Ch' 6 Measuring and Evaluating Bank Performance

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Ch. 6Measuring and Evaluating Bank Performance
Based on Rose and Hudgins, Bank Mgt Fin
Services, Gup text, and adapted by Dorla Evans
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Key Topics

• Stock values
• Profitability ratios
• Measuring credit, liquidity, and other risks
• Size and location effects
• UBPR and comparing performance

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Stakeholders of bank performance

• Stockholders
• Bank management
• Regulators
• Depositors
• Business community

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External performance

• Market value
• Is the bank maximizing shareholder wealth?
  Meeting its business goals relative to
  competitors in the region? Assets, deposits,
  loans, financial services?
• Regulatory compliance
• Is the bank complying with federal and state
  regulations dealing with capital adequacy,
  riskiness of assets, security laws, etc?
• Public confidence
• Does the public perceive the bank to be safe?

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Shareholders Wealth Value of stock

• Present value of future cash flows
• Determinants of stock price
• Size of cash flows
• Timing of cash flows
• Riskiness of cash flows
• Vo CF1 CF2 CF3 CFn
• (1 r)1 (1 r)2 (1 r)3
  (1 r)n

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Value of stock
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Value of stock

• Vo 20 20 20 20
  20 100 128.7
• (1.12)1 (1.12)2 (1.12)3
  (1.12)4 (1.12)5 (1.12)5

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Value of stock

• Changes in value due to
• Changes dividends
• Changes in discount rate -- bank risk and market
  interest rate changes

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Valuation using P/E ratio

• Forward looking price per share, based on future
  expected growth and earnings.
• Backward looking earnings based on historical
  data.

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Valuation using P/E ratio

• Expected P/E 20, 22, 24
• Earnings per share 4.50
• Estimated price
• 4.50 x 20 90
• 4.50 x 22 99
• 4.50 x 24 108

P/E
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Profitability ratios ROE
Compare to peer of 12.4
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Profitability ratios ROA
Compare to peer of 0.84
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Profitability ratios Net interest margin
Peer comparison 3.90
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Profitability ratios Net non-interest margin
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Profitability analysis

• Return on equity (ROE) can be decomposed as
  follows
• Profitability (or the lack thereof!) thus has two
  parts
• Managerial efficiency
• Financial leverage

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Profitability analysis
Peer comparison ROE 12.4 .84 x 14.8
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Profitability analysis

• The lower a banks ROA, the higher it must push
  its leverage to achieve a target ROE. Higher
  risk higher return.

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Profitability analysis The Du Pont Identity

• Return on equity (ROE) can be decomposed as
  follows
• ROE Net income / Total equity Profit
  margin x Total asset turnover x Equity
  multiplier
• Profitability (or the lack thereof!) thus has
  three parts
• Operating efficiency (keep expenses under
  control)
• Asset use efficiency (portfolio mgt policies, mix
  yield)
• Financial leverage (sources chosen to fund bank)

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Profitability Analysis The Du Pont Identity
Peer comparison ROE 12.4 8.4 x 10.0 x 14.8
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Profitability Analysis

• Leverage
• Usually largest contributor to ROE
• 15x for smaller banks
• 20x for larger banks
• Under managements control

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Trends in ROE
All FDIC-insured institutions
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Trends in Components of ROE
All FDIC-insured institutions
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Profitability Analysis
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Operating efficiency ratios

• Measure of expense control
• Wages and salaries are largest non-interest
  expense
• Fixed operating expenses

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Profitability Analysis

• Superior profitability is due to
• Careful use of financial leverage
• Careful use of operating leverage
• Careful control of operating expenses
• Careful management of asset portfolio to meet
  liquidity and return needs
• Careful control of exposure to risk to maintain
  profitability and equity capital.

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Which bank earnings matter?

• Earnings before securities gains and losses --
  fundamental deposit taking and lending activities
  of banks.
• Securities gains and losses -- More transitory
  and volatile than other components of earnings.
• Barth, Beaver, and Wolfson
• Stock prices positively related to operating
  earnings and negatively related to securities
  gains/losses.
• Market views securities gains/losses as attempt
  by management to smooth earnings

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Risk factors banks face

• Operational
• Legal and compliance
• Reputation
• Strategic
• Capital

• Credit
• Liquidity
• Market
• Price
• Interest rate

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Credit risk
Probability that an asset will decline in value
Non-performing assets include nonaccrual
loans, restructured loans, and other real-estate
owned They are a leading indicator of poor bank
performance
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Credit risk
Charge-offs are a lagging indicator of bank
performance
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Credit Risk
Peer comparison 1.18
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Credit Risk
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Credit risk
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Credit Risk
Peer comparison 48.70
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Liquidity risk

• Funds available to meet cash demand for loans and
  deposit withdrawal

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Liquidity ratios
Not broken out in financial statements
Peer comparison 43.50
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Liquidity ratios
Volatile liabilities brokered deposits, jumbo
CDs, fed funds purchased, deposits in foreign
offices 83,009 time depositsgt100K
142,101 90,101 ????
Peer comparison -5.41
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Liquidity risk

• Trend toward less liquidity
• Liability mgt replacing asset mgt resulting in
• Higher rates of return because more assets have
  greater maturity
• Lower holdings of U.S. Treasury securities
• Higher credit risk

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Market risk

• Uncertainty associated with changing market
  prices or rates
• Price risk
• Value of bond portfolios and equity capital most
  at risk with fast changes in market values of
  bonds
• Interest rate risk
• Impact on profit due to changes in interest rates

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Price risk
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Interest rate risk

• Interest rate-sensitive means short-term with
  maturities of less than one year (or repriced in
  less than one year).
• Liabilities gt assets, then bank at higher risk
  with rising rates
• Assets gt liabilities, then bank at higher risk
  with falling rates

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Operational risk

• Risk due to failing computer systems, errors,
  misconduct by employees, floods, tornadoes,
  lightning strikes

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Legal and compliance risk

• Legal risk legal system creates adverse
  outcomes, e.g., unenforceable contracts, adverse
  lawsuit judgments
• Compliance risk violations to the rules and
  regulations, e.g., insufficient capital

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Reputation risk

• Uncertainty due to public opinion as it pertains
  to confidence of customers and creditors

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Strategic risk

• Variation in earnings due to poor business
  decisions, improper implementation of decisions,
  lack of responsiveness to industry changes or
  public expectations.

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Capital risk

• Impact of all the previous risks affects capital
  and the banks survival chances

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Capital risk

• Spread between market yields on debt and on
  government securities of same maturity
• P/E ratio
• Equity to total assets
• Purchases funds to total liabilities
• Equity capital to risk assets

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Questions?