Rose−Hudgins: Bank

Management and Financial
Services, Seventh Edition

II. Financial Statements
and Financial Firm


6. Measuring and
Evaluating the
Performance of Banks and
Their Principal

© The McGraw−Hill
Companies, 2008


Measuring and
Evaluating the
Performance of Banks
and Their Principal
Key Topics in This Chapter

1• Stock Values and Profitability Ratios
2• Measuring Credit, Liquidity, and Other Risks
3• Measuring Operating Efficiency
4• Performance of Competing Financial Firms
5• Size and Location Effects
6• The UBPR and Comparing Performance

6–1 Introduction
Humorist and poet Ogden Nash once wrote, “Bankers are just like anybody else,
except richer.” It turns out that statement may or may not be true; a lot depends
upon how suc-cessful bankers and other financial-service managers are as
performers in the financial marketplace. Indeed, in today’s world, bankers and
their competitors are under great pres-sure to perform well all the time.
What do we mean by the word perform when it comes to financial firms? In this case
performance refers to how adequately a financial firm meets the needs of its stockholders
(owners), employees, depositors and other creditors, and borrowing customers. At the
same time, financial firms must find a way to keep government regulators satisfied that
their operating policies, loans, and investments are sound, protecting the public interest.
The success or lack of success of these institutions in meeting the expectations of others
is usually revealed by a careful study of their financial statements.
Why are financial statements under such heavy scrutiny today? One key reason is that
banks and other financial institutions now depend heavily upon the open market to raise
the funds they need, selling stocks, bonds, and short-term IOUs (including deposits). Entry

into the open market to raise money means that a financial firm’s financial statements will

Rose−Hudgins: Bank
Management and Financial
Services, Seventh Edition


II. Financial Statements
and Financial Firm

6. Measuring and
Evaluating the
Performance of Banks and
Their Principal

© The McGraw−Hill
Companies, 2008

Part Two Financial Statements and Financial Firm Performance

be gone over “with a fine tooth comb” by stock and bond market investors, credit
rating agencies (such as Moody’s and Standard & Poor’s), regulators, and scores
of other people and institutions.
This development has placed the management of banks and many of their competitors
under great pressure to set and meet the institution’s performance goals or suffer serious
financial and reputational losses. In 2002 J. P. Morgan Chase, the second largest banking
company in the United States, became a prominent example. The firm’s credit rating came
under review and, for a time, it faced rising borrowing costs as major depositors and other
creditors reacted negatively to the bank’s potential loan losses and the adverse pub-licity
from its alleged involvement with Enron Corporation and other troubled companies.
Subsequently, J. P. Morgan Chase’s position strengthened and improved.
At the same time, as we saw in Chapters 1–4, competition for traditional loan and deposit
customers has increased dramatically. Credit unions, money market funds, insurance companies, brokerage firms and security dealers, and even chain stores are fighting for a bigger
slice of nearly every credit or deposit market. Bankers have been called upon to continually
reevaluate their loan and deposit policies, review their plans for growth and expansion, and
assess their returns and risk exposure in light of this new competitive environment.
In this chapter we take a detailed look at the most widely used indicators of the quality and
quantity of bank performance and at some performance indicators used to measure banking’s
principal competitors. The chapter centers on the most important dimensions of perfor-mance—
profitability and risk. After all, financial institutions are simply businesses organized to maximize
the value of the shareholders’ wealth invested in the firm at an acceptable level of risk. The
objectives of maximum (or at least satisfactory) profitability with a level of risk acceptable to the
institution’s owners is not easy to achieve, as recent institutional failures around the globe
suggest. Aggressive pursuit of such an objective requires a financial firm to be continually on
the lookout for new opportunities for revenue growth, greater efficiency, and more effective
planning and control. The pages that follow examine the most important measures of return and
risk for banks and some of their toughest competitors.

6–2 Evaluating Performance
How can we use financial statements, particularly the Report of Condition
(balance sheet) and Report of Income (income statement), to evaluate how well
a financial firm is per-forming? What do we look at to help decide if a financial
institution is facing serious prob-lems that its management should deal with?

Determining Long-Range Objectives
The first step in analyzing financial statements is to decide what objectives the bank or
other financial firm is seeking. Performance must be directed toward specific objectives. A
fair evaluation of any financial firm’s performance should start by evaluating whether it has
been able to achieve the objectives its management and stockholders have chosen.

Certainly many financial institutions have their own unique objectives. Some
wish to grow faster and achieve some long-range growth objective. Others seem
to prefer the quiet life, minimizing risk and conveying the image of a sound
institution, but with modest rewards for their shareholders.
Maximizing the Value of the Firm: A Key Objective

for Nearly All Financial-Service Institutions
While all of the foregoing goals have something to recommend them, increasingly financial-service corporations are finding they must pay close attention to the value of their
Rose−Hudgins: Bank
Management and Financial
Services, Seventh Edition

II. Financial Statements
and Financial Firm

6. Measuring and
Evaluating the
Performance of Banks and
Their Principal

© The McGraw−Hill
Companies, 2008

Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 165

Key URLs
The most comprehensive sites on the World Wide Web for the
financial statements of individual banks and for the industry as a
whole are
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or the perception of investors that the institu-tion is less risky overall (perhaps because it has further diversified its service offerings and expanded the number of markets it serves) and. discounted by a minimum acceptab le rate of return (r) tied to the financial firm’s perceive d level of risk. The value of the stream of future stockholder dividends is expected to increase. The minimum acceptab le rate of return. is sometim es referred to as an institution’s cost of capital and has two main compone nts: (1) the riskfree rate of interest (often proxied by the current yield on governm ent bonds) and (2) the equity risk premium (which is g i v e n e a c h f i n a n c i a l f i r m ' s p e r c e i v e d l e v e l o f designed to compensate an investor for accepting the risk of investing in a finan-cial firm’s stock rather than in risk-free securities). and the strength or weakness of the economy that each serves. reduce risk. management can work to achieve policies that increase future earnings. the stock price equation can be greatly simplified into the form PoD1/(rg) where D1 is the expected dividend on stock in period 1. reducing shareholders’ acceptable rates of return via the risk-free rate of interest component of all market interest rates. 2. has a lower equity risk premium. g is the . The financial organization’s perceived level of risk falls. a decrease in its loan losses. r is the rate of discount reflecting the perceived level of risk attached to investing in the stock. due perhaps to an increase in equity capital. perhaps reflecting steady growth in earnings. as perceived by Research evidence over the years has found the stock values of financial institutions to be especially sensitive to changes in market interest rates. due per-haps to recent growth in some of the markets served or perhaps because of profitable acquisitions the organization has made. therefore. Expected dividend increases are combined with declining investors. risk. 4. r. currency exchange rates. The formula for the determinants of a financial firm’s stock price presented in Equation (6–1) assumes that the stock may pay dividends of varying amounts over time.t a where l E(Dt) represent s stockhold er dividends expected to be paid in future periods. if the dividends paid to stockholders are expected to grow at a constant rate over time. Market interest rates decrease. 3. However. Clearly. The value of the financial firm’s stock will tend to rise in any of the following situations: 1. or pursue a combination of both actions in order to raise its company’s stock price.

however. n 1 1r 2 1 . this indicator is often not available for smaller banks and other relatively small financial-service corporations because the stock issued by smaller institutions is frequently not actively traded in international or national markets. Most capital-market investors have a limited time horizon. suppose investors expect a bank to pay a $5 dividend at the end of period 1. in theory. suppose that a bank is expected to pay a dividend of $5 per share in period 1.10 0. and sell the stock for price P n at the end of the planned investment horizon. and the minimum required return to equity capital based on the bank’s perceived level of risk is 10 percent. If the relevant discount rate to capture risk is 10 percent. dividends are expected to grow 6 percent a year thereafter. Then the bank’s stock price must be valued at Po $5/(0. 1 n p 1 2 Po 1 1r 2 1 1r 2 where we assume the investor will hold the stock for n periods.Why should banks and other corporate financial firms be concerned about their level of profitability and exposure to risk? 6–2. I/Y = 10.. and r must be greater than g.10 2 1 10. Can you estimate the current value of the bank’s stock? Profitability Ratios: A Surrogate for Stock Values While the behavior of a stock’s price is. the best indicator of a financial firm’s performance because it reflects the market’s evaluation of that firm. Dn. For example. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies.78 per share 1 Concept Check 6–1.10 2 $136.Suppose that a bank is expected to pay an annual dividend of $4 per share on its stock in the current period and dividends are expected to grow 5 percent a year every year. FV = 155. and then plan to sell the stock for a price of $150 per share. and the appropriate discount rate to reflect shareholder risk is 10 percent. Pmt = 5. This fact forces the financial analyst to fall back on surrogates for market-value indicators in the form of various profitability ratios.What factors influence the stock price of a financialservice corporation? 6–4.. the current value of the bank’s stock should approach: $5 $10 $150 Po D A financial calculator can be used to help solve the above equation for stock price per share where N = 2. Seventh Edition 166 II. and plan to sell the stock at the end of their planned investment horizon. In this case the current value of a financial corporation’s stock is determined from D1 D2 1 11 0. PV = (?). 2008 Part Two Financial Statements and Financial Firm Performance expected constant growth rate at which stock dividends will grow each year.Rose−Hudgins: Bank Management and Financial Services.What individuals or groups are likely to be interested in these dimensions of performance for a financial institution? 6–3. receiving the stream of div-idends D1 D2. . $10 at the end of period 2.06) $125 per share The two stock-price formulas discussed above assume the financial firm will pay div-idends indefinitely into the future. Financial Statements and Financial Firm Performance 6. For example..10 2 2 2 11 0.

The same is true for the smallest banks. and Germany’s Deutsche Bank have Financial firms utilize information handled by computers for nearly become leaders in the adoption of every service they offer. By outfinancial-service firms. these leading financialto outside firms specializing in information technology. India. Seventh Edition II. Financial Statements and Financial Firm Performance 6. such as and time while improving overall accuracy. Savings on personnel China. Bank of America. Through outsourcing. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 167 E . their managers can realize cost advantages sourcing computer facilities and from outsourcing—transferring tasks from inside the financial firm itself people.B AN K I N G AN D E . Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. the largest banks in the industry are not always the most profitable. known as service firms hope to save money vendors. finan-cial institutions are basically “renting” the facilities and employ-ees of the vendor on an “as needed” basis. .C O M M E R C E benefits. Often the vendors are centered in distant locations. but outsourcing also Institutions FINANCIAL FIRMS IMPROVE PERFORMANCE BY OUTSOURCING like Wachovia Bank. The highest ROAs and ROEs often lie among medium-size institutions. and Factoid Contrary to popular opinion.Rose−Hudgins: Bank Management and Financial Services. As electronic data processing of financial outsourcing designed to reduce information becomes more and more integral to the functions of the cost of operations. and Costa Rica. Key Profitability Ratios Among the most important ratio measures of profitability used today are the following: equipment are obvi-ous improves nating financial efficiency “dead time” firm’s by elimi- when a computer equipment and staff are not being fully utilized.

but rather to Many authorities prefer those assets that account for the majority of all to use total earning assets in the denominator income. principally loans the rate of return and security investments. has Thus.Return on equity capital Net income 1ROE 2 Total equity capital Net income Return on assets 1ROA 2 Net interest margin Total assets Interest income a Interest expense 2 Total assets b Noninterest revenues Net noninterest margin Interpreti ng Net operating margin Profitabili Ratios Earningstyper share Each of the of stockforegoing 1EPS 2 Like all financial ratios. returnbee on assetsn in (ROA) iscon primarily anverti indicator ofng managerial ass efficiency. not to approximates the all assets. of the net interest margin 2 . Return on equityand noninterest margin. is a measure ofincome. a Noninterest expenses 2 Total assets profitability. itets indicates howinto capable net management ear (6–4) (6–5) (6–6) b (6–7) nings. on the otherEarning assets are those generating interest or fee hand. Itnet noninterest income should be compared. eachratios looks at of these profitabilitya slightly measures often varies substantially over time anddifferent aspect of from market to market. flowing to The reasoning is that net interest income as well as shareholders. (ROE).

Financial Statements and Financial Firm Performance 6. and its close attention today to the liabilities amounted to liabilities amount to $926 million. The net interest margin measures how large a spread between interest revenues and interest costs management has been able to achieve by close control over earning assets and pursuit of the cheapest sources of funding.e. 2008 Part Two Financial Statements and Financial Firm Performance net benefit that the stockholders have received from investing their capital in the finan-cial firm (i. or simply the spread. Why do the managers of 6–6. and loan-loss expenses). See if you can percent of determine this bank’s 6–7. though fee income has been rising rapidly in recent years as a percent-age of all revenues. measures the amount of noninterest revenues stemming from service fees the financial firm has been able to collect relative to the amount of noninterest costs incurred (including salaries and wages. Another traditional measure of earnings efficiency is the earnings spread. Its liabilities total $4. and why is Suppose it a banker tells you important? Might the ROA measure be important to that his bank in the year just banking’s key competitors? net 6–8. The net operating margin. net interest margin. What is return on equity capital and what aspect of bank’s return on assets? Is performance is it supposed to measure? Can you see this ROA high or low? How how this performance measure might be useful to the could you find out? managers of financial firms? 6–9. indicating how well management and staff have been able to keep the growth of revenues (which come primarily from loans.960 million while its noninterest expenses of $5 million. investments. forcing management to try to find other ways (such as generating fee income from new services) to make up for an eroding earnings spread.Rose−Hudgins: Bank Management and Financial Services. repair and maintenance of facilities. What is the return on assets (ROA). of which earning assets represented 85 percent of that total while total Suppose a bank reports that its net income for the current financial firms often pay interest-bearing year is $51 million. What is the and million. further amounted that to $480 million. the net noninterest margin is negative: Noninterest costs generally outstrip fee income. calculated as follows: Total interest income Total earning assets liabilities Earnings spread Total interest expen Total interest-bear The 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. most recent year. The net non-interest margin.. Typically. while interest income equity capital amounts from earning assets totaled total interest and noninterest margins and its earnings base and earnings spread for the . the spread will decline as competition increases. assets revenues $2 Suppose to $52 million. What is its return on equity net interest margin and 75 capital? Is the ROE you have calculated good or bad? What noninterest margin? To the information do you need to answer this last question? earnings spread? assets.144 million. completed had total interest A bank estimates that its total revenues will amount to $155 expenses on all borrowings million and its total expenses (including taxes) will equal $107 of $12 million and million this year. and service fees) ahead of rising costs (principally the interest on deposits and other borrow-ings and employee salaries and benefits). If other factors are held constant. in contrast. placing their funds at risk in the hope of earning a suitable profit). Seventh Edition 168 II. its assets total $1. $16 million noninterest totaled Concept Check 6–5. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. Greater competition tends to squeeze the difference between average asset yields and average liability costs. and net noninterest margin are efficiency measures as well as profitability measures.

