CHAPTER 6

MEASURING AND EVALUATING THE PERFORMANCE OF BANKS AND

THEIR PRINCIPAL COMPETITORS

Goal of This Chapter: The purpose of this chapter is to discover what analytical tools can
be applied to a bank’s financial statements so that management and the public can
identify the most critical problems inside each bank and develop ways to deal with those
problems.

Banks in the U.S. and most other countries are private businesses that must attract capital
from the public to fund their operations. If profits are inadequate or if risk is excessive,
they will have greater difficulty in obtaining capital and their funding costs will grow,
eroding profitability. Bank stockholders, depositors, and bank examiners representing
the regulatory community are all interested in the quality of bank performance. The
stockholders are primarily concerned with profitability as a key factor in determining
their total return from holding bank stock, while depositors (especially large corporate
depositors) and examiners typically focus on bank risk exposure.
The individuals or groups likely to be interested in bank profitability and risk include
other banks lending to a particular bank, borrowers, large depositors, holders of long-
term debt capital issued by banks, bank stockholders, and the regulatory community.

Maximizing The Value of the Firm: A Key Objective for Nearly All Financial-
Service Institutions
Maximizing the value of a firm’s stock is the key objective for all financial firms. If the
stock fails to rise in value that stockholders expect, current investors may seek to sell
their shares and the financial institutions will have difficulty raising new capital to
support its future growth. The value of a firm’s stock is given as:

Where E(Dt) is stockholder’s dividends expected to be paid in future period, discounted

by a minimum acceptable rate of return (r) tied to the firm’s perceived level of risk. The
minimum acceptable rate of return (r) is also known as cost of capital and has two main

1
components: (1) risk free interest rate and (2) the equity risk premium (to compensate an
investor for accepting the risk of investing in a financial firm’s stock rather than in risk-
free securities).
A bank's stock price is affected by all those factors affecting its profitability and risk
exposure, particularly its rate of return on equity capital and risk to shareholder earnings.
A bank can raise its stock price by creating an expectation in the minds of investors of
greater earnings in the future, by lowering the bank's perceived risk exposure, or by a
combination of increases in expected earnings and reduced risk. In particular, the value of
the financial firm’s stock will tend to rise in any of the following situations:
1. Expected Dividends Increase
2. Risk of the Bank Falls
3. Market Interest Rates Decrease
4. Combination of Expected Dividend Increase and Risk Decline
Recent research shows that stock values are especially sensitive to changes in market
interest rates, currency exchange rates, and the strength or weakness of the economy that
each serves.
If the dividends paid do not vary over time and dividends paid are expected to grow at a
constant rate of g , the stock price is simplified as
D1
P0 
rg
where D1 is the expected dividend on stock in period , r is the rate of discount and g is
the constant growth rate of dividend. This means D1 = D0 (1  g ) , where Do is the
current (period) dividend.
The two stock price formulas mentioned above assume that firm will pay dividend
indefinitely in the future. Most capital market investors have a limited time period and
they plan to sell their stocks in a limited time horizon. In this case, the value of stock is
determined as:

D1 D2 Dn Pn n
Dt Pn
P0 
(1  r ) 1

(1  r ) 2
 ..........
............... 
(1  r ) n

(1  r ) n
 
t 1 (1  r )
t

(1  r ) n

Here investors are expected to hold stock for n periods.

Key Profitability Ratios

Net Income
Return on Equity Capital (ROE) =
Total Equity Capital

Net Income
Return on Assets (ROA) =
Total Assets

2
 (Interest income
- Interest expense) Net Interest Income
Net Interest Margin  
Total Assets Total Assets

Noninterest reven ue
- PLLL
- Noninterest expenses Net Noninterest Income
Net Non interest Margin  
Total Assets Total Assets

Total Operating Revenues -

Total Operating Expenses
Net Bank Operating Margin 
Total Assets

Net Income After Taxes

Earnings Per Share (EPS) 
Common Equity Shares Outstanding

Return on equity (ROE) is a measure of the rate of return flowing to shareholders.

Example
Suppose a bank reports that its net after-tax income for the current year is $51 million, its
assets totally $1,144 million, and its liabilities amount to $926 million. What is its return
on equity capital? Is the ROE you have calculated good or bad? What information do
you need to answer this last question?

ROE = Net After Tax Income = $51 million = .098 or 9.8 percent
Equity Capital $1,444 mill.-$926
mill.

