MONASH

BUSINESS
SCHOOL

Lecture 2
ANALYSIS OF BANK PERFORMANCE

BFF2401 Commercial banking and finance

LEARNING OBJECTIVES

▪ Identify internal & external aspects of bank performance

▪ Outline the main components of bank financial statements
▪ Generate key return and risk measures from bank financial
statements
▪ Put it all together to evaluate bank financial performance
using the Dupont (Return on Equity) model as a foundation
▪ Explain the importance of supplementary data in addition to
financial analysis

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REFERENCES

▪ Text:
Gup et al (2007), Commercial Banking: The Management of Risk, Milton,
John Wiley & Sons, Chapter 3

▪ Other references
– Robert A. Eisenbeis (2008) “The Sub Prime Debacle and Financial
Turmoil”, Presentation at the 13th FINSIA and Melbourne Centre for
Financial Studies Banking and Finance Conference.
– ANZ Annual Report 2019
– KPMG (2019) Major Australian banks: Full year 2019 results analysis
https://home.kpmg/au/en/home/insights/2019/11/major-australian-banks-
full-year-2019.html

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LECTURE OUTLINE

▪ Introduction
– A performance framework
– Types of assessment
▪ Data
▪ Financial ratio analysis
▪ Conclusions

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BANK PERFORMANCE – A FRAMEWORK

Why do we need to evaluate bank performance?

Bank management Competitor financial institutions

▪ Policy setting and strategy ▪ Merger and acquisition decisions,
strategy

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BANK PERFORMANCE – A FRAMEWORK

Why do we need to evaluate bank performance?

Shareholders/investors Regulators and the community

▪ Investment decisions ▪ Supervisory assessments

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BANK PERFORMANCE – A FRAMEWORK

Objective: maximise shareholder wealth

Optimise risks and expected returns

Economic and political environment

Internal performance External performance

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INTERNAL PERFORMANCE

▪ Bank planning
– Setting objectives and planning to achieve them,
effective management
▪ Technology
– Contributes to improved service and lower costs
▪ Personnel development
– Needs a skilled highly motivated workforce
▪ Bank’s financial condition
– Reflected by financial accounts
– Measures of profitability and risk

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EXTERNAL PERFORMANCE

▪ Market share
– Can the bank respond to changing demand as it moves
through the business cycle?
– Is the bank growing its share of its chosen markets?
▪ Regulatory compliance
– Is the bank comfortably satisfying laws and regulations?
– Is it able to respond to changes in requirements?
▪ Public and investor confidence
‐ Does the market perceive the bank as safe and reliable?
‐ A bank cannot operate without public confidence.

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QUANTITATIVE ASSESSMENT

▪ Financial analysis
– Profitability & performance ratios, risk measures
• From financial reports e.g. ROE, ROA, Capital adequacy
▪ Share market data and ratings
▪ Purpose for bank management
– Provides measures of past performance
– Enables modeling for future planning periods

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QUALITATIVE ASSESSMENT

▪ Non-financial analysis
– Market perception
– Range of products & services
– Corporate citizenship or quality of management
– Staff morale

▪ Purpose for bank management

– Indicates non-financial performance
– Validates financial analysis of performance
– Contributes to modeling for future planning

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LECTURE OUTLINE

▪ Introduction
▪ Data
– Sources of data
– Absolute data and ratios
– Supplementary data and non-financial information
▪ Financial ratio analysis
▪ Conclusions

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SOURCES OF BANKING INFORMATION

▪ Bank annual reports and half-yearly reports

▪ Australian Bureau of Statistics (ABS)
▪ RBA and APRA
▪ Stockbrokers and large accounting firms e.g. KPMG
▪ Ratings agencies – e.g. Standard and Poor’s, Moody’s,
Fitch
▪ Australian Bankers’ Association (ABA)
▪ Financial Services Institute of Australasia (FINSIA)
▪ Financial press e.g. Australian Financial Review
▪ Australian Payments Clearing Association (APCA)
▪ Data services e.g. CANSTAR CANNEX

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BANK ANNUAL REPORT DATA

1. Balance sheet (statement of financial position)

– Shows the bank’s financial state at a point in time,
– E.g. Assets, liabilities and net worth
2. Income statement (statement of financial performance)
– Shows a bank’s major categories of revenue and expenses over
a period of time
3. Statement of changes in equity
– Shows items which impact on the bank’s equity
– E.g. Share transactions, changes in reserves, retained profits and
dividend payments
4. Cash flow statement
– All cash inflows and outflows for a given period

