CHAPTER 6MEASURING AND EVALUATING THE PERFORMANCE OF BANKS AND THEIR PRINCIPAL COMPETITORSGoal of This Chapter: The purpose of this chapter is to discover what analytical tools can be applied to a banks 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 Key Topics in This Chapter Stock Values and Profitability Ratios Measuring Credit, Liquidity, and Other Risks Measuring Operating Efficiency Performance of Competing Financial Firms Size and Location Effects The UBPR and Comparing PerformanceChapter OutlineI.Introduction:II.Evaluating a Banks PerformanceA.Determining Long-Range ObjectivesB.Maximizing The Value of the Firm: A Key Objective for Nearly All Financial-Service InstitutionsC.Profitability Ratios: A Surrogate for Stock Values1.Key Profitability Ratios2.Interpreting Profitability RatiosD.Useful Profitability Formulas for Banks and Other Financial Service CompaniesE.Breaking Down Equity Returns for Closer AnalysisF.Break-Down Analysis of the Return on AssetsG.What a Breakdown of Profitability Measures Can Tell UsH.Measuring Risk in Banking and Financial Services1.Credit Risk2.Liquidity Risk3.Market Risk4.Interest-Rate Risk5.Operational Risk6.Legal and Compliance Risk7.Reputation Risk8.Strategic Risk9.Capital RiskI.Other Goals in Banking and Financial Services ManagementIII.Performance Indicators among Bankings Key CompetitorsIV.The Impact of Size on PerformanceA.Size, Location and Regulatory Bias in Analyzing The Performance of Banks and Competing Financial InstitutionsB.Using Financial Ratios and Other Analytical Tools to Track Bank Performance-The UBPR.V.Summary of the ChapterAppendix to the Chapter - Improving the Performance of Financial Firms Through Knowledge: Sources of Information on the Financial-Services IndustryConcept Checks6-1.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.6-2.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.6-3.What factors influence the stock price of a financial-services corporation?A banks 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 banks perceived risk exposure, or by a combination of increases in expected earnings and reduced risk.6-4.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 banks perceived level of risk is 10 percent. Can you estimate the current value of the banks stock?In this constant dividend growth rate problem the current value of the banks stock would be:Po = D1 / (k g) = $4 / (0.10 0.05) = $80.6-5.What is return on equity capital and what aspect of performance is it supposed to measure? Can you see how this performance measure might be useful to the managers of financial firms?Return on equity capital is the ratio of Net Income/Total Equity Capital. It represents the rate of return earned on the funds invested in the bank by its stockholders. Financial firms have stockholders, too who are interested in the return on the funds that they invested.6-6 Suppose a bank reports that its net 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 d