Chapter Six

Measuring and Evaluating the

Performance of Banks and Their
Principal Competitors
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 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
• Appendix: Using Financial Ratios and Other
Analytical Tools to Track Financial Firm
Performance – The UBPR and BHCPR

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 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
• Financial institutions 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

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 6-4

Evaluating Performance
• Performance must be directed toward specific objectives
• 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
• A key objective is to maximize the value of the firm

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 6-6

Evaluating Performance (continued)

• The behavior of a stock’s price is, in theory, the best indicator of a
financial firm’s performance because it reflects the market’s
evaluation of that firm
• This indicator is often not available for smaller banks and other
relatively small financial-service corporations
• Key Profitability Ratios

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 6-7

Evaluating Performance (continued)

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Evaluating Performance (continued)

• 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
• Approximates the net benefit that the stockholders have received from investing
their capital in the financial firm
• 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 management has been able to achieve
▫ The net noninterest margin measures the amount of noninterest
revenues stemming from service fees the financial firm has been able to
collect relative to the amount of noninterest costs incurred
▫ Typically, the net noninterest margin is negative
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Evaluating Performance (continued)

• Another traditional measure of earnings efficiency is the
earnings spread

▫ Measures the effectiveness of a financial firm’s intermediation

function in borrowing and lending money and also the intensity of
competition in the firm’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

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 BMRI 2021 and 2020

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 6-11

Evaluating Performance (continued)

• Useful Profitability Formulas for Banks and Other Financial-
Service Companies

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 6-12

Evaluating Performance (continued)

or

where

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EXHIBIT 6–1 Elements That Determine the Rate of Return

Earned on the Stockholders’ Investment (ROE) in a Financial
Firm

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Evaluating Performance (continued)

• 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

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 6-15

Evaluating Performance (continued)

• We can also divide a financial firm’s return on assets into its
component parts

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TABLE 6–2 Calculating Return on Assets (ROA)

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 CAMELS Ratio as standard bank’s
performance evaluation
Meaning Ratio
Measures bank’s ability to maintain Capital Adequacy Ratio
C capital adequate with the bank’s risk
Reflects the amount of credit risk with Non Performing Loan
A the loan and investment portfolios Ratio
management’s ability to identify, Operating Expenses to
M measure, monitor, and control risks Income Ratio
Reflects the quantity, trend, and quality ROA, ROE
E of earnings
Reflects the sources of liquidity and Loan to Deposit Ratio
L funds management practices
Reflects the degree to which changes in Value at Risk, Stock
S market prices and rates adversely affect
earnings and capital
Price volatility
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 CAMELS Ratings
• Regulators assign a rating of 1 (best) to 5
(worst) in each of the six categories and an
overall composite rating
▫ 1 or 2 indicates a fundamentally sound bank
▫ 3 indicates that a bank shows some
underlying weakness that should be
corrected
▫ 4 or 5 indicates a problem bank

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 CAMELS
CAPITAL >> This ratio is used to protect depositors and promote
the stability and efficiency of financial systems around the world.
The following ratios measure capital adequacy:
Capital Adequacy Ratio = (Capital) / (Total Risk Weighted Assets)
Debt Equity Ratio: (Total Debt) / Total Equity

Criteria Rating Meaning

CAR  12% 1 Very Adequate
9%  CAR < 12% 2 Adequate
8%  CAR < 9% 3 Barely adequate
6% < CAR < 8% 4 Less adequate
CAR  6% 5 Not adequate

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 CAMELS
• ASSETS QUALITY >> impaired loans to total
loans
• NPL should be kept below 3% (BI standard)
Loan Status Days past due Allowance for impairment (from loan
amount – its collateral)
Current 0
Special Mention 1 – 90 25%
Substandard 91 – 120 50%
Doubtful 120 – 180 75%
Loss 180 100%

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 CAMELS

Kriteria Peringkat Nilai

BOPO  94% 1 Sangat baik
94% < BOPO  95% 2 Baik
95% < BOPO  96% 3 Cukup baik
96% < BOPO  97% 4 Kurang baik
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 CAMELS

Kriteria Peringkat Nilai

NIM > 3% 1 Sangat baik
2% < NIM  3% 2 Baik
1,5% < NIM  2% 3 Cukup baik
1% < NIM  1,5% 4 Kurang baik
NIM  1% 5 Tidak baik

