07% 1.41% 1.34% 1.28% 1.31% 0.95% 0.92% 1.61% 0.87% 0.85% 1.41%
70.78% 80.81% 73.70% 74.97% 80.65% 53.76% 55.17% 75.51% 54.29% 56.69% 74.88%
73.84%
1.22%
68.16%
55.41%
2.23%
0.90%
42.15%
0.57%
11.03%
3.12%
11.47%
3.14%
3.66%
0.99%
1.10%
2.19%
9.54%
67.79%
1.39%
53.90%
42.13%
1.81%
0.60%
30.73%
0.70%
9.59%
2.41%
23.24%
9.02%
2.38%
8.16%
1.15%
2.29%
8.93%
72.45%
1.18%
64.84%
53.38%
2.35%
#N/A
41.23%
#N/A
9.80%
#N/A
13.08%
3.67%
2.89%
1.55%
3.84%
2.81%
8.63%
72.30%
1.14%
64.29%
53.19%
2.15%
0.86%
41.28%
0.60%
9.76%
2.78%
12.11%
3.76%
2.81%
3.18%
1.37%
3.00%
8.72%
68.32%
1.25%
54.64%
43.03%
1.92%
0.62%
32.75%
0.69%
8.36%
2.03%
23.42%
8.99%
2.17%
8.00%
1.41%
2.81%
9.39%
91.72%
1.52%
84.26%
45.73%
6.55%
#N/A
25.67%
#N/A
13.51%
#N/A
8.03%
7.46%
2.83%
0.56%
1.10%
0.00%
7.48%
91.94%
1.49%
84.50%
45.52%
6.58%
0.29%
25.71%
0.90%
13.23%
2.51%
4.10%
7.44%
2.79%
0.55%
1.10%
0.00%
7.27%
85.07%
1.90%
72.07%
54.88%
10.37%
0.63%
22.70%
1.08%
21.81%
2.80%
11.90%
12.41%
2.72%
1.05%
0.82%
0.51%
9.22%
92.02%
1.38%
85.00%
46.77%
7.43%
#N/A
28.07%
#N/A
11.27%
#N/A
7.52%
7.02%
2.82%
0.50%
2.10%
0.00%
7.26%
91.96%
1.33%
84.90%
47.73%
7.02%
0.28%
29.57%
0.98%
11.14%
2.01%
4.84%
7.06%
2.78%
0.55%
1.75%
0.11%
7.16%
84.46%
1.66%
71.52%
53.88%
10.60%
0.59%
22.85%
1.00%
20.43%
2.43%
12.21%
12.39%
2.40%
1.07%
0.98%
0.84%
9.37%
Interest income
…composition, rate and volume effects for
PNC and Community National Bank
PNC BANK, NATIONAL ASSOCIATION
RISK RATIOS
COMMUNITY NATIONAL BANK
Dec-03
Dec-04
Dec-03
Dec-04
Pg # CALC BANK PG 1 CALC BANK PG 1 CALC BANK PG 4 CALC BANK PG 4
Interest Income: Composition, Rate and Volume Effects
Rate: Avg, yield on aTA
Memo: Avg. yield on earn. assets (rate) 1 4.98% 4.89% 4.98% 4.66% 4.46% 4.88% 5.91% 5.73% 5.95% 5.69% 5.59% 5.78%
Volume: Earn assets (avg.) / aTA
6 82.86% 82.60% 89.84% 82.85% 82.92% 90.08% 85.43% 86.74% 91.45% 86.83% 86.98% 91.76%
Non earning assets (avg.) / aTA
6-calc 17.14% 17.39% 9.75% 17.15% 17.07% 9.64% 14.57% 13.27% 8.25% 13.17% 13.03% 7.93%
Mix and Yield on Individual Assets:*
Total Loans (Gross loans - unearn inc.) (avg.) / 6aTA 57.55% 57.17% 57.69% 57.13% 57.25% 58.22% 65.76% 64.10% 66.45% 62.05% 61.33% 67.80%
Yield (rate): Total Loans & Leases (te) 3 5.48% 5.48% 5.66% 5.04% 5.04% 5.47% 6.89% 6.89% 6.91% 6.90% 6.90% 6.58%
Total Investments (avg.) / aTA:
6-calc 26.33% 26.46% 26.43% 26.60% 26.52% 26.50% 20.36% 23.28% 21.82% 25.50% 26.35% 20.98%
Total investment securities (avg.) / aTA 6-calc 21.41% 21.90% 22.56% 22.12% 22.03% 23.03% 16.43% 14.97% 17.89% 20.83% 20.78% 17.81%
Yield (rate): Total invest secs. (TE)
3 3.99% 3.81% 4.18% 3.54% 3.51% 3.98% 2.94% 3.32% 4.08% 3.00% 2.92% 3.91%