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BANK ANNUAL REPORT DATA

Simplified Balance Sheet

Assets = Liabilities + Equity

Liquidity Buffer against

run on deposits

Loans Deposits
Funding

Buffer against
loan losses Capital

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BANK ANNUAL REPORT DATA

Profit & Loss

Interest revenue
- Interest expense
= Net interest income
Non-interest revenue
- Non-interest expense
= Net non-interest cost
Net operating income
- Tax (30%)
= Net income
- Dividends
= Retained Earnings

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WHICH BANK IS MORE PROFITABLE?

If based on
absolute dollar
Large bank Small bank values of net
income, then
Net Income $200 million $20 million large bank
Total assets $10 billion $500 million performs better
since $200m >
ROA 2% 4% $20m BUT…

In fact, small bank is

more profitable than
large bank since its
return on assets
(ROA) is higher

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SUPPLEMENTARY INFORMATION

Other items that can be calculated, or may be provided

in Notes to the Accounts
– Earning assets (those earning an explicit interest income)
– Risk weighted capital adequacy (Basel 3)
– Maturities of investment securities
– Net write-offs (loan write-offs less recoveries)
– Past-due loans (late or delinquent loans)

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OFF BALANCE SHEET INFORMATION

▪ OBS transactions are significant.

▪ They affect bank revenues, expenses and risks.
▪ Important to look at the level and breakdown of different
types of OBS.
– Financial guarantees
• Direct credit substitutes – e.g. standby letters of credit
• Trade and performance-related items
– Commitments
• E.g. liquidity facilities

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SUPPLEMENTARY INFORMATION OUTSIDE THE ACCOUNTS

▪ Share market data

– share prices
– dividend payments
▪ Credit ratings
▪ Analysts’recommendations
▪ Market shares

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NON-FINANCIAL INFORMATION

Non-financial information may indicate bank performance

(or risk):
– Significant management changes?
▪ Maybe there was bad management and hence management was
dismissed…?
– Recent change of auditors?
– Approach to corporate governance?
– Conservative method (low estimates) for defining non-
performing loans?

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LECTURE OUTLINE

▪ Introduction
▪ Data
▪ Financial ratio analysis
– Financial ratios, benefits and problems
– DuPont model (breakdown of ROE)
– Example
– Other key ratios and supplementary data
▪ Conclusions

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FINANCIAL RATIOS

▪ Common size ratios

– Balance sheet items as a percentage of total assets or
income items as a percentage of total revenue

▪ Profitability ratios based on revenue and cost indicators

▪ Risk measures

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FINANCIAL RATIOS

▪ Benefits of Financial Ratios

– Allow valid comparisons (reduced impact of differences in size of
institutions)

▪ Effective performance measurement relies on

– Accurate data
– Intelligent interpretation

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FINANCIAL RATIOS

Financial ratio analysis relies on intelligent interpretation

based on comparisons with

▪ Trends
– Comparison relative to a bank’s own past performance
▪ Targets
– Comparison with the bank’s stated targets/objectives
▪ Peers
– Comparison with other similar banks

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PROBLEMS WITH RAW DATA

▪ Inaccurate data can give false inputs.

▪ Creative accounting can distort measures.
▪ Accounting data does not always accurately reflect
true market values.
▪ Changing accounting standards make trend analysis
difficult.
– Example: under the new International Financial Reporting
Standards (IFRS) of 2005, banks report higher levels of
return on equity (ROE) because some items are no longer
counted as equity. So reported equity tended to fall and
reported ROE tended to rise.

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PROBLEMS WITH RATIOS

▪ Averages/aggregates hide the details.

▪ Ratios are backward looking, reflect past
performance.
▪ Ratios tend to compartmentalize financial analysis,
so it is important to consider linkages, e.g. increase in
net interest income may reflect increase in credit risk.
▪ Omissions
– Off-balance sheet transactions may be omitted or not
comparable.
– Share market data are not considered
– Qualitative factors are omitted.