In order to evaluate the performance of the bank, you have to compare the ROE to the
ROE of some major competitors or some industry average.

Return on assets (ROA), on the other hand, indicates how capable management has been
in converting assets into net earnings (or net income); thus, it is indicator of managerial
efficiency.
Example
A bank estimates that its total revenues from all sources will amount to $155 million and
its total expenses (including taxes) will equal $107 million this year. Its liabilities total

3
$4,960 million while its equity capital amounts to $52 million. What is the bank's return
on assets? Is this ROA high or low? How could you find out?

ROA = Net After Tax = $155 mill. - $107 = 0.0096 or 0.96

Income mill. percent
Total Assets $4,960 mill. + $52
mill.

The size of this bank's ROA should be compared with the ROA's of other banks similar
in size and location to determine if this bank's ROA is high or low relative to the average
for
comparable banks.

The net operating margin, net interest margin, and net noninterest margin are efficiency
measures as well as profitability measures, indicating how well management and staff
have been able to keep the growth of revenues ahead of rising costs. 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. The net noninterest margin, in contrast, measures the
amount of noninterest revenues stemming from service fees to the amount of noninterest
costs incurred (including salaries and wages, repair and maintenance of facilities, and
loan loss expenses). Typically, net noninterest margin is negative. The earnings spread
measures the effectiveness of a firm’s intermediation function in borrowing and lending
money and also the intensity of competition in the firm’s market area. Greater
competition, ceteris paribus, reduces the spread.
Example
Suppose a banker tells you that his bank in the year just completed had total interest
expenses on all borrowings of $12 million and noninterest expense of $5 million, while
interest income from earning assets totaled $16 million and noninterest revenues added to
a total of $2 million. Suppose further that assets amounted to $480 million of which
earning assets represented 85 percent of total assets, while total interest-bearing liabilities
amounted to 75 percent of the bank's total assets. See if you can determine this bank's net
interest and noninterest margins and its earnings base and earnings spread for the most
recent year.

The bank's net interest and noninterest margins must be:

Net Interest = $16 mill. - $12 Noninterest = $2 mill. - $5 mill.

mill.
Margin $480 mill. Margin $480 mill.
=.00833 = -.00625

The bank's earnings spread and earnings base are:

4
 Earnings = $16 mill. - $12 mill.
Spread $480 mill * 0.85 $480 mill. * 0.75
= .0392 -.0333

= .0392 – .0333 = .0059

Earnings Base = $480 mill. - $480 mill. * = 0.85 or 85

0.15 percent
$480 mill.

Breaking Down ROE

Net income Net income Total assets

ROE     ROA  EM
Total equity capital Total assets Total equity capital

Where
Total assets
EM  , is the equity multiplier (EM) also known as leverage
Total equity capital
multiplier.

This breakdown of ROE shows how assets are financed – whether more debt or more
owners’ capital. A bank with low ROA can achieve a relatively high ROE through heavy
use of debt (leverage) and minimum use of owners’ capital as shown in the table below:

Example
Bank A Bank B
ROA = 1%; Equity capital = $10 m, Debt ROA = 0.6%; Equity capital = $5 m, Debt
= liabilities = $90 m, Assets = $100 = liabilities = $95 m, Assets = $100
EM = 10x EM = 20x
100 100
ROE  0.01   0.01  10  0.1  10% ROE  0.006   0.006  20  0.12  12%
10 5

This important breakdown also shows clearly the fundamental trade-off the managers
face between risk and return. Take the example of the Bank A above:
Bank A
ROA = 1%; Equity capital = $1 ROA = 0.5%; Equity capital = $1 Assets =
Assets = $10 $20
EM = 10x  Higher debt relative to equity
ROE  0.01 
10
 0.01  10  0.1  10% EM = 20x
1 20
ROE  0.005   0.005  20  0.1  10%
1

5
This example in the above table shows the trade-off that how much leverage (debt
relative to equity) must be used to achieve the desired rate of return to stockholders.
Clearly, as earnings efficiency represented by ROA declines (in the example 1% to .5%),
the firm must take more risk in the form of higher leverage to have any chance of
achieving its desired rate of return to its shareholders (ROE). Table below shows risk
return trade-off for return on assets (ROA) and return on equity (ROE):