Seventh Edition II. a bank whose ROA is projected to be 1 percent this year will need $10 in assets for each $1 in capital to achieve a 10 percent ROE. ROE Total revenuesTotal operating expensesTaxes Total assets The relationships in Equations (6–12) and (6–13) remind us that the return to a financial firm’s shareholders is highly sensitive to how its assets are financed —whether more debt or more owners’ capital is used. it is often useful to break down some of these profitabili ty ratios into their key compon ents. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. Financial Statements and Financial Firm Performance 6. That is. Both use the same numerator: net income. Even a financial institution with a low ROA can achieve a relatively high ROE through heavy use of debt (leverage) and minimal use of owners’ capital. Therefore. the ROE–ROA relationship illustrates quite clearly the fundamental trade-off the managers of financial-service firms face between risk and return. following Equation (6–11): T o t a l a s s e t s ROE ROA Total equity capital To . For example. For example . the seller or liquidator is normally the FDIC. two of the most popular profitabili ty measure s in use today. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 169 Factoid Who must declare that a bank operating in the United States has failed? Who usually sells or liquidates the failed institution? Answer: A failure declaration must come from the agency issuing the bank’s charter. In fact.Rose−Hudgins: Bank Management and Financial Services. Therefore. these two profit indicators can be linked directly: Total assets Total equity capi ROEROA Or. are closely related. Useful Profita bility Formu las for Banks and Other Finan cialServic e Comp anies In analyzin g how well any given financialservice firm is performi ng. it is easy to see that ROE and ROA. in other words: Net income Total equity capital Net income Total assets To Total But we note that net income is equal to total revenues minus operating expenses and taxes.

For example. Clearly. the firm must take on more risk in the form of higher leverage to have any chance of achieving its desired rate of return to its shareholders (ROE).5 percent and (b) a 10 percent ROE if ROA is 2 percent.01 $10 1 0 0 1 0 p e r c e n t $ 1 If. .005 $20 100 10 percent $1 Indeed. however. a 10 percent ROE is attain-able only if each $1 of capital supports $20 in assets. we could construct a risk-return trade-off table like the one following that will tell us how much leverage (debt relative to equity) must be used to achieve a financial institution’s desired rate of return to its stockholders. with a 20 to 1 assets-tocapital ratio a financial firm can achieve a 10 percent ROE simply by earning a modest 0. the trade-off table on page 170 indicates that a financial firm with a 5-to-1 assets-to-capital ratio can expect (a) a 2. In contrast. as earnings efficiency represented by ROA declines.5 percent ROA.5 percent.5 percent ROE if ROA is 0.0. the bank’s ROA is expected to fall to 0. In other words: ROE 0.

5% 1. especially institution (debt (EM) › the mix and yield on or equity). or assets to equity ratio. 20X or more. averaging about 15X or The multiplier is a .5% 15. Bigger management needs to pay close attention and banks often assess the reasons behind that change. For operate with example.) For example: effectiveness of assets.0 15. sources chosen utilization (AU) › portfolio to fund the management financial The equity multiplier reflects policies. The net profit margin reflects expense leverage or › (NPM) management (cost financing control) and service policies: the The degree of asset reflects pricing policies.0 22.5 10.5 30. Financial Statements and Financial Firm Performance 6. (See Exhibit 6–1. banks. 5:1 10:1 15:1 20:1 2.Rose−Hudgins: Bank Management and Financial Services.0 7.0% 1. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. 2008 Part Two Financial Statements and Financial Firm Performance Risk-Return Trade-Offs for Return on Assets (ROA) and Return on Equity (ROE) ROE with an ROA of: Ratio of Total Assets to Total Equity Capital Accounts 0.0 10 20 30 40 Breaking Down Equity Returns for Closer Analysis Another highly useful profitability formula focusing upon ROE is this one: Net income ROE Total operating revenue Total operating revenue Total assets Total assets Total equity capital or ROE Net profit margin Asset utilization ratio Equity multiplier where: The net profit margin 1NPM 2 The degree of asset utilization 1AU 2 The equity Net income Total operating reve Total operating reve Total assets Total assets multiplier 1EM 2 Total equity capital Each component of this simple equation is a telltale indicator of a different aspect of a financial firm’s operations. larger for most If any of these ratios begins to decline. is normally the largest.0 5. of these three financial ratios the multipliers of equity multi-plier (EM).5% 2.0% 10. Seventh Edition 170 II.5% 5.0 20.0 7.

Careful perusal of the figures in this table reveals very attractive ROEs for FDIC-insured deposi-tory institutions covering more than a decade. The lowest earnings over this period for depository institutions.Rose−Hudgins: Bank Management and Financial Services. or the Factoid ratio ofincrea net se income their to totalearnin revenue gs s. the larger the multiplier. or asset utilization). shown in Table 6– 1. The average ROE for the industry . the greater the potential for high returns for the stockholders. However. Because equity must absorb losses on assets. management can raise the average yield on assets (AU. Similarly. Itlling reminds expen us thatses financia and lmaxi service mizin corpora g tions reven can ues. Financial Statements and Financial Firm Performance 6. were a very acceptable 12. dollar of equity (owners’) capital and how much of the financial firm’s resources. An interesting case in point is the recent track record of average ROE for all FDIC-insured depository institutions between 1992 and 2005. the larger the multiplier. must rest on debt. as measured by ROE. Seventh Edition II. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. The net profit margin (NPM).S. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 171 EXHIBIT 6–1 Elements that Determine the Rate of Return Earned on the Stockholders’ Investment (ROE) in a Financial Firm Management decisions regarding capital  structure: Rate of return earned on the stockholders’ investment (ROE or net income/equity capital) Equity multiplier (EM) or the employment of financial leverage to raise net earnings for the stockholders (total assets/ equity capital) What   sources   of   funding should be used? What dividends should be  paid to stockholders? Management decisions regarding: Net profit margin (net income/ The mix of funds raised and  invested How big the institution should be operating Return on assets (ROA) as a measure of overall operating efficiency (ROA or net income/total assets) revenues) (NPM) Asset utilization (AU) as a Control of operating expenses The pricing of services How to minimize the financial firm’s  tax liability measure of asset management efficiency (operating revenue/total assets) direct measure of financial leverage— In the years since World War II the number how many dollars of of U. isand also the sub-ject return to somes to degree their of stock manage holder ment s by control succe and ssfully directio contro n. the more exposed to failure risk the financial institution is.21 percent in 1992. banks failing annually has averaged assets must be less than 1 or 2 percent of the industry supported by each population. by carefully allocating assets to the highestyielding loans and investments while avoiding excessive risk. therefore.

gradually increased over the years. which surged upward (particularly noninterest revenues or fee income). What created such healthy ROEs between 1992 and 2005? Table 6–1 shows clearly that the primary cause was the industry’s net profit margin (NPM). The industry’s expanding net profit margin more than off-set decreases in its asset utilization (AU) ratio and equity multiplier (EM).04 percent in 2003 before falling back slightly. . reaching 15. Operating revenues expanded significantly faster than operating expenses.

Seventh Edition 172 II. Financial Statements and Financial Firm Performance 6.Rose−Hudgins: Bank Management and Financial Services. © The McGraw−Hill Companies. Measuring and Evaluating the Performance of Banks and Their Principal Competitors Part Two Financial Statements and Financial Firm Performance TABLE 6–1 Components of Return on Equity (ROE) for All FDICInsured Institutions (1992–2005) Source: Federal Deposit Insurance Corporation. 2008 .

48 9.17x 12.21 = Net Profit Margin (NPM) (Net After-Tax Income/Total Revenues) X = = = = = = = = = 18.10 12.81 19.11 13.93x 10.68% 13.87x 11.27 15.72x 10.Year Return on Equity Capital (ROE) 2005* 2004 2003 2002 2000 1998 1996 1994 1992 12.11 9.63x 9.89% 19.34 9.51 6.33 12.02 12.73 12.93% 6. .74x 12.04 14.59 9. The the equity multiplier (EM) fell because equitynet capital increased due to record profitsprofit and encouragement from governmentmargi regulators that depository institutions usen more equity and less debt to finance their(NPM purchases of assets.01 8.53 13. At the same timetaxbanks managed to slow their assetmana growth by making much heavier use ofgeme off-balance-sheet transactions (as went saw in Chapter 5) and by increasingefficie revenues from the sale of fee-basedncy services rather than booking so manyratio. new assets.86 17.60 9. and this (2) the ratio of before-tax income to total revenue as an case indicator of how many dollars Why did these latter two ratios (AU we of and EM) decline? The industry’s assethave utilization (AU) ratio fell mainly becausemerel market interest rates stayed low andy split were declining much of the time. Regulators urged) into depository institutions to increase theirtwo capital in hopes of protecting depositorsparts: and preserving the government’s deposit(1) a insurance reserves.78x 11.51 13.11 X Equity Multiplier (EM) (Total Assets/ Total Equity Capital)          9.42x In ) to minimize tax exposure.31 13.95 7.80x 13. reflect A slight variation on this simpleing ROE model produces an efficiencythe equation useful for diagnosinguse of problems in four different areas in the securi management of financial-servicety firms: gains or losse s and Net income other ROE Pretax taxnet operating mana income geme nt Total operating tools revenue (such Totalas assets buyin or: g taxTax Expense exem pt ROEmanagementcontrolmanagementmanagement efficiency efficiency bonds *Figures for 2005 are for first half only.55          Asset Utilization (AU) (Total Revenues/ Total Assets) 6.21 12.

Accounting Standards Act of but did not report their findings until months later. filed suit against about three-quarters of a billion the public accounting firm of Ernst and Young LLP. The Sarbanes-Oxley firm’s auditors detected flawed accounting practices at Superior Bank. Financial Statements and Financial Firm Performance 6. Source: Federal Deposit Insurance Corporation. . In short. Seventh Edition II. However. assets. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. claiming that the dollars. acting as receiver and liquidator. relationships in order to Ernst and Young allegedly had both an auditor–client and a promote auditor objectivity and consultant–client relationship with Superior. The delay in Corporation (FDIC). that law was passed after the Superior Bank failure occurred. loss to eventually balloon to In 2002 the FDIC. this delay 2002 now restricts combined on the part of the out-side auditors prevented regulators from acting auditing and consulting quickly to min-imize losses to the government’s insurance fund. The FDIC charged inde-pendence. strong performance on the part of financial-ser-vice providers depends on honest reporting that fairly values current and expected revenues.Rose−Hudgins: Bank Management and Financial Services. operating costs. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 173 E T H I C S I N B AN K I N GAN D F I NAN C IALS E R V I C E S that this dual relationship compromised the auditors’ QUESTIONABLE ACCOUNTING PRACTICES CAN judgment and discouraged TURN BANK PERFORMANCE SOUR them from “blowing the whistle” In 2001 Superior Bank of Chicago—a federal savings bank— on the bank’s accounting failed and was taken over by the Federal Deposit Insurance problems. This failed banking firm provides a classic reporting overvalua-tion of the example of how misleading accounting practices that inflate asset bank’s mortgage-related assets values and revenues and deflate liabilities and expenses can hurt allegedly caused the FDIC’s a financial institution’s performance and ultimately bring it down. Allegedly. and liabilities so that both insiders and outsiders get a clear picture of how well a financial firm is performing and where it seems to be headed.

or 13.3 mil 0. the bank’s effectiveness in con-trolling operating expenses needs to be reviewed.3 million Its ROE must be ROE ROE 16.0 mil $1. And if the ratio of operating revenues to assets plummets from 0.322 to $1. if the ratio of net income to pretax net operating income falls from 0.3 million Total operating revenue $39.0 million Total equity capital $7. In the banking example shown above.769 to 0.3 mil $39. . when any one of these four ratios begins to drop. If pretax net operating income to operating revenue drops from 0.7 percent Clearly. a careful reexamination of asset portfolio poli-cies is warranted to see if the decline in asset yields is due to factors within manage-ment’s control.033 to 0. management will want to look closely at how well the bank’s tax expo-sure is being monitored and controlled. For example.71 $1.025 in the coming year.610 next year.0 million Pretax net operating income $1. management needs to reevaluate the financial firm’s efficiency in that area.3 mil 0.revenue survive after operating expenses are removed—a measure of operating efficiency and expense control. suppose a bank’s Report of Condition and Report of Income show the following figures: Net income $1.3 million Total assets $122.322 0.769 0.

Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. Financial Statements and Financial Firm Performance 6. resulted in a rapid expansion of fee (noninterest) income and loan revenues. 2008 Part Two Financial Statements and Financial Firm Performance Breakdown Analysis of the Return on Assets We can also divide a financial firm’s return on assets (ROA) into its component parts. For example. Actually. 2 or the ability of management to generate income EQUALS Net income Total assets from assets 2 Such a breakdown of the components of return on assets (ROA) can be very helpful in explaining some of the recent changes that financial-service providers have experienced in their financial position. securities gains 1or losses 2 taxesextraordinary net gains Total assets affecting its net income Return on assets 1ROA. the average ROA for all FDIC-insured institutions between 1992 and 2005 rose from 0. as shown in Table 6–3. as shown in Table 6–2. led by advances in automation and mergers that eliminated many overlapping facilities. Seventh Edition 174 II. along with an expanding economy.87 percent in 1992 to a high of 1. which Total assets TABLE 6–2 Calculation Return on Assets (ROA) Gross interest income ÷ Total assets – Interest expens e ÷ Total assets 1= Net inter est mar gin ÷ – Income taxes ÷ Total assets* + 2= Noninterest income ÷ Total assets – Noninterest expenses ÷ Total assets – Provision for loan losses ÷ Total assets 3= 1= Pretax net operating income ÷ Total assets Income before extraordinary items ÷ Total assets + Extraordinary net gains ÷ Total assets Net income ÷ Total assets (or ROA) (6–20 . All this occurred in the face of falling market interest rates. Why did ROA for 1992–2003 keep getting better and better? Better control over expenses. ROA is based on three simple component ratios: Components of ROA Net interest margin 1Interest income Interest expense 2 Total assets PLUS 1Noninterest income 2 Noninterest expense 2 Total assets Net noninterest margin LESS Provision for loan losses Special transactions .Rose−Hudgins: Bank Management and Financial Services.38 percent in 2003 before leveling out in 2004 and 2005. which propelled upward the public’s demand for financial services.

