BWBB2013 BANK MANAGEMENT

TOPIC 4
MEASURING AND EVALUATING BANK
PERFORMANCE
 INTRODUCTION

 Banks are under great pressure to

perform – to meet the objectives of their
stockholders, employees, depositors, and
borrowing customers, while somehow
keeping government regulators satisfied
that the bank’s policies, loans, and
investments are sound.

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 Commercial bank is simply a business
corporation organized for the purpose of
maximizing the value of the shareholders’
wealth invested in the firm at an
acceptable level of risk
 Thus, this topic centers on the most
important performance dimensions for any
bank – profitability and risk.

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 Performance refers to how adequately a bank
meets the objectives of its stockholders
(owners), employees, depositors, and other
creditors.
 At the same time, these financial institutions
must find a way to keep government regulators
satisfied that their operating policies, loans and
investments are sound, protecting the public
interest.
 The success of these institutions in meeting the
expectations of others is usually revealed by a
careful and thorough analysis of their financial
statements.

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 EVALUATING BANK PERFORMANCE
1. Internal performance
2. External performance

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 Internal Performance
1. Bank planning – Objectives, Budgets,
Strategies
2. Technology
3. Personal Development – training,
incentives
4. Bank condition - CAMELS

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 Determining the bank’s long-range
objectives
 Bank performance must be directed
toward specific objectives
A fair evaluation of any bank’s
performance should start by
evaluating whether it has been able to
achieve the objectives its
management and stockholders have
chosen

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 Maximizing the value of the firm
 A key objective for any bank

 Maximize a bank’s stock value

 All banks are corporation, with stockholders

interested in the value and yield of their
stock
 If the stock fails to rise in value
commensurate with stockholder
expectations, the investors may seek to
unload their shares and the bank will have
difficulty in raising new capital to support its
future growth

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 Formula:
P0 = D1
---------------------

r–g

P0 = value of the bank’s stock

D1 = expected dividend on stock in period 1
r = rate of discount reflecting the perceived
level
of risk attached to investing in the stock.
g = expected constant growth rate of dividend

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 The value of the bank’s stock will tend to
rise in any of the following situations:
 The value of the stream of future stockholder
dividends is expected to increase, due
perhaps to recent growth in some of the
markets served by the bank or because of
profitable acquisitions the banking
organization has made
 The banking organization’s perceived level
of risk has fallen, due perhaps to an increase
in capital or a decrease in loan losses
 Expected dividend increases combined with
declining risk, as perceived by investors in the
bank’s stock
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 Recent evidence has found that stock
values to be especially sensitive to
changes in:
 Interest rates
 Currency rates

 The economic conditions that the bank

serves

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 CAMELS
C – Capital adequacy
A – Asset quality
M – Management quality
E – Earning/profitability
L – Liquidity
S - Sensitivity to market risk

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 Capital adequacy – reduce risk,
absorb losses, support the financing &
operation of a bank, provide
protection to depositors & other
creditors, public confidence.
 Asset quality – determining the current
and future profitability of the bank.
- Loans exhibit the highest default rates,
hence, if NPLs increase, the asset
quality of a bank will deteriorate.

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 Management quality – the
management has an overview of a
bank’s operations, manages the
quality of loans & has to ensure that
the bank is profitable.
 Profitability – The most important
indicator of bank performance. The
popular ratios: ROA, ROE, and net
interest margin.

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 Liquidity –to meet deposit withdrawals
and satisfy customer loan demand.
 Liquidity refers to how fast and easy an
asset can be converted into cash.
 If a bank suffers financial distress for
any reason, asset liquidity can be a
reserve that the bank can draw on in
the event its access to purchased
funds is reduced.

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 Sensitivity to market risk
 Market risk – changes in the interest
rate that might affects the market
value of a security

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 External Performance
1. Market Share – equity/earnings,
technology
2. Regulatory compliance – capital,
lending
3. Public confidence – deposit
insurance, public image

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 Evaluating Bank Performance
 Profitability Ratios: A Surrogate for Stock
Values
 Firm performance – stock price is the best
indicator because it reflects the market’s
evaluation
 This indicator is not reliable in banking

 Most bank stock, especially stock issued

by smaller banks, is not actively traded in
international or national markets
 Thus, banking institutions used profitability
ratios as surrogates to market value
indicators
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 Key Profitability Ratios in Banking

 Return on Equity (ROE)

 Return on Assets (ROA)
 Net Interest Margin (NIM)
 Net Noninterest Margin (NNIM)
 Net Operating Margin
 Earnings Per Share of Stock (EPS)

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 Key Profitability Ratios in Banking

 Return on Equity (ROE)

Net income after taxes
Total equity capital
 ROE is a measure of the rate of return flowing to
the bank’s shareholders
 It approximates the net benefit that the
stockholders have received from investing their
capital in the bank (i.e., placing their funds at
risk in the hope of earning a suitable profit)

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 Return on Asset (ROA)
Net income after taxes
Total assets
 ROA is primarily an indicator of managerial
efficiency
 It indicates how capably the management
of the bank has been converting the
institution’s assets into net earnings

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 Net operating margin, net interest margin and
noninterest margin are efficiency measures as
well as profitability measures
 The measures indicate how well management
and staff have been able to keep the growth of
revenues (which come primarily from the bank’s
loans, investments and service fees) ahead of
rising costs (principally the interest on deposits
and money market borrowings and employee
salaries and benefits)

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 Net Interest Margin

(Interest income from loans and security

investments – Interest expense on deposits and
on other debt issued)
__________________________________________
Total assets

