6-1 TABLE 6–1 Components of Return on Equity (ROE) for All FDIC-Insured Institutions (1992-2009) Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Evaluating Performance (continued) 6-2 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 firms or Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Evaluating Performance (continued) 6-3 Evaluating Performance (continued) We can also divide a financial firm’s return on assets into its component parts Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

TABLE 6–2 Calculating Return on Assets (ROA) 6-4 TABLE 6–2 Calculating Return on Assets (ROA) Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

6-5 TABLE 6–3 Components of Return on Assets (ROA) for All FDIC-Insured Depository Institutions (1992–2009) Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Evaluating Performance (continued) 6-6 Evaluating Performance (continued) Achieving superior profitability for a financial institution depends upon several crucial factors Careful use of financial leverage (or the proportion of assets financed by debt as opposed to equity capital) Careful use of operating leverage from fixed assets (or the proportion of fixed-cost inputs used to boost operating earnings as output grows) Careful control of operating expenses so that more dollars of sales revenue become net income Careful management of the asset portfolio to meet liquidity needs while seeking the highest returns from any assets acquired Careful control of exposure to risk so that losses don’t overwhelm income and equity capital Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Evaluating Performance (continued) 6-7 Evaluating 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 event Among the more popular measures of overall risk for a financial firm are the following Standard deviation (σ) or variance (σ2) of stock prices Standard deviation or variance of net income Standard 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 risk Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Evaluating Performance (continued) 6-8 Evaluating Performance (continued) Bank Risks Credit Risk Liquidity Risk Market Risk Interest Rate Risk Operational Risk Legal and Compliance Risk Reputation Risk Strategic Risk Capital Risk Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Evaluating Performance (continued) 6-9 Evaluating Performance (continued) Other Goals in Banking and Financial-Services Management A 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 demand In 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 base Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Performance Indicators among Banking’s Key Competitors 6-10 Performance Indicators among Banking’s Key Competitors Among the key bank performance indicators that often are equally applicable to privately owned, profit-making nonbank financial firms are Prices on common and preferred stock Return on equity capital (ROE) Return on assets (ROA) Net operating margin Net interest margin Equity multiplier Asset utilization ratio Cash accounts to total assets Nonperforming assets to equity capital Interest-sensitive assets to interest- ratio sensitive liabilities Book-value assets to market-value assets Equity capital to risk-exposed assets Interest-rate spread between yields on Earnings per share of stock the financial firm’s debt and market yields on government securities Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

The Impact of Size on Performance 6-11 The Impact of Size on Performance When the performance of one financial firm is compared to that of another, size becomes a critical factor Size is often measured by total assets or, in the case of a depository institution, total deposits Most performance ratios are highly sensitive to the size group in which a financial institution finds itself The best performance comparison is to choose institutions of similar size serving the same market area Also, compare financial institutions subject to similar regulations and regulatory agencies Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

6-12 TABLE 6–4 Important Performance Indicators Related to the Size and Location of FDIC-Insured Depository Institutions (2009) Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5-13 Quick Quiz What 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 institution’s 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 bank’s 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? Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5-14 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 firm Through 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 analysts The UBPR, which is sent quarterly to all federally supervised banks, reports each bank’s assets, liabilities, capital, revenues, and expenses, and the BHCPR is similar for BHCs Web link for UBPR and BHCPR: www.ffiec.gov Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.