CHAPTER 6 (8th Ed.

, 2010): MEASURING AND EVALUATING THE PERFORMANCE

OF BANKS AND THEIR PRINCIPAL COMPETITORS

Goal of This Chapter: The purpose of this chapter is to discover what analytical tools can be
applied to a banks financial statements so that management and the public can identify the most
critical problems inside each bank and develop ways to deal with those problems

Evaluating a Bank's Performance

A. Determining Long-Range Objectives
B. Maximizing The Value of the Firm: A Key Objective for Nearly All Financial-
Services Institutions
C. Profitability Ratios: A Surrogate for Stock Values (Many small banks do not have
an active stock market and product or geographic subsets of a bank do not have
stock prices.)
1. Key Profitability Ratios (ROE, ROA, NIM, NIMPLL, Efficiency Ratio, Fee
Income Ratio)
2. Interpreting Profitability Ratios
D. Measuring Risk in Banking and Financial Services (pp. 181-188) We will not
cover these now but will cover them in detail in the appropriate places during the
semester. (Credit Risk, Liquidity Risk, Market Risk, Interest-Rate Risk, Operational Risk,
Legal and Compliance Risk, Reputation Risk, Strategic Risk, and Capital Risk)

Key Performance Indicators among Bankings Key Competitors (NOTE: when an income
statement item for a period is combined with a balance sheet item for a specific time the
average of the balance sheet item for the income statement period should be used.)

ROE = return on equity = net income/average common equity

A measure of the return to common stockholders on their investment.

ROA = return on assets = net income/average (total) assets

A measure of how well the assets are being managed. It does not take into account the
level of debt and equity financing as reflected in ROE.

NIM = net interest margin = net interest income/average (total) assets

(an alternative version uses average earning assets as denominator)
A good measure of traditional banking because it examines how well a bank gathers
deposits and nondeposit funds and transforms them into loans and securities.

NIMPLL = net interest margin after provision for loan losses

= net interest income minus provision for loans losses/average (total) assets
An alternative version of NIM that considers the higher risk that might be considered
with higher earning assets or loans. This is better when comparing banks with products
with different risks, e.g., credit card loans vs. other banks.

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Efficiency Ratio = noninterest expense/(net interest income + noninterest income)
A lower value indicates the bank is producing its net operating income at a lower cost. A
lower cost will allow the bank to increase its profits or lower prices and increase its
market share. This ratio is more commonly used than
net noninterest margin = (noninterest income noninterest expense)/average total
assets.

Fee Income Ratio = noninterest income/(net interest income + noninterest income)

A higher value indicates the bank is producing more of its net operating revenue from
noninterest income (fees). This is also considered a measure of modern banking because
banks are trying to generate more of their income from fees. A historical analysis
suggests that the NIM for banks is declining over time due to greater competition for
loans (lower interest rates and income) and deposits (higher interest rates and expenses).
A higher ratio is usually considered positive. These fees also may be less volatile than
interest rates.

EPS = earnings per share = net income/# of outstanding shares

Tax Management Efficiency = net income/pre-tax income

Higher ratios indicate lower taxes.

NPM = net profit margin = net income/total operating revenues

total operating revenues = total interest income + noninterest income

AU = Asset Utilization = total operating revenues/average total assets

Note that total operating revenues is similar to sales for a nonfinancial firm and this ratio
is similar to Total Asset Turnover or Sales/Total Assets

EM = Equity Multiplier = total assets/common equity

The reciprocal of EM is the common ratio of common equity/total assets.

ROE = NPM X AU X EM = net income/common equity

This is identical to the Du Pont analysis you learned in corporate finance. (pp. 174-179)

There are two ways to use financial ratios. (1) Examine the performance of a firm over time.
(2) Compare the performance of one firm with another firm or peer group. The comparison to a
peer group assumes the peer group is comparable to the firm.

Analysts try to control for three major things when comparing banks. Size is usually the first
basis of comparison because different size institutions have different characteristics. Location is
the second basis of comparison because a banks performance is usually a reflection of the

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economy where it operates. Product composition is the third basis of comparison because a
much heavier activity in one product than a peer group can affect the legitimacy of using the peer
group for comparison purposes. Examples include banks with very high fee income ratios (State
Street, Bank of New York Mellon, Northern Trust), banks with high credit card loans (Capital
One, American Express), banks that are former investment banks (Goldman Sachs, Morgan
Stanley), banks that are primarily insurance companies (MetLife), banks with high levels of real
estate loans (Colonial (now part of BB&T), Washington Mutual (now part of JP Morgan Chase)).
Of course these three bases can interact, e.g., bad real estate loans in Florida, California, Arizona,
and Nevada.

