cb lesson 5

McGraw-Hill/IrwinBank Management and Financial Services, 7/e

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Bank PerformanceBFB2033

Week 6



Key Topics• Stock Values and Profitability Ratios• Measuring Credit, Liquidity, and Other Risks• Measuring Operating Efficiency• Size and Location Effects



Why should banks be concerned about profitability and risk?• Profitability and risk are the most important

dimensions of performance. Banks are private businesses that must attract capital from the public to fund their operations.

• Bank stockholders, depositors, and bank

examiners representing the regulatory community are all interested in the quality of bank performance.



Stock Values and profitability ratio

• Performance refers to how adequately a firm meets the needs of its stockholders, employees, depositors, creditors and borrowing customers within the satisfaction of government regulators on operating policies, soundness of loans and investments and protecting public interest.

• Performance must be directed towards specific objectives and normally tied to value of stock.

• Management must pursue objective of maximizing the financial firm’s stock.



Who is likely to be interested in these dimensions of performance?• The individuals or groups likely to be interested in bank

profitability and risk are:• Other banks lending to a particular bank,• large depositors, • holders of long-term debt capital issued by banks, • bank stockholders, and the regulatory community.



Name LD change % chan Vol Buy V Buy Sell Sell V HighAmbank 7.5 0.01 0.13 1,725 697 7.49 7.5 1,071 7.5BIMB 4.94 - - 293 130 4.95 4.94 6 4.94CIMB 7.64 0.09 1.19 33,764 31 7.63 7.54 744 7.64



Importance of value of stock• If stock fails to rise in value commensurate with stockholder

expectations current investors may seek to unload their shares and financial institutions may have difficulty in raising new capital to support future growth.



Value of a Bank’s Stock Rises When:

• Expected Dividends Increase• Risk of the Bank Falls• Market Interest Rates Decrease• Combination of Expected Dividend Increase and Risk Decline



Value of the Bank’s Stock

0ttr) (1

)E(D P

t

0



Example• Suppose that stockbrokers have projected that Yorktown

Savings will pay a dividend of $3 per share on its common stock at the end of the year; a dividend of $4.50 per share is expected for the next year, and $ 5.50 per share in the following two year. The risk-adjusted cost of capital for banks in Yorktown’s risk class is 15 percent. If an investor holding Yorktown’s stock plans to hold that stock for only four years and hopes to sell it at a price of $60 per share, what should the value of the bank’s stock be in today’s market?

P0 = $47.08 per share.



Profitability ratios : A surrogate for stock values• Behavior of stock price is best indicator of financial firm’s performance because

it reflects market evaluation of firm. However not applicable to smaller institutions.

• Therefore to assess these banks we need to look at profitability ratios.

• Return on Assets = ( Net Income/ Total Assets ) Indicates managerial efficiency. It indicates how capable management has been in converting assets into net earnings.

• Return on Equity = ( Net Income/Total Equity capital) Return on Equity is determined by dividing net income (minus preferred dividends) by average common stockholders equity to get the return on equity. Net benefit that stockholders have received from investing their capital in the financial firm.



Value of Bank’s Stock if Earnings Growth is Constant

g -r

D P

1

0



Example• 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 / (r – g) = $4 / (0.10 – 0.05) = $80.



Key Profitability Ratios in Banking

Assets Total

IncomeInterest Net Margin Interest Net

Assets Total

Incomet NoninteresNet Margin t NoninteresNet

Net IncomeReturn on Equity Capital (ROE) =

Total Equity Capital

Net IncomeReturn on Assets (ROA) =

Total Assets



Problem

• The following information is for Blue Sky National Bank:• Interest income $2,200 • Interest expense $1,400 • Total assets $45,000 • Securities losses or gains $21 • Earning assets $40,000 • Total liabilities $38,000 • Taxes paid $16 • Shares of Common Stock outstanding $5,000 • Noninterest income $800 • Noninterest expense $900 • Provision for loan losses $100



ProblemPlease calculate:• ROE --------------• ROA• Net interest margin --------------• Earnings per share --------------• Net noninterest margin --------------• Net operating margin --------------



Solution• ROE = $605 . $45,000 - $38,000

= 0.0864or 8.64 percent

• ROA = $605 $45,000 = 0. 0134 or 1.34 percent



Solution

• Net Interest = $2,200 - $1400 = $800 = 0.02 or 2 % Margin $40,000 $40,000

• Net Noninterest = $800 - $900 = -$100 = -0.0025 or -0.25% Margin $40,000 $40,000



Key Profitability Ratios in Banking (cont.)

Assets Total

Expenses Operating Total

- Revenues Operating Total

Margin OperatingBank Net

gOutstandin SharesEquity Common

TaxesAfter IncomeNet (EPS) SharePer Earnings

Total Interest Income __ Total Interest ExpenseEarnings Spread = Total Earning Assets Total Interest Bearing Liability



Solution• Earnings = $605 = $.121 per share Per Share 5,000

• Net Operating = ($2,200 + $800) – ($1,400 + $900 + $100) Margin $45,000

= $600 = 0.0133 or 1.33 percent $45,000



ROE• Suppose a bank reports that its net income for the current

year is $51 million, its assets total $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 Income = $51 million Total equity Capital $1,144 mill.-$926 mill. = 0.234 or 23.39• I n 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.



ROA – indicates efficiency in generating income from its assets• A bank estimates that its total revenues 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 Income = $155 mill. - $107 mil = 0.0096 or 0.96 % 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.



Net interest and non-interest margins• 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

• 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).



Net interest and non – interest margins• 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. See if you can determine this bank's net interest and noninterest margins.



