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PERFORMANCEEVALUATING BANK

A Course for Bank Directors

October 5, 2004 3:30p.m. 4:45p.m.

2004 ABA Annual ConventionOctober 3-6, 2004

Marriott Marquis New York, NY

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E V A L U A T I N G B A N K P E R F O R M A N C E

A Course for Bank Directors

Agenda

The Role of the Bank Director Risks and Returns of Banking

Bank Performance Metrics

Evaluating Overall Bank Performance: Risk-Adjusted Measures

Other Performance Measurement Tools for the Bank Director

Historical Perspectives

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The Role of the Bank Director:Risk Governance

Banking is entirely a risk business

Positions = Financial Risk

Fee-Based Businesses = Reputation / Compliance Risk that cannot be

hedged and for which there is no materiality threshold

Bank Directors must approve business strategies with a key

focus on risk appetite

This, in turn, requires risk-adjusted performance measures

It also requires that risk be viewed from a qualitative as well asquantitative perspective

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The Role of the Bank Director:Risk Governance Framework

The People and their Roles:

Board of Directors

Approve strategies and risk appetite, monitor performance, exercise constructivecriticism

Senior Management

Develop strategies and execute day-to-day, be transparent and candid withBoard, encourage inquiry

Other Issues to Consider:

Appropriate policies, procedures and limits, including new product/businessprocesses

Effective infrastructure for measuring and monitoring performance

Comprehensive internal controls and audit

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The Role of the Bank Director:Assessing Financial Performance

Peer Group and Other Comparative Information

Uniform Bank Performance Report (UBPR)

Bank Holding Company Performance Report (BHCPR)

Profit and Loss = Risk Roadmap

But only if profit gets equal or greater focus than losses

Is high growth/profit based on well-understood, true competitive

advantage?

Lots of data but little information?

Are data viewed with a false sense of precision and

comprehensiveness?

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The Role of the Bank Director:Assessing Non-Financial Performance

Are there any patterns or themes of control weakness / non-

compliance?

Oversight of new businesses and products

Is requisite infrastructure in place?

Has pre-launch due diligence been thorough?

Is management dismissive of regulators or regulatory issues?

Are risks owned by line managers and overseen by independentrisk managers (including compliance and audit) with requisite

authority and competence?

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E V A L U A T I N G B A N K P E R F O R M A N C E

A Course for Bank Directors

Questions that were never asked

How can a significant portion of our trading revenue be generated by

someone engaged in arbitrage in a remote location?

How has our business made great returns every year for the last X,including during periods of significant market stress and turmoil?

Is this product truly the result of just tweaking an existing product? Or havewe actually put a jet engine on a tricycle we are planning to sell to a five-year old?

Is a limit that is never breached effective?

E V A L U A T I N G B A N K P E R F O R M A N C E

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Bank Performance Metrics:Risk & Returns

Channel / Market Wholesale / Retail Branch / Internet

Institutional /

Individual

Legal Structure Holding Company Bank

Broker / Dealer

Investment Manager

Business Lines Commercial Banking Retail Banking

Sales & Trading

Corp Finance / M&A

Asset Management Private Banking

Security Services

Risks Market Credit Operational

Liquidity Reputational Business

E V A L U A T I N G B A N K P E R F O R M A N C E

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Bank Performance Metrics:Commercial Banking

Financial Metrics

Earnings/Profitability Net Interest Margin, Return on

Assets, Loan Growth, Fee Income,Operating Efficiency

Asset Quality Write-offs, Loan Loss Reserves,

Non-Performing Ratio,Concentrations (Industry, Obligor,Country, Rating)

Capital Leverage Ratio, Regulatory

Capital

Interest Rate Sensitivity

Non-Financial Metrics Market Share Agent

Portfolio

Risks Market Credit Operational Reputational

E V A L U A T I N G B A N K P E R F O R M A N C E

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Bank Performance Metrics:Retail Banking

Financial Metrics Earnings / Profitability

Net Interest Margin, Return onAssets, Loan Growth, Fee Income,Operating Efficiency Ratio

Asset Quality FICO bands, Loss Rates, Loan

Loss Reserves, Liquidity Ratio,Non-Performing Ratio,Concentrations

Capital Leverage Ratio, Regulatory Capital

Interest Rate Sensitivity

Non-Financial Metrics Market Share

Reputation

Compliance Controls

Branch Network

Core Deposits

Risks Market Credit Operational Reputational

E V A L U A T I N G B A N K P E R F O R M A N C E

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Bank Performance Metrics:Sales and Trading

Financial Metrics Trading Income

Customer vs. Proprietary P&L

Daily Volatility / Information Ratio

Value-at-Risk

Stress Testing

Non-Financial Metrics Market Share of Over-the-Counter

(OTC) and Exchange Markets

League Table Standings

Sales and Coverage

Risks Market Credit Operational

E V A L U A T I N G B A N K P E R F O R M A N C E

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Bank Performance Metrics:Corporate Finance / M&A

Financial Metrics Fee Income

Principal Investments Income

Expenses (Fixed vs. Variable)

Non-Financial Metrics IPOs / Deals

League Tables

Volume of Securities Underwritten

% Acting as Lead Manager in

Syndicate

Specialization

Risks Reputational Business Operational

E V A L U A T I N G B A N K P E R F O R M A N C E

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Bank Performance Metrics:Asset Management

Financial Metrics Fee Income by Product Type

Asset-Under-Management

Profit Margin

Cost Ratio / Efficiency Ratio

Average Asset Size

Non-Financial Metrics Broker / Sales Force

Level of Cross-Selling

Number of Products Offered

Risks Business Reputational

E V A L U A T I N G B A N K P E R F O R M A N C E

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Evaluating Overall Bank Performance:Risk-Adjusted Measures