 Measures how large a spread between interest

revenues and interest costs management has
been able to achieve by close control over the
bank’s earning assets and the pursuit of the
cheapest sources of funding
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 Net noninterest margin

(Noninterest revenues – Noninterest expenses)

Total Assets

 Measures the amount of noninterest revenues

stemming from deposit service charges and other
service fees that bank has been able to collect
(fee income) relative to the amount of
noninterest costs incurred (including salaries and
wages, repair and maintenance costs on bank
facilities, and loan-loss expenses)

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 For most banks, the noninterest margin is
negative, noninterest costs generally outstrip
fee income, though bank fee income has
been rising rapidly in recent years as a
percentage of all bank revenues

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 Net bank operating margin
(Total operating revenues – Total operating
expenses)
Total assets

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 Earnings per share of stock (EPS)
Net income after taxes
common equity shares
outstanding

 Provides a direct measure of the returns flowing

to the bank’s owners, its stockholders-measured
relative to the number of shares sold to the
public

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 In an effort to maximize profitability and the
value of the shareholders’ investment in the
bank, greater efficiency is vital
 Efficiency – reduce operating expenses and
increase the productivity of bank employees
through the use of automated equipment and
improved employee training
 Among the most revealing measures of a
bank’s operating efficiency and employee
productivity are:

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 Operating Efficiency Ratio
Total operating expenses
Total operating revenues

 Employee productivity ratio

Net operating income
___________________________________________________________________________________________________________________

Number of full-time-equivalent
employees

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 MEASURING RISK IN BANKING
There are several types of risks in banking business:

 Credit risk  Legal and compliance

 Liquidity risk risk
 Market risk  Reputation risk
 Price risk  Strategic risk
 Interest rate risk  Capital risk
 Foreign exchange and
sovereign risk
 Off-balance-sheet risk
 Operational risk

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 In this topic, the two (2) key focus of risks are:
1. Credit risk

2. Liquidity risk

Credit risk
 The probability that some of a bank’s assets,
especially its loans, will decline in value and
perhaps become worthless.
 The most widely used ratios for credit risk
indicator are:
i. Nonperforming assets ÷ total loans and leases
ii. Net charge-offs of loans ÷ total loans and
leases
iii. Annual provision for loans losses ÷ total loans
and leases 31
iv. Annual provision for loans losses ÷ equity
capital
v. Allowance for loan losses ÷ total loans and
leases
vi. Allowance for loan losses ÷ equity capital

vii. Nonperforming assets ÷ equity capital

viii. Total loans ÷ total deposits (popular credit risk

measure)
 As this ratio grows, the regulator may become
more concerned because loans are usually
among the riskiest of all assets for depository
institutions, and therefore, deposits must be
carefully protected.
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Liquidity risk
 The danger of not having sufficient cash and
borrowing capacity to meet customer
withdrawals, loan demand, other cash needs.
 Low liquidity may force bank to borrow
emergency funds at excessive cost to cover its
immediate cash needs, and this may reduce its
earnings.
 Some useful ratios to measure liquidity risk are:
1. Purchased funds (including Eurodollars, federal funds,
security RPs, large CDs, and commercial paper) ÷ total
assets
2. Cash and due from balances held at other depository
institutions/total assets
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3. Cash assets and government securities ÷ total assets

 Standard remedies for reducing a bank’s

exposure to liquidity risk include increasing the
proportion of funds committed to cash and
readily marketable assets, such as government
securities, or using longer-term liabilities to fund
the bank’s operations.

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 WHY BANKS FAIL?
 Recent studies have identified a few factors
that most failing banks seem to have in
common.
1. Problem in their loan portfolio
- Banks have inadequate systems for spotting
problem loans early.
- ‘Over lending’ in which borrower receives
larger loans than they can carry.
- Concentrating loans in one industry or in a
single group of businesses.
- Do not follow their own loan policies.

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2. Economy
 Economic decline, with rising
unemployment, sluggish sales, and
increasing business failures.
 Banks that control their expenses well and
find ways to reach into other market areas
are not experiencing economic decline.

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3. Leadership problems
 BOD may lack knowledge of banking
and play only passive role in overseeing
the bank.
 Mistake and lack of scruples among
senior managers who may not be
capable and honest.

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4.Expense control problems
Invest the bank’s money in lavish
offices and enjoy handsome fringe
benefits that the bank’s earning
cannot support.
5. Audit and control procedures

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 THE IMPACT OF BANK SIZE ON PERFORMANCE

 When the performance of one bank is

compared to another, bank size – usually
measured by total assets or total deposits –
become a critical factor. Most of the bank
performance ratios are highly sensitive to the
size group in which a bank falls.

 In referring to U.S data, the most profitable

banks in terms of ROA were banks with more
than $10 billion in assets.

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 THE IMPACT OF BANK SIZE ON PERFORMANCE
 The largest banks also generally report the
highest (lease negative) noninterest margins
because they charge fees for so many of their
services.
 In terms of balance-sheet ratios, many of which
reflect the various kinds of risk exposure banks
face, the smallest banks usually report higher
ratios of equity capital to assets.

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 THE IMPACT OF BANK SIZE ON
PERFORMANCE
 Some bank analysts argue that larger banks
can get by with lower capital-to-asset cushions
because they are more diversified across many
different markets and have more risk-hedging
tools at their disposal.
 Smaller banks appear to be more liquid, as
reflected in their lower ratios of total loans to
total deposits, because loans are often among
a bank’s least liquid assets.

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 However, the biggest banks hold
larger proportion of cash assets
relative to total assets because they
hold the deposits of many smaller
banks. The biggest banks also appear
to carry greater credit risk as revealed
by their higher loan-loss ratios.

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