Another factor that may be important for younger banks is the age of the bank because it usually
takes two to three years for a bank to become profitable. The UBPR, which is discussed below,
does provide some comparisons for similar sized banks established during the same year.

See Table 6-3, p. 180 Explain why the ROA of 1.22% in 2007 is better than the 0.87% in 1992.
This analysis will be done in class. This exercise is a good example of analyzing the
banking industry over time.

Using Financial Ratios and Other Analytical Tools to Track Bank Performance
Bank Holding Company Performance Reports (BHCPR) and the Uniform Bank
PerformanceReport (UBPR) (discussed in Appendix, pp. 201-208) are excellent tools for
analysis. We will use the BHCPR for the class project and it will be explained in detail.

These problems are the same or similar (may contain different ratios not
included in text) to Prob. 6-3, 6-4, 6-5, 6-6,and 6-9, Rose & Hudgins (7TH
ED.), p.197-198 NOTE these problems are not from the current text (8th
edition).

6-3 Depositors Savings Association has a ratio of equity capital to total assets of 7.5 percent.
In contrast, Newton Savings reports an equity capital to asset ratio of 6 percent. What is the
value of the equity multiplier for each of these institutions? Suppose that both institutions have
an ROA of 0.85 percent. What must each institutions return on equity capital be? What do your
calculations tell you about the benefits of having as little equity capital as regulations or the
marketplace will allow?

Depositors Savings Association has an equity-to-asset ratio of 7.5 percent which means its equity
multiplier must be:

Assets
1/ (Common Equity Capital / Assets) = = 1 / 0.075 = 13.33x
EquityCapital

In contrast, Newton Savings has an equity multiplier of:

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 1
1/ (Common Equity Capital / Assets) = = 16.67x
0.06

With an ROA of 0.85 percent Depositors Savings Association would have an ROE of:

ROE = 0.85 x 13.33x = 11.33 percent.

With an ROA of .85 percent Newton Savings would have an ROE of:

ROE = 0.85 x 16.67x = 14.17 percent

In this case Newton Savings is making greater use of financial leverage and is generating a
higher return on equity capital.

6-4. The latest report of condition and income and expense statement for Galloping Merchants
National Bank are as shown in the following tables:

Galloping Merchants National Bank

Interest Fees on Loans $65

Interest Dividends on Securities 12
Total Interest Income 77

Interest Paid on Deposits 49

Interest on Nondeposit Borrowings 6
Total Interest Expense 55

Net Interest Income 22

Provision for Loan Losses 2
Noninterest Income and Fees 7
Noninterest Expenses:
Salaries and Employee Benefits 12
Overhead Expenses 5
Other Noninterest Expenses 3
Total Noninterest Expenses 20
Net Noninterest Income -13

Pre Tax Operating Income 7

Securities Gains (or Losses) 1
Pre Tax Net Operating Income 8
Taxes 1
Net Operating Income 7
Net Extraordinary Income -1
Net Income $6

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 Galloping Merchants National
Bank
Report of Condition

Cash and Due From Banks $100 Demand Deposits $190

Investment Securities $150 Savings Deposts $180
Federal Funds Sold $10 Time Deposits $470
Net Loans $670 Federal Funds Purch $69
(ALL 25) Total Liabilities $900
(Unearned Income 5) Common Stock $20
Plant and Equipment $50 Surplus $25
Retained Earnings $35
Total Assets $980 Common Equity $80

Memo:
Interest Bearing
Total Earnings Assets $830 Deposits $650

Fill in the missing items on the income and expense statement. Using these statements, calculate the
following performance measures: ROE, ROA, NIM, NIMPLL, Net noninterest margin, NPM, AU,
EM, Tax Management Efficiency, Efficiency Ratio, Fee Income Ratio.

Net Income $6
ROE = .075 or 7.5%
Total Equity Capital $80
Use common equity not total equity!