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EFFECTIVE FINANCIAL ANALYSIS

Effective analysis of bank performance includes:

– Financial ratio analysis
– Other key indicators
– Off-balance sheet indicators
– Share market data
– Indicators of qualitative performance
– Indicators of business unit performance

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ROE (DUPONT) MODEL

▪ Financial analysis using the ROE model

▪ Uses return to shareholders as the starting point
– Based on ratios
– Plus detailed data to explain observed changes in financial
ratios and their linkages
– Structured discussion
– Starts with ROE (Return on Equity)….

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MAJOR AUSTRALIAN BANKS - ROE

Operating profit after taxes

Return on Equity (ROE) =
Shareholders’funds
Return on Average Equity
20

18

16

14

12
Percent

10

0
2011 2012 2013 2014 2015 2016 2017 2018

WBC CBA NAB ANZ

Source: BankOrbis Database (Monash library website)

Is this cash?
Is ROE related to the share price on the stock exchange?
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DUPONT MODEL

▪ Breaks down ROE performance into component

parts

▪ An increase in any ratio contributes to an increase

in ROE

▪ It is important to investigate risks too i.e. how has a

higher ROE been achieved?

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REDUCED DUPONT MODEL

▪ It is called the “reduced Dupont Model” or “reduced

ROE model” as we will only look at the first 5 ratios

Leverage Measures leverage and dividend

Multiplier policies (financing effectiveness)
Total Assets Asset
Equity Measures
ROE Utilisation asset portfolio
Net Income = x Revenue management (mix
Equity Total Assets and yield)
ROA
Net Income = x
Measures return to
shareholders
Total Assets Net (Profit)
Measures
Margin effectiveness of
Measures overall Net Income cost controls
operating efficiency Revenue

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EXAMPLE OF DUPONT MODEL

Bank A Bank B Bank A Bank B

Assets 10 10 Liabilities 7 3
Equities 3 7
Total Assets 10 10 Total Liabilities & 10 10
Equities

▪ Which bank is riskier and why?

– Leverage multiplier:
• Bank A = 10/3 = 3.33x
• Bank B = 10/7 = 1.33x
• Bank A is riskier as it has more debt.

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Source: Eisenbeis, R.A. (2008) The Sub Prime Debacle and Financial Turmoil

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FINANCIAL ANALYSIS – DUPONT MODEL

▪ Risk versus return:

𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = 𝑅𝑂𝐴 ×
𝐸𝑞𝑢𝑖𝑡𝑦
𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡
= 𝑅𝑂𝐴 ×
𝐸𝑞𝑢𝑖𝑡𝑦
𝐷𝑒𝑏𝑡
= 𝑅𝑂𝐴 × 1+
𝐸𝑞𝑢𝑖𝑡𝑦

Return Credit Risk? Capital Risk?

▪ Important to investigate risks too

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FINANCIAL ANALYSIS: PROCESS

1. Collect the absolute data

2. Calculate the ratios
3. Identify the initial meaning of each ratio
4. Look for the linkages and consider other key ratios

Then to complete performance assessment:

▪ Look at share market data, credit ratings, non-financial indicators
and other measures of performance
▪ Calculate growth rates and market share
See hypothetical example of financial analysis...

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 1. COLLECT ABSOLUTE DATA

Sample balance sheet $

Assets 2018 2019 Liabilities 2018 2019
Cash/liquidity 8,000,000 10,000,000 Current debt 63,000,000 65,000,000
Loans etc 120,000,000 121,500,000 Long term debt 57,000,000 58,000,000
Premises etc 2,000,000 2,000,000 Equity 10,000,000 10,500,000
Total 130,000,000 133,500,000 Total 130,000,000 133,500,000
Sample Income Statement $ 2018 2019
Interest revenue 4,000,000 4,200,000
Interest expense (1,500,000) (1,677,419)
Net interest income 2,500,000 2,522,581
Non-interest income 1,000,000 1,100,000
Non-interest expense (1,500,000) (1,500,000)
Net non-interest cost (500,000) (400,000)
Net operating income 2,000,000 2,122,581
Tax (30%) (600,000) (636,774)
Net income 1,400,000 1,485,806

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2. CALCULATE RATIOS

▪ Dupont model: Data required ▪ Using 2018 data from

– Revenue = (Interest revenue) + example, calculate:
(Non-interest income) – Revenue
– Net income = (Revenue) -
(Interest expense) – (Non-
– Net Income
interest expense) – Taxes
– Total assets (average*)
– Assets
– Equity (average*)

* Assets for 2017 not provided, so – Equity

use year end

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3. IDENTIFY INITIAL MEANING OF RATIOS

Peer comparison for 2018 2018 Majors

▪ ROE 14% 13.83%
▪ Leverage multiplier 13.0x 13.97x
▪ ROA 1.08% 0.99%
▪ Asset utilisation 3.85% 3.50%
▪ Net margin 28% 28.40%

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3. IDENTIFY INITIAL MEANING OF RATIOS

Peer comparison for 2018:

Ratios compared with other peer banks (or industry average)

Leverage Higher/Lower: Why?