Measuring a banks performance across the enterprise:

Risk-Adjusted Return on Capital (RAROC) and Economic Profit (EP)

Shareholder Value Added (SVA)

Economic

Profit

Economic Capital Hurdle Rate

RAROC

x- [

Return Economic Capital

Return

]

SVA - [ ]xet Operating ProfitAfter Tax Cost of Capitalapital

E V A L U A T I N G B A N K P E R F O R M A N C E

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Evaluating Overall Bank Performance:Risk-Adjusted Measures

Risk-Adjusted Return on Capital (RAROC) and Economic Profit (EP)

It is a profitability ratio that can be calculated for the entire portfolio, or byproduct or business line

Because it is risk-adjusted, it can be used to compare different types ofbusinesses (trading book vs. banking book, asset vs. liability products)

It can be used to evaluate existing performance, and also to boostperformance through the proper allocation of capital among product orbusiness line

In some ways, it is a short-run perspective (business unit profit is compared tothe units current capital at risk)

According to a 2002 survey sponsored by ISDA and the RMA, 78% of thebanks surveyed used RAROC.

Regulatory drivers include SR 99-18 and Basel II, Pillar 2

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Evaluating Overall Bank Performance:Risk-Adjusted Measures

Shareholder Value Added (SVA) is a: Measure of economic profit, or the amount by which earnings exceed or fall

short of the required minimum rate of return that shareholders could get by

investing in other securities of comparable risk (often multi-period).

Long-run perspective in some ways, since business unit profit is compared tothe cost of capital of the bank.

E V A L U A T I N G B A N K P E R F O R M A N C E

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Evaluating Overall Bank Performance:Applications of Risk-Adjusted Measures

Annual Budgeting and Reporting of Actuals

Projections and monitoring of performance and capital requirements

Economic capital adequacy and usage

Strategic Planning

Scenario evaluation of business segments, acquisitions and divestitures

Evaluation of optimal capital and balance sheet structure

Allocation of capital resources among internal units

Risk-Based Pricing Evaluation of transaction pricing on a risk/return basis for businesses,

however in conjunction with other considerations (e.g. relationship

value)

E V A L U A T I N G B A N K P E R F O R M A N C E

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Evaluating Overall Bank Performance:Applications of Risk-Adjusted Measures

Risk Management

Alignment of risk limits with risk/return tolerances through capital based

limit frameworks

Incentive Compensation

Encourages behavior and culture consistent with organizations financialobjectives to manage return relative to risk

Addresses complications with GAAP reporting measures, which can

distort actual economic performance

External Disclosure Communication of metrics that show a truer economic picture

Demonstrates rigor around value-driven financial management to

clearly-defined objectives

E V A L U A T I N G B A N K P E R F O R M A N C E

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Evaluating Overall Bank Performance:Risk-Adjusted Measures and Relationship Pricing

Risk-Adjusted Measures are being increasingly used in capturing

Relationship Pricing / Customer Profitability

Focus on capturing maximum share of customer wallet

Offers a method of capturing very different businesses under a common,

risk-based method

Example: Commercial Lending and Corporate Finance / M&A

Used to price new business, identify high / low value existing business

Multi-period relationships can be managed on a new and old business

basis

E V A L U A T I N G B A N K P E R F O R M A N C E

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A Course for Bank Directors

Other Performance Measurement Tools:Balanced Scorecard

The Balanced Scorecard:

Is a framework for translating strategic objectives into a set of performanceindicators (financial, customer, internal business processes, and learningand growth)

Argues that return-on-investment, market share, and earnings-per-share donot provide the full perspective of an organizations performance

Must balance internal and process measures with results and financialmeasures (i.e. balanced scorecard)

Also balances short-term and long-term goals

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A Course for Bank Directors

Other Performance Measurement Tools:Balanced Scorecard

Sample objectives of a balanced scorecard:

Loan volume growth

Customer retention

Percentage return on equity (ROE)

Number of hours spent with customers

Level of credit authority

Cross-selling to customer base

Internal Audit and Compliance scores

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A Course for Bank Directors

Other Performance Measurement Tools:Uniform Bank Performance Report (UBPR)

The UBPR:

Is an analytical tool created for bank supervisory, examination, andmanagement purposes

Comes from the Federal Financial Institutions Examination Council (FFIEC),

an inter-agency body for the Federal Reserve (FRB), Federal DepositInsurance Corporation (FDIC), Office of the Comptroller of the Currency(OCC), among others

Provides performance and balance sheet composition data

Helps evaluate adequacy of earnings, liquidity, capital, asset and liabilitymanagement, and growth management

Is produced quarterly using bank call reports

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Other Performance Measurement Tools:Uniform Bank Performance Report

The UBPR can be used to:

Evaluate the banks current condition and trends in its financial performance

Compare the banks performance to its peer group

For instance, the UBPR allows uniform comparison of commercial banks:

A UBPR is produced for each commercial bank in the U.S. that issupervised by the Board of Governors of FRB, FDIC, or OCC

UBPRs are also produced for FDIC insured savings banks

Provides statistics of peer groups (Peer Group Report and percentilerankings)

E V A L U A T I N G B A N K P E R F O R M A N C E

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Other Performance Measurement Tools:Uniform Bank Performance Report

Limitations of the UBPR include:

UBPR definition of peers?

The Peer Group Report is a relative measure

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Contacts

Donald Vangel (212) 773-2129Office of the Chairman donald.vangel@ey.com

Advisor, Regulatory Compliance

Hank Prybylski (212) 773-2823Practice Leader lawrence.prybylski@ey.com

Financial Services AdvisoryRisk Management

Samir Nangea (212) 773-6742Senior Manager samir.nangea@ey.com

Financial Services AdvisoryRisk Management