Net Income $6
ROA = .00612 or .612%
Total Assets $980

Net Interest Income $22

Net Interest Margin = .0224 or 2.24%
Total Assets $980

NIMPLL = (Net In. Inc. PLL)/Total Assets = (22-2)/980 = 0.0204 = 2.04%

-$13
Net Noninterest Margin = .0133 or -1.33 percent
$980

Net Income $6
Net Profit Margin = .0714 or 7.14 percent
Total Operating Revenues $84

Total Operating Revenues $84

Asset Utilization = .0857 or 8.57%
Total Assets $980

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 Total Assets $980
Equity Multiplier = 12.25 x
Total Equity Capital $80

Net Income $6
Tax Management Efficiency .857 or 85.7%
Pre Tax Income $7

Fee Income Ratio = noninterest income/(net interest income + noninterest income)

= (7/(22 + 7) = 0.2414 = 24.14%

Efficiency Ratio = noninterest expense/(net interest income + noninterest income)

= (20/(22 + 7) = 0.6897 = 68.97%

6-5. The following information is for Shallow National Bank

Interest Income $2,100

Interest Expense $1,400
Total Assets $30,000
Securities Gains
(losses) $21
Earning Assets $25,000
Total Liabilities $27,000
Taxes Paid $16
Shares of Common
Stock 5,000
Noninterest income $700
Noninterest Expense $900
Provision for Loan
Losses $100

a. ROE = NI/E = NI/(TA-TL) = 405/(30000 - 27000) = .135 = 13.5%

NI = (II-IE)+(NII-NIE) - PLL -TAX + SEC GN (assume after tax) =
= (2100 - 1400) + (700 - 900) - 100 - 16 + 21 = 405
b. ROA = NI/TA = 405/30000 = 0.0135 = 1.35%
c. NIM = (II - IE)/TA = (2100 - 1400)/30000 = .0233 = 2.33%
d. EPS = NI/#SH = 405/5000 shares = $.081/SH
e. Net Nonint. Margin = (NONINT. INC - NONINT. EXP)/TA = (700 - 900)/30000 = -0.0067
= -0.67%

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(NOT IN TEXT): Efficiency Ratio = Noninterest exp./(Noninterest inc. + net int. inc.)
= 900/(700 + (2100 - 1400)) = .643 = 64.3%
(NOT IN TEXT): Fee Income Ratio = Noninterest inc./ (Noninterest inc. + net int. inc.)
= 700/(700 + (2100 - 1400)) = .50 = 50.0%
(NOT IN TEXT): NIMPLL = (Net Int. Inc. PLL)/Total Assets =
= (2100 1400 100)/30000 = 0.0200 = 2.00%

6-6. Blue and White National Bank holds total assets of $1.69 billion and equity capital of $139
million and has just posted an ROA of 1.1 percent. What is this banks ROE? Make sure you
use common equity.

Total Assets $1,690

ROE = ROA * = 0.011 * = 0.1337 or 13.37%
Equity Capital $139

6-9. Saylor County National Bank presents us with these figures for the year just concluded.
Please determine the net profit margin, equity multiplier, asset utilization ratio, and ROE:

Net Income = $18

Total Operating Revenues = $125
Total Assets = $1,500
Total Equity Capital Accounts = $155

a. Net Profit Margin = Net Income = $18 mill. = 0.144 or 14.4%

Total Operating Revenue $125 mill.

b. Asset Utilization = Total Operating Revenues = $125 mill. = 0.083 or 8.3%

Total Assets $1500 mill.

c. Equity Multiplier = Total Assets = $1500 mill. = 9.68 times

Common Equity $155 mill.
Capital

d. ROE = Net Income = $18 mill. = 0.1161 or 11.61%

Common Equity Capital $155 mill.

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Another common ratio that combines market information with accounting information is the
price/book or market value/book value ratio. If the ratio is less than one the ratio suggests that
the market disagrees with the accounting (book) value of the common equity. This may mean
that the market value of the assets are less than the accounting (book) value of the assets or some
other factor is negatively affecting the future earnings. Examples from Yahoo!Finance on the
afternoon of January 24, 2012 for price/book (mrq) follow.

Bank of America (BAC) = 0.35

Regions Financial (RF) = 0.45
Citigroup (C) = 0.49
SunTrust (STI) = 0.57
JP Morgan Chase (JPM) = 0.81
BB&T (BBT) = 1.11
Wells Fargo (WFC) = 1.25