Chapter 4

Measuring and Evaluating

Bank Performance
Part 1
BANK MANAGEMENT
What is the basic calculation of profits/losses?

What is the main source of bank revenues?

What is the main source of bank expenses?

Service fees bank receive from customers is under

what category?
Introduction
 Banks are businesses that aim to maximize shareholders’ values
and at the same time keeping regulators satisfy with the level of
risk banks take.

 Therefore, this chapter will discuss bank profitability and risk.

 Performance refers to how adequately a bank meets the

objectives of its stockholders (owners), employees, depositors,
and other creditors.

 The success or lack of success of these institutions in meeting the

expectations of others is usually revealed by a careful analysis of
their financial statements.
The value of bank stocks
 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

 The value of the bank’s stock will tend to rise in any of the following situations:
 Expected dividend increase
 Risk of the bank falls
 Market interest rates decrease
 Combination of expected dividend increase and risk decline

 Management can work to achieve policies that increase future earnings, reduce risk, or pursue a
combination of both actions in order to raise its bank's stock price
Profitability ratios
 Return on Assets (ROA)
 Return on Equity (ROE)
 Net Interest Margin
 Net Noninterest Margin
 Net Operating Margin
 Earnings Spread
 Earnings Per Share (EPS)
Return on Assets (ROA)

 ROA is primarily an indicator of managerial

efficiency
 This ratio indicates how much net income is
generated per RM1 of assets
 It indicates how capable (good) the
management of the bank has been in
converting the institution’s assets into net
earnings
Return on Equity (ROE)

 ROE is a measure of the rate of return flowing to

the bank’s shareholders
 This ratio indicates how much net income is
generated per RM1 of equity invested in the bank
 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)
Net Interest Margin (NIM)

 One of efficiency measures, indicates how well management and staff able to keep the growth of
revenues (loans, investment, etc) ahead of rising costs (deposits, borrowings, etc)
 NIM measures how large a spread (i.e. difference) between interest income and interest expenses
the management has been able to achieve by close control over the bank’s earning assets and the
pursuit of the cheapest sources of funding
Net Noninterest Margin

 Another efficiency measure

 It measures the amount of noninterest income 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)
 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
Net Operating Margin

 Another efficiency measure

 It is pretax profitability measure. It shows how the performance of bank in running its day to day
business
Earnings Spread
-

 Measures the effectiveness of a financial firm’s intermediation function in borrowing and lending
money and also the intensity of competition in the firm’s market area
 Greater competition tends to squeeze the difference between average asset yields and average
liability costs

 E.g., Higher competition means banks earn less income and incur high expenses. Therefore,
earning spread will become lower
Earnings Per Share (EPS)

 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
Efficiency indicators
 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

 Operating Efficiency Ratio (The lower the better). How much expense spent on RM1 of
revenue.
= Total Operating Expenses / Total Operating Revenues

 Employee Productivity Ratio (The higher the better). How much income generated from one
employee.
= Net Operating Income / Number of Full Time Employees
 ROE depends on

R O E = N e t In c o m e / T o ta l E q u ity C a p ita l

ROA = E q u ity M u ltip lie r =

N e t In c o m e /T o ta l A s s e ts T o ta l A s s e ts /E q u ity C a p ita l

N e t P ro fit M a rg in = A s s e t U tiliz a tio n =

N e t In c o m e /T o ta l O p e ra tin g R e ve n u e T o ta l O p e ra tin g R e v e n u e /T o ta l A s s e ts
Breaking down ROE
 Equity Multiplier
=Total Assets/Total Equity Capital

 Financial Leverage or Financing Policies: the choice of sources of funds (debt or equity)
 A risk indicator that measures the portion of a company's assets that is financed by stockholder's
equity rather than by debt
 Larger EM means that bank is financed using more debt and less equity.
 Because equity must absorb losses on assets, the larger the multiplier, the more exposed to failure
risk the financial institution is

 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)
 Balance Sheets
Bank A Bank B Bank C
Asset (A) 20 20 20
20 20 20

Liability (L) 18 16 18
Equity (E) 2 4 2
20 20 20

Income Statement

Illustration Operating Revenue (OR)

Bank A
4
Bank B
4
Bank C
4
of ROE Operating Expenses (OE)
Net Income (NI)
2
2
2
2
3
1

ROA (NI/A) 0.10 0.10 0.05

ROE (NI/E) 1.00 0.50 0.50
Equity Multiplier (EM) (A/E) 10.00 5.00 10.00
Net Profit Margin (NPM) (NI/OR) 0.50 0.50 0.25
Asset Utilization (AU) (OR/A) 0.20 0.20 0.20

ROE = ROA x EM 1.00 0.50 0.50

ROE = NPM x AU x EM 1.00 0.50 0.50
 Illustration of ROE
Asset 100Liabilities 80 Asset 100Liabilities 90 Asset 100Liabilities 95
Equity 20 Equity 10 Equity 5
100 100 100 100 100 100
Determinants of
ROE in a financial
firm
Higher equity multiplier indicates that banks are more
risky. Why so?

ROA indicates the ability of the management team to

efficiently generate income from bank's equity capital.
TRUE or FALSE?

What is the ultimate objective of a bank?

What ratio tells you the returns generated for

shareholders' investment?