UNIT 5: BANK PERFORMANCE

Contents
5.0 Aims and Objectives
5.1 Introduction
5.2 Performance Evaluation of Banks
5.3 Interest Income and Expense
5.4 Non-Interest Income and Expenses
5.5 Return on Assets and Equity
5.6 Risk Evaluation of Banks
5.7 How to Evaluate a Bank Performance
5.8 Examination of Return on Assets
5.9 Bank Failures
5.10 Reasons for Bank Failures
5.11 Summary
5.12 Answers to Check Your Progress Questions
5.13 Model Examination Questions

5.0 AIMS AND OBJECTIVES

The specific objectives of this chapter are to:

 Compare the performance of banks in different size classifications over recent
years, and
 explain how to evaluate the performance of banks based on financial statement
data.

5.1 INTRODUCTION

A commercial bank’s performance is examined for various reasons. Bank regulators

identify banks that are experiencing severe problems so that they can remedy them.
Shareholders need to determine whether they should buy or sell the stock of various
banks. Investment analysts must be able to advise prospective investors on which banks
to invest in.

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 Furthermore, commercial banks evaluate their own performance over time to determine
the outcomes of previous management decisions so that changes can be made where
appropriate. Without persistent monitoring of performance, existing problems can remain
unnoticed and lead to financial failure in the future.

5.2 PERFORMANCE EVALUTION OF BANKS

Exhibit 19.1 summarizes the performance of all U.S.- chartered insured commercial
banks. The characteristics identified in the first column are discussed in order from the
top down. Each characteristic is measured as a percentage of assets to control for growth
when assessing the changes in each characteristic over time. Exhibit 19.1 serves as a
useful reference point for assessing each of the performance proxies discussed throughout
this chapter.

5.3 INTEREST INCOME AND EXPENSES

Gross interest income (in Row 1 of Exhibit 19.1) represents interest income generated
from all assets. It is affected by market rates and the composition of assets held by banks.
As a percentage of assets for all banks in aggregate, it was highest

Exhibit 19.1 PERFORMANCE SUMMARY OF ALL INSURED COMERCIAL

BANKS,1981 – 1995
Item 1982 1984 1986 1988 1990 1992 1995
1. Gross interest income 11.36% 10.23% 8.38% 8.95% 9.57% 7.47% 7.30%
2. Gross interest expenses 8.07 6.97 5.10 5.42 6.13 3.57 3.58
3. Net interest income 3.28 3.26 3.28 3.53 3.44 3.90 3.72
4. Noninterest income .96 1.19 1.40 1.47 1.63 1.95 2.02
5. Loan loss provision .40 .57 .77 .54 .93 .77 .30
6. Noninterst expenses 293 3.05 3.22 3.33 3.45 3.87 3.64
7. Securities gains (losses) -.06 -.01 .14 .01 .02 .12 .01
8. Income before tax .85 .83 .82 1.14 .70 1.33 1.81
9. Taxes .14 .19 .19 .36 .23 .42 .63
10. Net income .71 .64 .64 .84 .50 .91 1.18
11. Cash dividends provided .31 .32 .33 .44 .42 .42 .75
12. Retained earnings .40 .33 .31 .40 .08 .49 .43
SOURCE: Federal Reserve Bulletin, Various issues.

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In the early 1980s, interest rates were at their peak. It was lowest in the middle 1990s
when interest rates declined.

A comparison of gross interest income levels among four bank size classifications is
shown in Exhibit 19.2. The size classifications range from “small” banks (with assets of
less than $300 million) to “money center” banks, which are the 10 largest banks that
serve money centers such as New York and San Francisco. Exhibit 19.2 shows that since
1987, the gross interest income of money center banks was typically higher than that of
other banks, as more of their funds were used for commercial loans (which generate high
interest payments).

Gross interest expenses (in Row 2) represent interest paid on deposits and on other
borrowed funds (from the federal funds market, discount window, etc.). It is affected by
market rates and the composition of liabilities. Since NOW accounts and money market
deposit accounts (MMDAs) have become popular, banks have recently attracted a smaller
percentage of funds through traditional noniterest-bearing demand deposit accounts. In
addition, low interest rate passbook savings accounts have not drawn as much funds
because of the alternative CDs available. Because of deregulation, a greater percentage
of Banks sources of funds have market- determined interest rates. Gross interest
expenses were less in the late 1980s and 1990s for all banks in general because of a
decline in market interest rates.