Re tur n on as set s bef or e tax es 8d 9d The financial firm’s share of the cost of govern ment services Net income from recurring sources of revenue 10d Nonrecurring sources of income or loss 11d Earnings left over for the stockholders after all costs are met . One can restate such income on a fully tax-equivalent basis by multiplying the amount of tax-exempt income by the expression 1 ÷ (1 – t) where t is the firm’s tax bracket rate.1d 2d 3d 4d 5d 6d 7d Income from holding assets Supply cost of funds for holding assets Return earned because the lending institution’s credit quality is better than its customers’ credit quality Income from handling customer transactions Cost of operations Accrual expense *Both income and taxes applicable to income need to be adjusted for any tax-exempt earnings received.

Financial Statements and Financial Firm Performance 6.64 0. averaging 1.13 TABLE 6–3 Total interest income/ – Applicable income taxes/ Components of Return on Assets (ROA) for All FDIC Total assets Total assets 0.38 lease losses/Total assets + Total noninterest income/ Notes: Figures may not add Total assets exactly to totals due to rounding and the exclusion – Total noninterest expense/ of extraordinary items.02 0.31 1. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 175 + Securities gains(losses)/ Income Statement Items Total assets 0.37 = Net interest income/ + Extraordinary gains (net)/ Source: Federal Deposit Total assets Total assets 0.00** 1.15 –0.Rose−Hudgins: Bank Management and Financial Services.67 Insured Depository – Total interest =expense/ Income before extraordinary Total assets items/Total assets Institutions (1992–2005) 1.31 1.38 per-cent.00** Insurance Corporation.00** 0. The decline in banks’ net interest earnings was more than made up for. income/ Total assets **Less than 0.14 0.005 percent. By 2003 the industry’s ROA.61 1.30 0.64 0. by dramatic increases in their fee income and improved loan quality as reflected in somewhat smaller loan-loss expenses. Seventh Edition II. lowered banking’s ratio of gross interest income to total assets and reduced its net inter-est margin. how-ever.00** 1.30 1. *2005 Total assets figures are for first half of = Pretax net operating year only.06 0. 0.14 . represented the biggest average rate of return on bank assets since the FDIC began its operations in 1934. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. – Provision for =loan Netand income/Total assets 1.

50%. If a bank has a net interest components of ROE ande what does each of thesecon components measure? trol 6–12. and $50 in equitycie ncy capital. WhatAss size equity multiplieret must it have to hold itsma nROE unchanged? 6–13. security gains. taxes. What is the bank’s indi ROE? Tax-management cat efficiency indicator? or? Fun ds ma nag em ent effi cie ncy indi cat or? Wh at are the mo st imp orta nt co mp one nts of RO A and wh at margin of 2. operatingnt revenues of $100. What are the Exp aspects of a financial institution’s performance do they reflect? principalens 6–15. Suppose a bank haseffi an ROA of 0. what is its ROA? . pretax netme income of $15. assets of effi $600.47%.85%.80cie percent and an equityncy multiplier of 12. Whatindi is its ROE? Supposecat this bank’s ROA falls toor? 0.60 percent.Concept Check 6–11. a noninterest margin of –1. and a ratio of provision for loan losses. Suppose a bank reports net age income of $12. and extraor-dinary items of –0.

breaking down profitability measures into their respective components tells us much about the causes of earnings difficulties and suggests where management needs to look for .What a Breakdown of Profitability Measures Can Tell Us Clearly.

Measuring and Evaluating the Performance of Banks and Their Principal Competitors Part Two Financial Statements and Financial Firm Performance possible Factoid © The McGraw−Hill Companies. problems that surface. Careful management of the asset portfolio to meet liquidity needs while seeking the highest returns from any assets acquired. 3. Seventh Edition 176 II. 2008 cures for Which banks in the industry tend to have the biggest net interest any margins between their interest income from loans and securities and the interest cost of borrowed funds? Answer: The smallest earnings banks usually do. Caref ul use of finan cial lever age (or the prop ortio n of asset s finan ced by debt as oppo sed to equit y capital). 4.Rose−Hudgins: Bank Management and Financial Services. Financial Statements and Financial Firm Performance 6. Careful use of operating leverage from fixed assets (or the proportion of fixed-cost inputs used to boost operating earnings as output grows). Careful control of exposure to risk so that losses don’t overwhelm income and equity capital. 5. 2. The foregoing analysis reminds us that achieving superior profitabilit y for a financial institution depends upon several crucial factors: 1. . Careful control of operating expenses so that more dollars of sales revenue become net income.

S. For example. fed-eral regulatory agencies and summarized below. eroding its resources for future growth. for example are usually an interested in achieving high stock values Banker [3] and and high profitability.S. funds grow next month? Will the financial on firm’s stock price rise and its earnings Peter increase? Are interest rates going to rise or S. 3• Standard deviation or variance of return on equity (ROE) and return on assets (ROA). such as changes in economic conditions. Risk Matrices Used by Selected U. Among the more popular measures of overall risk for a financial firm are the following: 1• Standard deviation (σ) or variance 2 (σ ) of stock prices. will the customer renew his or her is loan? Will deposits and other sources of based. and will a financial institution article in the lose income or value if they do? Canadi Bankers.Measuring Risk in Banking 3 and Financial Services Market Operational Legal Reputation Risk to the manager of a financial institution or to a regulator supervising a financial institu-tion means the perceived uncertainty 3 associated with a particular event. Thus. Earnings may decline unexpectedly due to factors inside or outside the finan-cial firm. Rose’s fall next week. Risk can be broken down into a number of components and even referenced using different terms as illustrated by the different risk matrices used currently by U. but none can fail to is used pay attention to the risks they are with permis accepting to achieve these goals. competition. which could cause the bank’s stock price to fall. For This section example. the greater the overall risk. or laws and regulations. Regulatory Agencies Federal Reserve System Comptroller of the Currency Credit Liquidity Credit Liquidity . recent increases in competition have tended to narrow the spread between earnings on assets and the cost of raising funds. sion. The higher the standard deviation or variance of the above measures. in part. stockholders always face the possi-bility of a decline in their earnings per share of stock. 2• Standard deviation or variance of net income.

deposits. generally posting example. high-profit motivator. pp.leveraging effects of cheaper debt. growth should not become a substitute for profits. Relat-edly. banks the banking industry in an effort to answer a simple question: with the best profits seem to What distinguishes a bank with above-average profitability generate and manage more from banks that are only average performers? How did top-assets and income per employee and pay their more earning banks get that way? Bank size is clearly one factor. Their ratios of operating expenses to capital and rely on the earningsoperating revenues tend to be significantly below the expense-to. increase profits in recent many highly profitable banks hold a large volume of core deposits—years. at least as measured by their ROA and ROE. pos-sibly reflecting the presence of more aggressive management or greater customer acceptance of their services. For example. Top-earning recognize banks that seem growth can to be overdone.S. revenue ratios of low-profit institutions. Top-earning banks. Klee and Fabio M. these checkable deposits pay little or no interest and element in strategies to carry customer service fees that bring in more revenues. HOW TOP-EARNING BANKS GET THAT WAY Leverage (lower equity medium-size or larger institutions that seem to benefit from lower capital and greater use of debt) overall operating costs and greater operating efficiency.Rose−Hudgins: Bank Management and Financial Services. Growth in assets. For further information on the characteristics of high-profit banks see especially Elizabeth C. Spring 2005. 143–74.” Federal Reserve Bulletin. Expense control stands out as the most important discrimina-tor also emerges as a profit between top performers and the also-rans. Commercial Banks in 2004. Financial Statements and Financial Firm Performance 6. generally economize lower average interest costs. are often salaries. for banks manage their operating expenses better. and loans seems to play a role because top-earning banks seem to grow faster than average. and especially lower per-sonnel on using high-cost owners’ expenses and overhead. “Profits and Balance Sheet Developments at U. However. The top-earning banks in the productive employees higher industry. Seventh Edition II. . formerly “free” services and develop new fee-generating services. Government deregulasmaller denomination deposits from individuals and smalltion has put added pressure businesses that pay low interest rates and are more loyal to the on financial institutions to charge fees for many bank than larger deposit accounts. The deposit structure also appears to influence profit perforThe expansion of fee mance. 2008 Insights and Issues Employee productivity tends to be higher among top A number of research studies have examined top-earning firms in earners. Moderate growth is usually a better route to high profits. Top-earning banks often hold more demand deposits than income has become a key other banks. resulting in uncontrolled expansion that increases operating expenses faster than revenues. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. Natalucci. For example.

Nonperforming assets are incomegenerating assets. including loans. especially its loans. Because financial firms tend to hold little owners’ capital relative to the aggregate value of their assets. exposure to credit risk grows. are loans that have been declared worth-less and written off the lender’s books. 3• The ratio of the annual provision for loan losses to total loans and leases or to equity capital. that are past due for 90 days or more. As these ratios rise. Credit Risk The probability that some of a financial institution’s assets. Let’s examine now several of the most important types of risk encountered daily by financial institutions. and failure of a lending institution may be . If some of these loans ultimately generate income. only a small percentage of total loans needs to turn bad to push them to the brink of failure. on the other hand. Charge-offs. The following are four of the most widely used indicators of credit risk: 1• The ratio of nonperforming assets to total loans and leases. 5• The ratio of nonperforming assets to equity capital. 4• The ratio of allowance for loan losses to total loans and leases or to equity capital. 2• The ratio of net charge-offs of loans to total loans and leases. will decline in value and perhaps become worthless is known as credit risk.Each of these forms of risk can threaten a financial firm’s day-to-day performance and its solvency and long-run survival. the amounts recovered are deducted from gross charge-offs to yield net charge-offs.

loan demand. the market values of assets. A rise in bad loans or declining market values of otherwise good loans relative to the amount of deposits creates greater depositor risk. or using longer-term liabilities to fund the institution’s operations. In fact. For example. federal funds. 2• Cash assets and government securities to total assets. Cash assets include vault cash held on the financial firm’s premises.” there was a federal investigation of the incident! Somewhat more common is a shortage of liquidity due to unexpectedly heavy deposit withdrawals. deposits must be carefully protected. deposits held with the central bank in the region. Liquidity Risk Financial-service managers are also concerned about the danger of not having sufficient cash and borrowing capacity to meet customer withdrawals. One useful measure of liquid-ity risk exposure is the ratio of 1• Purchased funds (including Eurodollars. higher than the interest rates other institutions are paying for similar borrowings. deposits held with other depository institutions to compensate them for clearing checks and other interbank services. security RPs. Other indicators of exposure to liquidity risk include the ratios of 1• Cash and due from balances held at other depository institutions to total assets. liabilities.Rose−Hudgins: Bank Management and Financial Services. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. large CDs. As this ratio grows. 2008 Part Two Financial Statements and Financial Firm Performance just around the corner. Financial Statements and Financial Firm Performance 6. examiners representing the regulatory community may become more concerned because loans are usually among the riskiest of all assets for depository institu-tions. where most of the world’s leading financial institutions offer their services today. Market Risk In market-oriented economies. Faced with liquidity risk a financial institution may be forced to borrow emergency funds at excessive cost to cover its immediate cash needs. Very few financial firms ever actually run out of cash because of the ease with which liquid funds can be borrowed from other institutions. Heavier use of purchased funds increases the chances of a liquidity crunch in the event deposit withdrawals rise or loan quality declines. and other cash needs. and net worth of financialservice providers are constantly in a state of flux due to uncertainties concerning market . significant decline in its liquidity position often forces a bank to pay higher inter-est rates to attract negotiable money market CDs. Standard remedies for reducing a financial institution’s exposure to liquidity risk include increasing the proportion of funds committed to cash and readily marketable assets. reducing its earnings. The final two credit risk indicator ratios reveal the extent to which a lender is preparing for loan losses by building up its loan-loss reserves (the allowance for loan losses) through annual charges against current income (the provision for loan losses). and commercial paper) to total assets. such as government securities. which are sold in million-dollar units and therefore are largely unprotected by deposit insurance. and cash items in the process of collection (mainly uncollected checks). and. Another popular and long-standing credit risk measure is: • The ratio of total loans to total deposits. therefore. which forces a depository institution to borrow funds at an elevated interest rate. Seventh Edition 178 II. so rare is such an event that when a small Montana bank in the early 1980s had to refuse to cash checks for a few hours due to a tem-porary “cash-out.

rates or prices. but not reputation or strategic risk. errors. 2• The ratio of book-value equity capital to the market value of equity capital. 4• The market value of common and preferred stock per share. rising interest rates can lower the margin of profit if the structure of a financial institution’s assets and liabilities is such that interest expenses on borrowed money increase more rapidly than interest rev-enues on loans and security investments. Others say it includes legal and com-pliance risk. Among the most widely used measures of interestrate risk expo-sure are these: 1• The ratio of interest-sensitive assets to interest-sensitive liabilities: when interest-sensi-tive assets exceed interest-sensitive liabilities in a particular maturity range. options. and similar events. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. We will examine these and other risk-management tools in Chapters 7. 2• For a depository institution. bankers and their competitors have developed several new ways to defend their earnings margins against interest-rate changes. Rose−Hudgins: Bank Management and Financial Services. and 9. losses are likely to be incurred if market interest rates rise. reflecting investor per-ceptions of a financial institution’s risk exposure and earnings potential. 8. Operational (Transactional) Risk Operational risk refers to uncertainty regarding a financial firm’s earnings due to failures in computer systems. Market risk is composed of both price risk and interest rate risk. misconduct by employees. In contrast. the ratio of uninsured deposits to total deposits. The consolidation and convergence of finan-cial firms and the complexity of today’s financial-services technology has made operational risk a broad risk category that needs to be addressed by both managers of financial firms and government regulators. lightning strikes. The impact of changing interest rates on a financial institution’s margin of profit is called interest rate risk. . when rate-sensitive liabilities exceed rate-sensitive assets. floods. For example. Financial Statements and Financial Firm Performance 6. Some analysts say that operational risk is the risk of loss due to anything other than credit or market risk. Among the most important indicators of price risk in financial institutions’ management are 1• The ratio of book-value assets to the estimated market value of those same assets. The broad group of actions included in this risk definition often decrease earnings due to unexpected operating expenses. where uninsured deposits are usually government and corporate deposits that exceed the amount covered by insurance and are usually so highly sensitive to changing interest rates that they will be withdrawn if yields offered by competitors rise even slightly higher. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 179 Price Risk Especially sensitive to these market-value movements are bond portfolios and stockhold-ers’ equity (net worth). including interest-rate swaps. a financial firm is vulnerable to losses from falling interest rates. 3• The market value of bonds and other fixed-income assets held relative to their value as recorded on a financial institution’s books. With more volatile market interest rates in recent years. and financial futures contracts. Interest Rate Risk Movements in market interest rates can also have potent effects on the margin of revenues over costs for both banks and their competitors. Seventh Edition II. which can dive suddenly as market prices move against a finan-cial firm.

