evaluating bank performance outline –a framework for evaluating bank performance internal...

Evaluating Bank Performance• Outline

– A Framework for Evaluating Bank Performance Internal Performance

External Performance

Presentation of Bank Financial Statements

– Analyzing Bank Performance with Financial Ratios Profit Ratios

Risk Ratios

– Internal Performance Evaluations Based on Economic Profit RAROC (Risk-Adjusted Return on Capital)

EVA (Economic Value Added)

A Framework for Evaluating Bank Performance

• Internal Performance– Bank planning (policy formulation)

Goals, budgets, strategic planning

– Technology

Computers, communications, payments

– Personnel development

Challenges (personal selling and geographic expansion)

Job satisfaction (training and compensation)


• External Performance– Market share

Earnings effects

Role of technology

– Regulatory compliance

Capital

Lending

Securities

Other

– Public confidence

Deposit insurance

Public image


• Presentation of Bank Financial Statements– Balance sheet (Report of Condition)

Assets: cash assets, loans, and securities

Liabilities: deposit funds and nondeposit funds

Capital: equity capital, subordinated notes and debentures, loan loss reserves

– Income Statement (Report of Income)

Interest income

Noninterest income

Interest expenses

Noninterest expenses (including provision for loan losses)

Net profit


Table 3.1 Balance Sheet for State Bank ($Thousands)

ASSETS DEC. 31, 2000 DEC. 31, 1999

Cash assets $ 9,039 $ 10,522

Interest bearing bank balances 0 1,000

Federal funds sold 10,500 1,500

U.S. Treasury and agency securities 54,082 44,848

Municipal securities 32,789 34,616

All other securities 0 0

Net loans and leases 90,101 81,857

Real estate loans 50,393 38.975

Commercial loans 9,615 11,381

Individual loans 8,824 10,640

Agricultural loans 20,680 19,654

Other loans and leases-domestic 3,684 4,025

Gross loans and leases 93,196 84,675

Less: unearned income reserves 89 282

Reserve for loan and lease losses 3,006 2,356

Premises, fixed assets, and capitalized leases 2,229 2,398

Other real estate 2,282 3,012

Other assets 4,951 4,014

Total assets $205,973 $183,767


Table 3.1 Balance Sheet for State Bank ($Thousands)

LIABILITIES & CAPITAL DEC. 31, 2000 DEC. 31, 2001

Demand deposits $ 23,063 $ 22,528

All NOW and ATS accounts 6,021 5,322

MMDA accounts 41,402 49,797

Other savings deposits 3,097 2,992

Time deposits<$100K 31,707 28,954

Time deposits>$100K 83,009 57,665

Total deposits 188,299 167,258

Fed funds purchase and resale 0 0

Other borrowings 0 0

Bankers’ acceptance and other liabilities 3,546 3,101

Total liabilities 191,845 170,359

Subordinated notes and debentures 0 0

All common and preferred equity 14,128 13,408

Total liabilities and capital $205,973 $183,767

Analyzing Bank Performance with Financial Ratios

• Profit ratios– Rate of return on equity

ROE = NI/TE (net income after taxes/total equity)

– Rate of return on assets

ROA = NI/TA (net income after taxes/total assets)

– Other profit measures

Net interest margin

NIM = (Total interest income - Total interest expense)/Total assets

Note: municipal bond interest is not taxable, such that it must be grossed up to a pre-tax equivalent basis by dividing munis interest earned by the factor (1 - tax rate of bank).


• Profit ratios– Unraveling profit ratios

ROE = ROA x TA/TE (total assets/total equity or equity multiplier).

Thus, by decreasing equity, a bank can increase ROE based on any given level of ROA.

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

The NI/OR ratio is the profit margin, while OR/TA reflects asset utilization. By using this breakdown, one can make inferences

concerning the reason for say increases in ROE. If asset utilization and equity multiplier did not change, the profit

margin must have increased due to cost savings pushing this ratio up.


• Risk ratios– Capitalization

Leverage ratio

Total equity/Total assets

Total capital ratio

(Total equity + Long-term debt + Reserve for loan

losses)/Total assets

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


• Risk ratiosAsset quality

Provision for loan loss ratio = PLL/TL (provision for loan losses/total loans and leases)

Loan ratio = Net loans/Total assetsLoss ratio

= Net charge-offs on loans (gross charge-offs minus recoveries)/Total loans and leases

Reserve ratio = Reserve for loan losses (reserve for loan losses last year

minus gross charge-offs plus PLL and recoveries)/Total loans and leases

Nonperforming ratio = Nonperforming assets (nonaccrual loans and restructured loans)/Total loans and leases


• Risk ratios– Operating efficiency (cost control)

Wages and salaries/Total expenses

Fixed occupancy expenses/Total expenses– Liquidity

Temporary investments ratio

= (Fed funds sold, short-term securities, cash, trading account

securities)/Total assets

Volatile liability dependency ratio

= (Total volatile liabilities - Temporary investments)/Net loans

and leases

Note: This ratio gives an indication of the extent to which “hot” money is being used to fund the riskiest assets of the bank.


• Other financial ratios– Tax rate = Total taxes paid/Net income before taxes

– Dollar gap ratio

= Interest rate sensitive assets - Interest-rate sensitive liabilities

Total assets

where rate-sensitive means short-term with maturities of less than one year (or repriced in less than one year).

Internal Performance Evaluations Based on Economic Profit

• RAROC (Risk-adjusted return on capital)– Example

Cost of funds 5.00%Provision for loan losses 1.00Direct expense 0.50Indirect expense 0.25Overhead 0.25 Total charges before capital charge 7.00%

Capital charge* 2.29Total required loan rate 9.29%*Note: The capital charge is determined by multiplying the equity capital allocated to the loan

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

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

Internal Performance Evaluations Based on Economic Profit

• EVA (Economic value added)

= Adjusted earnings – Opportunity cost of capital,

where adjusted earnings is net income after taxes, and the opportunity cost of capital equals the cost of equity times equity capital.

• RAROC and EVA– Both methods are beneficial in assessing managerial performance

and developing incentive compensation schemes compatible with shareholder wealth goals.

– RAROC has a short-run perspective (i.e., business unit profit is compared to the unit’s capital at risk)

– EVA has a long-run perspective (i.e., business unit profit is compared to the cost of capital of the bank)

evaluating bank performance outline –a framework for evaluating bank performance internal...

Documents