A comparison of gross interest expenses among the four bank size classes is presented in
Exhibit 19.3. The interest expense of money center banks is consistently above that of
other banks, as money center banks obtain a greater percentage of their deposits on a
wholesale (large-denomination) basis. In contrast, small banks attract significantly more
small-denomination deposits from households at the passbook savings rate.

The net interest income (in Row 3) represents the difference between gross interest
income and interest expenses and is measured as a percentage of assets. This measure is
commonly referred to as net interest margin. Exhibit 19.1 shows that gross interest
income and gross interest expenses have been similarly affected by interest rate

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movements; therefore, the net interest margin of all banks in aggregate has remained
some what stable. However, in the early 1990s, when market
Interest rates declined, interest expenses generally decreased at a faster rate than interest
income, allowing for larger net interest margins.

Exhibit 19.4 shows that the net interest margin is consistently highest for the small banks,
and lowest for the money center banks. These results are expected, given that the money
center banks tend to incur larger interest expenses than the other banks.

5.4 NONINTEREST INCOME AND EXPENSES

Noninterest income (in Row 4) results from fees charged on services provided, such as
lockbox services, banker’s acceptances, cashier’s checks, and foreign exchange
transactions. It has consistently risen over time for all banks in aggregate, as banks are
offering more fee-based services than in the past. As banks continue to offer new
services (such as insurance or securities services), noninterest income will increase over
time

Exhibit 19.5 shows that noninterest income is consistently highest for money center
banks and lowest for the smallest banks. These differences occur because money center
banks provide more services for which they can charge fees.

The loan loss provision (in Row 5) is a reserve account established by the bank in
anticipation of loan losses in the future. It should increase during periods when loan
losses are more likely, such as during a recessionary period. In many cases, there is a
lagged impact as some borrowers survive the recessionary period but never fully recover
from it and subsequently fail. As shown in Exhibit 19.1, the provision for loan losses for
all banks in aggregate was much lower in 1995 relative to the other years. The 1982
recession combined with the international debt crisis had an impact on loan losses in the
early 1980s. The impact of the international debt crisis continued throughout the entire
decade. Money center banks and other large banks boosted their loan loss reserves
substantially in 1987 and again in 1989 because of exposure to debt of less developed
countries.

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The high level of loan losses in specific years is not solely attributed to the international
debt crisis. A large proportion of agricultural loans defaulted throughout the 1980s. In
the late 1980s, there was also a high percentage of defaults on real estate loans. For
example, the Bank of New England experienced

Severe financial problems in 1989 and 1990 as a result of nonperforming real estate
loans, which led to its failure in 1991.

Exhibit 19.6 shows that the loan loss provision was lower for the money center banks in
the early 1980s, However, the international debt crisis caused some money center banks
to boost their loan loss reserves in the mid-1980s. The amount of loan loss reserves was
high for most banks during the 1992 recession, but declined in the middle 1990s.

Noninterest expenses (in Row 6 of Exhibit 19.1) include salaries, office equipment, and
other expenses not related to the payment of interest on deposits. These expenses have
generally increased over time.

Securities gains and losses (in Row 7 of Exhibit 19.1) result from the bank’s sale of
securities. They have been negligible, when all banks in aggregate are considered. An
individual bank’s gains and losses might be more significant.

When summing net interest income, noninterest income, and securities gains and
subtracting from this sum the provision for loan losses and noninterest expenses, the
result is income before tax (in Row 8 of Exhibit 19.1). This income figure decreased
over the early 1980s, primarily because of an increase in noninterest expenses and
provision for loan losses. In the 1990s, bank income was enhanced by the increase in
noninterest income and in net interest margins.

5.5 RETURN ON ASSETS AND EQUITY

The key incomes statement item, according to many analysts, is net income (in Row 10
of Exhibit 19.1), which accounts for any taxes paid. The net income figure disclosed in
Exhibit 19.1 is measured as a percentage of assets and therefore represent the return on
assets (ROA). Fluctuations in the ROA for banks in aggregate can be explained by

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assessing changes in its components, as shown in Exhibit 19.7 Although the net interest
margin has been some what stable, the noninterest income has risen over time. However,
this has been roughly offset by the combined increase in noninterest expenses and the
loan loss provision. The ROA was low in 1984,1986 and 1990 because of the high level
of loan loss reserves, but was unusually high in the 1990s because of the increase in net
interest margins and in noninterest income.

