Chapter 6: Measuring and Evaluating the Performance of Banks and Their Principal Competitors

Bank Risk Categories

CAMELS:

• Capital Adequacy

• Asset Quality

• Management Quality

• Earnings Record

• Liquidity Position

• Sensitivity to market risk

A key objective of financial-service institutions

Maximize the value of the firm through stock price.

Minimum acceptable rate of return, r, is sometimes referred to as as an institution’s

Cost of Capital

• Two main components

  • Risk-free rate of interest

  • Equity risk premium

The value of the financial firm’s stock will tend to rise in any of the following situations

• The value of the stream of future stockholder dividends is expected to increase

• The financial organization’s perceived level of risk falls

• Market interest rates decrease, reducing shareholder’s acceptable rates of return via the risk-free rate of interest component of all market interest rates

• Expected dividend increases are combined with declining risk, as perceived by investors

Return on equity capital (ROE)

• Net Income/Total equity capital

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

  • Approximated the net benefit that the stockholders have received from investing their capital in the financial firm

• ROE = net profit margin x asset utilization ratio x equity multiplier

• ROE = Tax management efficiency x expense control efficiency x asset management efficiency x funds management efficiency

Return on assets (ROA)

• Net Income/Total Assets

• Return on assets (ROA) is primarily an indicator of managerial efficiency

  • Indicated how capable management has been in converting assets into net earnings

Net Interest Margin

• (Interest Income - Interest Expense)/ Total Assets

• The net interest margin measures how large a spread between interest revenues and interest costs management has been able to achieve

Net Noninterest Margin

• (Noninterest revenues - PLL)/ Total Assets

• 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

Net Operating Margin

• (total operating revenues-total operation expenses)/total assets

• operating income/total assets

Earnings Per Share (EPS)

Net Income/Shares Outstanding

Earnings Spread

• (Total Interest Income/Total Earnings Assets) - (Total Interest Expense/Total Interest-bearing liabilities)

• Measured the effectiveness of a financial firm’s intermediation function in borrowing and lending money and also intensity of competition in the firm’s market area

• Greater competition tends to squeeze the difference between average asset yields and average liability costs

• In other factors are held constant, the spread will decline as competition increases

Net Profit Margin (NPM)

Net Income / Total Operating Revenues

Degree of Asset Utilization (AU)

Total Operating Revenues / Total Assets

Equity Multiplier (EM)

Total Assets/Total Equity Capital

Achieving superior profitability for a financial institution depends upon several crucial factors

• Careful use of financial leverage (or the proportion of assets financed by debt as opposed to equity capital)

• Careful use of operating leverage from fixed assets (or the proportion of fixed-cost inputs used to boost operating earnings a output growths)

• Careful management of the asset portfolio to meet liquidity needs while seeking’s the highest returns from any asset acquired

• Careful control of exposure to risk so that losses don’t overwhelm income and equity capital

• Careful control of operating expenses so that more dollars of sales revenue become net income

Measuring Risk in Banking and Financial Services

• Risk to 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 or variance of stock price

• Standard deviation or variance of net income

• Standard deviation or variance of return on equity and return on assets

• The higher the standard deviation or variance of the above measures, the greater the overall risk

Credit Risk

The probability that some of a financial institution’s assets, especially its loans will decline in value and perhaps become worthless

Liquidity Risk

Financial-service managers are concerned about the danger of not having sufficient cash and borrowing capacity to meet customer withdrawals, loan demands, and other cash needs

Market Risk

Market value of assets, liabilities, and net worth of financial service providers are constantly in a state of flux due to uncertainties concerning market rates or prices

Interest Rate Risk

The impact of changing interest rates on a financial institution’s margin of profit

Operational Risk

Uncertainty regarding a financial firm’s earnings due to failures in computer systems, misconduct by employees, floods, lightning, and similar events

Strategic Risk

Variations in earnings due to adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes

Employee Productivity Ratio

net operating income / number of full time equivalent employees

Operating Efficiency Ratio

total operating expenses / total operating revenues