Yield (rate): Total invest secs. (Book) 3 3.99% 3.81% 4.00% 3.52% 3.48% 3.84% 2.86% 3.24% 3.75% 2.91% 2.83% 3.61%
Trading account assets (avg.) / aTA
6 1.61% 1.63% 0.39% 1.92% 2.09% 0.34% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
6-25
Quick quiz
1.
What individuals or groups are likely to be interested
in the banks’ level of profitability and exposure to risk?
2.
What are the principal components of ROE, and what
does each of these components measure?
3.
Suppose a bank has an ROA of 0.80% and an equity
multiplier of 12x. What is its ROE? Suppose this
bank’s ROA falls to 0.60%. What size equity multiplier
must it have to hold its ROE unchanged?
4.
What are the most important components of ROA and
what aspects of a financial institution’s performance
do they reflect?
Bank risk
…Popular measures of overall risk
1.
Standard deviation (σ) or variance (σ2) of
stock price
2.
Standard deviation or variance of net income
3.
Standard deviation or variance of ROE & ROA
The higher σ and σ2, the greater the overall risk
6-27
Bank risks
… most important types of risk
1.
Credit risk
2.
Liquidity risk
3.
Market risk
7.
Reputation risk
4.
Interest rate risk
8.
Strategic risk
5.
Operational risk
9.
Capital risk
6.
Legal and compliance
risk
6-28
Credit risk
The probability that some of the financial firm’s
assets will decline in value and perhaps become
worthless resulting from nonpayment or delayed
payment on loans and securities.
6-29
Credit risk measures
1.
Nonperforming loans/Total loans
2.
Net charge-offs/Total loan
3.
Provision for loan losses/Total loan
4.
Provision for loan losses/Equity capital
5.
Allowance for loan losses/Total loan
6.
Allowance for loan losses/Equity capital
7.
Nonperforming loans/Equity capital
Credit risk: more ratios to consider

Three Questions need to be addressed:
1.
What has been the loss experience?
2.
What amount of losses do we expect?
3.
How prepared is the bank?
Credit ratios to consider
 What has been the loss experience?
1.
2.
3.
4.
5.
Net loss to average total Loan & Lease (LN&LS)
Gross losses to average total LN&LS
Recoveries to avg. total LN&LS
Recoveries to prior period losses
Net losses by type of LN&LS
 What amount of losses do we expect?
1.
2.
3.
4.
5.
Non-current LN&LS to total loans
Total Past/Due LN&LS - including nonaccrual
Non-current & restruc LN&LS / Gross LN&LS
Current - Non-current & restruc/ Gr LN&LS
Past due loans by loan type
Credit ratios to consider (cont.)
 How prepared are we?
1.
Provision for loan loss to: average assets
and average total LN&LS
2.
LN&LS Allowance to: net losses and total
LN&LS
3.