Exhibit 19.8 shows that the ROA for small banks more than doubled that of money center
banks in the early 1980s, partially because of the higher net interest margin. Even though
small banks continued to have a higher net interest margin in the mid-1980s, their loan
loss provision increased at a higher rate. Consequently, their ROA declined significantly.
The small and medium-sized banks have consistently had higher ROAs than the money
center banks.

Any individual bank’s ROA depends on the bank’s policy decisions as well as
uncontrollable factors relating to the economy and government regulations, as shown in
Exhibit 19.9. Gross interest income and expenses are affected by the sources and uses of
bank funds and the movements in market interest rates.

Noninterest income is earned on a variety of services, including many new services being
offered by banks as some regulatory provisions have been eliminated. Noninterest
expenses are partially dependent on personnel costs associated with the credit assessment
of loan applications, which in turn are affected by the bank’s asset composition
(proportion of funds allocated to loans). Noninterest expenses also depend on the
liability composition because the handling of small deposits is more time consuming than
that of large deposits. Banks offering more nontraditional services will incur higher
noninterest expenses, although they expect to offset the higher costs with higher
noninterest income. Loan losses depend on the composition of assets (proportion of loans
versus securities), the quality of these assets, and the economy. The return on assets is
influenced by all previously mentioned income statement items and therefore by all
policies and other factors that affect those items.

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The performance characteristics of money center banks differ from small banks because
of the differences in their balance sheet composition. For instance, small banks obtain a
greater percentage of their funds from traditional demand deposits (at zero percent
interest) and small savings accounts (at a relatively low interest rate), while money center
banks attract much of their funds through large deposits at a market-determined interest
rate. Thus, the net interest margin for money center banks is typically lower than for
smaller banks. Consequently, their ROA would likely be lower, unless their noninterest
income as a percentage of assets is significantly higher.

An alternative measure of overall bank performance is return on equity (ROE). A

bank’s ROE is affected by the same income statement items that affect ROA as well as
by the bank’s degree of financial leverage, as follows:
ROE = ROA x Leverage measure

= x

The leverage measure is simply the inverse of the capital ratio (when only equity counts
as capital). The higher the capital ratio is, the lower the leverage measure and the lower
the degree of financial leverage.

Exhibit 19.10 shows that in the early 1980s, the ROE was somewhat similar among banks
of all classes. Although banks with a greater amount of assets generally experienced a
lower ROA during this period (refer to Exhibit 19.8), they

Exhibit 19.9 Influence of Bank Policies And Other Factors On a Bank’s Income
Statement
Income Statement Item as
a Percent of Assets
(1) Gross interest income
(2) Gross interest expenses
Bank Policy Decisions Affecting the
income Statement Item
 Composition of assets
 Quality of assets
 Maturity and rate sensitivity of
assets
 Loan pricing policy
 Composition of liabilities
Uncontrollable Factors Affecting
the Income statement Item
 Economic conditions
 Market interest rate
Movements
 Market interest

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(3) Net interest margin =
(1) – (2)
(4) Noninterest income
(5) Noninterst expenses
(6) Loan losses
(7) Pretax return on assets =
(3) + (4) – (5) – (6)
(8) Taxes
(9) After-tax return on assets
= (7) – (8)
(10) Financial leverage,
Measured here as
(assets/equity)
(11) Return on equity = (9) x (10)
 Maturities and rate sensitivity of Rate movements
liabilities
 Service charges  Regulatory provision
 Nontraditional activites
 Composition of assets  Inflation
 Compositional of liabilities
 Nontraditional activites
 Efficiency of personnel
 Costs of office space and
equipment
 Marketing costs
 Other costs
 Composition of assets  Economic conditions
 Quality of assets  Market interest rate
 Collection department capabilities movements
 Tax planning  Tax laws
 Capital structure policies  Capital structure
regulations

Had a lower capital ratio (implying a higher degree of financial leverage), offsetting the
relatively low ROA.