Table of Risk-return trade off: (ROE) with different ROA and EM

Ratio of TA to total
equity capital (EM) ROA 0.5% 1% 1.5% 2%
→
↓
5:1 2.5% 5.0% 7.5% 10%
10:1 5.0 10.0 15.0 20.0
15:1 7.5 15.0 22.5 30.0
20:1 10.0 20.0 30.0 40.0

ROE and its Principal Components

Net income Total operating revenues Total assets

ROE     NPM  AU  EM
Total operating revenues Total assets Total equity capital
Or
ROE = Net profit margin (NPM) × Asset utilization ratio (AU) × Equity multiplier
(EM)
where

Net income Total operating income

NPM  , AU 
Total operating income Total assets

The NPM reflects the effectiveness of expense management (cost control) and service
pricing policies. In other words, a low profit margin most likely would indicate that the
bank is doing poor job in controlling expenses. The degree of AU reflects portfolio
management policies, especially mix and yield on assets. The EM reflects the leverage or
financing policies: the sources chosen to fund the financial institution (debt or equity).
See exhibit 6.1 below.
If any of these ratios begins to decline, the management needs to pay close attention and
asses the reasons behind the change. The EM is a direct measure of financial leverage –
how many dollars of assets must be supported by each dollar of equity (owners’) capital
and how much of the firm’s resources, therefore, must rest on debt. The larger the EM,
the firm is more exposed to failure risk but has the potential for high returns for the
stockholders. The NPM is also under some degree of management control and direction.
Banks can increase their earnings and returns to their stockholders by successfully
controlling expenses and maximizing revenues. Similarly, by carefully allocating assets

6
to the higher-yielding loans and investments while avoiding excessive risk, management
can raise the average yield on assets (AU).
Table 6-1 (and figure 1) below shows FDIC insured institutions between 1992-2007
created healthy ROA between 1992 to 2005 and this is primarily because of the surge in
NPM. Why did AU and EM declined lately? The AU fell mainly because of market
interest rates stayed low and declining. The EM fell because equity capital increased due
to record profits and government regulations.

Exhibit 6.1

Table 6-1

7
 Figure 1
14
13

Times (X)
12
11
10
20
9
16
Percent (%)

12

4
92 94 96 98 00 02 03 04 05 06 07
AU EM NPM ROE

A slight Variation on ROE

Net Income Pre-Tax Net Operating Income
ROE =  
Pre-Tax Net Operating Income Total Operating Revenue

Total Operating Revenue Total Assets


Total Assets Total Equity Capital

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ROE  Tax management efficiency Expense control efficiency Asset management
Funds managemnt efficiency
 Tax management efficiency Expense management efficiency AU  EM

In this case the NPM is split into two parts: (1) the tax management ratio reflects the use
of
security gains or losses and other tax management tools (such as buying tax-exempt
bonds) to minimize tax exposure, and (2) the ratio of before-tax income to total revenue
as an indicator of how many dollars of revenue survive after operating expenses are
removed – a measure of operating efficiency and expense control.
Clearly, when any one of these four ratios begins to drop, management needs to
reevaluate the financial firm’s efficiency in that area.
Example
Suppose a bank reports net income after taxes of $12, before-tax net income of $15,
operating revenues of $100, assets of $600, and $50 in equity capital. What is the bank's
ROE? Tax-management efficiency indicator? Expense control efficiency indicator?
Asset management efficiency indicator? Funds management efficiency indicator?

$12
ROE = $50 = 0.24 or 24 percent

Its tax-management, expense control, asset management, and funds management

efficiency indicators are:

Tax Management = $12 Expense Control = $15

Efficiency $15 Efficiency $10
indicator Indicator 0

= .8 or 80 percent =.15 or 15 percent

Asset Management = $100 Funds = $60

Management 0
Efficiency Indicator $600 Efficiency $50
Indicator

= 0.1666 or 16.67 percent = 12 x

Principal components of ROA

What are the most important components of ROA and what aspects of a financial
institution’s performance do they reflect?
The principal components of ROA are:
Interest income  int erest exp ense
Net int erest m arg in  ,
Total assets
It measures a bank's success at intermediating funds between borrowers and lenders;

9
 Non int erest income  Non int erest exp ense
Net non int erest m arg in 
Total assets
It indicates the ability of management to control salaries and wages and other noninterest
costs and generate tee income;
( PLLL  sec urities gains (losses )  taxes
 extraordin ary net gains )
ROA  Net int erst m arg in  net non int erest m arg in 
Total assets
Net income
 .
Total assets
Example
If a bank has a net interest margin of 2.50%, a noninterest margin of -1.85%, and a ratio
of provision for loan losses, taxes, security gains, and extraordinary items of -0.47%,
what is its
ROA?
ROA = 2.50 percent - 1.85 percent - 0.47 percent = 0.18 percent

