Chapter Six

Measuring and Evaluating the

Performance of Banks and Their
Principal Competitors
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 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
• Appendix: Using Financial Ratios and Other
Analytical Tools to Track Financial Firm
Performance – The UBPR and BHCPR

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-2
 Introduction

• Banks are simply businesses organized to maximize the

value of the shareholders’ wealth invested in the firm at an
acceptable level of risk

• Must continually be on the lookout for new opportunities

for revenue growth, greater efficiency, and more effective
planning and control

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-3
 Evaluating Performance
• Performance must be directed toward specific objectives
• A fair evaluation of any bank’s performance should start by
evaluating whether it has been able to achieve the objectives its
management and stockholders have chosen
• A key objective is to maximize the value of the firm

• Equation (6–1) assumes that the stock may pay dividends of

varying amounts over time
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-4
 Evaluating Performance
• The minimum acceptable rate of return, r, is sometimes referred to as
a Bank’s cost of capital
▫ Two main components
▫ The risk-free rate of interest
▫ The equity risk premium
• The value of the Bank firm’s stock will tend to rise in any of the
following situations
1. The value of the stream of future stockholder dividends is expected to
increase
2. The financial organization’s perceived level of risk falls
3. Market interest rates decrease, reducing shareholders’ acceptable rates
of return via the risk-free rate of interest component of all market
interest rates
4. Expected dividend increases are combined with declining risk
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-5
 Evaluating Performance
• The stock values of banks are sensitive to changes in market
interest rates, currency exchange rates, and the economy

• If the dividends paid to stockholders are expected to grow at a

constant rate over time, perhaps reflecting steady growth in
earnings, the stock price equation can be greatly simplified into

▫ D1 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
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-6
 Evaluating Performance
• The previous two stock price formulas assume the bank will pay
dividends indefinitely 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 D1, D2, . . . , Dn and sell the
stock for price Pn at the end of the planned investment horizon

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-7
 Evaluating Performance
• The behavior of a stock’s price is, in theory, the best indicator of a
bank’s performance because it reflects the market’s evaluation
• This indicator is often not available for smaller banks

• Key Profitability Ratios

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-8
 Evaluating Performance

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-9
 Evaluating Performance
• Return on assets (ROA) is primarily an indicator of managerial
efficiency
▫ Indicates how capable management has been in converting assets
into net earnings

• Return on equity (ROE) is a measure of the rate of return

flowing to shareholders
• net benefit that the stockholders have received from investing their
capital in the banking firm

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-10
 Evaluating Performance
• The net operating margin, net interest margin, and net
noninterest margin are efficiency measures as well as
profitability measures
▫ The net interest margin measures how large a spread between
interest revenues and interest costs

▫ The net noninterest margin measures the amount of

noninterest revenues stemming from service fees collected
relative to the amount of noninterest costs incurred
▫ Typically, the net noninterest margin is negative

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-11
 Evaluating Performance
• Another traditional measure of earnings efficiency is the
earnings spread

▫ Measures the effectiveness of a bank’s intermediation function in

borrowing and lending money and also the intensity of competition
in the bank’s market area
▫ Greater competition tends to squeeze the difference between
average asset yields and average liability costs
▫ If other factors are held constant, the spread will decline as
competition increases

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-12
 Evaluating Performance
• Useful Profitability Formula for Banks

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-13
 Evaluating Performance (continued)

or

where

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-14
 EXHIBIT 6–1 Elements That Determine the Rate of Return
Earned on the Stockholders’ Investment (ROE) in a Banking
Firm

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-15
 Evaluating Performance
• A slight variation of the simple ROE model produces an
efficiency equation useful for diagnosing problems in four
different areas in the management of banks

or

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-16
 Evaluating Performance (continued)
• We can also divide a bank’s return on assets into its component
parts

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-17
 TABLE 6–2 Calculating Return on Assets (ROA)

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-18
 Evaluating Performance
• Achieving superior profitability for a banking institution
depends upon several crucial factors
1. Careful use of financial leverage (or the proportion of assets financed
by debt as opposed to equity capital)
2. Careful use of operating leverage from fixed assets (or the proportion
of fixed-cost inputs used to boost operating earnings as output grows)
3. Careful control of operating expenses so that more dollars of sales
revenue become net income
4. Careful management of the asset portfolio to meet liquidity needs
while seeking the highest returns from any assets acquired
5. Careful control of exposure to risk so that losses don’t overwhelm
income and equity capital

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-19
 Evaluating Performance
• Risk to the manager of a bank or to a regulator
supervising banks means the perceived uncertainty
associated with a particular event
• Popular measures of overall risk for a bank 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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-20
 Evaluating Performance
• Bank Risks
▫ Credit Risk
▫ Liquidity Risk
▫ Market Risk
▫ Interest Rate Risk
▫ Operational Risk
▫ Legal and Compliance Risk
▫ Reputation Risk
▫ Strategic Risk
▫ Capital Risk

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-21
 Evaluating Performance
• Other Goals in Banking 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

▫ 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
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-22
 The Impact of Size on Performance
• When the performance of one bank is compared to
that of another, size becomes a critical factor
▫ Size is often measured by total assets
• Most performance ratios are highly sensitive to the
size group in which a bank finds itself
• The best performance comparison is to choose banks
of similar size serving the same market area
• Also, compare banks subject to similar regulations
and regulatory agencies

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 6-23