In the mid-1980s, the ROA of small banks declined. Although it still exceeded that of
money center banks, the small banks’ relatively high level of equity investment caused
their ROE to be significantly lower than that of money center banks as well as other
banks. In the mid-1980s, the large banks (except money center banks) experienced the
highest ROE, because they improved their ROA and also used relatively low level of

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equity capital. Small banks earned the highest ROE in the early 1990s, while large banks
earned the highest ROE in the mid-1990s.

5.6 RISK EVALUATION OF BANKS

In assessing bank performance, risk should not be ignored. However, no consensus

measurement exists that would allow for comparison among all banks of various types of
risk (such as loan default risk and liquidity risk).

Some analysts measure a firm’s risk by its beta, which represents the degree of sensitivity
of its stock returns to the returns of the stock market as a whole. Beta is normally
measured by the following regression model:
Rj.t = B0 + B1Rm.t + Ut
Where Rj.t = the stock return for the firm of concern in period t
Rm.t = the return on a stock market index (such as the S & P 500 index) in
period t
B0 = intercept
B1 = slope coefficient
Ut = error term

The regression model is applied to historical data (usually on a quarterly basis). The
regression coefficients B0 and B1 are estimated by the regression analysis. The coefficient
B1 is an estimate of beta, because it measures the sensitivity of Rj to Rm. The banks whose
stock returns are less vulnerable to economic conditions have relatively low betas. The
stock returns of a bank with very conservative management are likely to be less sensitive
to stock market movements.

Although the beta reflects sensitivity to market conditions, it ignores any firm-specific
characteristics. That is, the beta measures systematic risk but ignores unsystematic risk.
A bank’s beta will not necessarily remain constant from one period to another. If the
bank decides to use more aggressive policies, its beta will likely increase. Its
performance and therefore its stock price would become more volatile, because the

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sensitivity of the bank’s stock returns to economic conditions would increase. A higher
beta can work for or against the bank, depending on future economic conditions.

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How to Evaluate a Bank’s Performance
Up to this point, the discussion of bank performance has mostly focused on the overall
industry and different size classifications. Although this information can be beneficial,
analysts often need to evaluate an individual bank’s performance, in which case financial
statements are used. The income and expenses disclosed earlier in Exhibit 19.1 serve as
an industry benchmark for evaluating a bank’s performance.

5.7 EXAMINATION OF RETURN ON ASSETS (ROA)

The ROA will usually reveal when a bank’s performance is not up to par, but it does not
indicate the reason for poor performance. Its components must be evaluated separately.
Exhibit 19.11 identifies the factors that affect bank performance as measured by the ROA
and ROE. If a bank’s ROA is less than desired, the bank is possibly incurring excessive
interest expenses. Banks typically know what deposit rate is necessary to attract deposits
and therefore are not likely to pay excessive interest. Yet, if all their sources of funds
require a market-determined rate, that will force relatively high interest expenses. A
relatively low ROA could also be due to low interest received on loans and securities
because of a bank’s being overly conservative with its funds or being locked into fixed
rates prior to an increase in market interest rates. High interest expenses and/or low
interest

Exhibit 19.11 BREAKDOWN OF PERFORMANCE MEASURES

Measures of Bank Financial Characteristics Bank Decisions Affecting
Performance Influencing Performance Financial Characteristics

1) Return on assets (ROA) Net interest margin Deposit rate decisions

2) Return on equity (ROE)
Noninterest revenues
Noninterest expenses
Loan losses
ROA
Leverage measure
Loan rate decisions
Loan losses
Bank services offered
Overhead requirements
Efficiency
Advertising
Risk level of loans provided
See above
Capital structure decision

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Revenues (on a relative basis) will reduce the net interest margin and therefore reduce the
ROA.

A relatively low ROA may also result from insufficient noninterest income. Some banks
have made a much greater effort than others to offer services that generate fee
(noninterest) income. Because a bank’s net interest margin is somewhat dictated by
interest rate trends and balance sheet composition, many banks attempt to focus on
noninterest income in order to boost their ROA.

A bank’s ROA can also be damaged by heavy loan losses. Yet, if the bank is too
conservative in its attempt to avoid loan losses, its net interest margin will below
(because of the low interest rates received from very safe loans and investments).
Because of the obvious trade-off here, banks generally attempt to shift their risk-return
preferences according to economic conditions. They may increase their concentration of
relatively risky loans during periods of prosperity when they might improve their net
interest margin without incurring excessive loan losses. Conversely, they may increase
their concentration of relatively low risk (and low-return) investments when economic
conditions are less favorable.

