Measuring and Evaluating Bank Performance 6 July 2009 Ms. Kashmirr C. Ibanez

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez What is performance? How adequately a financial firm meets the needs of its stockholders, employees, depositors and other creditors and borrowing customers Keep regulators satisfied that operating policies, loans and investments are sound Must be directed towards specific objectives

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Value of the Bank’s Stock

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Value of a Bank’s Stock Rises When: Expected dividends increase Risk of the bank falls Market interest rates decrease Combination of expected dividend increase and risk decline

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Value of Bank’s Stock if Earnings Growth is Constant

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Key Profitability Ratios in Banking ** use total earning assets for NIM and NNM

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Key Profitability Ratios in Banking

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Interpreting the key profitability ratios Return on Equity (ROE) Measure of rate of return flowing to shareholders Return on Assets (ROA) Managerial efficiency How capable management has been in converting assets into net earnings Net Interest MarginHow large a spread between interest revenues and interest costs management has been able to achieve Net Non-interest Margin Amount of non-interest revenues stemming from service fees relative to the amount of non- interest costs incurred Usually negative

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Zoom in on ROE Return to shareholder is sensitive to how its assets are financed Financial institutions with low ROA can achieve a relatively high ROE through heavy use of debt (leverage) and minimal use of owner’s capital As earnings efficiency (ROA) declines, the firm must take on more risk in the form of higher leverage to have any chance of achieving its desired ROE

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Zoom in on ROE Net Profit MarginNet Income Total operating revenue Degree of Asset Utilization Total operating revenue Total assets Equity MultiplierTotal assets Total equity capital

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Zoom in on ROE Net Profit Margin Effectiveness of expense management (cost control) and service pricing policies Degree of Asset Utilization Portfolio management policies, especially the mix and yield on assets Equity Multiplier Leverage of financing policies (debt or equity)

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Achieving profitability depends on several crucial factors Careful use of financial leverage Proportion of assets financed by debt as opposed to equity capital Careful use of operating leverage Proportion of fixed cost inputs used to boost operating earnings as output grows Careful control of operating expenses Careful management of asset portfolio Careful control of exposure to risk

Other measures of bank performance

All about risk Risk perceived uncertainty associated with a particular event Deviation from expectations Popular measures for overall risk for a financial firm Standard deviation or variance of stock prices, net income, ROE or ROA FINBANK SY Term 2 Ms. Kashmirr C. Ibañez

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Measuring Bank Risks Credit Risk The probability that some of the bank’s assets will decline in value and perhaps become worthless Liquidity Risk Probability the bank will not have sufficient cash and borrowing capacity to meet deposit withdrawals and other cash needs Market Risk Probability of the market value of the bank’s investment portfolio declining in value due to a rise in interest rates

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Bank Risks Interest Rate Risk The danger that shifting interest rates may adversely affect a bank’s net income, the value of its assets or equity Earnings Risk The risk to the bank’s bottom line – its net income after all expenses Capital Risk Probability of the value of the bank’s assets declining below the level of its total liabilities. The probability of the bank’s long run survival

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Bank Risks Legal risk Creates variability in earnings resulting from actions taken by leval system (e.g. unenforceable contracts, lawsuits, adverse judgments Compliance risk Reaches beyond violation of the legal system and includes violations of rules and regulations. Reputational risk Uncertainty associated with public opinion Strategic risk Variations in earnings due to adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Credit Risk Measures Nonperforming Loans/Total Loans Net Charge-Offs/Total Loans Provision for Loan Losses/Total Loans Provision for Loan Losses/Equity Capital Allowance for Loan Losses/Total Loans Allowance for Loan Losses/Equity Capital Total Loans/Total Deposits

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Liquidity Risk Measures Purchased Funds/Total Assets Net Loans/Total Assets Cash and Due from Banks/Total Assets Cash and Government Securities/Total Assets

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Market Risk Measures BV of Assets/ MV of Assets BV of Equity/ MV of Equity BV of Bonds/MV of Bonds MV of Preferred Stock and Common Stock

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Interest Rate Risk Measures Interest Sensitive Assets/Interest Sensitive Liabilities Uninsured Deposits/Total Deposits

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Earnings Risk Measures Standard Deviation of Net Income Standard Deviation of ROE Standard Deviation of ROA

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Capital Risk Measures Interest rate spread between market yields on debt issues and market yields on GS with the same maturity Stock Price/ Annual EPS Ratio falls if investors believe that a financial firm is undercapitalized relative to the risk it is taking on Equity Capital/Total Assets Purchased Funds/Total Liabilities Equity Capital/Risk Assets

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Other Forms of Risk in Banking Inflation Risk Currency or Exchange Rate Risk Political Risk Crime Risk

FINBANK SY Term 2 Ms. Kashmirr C. Ibañez Don’t Forget to be FAIR! Compare institutions with similar… SizeLocation Regulation Target Market