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 CAMELS
• LIKUIDITAS >> kemampuan bank
menyediakan uang kas
• Diukur dari 2 sisi yaitu dengan LDR (loan to
deposit ratio) >> proporsi antara dana
masyarakat
Kriteria
LDR  75%
yang diterima
Peringkat
1
Nilai
Sangat baik
dengan kredit
yang
75% < LDRdisalurkan
 85% 2 Baik
85% < LDR  100% 3 Cukup baik
Atau
• 100% < LDRdari
 120%proporsi
4 asetbaik
Kurang likuid yang dimiliki
bank terhadap total
LDR > 120% 5
aset sehingga benar –
Tidak baik

benar melihat tingkat likuiditas bank

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 CAMELS
• Sensitivity to market risk >> melihat
seberapa jauh dampak dari perubahan
pasar khususnya suku bunga dan kurs valas
terhadap kinerja bank
• Menggunakan pengukuran yang lebih rumit
dengan sistem VAR atau value at risk, dari
probabilitas terjadinya risiko dikalikan
seberapa besar dampak perubahan tsb
• Bank diwajibkan melakukan pengukuran ini
setelah krisis tahun ©1998
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 Composite CAMEL rating
• An overall composite CAMEL rating, also
ranging from one(1) to five(5), is then
developed from this evaluation. As a whole,
the CAMEL rating, which is determined after
an on-site examination, provides a means
to categorize banks based on their overall
health, financial status, and management.

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 6-28

Evaluating Performance (continued)

• Achieving superior profitability for a financial 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

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Evaluating Performance (continued)

• Risk to the manager of a financial institution or to a
regulator supervising financial institutions means the
perceived uncertainty associated with a particular
event
• Among the more popular measures of overall risk for
a financial firm 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
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Evaluating Performance (continued)

• Bank Risks
▫ Credit Risk
▫ Liquidity Risk
▫ Market Risk
▫ Interest Rate Risk
▫ Operational Risk
▫ Legal and Compliance Risk
▫ Reputation Risk
▫ Strategic Risk
▫ Capital Risk

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Evaluating Performance (continued)

• Other Goals in Banking and Financial-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
▫ 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
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Performance Indicators among Banking’s

Key Competitors
• Among the key bank performance indicators that often are equally
applicable to privately owned, profit-making nonbank financial firms
are
Prices on common and preferred stock Return on equity capital (ROE)
Return on assets (ROA) Net operating margin
Net interest margin Equity multiplier
Asset utilization ratio Cash accounts to total assets
Nonperforming assets to equity capital Interest-sensitive assets to interest-
ratio sensitive liabilities
Book-value assets to market-value assets Equity capital to risk-exposed assets
Interest-rate spread between yields on Earnings per share of stock
the financial firm’s debt and market
yields on government securities

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The Impact of Size on Performance

• 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

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TABLE 6–4 Important Performance Indicators Related to the Size

and Location of FDIC-Insured Depository Institutions (2009)

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Quick Quiz
• What individuals or groups are likely to be interested in the banks’
level of profitability and exposure to risk?
• What are the principal components of ROE, and what does each of the
these components measure?
• What are the most important components of ROA and what aspects of
a financial institution’s performance do they reflect?
• Why do the managers of financial firms often pay close attention
today to the net interest margin and noninterest margin? To the
earnings spread?
• To what different kinds of risk are banks and their financial-service
competitors subjected today?
• What items on a bank’s balance sheet and income statement can be
used to measure its risk exposure? To what other financial institutions
do these risk measures seem to apply?
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Appendix: Using Financial Ratios and Other Analytical

Tools to Track Financial-Firm Performance – The UBPR
and BHCPR
• Compared to other financial institutions, more information is
available about banks than any other type of financial firm
• Through the cooperative effort of four federal banking agencies –
the Federal Reserve System, the Federal Deposit Insurance
Corporation, the Office of Thrift Supervision, and the Office of the
Comptroller of the Currency – the Uniform Bank Performance
Report (UBPR) and the Bank Holding Company Performance
Report (BHCPR) provide key information for financial analysts
• The UBPR, which is sent quarterly to all federally supervised
banks, reports each bank’s assets, liabilities, capital, revenues, and
expenses, and the BHCPR is similar for BHCs
• Web link for UBPR and BHCPR: www.ffiec.gov

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