Measuring Risk in Banking

These risk measures determine the performance of a bank in the market.
Among the more popular measures of overall risk for financial firm are the following:
 Standard deviation (  ) or variance (  2 ) of stock prices.
 Standard deviation (  ) or variance (  2 ) of net income.
 Standard deviation (  ) or variance (  2 ) of ROE and ROA.
The higher the standard deviation or variance of the above measures, the greater the
overall risk. Risk can be broken down into number of components:
• Credit Risk
• Liquidity Risk
• Market Risk
1. Price Risk
2. Interest Rate Risk
• Operational Risk
• Legal and Compliance Risk
• Reputation Risk
• Strategic Risk
• Capital Risk

10
Credit Risk
The probability that some of the financial firm’s assets, especially its loans, will decline
in value and perhaps become worthless. The following are the most widely used ratio
indicators of credit risk:
• Nonperforming Assets (Loans)/Total Loans and Leases
• Net Charge-Offs of Loans/Total Loans and Leases
• Annual Provision for Loan Losses/Total Loans and Leases or
• Annual Provision for Loan Losses/Equity Capital
• Allowance for Loan Losses/Total Loans and Leases or
• Allowance for Loan Losses/Equity Capital
• Nonperforming Assets (Loans)/Equity Capital
• Total loans/total deposits

For example, if the ratio total loans to total deposits grows (increases)
bank regulators become more concerned because loans are usually
among the riskiest of all assets for depository institutions and
therefore, deposits must be protected. A rise in bad loans or declining
market values of good loans relative to the amount of deposits create
greater depositor risk.

Example: Walkeva Bank is thinking about investing in Falcon Bank. He

is examining certain ratios of the bank including the ratio of
nonperforming loans to total loans and leases and the provision for
loan losses to total loans and leases. This means the Walkeva is
attempting to measure credit risk with these ratios.

Liquidity Risk
Probability the financial firm will not have sufficient cash and borrowing capacity to
meet deposit withdrawals and other cash needs. Useful measures of liquidity risk are:
• Purchased Funds/Total Assets
Purchase funds include Eurodollars, federal funds, security RPs, large CDs, and
commercial paper.
• Net Loans/Total Assets
• Cash and Due from Banks/Total Assets
• Cash and Government Securities/Total Assets

Example: John is thinking about investing in Sea Island Bank. He is

examining certain ratios of the bank including the ratio of cash assets
and government securities to total assets and purchased funds to total
assets. This means John is attempting to measure the liquidity risk of
the Sea Island Bank with these ratios.

11
Market Risk: Comprises Price Risk and Interest Rate Risk
Price Risk. Especially sensitive to these market-value movements are bond portfolios
and stockholders’ equity (net worth) which can dive suddenly as market prices move
against a financial firm. Important indicators of price risk are:
• Book-Value of Assets/ Market Value of Assets
• Book-Value of Equity/ Market Value of Equity
• Book-Value of Bonds/Market Value of Bonds
• Market Value of Preferred Stock and Common Stock

Lower of these ratios means higher market performance. For example,

suppose book-value of equity to market value of equity of Bank A =
1.55 and Bank B = 0.42. This means Bank B has a higher market
performance than bank A.

Example: Beth is thinking about investing in the First Choice Bank. She is
examining certain ratios of the bank including the ratio of the book
value of the assets to the market value of the assets and the market
value of the bonds held by the bank to their recorded value. That is,
Beth is attempting to measure the market risk (price risk of market
risk) with these ratios.

Interest Rate Risk. The danger that shifting interest rates may adversely affect a bank’s
net income, the value of its assets or equity. For example, rising interest rates can lower
the margin of profit if interest expenses on borrowed money increase more rapidly than
interest revenues on loans and security investments.

Example: Bob is thinking about investing in Small City Bank. He is

examining certain ratios of the bank including the ratio of interest
sensitive assets to interest sensitive liabilities and uninsured deposits
to total deposits. Bob is attempting to measure the interest rate risk
(credit risk) with these ratios.

