FINC 4320

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FINC 4320

• Alternative Models for Evaluating Bank
  Performance
• Fall 2007

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The Need for Alternative Models

• Traditional bank performance analysis carries
  three basic flaws
• It ignores the wide diversity in strategies
  pursued by different institutions
• A banks total assets no longer serve as a
  meaningful yardstick when banks engage in
  off-balance sheet activities
• The analysis provides no directinformation
  concerning how or which of the banks activities
  contribute to the creation of shareholder value

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Can ROE be rescued?

• Although ROA might be a biased indicator of
  performance, return on equity (ROE) doesnt
  suffer from the same weaknesses.
• When considering the entire bank, stockholders
  equity must support all activities, whether on-
  or off-balance sheet.
• Thus, a comparison of net income to equity
  captures the returns to owners contributions.

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The Key to UBPR Use

• As long as banks have a similar strategic focus
  and offer similar products and services, asset
  size and UBPR ratios can provide meaningful
  comparisons.
• To identify the appropriate peer institutions,
  management should consider the following
• What is the banks strategic focus?
• What are the traditional balance sheet and
  off-balance sheet characteristics of firms with
  this focus?
• How do the banks activities affect its operating
  revenue?

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What kind of bank?

• A common starting point is to determine whether
  the banks strategy is more loan-driven or
  deposit-driven.
• A loan-driven banks profitability is generally a
  function of net interest income (the margin) with
  loan volume a major factor.
• A deposit-driven banks profitability is
  generally a function of noninterest income with
  franchise value and deposit volume a major factor.

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Operating Income Measures

• One way to construct ratios that avoid the
  problems of off-balance sheet activities is to
  calculate ratios tied to a banks total operating
  revenue (net interest income plus noninterest
  income)- (David Cates (1996))
• Fundamentally this means calculate performance
  measures using total operating revenue as the
  denominator rather than assets.

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Operating Income Measures

• The efficiency ratio, measured as noninterest
  expense divided by total operating revenue, is a
  popular measure used by stock analysis based on
  operating revenue rather than assets.
• Analysts strongly encourage banks, regardless of
  size, to meet fairly specific targets in this
  ratio.
• Because operating revenue includes both interest
  income and noninterest (fee-based) income, it
  captures all activities.

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How does the market assess performance?

• Bank stock analysts follow a standard procedure
  when evaluating firm performance
• Initially use GAAP-based financial information to
  calculate performance measures
• Based on his or her own analysis and
  conversations with specialists within the bank,
  the analyst then assesses the quality of earnings
  based on
• The next step is to forecast earnings, cash flow,
  and market value of equity over a three- to
  five-year time horizon
• Finally, the analyst makes a stock
  recommendation

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Total Return Measures

• Investors in bank stocks are primarily concerned
  with whether the banks management is creating
  value for stockholders
• When analysts compare performance over some
  historical period, they are less concerned with
  ROE, ROA, and efficiency ratios rather the
  overall total return from investing in the banks
  stock.
• Total return equals dividends received plus stock
  price appreciation/depreciation relative to the
  initial investment.

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Total Returns and other Market Measures

• Return to stockholders (Dprice dividends) /
  pricet-1
• Earnings per share
• Price to earnings (P/E) stock price / EPS
• Price to book value stock price / book value
  per share
• Market value (MV) of equity MV of assets - MV
  of liabilities or share of common stock x
  stock price

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Line of Business Profitability Analysis

• By allocating operating expenses to activities
  that support bank customers and bank management,
  banks can obtain at least a rough estimate of
  segment net income.
• Leads to the reporting and use of both financial
  and nonfinancial performance data, based on
  specific customers.
• Many banks attempt to measure profitability by
• type of loan customer (small business, middle
  market, consumer installment, etc.)
• type of depositor by characteristics of the
  relationship (account longevity, cross-sell
  patterns, profitability, etc.) and
• delivery system (branch, ATM, tele-phone, home
  banking, etc.).