Solution• The bank's net interest and noninterest margins must be: • Net Interest = $16 mill. - $12 mill. = 0.00833 Margin 480 mill.

• Noninterest = $2 mill. - $5 mill. = -0.00625 Margin $480 mill.• The bank's earnings spread and earnings base are:Earnings = $16 mill. - $12 mill. Spread $480 mill * 0.85 $480 mill. * 0.75 = 0.0392 = 0.0333 = 0.005



Solution

Earnings Base = $480 mill. – ($480 mill. * 0.15) $480 mill.= 0.85 or 85 percent• •



Breaking Down ROE

N e t P ro fit M a rg in =N e t In com e /T o ta l O pe ra tin g R e ve n ue

A sse t U tiliza tio n =T o ta l O p era ting R eve n ue /T o ta l A sse ts

R O A =N e t In co m e /T o ta l A sse ts

E q u ity M u lt ip lie r =T o ta l A sse ts /E q u ity C a p ita l

R O E = N e t In co m e / T o ta l E qu ity C a p ita l

x

x



ROE Depends On:

• Equity Multiplier = Assets/Equity• Leverage or Financing Policies

• Net Profit Margin= Net Income/Total Operating revenue• Effectiveness of Expense Management

• Asset Utilization = Total operating revenue/Total Assets• Portfolio Management Policies



Bank Risks

• Credit Risk• Liquidity Risk• Market Risk• Interest Rate Risk• Operational Risk

• Legal and Compliance Risk

• Reputation Risk• Strategic Risk• Capital Risk



Credit Risk

The Probability that Some of the Financial Firm’s Assets Will Decline in Value and Perhaps Become Worthless



Credit Risk• Probability that some of the financial institution’s assets

especially its loans will decline in value is known as credit risk.• 4 widely used indicators are:

1.Non performing assets/ total loans and leases.2.Net charge offs (write offs) of loans/ total loans and

leases3.Annual provision of loan losses/ total loans and leases4.Allowance for loan losses/ Total loans and leases5.Non performing assets/ equity capital



Liquidity Risk

Probability the Financial Firm Will Not Have Sufficient Cash and Borrowing Capacity to Meet Deposit Withdrawals and Other Cash Needs



Liquidity Risk Measures

• Purchased Funds/Total Assets• Net Loans/Total Assets• Cash and Due from Banks/Total Assets• Cash and Government Securities/Total

Assets



Market Risk

Probability of the Market Value of the Financial Firm’s Investment Portfolio Declining in Value Due to a Change in Interest Rates



Market Risk Measures

• 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



Interest Rate Risk

The Danger that Shifting Interest Rates May Adversely Affect a Bank’s Net Income, the Value of its Assets or Equity



Interest Rate Risk Measures

• Interest Sensitive Assets/Interest Sensitive Liabilities

• Uninsured Deposits/Total Deposits



Operational Risk

Uncertainty Regarding a Financial Firm’s Earnings Due to Failures in Computer Systems, Errors, Misconduct by Employees, Floods, Lightening Strikes and Similar Events or Risk of Loss Due to Unexpected Operating Expenses



Legal and Compliance Risk

Risk of Earnings Resulting from Actions Taken by the Legal System. This can Include Unenforceable Contracts, Lawsuits or Adverse Judgments. Compliance Risk Includes Violations of Rules and Regulations



Reputation Risk

This is Risk Due to Negative Publicity that can Dissuade Customers from Using the Services of the Financial Firm. It is the Risk Associated with Public Opinion.



Capital Risk

Probability of the Value of the Bank’s Assets Declining Below the Level of its Total Liabilities. The Probability of the Bank’s Long Run Survival



Capital Risk Measures

• Stock Price/Earnings Per Share• Equity Capital/Total Assets• Purchased Funds/Total Liabilities• Equity Capital/Risk Assets



Other Goals in Banking

Total Operating ExpensesOperating Efficiency Ratio =

Total Operating Revenues

Net Operating IncomeEmployee Productivity Ratio =

Number of Full Time-Equivalent Employees



Measuring operating efficiency• Many firms recognize the need for greater efficiency in their

operations. Means reducing op expenses and increasing productivity of employees through use of automated equipment and improved employee training.

• Operating Efficiency Ratio A common means of measuring the operating efficiency for banks is a ratio that divides the total operating expense of the bank/total operating revenues.• Employee productivity ratio Net operating income/ number of full time employees



Size and location effects• Size bias is evident in banking industry. Measured by assets,

deposits or equity capital. Largest bank usually report highest non interest margins. Most profitable banks in terms of ROA were banks with more than 10 billion in assets. Local- CIMB, Maybank.

• Location effects- Performance is influenced by whether it operates in a major financial centre, smaller city or rural area.



Calculate as many risk measures as you can from the following data• Net loans and leases book value = $936• Total assets = $1324 mill• Equity capital book value =$ 110 mill• Deposits book value = $1150 mill• Market value assets = $1443 mill• Market value of equity cap = $130 mill• Current stock price = $60 with annual per share earnings

of $2.50• Uninsured deposits = $243 mill• Money market borrowings = $132 mill• Non performing loans = $43 mill• Loans charged off = $21 mill



solution• Net loans and leases/total assets = 936/1324• Equity capital/total assets = 130/1443• Uninsured deposits/total deposits = 243/1150• Stock price/EPS = 60/250• Non performing assets/net loans and leases 43/936• Charge offs of loans/total loans and leases= 21/936• Purchased funds /total liabilities = 243 +132/1324-110• Book value of assets/market value of assets = 1324/1443

cb lesson 5

Economy & Finance