Multiplier Majors, 2018: 13.97
Higher/Lower than
Majors: Why?
13x
Asset Higher/Lower: Why?
ROE Utilisation
= x Majors, 2018: 3.50%
14% 3.85%
Majors, 2018: 13.83% ROA
= x
1.08%

Higher/Lower : Why? Net margin Higher/Lower: Why?

Majors, 2018: 0.99% 28% Majors, 2018: 28.40%

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3. IDENTIFY INITIAL MEANING OF RATIOS

Trend comparison 2018 to 2019

2018 2019
▪ ROE 14.0% 14.2%
▪ Leverage multiplier 13.0x 12.7x
▪ ROA 1.08% 1.11%
▪ Asset utilisation 3.85% 3.97%
▪ Net margin 28.0% 28.03%

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4. LOOK FOR LINKAGES

Trend comparison 2018 to 2019:

Fall of 0.3 points
Leverage (Slightly lower capital risk)
Increase of 0.12 percentage
multiplier
points.
13.0->12.7 • Have asset interest rates
ROE Asset risen?
= x Utilisation • Has mix of assets moved
14.0->14.2% to higher credit risk?
3.85->3.97% • Has non-interest income
ROA increased?
= x
1.08->1.11%
Increase of 0.2 Increase of 0.03
percentage points Net margin percentage points.
• Have costs decreased?
Increase of 0.03
28.0->28.03% • Have non-interest costs
percentage points fallen?
• Lower taxes?

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OTHER KEY FINANCIAL RATIOS

▪ Other key ratios such as:

– Bank efficiency
– Interest differentials
– Risk measures – interest rate risk, credit risk, liquidity risk,
capital risk (will be covered in subsequent topics)

▪ These ratios can

– Help answer some of the questions raised during the ROE
analysis
– Give additional information

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OTHER KEY EFFICIENCY RATIOS

▪ Operating income per employee

Net operating income
Number of employees (FTE)
▪ Cost to assets ratio:
Operating expenses
Total Assets
▪ Efficiency ratio, or cost to income ratio
Operating expenses
Operating income

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KEY INTEREST DIFFERENTIAL RATIOS

▪ Net interest income (dollar interest margin)

Interest earned - Interest expense
▪ Percentage interest spread
– average interest earned on interest earning assets less average
interest paid on interest bearing liabilities
Interest earnings Interest expense
Interest earning assets Interest bearing liabilities
▪ Percentage interest margin (net interest margin)
Interest earned - Interest expense
Earning assets

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INTEREST DIFFERENTIALS EXAMPLE

Example 3.4 (Gup et al (2007), page 83): Interest margin ratios

Interest income $500 million
Interest expense $280 million
Total earning assets at 1 July 2005 $8.1 billion
Total earning assets at 30 June 2006 $9.5 billion
Interest-bearing liabilities at 1 July 2005 $6.5 billion
Interest-bearing liabilities at 30 June 2006 $7.5 billion
What are its interest differentials?
Solution:
Net interest income/margin = $500m - $280m = $220m
% net interest margin = $220m/[($8.1b+$9.5b)/2] = 2.5%
% interest spread = $500m/[($8.1b+$9.5b)/2] - $280m/[($6.5b+$7.5b)/2]
= 5.68% - 4% = 1.68%
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MAJOR BANKS’ INTEREST MARGINS

KPMG (2018), Major Australian banks: Full year 2018 results analysis, p.10

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KEY RISK RATIOS

Risk Measurement - Interest rate risk

▪ Interest sensitivity ratio - a sample measure
Interest sensitive assets ($RSA)
Interest sensitive liabilities ($RSL)
▪ Interpretation:
• If ratio = 1 i.e. RSA = RSL
– Change in interest rates will affect both income and
expense.
– Two effects will tend to offset each other.
– NET interest income will remain largely unchanged.
– Interest rate risk (repricing risk) will be minimised.