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Line of Business Profitability Analysis

• There are several key ideas to be careful about
  when using this type analysis
• RAROC/RORAC
• Transfer Pricing
• Risk-adjusted Income
• Allocated Risk Capital

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Using RAROC/RORAC Measures

• RAROC refers to risk-adjusted return on capital,
  while RORAC refers to return on risk-adjusted
  capital.
• RAROC Risk-adjusted income / Allocated capital
• Using this method, income is adjust for risk.
• Typically, income is adjusted for expected
  losses.
• RORAC Net income / Allocated risk capital
• Using this method, capital is adjusted for risk.
• Typically, capital is adjusted for a maximum
  potential loss based on the probability of future
  returns or volatility of earnings.

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Using RAROC/RORAC Measures

• In order to analyze profitability and risk
  precisely, each line of business must have its
  own balance sheet and income statement.
• The critical issue is to determine how much
  equity capital to assign each unit. Alternative
  capital allocation methods include
• using regulatory risk-based capital standards
• assignment based on the size of assets
• benchmarking each unit to pure-play peers that
  are stand-alone, publicly held firms and
• measures of each line of businesss riskiness.
• The results provide useful information in helping
  management decide where to allocate resources.

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Funds Transfer Pricing

• When management creates balance sheets for each
  line of business, it must allocate capital as
  well as assets or liabilities to make the balance
  sheet balance.
• It must then assign a cost or yield to each of
  these components to produce income statement for
  each line of business.
• The transfer price is the interest rate at which
  a firm could buy or sell funds in the external
  capital markets.

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Funds Transfer Pricing

• Example 2-year loan financed by a 3-month deposit

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Risk-adjusted income and economic income

• Two adjustments are frequently made to income in
  line of business profitability analysis
• The return is adjusted for risk by subtracting
  expected losses
• The return nets out required returns expected by
  stockholders.
• This minimum required return, or cost of equity,
  represents a hurdle rate, or stockholders
  minimum required rate of return.
• The specific concern is whether RAROC is greater
  than the firms cost of equity.

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Allocated Capital

• The objective of RAROC analysis is to assist in
  risk management and the evaluation of line of
  business performance. As part of this, it is
  necessary to assign capital to each line of
  business.
• Unfortunately, most lines of business do not have
  market value balance sheets. Hence, many banks
  focus on the volatility in economic earnings
  (earnings-at-risk) or estimate a value-at-risk
  figure.

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Bank Performance and EVA

• Some analysts criticize traditional earnings
  measures such as ROE, ROA, and EPS because they
  provide no information about how a banks
  management is adding to shareholder value.
• Stern, Stewart Company has introduced the
  concepts of economic value added (EVA) in an
  attempt to directly link performance to
  shareholder wealth creation.

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Bank Performance and EVA

• Stern Stewart and Company measures economic
  profit with EVA, which is equal to a firm's
  operating profit minus the charge for the cost of
  capital
• EVA Net Operating Profit After Tax (NOPAT)
  Capital Charge
• where the capital charge equals the product of
  the firms value of capital and the associated
  cost of capital.
• What are the concerns with applying this approach?

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The Balanced Scorecard

• The balanced scorecard is an attempt to balance
  management decisions based on financial measures
  with decisions based on a firms relationships
  with its customers and the effectiveness of
  support processes in designing and delivering
  products and services
• The result is that line of business managers use
  indicators such as
• market share,
• customer retention and attrition,
• customer profitability, and
• service quality to evaluate performance
• Internally, they also track productivity and
  employee satisfaction

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The Balanced Scorecard

• Think of the bank as being two banks in one
  house
• Traditional or Customer Bank
• Investment or House Bank
• Items are assigned based on whether the
  underlying activities pertain to bank customers
  (Customer Bank) or the bank itself (Investment
  Bank).
• Evaluate the returns on each Bank relative to the
  risks and relevant benchmarks.

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Using the Balanced Scorecard

• Financial Performance
• How Do Stockholders View Our Risk and Return
  Profile?
• Customer Performance
• How Do Customers See Us?
• Internal Process Management
• At What Must We Excel?
• Innovation and Learning
• How Can We Continue to Improve and Create Value?

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Using the Balanced Scorecard Scorecard measures