Chapter SixMeasuring and Evaluating the Performance of Banks and Their Principal CompetitorsKey TopicsStock Values and Profitability Ratios Measuring Credit, Liquidity, and Other Risks Measuring Operating Efficiency Performance of Competing Financial Firms Size and Location Effects Appendix: Using Financial Ratios and Other Analytical Tools to Track Financial Firm Performance The UBPR and BHCPR IntroductionThis chapter focuses on the most widely used indicators of the quality and quantity of bank performance and their principal competitors Focus on the most important dimensions of performance profitability and riskFinancial institutions are simply businesses organized to maximize the value of the shareholders wealth invested in the firm at an acceptable level of riskMust continually be on the lookout for new opportunities for revenue growth, greater efficiency, and more effective planning and controlEvaluating Performance Performance must be directed toward specific objectivesA fair evaluation of any financial firms performance should start by evaluating whether it has been able to achieve the objectives its management and stockholders have chosenA key objective is to maximize the value of the firmEvaluating Performance (continued)The minimum acceptable rate of return, r, is sometimes referred to as an institutions cost of capitalTwo main componentsThe risk-free rate of interest The equity risk premium The value of the financial firms stock will tend to rise in any of the following situations1.The value of the stream of future stockholder dividends is expected to increase2.The financial organizations perceived level of risk falls3.Market interest rates decrease, reducing shareholders acceptable rates of return via the risk-free rate of interest component of all market interest rates4.Expected dividend increases are combined with declining risk, as perceived by investorsEvaluating Performance (continued)The stock values of financial institutions are sensitive to changes in market interest rates, currency exchange rates, and the strength or weakness of the economyEquation (61) assumes that the stock may pay dividends of varying amounts over timeIf the dividends paid to stockholders are expected to grow at a constant rate over time, perhaps reflecting steady growth in earnings, the stock price equation can be greatly simplified intoD1 is the expected dividend in period 1r is the rate of discount reflecting the perceived level of riskg is the expected constant growth rate at which all future stock dividends will grow each yearEvaluating Performance (continued)The previous two stock price formulas assume the financial firm will pay dividends indefinitely into the future Most capital market investors have a limited time horizonwhere we assume an investor will hold the stock for n periods, receiving the stream of dividends D1, D2, . . . , Dn and sell the stock for price Pn at the end of the planned investment horizonEvaluating Performance (continued)The behavior of a stocks price is, in theory, the best indicator of a financial firms performance because it reflects the markets evaluation of that firmThis indicator is often not available for smaller banks and other relatively small financial-service corporationsKey Profitability RatiosEvaluating Performance (continued)Evaluating Performance (continued)Return on assets (ROA) is primarily an indicator of managerial efficiencyIndicates how capable management has been in converting assets into net earningsReturn on equity (ROE) is a measure of the rate of return flowing to shareholdersApproximates the net benefit that the stockholders have received from investing their capital in the financial firmThe net operating margin, net interest margin, and net noninterest margin are efficiency measures as well as profitability measuresThe net interest margin measures how large a spread between interest revenues and interest costs management has been able to achieveThe net noninterest margin 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 incurredTypically, the net noninterest margin is negativeEvaluating Performance (continued) Another traditional measure of earnings efficiency is the earnings spreadMeasures the effectiveness of a financial firms intermediation function in borrowing and lending money and also the intensity of competition in the firms market areaGreater competition tends to squeeze the difference between average asset yields and average liability costsIf other factors are held constant, the spread will decline as competition increasesEvaluating Performance (continued)Useful Profitability Formulas for Banks and Other Financial-Service Companies Evaluating Performance (continued) or whereEXHIBIT 61 Elements That Determine the Rate of Return Earned on the Stockholders Investment (ROE) in a Financial FirmTABLE 61 Components of Return on Equity (ROE) for All FDIC-Insured Institutions (1992-2009)Evaluating Performance (continued)A slight variation of the simple ROE model produces an efficiency equation useful for diagnosing problems in four different areas in