Earnings coverage of net loss
Credit risk ratios :
PNC and Community National
RISK RATIOS
PNC BANK, NATIONAL ASSOCIATION
COMMUNITY NATIONAL BANK
Dec-03
Dec-04
Dec-03
Dec-04
Pg # CALC BANK PG 1 CALC BANK PG 1 CALC BANK PG 4 CALC BANK PG 4
Credit Risk
Gross loss / Avg. tot LN&LS
7 0.73%
Net loss / Avg. tot LN&LS
7 0.59%
Recoveries / Avg. tot LN&LS
7 0.13%
Recoveries to prior credit loss
7 19.0%
0.00%
90 days past due / EOP LN&LS
8A 0.21%
total Nonaccrual LN&LS / EOP LN&LS 8A 0.79%
total Noncurrent / EOP LN&LS
8A 1.00%
LN&LS Allowance to total LN&LS
7 1.77%
LN&LS Allowance / Net losses
7
2.9x
LN&LS Allowance / total nonaccural LN&LS7
1.77x
Earn Coverage of net losses
7
7.44x
Net Loan and lease growth rate
1 -4.55%
0.00%
0.73%
0.59%
0.13%
19.03%
0.21%
0.79%
1.00%
1.78%
2.92x
2.24x
7.44x
-4.55%
0.53%
0.41%
0.12%
22.26%
#NA
0.13%
0.66%
0.83%
#NA
1.44%
4.18x
2.73x
10.92x
10.14%
0.40%
0.28%
0.12%
19.5%
0.00%
0.13%
0.33%
0.46%
1.34%
5.2x
2.92x
11.61x
27.51%
0.00%
0.40%
0.28%
0.12%
19.52%
0.13%
0.33%
0.46%
1.35%
5.23x
4.12x
11.61x
27.51%
0.36%
0.25%
0.11%
23.76%
#NA
0.10%
0.46%
0.59%
#NA
1.27%
7.51x
3.73x
19.94x
17.96%
0.54%
0.53%
0.01%
6.7%
0.00%
0.16%
0.19%
0.35%
1.07%
2.1x
3.05x
2.57x
2.16%
0.00%
0.54%
0.53%
0.01%
6.75%
0.16%
0.19%
0.35%
1.07%
2.08x
5.49x
2.57x
2.16%
0.26%
0.21%
0.06%
29.21%
#NA
0.13%
0.47%
0.66%
#NA
1.25%
11.89x
4.35x
23.89x
11.61%
0.21%
0.20%
0.02%
3.1%
0.00%
0.00%
0.16%
0.16%
1.23%
6.7x
7.77x
10.38x
11.49%
0.00%
0.21%
0.20%
0.02%
3.08%
0.00%
0.16%
0.16%
1.23%
6.71x
7.77x
10.38x
11.49%
0.20%
0.16%
0.05%
24.53%
#NA
0.10%
0.41%
0.55%
#NA
1.20%
14.52x
5.63x
30.80x
14.24%
6-34
Liquidity risk
Probability the financial firm will not have
sufficient cash and borrowing capacity to meet
deposit withdrawals and other cash needs.
6-35
Liquidity risk measures
1.
Purchased funds/Total assets
2.
Net loans/Total assets
3.
Cash and due from banks/Total assets
4.