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KEY RISK RATIOS

Risk Measurement - Credit risk (asset quality)

▪ Ratios reflecting losses - a sample measure:
Net write-offs
Total assets
OR
Past due loans
Total loans

▪ Ratios reflecting the level of diversification

– Exposure ratios - example: Loans to farmers (or other
industry segment) as a percentage of total assets

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KEY RISK RATIOS

Risk Measurement - Liquidity risk

– Liquidity ratios - sample measures:

Liquid assets
Total assets

Liquid assets
Deposits

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KEY RISK RATIOS

Risk Measurement - Capital risk

– Simple capital ratio
Shareholders’ funds
Total assets
– Capital adequacy ratio (CAR)
Total regulatory capital
Total risk-adjusted assets

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OFF-BALANCE SHEET INDICATORS

▪ Ratios such as:

Off-balance sheet business (nominal values)
Total balance sheet assets

Off-balance sheet credit risk exposures

Total risk-weighted assets
▪ Value-at-Risk of off-balance sheet items
– Modern statistical measure of risk
– VaR = how much a bank might lose over a given time with a
given probability

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SHARE MARKET DATA

Share value
– Price/earning ratio (P/E ratio) is the share price
divided by bank earnings per share.
– If the P/E ratio is higher than average, the market
expects that the bank will perform better in the
future.

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SHAREHOLDERS’ RETURNS

Single period shareholder returns:

𝐷𝑖𝑣1
– Dividend yield =
𝑃0
𝑃 −𝑃
– Capital gain rate = 1 0
𝑃0
– Shareholders’ total return = dividend yield + capital
gain rate

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EXAMPLE OF SHAREHOLDERS’ RETURNS

Single period shareholder returns:

Example:
▪ Share price at beginning of period = $21
▪ Share price at end of period = $25
▪ Dividend paid during period = $1.20
Solution:
▪ Dividend yield = ($1.20/$21) x 100 = 5.7%
▪ Capital gain rate = [($25 - $21)/$21] x 100 = 19.0%
▪ Shareholders’total return
= {[$1.20 + ($25 - $21)]/$21} x 100 = 24.8%

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GROWTH RATES & MARKET SHARE

Asset growth rate e.g. for 2019:

$133.5𝑏 − $130𝑏 100
× = 2.7%
130 1

– How does this compare to GDP growth (economy)?

– How does this compare to previous years?
– How does this compare to other peer banks’growth rates?
– If high (low) growth: does this reflect more (less) risk taking?
Does it reflect more (less) market share?

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GROWTH RATES & MARKET SHARE

Market-share movements e.g. in 2019:

$133.5𝑏 100
× = 𝑋%
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑜𝑓 𝑎𝑙𝑙 𝑏𝑎𝑛𝑘𝑠 1

– If gained or lost market share, why? If gain, has the bank

‘bought’ market share (sacrificed margins)?
– Can do similar assessments of the bank’s share of the loan
market, the deposit market, etc.

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Source: KPMG (2018), Major Australian banks: Full year 2018 results analysis, p.11

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LECTURE OUTLINE

▪ Introduction
▪ Data
▪ Financial ratio analysis
▪ Conclusions

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 PERFORMANCE ANALYSIS - CONCLUSION

Fundamental question is whether shareholder value has

been maximized.

Good financial analysis requires:

(1) Quality inputs (data)
– Verify the data quality – e.g. look at notes to accounts
– Ratio analysis focused on ROE
– Share market indicators of performance
– Other measures of returns and risks
– Off-balance sheet indicators
– Qualitative indicators and external economic and political factors

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PERFORMANCE ANALYSIS - CONCLUSION

Good financial analysis requires:

(2) Comparative analysis i.e. comparisons
– Between planning periods (to identify trends)
– With competitors/peers
– With forecasts/objectives/targets
(3) An understanding of the strategic context
– Current business/economic climate
(4) ‘Drilling down’ to discover WHY ratios change
– Look at linkages
– Look at risk-adjusted analysis of business units

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LECTURE 2 - SUMMARY

▪ Introduction

▪ Data

▪ Financial ratio analysis

▪ Conclusions

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