the management of financial-service firmsorEvaluating Performance (continued)We can also divide a financial firms return on assets into its component partsTABLE 62 Calculating Return on Assets (ROA)TABLE 63 Components of Return on Assets (ROA) for All FDIC-Insured Depository Institutions (19922009)Evaluating Performance (continued)Achieving superior profitability for a financial institution depends upon several crucial factors1.Careful use of financial leverage (or the proportion of assets financed by debt as opposed to equity capital)2.Careful use of operating leverage from fixed assets (or the proportion of fixed-cost inputs used to boost operating earnings as output grows)3.Careful control of operating expenses so that more dollars of sales revenue become net income4.Careful management of the asset portfolio to meet liquidity needs while seeking the highest returns from any assets acquired5.Careful control of exposure to risk so that losses dont overwhelm income and equity capitalEvaluating Performance (continued)Risk to the manager of a financial institution or to a regulator supervising financial institutions means the perceived uncertainty associated with a particular eventAmong the more popular measures of overall risk for a financial firm are the followingStandard deviation () or variance (2) of stock pricesStandard deviation or variance of net incomeStandard deviation or variance of return on equity (ROE) and return on assets (ROA)The higher the standard deviation or variance of the above measures, the greater the overall riskEvaluating Performance (continued)Bank RisksCredit RiskLiquidity RiskMarket RiskInterest Rate RiskOperational RiskLegal and Compliance RiskReputation RiskStrategic RiskCapital RiskEvaluating Performance (continued)Other Goals in Banking and Financial-Services ManagementA rise in the value of the operating efficiency ratio often indicates an expense control problem or a falloff in revenues, perhaps due to declining market demandIn contrast, a rise in the employee productivity ratio suggests management and staff are generating more operating revenue and/or reducing operating expenses per employee, helping to squeeze out more product with a given employee basePerformance Indicators among Bankings Key CompetitorsAmong the key bank performance indicators that often are equally applicable to privately owned, profit-making nonbank financial firms arePrices on common and preferred stock Return on equity capital (ROE)Return on assets (ROA) Net operating marginNet interest margin Equity multiplierAsset utilization ratioCash accounts to total assetsNonperforming assets to equity capitalInterest-sensitive assets to interest-ratiosensitive liabilitiesBook-value assets to market-value assetsEquity capital to risk-exposed assetsInterest-rate spread between yields on Earnings per share of stockthe financial firms debt and market yields on government securitiesThe Impact of Size on PerformanceWhen the performance of one financial firm is compared to that of another, size becomes a critical factorSize is often measured by total assets or, in the case of a depository institution, total depositsMost performance ratios are highly sensitive to the size group in which a financial institution finds itselfThe best performance comparison is to choose institutions of similar size serving the same market areaAlso, compare financial institutions subject to similar regulations and regulatory agenciesTABLE 64 Important Performance Indicators Related to the Size and Location of FDIC-Insured Depository Institutions (2009)Quick QuizWhat individuals or groups are likely to be interested in the banks level of profitability and exposure to risk?What are the principal components of ROE, and what does each of the these components measure?What are the most important components of ROA and what aspects of a financial institutions performance do they reflect? Why do the managers of financial firms often pay close attention today to the net interest margin and noninterest margin? To the earnings spread? To what different kinds of risk are banks and their financial-service competitors subjected today? What items on a banks balance sheet and income statement can be used to measure its risk exposure? To what other financial institutions do these risk measures seem to apply? Appendix: Using Financial Ratios and Other Analytical Tools to Track Financial-Firm Performance The UBPR and BHCPR Compared to other financial institutions, more information is available about banks than any other type of financial firmThrough the cooperative effort of four federal banking agencies the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the Office of the Comptroller of the Currency the Uniform Bank Performance Report (UBPR) and the Bank Holding Company Performance Report (BHCPR) provide key information for financial analystsThe UBPR, which is sent quarterly to all federally supervised banks, reports each banks assets, liabilities, capital, revenues, and expenses, and the BHCPR is similar for BHCsWeb link for UBPR and BHCPR: www.ffiec.gov