1 Chapter 20 Bank Performance Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2 Chapter Outline Valuation of a commercial bank Performance evaluation of banks Risk evaluation of banks How to evaluate a bank’s performance Bank failures

3 Valuation of a Commercial Bank The value of a commercial bank is the present value of its future cash flows: The value should change in response to changes in its expected cash flows and to changes in the required rate of return:

4 Valuation of a Commercial Bank (cont’d) Factors that affect cash flows  Change in economic growth During periods of strong economic growth:  Loan demand is higher  Commercial banks provide more loans  Demand for other bank products tends to be higher  Fewer loan defaults occur  Expected cash flows should be higher

5 Valuation of a Commercial Bank (cont’d) Factors that affect cash flows (cont’d)  Change in the risk-free interest rate If the risk-free rate decreases and other market rates decline, there may be stronger demand for the bank’s loans Banks’ cost of funds decreases when the risk-free rate decreases  Change in industry conditions If regulators reduce the constraints imposed on commercial banks, expected cash flows should increase Technical innovation can improve efficiencies and enhance cash flows A high level of competition may reduce the bank’s volume of business or reduce the prices it can charge for its services

6 Valuation of a Commercial Bank (cont’d) Factors that affect cash flows (cont’d)  Change in management abilities Managers can attempt to make internal decisions that will capitalize on the external forces that the bank cannot control Skillful managers will recognize how to revise the composition of the bank’s assets and liabilities to capitalize on existing economic or regulatory conditions

7 Valuation of a Commercial Bank (cont’d) Factors that affect the required rate of return by investors  Change in the risk-free rate When the risk-free rate increases, so does the return required by investors:

8 Valuation of a Commercial Bank (cont’d) Factors that affect the required rate of return by investors (cont’d)  Change in the risk premium When the risk premium increases, so does the return required by investors: Impact of the September 11 Crisis on commercial bank values  Commercial bank valuations declined as a result because economic conditions were weakened and the volume of bank loans declined

9 Performance Evaluation of Banks In the recessions of 1982, the early 1990s, and the early 2000s, banks were adversely affected The international debt crisis of the 1980s had a major impact on the largest banks with loans to less developed countries

10 Performance Evaluation of Banks (cont’d) Interest income and expenses  Gross interest income is interest income generated from all assets Affected by market rates and the composition of assets held by banks Gross interest income on small and medium banks is typically higher than that of other banks  Gross interest expenses represent interest paid on deposit and on other borrowed funds Affected by market rates and the composition of the bank’s liabilities In recent years, gross interest expenses have been similar among banks

11 Performance Evaluation of Banks (cont’d) Interest income and expenses (cont’d)  Net interest income is the difference between gross interest income and interest expenses and is measured as a percentage of assets The net interest margin of all banks in aggregate has remained somewhat stable Net interest margin has generally been highest for the small banks and lowest for money center banks

12 Performance Evaluation of Banks (cont’d) Noninterest income and expenses  Noninterest income results from fees charged on services provided Has consistently risen over time for all banks in aggregate Usually higher for money center, large, and medium banks than for small banks because larger banks provide more services  The loan loss provision is a reserve account established in anticipation of future loan losses Should increase in recessionary periods Was high for most banks during the early 1990s recession but declined for the next several years

13 Performance Evaluation of Banks (cont’d) Noninterest income and expenses (cont’d)  Noninterest expenses include salaries, office equipment, and other expenses Generally increased over time  Securities gains and losses result from a bank’s sale of securities Have been negligible in the aggregate  Income before tax is obtained by summing net interest income, noninterest income, and securities gains and subtracting the provision for loan losses and noninterest expenses In recent years, bank income was enhanced by the increase in noninterest income and in net interest margins

14 Performance Evaluation of Banks (cont’d) Net income  Net income accounts for any taxes paid  Return on assets (ROA): Is net income measured as a percentage of assets Has been unusually high in recent years because of the increase in noninterest income Has been high for medium and large banks recently Depends on the bank’s policy decisions as well as uncontrollable factors relating to the economy and government regulations

15 Performance Evaluation of Banks (cont’d) Net income (cont’d)  Return on equity (ROE) ROE is affected by the same income statement items that affect ROA as well as the bank’s degree of financial leverage: The leverage measure is the inverse of the capital ratio In recent years, money center banks have experienced a lower ROE than other banks because of their low ROA and high degree of capital

16 Risk Evaluation of Banks No consensus measurement of risk exists that allows for comparison of various types of risk among all banks Beta is the degree of sensitivity of stock returns to the returns of the stock market as a whole:  The regression model is applied to quarterly historical data  The coefficient is an estimate of beta because it measures the sensitivity of bank returns to market returns Banks whose stock returns are less vulnerable to economic conditions have relatively low betas Beta ignores unsystematic risk

17 How to Evaluate a Bank’s Performance Analysts often need to evaluate an individual bank’s performance Examination of return on assets  ROA usually reveals when a bank’s performance is not up to par The components of ROA must be evaluated separately to determine the reason (see next slide)

18 How to Evaluate a Bank’s Performance (cont’d) Measures of Bank Performance Financial Characteristics Influencing Performance Bank Decisions Affecting Financial Characteristics Return on assets (ROA) Net interest margin  Deposit rate decisions  Loan rate decisions  Loan losses Noninterest revenues  Bank services offered Noninterest expenses  Overhead requirements  Efficiency  Advertising Loan losses  Risk level of loans provided Return on equity (ROE) ROA  See above Leverage measure  Capital structure decision

19 Bank Failures From 1940 to 1980, there were generally fewer than 20 bank failures per year In the late 1980s, there were about 200 failures per year Failures declined in the early 1990s In the mid and late 1990s, the number of bank failures declined substantially

20 Bank Failures (cont’d) Reasons for bank failure  The bank may have experienced fraud Includes embezzlement of funds  The bank may have a high loan default percentage No matter how well a bank diversifies its loans, it is still subject to a recessionary cycle  The bank may experience a liquidity crisis Rumors may cause depositors to withdraw funds and the bank may be unable to attract new deposits  The bank may face increased competition Deregulation has made the banking industry more competitive A reduced net interest margin could lead to failure

21 Bank Failures (cont’d) Reasons for bank failure (cont’d)  The Office of the Comptroller of the Currency reviewed 162 national failed banks since 1979 and found the following common characteristics: 81 percent of the banks did not have a loan policy or did not closely follow their loan policy 59 percent of the banks did not use an adequate system for identifying problem loans 63 percent of the banks did not adequately monitor key bank officers or departments 57 percent of the banks allowed one individual to make major corporate decisions