A financial firm’s owners. costly corrective actions must be taken to avoid its closure.bis. employees. For example. sometimes leading to devastating losses to otherwise well-managed financial institutions. computer hardware and software systems have become essential to the daily operations of most financial firms. reports. requiring employee intervention to reconcile and create Rose−Hudgins: Bank Management and Financial Services. The Bank. such as Rogue Trader. and the ultimate failure of some at-risk institutions.As technology has improved. heavy reliance by the institutio n’s personn el and custom ers on such systems creates vulnera bility for any financial firm. earthquakes. It’s about money. Foregone income from such disasters is unpredictable. These cor-rective actions are laid out in capital adequacy regulations and are examined in more detail in Chapter and by a related entity. resulting in unexpected operating expenses and greater variability in earnings. if a depository institution fails to hold adequate capital. While the failure of a new comput er system may be less likely. or other illegal acts. just as positive publicity may serve to promote a financial firm’s services and products. Reputation . Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. 107. acts of terrorism such as 9/11 and natural disasters such as hurricane s.htm. and tsunamis can lead to great loss for any financial firm. Reputation Risk Negative publicity. If computer systems involve a patchwork of old programs. Legal and Compliance Risks Legal risk creates variability in earnings resulting from actions taken by our legal system. can affect a financial firm’s earnings by dissuading customers from using the services of the institution. theft. the Basel Committee on International Capital Standards. at www. whether true or not. Unenforceable contracts. or adverse judgments may reduce a financial firm’s rev-enues and increase its expenses. and the basis for many “60 Minutes” episodes. Seventh Edition 180 II. misrepresenta-tion. Financial fraud provides the plots for great movies. then operatio nal risk may be high. Financial Statements and Financial Firm Performance 6. or outsiders may violate the law and perpetrate fraud. which is explored in detail in Chapter 15. and Boiler Room. Lawyers are never cheap and fines can be expensive! In a broader sense compliance risk reaches beyond violations of the legal system and includes violations of rules and regulations. lawsuits. stealing. 2008 Part Two Financial Statements and Financial Firm Performance Key URLs Many of the types of risk discussed in this section have been developed and refined by the Bank for International Settlements at www. Today .bis. cus-tomers. These natural and not-so-natural disasters may close financial institutions for extended periods and interrupt their service to customers.

lack of persistence.risk is the uncertainty associ-ated with public opinion. For example. which is designed to absorb such losses. often red Strategic Risk separately by government regulatory agencies. regulators may have no choice but to declare the institution insolvent and close its doors. Becaus e Variations in earnings due to adverse business variabilit decisions. then its equity capital account. lack of foresight. often Capital Risk not The impact of all the risks examined above can conside affect a financial firm’s long-run survival. risks to the capital that underlies every financial firm captures the all-important risk of insolvency or ultimate failure. may be over-whelmed. referred The very nature of a financial firm’s business requires to as its maintain-ing the confidence of its customers and capital risk. However. . creditors. if a bank takes on an excessive number of bad loans or if a large portion of its security portfolio declines in market value. or y in lack of responsiveness to industry changes are parts capital of what is called strategic risk. This risk category canstems be characterized as the human element in making bad from long-range management decisions that reflect poor other timing. If investors and depositors become aware of the problem and begin to withdraw their funds. improper implementation of deci-sions. and lack types of risk it is of determination to be successful. generating serious capital losses when sold.

forcing it to make crucial adjustments in policies and performance in order to calm investors’ worst fears. where a decline in equity funding relative to assets may indicate increased risk exposure for shareholders and debtholders. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 181 Filmtoid What 2000 film stars Paul Newman as an incarcerated bank robber who had stolen millions from the banks to which he sold and installed security systems and then returned to rob them? Answer: Where the Money Is. reflecting how well the current level of a fi-nancial institution’s capital covers potential losses from those assets most likely to de-cline in value.Rose−Hudgins: Bank Management and Financial Services. Purchased funds usually include unin-sured deposits and borrowings in the money market from banks. Economists call this phenomenon market discipline: interest rates and security prices in the financial marketplace move against the troubled firm. Risk assets consist mainly of loans and . deposito rs not covered by insuranc e also risk losing a substanti al portion of their funds. 4• The ratio of purchased funds to total liabilities. When investors believe that a financial firm has an increased chance of failing. An increase in that spread indicates that investors in the market ex-pect increased risk of loss from purchasing and holding a financial institution’s debt. Seventh Edition II. the prices and yields on capital stock and on large uninsure d deposits can serve as an early warning sign of solvency problems. This suggests that capital risk can be measured approximately by such factors as 1• The interest rate spread between market yields on debt issues (such as capital notes and CDs issued by depository institutions) and the market yields on government securities of the same maturity. This ratio often falls if investors come to believe that a financial firm is undercapitalized relative to the risks it has taken on. 5• The ratio of equity capital to risk assets. For this reason. The failure of a financialservice corporati on may leave its stockhol ders with none of the capital they committe d to the institutio n. the market value of its capital stock usually begins to fall and it must post higher interest rates on its borrowings in order to attract needed funds. and governmental units that fall due within one year. in the case of deposito ry institutions. Financial Statements and Financial Firm Performance 6. 3• The ratio of equity capital (net worth) to total assets. 2• The ratio of stock price per share to annual earnings per share. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. nonbank corporations. Moreove r.

has moved significantly higher relative to the industry’s assets and liabilities in recent years. its $1. respe ctively . all expressed in book$130 6–17. Some authorities also exclude depositor holdings of short-term government securities from risk assets y because the market values of these securities tend to be institution stable and there is always a ready resale market for them. s has Concern in the regulatory community over the risk exposure resulted in heavy pressure on their management to increase capital. andof miscellaneous assets.50. its 3 equity capital amounts to $110 millio million.324 million. The esti- millio n. Unins ured depos its amou nt to $243 millio n and mone . A bank reports that the total amount capita of its net loans and leases l are outstanding is $936 million. while nonperforming loans currently amount to $43 Concept Check mated million and the bank just charged 6–16.securities and exclude cash. The bank’ s stock is curre ntly value d at $60 per share with annua l pershare earnin gs of $2. value. Calculate banks and their financial-servicet as many of the risk measures as competitors subjected today? you can from the foregoing data. capital. y-market borrowings total $132 million. plant and equipment. at least in the banking industry. and it holds $1.44 assets total $1. value What items on a bank’s balances of the sheet and income statement can be bank’ used to measure its risk expo-sure? s total To what other financial institutions asset do these risk measures seem to s and apply? equity 6–18. As we saw earlier in this chapter.150 million n and in deposits. To what different kinds of risk are marke off $21 million in loans.

increased growth.Rose−Hudgins: Bank Management and Financial Services. Among the most revealing mea-sures of operating efficiency and employee productivity for a financial institution are its Total opera Operating efficiency ratioTotal o N et operating income Employee productivity ratio Number of full-time-equivalent employees Not all financial firms pursue high and mutual . 2008 Part Two Financial Statements and Financial Firm Performance Other Key URLs Goals Performance data on banking’s closest competitors— in nonbank depository institutions—can most easily be found at such Web sites as www. This usually means reducing 6–3 Perf lowe r Factoid In recent years FDIC-insured savings associations (savings and loans and savings banks) have had operating expenses and increasing the productivity of their employees through the use of automated equipment and improved employee training.ncua. enjoy more fringe Several recent studies have found. especially employee salaries and benefits and overhead costs.ots. There is considerable evidence that some institutions prefer greater market power in the markets they serve. Financial Statements and Financial Firm Performance 6. Seventh Edition 182 II.treas. finance and credit-card companies. ormance Indicators Competitors among Banking’s Key Many of thebanks and theirincl performance nonbank competitors. many financial firms recognize the need for greater efficiency in their operations. to pay higher interest costs for their funds and encouraged management to reduce noninterest costs. that some banks in this situation display expense preference behavior: They spend more on salaries and wages of management and staff.” or face less risk of losing earnings or market share. or greater efficiency as key goals. insurance companies. but also because a financial-service provider with greater market influence can enjoy a more “quiet life. maximum stock values. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. Unfortunately for the stockholders of these institutions. maximize profitabilit y and the value of the sharehold ers’ investme nt in a finan-cial institution. for example. security broker and dealer firms. ng and Finan cialServic es Manag Factoid ement Which banks tend to be most efficient in controlling costs and In an revenues? Answer: Usually medium-size and larger effort to institutions (over $100 million in assets). not only because it gives them increased control over prices and customer relationships. The government deregulation movement has forced depository institutions. a preference for expenses sacrifices profits and limits potential gains in stock values. for example.fdic. or build larger and more sumptuous indicators discussed inThis is espe-cially trueng the foregoing sectionsof those nonbanksto apply equally well forfinancial institutionsckh measuring thethat are private. however. profit-old performance of bothmaking owned thrift institutions. and Banki www. www.

31 i e N Net l percent versus 1.87 percent for S savings associations.perf ance indicators thatapplicable to pri-ma Among the key bankorm often are equallyvately owned. p example. but not by much. o Why do you think these m differences exist? r g i n assets to equity capital ratio Book-value assets to market-value assets Equity capital to risk-exposed assets A s s e t each nonbank financialservice e industry. p r e f e r r e d 10.17 percent n s operating e i for savings associations and g margin t an average ROE of 13. m key a performance nc measures e include in growth of net di premiums ca written to measure rs total ar and the size of e life u pension ni reserves (their q u e to For the (a of sales) and s t o c k yields on the financial firm’s debt and market yields on government securities g nonbank financial firms are these: . er among fo insurance r companies. profit-kin assets and equity returns P stock E Return on than insured commercial a r Return on equity u banks. for all of 2004 n (ROA) (ROE) commercial banks reported c i an average ROA of 1. For r i assets capital t example.80 z s o percent versus Equity a n multiplier i t p Cash n i e c accounts to t r o o total assets e n m Interests r m sensitive h e o r assets to a s n a interestr t t sensitive e a liabilities i n m Interest-rate o o d a spread between f Nonperforming funds.

the most profitable banks in terms of ROA were banks with more than $1 billion in assets and less than $10 billion in assets. Finally. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 183 chief liabilities) relative to total assets. many of which reflect the various kinds of risk exposure banks face. as Table 6–4 shows. because loans are often among a bank’s least liquid assets. the largest banks generally report the highest (least negative) nonin-terest margins because they charge fees for so many of their services.. Among mutual funds. key performance markers include the growth of net sales (i. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. Measuring and © The McGraw−Hill . key earnings and risk measures change dramatically as we move from the smallest banks (those in the table with assets of less than $100 million) to the largest banking firms (with assets exceeding $10 billion). Financial Statements and Financial Firm Performance 6. Rose−Hudgins: Bank II. Smaller banks appear to be more liquid. a larger proportion of small and medium-size banks’ loans tend to be higher-interest consumer loans. Moreover. For example. as reflected in their lower ratios of net loans to deposits. Financial Statements 6. while the largest equity returns (ROE) were obtained by the very largest banks with more than $10 billion in assets in 2005. Most of the performance ratios presented in this chapter are highly sensi-tive to the size group in which a financial institution finds itself. the smallest banks usually report higher ratios of equity capital to assets. Seventh Edition II. 6–4 The Impact of Size on Performance When the performance of one financial firm is compared to that of another. The biggest banks also appear to carry greater credit risk as revealed by their higher loan-loss (net charge-offs to total loans and leases) ratios. in the case of a depository institution. among com-peting depository institutions. In contrast. both the public and the regulatory com-munity clearly do. home mortgage loans to total assets (a rapidly growing credit ser-vice). Even if some financialservice institu-tions don’t seem to care about their performance. For example. Insurers also pay close attention to an efficiency measure—the combined ratio of claims paid out plus operating expenses relative to premi-ums earned from policyholders. On the other hand. service fees relative to aver-age assets. key performance measures include total loans to members relative to capital reserves (a measure of risk). “size bias” is especially evident in the banking industry. middle-size and large banks with assets ranging from $100 mil-lion to $10 billion in total assets often display the most favorable net operating margins and the best operating efficiency (often with the lowest operatingexpense-to-revenue ratio).Rose−Hudgins: Bank Management and Financial Services. In terms of balance-sheet ratios. Thus. Smaller and medium-size banks frequently display larger net interest margins and. 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-hedg-ing tools at their disposal.e. therefore. greater spreads between interest revenue and interest costs because most of their deposits are small-denomination accounts with lower average interest costs. and the number of actual members (customers) relative to potential members (customers). total deposits— becomes a critical factor. finance and credit-card companies often pay close attention to the growth of their outstanding debt and their gross receivables (a measure of total loans extended to customers). No financial institution can safely ignore its level of performance today relative to its past performance and relative to its competitors. and the rate of return on funds invested. Similarly. such as credit unions and mutual savings associations. gross sales of shares less share redemptions by the public). size—often measured by total assets or.