Cash and government securities/Total sssets
Liquidity risk ratios :
PNC and Community National
RISK RATIOS
COMMUNITY NATIONAL BANK
PNC BANK, NATIONAL ASSOCIATION
Dec-04
Dec-03
Dec-04
Dec-03
Pg # CALC
0.00% BANK PG 4
0.00% BANK PG 4 CALC
0.00% BANK PG 1 CALC
0.00% BANK PG 1 CALC
Liquidity Risk
%Total (EOP) Assets (except where noted)
11
Total equity
10
Core deposits
10
S.T Non-core funding
Net loans & leases / Total Deposits 10
Net loans & leases / Core Deposits 10
Avg. Available for sale securities / aTA 6
10
Short-term investments
10
Pledged securities
9.07% 9.07% 8.95% 8.26% 8.26% 9.74% 7.29% 7.29% 9.28% 7.23% 7.23% 9.42%
67.41% 66.75% 53.75% 64.84% 63.23% 54.19% 84.26% 84.95% 71.85% 85.00% 85.04% 71.10%
#N/A 11.47% 23.24% #N/A 12.11% 23.42% #N/A 4.10% 11.90% #N/A 4.84% 12.21%
73.73% 73.73% 87.72% 81.00% 81.00% 88.28% 65.90% 65.90% 78.94% 67.35% 67.35% 81.42%
81.11% 81.11% 115.16% 91.76% 91.76% 116.10% 71.36% 71.36% 93.85% 72.89% 72.89% 97.58%
21.41% 21.90% 21.11% 22.12% 22.03% 21.00% 14.44% 13.39% 15.88% 19.38% 19.04% 15.80%
#N/A 2.73% 6.25% #N/A 3.02% 5.23% #N/A 5.99% 5.41% #N/A 5.72% 5.26%
#N/A
0.00% 28.49% 41.20%
0.00% 29.25% 40.34% #N/A
0.00% 51.76% 54.78% #N/A
0.00% 46.50% 49.08% #N/A
Market risk: comprises price risk and
interest rate risk
Probability of the market value of the financial
firm’s investment portfolio declining in value
due to a change in interest rates.
6-37
6-38
Market risk measures
1.
Book-value of assets/ Market value of assets
2.
Book-value of equity/ Market value of equity
3.
Book-value of bonds/Market value of bonds
4.
Market value of preferred stock and common
stock
6-39
Interest rate risk
The danger that shifting interest rates may
adversely affect a bank’s net income, the value
of its assets or equity.
6-40
Interest rate risk measures
1.
Interest sensitive assets/Interest sensitive
liabilities
2.
Uninsured deposits/Total deposits
Foreign exchange risk
… the risk to a financial institution’s condition resulting
from adverse movements in foreign exchange rates
 Foreign exchange risk arises from changes in foreign
exchange rates that affect the values of assets,
liabilities, and off-balance sheet activities denominated
in currencies different from the bank’s domestic
(home) currency.
 This risk is also often found in off-balance sheet loan
commitments and guarantees denominated in foreign
currencies; foreign currency translation risk
6-42
Off-balance-sheet risk
The volatility in income and market value of bank
equity that may arise from unanticipated losses
due to OBS activities (activities that do not have
a balance sheet reporting impact until a
transaction is affected).
6-43
Operational risk
Uncertainty regarding a financial firm’s earnings
due to failures in computer systems, errors,
misconduct by employees, floods, lightening
strikes and similar events or risk of loss due to
unexpected operating expenses.
Ethics in banking and finance
services
 Box – p.187 – France’s Societe
General
 What is the operational risk here?
Why?
 How big is the problem?
6-45
Legal and compliance risk
Risk of earnings resulting from actions taken by
the legal system. This can include unenforceable
contracts, lawsuits or adverse judgments.
Compliance risk includes violations of rules and
regulations.
6-46
Reputation risk
This is risk due to negative publicity that can
dissuade customers from using the services of
the financial firm. It is the risk associated with
public opinion.
6-47
Strategic risk
The variations in earnings due to adverse
business decisions, improper implementation of
decisions, or lack of responsiveness to industry
changes.
6-48
Capital risk
Probability 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.
6-49
Capital risk measures
1.
Stock price/Earnings per share
2.
Equity capital/Total assets
3.
Purchased funds/Total liabilities
4.
Equity capital/Risk assets
Quick quiz
 Reading: Ebanking & E-commerce
(Insights and Issues - p.182)
 What is the story of Netbank?
 What are the implications for profit
management?
