Solution manual bank management and financial services 9th edition by rose, peter chap006

Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors CHAPTER 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 bank’s 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 Key Topics in this Chapter       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 Chapter Outline I II Introduction: Evaluating Performance A Determining Long-Range Objectives B Maximizing the Value of the Firm: A Key Objective for Nearly All FinancialService Institutions C Profitability Ratios: A Surrogate for Stock Values Key Profitability Ratios Interpreting Profitability Ratios D Useful Profitability Formulas for Banks and Other Financial-Service Companies E Return on Equity and Its Principal Components F The Return on Assets and Its Principal Components G What a Breakdown of Profitability Measures Can Tell Us H Measuring Risk in Banking and Financial Services Credit Risk Liquidity Risk Market Risk a Price Risk b Interest Rate Risk Foreign Exchange and Sovereign Risk Off-Balance-Sheet Risk Operational (Transactional) Risk Legal and Compliance Risks Reputation Risk 6-1 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Strategic Risk 10 Capital Risk I Other Goals in Banking and Financial-Services Management III Performance Indicators among Banking’s Key Competitors IV The Impact of Size on Performance A Size, Location, and Regulatory Bias in Analyzing the Performance of Banks and Competing Financial Institutions V Summary of the Chapter Appendix to the Chapter - Using Financial Ratios and Other Analytical Tools to Track FinancialFirm Performance-The UBPR and BHCPR Concept Checks 6-1 Why should banks and other corporate financial firms be concerned about their level of profitability and exposure to risk? Banks in the U.S and most other countries are like private businesses that must attract capital from the public to fund their operations If profits are inadequate or if risk is excessive, they will have greater difficulty in obtaining capital and their funding costs will grow, eroding profitability Bank stockholders, depositors, and bank examiners representing the regulatory community are all interested in the quality of bank performance The stockholders are primarily concerned with profitability as a key factor in determining their total return from holding bank stock, while depositors (especially large corporate depositors) and examiners typically focus on bank risk exposure 6-2 What individuals or groups are likely to be interested in these dimensions of performance for a financial institution? The individuals or groups likely to be interested in the dimensions i.e., profitability and risk are – other banks lending to a particular bank, borrowers, large depositors, holders of long-term debt capital issued by banks, bank stockholders, and bank examiners representing the regulatory community 6-3 What factors influence the stock price of a financial-service corporation? A bank's stock price is affected by all those factors affecting its profitability and risk exposure, particularly its rate of return on equity capital and risk to shareholder earnings Research evidence over the years has found that the stock prices of financial institutions is sensitive to changes in market interest rates, currency exchange rates, and the strength or weakness of the economy A bank can raise its stock price by working to achieve policies that increase future earnings, reduce risk, or pursue a combination of both actions 6-4 Suppose that a bank is expected to pay an annual dividend of $4 per share on its stock in the current period and dividends are expected to grow percent a year every year, and the 6-2 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors minimum required return-to-equity capital based on the bank's perceived level of risk is 10 percent Can you estimate the current value of the bank's stock? In this constant dividend growth rate problem, the current value of the bank's stock would be: Po = D1  (1+0.05) 4.2 = = =$84 (r-g) (0.10-0.05) 0.05 6-5 What is return on equity capital, and what aspect of performance is it supposed to measure? Can you see how this performance measure might be useful to the managers of financial firms? Return on equity capital is the ratio of net income over total equity capital It represents the rate of return earned on the funds invested in the bank by its stockholders They expect to earn a suitable profit over the risk of their investment Return on equity capital can also be calculated using the return on assets as follows: Total assets ROE = ROA  Total equity capital This ROE–ROA relationship illustrates the fundamental trade-off between risk and return This equation reminds us that the return to a financial firm’s shareholders is highly sensitive to how its assets are financed—the proportion of debt and owner’s capital used Constructing a risk-return trade-off table can help the managers understand how much leverage (debt relative to equity) must be used to achieve a financial institution’s desired rate of return to its stockholders 6-6 Suppose a bank reports that its net income for the current year is $51 million, its assets total $1,144 million, and its liabilities amount to $926 million What is its return on equity capital? Is the ROE you have calculated good or bad? What information you need to answer this last question? The bank's return on equity capital should be: ROE  = Net income Total equity capital $51 million  0.2339 or 23.39 percent $1,144 million  $926 million In order to evaluate the performance of the bank, you have to compare its ROE to the ROE of some major competitors or the industry average 6-7 What is the return on assets (ROA), and why is it important? Might the ROA measure be important to banking’s key competitors? 