McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Measuring and Evaluating the Performance of Banks and Their Principal Competitors

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-2 Key Topics Stock Values and Profitability Ratios Measuring Credit, Liquidity, and Other Risks Measuring Operating Efficiency Performance of Competing Financial Firms Size and Location Effects

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-3 Introduction This 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 risk

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-4 Introduction Financial institutions are businesses organized to maximize the value of the shareholders’ wealth invested in the firm at an acceptable level of risk Must always be looking for new opportunities for revenue growth, greater efficiency, and more effective planning and control

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-5 Introduction Individuals or groups that are interested in how well a bank performs includes the: stockholders (owners) employees depositors and creditors borrowing customers bank examiners representing the laws and regulations

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-6 Evaluating Performance p Performance must be directed toward specific objectives, such as: Growing faster Longer term growth (growing over time) Minimizing risk and being a safe bank 2. A fair evaluation of any financial firm’s performance should start by evaluating whether it has been able to achieve the objectives its management and stockholders have chosen 3. A key objective is to maximize the value of the firm

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-7 Evaluating Performance (continued) p. 89 The minimum acceptable rate of return, r, is referred to as an bank’s cost of capital ▫ Risk-free rate of interest ▫ Equity risk premium (return to investors for risk) The value of the financial firm’s stock will tend to rise in any of the following situations 1.Stockholder dividends is expected to increase 2.The level of risk falls 3.Market interest rates decrease, reducing shareholders’ acceptable rates of return with the risk-free rate of interest component of all market interest rates 4.Dividend increases combined with declining risk, as seen by investors

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-8 Evaluating Performance (continued) p. 89 The stock values of banks are sensitive to changes in market interest rates and the strength or weakness of the economy Stocks may pay dividends of varying amounts over time If the dividends paid to stockholders are expected to grow at a constant rate over time, the stock price equation can be greatly simplified into ▫ D 1 is the expected dividend in period 1 ▫ r is the rate of discount reflecting the perceived level of risk ▫ g is the expected constant growth rate at which all future stock dividends will grow each year

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 6-9 Concept Check p. 90 What factors influence the stock price of a financial firm? What individuals or groups are likely to be interested in the banks’ level of profitability and exposure to risk? A bank is expected to pay an annual dividend of $4 per share and the dividends are expected to grow at 5% by the end of year and the return-to-equity capital based on the level of risk is 10%. Estimate the current value of the bank’s stock?

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 90 The previous price formula assumes the financial firm will pay dividends ongoing into the future Most capital market investors have a limited time horizon ▫ where we assume an investor will hold the stock for n periods, receiving the stream of dividends D 1, D 2,..., D n and sell the stock for price P n at the end of the planned investment horizon

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 91 The behavior of a stock’s price is the best indicator 指针 ( zhǐzhēn) of a financial firm’s performance because it reflects the market’s evaluation of that firm The stock price indicator is often not available for smaller banks and other relatively small financial firms KEY PROFITABILITY RATIOS (in simple form):

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 91

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) P Return on assets (ROA) is primarily an indicator of managerial efficiency Indicates how capable 能 (néng) management has been in converting 兑换 ( duìhuàn) assets into net earnings Return on equity (ROE) is a measure of the rate of return flowing to shareholders The net benefit that the stockholders have received from investing their capital in the financial firm

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) P The net operating margin (difference), net interest margin, and net noninterest margin are efficiency measures as well as profitability measures ▫ The net interest margin measures how large a difference between interest revenues and interest costs ▫ The net noninterest margin measures the noninterest revenues from service fees the firm has been able to collect relative to the amount of noninterest costs ▫ Typically, the net noninterest margin is negative

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 92 Another measure of earnings efficiency is the earnings spread ▫ Measures the effectiveness of a financial firm’s function in borrowing and lending money and also the amount of competition in the firm’s market area ▫ Greater competition tends to make the difference between average asset yields and average liability costs lower ▫ If other factors are held constant, the spread will decline as competition increases

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Concept Check P What is Return on Equity (REO) capital and what is it supposed to measure? How is this helpful to managers of financial firms? 4-6 A bank reports that its net income for the year is $51 million, its asset total is &1,144 million and liabilities are $926 million. What is its return on equity capital? Is the ROE good or bad? What information do you need to answer this question? 4-7 What is the return on assets (ROA) and why is it important?

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Concept Check P. 92, A bank estimates that its total revenues will amount to $155 million and its total expenses (including taxes) will equal $107 million this year. It’s liabilities total $4,960 million while it’s equity capital amounts to $52 million. What is the bank’s return on assets? Is this ROA high or low? How could you find out? 4-9 Why do the managers of financial firms often pay close attention today to the net interest margin and noninterest margin? To the earnings spread?

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p Useful Profitability Formulas for Banks and Other Financial-Service Companies. Both ROE and ROA use the same numerator of net income, so they can be linked directly, as such, or in other words: In a more detailed form, we note that net income is equal to total revenues minus total operating expenses and taxes, thus

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 93, 94 or where

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved EXHIBIT 4–1 Elements That Determine the Rate of Return Earned on the Stockholders’ Investment (ROE) in a Financial Firm p. 94

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved TABLE 4–1 Components of Return on Equity (ROE) for All FDIC-Insured Institutions ( ) p. 95

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 96, 97 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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 98 We can also divide a financial firm’s return on assets into its component parts

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved TABLE 4–2 Calculating Return on Assets (ROA) p. 98

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved TABLE 6–3 Components of Return on Assets (ROA) for All FDIC-Insured Depository Institutions (1992–2009) p. 99

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 100 Achieving superior profitability for a financial institution depends upon several crucial factors Careful use of financial leverage 杠杆作用 ( Gànggǎn zuòyòng) (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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (cont) p Bank Risks ▫ Credit Risk – loans might be bad or decline in value ▫ Liquidity Risk – danger of bank not having enough cash to meet customers ned for cash or loan demand. ▫ Market Risk includes price risk and interest rate risk ▫ Price risk – price goes up or down on assets like stock. ▫ Interest Rate Risk – interest rate changes. ▫ Operational Risk – computer failure, employee errors or mistakes. ▫ Legal and Compliance Risk ▫ Reputation Risk ▫ Strategic Risk ▫ Capital Risk

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating Performance (continued) p. 107 Other Goals in Banking and Financial-Services Management 2 Other Key Operating Efficiency Ratios 1. 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 2. 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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved The Impact of Size on Performance p. 108,109 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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved TABLE 4–4 Important Performance Indicators Related to the Size and Location of FDIC-Insured Depository Institutions (2009) p.109

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Concept Check To what different kinds of risk are banks and their financial-service competitors subjected today?

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter Summary The focus of this chapter shows how well banks perform in serving their customers and providing a good rate of return to their owners. We have also looked at the many ways banks measure their own performance and that of other banks. The 2 key ways of looking at performance are profitability and risk. Good profits and controlling risk insure growth for a bank.

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter Summary Return on Assets (ROA) – measures how efficient is management. Return on Equity (ROE) – measures rate of return to shareholders. Net operating margin 差额 ( chā'é), net interest and net non-interest margin measure how management is keeping growth ahead of costs.

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter Summary There are other ratios to measure operating efficiency of a bank such as the Operating efficiency ratio and employee productivity ratio. Making a profit must always be balanced against risk. There are several types of risk. These risks are shown on a previous slide.

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter Summary There are other ratios to measure operating efficiency of a bank such as the Operating efficiency ratio and employee productivity ratio. Making a profit must always be balanced against risk. There are several types of risk. These risks are shown on a previous slide.