Banks with relatively low ROAs often incur excessive noninterest expenses, such as
overhead and advertising expenses. Any waste of resources due to inefficiencies can lead
to relatively high noninterest expenses.

Example
Consider the information disclosed in Exhibit 19.12 for BankAmerica and the industry
over recent years. Because of differences in accounting procedures, the information may
not be perfectly comparable. The industry data based on the class of money center banks.
The comparison in Exhibit 19.12 can at least identify some general reasons for the
financial problems experienced by BankAmerica.

BankAmerica’s income before tax was below the industry norm in the middle and late
1980s. A comparison with the industry figures suggests that bankAmerica’s net interest
margin and noninterest income were generally higher than the norm until 1987. Its loan

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 loss provision was also higher until 1987. In addition, its noninterest expenses were
consistently much higher than the norm

Exhibit 19.12 EVALUATION OF BANKAMERICA

1983 1985 1987 1989 1990
BA Industry BA Industry BA Industry BA Industry BA Industry
Net interest
Margin 3.30% 2.40% 3.94% 2.36% 3.28% 2.06% 4.07% 2.68% 3.85% 3.31%
Noninterest
Income 1.27 1.12 2.06 1.75 2.04 2.50 1.85 2.22 1.93 1.84
Loan loss
Provision .62 .36 2.09 .74 1.97 2.16 .78 1.50 .84 1.17
Noninterest
Expenses 3.35 2.34 4.24 2.71 4.24 3.18 3.78 3.42 3.64 3.47
Income
Before tax .60 .84 (0.33) .71 (0.89) (.70) 1.36 .02 1.30 .54
1991 1992 1993 1994 1995
BA Industry BA Industry BA Industry BA Industry BA Industry
Net interest

Margin 3.88% 2.92% 3.72% 3.18% 3.98% 3.16% 3.50% 2.86% 3.64% 2.68%
Noninterest

Income 2.04 2.37 2.00 2.59 2.28 2.99 1.92 2.33 1.96 2.16
Loan loss
Provision .69 1.20 .55 1.09 .43 .64 .21 .26 .19 .11
Noninterest
Expenses 3.62 3.79 3.70 3.83 4.00 4.13 3.48 3.56 3.44 3.32
Income
Before tax 1.61 .34 1.48 .96 1.83 1.50 1.73 1.39 1.97 1.44

All variables are measured as a percentage of assets. The industry net income before tax also accounts for securities gains
and losses.
SOURCE: Bank of America’s Annua Reports and Federal Reserve Bulletin, Various issues

Until 1989. In the 1990s, BankAmerica had a much higher income than the industry
norm, mainly because of its relatively high net interest margin and its relatively low loan
loss provision. Exhibit 19.13 provides a separate comparison of each variable to the
industry norm over time to confirm the conclusions drawn.

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Any particular bank will perform a more thorough evaluation of itself than that shown
here. For example, the recent annual reports provided by BankAmerica provide a
comprehensive explanation for its strong performance in recent years, along with a
discussion of how it plans to improve its performance over time.

A troubled bank’s dividend payout policy should always be examined. Many banks that
experience a sharp drop in earnings continue to pay out the same amount of dividends to
shareholders as before, perhaps believing that their drop in earnings is just a one-time
occurrence. If earnings remain low, though, and dividends are not reduced, the bank’s
capital will be reduced. However, some banks prefer not to reduce their dividend if
possible, because they worry that it might signal to investors (correctly or not) that future
earnings will not be sufficient to maintain current dividends.

5.8 BANK FALURES

The extreme consequence of poor performance of poor performance is failure. Exhibit

19.14 illustrates bank failure frequency over time. From 1940 to 1980, there were
usually fewer than 20 bank failures per year. But in the late 1980s, there were about 200
failures per year. In the early 1990s, the number of failures declined, but was still much
larger than in any precious period except the late 1980s. In the mid-1990s, the number of
bank failures declined substantially, reaching a low of six in 1995.

