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Ch. 6 Measuring and Evaluating Bank Performance

Ch. 6 Measuring and Evaluating Bank Performance. Based on Rose and Hudgins, Bank Mgt & Fin Services , Gup text, and adapted by Dorla Evans. Key Topics. Stock values Profitability ratios Measuring credit, liquidity, and other risks Size and location effects UBPR and comparing performance.

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Ch. 6 Measuring and Evaluating Bank Performance

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  1. Ch. 6Measuring and Evaluating Bank Performance Based on Rose and Hudgins, Bank Mgt & Fin Services, Gup text, and adapted by Dorla Evans

  2. Key Topics • Stock values • Profitability ratios • Measuring credit, liquidity, and other risks • Size and location effects • UBPR and comparing performance

  3. Stakeholders of bank performance • Stockholders • Bank management • Regulators • Depositors • Business community

  4. External performance • Market value • Is the bank maximizing shareholder wealth? Meeting its business goals relative to competitors in the region? Assets, deposits, loans, financial services? • Regulatory compliance • Is the bank complying with federal and state regulations dealing with capital adequacy, riskiness of assets, security laws, etc? • Public confidence • Does the public perceive the bank to be safe?

  5. Shareholders’ Wealth: Value of stock • Present value of future cash flows • Determinants of stock price: • Size of cash flows • Timing of cash flows • Riskiness of cash flows Vo = CF1 + CF2 + CF3 + … + CFn (1 + r)1 (1 + r)2 (1 + r)3 (1 + r)n

  6. Value of stock

  7. Value of stock • Vo = $20 + $20 + $20 + $20 + $20 + $100 = $128.7 • (1.12)1 (1.12)2 (1.12)3 (1.12)4 (1.12)5 (1.12)5

  8. Value of stock • Changes in value due to • Changes dividends • Changes in discount rate -- bank risk and market interest rate changes

  9. Valuation using P/E ratio • Forward looking price per share, based on future expected growth and earnings. • Backward looking earnings based on historical data.

  10. Valuation using P/E ratio • Expected P/E: 20, 22, 24 • Earnings per share: $4.50 • Estimated price: • $4.50 x 20 = $90 • $4.50 x 22 = $99 • $4.50 x 24 = $108 P/E

  11. Profitability ratios: ROE Compare to peer of 12.4%

  12. Profitability ratios: ROA Compare to peer of 0.84%

  13. Profitability ratios: Net interest margin Peer comparison: 3.90%

  14. Profitability ratios: Net non-interest margin

  15. Profitability analysis Return on equity (ROE) can be decomposed as follows: Profitability (or the lack thereof!) thus has two parts: • Managerial efficiency • Financial leverage

  16. Profitability analysis Peer comparison: ROE= 12.4%= .84% x 14.8

  17. Profitability analysis • The lower a bank’s ROA, the higher it must push its leverage to achieve a target ROE. Higher risk; higher return.

  18. Profitability analysis: The Du Pont Identity Return on equity (ROE) can be decomposed as follows: ROE = Net income / Total equity = Profit margin x Total asset turnover x Equity multiplier Profitability (or the lack thereof!) thus has three parts: • Operating efficiency (keep expenses under control) • Asset use efficiency (portfolio mgt policies, mix & yield) • Financial leverage (sources chosen to fund bank)

  19. Profitability Analysis: The Du Pont Identity Peer comparison: ROE= 12.4%= 8.4% x 10.0% x 14.8

  20. Profitability Analysis • Leverage • Usually largest contributor to ROE • 15x for smaller banks • 20x for larger banks • Under management’s control

  21. Trends in ROE All FDIC-insured institutions

  22. Trends in Components of ROE All FDIC-insured institutions

  23. Profitability Analysis

  24. Operating efficiency ratios • Measure of expense control • Wages and salaries are largest non-interest expense • Fixed operating expenses

  25. Profitability Analysis • Superior profitability is due to • Careful use of financial leverage • Careful use of operating leverage • Careful control of operating expenses • Careful management of asset portfolio to meet liquidity and return needs • Careful control of exposure to risk to maintain profitability and equity capital.

  26. Which bank earnings matter? • Earnings before securities gains and losses -- fundamental deposit taking and lending activities of banks. • Securities gains and losses -- More transitory and volatile than other components of earnings. • Barth, Beaver, and Wolfson • Stock prices positively related to operating earnings and negatively related to securities gains/losses. • Market views securities gains/losses as attempt by management to smooth earnings

  27. Credit Liquidity Market Price Interest rate Operational Legal and compliance Reputation Strategic Capital Risk factors banks face

  28. Credit risk Probability that an asset will decline in value Non-performing assets include nonaccrual loans, restructured loans, and other real-estate owned They are a leading indicator of poor bank performance

  29. Credit risk Charge-offs are a lagging indicator of bank performance

  30. Credit Risk Peer comparison: 1.18%

  31. Credit Risk

  32. Credit risk

  33. Credit Risk Peer comparison: 48.70%

  34. Liquidity risk • Funds available to meet cash demand for loans and deposit withdrawal

  35. Liquidity ratios * Not broken out in financial statements Peer comparison: 43.50%

  36. Liquidity ratios Volatile liabilities: brokered deposits, jumbo CDs, fed funds purchased, deposits in foreign offices *$83,009 = time deposits>$100K $142,101 = $90,101 +???? Peer comparison: -5.41%

  37. Liquidity risk • Trend toward less liquidity • Liability mgt replacing asset mgt resulting in: • Higher rates of return because more assets have greater maturity • Lower holdings of U.S. Treasury securities • Higher credit risk

  38. Market risk • Uncertainty associated with changing market prices or rates • Price risk • Value of bond portfolios and equity capital most at risk with fast changes in market values of bonds • Interest rate risk • Impact on profit due to changes in interest rates

  39. Price risk

  40. Interest rate risk • Interest rate-sensitive means short-term with maturities of less than one year (or repriced in less than one year). • Liabilities > assets, then bank at higher risk with rising rates • Assets > liabilities, then bank at higher risk with falling rates

  41. Operational risk • Risk due to failing computer systems, errors, misconduct by employees, floods, tornadoes, lightning strikes

  42. Legal and compliance risk • Legal risk – legal system creates adverse outcomes, e.g., unenforceable contracts, adverse lawsuit judgments • Compliance risk – violations to the rules and regulations, e.g., insufficient capital

  43. Reputation risk • Uncertainty due to public opinion as it pertains to confidence of customers and creditors

  44. Strategic risk • Variation in earnings due to poor business decisions, improper implementation of decisions, lack of responsiveness to industry changes or public expectations.

  45. Capital risk • Impact of all the previous risks affects capital and the bank’s survival chances

  46. Capital risk • Spread between market yields on debt and on government securities of same maturity • P/E ratio • Equity to total assets • Purchases funds to total liabilities • Equity capital to risk assets

  47. Questions?

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