Chapter Six

Measuring and Evaluating the

Performance of Banks and
Their Principal Competitors

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 6-2

Key Topics

• Stock Values and Profitability Ratios

• Measuring Credit, Liquidity, and Other Risks
• Measuring Operating Efficiency
• Performance of Competing Financial Firms
• Size and Location Effects
• The UBPR and Comparing Performance
 6-3

Value of the Bank’s Stock

 6-4

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
 6-5

Value of Bank’s Stock if Earnings Growth

is Constant

D1
P0 
r-g
 6-6

Key Profitability Ratios in Banking

Net Income
Return on Equity Capital (ROE) =
Total Equity Capital
Net Income
Return on Assets (ROA) =
Total Assets
(Interestincome
- Interestexpense)  Net Interest Income
Net Interest Margin  
TotalAssets TotalAssets

Noninterest revenue
- PLLL
Net Noninterest Margin  - Noninterest expenses  Net Noninterest Income
TotalAssets TotalAssets
 6-7

Key Profitability Ratios in Banking (cont.)

Total Operating Revenues -

Net Bank Operating Margin  Total Operating Expenses
Total Assets

Earnings Per Share (EPS)  Net IncomeAfter Taxes

Common Equity Shares Outstanding

Total Interest Income Total Interest Expense

Earnings Spread = Total Earning Assets Total Interest Bearing Liability
Total Operating Revenue/Total Assets 6-8

x
 6-9

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)
 6-10

Components of ROE for All Insured U.S.

Banks (1992-2007)
 6-
11

Breakdown of ROA
 6-12

Bank Risks

• Credit Risk • Legal and

• Liquidity Risk Compliance Risk
• Market Risk • Reputation Risk
• Interest Rate Risk • Strategic Risk
• Operational Risk • Capital Risk
 6-
13

Credit Risk

The Probability that Some of the

Financial Firm’s Assets Will
Decline in Value and Perhaps
Become Worthless
 6-14

Liquidity Risk

Probability the Financial Firm Will

Not Have Sufficient Cash and
Borrowing Capacity to Meet
Deposit Withdrawals and Other
Cash Needs
 6-
15

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
 6-16

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-
17

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)
 6-18

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
 6-
19

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
 6-20

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-
21

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
 6-22

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