CHAPTER 20 Bank Performance

Chapter Objectives n Identify the factors that affect the valuation of a commercial bank n Compare the performance of banks in different size classifications over recent years n Explain how to evaluate the performance of banks based on financial statement data

Value =  E(CF t ) (1+k) t t=1 n Valuation of a Commercial Bank n Banks are commonly valued by managers to monitor performance over time and determine the proper mix of services that will maximize the value of the bank n Banks are also valued by other financial institutions that are considering an acquisition n The value of a bank can be modeled as the present value of future cash flows

Valuation of a Commercial Bank Value of a commercial bank depends on its expected cash flows and required rate of return  V = f [  E(CF),  k]  V = Change in value of the institution  k = Change in required rate or return Where:  E(CF) = Change in expected cash flows +

Valuation of a Commercial Bank Factors that affect cash flows E(CF) = Expected cash flow R f = Risk free interest rate INDUS = Prevailing industry conditions for the institution Where:  E(CF)= f (  ECON,  R f,  INDUS,  MANAB) ECON = Economic growth MANAB = The ability of the institution’s management + - ? +

Valuation of a Commercial Bank n Economic growth l Increases household or business demand for loans l Banks move assets from T-bills and other securities to more profitable loans l Loan defaults tend to be lower during period of strong economic growth u Other financial services provided by commercial banks also experience increases in demand n Insurance, brokerage n financial planning

Valuation of a Commercial Bank n Change in the risk-free interest rate l Interest rate movements are inversely related to a commercial bank’s cash flows u Banks rely on interest-sensitive short-term deposits as a source of funds u Bank’s use of funds (such as loans) are less sensitive to interest rates than deposits

Valuation of a Commercial Bank n Change in industry conditions l One of the most important: regulation u If regulators reduce constraints, bank’s expected cash flows increase l Technological innovation u Improves efficiency l Level of competition n Change in management abilities l The only one of the factors within bank’s control l Skillful managers enhance a bank’s cash flows

Exhibit 20.1 Framework for Valuing A Commercial Bank a Abilities of the Commercial Bank’s Managers Bank Industry Conditions (such as Regulations, Technology, and Competition) Economic Growth Expected Cash Flows to Be Generated by the Commercial Bank Required Return by Investors Who Invest in the Commercial Bank Inflation Money Supply Budget Deficit Risk-Free Interest Rate Risk Premium on the Commercial Bank Value of the Commercial Bank

Valuation of a Commercial Bank n Factors that affect the required rate of return by investors:the risk-free rate and the risk premium n Investors required rate of return: Where: R f = Risk free interest rate RP = Risk premium  k = f(  R f,  RP) ++

Valuation of a Commercial Bank Change in the risk-free rate  R f = f (  INF,  ECON,  MS,  DEF) INF = Inflationary expectations R f = Risk free interest rate MS =Money supply ECON = Economic growth Where: DEF =Budget deficit +++

Change in the risk premium INDUS = Prevailing industry conditions for the institution Where: ECON = Economic growth MANAB = The ability of the institution’s management RP = Risk premium  RP = f (  ECON,  INDUS,  MANAB) ? Valuation of a Commercial Bank

Performance Evaluation of Banks n Interest income and expenses l Gross interest income = interest income generated from all interest-bearing assets u Affected by market rates u Impacted by the composition of bank assets l Gross interest expenses = interest paid on deposits and borrowed funds u Affected by market rates u Impacted by the composition of bank liabilities l Net interest income = gross interest income – interest expenses

Exhibit 20.3 Gross Interest Income Among Bank Classes aa a Year Small Banks Money Center Banks Large Banks Medium Banks Gross Interest Income (as% of Assets)

Exhibit 20.4 Gross Interest Expenses Among Bank Classes aa Medium Banks Small Banks Year Money Center Banks Large Banks Gross Interest Income (as% of Assets)

Exhibit 20.5 Net Interest Margins Among Bank Classes aa Money Center Banks Large Banks Medium Banks Year Small Banks Net Interest Margin (In Percent)

Performance Evaluation of Banks n Noninterest income and expenses l Noninterest income results from fees charged on services u Lockboxes, banker’s acceptances, cashier’s checks, foreign exchange transactions l Loan loss provision is a reserve account established in anticipation of future losses l Noninterest expenses include salaries, office equipment l Securities gains and losses

Exhibit 20.6 Noninterest Income Among Bank Classes aa Year Money Center Banks Large Banks Medium Banks Small Banks Noninterest Income (as % of Assets)

Exhibit 20.7 Loan Loss Provisions Among Bank Classes aa Money Center Banks Year Small Banks Medium Banks Large Banks Loan Loss Provision (as % of Assets)

Performance Evaluation of Banks n Net income l Return on assets u Net income as a percent of assets u Different for small banks vs. large banks l Return on equity u Affected by ROA and leverage u ROE = ROA x leverage multiplier

Exhibit 20.8 Key Components Affecting ROA aa Year Noninterest Expenses, Plus Loan Loss Provision Net Interest Margin Noninterest Income AssetsReturn on Key Components Affecting Return on Assets (as % of Assets)

Exhibit 20.9 Return on Assets Among Bank Classes aa Year – – 0.4 –0.8 – Small Banks Medium Banks Large Banks Money Center Banks Return on Assets (in Percent)

Exhibit Return On Equity Among Bank Classes aa Year Medium Banks Large Banks Money Center Banks Small Banks Return on Equity (%)

Risk Evaluation of Banks n No consensus measurement exists that would allow for comparison of various types of risk among all banks n Some analysts measure a firm’s risk by its beta, which measures the sensitivity of stock returns to the market as a whole n R i,t = B 0 + B 1 R m,t + u t n Beta ignores firm-specific characteristics

How to Evaluate a Bank’s Performance n Examination of Return on Assets (ROA) l Will usually reveal poor performance, but will not indicate the source of the problem u Must examine its revenue/expense components separately l Possible reasons for a low ROA: u Excessive interest expenses u Low interest received on loans and securities n Too conservative—excessive short-term securities n Economic decline in market area reduces loans u Insufficient noninterest income n Increase service fees n Consider other fee income services u High provisions for loans losses in anticipation of increased loan write-offs

Bank Failures n Reasons for bank failure l Fraud u Embezzlement of funds u No separation of personnel duties—small banks l High loan default percentage u Excessive reliance on a specific industry such as oil, defense, agriculture u Recession periods l Liquidity crisis u Bank runs, panics u Loss of confidence of financial markets l Increased competition

Bank Failures n Study by the Office of the Comptroller of the Currency reviewed 162 national banks that have failed since 1979 and found that: l 81 percent did not have a loan policy or did not closely follow their policy l 59 percent did not use an adequate system to identify problem loans l 63 percent did not adequately monitor key bank officers or departments l 57 percent allowed one individual to make major corporate decisions

Bank Failures n Note that all of these characteristics are controllable n It appears that many banks fail not because of environment but because of inadequate management