6-3 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Return on assets is the ratio of net income over total assets The rate of return secured on a bank's total assets indicates the efficiency of its management in generating net income from all of the resources (assets) committed to the institution This would be important to banks and their major competitors 6-8 A bank estimates that its total revenues will amount to $155 million and its total expenses (including taxes) will equal $107 million this year Its liabilities total $4,960 million while its equity capital amounts to $52 million What is the bank's return on assets? Is this ROA high or low? How could you find out? The bank's return on assets would be: ROA  = Net income Total Assets $155 million  $107 million  0.0096 or 0.96 percent $4,960 million  $52 million The size of this bank's ROA should be compared with the ROA's of other banks similar in size and location to determine whether this bank's ROA is high or low 6-9 Why the managers of financial firms often pay close attention today to the net interest margin and noninterest margin? To the earnings spread? The net interest margin (NIM) indicates how successful the bank has been in borrowing funds from the cheapest sources and in maintaining an adequate spread between its returns on loans and security investments and the cost of its borrowed funds If the NIM rises, loan and security income must be rising or the average cost of funds must be falling or both A declining NIM is undesirable because the bank's interest spread is being squeezed, usually because of rising interest costs on deposits and other borrowings and increased competition today In contrast, the noninterest margin reflects the banks spread between its noninterest income (such as service fees on deposits) and its noninterest expenses (especially salaries and wages and overhead expenses) For most banks the noninterest margin is negative Management will usually attempt to expand fee income, while controlling closely the growth of noninterest expenses in order to make a negative noninterest margin less negative The earnings spread measures the effectiveness of the bank's intermediation function of borrowing and lending money, which, of course, is the bank's primary way of generating earnings As competition increases, the spread between the average yields on assets and the average cost of liabilities will be squeezed, forcing the bank's management to search for alternative sources of income, such as fees from various services the bank offers 6-10 Suppose a banker tells you that his bank in the year just completed had total interest expenses on all borrowings of $12 million and noninterest expenses of $5 million, while interest income from earning assets totaled $16 million and noninterest revenues totaled $2 million 6-4 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Suppose further that assets amounted to $480 million, of which earning assets represented 85 percent of that total while total interest-bearing liabilities amounted to 75 percent of total assets See if you can determine this bank's net interest and noninterest margins and its earnings base and earnings spread for the most recent year The bank's net interest and noninterest margins must be: Net interest margin = =  Interest income - Interest expense  Total assets $16 million - $12 million = 0.00833 $480 million  Noninterest revenues    Provision for loan and lease losses - Noninterest expenses   Net noninterest margin = Total assets = $2 million - $5million = -0.00625 $480 million The bank's earnings spread and earnings base are: Earnings spread = = $16 million $12 million = 0.0059 $480 million × 0.85 $480 million × 0.75 Earnings base = = Totalinterest income Total interestexpense Total earning assets Total interest-bearing liablities Total earning assets Total assets $480 million -  $480 million  0.15  $480 million = 0.85 or 85 percent 6-11 What are the principal components of ROE, and what does each of these components measure? The principal components of ROE are: a The net profit margin or the Net after-tax income to Total operating revenues which reflects the effectiveness of a bank's expense control program and service pricing policies; 6-5 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors b The degree of asset utilization or the ratio of Total operating revenues to Total assets which measures the effectiveness of the bank's portfolio management policies, especially the mix and yield on assets; and, c The equity multiplier or the ratio of Total assets to Total equity capital which measures a bank's use of leverage in funding its operations: the sources chosen to fund the financial institution (debt or equity) 6-12 Suppose a bank has an ROA of 0.80 percent and an equity multiplier of 12X What is its ROE? Suppose this bank's ROA falls to 0.60 percent What size equity multiplier must it have to hold its ROE unchanged? The bank's ROE is: ROE = 0.80 percent ×12 = 9.60 percent If ROA falls to 0.60 percent, the bank's ROE and equity multiplier can be determined from: ROE = 9.60 percent = 0.60 percent × Equity multiplier Equity Multiplier  9.60 percent  16X 0.60 percent 6-13 Suppose a bank reports net income of $12, pre-tax net income of $15, operating revenues of $100, assets of $600, and $50 in equity capital What is the bank's ROE? Tax-management efficiency indicator? Expense control efficiency indicator? Asset management efficiency indicator? Funds management efficiency indicator? The bank's ROE must be: ROE = $12 = 0.24 or 24 percent $50 Its tax-management, expense control, asset management, and funds management efficiency