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CHAPTER 5

CHAPTER 5. ACCOUNTING AND ECONOMIC MODELS OF BANK PERFORMANCE AND VALUATION. LEARNING OBJECTIVES . TO UNDERSTAND . The Return-On-Equity Model and its Decomposition Analysis Variability of Return as a Measure of Risk Modern Finance in the Real World

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CHAPTER 5

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  1. CHAPTER 5 ACCOUNTING AND ECONOMIC MODELS OF BANK PERFORMANCE AND VALUATION Chapter 5

  2. LEARNING OBJECTIVES TO UNDERSTAND ... • The Return-On-Equity Model and its Decomposition Analysis • Variability of Return as a Measure of Risk • Modern Finance in the Real World • Accounting and Economic Models of Bank Valuation • The Notion of “Hidden Capital” in Banks Chapter 5

  3. CHAPTER THEME • Stamp bank financial statements: “Once upon a time” • Why? Because they are “fairy tales” of the risks embodies in them! • For many banks, however, only these statements are available for performance analysis • ROE Model and Decomposition Analysis Chapter 5

  4. FDCI QUARTERLY BANKING PROFILE: BULLET POINTS • Third Quarter, 2000 • 1. Industry earnings rebound • 2. Net income of $19.3 billion (3rd highest) • 3. Troubled commercial loans continue to rise • 4. PLL absorbs a growing share of revenues • 5. Assets surpass $6-trillion level Chapter 5

  5. ROA by Bank Size(third quarter, 2000) • Asset sizeROA (%, annualized) • < $100 million 1.16 • $100-$1,000 1.30 • $1B-$10B 1.36 • > $10B 1.16 • All banks 1.20 • ROE (all banks) = 14.25% = 1.2% x 11.87 Chapter 5

  6. BANKING STRUCTURE(September 30, 2000) • Asset sizeNumber of banks • < $100 million 4,922 • $100-$1,000 3,070 • “Community banks” 7,992 (95%) • $1B-$10B 301 • > $10B 82 • “Large banks” 383 (5%) Chapter 5

  7. Banking Structure: A More Detailed View(Box 5-1, p. 137) • Description based on 25 asset-size groups • Number of banking offices (1, 2, 3+) • Location (SMA or non-SMA) • Number of banks in peer group • Example: As of 12-31-00, there 830 banks with two or fewer banking offices and total assets between $50-$100 million located in non-SMAs Chapter 5

  8. More Banking Structure • 521 FDIC-insured savings banks • 57 credit-card specialty banks • 5,109 BHCs across four size groups • > $10 billion 64 • $1B-$10B 246 • $150M-$1B 1,407 • < $150 million 3,392 Chapter 5

  9. Overall Bank Performance EM ROE< NonControllable Factors ROA< Overall Bank Controllable Factors Performance < Risk Variability Credit Risk Balance Sheet Risk < Interest-Rate Risk Regulatory Risk Liquidity Risk Technological Risk Exchange-Rate Risk Affiliation Risk Operating-Efficiency Risk Strategic Risk Chapter 5

  10. The ROE Model ROE ROA x EM ROA Net Income / Assets or PM x AU Profit Margin (PM) Net Income / Revenue Asset Utilization (AU) Revenue / Average Total Assets Chapter 5

  11. ROE DECOMPOSITION ANALYSIS • Stage One: ROE = ROA x EM • Stage Two: ROA = PM x AU • Substituting:ROE = PM x AU x EM • Stage Three: Figure 5-2, p. 135 • Conduct a Sherlock-Holmes-type investigation to determine strengths and weaknesses Chapter 5

  12. MEANINGFUL COMPARISONS • Trend or time-series analysis • Peer-group or cross-sectional analysis • Potential “control variables” include: • Bank size • Location • Type of business • Organizational structure Chapter 5

  13. Bank Profitability Factors Contributing to Improved Bank Profitability Since 1992 • Improved Loan Quality • Lower and More Stable Interest Rates • Enhanced Generation of Fees and Other NonInterest Income • Improved Operating Efficiency Chapter 5

  14. Catastrophic Risk11 September 2001 • The bad news of over 6,000 innocent deaths overwhelmed the following good news • The banks and securities firms affected had secondary and tertiary backup systems • The Fed provided ample liquidity to ease the financial aftermath of the market crash in the week that followed and continued its policy of “easy money” to attempt to stimulate the economy Chapter 5

  15. Measures of Dispersion Standard Deviation The Square Root of the Sum of Squared Deviations from the Mean Coefficient of Variation The Ratio of the Standard Deviation to the Mean Chapter 5