One reason is that similar-size financial firms tend to offer the same or similar services.23 5.60 1.68 1.89 –1.40 0.31% 12.36 1.99 0.56 Notes: Data for all U. we should also compare financial firms serving the same or similar market areas.31 85.40 1.34% 13.69 1.59 –1. if not impossible. Return on assets (ROA) Return on equity (ROE) Net operating income to assets Net interest margin Net noninterest margin Efficiency ratio Credit loss provision to net charge-offs Net charge-offs to loans Loss allowance to loans Noncurrent assets plus other real estate owned to assets Net loans and leases to deposits Equity capital to assets Yield on earning assets Cost of funding earning assets Noninterest income to earning assets Average for All FDICInsured Institutions Average for All FDICInsured Banks Banks Arrayed by Total Assets in the Size Range Under $100 $1 Billion Greater $100 Million to $10 than $10 Million to $1 Billion Billion Billion 1. Finally.56 83.82 0.42 –0.52 1.15 3. For example. and Regulatory Bias in Analyzing the Performance of Banks and Competing Financial Institutions As we saw in the preceding section.99 2.50 1. Even in the United States.26 1. Similarly. Seventh Edition 184 and Financial Firm Performance Evaluating the Performance of Banks and Their Principal Competitors Companies.70 1.23 91.34 0.76 10.05 57. in the banking community each regulator has a somewhat different set of rules banks must follow.80 0. Unfortunately. The best performance comparison of all is to choose institutions of similar size serving the same market area.09 0.34 0.41% 13. To conduct even more valid performance comparisons.01 10.32 115. preferably a community with comparable businesses and households because the character of a financial firm’s customer base significantly impacts how it performs.34% 13. The financial analyst will then usually look for another community with a similar-size financial institution.38 183.48 92. analysts often stress the importance of comparing member banks of the Federal Reserve System against other member banks of the Federal Reserve System. For example.05% 8.01 57.74 10.16 1.09 1. This is why comparison of financial firms in different countries is often so difficult and must be done with great caution. or rural area.26 1.32 4.49 87. smaller city.46 2. commercial banking and savings institutions whose deposits are FDIC insured.50 87.12 1.66 0.43 148.S.33% 13.15 1.44 0. *Figures shown are for the first 2 quarters of 2005 and are annualized. Size. or equity capital) can have a highly significant impact on profitability and other performance measures.25 –2.50 1.45 92. Location.72 74.32 3.87 5.45 2.80 1.35 56. the performance of national .82 0. where possible. deposits.94 0.44 1.22 10. with so many different regulatory agencies.20 1.35 1.21 11.47 0.41 3.89 1. in some smaller communities it may be difficult.27 3.02 1.84 1. to find another financial firm comparable in size.74 56.Management and Financial Services.09 61.10 5.67 1. Performance is usually greatly influenced by whether a financial-service provider operates in a major financial center.38 5.02 1. it’s a good idea to compare financial institutions subject to similar regulations and regulatory agencies.51 –1.23 –2.29 10.05 1.32 3.60 68. and these government-imposed rules can have a profound impact on performance. the size of a financial institution (often measured by its assets. it is best to compare institutions of similar size. so you can be a bit more confident that your performance comparisons have some validity.74 92. when we compare the performance of one financial firm with another.13 6.05 4.87 5. 2008 Part Two Financial Statements and Financial Firm Performance TABLE 6–4 Important Performance Indicators Related to the Size and Location of FDIC-Insured Banks (2005) * Source: Federal Deposit Insurance Corporation.

F The i perforn mance analys a t mustn make c his or i her best a effort l to find the most R compaa rable andt with i i c o a s l a T n o d o l O s t h t e o r T A r n a a c l k y t B .Rose−Hudgins: Bank Management and Financial Services. locatio U n. particularly by credit quality of financial institutions is Thomson’s BankWatch. to 27: Strong ability to repay. ThereNo is an oldtwo saying finan about cial avoiding firms comparin are g applesever and exact BankWatch ratings of credit worthi-ness include these: 29: Subordi nated to CCC obligations with less risk protection. appears to top or nearer the bottom of each lie nearer therating would be chartered helpful. firms. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. TBW-2: Strong likelihood of timely repayment of principal and interest. uncertainty 28: Likeliho and greater od of default just likelihood of above investment default than highergrade with some for rated issues significant uncertainties affecting the capacity to repay. where would d against you look? The data that of supplied by the other American Council of national Life Insurance at www.beca it can beuse revealing of to their compare obvio its per-us formance differ with ence other s. assessing the likelihood that the capital notes of financial institutions issuing these obligations may not be able to pay. large depositors and those Thomson’s rates both short-term debt and long-term obliga-tions who purchase the stock and (debt and preferred stock). 2008 Insights and Issues BankWatch’s credit ratings are among the most widely CREDIT RATINGS BY THOMSON’S BANKWATCH. n or g custo mer base. TBW-3: Adequate capacity to service principal and interest in a timely way. ly institutions— alike then proceed in caution. If a financial firm is an Key URLs 53: Extremely high investment grade2: Hi rating with an gher degree acceptable capacity of to repay.iii. Inc. s servic i e menu. the holding same company is affiliates true rather in the than withfinan independ cialently servi owned ces institution field. depending upon rated whether the institution affiliate oforang a holdinges company. 1: Relatively strong ability to repay. Note: The long-term credit ratings capacity repay. the Insurance and Information Institute at statewww. where If you wanted to possible. Examples of Thomson’s Long-Term Ratings Short-Term Ratings TBW-1: Very high likelihood of timely repayment of principal and interest. institution s should be compare d against other statelicensed institution s. Seventh Edition II.acli. INC. TBW-4: Noninvestment grade and speculative in nature. 54: Lowest may be marked with a + or a – banks. D: Defaulted obligation. and by banks. . Financial Statements and Financial Firm Performance 6. followed risk indicators One of the most widely respected private institutions that rates the anywhere. s. compare the overall should profitability of the be insurance industry to that of the banking compare industry. 55: High likelihood of default.

which iswhich sent quarterly to allpermit federally supervisedcompariso banks. capital. and information forstate financial analysts. Supple mentary items in r the UBPR f include o breakdow ns of loan r and lease m commitme a nts. available aboutwhich banks than any otherallow them type of financial firm.reports. the Federal comparabl Deposit Insurance e size.between e an individual bank and the combined financial statement s of all banks in a given state. and more information isreports. An important added feature is that a banker can acquire the UBPR report for any . Corporation. analysis of n problem c loans and e loan — losses. Bankers P can also R obtain Compared to otherpeer financial institutions. the average Office of Thrift Supervision. and expenses . to comThrough the pare their cooperative effort of bank with four federal banking other agencies—the institutions Federal Reserve of System. Office of thewhich Comptroller of theprovide Currency—the Uni-mean ratio form Bankvalues for Performance Reporteach peer (UBPR) provides keygroup.a n k P liabilities. reports eachns bank’s assets. revenues . and a T profile of h each e bank’s exposure to risk and U its sources B of capital. The UBPR.

48% –16.87 9.271. with total assets exceeding $52 billion on December 31. Agricultural loans 5.324. 20. Commercial loans 3.363 86.143 2.387 234.717.581 –236.26 other federally supervised bank.89 325.77 297.41 –13.588 $6.45 14.817 7.98 17.563 7. Loans and leases in foreign offices 7.276. U.884 9.806 47. which increased the prices of homes and other properties while increasing the demand for real estate loans.388 599. Individual loans 4.625. Gross loans and leases 8.420 85 984.86 8.372 463. To get a better picture of the type of information in the UBPR.264.259. Financial Statements and Financial Firm Performance 6. Items (dollar amounts in thousands) Assets 1. are focused on a single bank. The lowered interest rates and disappointing stock returns inspired consumers to invest in real estate.369 639.317 212. 2004.984.022 146.982 18.259 0 –518. Other loans and leases in domestic offices 6.672.168 –18.738 592.08 10. Total earning assets 20. Premises.731 0 2. reduced short-term interest rates 13 times from 2001 to 2003 as they tried to stimulate a sluggish economy. using data found at the FDIC’s Web site.894 8. the Federal Reserve System.S.312. The 10-year Treasury bond yield dropped to a 45-year low in June of 2003. Federal funds sold and resale agreements 17.15 22626. Ohio. Investments in unconsolidated subsidiaries 24.103. Loans held for sale 28.307 –16.393 2.26 16. Interest-bearing bank balances 16.899 0 2.705 511. In Chapter 5.741 1.946.65 137. however. Other real estate owned 23.958.974. NCB is a large national bank located in Cleveland.24 –96.293 78 1.067 193.318 41.67 –17.694.232.539 –1.130 514. Foreign debt securities 14.394 37. but similar to the financial statements presented in Chapter 5.760 210.733 1.259 –726.076 4. we examined the aggregate numbers for all the banks in this holding company. we should recall that the U.932 3. we present an example based on the 2004 and 2003 UBPRs of the lead bank for National City Corporation.526 6.209.179 –1.902 0 3. Noninterest-bearing cash and deposits due from other banks 21.023. As the econ-omy slowly recovered from the .Rose−Hudgins: Bank Management and Financial Services.090 –60.945 3. Less: Loan and lease loss allowance 10. Municipal securities 13. capital leases 22.544 25.S.152.112 272.577.10 –18.698.15 1. Available-for-sale securities 12/31/2004 12/31/2003 $ Change Percentage Change $24.913 $52.392 –78.501 $46.909 66.002.18 10.91 –0.275 37.058 5.181 27. Acceptances and Other assets 25.30 5.03 91. Trading account assets 18.84 –16.496 8. fixed assets. Less: Unearned Income 9.284 25. cen-tral bank.689 38.24 5.ffiec.058 46.643 23. All other securities 15. Net loans and leases 11.811.395 $3. Total assets Memoranda: 26. To put this analysis in context.907 7.987 6.152 1.50 –23.916 1. How well or how poorly has NCB performed in recent years? We will examine this bank’s financials for 2003 and 2004 in order to provide insights regarding this 40. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies.948 –64.536 12.127 7 –248. The financial statements we see in this analysis. National City Bank (NCB).792.799. Treasury and agency securities 12. The format of the UBPR is more detailed and extensive. 2008 Part Two Financial Statements and Financial Firm Performance TABLE 6–5 The Assets Section from the Balance Sheet for National City Bank Source: Uniform Bank Performance Reports (www.144 16.97 –20.011 6.633.646. Noninvestment other real estate owned 27.902 749.519 6.85 –8. thus enabling comparison of banks in the same market area subject to the same environmental conditions.643 0 2. Seventh Edition 186 II.851.897 1. Total investments 19.763 558.369 276.728 3.087. Held-to-maturity securities 29.11% 6.417 42.912. Real estate loans 2.168 0 –419.539 $21.

598 1.006 1. investors and lenders talked about whether a real estate bubble was about to burst! Tables 6–5 through 6–9.219.346 41.000 6. Other savings deposits 5.618 3.343.11 percent or $3.988 1.852. Core deposits 7.91 169.395 2.902.919. representing stable funds that are less likely to be removed from the bank.527 5.611.888.883 4.224 189. In a period characterized by low. the Federal Reserve began to Rose−Hudgins: Bank Management and Financial $4. Total deposits 10. In 2004 NCB increased its real estate loans (item 1) by 16.64 recession of 2001.984 159.25 53.652.881.102 5.6 billion for an annual growth rate close to 14. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 187 slowly increase interest rates in 2004.761.348.000 or more 8.873. Table 6–5 indicates that NCB focuses on traditional banking services with $41.213. All common and preferred capital $3. Subordinated notes and debentures 18.777. we find that net loans and leases (item 10) increased by $4.318. Federal funds purchased and REPOs 11. Time deposits under $100.7 bil-lion in net loans and leases (item 10).763 1. a concept introduced earlier in this chapter and discussed in detail in Part Three of this book.512 7.768 –1. Other borrowings with maturities greater than 1 year 15.92 –1.938.783.809 Percentage Change –10.4 billion. Money market deposit accounts 4. but volatile interest rates.551 576. taken from UBPR reports for 2004 and 2003.274.98 percent).585 2. In terms of growth. NCB’s assets increased by more than $6.764 3.820.534 1.253 9.66 10.335 80. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies.388 22 1.387 784. Essentially.34 .713 244.87 68.064 –20.01 –31.701 6.655. and capital items held by this bank and show how these items and their components have increased or decreased in volume since the same time a year earlier. liabilities. Total liabilities (including mortgages) 17.07 13. Core deposits also tend to be TABLE 6–6 The Liabilities and Capital Section from the Balance Sheet for National City Bank Source: Uniform Bank Performance Reports (www. while the balances in most other loan categories (items 2–5) increased or decreased by smaller dollar amounts.87 5.5 percent (Table 6–5.673 24. government and private bonds) were offering histori-cally low returns.02 billion (10.641. Items (dollar amounts in thousands) 12/31/2004 12/31/2003 Liabilities and Capital 1.259 1. All NOW and ATS accounts 3.895 20.37 –32.413.139.01 percent) in total deposits (Table 6–6.934. NCB’s deposit growth and its growth in nondeposit liabilities more than covered the growth in its loan portfolio.291 27.16 –8.880.122. Core deposits are the sum of items 1–5 in Table 6–6. Financial Statements and Financial Firm Performance 6. are used to assess the performance of NCB.087.219 2.56 –0.002 –726.21 billion rise (13.839.244 47.903 $ Change –$474.37 2.86 1113563.e.149.709 6. The sources of funds supporting this growth included a $3. FHL borrowing with maturities greater than 1 year 13. up more than 53 percent.746 4.46 30. If we examine the asset items having the largest dollar increases.201. while core deposits (item 6) increased a mere 2.434.87 percent. Acceptances and other liabilities 16. Time deposits of $100.98 13.797.88 billion increase (169.67 per-cent) and total investments (item 18) increased by $3 billion (91.281.375 1.193 2.ffiec.490. Demand deposits 2.008 –613.627 142.425 4. FHL borrowing with maturities less than 1 year 12.705.675 245.344 20.064.91% 42.475. Deposits in foreign offices 9. Tables 6–5 and 6–6 indicate the principal assets.606 3.768 4.978 –40.979 880.592 2.820 867. The increased proportion of real estate loans would most likely increase the average maturity of the bank’s loan portfolio and also increase its interest-rate risk exposure. NCB provided what customers wanted—financing for housing at a time when prices in the stock market were declining and securities (i.73 percent) in other borrowings with maturities greater than one year (item 14). item 9) and a dramatic $4.433 8.889 270. line 25). Seventh Edition II. In Table 6–6 we see that deposits in foreign offices (item 8) increased significantly. Other borrowings with maturities less than 1 year 14.257 2.