5.9 REASONS FOR BANK FAILURE

The cause of failure is often attributed to one or more of the following characteristics.
First, fraud within the bank could have existed. Fraud represents a wide range of
activities, including embezzlement of funds. Second, a high loan default percentage can
lead to failure. Although banks recognize the potential consequence of a high loan
default percentage, some continue to fail for this reason anyway. A thorough
examination of any bank may show a general emphasis toward a specific industry-such as
oil, shipbuilding, aerospace, agriculture, or national defense systems-that makes it
vulnerable to a slowdown in that industry (or a related one). Moreover, no matter how

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well a bank diversifies its loans, its loan portfolio is still susceptible to a recessionary
cycle.

A third reason for bank failure is a liquidity crisis. If a rumor of potential failure for a
particular bank circulates, depositors may begin to withdraw funds from that bank, even
though the bank is insured by the FDIC. The panic can even occur when the rumor is not
justified. Under these conditions, a bank may be unable to attract a sufficient amount of
new deposits, and its existing deposit accounts will subside. Once deposit withdrawals
begin, it is difficult to stop the momentum.

A fourth reason for bank failures is increased competition. Deregulation has made the
banking industry more competitive. When banks offer more competitive rates on
deposits and loans, the result is a reduced net interest margin, and possibly failure if the
margin is not large enough to cover other noninterest expenses and loan losses.

The office of the comptroller of the currency reviewed 162 national banks that failed
since 1979 and found the following common characteristics among many of these banks:
 81 percent of the banks did not have a loan policy or did not closely follow their
loan policy.
 59 percent of the banks did not use an adequate system for identifying problem loans.
 63 percent did not adequately monitor key bank officers or departments
 At 57 percent of the banks, major corporate decisions were made by one
individual.

Because all of these characteristics are controllable at banks, it appears that many banks
failed not because of the environment but because of inadequate management.

Check your progress

1. How can gross interest income rise while the net interest margin remains somewhat
stable for a particular bank?
……………………………………………………………………………………………
……………………………………………………………………………………………
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2. How did deregulation affect gross interest expenses (as a percentage of assets)?
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3. What has been the trend in non-interest income in recent years? Explain.
Explain
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4. How would a bank generate a higher income before tax (as a percentage of
assets) when its net interest margin has decreased?
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5. Why are large money center banks’ net interest margins typically lower than those of
smaller banks?
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6. What does the beta of a bank indicate?
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7. What are some of the more common reasons for a bank to experience a low ROA?
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8. Why is it important for banks to have a consistent dividend payout policy, even if
they are in trouble?
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 9. When evaluating a bank, what are some of the key aspects to review?
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10. What are some reasons for bank failures identified in this chapter?
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5.10 SUMMARY

 A bank’s performance can be evaluated by comparing its income statement items

(as a percentage of total assets) to a control group of other banks with a similar size
classification. The return on assets (ROA) of the bank may be compared to that of
the control group’s mean ROA. Any difference in ROA between the bank and the
control group is typically because of differences in net interest margin, loan loss
reserves, noninterest income, or noninterest expenses.
 If the bank’s net interest margin is relatively low, it either is relying too heavily on
deposits with higher interest rates, or is not earning adequate interest on its loans.
If the bank is forced to boost loan loss reserves, this suggests that its loan portfolio
may be too risky. If its noninterest income is relatively low, the bank is not
providing enough services that generate fee income. If the bank’s noninterest
expenses are relatively high, its cost of operations is excessive. There may be other
specific details that make the assessment more complex, but the key problems of a
bank can usually be detected with the approach described here.
 A common measure of a bank’s overall performance is its return on assetsf (ROA).
The ROA has consistently been lower for money center banks than other banks.
Their relatively low ROA is attributed to a lower net interest income (relatively
high interest expenses due to the heavy reliance on large deposits for funds). Loan
losses have also been higher for money center banks than other banks. Conversely,
small banks have had a relatively high ROA, because of a relatively high net
inteeest margin and a low level of loan loss reserves.