  16. Risk Index for Banks RI = [E(ROA) + CAP] / sROA Where E(ROA) = Expected Return on Assets CAP = The Inverse of the EM, or the bank’s ratio of equity capital to total assets SROA = The Standard Deviation of ROA Chapter 5

  17. PROBABILITY OF BOOK-VALUE INSOLVENCY • The risk index (RI) is a distance measure in terms of the number of standard deviations that a bank is away from book-value insolvency • Given an RI, we can compute (an upper bound) probability of book-value insolvency as Pr(BV<0) = 1/2[(RI)2] Chapter 5

  18. RI and Pr(BV<0) • ComponentStrong bankWeak bank • E(ROA) 0.02 -0.02 • CAP 0.10 0.03 • sROA 0.001 0.007 • RI 120.0 1.43 • Pr(BV<0) 0.0035% 24.5% Chapter 5

  19. The Critical Role of Credit Risk • When a bank has too many bad loans what happens? • It has to take such a large PLL that E(ROA) < 0 and it wipes out CAP such that NW < 0. In terms of RI, the numerator < 0. Chapter 5

  20. Market Values, Book Values, and Transparency Itemization Principles Procedures that Govern what Entries do or do not Need to be Recognized in the Body of Each Financial Statement Valuation Principles Procedures that Determine the Worth or Value Assigned to Itemized Entries Chapter 5

  21. Economic Values vs. Accounting Numbers ECONOMICS Market-Value Analysis ACCOUNTING Book-Value Analysis Chapter 5

  22. A Comparative-Statics Experiment: Initial Conditions • Balance sheet: $100,000 = $90,000 + $10,000 • Income-expense statement: 100,000 x .075 – 90,000 x 0.6 = 2,100 • Asset is a five-year, fixed-rate bond with an annual coupon of 7.5% funded by a one-year CD at 6% Chapter 5

  23. A Comparative-Statics Experiment: Interest-Rate Shock • Assume interest rates double immediately after the balance sheet is set • Net income in the second year is: 7,500 – 90,000 x 0.12 = -3,300 • Immediately after the shock, MVE = PV(A) – PV(L) = 74,859 – 85,178 = -10,319 Chapter 5

  24. THE ROLE OF GOVERNMENT GUARANTEES • A + G = L + NW • G, the government guarantee, is an unbooked intangible asset • As a bank’s NW => 0, G becomes more important • Since an unbooked intangible asset must have an offsetting entry, what is it and where is it booked? Chapter 5

  25. Modern Finance in the Real World • Acquisition and Funding of Assets • Risks: Credit, Liquidity, Prepayment, Interest Rate, Sovereign, and Foreign Exchange • Stock Price = EPS x P/E Chapter 5

  26. Discounted Cash Flow • Economic, Real, and Market Value • PV = CF1/(1+r)+CF2/(1+r)2+...+CFn/(1+r)n • Risk/Return Tradeoffs Chapter 5

  27. Compromise Model P = EPS* x P/E x K Where: EPS* = current economic or real earnings and K = an adjustment factor that marks the industry P/E ratio either up or down to reflect the firm’s unique risk profile Chapter 5

  28. Pricing Capital Assets and BETA • Capital Asset Pricing Model (CAPM) = provides a method for determining asset prices based on the asset’s contribution to portfolio risk r = rf + beta(rM + rf) • Beta = index of systematic risk Chapter 5

  29. Market Measures of Financial Performance • Market-To-Book Ratio • Price-Earnings Ratio • Constant-Growth Model • Dividend-Payout Ratio • Dividend Yield Chapter 5

  30. Hidden Capital Two Sources of Hidden Capital 1. Differences Between the Market Values (MV) and Book Values (BV) of on-balance-sheet items 2. Neglect off-balance-sheet items that Generally Accepted Accounting Principles do not Permit to be Formally Booked Chapter 5

  31. SMVAM • Statistical Market Value Accounting Model (SMVAM) • MVE = a + b (BVE) + e • Joint hypothesis: [a = 0, b = 1] • If so, MVE = BE • Do we expect this to hold? • How do we interpret the rejection of the null hypothesis? Chapter 5

  32. SMVAM Results (2000) • SampleIntercept (a)Slope (b) • 28 BHCs - 2.60 3.03* • 9 largest -24.1 3.66* • 19 large 1.0 2.91* *Significantly different from 1.0 at the 1% level of significance Chapter 5

  33. CHAPTER SUMMARY • Accounting and economic models can be used to measure bank performance • Economic models are more realistic but accounting frameworks are the only game in town for many banks • ROE = PM x AU x EM • Credit risk has caused the greatest fluctuations in bank earnings Chapter 5

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