48 percent (sum of items 17 and 18) and the peer group reports 8. Given that their checkable deposits are comparable—NCB has 8.91 percent in 2004. want to have enough liquid assets to meet their needs without oppressing profitability with excessive funds invested in relatively low-yielding instru-ments.. In 2003 and 2004.01 percent or $3. As interest rates began to rise. Seventh Edition 188 52.276. Because loans often represent the highest-yielding assets a bank can hold. 7. regular savings deposits. the peer group has about twice the por-tion of liquid assets relative to total assets. From this point on. As market interest rates increased the growth in core deposits subsided and NCB apparently worked to lock in longer-term nondeposit borrowings. negotiable order of withdrawal (NOW) accounts. like other firms. In contrast. we find that interest-bearing liquid assets and cash assets accounted for 13. Table 6–7 shows the composition of assets and liabilities held by NCB. liquid assets accounted for 28. and presents analogous information for a peer group of banks.698. and time deposits of less than $100.56 percent—the .85 percent) in Federal funds sold and resale agreements (Table 6–5. driven by a sharp advance (137. The peer group used for NCB consists of all national banks with average assets in excess of $3 billion.74 percent increase in net loans and leases relative to average assets. NCB apparently increased the liquidity of its investment portfolio by changing its composition while nearly doubling the overall size of that portfolio. For NCB we see relatively small changes in asset composition in Table 6–7. we note from Table 6–7 that NCB holds a significantly smaller proportion of core deposits (item 22) than the peer group of banks. NCB has slightly decreased its holdings of liquid assets (short-term securities and cash assets). using averages across the four quarters of the year.47 percent in 2003 and 58.61 percent of assets in 2004. our dis-cussion will focus on average data for NCB and its peers. NCB reported substantial growth in security investments. Financial Statements and Financial Firm Performance 46.17 percent of assets at peer institutions. On the sources of funds side. as reported in the UBPR. Total liabilities and capital Rose−Hudgins: Bank Management and Financial Services. 2008 Part Two Financial Statements and Financial Firm Performance among the least expensive sources of funds. total deposits (item 9) increased by 13.2 billion.974. NCB’s higher loan-asset ratio would be expected to produce relatively higher earnings than the average earnings for the peer group. The cost of MMDAs is comparable to the cost of many nondeposit sources of funds. Overall. include demand deposits.34 percent as 2004 ended—a 3. NCB increased its borrowings with maturities greater than one year (item 14) which soared upward by nearly $5 billion. the possibility of a cash-out) than is warranted? Banks.41 percent at the end of 2003 to 81.894 14. money market deposits. Liquidity choices on the asset side of the balance sheet teamed up with increases in long-term nondeposit borrowings as sources of bank funds to help this large banking firm get ready for rising market interest rates. Net loans and leases as a percentage of average assets (line 4) increased from 78. including the largest 170 banks in 2004 and biggest 163 banks in 2003. However.11 percent and 27. If we sum the percentages for items 5. in both years larger percentages of assets were accounted for by loans at NCB than was true for its peer group who reported ratios of net loans and leases to average assets of only 58.48 © The McGraw−Hill Companies. Core deposits. 9. Measuring and Evaluating the Performance of Banks and Their Principal Competitors 6.000.19. and 11 in Table 6–7.25 percent of assets in 2003 and 11.916 II.e. Their needs for funds are usually derived from their customers’ needs for funds where the customer draws down loan commitments (off-balance-sheet items that become on-balance-sheet assets) or withdraws deposits. item 16) and a very large gain in interest-bearing bank balances (item 15).022 6. The changes in assets and liabilities that we discussed in Tables 6–5 and 6–6 are based on year-end numbers whereas the percentages in Table 6–7 represent averages that tend to reduce the effects of seasonality and window dressing. The difference is derived for the most part from money market deposit accounts (MMDAs) (in item 19). Could NCB’s management be accepting greater liquidity risk (i. 6.

29 percent in June 2004.37 0.01 21.00 79. Money market deposit accounts 20.47 0. The federal funds rate dropped below 1 percent in December 2003 and then climbed to 2.50 99.82 8.34 8.28 percent by year-end 2004.ffiec.23 percent in June 2003.29 12. Net loans and leases 5.50% 0.05 percent. Subtotal 16. we see that total other borrowings are significantly higher for NCB than for the peer group.02 2.05 0.24 0.83 0.62 89.62 9. Lease financing receivables 3.43 1. Total assets Liabilities 17. Turning to NCB’s statement of earnings and expenses (Table 6–8).93 9.80 2.00 8. Other real estate owned 14.52 3.48 100. Subordinated notes and debentures 33.67 8.63 0.99 1.63 2.59 1. Acceptances and other liabilities 31. Total federal home loan borrowings 28.30 41.59 53.46 2. fixed assets.34 2. Total liabilities (including mortgages) 32.39 5.28 0. Noninterest-bearing cash and deposits due from other banks 12.39 1. we must recall the changing interest rate environment from the beginning of 2003 to the conclusion of 2004.95 4.71 percent.34 9.64 22.84 22. The 30-year home mortgage interest rate dropped to a low of 5. Memo:Short-term noncore funding 30.42 19. Available-for-sale securities 10.26 78.02 90.49 10. Demand deposits 18.91 9. Other savings deposits 21. All NOW and ATS accounts 19.71 8.11 89. NCB has substituted nondeposit borrowings for money market deposits compared to its peers.17 81.43 17. All common and preferred capital 34.34 1. Federal funds purchased and REPOs 27.53 0.19 0.06 0. Total loans 2.81 2.39 100.01 1.85 2. Total other borrowings 29.82 9. When we look at nondeposit liabilities.00 4.64 99.83 6.42 8.05 5.45 21.35 8.56 percent—a favorable result—total interest expenses also increased. Rose−Hudgins: Bank Management and Financial Services.lower proportion of core deposits does not necessarily indicate excessive funding costs. capital leases 13. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies.36 54. Interest rates hit bottom in 2003 and then began to rise slowly. In an ideal world we would like income to .92 100.65 1.34 17. Total earning assets 11.55 87.000 22. Federal funds sold and resale agreements 7. To some extent.80 9. Total liabilities and capital NCB 12/31/04 Peer 12/31/04 NCB 12/31/03 Peer 12/31/03 82. Financial Statements and Financial Firm Performance 6. Less: Loan and lease loss allowance 4. Seventh Edition II.13 1.27 3.10 89.05 5.09 0.16 100. Trading account assets 8.99 6. Deposits in foreign offices 25.73 8.65% 0. Premises.99 6.76 2.18 1.00 9.86 53.16 4.81 3.03 90.68 1.08 0.98 10.61 0.93 100.73 9.46 90. Total deposits 26.00* 6.00 58.85 1.86 58.81 22. While total interest income (item 16) increased by 11. Interest-bearing bank balances 6.68% 1.22% 1.03 2. rose to a high of 6. and ended that year at 5. Held-to-maturity securities 9.00 4. Time deposits of $100.19 100.03 0. Core deposits 23.62 21.12 2.36 3. Time deposits under $100.000 or more 24.02 7.19 0.08 2.07 2.02 1.47 4.04 67.87 2.40 45.03 0.77 26.00 57.38 5.00 8.75 53. Acceptances and other assets 15.01 5.85 0.41 0.97 10.90 6.14 6.00 * Figure is less than 0.84 2.94 68. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 189 TABLE 6–7 Percentage Composition of Assets and Liabilities for National City Bank and Its Peer Group (all figures are percentages of average total assets) Source: Uniform Bank Performance Reports (www. Assets: Percentage of average assets 1.91 24.84 3.91 0.46 90.97 22.

40 13.140 208. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies.393 4. 22. 8.806 989 0 422. 13.225 5.020 0 3. 6.562 759.620 2.342.449 43.00 –12.241 493 15.143. Financial Statements Management and Financial and Financial Firm Services.379 13 35.69 0.37 12.00 64.851 0 25.944 783. 7.00 101. 42. 23.50 0.147 1.239 1.644 4.63% 18.310 2.ffiec.47 –50. 5. 35.743 36.222 11 50.927.60 3. 19. 37.688 4. 18. 25.160 88. 31.472 0 34. 36.615 1.00 31. 2. Items (dollar amounts in thousands) 12/31/2004 12/31/2003 Percentage Change 1.558.542 102 2. 15.16 219. (We will soon be exploring the effects of these correlations in Chapter 7.817 920 0 209. 38.171. 27.000 Interest on all other deposits Interest on federal funds purchased & repurchase agreements Interest on trading liabilities and other borrowings Interest on mortgages and leases for other property & equipment Interest on subordinated notes and debentures Total interest expense Net interest income (tax-equivalent basis) Noninterest income Adjusted operating income (tax-equivalent basis) Noninterest expense Provision: Loan and lease losses Pretax operating income (tax-equivalent basis) Realized gains/losses on held-to-maturity securities Realized gains/losses on available-for-sale securities Pretax net operating income (tax-equivalent basis) Applicable income taxes Current tax equivalent adjustments Other tax-equivalent adjustments Applicable income taxes (tax-equivalent basis) Net operating income Net extraordinary items Net income Cash dividends declared Retained earnings (addition to) go up and expenses to go down. 20.752 0 5. especially when we are talking about interest income and expenses and both items are correlated with market interest rates. 21.333 73.196 25 127.616 802. 26. 9.65 7.654 64.317.71 26. 32.922 300.534.01 18. 10.071 976 2.15 –65.31 –16.351 2. Measuring and © The McGraw−Hill .079 7. 40.999 2.317 1.44 8.919 27 111. 2008 190 Part Two Financial Statements and Financial Firm Performance TABLE 6–8 National City Bank Income Statement (Revenues and Expenses) Source: Uniform Bank Performance Reports (www.248 188.243.949 150.922 0 552.00 128.949 $1.992 1.021 156.08 2. 14. $2.49 –0. 29.11 Interest and fees on loans Income from lease financing Tax-exempt Estimated tax benefit Income on loans and leases (tax-equivalent basis) Income from U.S.716 147. 12.084 86 1.968 19.14 6. 17.731. Seventh Edition Performance 6. the overall effect was an increase in NCB’s total interest expenses (item 24).47 0.744 421.63 –70. 16.812 69.019 518.00 7. This ideal situation is similar to the famous directive to investors to “Buy Low and Sell High”—simplistic in theory but hard to apply.091 33.21 7. 34.627 585.926 162.544 1.147 1.51 8.) Most interest income items (items 1 through 15 in Table 6–8) increased and.735 422.18 50.373 2.56 165.659 208. Rose−Hudgins: Bank II.75 102. 11. 41.01 0.000 576.998 909 1.639 762.149.170. Financial Statements 6. 33. 4. 28.71 –17. 24.18 –28.58 31. while the signs were mixed for individual interest expense items (items 17–23). 3.160.795 726.000 252.541 61.949 0 726.94 11.Rose−Hudgins: Bank II.66 50.02 –5.922 28.01 11.00 38. Treasury and agency securities Mortgage-backed securities (MBS) income Estimated tax benefit Income from all other securities Tax-exempt securities income Investment income (tax-equivalent basis) Interest on due from other banks Interest on federal funds sold and resales Trading account income Other interest income Total interest income (tax-equivalent basis) Interest on deposits in foreign offices Interest on time deposits over $100.26 907. 39. 30.737 552.

the net interest margin (NIM) increase s slightly as illustrate d by the following : . Seventh Edition and Financial Firm Performance Evaluating the Performance of Banks and Their Principal Competitors Companies.08 percent during the year. When net interest income is measure d relative to average total assets. which are NCB’ s net interest income (item 25) increase d by 11. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 191 Factoid Beginning in 1997 federal law allowed banks and other corporate financial institutions that qualify to become Subchapter S corporations.Management and Financial Services.

Avera ge assets borrowed funds Net interest margin 4 .Interest income from loans andInterest expense on security investments treated like partnerships for federal tax purposes.

gov).TABLE 6–9 Relative Income Statement and Margin Analysis for National City Bank and Its Peer Group (all figures are percentages of average total assets) Source: Uniform Bank Performance Reports (www.ffiec. .

31 4.05 2.39 1. Minus: Noninterest expense 6. Minus: Provision for loan and lease losses 7.59 0.97 0. Total interest income (tax-equivalent basis) 2.82% 1.89 0.67% 1. Net income adjusted for Subchapter S status 13.51 1. Plus: Noninterest income 5.89 0.306 thousand and for 2003 of $44.20 3. items 16 and 24.38 0. 5 The numerator is based on item 38 in Table 6–8 and the denominator is average assets as provided in footnote 4.31 1.22 3.01 1.27 2.51 1.24 1.17 3.28 1. Net income 4 The numbers in the numerator are taken from Table 6–8.00 1.57% 1.83 2.02 1.95 4.31 1. The denominator is average assets based on quarterly totals for 2004 of $48.794 thousand.31 1.51 1.72 1.43 2.28 1.95 0.76 2.46% 1. Less: Interest expense 3. Peer Group NCB 2004 2003 Peer Group 2003 4.73 2.23 1.28 1.01 1.29 1.61 1.NCB 2004 1.95 1.445. Net operating income 11.61 0.71 0.29 3.67 2. Equals: Pretax net operating income (tax-equivalent basis) 10.14 4.025. Equals: Net interest income (tax-equivalent basis) 4. Adjusted net operating income 12. Plus: realized gains/losses on securities 9.29 1.24 . Equals: Pretax operating income (tax-equivalent basis) 8.23 1.37 1.

Using this data we can calculate the EPS on a bank basis (using net income from NCB). the successes regarding interest income and noninterest expenses illustrated in the upper portion of Table 6–9 led to both higher net operating income (item 10) and higher net income (item 13) . Overall.51 percent increase in noninterest income (item 26). It outperformed its peer group on interest income (item 1) and noninterest expense (item 5) in both 2003 and 2004. Seventh Edition 192 II. net income (item 40) increased by a remarkable 31.18 percent decrease in the provision for loan and lease losses (item 29). management would certainly like to see this trend continue. According to Table 6–7 the loan and lease loss allowance to average assets (item 3) went from 1. Hence. Remem-ber this calculation is based on the net income for the lead bank divided by the number of shares of National City Corporation.996.749.18 per-cent to $514. caution in inter-preting these results is important.949. The loan-loss allowance account decreased 13. This tells us that the annual loan-loss expense was less than the actual volume of net charge-offs. NCB improved its performance in 2004.120 shares outstanding in 2003 and 646. the bank holding company. (Note: If you are a bit confused about what these accounts represent. Financial Statements and Financial Firm Performance 6. Outperformed means NCB’s interest income was higher as a percentage of its average assets and its noninterest expenses were lower as a percent-age of its average assets than comparable banks.000 646. How did NCB do relative to its peer group with regard to income and expenses? Table 6–9 provides a glimpse of an answer for this question. However.650 $1. please review the discussion in Chapter 5.000 605.91 pe The bank experienced a significant jump in stockholders’ earnings per share.749. while net interest income increased by 11. By this measure NCB outshines its peer group of banking firms. As we move further down the income and expense statement in Table 6–8 we see that. 2008 Part Two Financial Statements and Financial Firm Performance increased significantly: while NCB’s net operating margin rose by a whopping 21.47 percent! This was due to a small 2.Rose−Hudgins: Bank Management and Financial Services. the peer group’s comparable ratio increased by only 2.996. and a 65.34 percent. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. The lower noninterest expense indicates that management has succeeded in controlling overhead costs relative to its peer group.) NCB’s loan-loss provision expense of $147.922.318 thousand. NCB’s stockholders will probably be most concerned about the earnings per share (EPS) of stock that they hold. With a bank that focuses substantially on lending like NCB.66 percent increase in realized gains on available-for-sale securities (item 32). resulting in a smaller allowance account on NCB’s Report of Condition. National City Corporation (the bank holding com-pany) had 605. a 64. Management appears to be cashing in on the low loan losses that were characteristic of this time period.08 percent in 2004.17 percent in 2004.77 per-cent.650 shares of stock in 2004 (according to its annual report submitted to the SEC and accessible using the student version of S&P’s Market Insights and the associated Edgar link).26 percent in 2003 to 1.12 per share 2003 $552. Its EPS changed as fol-lows between year-end 2003 and 2004: EPS Net income Common equity shares outstanding 2004 $726.120 $0. Keeping this in mind.147 thousand was just over a third of the loss provision for the previous year. changes in the Report of Income’s provision for loan and lease losses (item 29) and the related loan and lease allowance for losses account (item 9 in Table 6–5) contained in the Report of Condition may provide some insights into the quality of the bank’s loan portfolio.