6-51
Other goals in banking
Total Operating Expenses
Operating Efficiency Ratio =
Total Operating Revenues
Net Operating Income
Employee Productivity Ratio =
Number of Full Time-Equivalent Employees
Average performance characteristics of
banks by business concentration and size
 ROE and ROA (up to $10 billion in assets)
increases with bank size
 Employees per dollar of assets decreases with
bank size
 Larger banks have lower efficiency ratios than
smaller banks
 Smaller banks:
have proportionately more core deposits and
fewer volatile liabilities than larger banks
 have a proportionately larger earnings base
than larger banks
 have proportionately lower charge-offs than
larger banks

Bank performance measure by size
Assets Size
Number of institutions reporting
% of unprofitable institutions
% of institutions with earn gains
Performance ratios (%)
Return on equity
Return on assets
Pretax ROA
Equity capital ratio
Net interest margin
Yield on earning assets
Cost of funding earn assets
Earning assets to total assets
Efficiency ratio
Burden ratio
Noninterest inc to earn assets
Noninterest exp to earn assets
Net charge-offs to LN&LS
LN&LS loss provision to assets
< $100M
$100M $1B
$1B $10B
> $10B
3,655
9.80
59.30
3,530
2.00
70.70
360
1.90
71.90
85
1.20
68.20
8.46
0.99
1.24
11.52
4.18
5.65
1.47
91.86
69.54
2.60
1.03
3.63
0.27
0.22
12.88
1.28
1.73
10.00
4.22
5.73
1.51
91.93
62.22
2.07
1.54
3.61
0.31
0.26
13.48
1.46
2.21
10.90
4.00
5.39
1.39
91.01
55.54
1.21
2.46
3.67
0.43
0.34
14.24
1.30
1.93
9.95
3.43
4.83
1.40
84.39
57.42
0.82
2.93
3.75
0.73
0.34
All
Trend Commercial
Banks
with Size


 then 

generally
then 
then 











7,630
5.70
65.30
13.82
1.31
1.92
10.10
3.61
5.02
1.41
86.18
57.96
1.06
2.66
3.72
0.63
0.33
Bank risk measures by size
Assets Size
Asset Quality
Net charge-offs to LN&LS
Loss allow to Noncurr LN&LS
LN&LS provision to net charge-offs
Loss allowance to LN&LS
Net LN&LS to deposits
Capital Ratios
Core capital (leverage) ratio
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Structural Changes
New Charters
Banks absorbed by mergers
Failed banks
< $100M
$100M $1B
$1B $10B
All
Trend Commercial
Banks
with Size
> $10B
0.27
151.5
134.2
1.44
72.67
0.31
196.2
125.7
1.39
82.11
0.43
206.0
125.5
1.47
92.82
0.73
168.0
83.0
1.53
86.68
11.31
16.83
17.93
9.47
12.85
14.06
9.36
12.34
13.92
7.23
9.11
12.07
118
102
3
2
125
0
1
30
0
1
7
0


 then 


 then 








0.63
174.6
89.9
1.50
86.38
7.83
10.04
12.62
122
264
3
Average performance characteristics of
banks by business concentration and size
 Wholesale Banks
 Focus
on loans for the largest commercial
customers and purchase substantial funds from
corporate and government depositors
 Retail Banks
 Focus
on consumer, small business, mortgage,
and agriculture loans and obtain deposits form
individuals and small businesses
Profitability measures of banks by
business concentration
All
Credit Inter Institu
Card national
# of institutions reporting
Commercial banks
Savings institutions
Performance ratios (%)
Return on equity
Return on assets
Pretax ROA
Equity capital ratio
Net interest margin
Yield on earning assets
Cost of funding earn assets
Earning assets to total assets
Efficiency ratio
Burden
Noninterest inc to earn assets
Noninterest exp to earn assets
LN&LS loss provision to assets
8,975
7,630
1,345
34
30
4
5
5
0
13.28
1.29
1.90
10.28
3.53
5.02
1.49
87.13
58.03
0.97
2.13
3.10
0.30
22.16
4.01
6.21
20.52
9.05
11.25
2.20
82.95
45.29
-2.15
11.18
9.03
3.96
10.35
0.76
1.09
8.05
2.50
4.02
1.52
81.47
70.16
0.75
2.51
3.26
0.25
Asset Concentration Groups
CommCon – Other All
All
Ag.