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  Money center banks have generated more noninterest income than the other banks,
but this did not completely offset the relatively poor performance on the items just
described

5.11 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

1. Gross interest income (in Row 1 of Exhibit 19.1) represents interest income
generated from all assets. It is affected by market rates and the composition of
assets held by banks

The net interest income represents the difference between gross interest income
and interest expenses and is measured as a percentage of assets. This measure is
commonly referred to as net interest margin. gross interest income and interest
rate movements have similarly affected gross interest expenses; therefore, the net
interest margin of all banks in aggregate has remained some what stable.
However, in the early 1990s, when market
Interest rates declined, interest expenses generally decreased at a faster rate than
interest income, allowing for larger net interest margins.
The net interest margin is consistently highest for the small banks, and lowest for
the money center banks. These results are expected, given that the money center
banks tend to incur larger interest expenses than the other banks.
2. Gross interest expenses represent interest paid on deposits and on other borrowed
funds (from the federal funds market, discount window, etc.). It is affected by market
rates and the composition of liabilities. Since NOW accounts and money market
deposit accounts (MMDAs) have become popular, banks have recently attracted a
smaller percentage of funds through traditional no interest-bearing demand deposit
accounts. In addition, low interest rate passbook savings accounts have not drawn as
much funds because of the alternative CDs available. Because of deregulation, a
greater percentage of Banks sources of funds have market- determined interest rates.
Gross interest expenses were less in the late 1980s and 1990s for all banks in general
because of a decline in market interest rates.

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3. Noninterest income results from fees charged on services provided, such as
lockbox services, banker’s acceptances, cashier’s checks, and foreign exchange
transactions. It has consistently risen over time for all banks in aggregate, as
banks are offering more fee-based services than in the past. As banks continue to
offer new services (such as insurance or securities services), noninterest income
will increase over time.
Noninterest income is consistently highest for money center banks and lowest for
the smallest banks. These differences occur because money center banks provide
more services for which they can charge fees.
4. Any individual bank’s ROA depends on the bank’s policy decisions as well as
uncontrollable factors relating to the economy and government regulations, Gross
interest income and expenses are affected by the sources and uses of bank funds
and the movements in market interest rates.
Noninterest income is earned on a variety of services, including many new
services being offered by banks as some regulatory provisions have been
eliminated. Noninterest expenses are partially dependent on personnel costs
associated with the credit assessment of loan applications, which in turn are
affected by the bank’s asset composition (proportion of funds allocated to loans).
Noninterest expenses also depend on the liability composition because the
handling of small deposits is more time consuming than that of large deposits.
Banks offering more nontraditional services will incur higher noninterest
expenses, although they expect to offset the higher costs with higher noninterest
income. Loan losses depend on the composition of assets (proportion of loans
versus securities), the quality of these assets, and the economy. All previously
mentioned income statement items influence the return on assets and therefore by
all policies and other factors that affect those items.
The performance characteristics of money center banks differ from small banks
because of the differences in their balance sheet composition. For instance, small
banks obtain a greater percentage of their funds from traditional demand deposits
(at zero percent interest) and small savings accounts (at a relatively low interest

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 rate), while money center banks attract much of their funds through large deposits
at a market-determined interest rate. Thus, the net interest margin for money
center banks is typically lower than for smaller banks. Consequently, their ROA
would likely be lower, unless their noninterest income as a percentage of assets is
significantly higher.
5. The ROA for small banks more than doubled that of money center banks in the
early 1980s, partially because of the higher net interest margin. Even though
small banks continued to have a higher net interest margin in the mid-1980s, their
loan loss provision increased at a higher rate. Consequently, their ROA declined
significantly. The small and medium-sized banks have consistently had higher
ROAs than the money center banks.
6. Some analysts measure a firm’s risk by its beta, which represents the degree of
sensitivity of its stock returns to the returns of the stock market as a whole. Beta
is normally measured by the following regression model:
Rj.t = B0 + B1Rm.t + Ut
Where Rj.t = the stock return for the firm of concern in period t
Rm.t = the return on a stock market index (such as the S & P 500 index) in
period t
B0 = intercept
B1 = slope coefficient
Ut = error term
7. The ROA will usually reveal when a bank’s performance is not up to par, but it
does not indicate the reason for poor performance. Its components must be
evaluated separately. Exhibit 19.11 identifies the factors that affect bank
performance as measured by the ROA and ROE. If a bank’s ROA is less than
desired, the bank is possibly incurring excessive interest expenses. Banks
typically know what deposit rate is necessary to attract deposits and therefore are
not likely to pay excessive interest. Yet, if all their sources of funds require a
market-determined rate, that will force relatively high interest expenses. A
relatively low ROA could also be due to low interest received on loans and
securities because of a bank’s being overly conservative with its funds or being