Operational (Transactional) Risk

Operational risk refers to uncertainty regarding a financial firm’s earnings due to failures
in computer systems, errors, misconduct by employees, floods, lightning strikes, and
similar events.
Operational risk includes the following:
 Failure of bank’s computer system
 Closure of a bank for three months due to flooding from a major
hurricane
 Embezzlement of funds of a bank by a teller of the bank

12
 Closure of a bank for two weeks due to a fire from a lightening strike

13
Example: The Garic State Bank of New Orleans was under water for
three weeks after Hurricane Katrina hit the state. The lobby is full of
mud and other debris. Many of the valuables stored in the bank’s
safety deposit boxes have been ruined. John Garic, the President and
CEO of the bank, has been working night and day to reopen the bank.
Here John has been dealing with operational risk.
Example: Louisiana State Bank has an old computer system which can
go down for weeks at a time, leaving customers unable to access their
accounts online. Many customers have left the bank for banks with
more reliable computer systems. This is an example of operational risk.

Legal and Compliance Risk

Unenforceable contracts, lawsuits, or adverse judgments may reduce a financial firm’s
revenues and increase its expense.

Example: National Bank made a loan of $1 million to John Carlsson. John

has declared bankruptcy and National Bank has just learned that the
judge in the case has ruled that John does not have to pay any of the
loan back or forfeit any of his assets. This is an example of legal risk.

Example: Osaka State Bank has a ratio of equity capital to total assets
of 1.9%. The FDIC which regulates this bank has determined that this
is not enough equity capital and is making the bank issue new stock in
the market. In addition, they are not allowing the bank to issue a
dividend to their current stockholders. This is an example of
compliance risk.

Reputation Risk
Negative publicity can affect a financial firm’s earnings and dissuading customers from
using the services for the institution, just as positive publicity may serve to promote
services and products.

Example: East Land Bank has just learned that there is a disgruntled
former employee who has created a blog that is telling everyone that
East Bank has halved their customer service representatives and so
customers have great difficulty getting through to a live person when
there is a problem with their account. Everett is worried that they may
lose customers as a result. This is an example of reputation risk.

Strategic Risk
Variations in earnings due to adverse business decisions, lack of responsiveness to
industry changes are part of what is called strategic risk.

14
Example: The CEO of Falcon Bank decides that interest rates are going to fall in the
future and as a result buys $100 million in 30 year Treasury Bonds for the bank’s
security portfolio. Instead, interest rates rise causing the value of these bonds to
fall. This is an example of strategic risk.

Capital Risk
The impact of all the risk mentioned above can affect a financial firm’s long-run
survival, often referred to its capital risk.

The Impact of Size on Performance

Most of the performance ratios are highly sensitive to the size (measured by total deposits
for banks) of the financial firms. Table 6-4 shows, key earnings and risk measures change
dramatically as we move from the smallest banks to the largest banking firm. For
example, the most profitable banks in terms of ROA were banks with more than $10
billion in assets, the same was true for the ROE. The smaller and medium banks obtain
greater spreads between interest revenue and interest cost and as a result higher net
interest margin.

Table 6-4

15
 Concept Checks

5-1. Why should banks and other corporate financial firms be concerned about their
level of profitability and exposure to risk?

Banks in the U.S. and most other countries are private businesses that must attract capital
from the public to fund their operations. If profits are inadequate or if risk is excessive,
they will have greater difficulty in obtaining capital and their funding costs will grow,
eroding profitability. Bank stockholders, depositors, and bank examiners representing
the regulatory community are all interested in the quality of bank performance. The
stockholders are primarily concerned with profitability as a key factor in determining
their total return from holding bank stock, while depositors (especially large corporate
depositors) and examiners typically focus on bank risk exposure.

5-2. What individuals or groups are likely to be interested in these dimensions of

performance for a bank or other financial institution?

The individuals or groups likely to be interested in bank profitability and risk include
other banks lending to a particular bank, borrowers, large depositors, holders of long-
term debt capital issued by banks, bank stockholders, and the regulatory community.

5-3. What factors influence the stock price of a bank or other financial corporation?

A bank's stock price is affected by all those factors affecting its profitability and risk
exposure, particularly its rate of return on equity capital and risk to shareholder earnings.
A bank can raise its stock price by creating an expectation in the minds of investors of
greater earnings in the future, by lowering the bank's perceived risk exposure, or by a
combination of increases in expected earnings and reduced risk.

5-4. 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, and the minimum required return to equity capital based on the bank's perceived
level of risk is 10 percent. Can you estimate the current value of the bank's stock?