Mort ercial
summer spec. < Other Other
Lending
gage
Lending
Lending $1B <$1B > $1B
1,730
4,424
990
132
465 1,120
75
1,725
4,019
250
101
414 1,026
60
5
405
740
31
51
94
15
11.45
1.23
1.51
10.79
4.07
5.68
1.61
91.91
62.07
2.08
0.69
2.77
0.16
13.48
1.30
1.89
10.09
3.86
5.26
1.40
90.18
57.10
1.40
1.51
2.91
0.22
11.61
1.18
1.81
10.55
3.05
4.80
1.75
92.17
56.46
1.07
1.20
2.27
0.08
16.81
1.66
2.56
11.36
4.71
6.88
2.17
90.73
45.53
0.78
2.26
3.04
1.05
10.03
1.66
2.43
16.94
3.20
4.54
1.33
88.93
72.42
0.34
6.55
6.89
0.11
10.18
1.10
1.41
10.79
3.86
5.40
1.53
92.11
66.92
2.01
1.16
3.17
0.17
13.69
1.35
1.98
10.25
3.27
4.54
1.27
84.36
57.71
0.84
1.96
2.80
0.07
Risk measures of banks by business
concentration
Asset Concentration Groups
All
CommCon – Other All
Credit Inter - Ag.
Mort Institu
ercial
summer spec. < Other
Card national Lending
gage
Lending
Lending $1B <$1B
Asset Quality
Net charge-offs to LN&LS
0.56
4.67
0.91
0.21
0.30 0.12
Loss allow to Noncurr LN&LS
167.8 215.8 135.3 156.7
206.3 97.1
LN&LS provs. to net charge-offs
90.6 108.8
63.1 118.3
105.2 100.2
Loss allowance to LN&LS
1.34
4.27
1.74
1.43
1.30 0.53
Net LN&LS to deposits
91.69 239.79 69.91 76.64
93.90 120.82
Capital Ratios
Core capital (leverage) ratio
8.12 16.64
6.05 10.37
8.29 9.10
Tier 1 risk-based capital ratio
10.76 14.59
8.38 14.71
10.14 15.36
Total risk-based capital ratio
13.19 17.34 12.03 15.82
12.18 16.86
Structural Changes
New Charters
128
0
0
5
35
4
Banks absorbed by mergers
322
1
2
24
210
26
Failed institutions
4
0
0
0
3
0
SOURCE: FDIC Quarterly Banking Profile, http://www.fdic.gov/, http://www2.fdic.gov/qbp.
All
Other
> $1B
1.57
259.4
85.5
1.66
135.96
0.59
168.4
67.3
1.66
33.54
0.31
155.3
99.4
1.34
67.56
0.25
156.3
52.0
1.16
80.51
8.82
13.07
14.62
15.17
34.70
35.95
10.38
17.32
18.55
7.20
9.45
12.12
1
13
0
77
6
0
5
20
1
1
20
0
Performance indicators related to the size
of a firm, 2007
6-58
Questions & Problems
1. Why should banks and other corporate financial firms be
concerned about their level of profitability and exposure to
risk?
2. Why do the managers of financial firms often pay close
attention today to the net interest margin and noninterest
margin? To the earnings spread?
3. What items on a bank's balance sheet and income
statement can be used to measure its risk exposure? To
what other financial institutions do these risk measures
seem to apply?
4. Problem 4, 10 and 11 (page 193-6)
MEASURING &
EVALUATING THE
PERFORMANCE OF BANKS
Chapter 5
William Chittenden edited and updated the PowerPoint slides for this edition.