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 locked into fixed rates prior to an increase in market interest rates. High interest
expenses and/or low interest Revenues (on a relative basis) will reduce the net
interest margin and therefore reduce the ROA.
A relatively low ROA may also result from insufficient noninterest income.
Some banks have made a much greater effort than others to offer services that
generate fee (noninterest) income. Because a bank’s net interest margin is
somewhat dictated by interest rate trends and balance sheet composition, many
banks attempt to focus on noninterest income in order to boost their ROA.
A bank’s ROA can also be damaged by heavy loan losses. Yet, if the bank is too
conservative in its attempt to avoid loan losses, its net interest margin will below
(because of the low interest rates received from very safe loans and investments).
Because of the obvious trade-off here, banks generally attempt to shift their risk-
return preferences according to economic conditions. They may increase their
concentration of relatively risky loans during periods of prosperity when they
might improve their net interest margin without incurring excessive loan losses.
Conversely, they may increase their concentration of relatively low risk (and low-
return) investments when economic conditions are less favorable.
Banks with relatively low ROAs often incur excessive noninterest expenses, such
as overhead and advertising expenses. Any waste of resources due to
inefficiencies can lead to relatively high noninterest expenses.
8. A troubled bank’s dividend payout policy should always be examined. Many banks
that experience a sharp drop in earnings continue to pay out the same amount of
dividends to shareholders, as before, perhaps believing that their drop in earnings is
just a one-time occurrence. If earnings remain low, though, and dividends are not
reduced, the bank’s capital will be reduced. However, some banks prefer not to
reduce their dividend if possible, because they worry that it might signal to investors
(correctly or not) that future earnings will not be sufficient to maintain current
dividends.

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9.
 Net interest Margin
 Non interest Income
 Loan loss Provision
 Noninterest Expenses
 Income Before tax
10. Reasons for Bank Failure
The cause of failure is often attributed to one or more of the following characteristics.
First, fraud within the bank could have existed. Fraud represents a wide range of
activities, including embezzlement of funds.
Second, a high loan default percentage can lead to failure. Although banks recognize
the potential consequence of a high loan default percentage, some continue to fail for
this reason anyway. A thorough examination of any bank may show a general
emphasis toward a specific industry-such as oil, shipbuilding, aerospace, agriculture,
or national defense systems-that makes it vulnerable to a slowdown in that industry
(or a related one). Moreover, no matter how well a bank diversifies its loans, its loan
portfolio is still susceptible to a recessionary cycle.
A third reason for bank failure is a liquidity crisis. If a rumor of potential failure for a
particular bank circulates, depositors may begin to withdraw funds from that bank,
even though the bank is insured by the FDIC. The panic can even occur when the
rumor is not justified. Under these conditions, a bank may be unable to attract a
sufficient amount of new deposits, and its existing deposit accounts will subside.
Once deposit withdrawals begin, it is difficult to stop the momentum.
A fourth reason for bank failures is increased competition. Deregulation has made
the banking industry more competitive. When banks offer more competitive rates on
deposits and loans, the result is a reduced net interest margin, and possibly failure if
the margin is not large enough to cover other noninterest expenses and loan losses.

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5.12 MODEL EXAMINATION QUESTIONS

1. How can gross interest income rise while the net interest margin remains somewhat
stable for a particular bank?
2. How did deregulation affect gross interest expenses (as a percentage of assets)?
3. What has been the trend in noninterest income in recent years? Explain.
4. How would a bank generate a higher income before tax (as a percentage of assets)
when its net interest margin has decreased?
5. Suppose a bank generates net interest margin of 1.50 percent. Based on past
experience, would the bank experience a loss or a gain? Explain.
6. Why are large money center banks’ net interest margins typically lower than those of
smaller banks?
7. What does the beta of a bank indicate?
8. What are some of the more common reasons for a bank to experience a low ROA?
9. Why is it important for banks to have a consistent dividend payout policy, even if
they are in trouble?
10. When evaluating a bank, what are some of the key aspects to review?
11. What are some reasons for bank failures identified in this chapter?
12. Assume that SUNY Bank plans to liquidate Treasury security holdings and use the
proceeds for small business loans Explain how the different income statement items
would be affected over time as a result of this strategy. Also identify ant income
statement items that are more difficult to estimate as a result of this strategy.

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