Equation (6–11) pro-vides the following breakdown using quarterly average figures for Report of Condition items: ROE Average assets ROA Average equity capital NCB’s ROE in 2004: 6 ROE 0 .relative to average total assets for NCB versus its peer group of banks in 2004. the We can expand this analysis a bit boar further using Equation (6–14) for d of ROE: direc tors expa nded the amo unt of equit y capit al throu gh incre ased profit s and redu ction s in stock divid end pay ment s. and (6–18) discussed earlier in this chapter. Financial Statements and Financial Firm Performance 6. We can explore NCB’s earnings further using Equa-tions (6–11).e. 0 6 0 . 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 193 NCB looks good relative to its peers and the profitability ratios are getting better. Seventh Edition II. Mana gem red in 2004 was half the 2003 dividend ent declaration and this tended to lower the and equity multiplier. the propo rtion of its asset s supporte d by debt) decre ased. Rose−Hudgins: Bank Management and Financial Services. The dolla r amo unt of divid ends decla . Cle arly. 2 2 8 0 o r 2 2 . NCB’ s ROE increa sed becau se its ROA —a meas ure of mana gerial efficie ncy— impro ved. At the same time NCB’ s use of levera ge (i. 8 0 % NCB’s ROE in 2003: 6 ROE 0 ..77 percent. ROA increased by 21. (6–14). 0 1 5 1  1 5 . Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies.

1933 inc 0 se 19.306. 3 whi 3 ch 0.880 0 Average assets Avera ge assets .025.64 percent of average assets where 20 ng average assets were 03.949 $ 3.025.38rea 0.188.445.860.306 48. rn 2 to 2 stoc 8 0 its khol der s (RO o E) r rise to ? 2 2 0.0644 15.464 $ 44.025. net $48. 7 7 pro Total operating revenue is item ROEfit .1914 or 0 6 16 plus item 26 from Table 6–8.159 $ $ 48.159 $ 3. For B’s 2004 average equity capital E in risi equaled 6.14% W .306 $ 3.445.120. an d (2) the ne arl y 1 per ce nt ris e in NC B’s as set utili zat ion rati o (op era tin g 6 . 54 per ce nt. The key fact ors d by 20. ma $ 2.794 $ 2 rgi n.80%we ROA is item 13 from Table 6–9 and for balance sheet items re: we use average assets as NC (1) reported in the UBPR and B’s NC derive average equity capital RO from item 33 in Table 6–7. hat 0 fact ors in 5 the 0 se ear nin 1 5 gs rela tion .794 $ 44.120. ship 0 s 6 cau sed NC 0 B’s retu .Net income ROE Total operating revenue Total operating revenue Average equity capital NCB’s ROE in 2004: 7 ROE $ 726.

38 0.659 0.149.6323 $ 1.794 0.306 $ 3. www. however. 8 Pretax net operating income is item 33 from Table 6–8. which rose further to nearly 37 cents in 2004.mhhe.922 $ 762. Its operations have generated higher revenues and lower expenses than its peers and this performance superiority generally broadened between 2003 and 2004. Analysis of ROE using Equation (6–18) emphasizes NCB’s record of expense control as illustrated by its rising net profit margin and improved asset management efficiency.445.1914 or 19.025.Rose−Hudgins: Bank Management and Financial Services. pointing to improved expense control. Financial Statements and Financial Firm Performance 6.50 percent in 2003 to 63. For every dollar of pretax operating income NCB paid out about 27 cents in taxes in 2003.120. Seventh Edition 194 II.888.744 0. 2008 Part Two Financial Statements and Financial Firm Perfromance revenues to average assets).0644 $ 44.2666 $ 2.794 $ 2.977 15.949 $ 1.7250 $ 762. On a brighter note.23 percent in 2004. we have utilized the tools developed in this chapter and NCB’s UBPR to get a better picture of the operations and management of this bank. These positive effects were mitigated to some extent by the 2.06 0.38 times to 15.880 15. In conclusion.2280 or 22.159 0.3685 $ 3.06 times. NCB appears to be more focused on the traditional business of lending than is the average large bank today.14% A glance at the breakdown of ROE above shows a decline in tax-management efficiency with net income to pretax operating income decreasing from 72.306 We have also noted that many of the measures of financial-firm performance provide key insights regarding the interindustry .744 $ 3.445.80% NCB’s ROE in 2003: ROE 8 $ 552.159 $ 48.025. the measure of expense-control efficiency (pretax net operating income to total operating revenue) advanced by more than 38 percent.08 percent decline in the equity multiplier from 15. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies.188. The relevant equation is: Net income Pretax net operating income ROE Total operating revenues Average assets NCB’s ROE in 2004: ROE Pretax net operating incom Total operating revenues Average assets Average equity capital 8 $ 726.0650 $ 48.464 S u m m a r y The principal focus of this chapter has been on how well banks and other financial firms perform in serving their customers and in providing acceptable returns to their owners.860.659 $ 2.464 $ 44.

mutual funds. . analyze the reasons for any performance problems that appear. finance companies. Increasingly. bankers and their competitors are being forced to assess their performance over time.competition today between banks. security brokers and dealers. and insurance firms. thrift institutions. and find ways to strengthen their performance in the future.

and the general public. . This financial report on individual FDIC-insured commercial and savings banks has become one of the most widely used performance summaries available to bankers. return on equity capital. net interest margin. Satisfactory profits and adequate risk controls preserve capital. and capital risk. interest-rate risk. and earnings spread) become important performance measures and significant managerial targets. 3• For smaller financial firms whose stock is not actively traded every day a number of key profitability ratios (such as return on assets. legal and compliance risks. Financial Statements and Financial Firm Performance 6. 6• The chapter concludes with a discussion of the Uniform Bank Performance Report (UBPR) available from the Federal Financial Institutions Examination Council. strategic risk. includ-ing the management and control of credit or default risk. 4• Pursuit of profitability must always be tempered with concern for risk exposure. noninterest margin. operational risk. The latter risk measure focuses upon the probability of ultimate failure if a financial firm is undercap-italized relative to the risks it faces. Seventh Edition II. customers. and income. focusing upon measures of expense control and the productivity of employees in managing assets. regulators.Rose−Hudgins: Bank Management and Financial Services. reputation risk. 5• Increasingly financial-service firms are adding operating efficiency to their list of perfor-mance criteria. 2• For the largest profit-oriented financial institutions the market value of their stock (equities) is usually the best overall indicator of profitability and risk exposure. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 195 Among the key points made in the chapter are these: 1• The two key dimensions of performance among financial-service firms are profitability and risk. revenues. providing a basis for a financial firm’s survival and future growth. liquidity or cash-out risk. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. mar-ket risk to the value of assets and liabilities held.

180 compli ance risk. 180 capital risk.www. 178 mar ket risk. 179 operati onal risk.mhhe. 180 reputat ion risk. 177 liqui dity risk. 170 cre dit risk. 178 inte rest rate risk. 180 UBPR. 179 legal risk. 180 strateg ic risk. 170 equ ity mul tipli er. Key Terms net prof it mar gin. 185 . 170 ass et utili zati on.

com/rose7e 1. a n d if th e a p pr o pr ia te ri s ka dj u st e d c o st of c a pi ta l (d is c o u nt ra te ) fo r th e b 2.r Problems and Projects e c e i v e a d i v i d e n d o f $ 1 2 p e r s h a r e a t t h e e n d o f t h e y e a r. If th is is tr u e. S t o c k a n a l y s t s h av e re ce ntl y pr e di ct e d th at th e b a nk ’s di vi d e n ds wi ll gr o w at a p pr ox im at el y 3 p er ce nt a ye ar in d efi nit el y int o th e fu tu re . D . a n S 3.

What must each institution’s return on equity capital be? What do your calculations tell you about the benefits of having as lit-tle equity capital as regulations or the marketplace will allow? Interest and fees on loans Interest and dividends on securities Total interest income Interest paid on deposits Interest paid on nondeposit borrowings Total interest expense Net interest income Provision for loan losses Noninterest income and fees Noninterest expenses: Salaries and employee benefits Overhead expenses Other noninterest expenses Total noninterest expenses Pretax operating income Securities gains (or losses) Pretax net operating income Taxes Net operating income Net extraordinary items Net income *Note: the bank currently has 40 FTE employees. Galloping Merchants National Bank Report of Condition Assets Cash and deposits due from banks Investment securities Federal funds sold Net loans (Allowance for loan losses = 25) (Unearned income on loans = 5) Plant and equipment Total assets Total earning assets $100 150 10 670 50 980 830 Liabilities Demand deposits Savings deposits Time deposits Federal funds purchased Total liabilities Equity capital Common stock Surplus Retained earnings Total capital Interest-bearing deposits Fill in the missing items on the income and expense statement. Financial Statements and Financial Firm Performance 6. The latest report of condition and income and expense statement for Galloping Mer-chants National Bank are as shown in the following tables: Galloping Merchants National Bank Income and Expense Statement (Report of Income) www.mhhe.85 percent. 2008 Part Two Financial Statements and Financial Firm Perfromance What is the value of the equity multiplier for each of these institutions? Suppose that both institutions have an ROA of 0. Seventh Edition 196 II. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies.Rose−Hudgins: Bank Management and Financial Services. calculate the following performance measures: ROE Asset utilization . Using these statements.

ROA Net interest margin efficiency .

Rose−Hudgins: Bank
Management and Financial
Services, Seventh Edition

II. Financial Statements
and Financial Firm

6. Measuring and
Evaluating the
Performance of Banks and
Their Principal

© The McGraw−Hill
Companies, 2008

Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 197

Net noninterest margin Expense control efficiency
Net operating margin Asset management efficiency
Earnings spread

Funds management efficiency

Net profit margin

Operating efficiency ratio

What strengths and weaknesses are you able to detect in Galloping
Merchants’ perfor-mance?
5. The following information is for Shallow National Bank:

Interest income
Interest expense
Total assets
Security losses or gains
Earning assets
Total liabilities
Taxes paid
Shares of comon stock outstanding
Noninterest income
Noninterest expense
Provision for loan losses





Please calculate:
Net interest margin
Earnings per share
Net noninterest margin
Net operating margin
Alternative scenarios:


1. Suppose interest income, interest expenses, noninterest income, and
noninterest expenses each increase by 5 percent while all other revenue
and expense items shown in the preceding table remain unchanged. What
will happen to Shallow’s ROE, ROA, and earnings per share?

2. On the other hand, suppose Shallow’s interest income and expenses as well as its
noninterest income and expenses decline by 5 percent, again with all other factors
held constant. How would the bank’s ROE, ROA, and per-share earnings change?

6. Blue and White National Bank holds total assets of $1.69 billion and equity capital of
$139 million and has just posted an ROA of 1.10 percent. What is the bank’s ROE?

Alternative scenarios:

1. Suppose Blue and White Bank finds its ROA climbing by 50 percent, with
assets and equity capital unchanged. What will happen to its ROE? Why?

2. On the other hand, suppose the bank’s ROA drops by 50 percent. If total assets
and equity capital hold their present positions, what change will occur in ROE?

3. If ROA at Blue and White National remains fixed at 0.0076 but both total
assets and equity double, how does ROE change? Why?

4. How would a decline in total assets and equity by half (with ROA still at
0.0076) affect the bank’s ROE?

remain fixed?

2. Suppose Monarch State’s total assets and total liabilities increase by
10 percent, but its revenues and expenses (including taxes) are
unchanged. How will the bank’s ROE change?

3. Can you determine what will happen to ROE if both operating
198 Pa


revenues and expenses (including taxes) decline by 10 percent, with
the bank’s total assets and liabilities held constant?

4. What does ROE become if Monarch State’s assets and liabilities
decrease by 10 percent, while its operating revenues, taxes, and
operating expenses do not change?

