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Chapter 20

Bank Performance

Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.



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Chapter Outline Valuation of a commercial bank

Performance evaluation of banks

Risk evaluation of banks

How to evaluate a bank¶s performance

Bank failures



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Valuation of a Commercial Bank The value of a commercial bank is the present

value of its future cash flows:

The value should change in response to

changes in its expected cash flows and tochanges in the required rate of return:

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Valuation of a Commercial Bank

(cont¶d) Factors that affect cash flows

Change in economic growth During periods of strong economic growth:

Loan demand is higher

Commercial banks provide more loans

Demand for other bank products tends to be higher Fewer loan defaults occur

Expected cash flows should be higher

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(cont¶d) Factors that affect cash flows (cont¶d)

Change in the risk-free interest rate

If the risk-free rate decreases and other market rates decline, there

may be stronger demand for the bank¶s loans Banks¶ cost of funds decreases when the risk-free rate decreases

Change in industry conditions

If regulators reduce the constraints imposed on commercial banks,expected cash flows should increase

Technical innovation can improve efficiencies and enhance cash

flows

A high level of competition may reduce the bank¶s volume of business or reduce the prices it can charge for its services



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(cont¶d)

Factors that affect cash flows (cont¶d)

Change in management abilities

Managers can attempt to make internal decisions

that will capitalize on the external forces that the

bank cannot control

Skillful managers will recognize how to revise the

composition of the bank¶s assets and liabilities tocapitalize on existing economic or regulatory

conditions



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(cont¶d)

Factors that affect the required rate of

return by investors

Change in the risk-free rate

When the risk-free rate increases, so does the returnrequired by investors:

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(cont¶d) Factors that affect the required rate of return by

investors (cont¶d) Change in the risk premium

When the risk premium increases, so does the return required byinvestors:

Impact of the September 11 Crisis on commercial bankvalues Commercial bank valuations declined as a result because

economic conditions were weakened and the volume of bankloans declined

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Performance Evaluation of Banks

In the recessions of 1982, the early 1990s,

and the early 2000s, banks were

adversely affected

The international debt crisis of the 1980s

had a major impact on the largest banks

with loans to less developed countries



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(cont¶d) Interest income and expenses

Gross interest income is interest income generated

from all assets Affected by market rates and the composition of assets held

by banks

Gross interest income on small and medium banks istypically higher than that of other banks

Gross interest expenses represent interest paid ondeposit and on other borrowed funds Affected by market rates and the composition of the bank¶s

liabilities

In recent years, gross interest expenses have been similar among banks



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(cont¶d)

Interest income and expenses (cont¶d)

Net interest income is the difference between

gross interest income and interest expenses

and is measured as a percentage of assets

The net interest margin of all banks in aggregate

has remained somewhat stable

Net interest margin has generally been highest for

the small banks and lowest for money center

banks



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(cont¶d) Noninterest income and expenses

Noninterest income results from fees charged on

services provided Has consistently risen over time for all banks in aggregate

Usually higher for money center, large, and medium banksthan for small banks because larger banks provide moreservices

The loan loss provision is a reserve accountestablished in anticipation of future loan losses Should increase in recessionary periods

Was high for most banks during the early 1990s recessionbut declined for the next several years



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(cont¶d) Noninterest income and expenses (cont¶d)

Noninterest expenses include salaries, officeequipment, and other expenses Generally increased over time

Securities gains and losses result from a bank¶ssale of securities Have been negligible in the aggregate

Income before tax is obtained by summing net

interest income, noninterest income, and securitiesgains and subtracting the provision for loan lossesand noninterest expenses In recent years, bank income was enhanced by the increase

in noninterest income and in net interest margins



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(cont¶d) Net income

Net income accounts for any taxes paid

Return on assets (ROA): Is net income measured as a percentage of assets

Has been unusually high in recent years becauseof the increase in noninterest income

Has been high for medium and large banksrecently

Depends on the bank¶s policy decisions as well asuncontrollable factors relating to the economy andgovernment regulations



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(cont¶d)

Net income (cont¶d) Return on equity (ROE)

ROE is affected by the same income statement items that affectROA as well as the bank¶s degree of financial leverage:

The leverage measure is the inverse of the capital ratio

In recent years, money center banks have experienced a lower ROE than other banks because of their low ROA and high degreeof capital

Equity

Assets

Assets

taxesafter profitNet

measureLeverage(ROA)assetsonReturnROE

v!

v!



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Risk Evaluation of Banks No consensus measurement of risk exists that allows for

comparison of various types of risk among all banks

Beta is the degree of sensitivity of stock returns to the

returns of the stock market as a whole:

The regression model is applied to quarterly historical data

The coefficient is an estimate of beta because it measures thesensitivity of bank returns to market returns Banks whose stock returns are less vulnerable to economic

conditions have relatively low betas

Beta ignores unsystematic risk

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How to Evaluate a Bank¶s

Performance Analysts often need to evaluate an individual

bank¶s performance

Examination of return on assets ROA usually reveals when a bank¶s performance is

not up to par

The components of ROA must be evaluated separately to

determine the reason (see next slide)



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How to Evaluate a Bank¶s

Performance (cont¶d)Measures of

Bank Performance

Financial Characteristics

Inf luencing Performance

Bank DecisionsAffecting

Financial Characteristics

Return on assets

(ROA)

Net interest margin Deposit rate decisions

Loan rate decisions Loan losses

Noninterest revenues Bank services offered

Noninterest expenses Overhead requirements

Efficiency

Advertising

Loan losses Risk level of loans provided

Return on equity

(ROE)

ROA See above

Leverage measure Capital structure decision



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BankF

ailures From 1940 to 1980, there were generally fewer

than 20 bank failures per year

In the late 1980s, there were about 200 failuresper year

Failures declined in the early 1990s

In the mid and late 1990s, the number of bankfailures declined substantially



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BankF

ailures (cont¶d) Reasons for bank failure

The bank may have experienced fraud Includes embezzlement of funds

The bank may have a high loan default percentage No matter how well a bank diversifies its loans, it is still

subject to a recessionary cycle

The bank may experience a liquidity crisis Rumors may cause depositors to withdraw funds and the

bank may be unable to attract new deposits The bank may face increased competition

Deregulation has made the banking industry morecompetitive

A reduced net interest margin could lead to failure



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BankF

ailures (cont¶d) Reasons for bank failure (cont¶d)

The Office of the Comptroller of the Currency

reviewed 162 national failed banks since 1979 and

found the following common characteristics: 81 percent of the banks did not have a loan policy or did not

closely follow their loan policy

59 percent of the banks did not use an adequate system for

identifying problem loans

63 percent of the banks did not adequately monitor key bank

officers or departments

57 percent of the banks allowed one individual to make

major corporate decisions

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