In this constant dividend growth rate problem the current value of the bank's stock would
be:

Po = D1 / (k – g) = $4 / (0.10 – 0.05) = $80.

16
5-5. What is return on equity capital and what aspect of bank performance is it
supposed to measure? Can you see how this performance measure might be useful to the
managers of nonbank financial firms?

Return on equity capital is the ratio of Net Income After Taxes/Total Equity Capital. It
represents the rate of return earned on the funds invested in the bank by its stockholders.
Nonbank financial firms have stockholders, too who are interested in the return on the
funds that they invested.

5-6 Suppose a bank reports that its net after-tax income for the current year is $51
million, its assets totally $1,144 million, and its liabilities amount to $926 million. What
is its return on equity capital? Is the ROE you have calculated good or bad? What
information do you need to answer this last question?

The bank's return on equity capital should be:

ROE = Net After Tax Income = $51 million = .098 or 9.8 percent
Equity Capital $1,444 mill.-$926
mill.

In order to evaluate the performance of the bank, you have to compare the ROE to the
ROE of some major competitors or some industry average.

5-7 What is the return on assets (ROA), and why is it important in banking? Might the
ROA measure be important to banking’s key competitors?

Return on assets is the ratio of Net Income After Taxes/Total Assets. The rate of return
secured on a bank's total assets indicates the efficiency of its management in generating
net income from all of the resources (assets) committed to the institution.

5-8. A bank estimates that its total revenues from all sources will amount to $155
million and its total expenses (including taxes) will equal $107 million this year. Its
liabilities total $4,960 million while its equity capital amounts to $52 million. What is
the bank's return on assets? Is this ROA high or low? How could you find out?

The bank's return on assets would be:

ROA = Net After Tax = $155 mill. - $107 = 0.0096 or 0.96

Income mill. percent
Total Assets $4,960 mill. + $52
mill.

17
The size of this bank's ROA should be compared with the ROA's of other banks similar
in size and location to determine if this bank's ROA is high or low relative to the average
for
comparable banks.

5-9. Why do bankers and the managers of competing financial firms often pay close
attention today to the net interest margin and noninterest margin? To the earnings spread?

The net interest margin (NIM) indicates how successful the bank has been in borrowing
funds from the cheapest sources and in maintaining an adequate spread between its
returns on loans and security investments and the cost of its borrowed funds. If the NIM
rises, loan and security income must be rising or the average cost of funds must be falling
or both. A declining NIM is undesirable because the bank's interest spread is being
squeezed, usually because of rising interest costs on deposits and other borrowings.

In contrast, the noninterest margin reflects the banks spread between its noninterest
income (such as service fees on deposits) and its noninterest expenses (especially salaries
and wages and overhead expenses). For most banks the noninterest margin is negative.
Management will usually attempt to expand fee income, while controlling closely the
growth of noninterest expenses in order to make a negative noninterest margin as least
negative as possible.

The earnings base indicates the proportion of the bank's earning assets (loans, leases, and
investments) relative to its total assets. As competition increases, greater pressure is
placed on the bank's management to maintain the quality and quantity of these earning
assets. Additionally, the bank's managers typically will shift some of their emphasis to
increasing noninterest income generated by fees.

The earnings spread measures the effectiveness of the bank's intermediation function of
borrowing and lending money, which, of course, is the bank's primary way of generating
earnings. As competition increases, the spread between the average yields on assets and
the average cost of liabilities will be squeezed, forcing the bank's management to search
for alternative sources of income, such as fees from various services the bank offers.

5-10. Suppose a banker tells you that his bank in the year just completed had total
interest expenses on all borrowings of $12 million and noninterest expense of $5 million,
while interest income from earning assets totaled $16 million and noninterest revenues
added to a total of $2 million. Suppose further that assets amounted to $480 million of
which earning assets represented 85 percent of total assets, while total interest-bearing
liabilities amounted to 75 percent of the bank's total assets. See if you can determine this
bank's net interest and noninterest margins and its earnings base and earnings spread for
the most recent year.

18
 The bank's net interest and noninterest margins must be:

Net Interest = $16 mill. - $12 Noninterest = $2 mill. - $5 mill.

mill.
Margin $480 mill. Margin $480 mill.
=.00833 = -.00625

The bank's earnings spread and earnings base are:

Earnings = $16 mill. - $12 mill.