8. Suppose

a stockholder-owned thrift institution is projected to achieve a 1.25
per-cent ROA during the coming year. What must its ratio of total assets to
equity cap-ital be if it is to achieve its target ROE of 12 percent? If ROA
unexpectedly falls to

0.75 percent, what assets-to-capital ratio must it then have to reach a
12 percent ROE?
9. Saylor County National Bank presents us with these figures for the year
just con-cluded. Please determine the net profit margin, equity
multiplier, asset utilization ratio, and ROE.
Net income
Total operating revenues
Total assets
Total equity capital accounts

10. Lochiel Commonwealth Bank and Trust Company has experienced the
following trends over the past five years (all figures in millions of


Net Income

Total Operating

Total Assets






Determine the figures for ROE, profit margin, asset utilization, and equity
multiplier for this bank. Are any adverse trends evident? Where would you
recommend that management look to deal with the bank’s emerging
11. Wilmington Hills State Bank has just submitted its Report of Condition and
Report of Income to its principal supervisory agency. The bank reported net
income before taxes and securities transactions of $27 million and taxes of $6
million. If its total operating



2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 199 revenues were $780 million. ROE.1 billion. ROE. net interest and operating margins. determine the following for Wilmington: 1. the various mea-sures of earnings risk. what will happen to Wilmington’s efficiency ratio and ROE? 3. Interest income Interest expense Provision for loan losses Security gains (or losses) Noninterest expense Noninterest income Extraordinary net gains Total assets 13. Tax management efficiency ratio. and ROA. assets. What would happen to ROE and its components? 2. and capital risk were not discussed in detail. Alternative scenarios: 1. Asset management efficiency ratio. 4. its total assets $2. Funds management efficiency ratio. Are there any adverse trends? Any favorable trends? What seems to be happening to this institution? Gross interest income Interest expenses Noninterest income Noninterest expense Provision for loan losses Income taxes owed Net securities gains (losses) Total assets Current Year One Year Ago Two Years Ago Three Years Ago $40 24 4 8 2 1 –2 385 $41 23 4 7 1 1 –1 360 $38 20 3 7 1 0 0 331 $35 18 2 6 0 1 1 319 14. net profit mar-gin. Using this information for Lochness International Bank and Trust Company (all figures in millions). If total assets climb by 20 percent.Rose−Hudgins: Bank Management and Financial Services. Suppose Wilmington Hills State Bank experienced a 20 percent rise in net before-tax income. Financial Statements and Financial Firm Performance 6. Valley Savings reported these figures (in millions) on its income statement for the past five years. market risk (price risk and interest rate risk). and equity unchanged. What effect would a 20 percent higher level of equity capital have upon Wilmington’s ROE and its components? 12. However. and its equity capital $125 million. 2. Seventh Edition II. with its tax obligation. calculate the bank’s net interest margin. and asset utilization. 5. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. calculate each of these dimensions of risk for NCB for the most recent two years and Fou . Calculate the institution’s ROA in each year. Using the data in Tables 6–5 through 6–9. An analysis of the UBPR reports on NCB was presented in this chapter. 3. operating revenues. credit risk. We examined a wide variety of profitability measures for that bank. Expense control efficiency ratio. including ROA. noninterest margin. liquidity risk.

com/rose7e .com/rose7e www.discuss how the bank’s risk exposure appears to be changing over time. What steps would you recommend to management to deal with any risk exposure problems you observe? www.mhhe.mhhe.

S. Capital One Financial Group (COF). You can depend on S&P Industry Surveys concluding with sections on “How to Analyze a Company” and a “Comparative Company Analysis. In each category of financial firms found in the Comparative Company Analysis. see if you can determine which of these financial-service industries are outperforming the others in terms of returns on equity capital and risk exposure. Investment BB&T ( SunTrust Banks (www.mhhe. Please download S&P Industry Surveys for two of these financial sectors and review the How to Analyze and Comparative Company Analysis write-ups on each. Which would you recommend as a possible takeover target and why? be growing faster and why. identify the firm with the highest return on equity capital (ROE). Goldman Sachs Group (GS). Insurance Brokers. Consumer Finance. and the drop-down menu supplies several subfinancial-service indus-try selections. Using the Web site of the Federal Financial Institutions Examination Council (at www. (FBF).fdic. such as Asset Management & Custody Banks. Educational Version. S&P Market Insight Challenge (www. Check these claims out on the Web (for example. Regional and www. Life & Health Insurance. and Thrifts & Mortgage Finance.bankofamerica.wachovia.suntrust. Once an industry has been selected you will find downloadable S&P Industry Surveys. and Wells Fargo Bank ( it tends to be a middle-of-the-road performer. How do the ROEs compare across categories and subindustries? Are there any other performance measures that could be compared across financial-service sectors? Internet Exercises 2. As a result there is keen interest today in the compara-tive financial performance of firms in these four competing industries. and FleetBoston Financial Corp.amsouth. Property & Casualty Using the above company Web sites and other appropriate sites. Investment Banking and Brokerage. 1. you can compare the financial statements of such companies as MetLife Insurance Inc. Your instructor says that’s really not true. securities firms. and finance/credit-card businesses are battling for many of the same customers and for many of the same sources of capital to sup-port their growth and expansion. at www. covering such key financial-services sectors as Banking. Amsouth Bank (www.” To access these surveys use the Industry in the most recent year for which data is available. and Savings and Loans. Insur-ance: Property and Casualty. Today 1. (www. Diver-sified Banks. For example. see if you can deter-mine what happened to the earnings and credit risk exposure of Wachovia Corp. (MET).gov). The Uniform Bank Performance Reports (UBPRs) provide detailed 0 Pa rt T w o Fi na nc ial St at e m en ts an d Fi na nc ial Fi r m P er fr o m an ce financial perfor-mance data on all federally supervised U.wellsfargo. Financial Services Diversified.ffiec. Diversified Capital Markets. Who is right and what makes you think so? 20 3. You may find it useful to select certain firms from the Market Insight file to com-pare performances across these industries. Insurance: Life and Health. Using S&P’s Market Insight. insurance companies. A guest speaker visiting your class contends that Bank of America is one of the most profitable banks of its size in the United States. Multiline Insurance. determine which of these banks seems .

ge composition group. to illustrate trends (comparison of December 2004 with December 2003 bank data) and for comparative analysis (comparison of bank data with peer group data). Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. Write one comparing sources the of funds composition for your BHC with that of the peer group. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 201 R E AL N U M B E R S F O R R EAL BAN K S Assignment for Chapter 6 EVALUATION OF YOUR BANK’S PROFITABILITY Part One: A Performance Comparison to Peers In Chapter 6 we focus on the evaluation of financial statements. We used the UBPR for National City Bank. the formula for ROE entered in cell B54 would be: “=B52/B26”. and (3) utilizing the profitability developed ratios discussed in this chapter to evaluate management’s performance. Open ba Year the Year-toComparisons th e si . of assets for with the 5’s Real Numbers for for NCB 1. and Total Equity Capital. Write one paragraph discussing the us in paragraph Excel and the data in Rows 1 through 52 to cre-ate the entries. 4. Delete any numbers in Real Banks assignment columns D and E. Key profitability ratios are introduced and ROE and ROA are bro-ken down into component ratios to aid interpretation. In rows 54 through 58. calculate the key profitability ratios from Equations (6–4) through (6–8) in the chapter. Calculate the ratios for the most recent year in Column B and s p one paragraph comparing the components of income and expenses for your BHC with that of the peer group. Write in one paragraph asset the in for your BHC with R that O of the peer E 2. 6–6. (2) comparing your BHC with the group of peer banks using percentages the percentages-to-total assets data. 3. Financial Statements and Financial Firm Performance 6. the lead bank of National City Corporation. 2. Open your Excel Workbook and go to the spreadsheet con-taining Peer Group in Chapter dollar amounts for Year-to-Year Comparisons. Total Liabilities. The spreadsheet containing items expressed as information. Calculate the dollar changes in Column D provided and the Percentage Changes Tables 6–7 and 6–9. Seventh Edition II. Write one paragraph discussing the percentage changes in Total Assets. Comparisons 1. Write one paragraph comparing profitability across years. and 6–8 as examples for is very similar to the data what you are about to do. 3. then for the prior year in column C using the formula functions in ch an comparing 2. Rows 59 through 62 provide the framework for a break-down of equity returns using Equations (6–14) through (6–17) in this chapter. You will be eval-uating your BHC by (1) calculating percentage changes using your dollar data and interpreting this in Column E for each item. g thi s br ea kd o w n. Write For example. In co rp or at Part Two: A Breakdown of Returns e 1. Refer to Tables 6–5.Rose−Hudgins: Bank Management and Financial Services.

5. Rows 63 through 65 call for a breakdown of the net profit margin. . Write one paragraph discussing the change in ROA and its components for your bank.c equation and interpret the information for your bank. Write one paragraph discussing the components of the net profit margin for your bank and the implications of the changes occur-ring across the years. Rows 66 through 69 provide the framework for a breakdown of ROA (Equation [6–20] in this chapter). 6. as illustrated by Equation (6–18).

mhhe. and James Houpt.” The Canadian Banker. 8.. and Fabio Rose−Hudgins: Bank Management and Financial Services.” Federal Reserve Bulletin. D.” Journal of Economics and Business 50 (1998). Alton. 30–35. Natalucci. pp. Janu-ary/February 2003. Jill L.. Kristad.mhhe. see the following: 5.C.. R. Jeffrey. Gilbert. Moore. “Risk—Taking the Temperature and Finding a Cure. Vaughn. Wright. “Financial Statements and Reality: Do Trou-bled Banks Tell All?” Economic and Financial Review. “An Examiner’s View of Operational Risk. Spring 2005. and Pat Donnelly. R. Louis. and Robert R. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill Companies. Sierra. 7. 2001. see the following studies: 1. 3. Elizabeth C. Peter S.. 116–28. 25–27. Banks: How Different Are Community Banks?” Review. For information on how to read bank financial statements and make comparisons among different institutions. 2008 202 Part Two Financial Statements and Financial Firm Perfromance Selected References For an explanation of measuring and evaluating risk in banking and financial services. 2. “An Analysis of Commercial Bank Exposure to Interest Rate Risk. 67–76. pp. Commercial Banks in 2004. pp. “The Financial Condition of U.www.. pp. and Gregory E. A User’s Guide for www. Meyer.” Bank News. 6. Seventh Edition II. pp. Jeffrey W. Brick. Gunther. Gilbert. Andrew P. Federal Financial Institutions Examination Council. pp. Rose. and Mark D. Washington. 143– 74. Alton. pp. “How Healthy Is the Bank-ing System? Funneling Financial Data into Failure Probability. Federal Reserve Bank of St. November/December.” Regional Economist. 4. Third Quarter 2000. pp. 12–13. Federal Reserve Bank of Dallas. 54–63. Federal Reserve Bank of St. Financial Statements and Financial Firm Performance 6. 1987. “Profits and Balance Sheet Developments at U. April 2001.” Federal Reserve Bulletin. 2002. February 1996. and John R.S. David M. 43–56. Louis. “The Basis Risk Component of Commercial Bank Stock Returns. Wetmore. . Klee. the Uniform Bank Performance Report. July 31.

shift over time.Rose−Hudgins: Bank Management and Financial Services. Seventh Edition II.banking. design-ing a financial plan. Each offers Financial-Service educational materials and often supplies homework problems to Industries solve. of Risk Management and Lending Professionals at www. Measuring and Evaluating the Performance of Banks and Their Principal Competitors © The McGraw−Hill They must often reach far afield to gather government vital information in order to evaluate their financial-service Among the most impor-tant of these recurring sources providers and get the best service from 3• The Canadian Banker rmahq. ketingNetwork. Canadian Bankers Association at 5• Credit Union National Association (CUNA) at but man-agers will journals and books are always need more information than textbooks can provide. services.4• ABA Magazine at acli. Among the most popular trade associations publishing2• Risk Management problem-solving information in the financial-services field are: and Lending 1• The American Bankers Association at www. (published by the 4• America’s Community Bankers at mere measurement of the at www. working out problem 2• Bank Administration Institute at www.S. Managers must In addition to the material have the tools and the knowledge necessary to improve provided by these and performance over time. 3• Risk Management Association (RMA). and online at www. Inc.ici. such as marketing. Association Professionals Journal (pub-lished by the Risk Management Association at and customers. selected industry trade 1• ABA Banking Journal (published by the associations annually publish a prodigious volume of written American Bankers studies and management guidelines for wrestling with important Association at performance problems. However. dozens of management of a financial Economic and Financial Trends Affecting Banking and the Financial Services Sector 1• Survey of Current Business (published by the Where do the managers of financial institutions find the are the following: information they need? One good source is the professional schools in many regions of the r. Beyond the professional schools. Depart-ment of .bai. 4• The Wall Street Journal (published by Dow Jones & Co. often at a faster pace than the one at which publishing textbooks are written. rmahq. and commercial lending. Other professional schools Banking and are often devoted to specific problem areas.fiec. www. www. Sources of Data on Individual Banks and Competin g Financial Firms 1• Uniform Bank Performance Reports (UBPR) (published quarterly by the Federal Financial Institutions Examina-tion Council at www. and so on.aba.ntis. The same difficulty confronts regulators magazine pub-lishers. 2008 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 203 Appendix Improving the Performance of Financial Firms through Knowledge: Sources of Information on the Financial-Services Industry Chapter 6 focused on how to measure the performance of Insurance banks and some of their closest competitors in today’s Information Institute (III) financial marketplace. such as developing and promoting new www. Competing consumer cuna. and 2• Historical Bank Condition and Income Reports (avail-able from the National Technical Information Service at www. Their problems and solutions may be highly technical and will released each year by book houses. 3• American Banker Online (banking industry newspaper published by the American Bankers Association at Bank Marketing 6• American Council of Life Insurance (ACLI) at www. Financial Statements and Financial Firm Performance 6. Among the most popularGeneral of these is the Stonier Graduate School of Banking sponsored by Information on the American Bankers• Investment Company Institute (ICI) at www. dimensions of performance is not The chapters that follow this one will other trade provide many of the tools needed for suc-cessful numerous associations.

.gov/bea/pubs.htm).federalreserve. 2• Federal Reserve Bulletin (published by the Board of Governors of the Federal Reserve System and available at www. Louis at 3• National Economic Trends and Monetary Trends (all pub-lished by the Federal Reserve Bank of St.bea.Commerce at

Rose−Hudgins: Bank Management and Financial Services.consumeraction. 2008 of these directories is to pursue possible employment opportunities. Some of the more complete directories provide www. and country 1• Office of the Comptroller of the Currency (OCC) at of 4• Directory of Savings and Loans at One common use © The McGraw−Hill Companies. 2• The Reserve System at each firm. Financial Statements and Financial Firm Performance 6.frb. Industry Directories Economist (London) (available by Louis at www.abbycon.ots. company’s mailing financial. .chicagobusiness. such as at www. Seventh Edition 204 II. tele-phone number.c om. the names of key offi-cers 3• Federal Deposit Insurance Corporation (FDIC) at within a firm and the insurancenetwork. Measuring and Evaluating the Performance of Banks and Their Principal Competitors Part Two Financial Statements and Financial Firm Performance 1• Federal Books and Journals Focusing on Laws and Regulations and International Developments Affecting Banks and Other Financial-Service Providers 1• International Economic Conditions (published by the Federal Reserve Bank of St. state. 4• Office of Thrift Supervision at www. More detailed Basic Education in Banking and Financial Services directories have abbreviated financial statements of the for Both Bankers and Their Customers firms listed and may even have a historical sketch about Consumer Action at www. 2• Investment Bankers Directory at www. Among the better-known indus-try directories are these: 1• The Bankers Almanac at 2• Federal Reserve Bank of Minneapolis at www. and email for many industries give lists of businesses in an industry by Key Regulatory Agencies name. avenues of contact 2• Board of Governors of the Federal Reserve System essential for directory users.bankersalmanac.treas. Directories information may be found at www. 3• International Insurance Directory (also described at www.