Evaluating Bank Performance

Outline
A Framework for Evaluating Bank Performance
Internal Performance External Performance Presentation of Bank Financial Statements

Analyzing Bank Performance with Financial Ratios

Profit Ratios Risk Ratios

Internal Performance Evaluations Based on Economic Profit

RAROC (Risk-Adjusted Return on Capital) EVA (Economic Value Added)

A Framework for Evaluating Bank Performance

Internal Performance
Bank planning (policy formulation) Goals, budgets, strategic planning Technology Computers, communications, payments Personnel development Challenges (personal selling and geographic expansion) Job satisfaction (training and compensation)

A Framework for Evaluating Bank Performance

External Performance
Market share Earnings effects Role of technology Regulatory compliance Capital Lending Securities Other Public confidence Deposit insurance Public image

A Framework for Evaluating Bank Performance

Presentation of Bank Financial Statements
Balance sheet (Report of Condition) Assets: cash assets, loans, and securities Liabilities: deposit funds and nondeposit funds Capital: equity capital, subordinated notes and debentures, loan loss reserves Income Statement (Report of Income) Interest income Noninterest income Interest expenses Noninterest expenses (including provision for loan losses) Net profit

A Framework for Evaluating Bank Performance

Table 3.1 Balance Sheet for State Bank ($Thousands) ASSETS DEC. 31, 2000 Cash assets $ 9,039 Interest bearing bank balances 0 Federal funds sold 10,500 U.S. Treasury and agency securities 54,082 Municipal securities 32,789 All other securities 0 Net loans and leases 90,101 Real estate loans 50,393 Commercial loans 9,615 Individual loans 8,824 Agricultural loans 20,680 Other loans and leases-domestic 3,684 Gross loans and leases 93,196 Less: unearned income reserves 89 Reserve for loan and lease losses 3,006 Premises, fixed assets, and capitalized leases Other real estate Other assets Total assets 2,229 2,282 4,951 $205,973 DEC. 31, 1999 $ 10,522 1,000 1,500 44,848 34,616 0 81,857 38.975 11,381 10,640 19,654 4,025 84,675 282 2,356 2,398 3,012 4,014 $183,767

A Framework for Evaluating Bank Performance

Table 3.1 Balance Sheet for State Bank ($Thousands) LIABILITIES & CAPITAL DEC. 31, 2000 Demand deposits $ 23,063 All NOW and ATS accounts 6,021 MMDA accounts 41,402 Other savings deposits 3,097 Time deposits<$100K 31,707 Time deposits>$100K 83,009 Total deposits 188,299 Fed funds purchase and resale Other borrowings Bankers acceptance and other liabilities Total liabilities Subordinated notes and debentures All common and preferred equity Total liabilities and capital 0 0 3,546 191,845 0 14,128 $205,973

DEC. 31, 2001 $ 22,528 5,322 49,797 2,992 28,954 57,665 167,258
0 0 3,101 170,359 0 13,408 $183,767

Analyzing Bank Performance with Financial Ratios

Profit ratios
Rate of return on equity ROE = NI/TE (net income after taxes/total equity) Rate of return on assets ROA = NI/TA (net income after taxes/total assets) Other profit measures Net interest margin NIM = (Total interest income - Total interest expense)/Total assets Note: municipal bond interest is not taxable, such that it must be grossed up to a pre-tax equivalent basis by dividing munis interest earned by the factor (1 - tax rate of bank).

Analyzing Bank Performance with Financial Ratios

Profit ratios
Unraveling profit ratios ROE = ROA x TA/TE (total assets/total equity or equity multiplier).
Thus, by decreasing equity, a bank can increase ROE based on any given level of ROA.

ROE = NI/OR x OR/TA x TA/TE (where OR is operating revenue).

The NI/OR ratio is the profit margin, while OR/TA reflects asset utilization. By using this breakdown, one can make inferences concerning the reason for say increases in ROE. If asset utilization and equity multiplier did not change, the profit margin must have increased due to cost savings pushing this ratio up.

Analyzing Bank Performance with Financial Ratios

Risk ratios
Capitalization Leverage ratio Total equity/Total assets Total capital ratio (Total equity + Long-term debt + Reserve for loan losses)/Total assets

Note: book values and market values likely are different and yield different results.

 Risk ratios

Analyzing Bank Performance with Financial Ratios

Asset quality Provision for loan loss ratio = PLL/TL (provision for loan losses/total loans and leases) Loan ratio = Net loans/Total assets Loss ratio = Net charge-offs on loans (gross charge-offs minus recoveries)/Total loans and leases Reserve ratio = Reserve for loan losses (reserve for loan losses last year minus gross charge-offs plus PLL and recoveries)/Total loans and leases Nonperforming ratio = Nonperforming assets (nonaccrual loans and restructured loans)/Total loans and leases

Analyzing Bank Performance with Financial Ratios

Risk ratios
Operating efficiency (cost control) Wages and salaries/Total expenses Fixed occupancy expenses/Total expenses Liquidity Temporary investments ratio = (Fed funds sold, short-term securities, cash, trading account securities)/Total assets Volatile liability dependency ratio = (Total volatile liabilities - Temporary investments)/Net loans and leases Note: This ratio gives an indication of the extent to which hot money is being used to fund the riskiest assets of the bank.

Analyzing Bank Performance with Financial Ratios

Other financial ratios
Tax rate = Total taxes paid/Net income before taxes Dollar gap ratio = Interest rate sensitive assets - Interest-rate sensitive liabilities Total assets where rate-sensitive means short-term with maturities of less than one year (or repriced in less than one year).

Internal Performance Evaluations Based on Economic Profit

RAROC (Risk-adjusted return on capital)
Example
Cost of funds Provision for loan losses Direct expense Indirect expense Overhead Total charges before capital charge Capital charge* Total required loan rate 5.00% 1.00 0.50 0.25 0.25 7.00% 2.29 9.29%

*Note: The capital charge is determined by multiplying the equity capital allocated to the loan times the opportunity cost of equity and then converting to a pre-tax level. Assume that the allocated equity to loan ratio is 10% and the opportunity cost of equity is 16%, such that the after-tax capital charge is 1.6%. If the tax rate for the bank is 0.3, the pre-tax capital charge is 1.6/(1.0-0.3), or 2.29.

In this example, if the loan rate is 9.29%, the bank will earn the target return on equity of 16%. Of course, if the bank can price the loan at a rate higher than 9.29%, it will earn profit over the target level of equity returns. In this case an economic profit is earned in that the value of equity is increased.

Internal Performance Evaluations Based on Economic Profit

EVA (Economic value added)
= Adjusted earnings Opportunity cost of capital, where adjusted earnings is net income after taxes, and the opportunity cost of capital equals the cost of equity times equity capital.

RAROC and EVA

Both methods are beneficial in assessing managerial performance and developing incentive compensation schemes compatible with shareholder wealth goals. RAROC has a short-run perspective (i.e., business unit profit is compared to the units capital at risk) EVA has a long-run perspective (i.e., business unit profit is compared to the cost of capital of the bank)