Chapter Six
Measuring and Evaluating the
Performance of Banks
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Key Topics
• Stock Values and Profitability Ratios
• Measuring Credit, Liquidity, and Other Risks
• Size and Location Effects
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Introduction
• Focus on the most widely used indicators of the quality
and quantity of bank performance
• Focus on the most important dimensions of performance –
profitability and risk
• Main goal of a bank (like other businesses) is to maximize
the value of its shareholders’ wealth at an acceptable level
of risk
• Must frequently be monitored
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Evaluating Performance
• A key objective of financial managers is to maximize the value
of the firm
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Evaluating Performance (continued)
• The minimum acceptable rate of return, r, is sometimes referred
to as an institution’s cost of capital
▫ Two main components
▫ The risk-free rate of interest
▫ The equity risk premium
• The value of the financial firm’s stock will tend to rise in any of
the following situations
1. The value of dividends is expected to increase
2. The level of risk falls
3. Market interest rates decrease
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Evaluating Performance (continued)
• Equation (6–1) assumes that the stock 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 level of risk
▫ g is the expected constant dividend growth rate
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Evaluating Performance (continued)
• The previous two stock price formulas assume the financial firm
will pay dividends indefinitely
• 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)
• The behavior of a stock’s price is, in theory, the best indicator of a
financial firm’s performance because it reflects shareholders’ wealth
• This indicator, however, is often not available for smaller banks
• Thus, we should consider other performance ratios
• Three important profitability ratios
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Evaluating Performance (continued)
Other profitability ratios
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Evaluating Performance (continued)
• Return on assets (ROA) indicates how capable management has been
in converting assets into net earnings
• Return on equity (ROE) is a measure of the rate of return flowing to
shareholders
• The net interest margin, net operating margin, and net noninterest
margin are efficiency measures as well as profitability measures
▫ The net interest margin measures how large a spread between
interest revenues and interest costs
▫ The net noninterest margin measures the amount of noninterest
revenues stemming from service fees relative to the amount of
noninterest costs
▫ Typically, the net noninterest margin is negative
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Evaluating Performance (continued)
• Another traditional measure of earnings efficiency is the
earnings spread
▫ Measures the effectiveness of a bank’s intermediation function in
borrowing and lending money and also the intensity of competition
in the firm’s market area
▫ If other factors are held constant, the spread will decline as
competition increases
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Evaluating Performance (continued)
• Other Goals in Banking
▫ A rise in the value of the operating efficiency ratio often
indicates an expense control problem or a falloff in
revenues,
▫ 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
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Evaluating Performance (continued)
• Relationship between ROA and ROE
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Evaluating Performance (continued)
or
where
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Evaluating Performance (continued)
• Components of ROE representing efficiency equations:
or
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Evaluating Performance (continued)
• We can also divide a bank’s return on assets (ROA) into its
component parts
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Evaluating Performance (continued)
• Overall Risk
• Among the more popular measures of overall risk for
a financial firm are the following
▫ Standard deviation (σ) or variance (σ2) of stock prices
▫ Standard deviation or variance of net income
▫ Standard deviation or variance of ROE and ROA
• The higher the standard deviation or variance of the
above measures, the greater the overall risk
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Evaluating Performance (continued)
• Bank Specific Risks
▫ Credit Risk
▫ Liquidity Risk
▫ Market Risk (Price Risk and Interest Rate Risk)
▫ Foreign Exchange and Sovereign Risk
▫ Off-Balance-Sheet Risk
▫ Operational Risk
▫ Legal and Compliance Risk
▫ Reputation Risk
▫ Capital Risk
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The Impact of Size on Performance
• When the performance of a bank is compared to that
of another, size becomes a critical factor
▫ Size is often measured by total assets or 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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Quick Quiz
• What individuals or groups are likely to be interested in the banks’
level of profitability and exposure to risk?
• What are the principal components of ROE?
• What are the most important components of ROA?
• 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?
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