Spread $480 mill * 0.85 $480 mill. * 0.75
= .0392 -.0333

Earnings Base = $480 mill. - $480 mill. * = 0.85 or 85

0.15 percent
$480 mill.

5-11. What are the principal components of ROE and what do each of these components
measure?

The principal components of ROE are:

a. The net profit margin or net after-tax income to operating revenues which reflects
the effectiveness of a bank's expense control program;

b. The degree of asset utilization or ratio of operating revenues to total assets which
measures the effectiveness of managing the bank's assets, especially the loan portfolio;
and,

c. The equity multiplier or ratio of total assets to total equity capital which measures
a bank's use of leverage in funding its operations.

5-12. Suppose a bank has an ROA of 0.80 percent and an equity multiplier of 12x what
is its ROE? Suppose this bank's ROA falls to 0.60 percent. What size equity multiplier
must it have to hold its ROE unchanged?

The bank's ROE is:

ROE = 0.80 percent *12 = 9.60 percent.

If ROA falls to 0.60 percent, the bank's ROE and equity multiplier can be determined
from:

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 ROE = 9.60% = 0.60 percent * Equity Multiplier

Equity Multiplier = 9.60 percent = 16x.

0.60 percent

5-13. Suppose a bank reports net income after taxes of $12, before-tax net income of
$15, operating revenues of $100, assets of $600, and $50 in equity capital. What is the
bank's ROE? Tax-management efficiency indicator? Expense control efficiency
indicator? Asset management efficiency indicator? Funds management efficiency
indicator?

The bank's ROE must be:

$12
ROE = $50 = 0.24 or 24 percent

Its tax-management, expense control, asset management, and funds management

efficiency indicators are:

Tax Management = $12 Expense Control = $15

Efficiency $15 Efficiency $10
indicator Indicator 0

= .8 or 80 percent =.15 or 15 percent

Asset Management = $100 Funds = $60

Management 0
Efficiency Indicator $600 Efficiency $50
Indicator

= 0.1666 or 16.67 percent = 12 x

5-14. What are the most important components of ROA and what aspects of a financial
institution’s performance do they reflect?

The principal components of ROA are:

a. Total Interest Income Less Total Interest Expense divided by Total Assets, measuring a
bank's success at intermediating funds between borrowers and lenders;

b. Provision for Loan Losses divided by Total Assets which measures management's
ability to control loan losses and manage a bank's tax exposure;

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c. Noninterest Income less Noninterest Expenses divided by Total Assets, which
indicates the ability of management to control salaries and wages and other noninterest
costs and generate tee income;

d. Net Income Before Taxes divided by Total Assets, which measures operating
efficiency and expense control; and

e. Applicable Taxes divided by Total Assets, which is an index of tax management

effectiveness.

5-15. If a bank has a net interest margin of 2.50%, a noninterest margin of -1.85%, and a
ratio of provision for loan losses, taxes, security gains, and extraordinary items of
-0.47%, what is its
ROA?

The bank's ROA must be:

ROA = 2.50 percent - 1.85 percent - 0.47 percent = 0.18 percent

5-16. To what different kinds of risk are banks and their financial-service competitors
subjected today?

a. Earnings Risk -- the probability that a bank's earnings (net income) will fall, subjecting
its stockholders to actual losses or to lower rates of return.

b. Credit Risk -- the probability that loans and securities the bank holds will not pay out
as promised.

c. Solvency Risk -- the possibility or probability the bank will fail.

d. Liquidity Risk -- the probability the bank will not have sufficient cash on hand in the
volume needed precisely when cash demands arise.

e. Market Risk -- the probability that the value of assets held by the bank will decline due
to falling market prices.

f. Interest-Rate Risk - the possibility or probability interest rates will change, subjecting
the bank to losses.

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5-17. What items on a bank's balance sheet and income statement can be used to
measure its risk exposure? To what other financial institutions do these risk measures
apply?

There are several alternative measures of risk in banking and financial services. Capital
risk is often measured by bank capital ratios, such as the ratio of total capital to total
assets or total capital to risk assets. Credit risk can be tracked by such ratios as net loan
losses to total loans or relative to total capital. Liquidity risk can be followed by using
such ratios as cash assets to total assets or by total loans to total assets. Interest-rate risk
may be indicated by such ratios as interest-sensitive liabilities to interest-sensitive assets
or the ratio of money-market borrowings to money-market assets.

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