indicators are: Tax Management Effeciency Indicator = $12 = 0.8or 80 percent $15 Expense Control Effeciency Indicator = $15 = 0.15or15percent $100 Asset Management Effeciency Indicator = $100 = 0.1667 or16.67 percent $600 Fund Management Effeciency Indicator = $600 = 12x $50 6-6 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Alternative calculation for ROE: = 0.8 × 0.15 × 0.1667 × 12 = 0.24 or 24 percent 6-14 What are the most important components of ROA, and what aspects of a financial institution’s performance they reflect? The principal components of ROA are: a Total Interest Income less Total Interest Expense divided by Total Assets, measuring a bank's success at intermediating funds between borrowers and lenders b Provision for Loan Losses divided by Total Assets, which measures management's ability to control loan losses and manage a bank's accrual expense c Noninterest Income less Noninterest Expenses divided by Total Assets, which indicates the ability of management to control salaries and wages, other noninterest costs of operations and generate income from handling customer transactions d Applicable Taxes divided by Total Assets, which is an index of tax management effectiveness, measures the financial firm’s share of the cost of government securities 6-15 If a bank has a net interest margin of 2.50%, a noninterest margin of −1.85%, and a ratio of provision for loan losses, taxes, security gains, and extraordinary items of −0.47%, what is its ROA? The bank's ROA must be: ROA = Net interest margin + Noninterest margin – Ratio of provision for loan losses, taxes, security gains, and extraordinary items ROA = 2.5 percent + (−1.85 percent) – (−0.47 percent) = 1.12 percent 6-16 To what different kinds of risk are banks and their financial-service competitors subjected today? a Credit Risk: the probability that the loans and securities the bank holds will not pay out as promised b Liquidity Risk: the probability that the bank will not have sufficient cash on hand in the volume needed precisely when cash demands arise c Market Risk: the probability that the market value of assets held by the bank will decline due to falling market prices Market risk is composed of both price risk and interest rate risk 6-7 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Price Risk: the probability or possibility that the value of bond portfolios and stockholders’ equity may decline due to market prices movement against the financial firm Interest-Rate Risk: the possibility or probability that the interest rates will change, subjecting the bank to incur a lower margin of profit or a lower value for the firm’s capital d Foreign Exchange and Sovereign Risk: the uncertainty that due to fluctuation in currency prices, assets denominated in foreign currencies may fall, forcing the write-down of these assets on its Balance Sheet e Off-Balance-Sheet Risk: the probability that the volume of off-balance-sheet commitments far exceeds the volume of conventional assets f Operational (Transactional) Risk: the uncertainty regarding a financial firm’s earnings due to failures in computer systems, employee misconduct, floods, lightening strikes and other similar events g Legal and Compliance Risk: the uncertainty regarding a financial firm’s earnings due to actions taken by our legal system or due to a violation of rules and regulations h Reputation Risk: the uncertainty due to public opinion or the variability in earnings due to positive or negative publicity about the financial firm i Strategic Risk: the uncertainty in earnings due to adverse business decisions, lack of responsiveness to industry changes, and other poor decisions by management j Capital Risk: the risk that the value of the assets will decline below the value of the liabilities All of the other risks listed above can affect earnings and the value of the assets and liabilities and therefore can have an effect on the capital position of the firm 6-17 What items on a bank's balance sheet and income statement can be used to measure its risk exposure? To what other financial institutions these risk measures seem to apply? There are several alternative measures of risk in banking and financial service firms Capital risk is often measured by bank capital ratios, such as the ratio of total capital to total assets or total capital to risk assets Credit risk can be tracked by such ratios as net loan losses to total loans or relative to total capital Liquidity risk can be followed by using such ratios as cash assets and government securities to total assets or by purchased funds to total assets Interest-rate risk may be indicated by such ratios as interest-sensitive assets to interest-sensitive liabilities or the ratio of money-market assets to money-market borrowings These risk measures also apply to those nonbank financial institutions that are private, profit making corporations, including stockholder-owned thrift institutions, insurance companies, 6-8 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors finance and credit card companies, security broker and dealer firms, mutual funds, and hedge funds 6-18 A bank reports that the total amount of its net loans and leases outstanding is $936 million, its assets total $1,324 million, its equity capital amounts to $110 million, and it holds $1,150 million in deposits, all expressed in book value The estimated market values of the bank's total assets and equity capital are $1,443 million and $130 million, respectively The bank's stock is currently valued at $60 per share with annual per-share earnings of $2.50 Uninsured deposits amount to $243 million and money-market borrowings total $132 million, while nonperforming loans currently amount to $43 million and the bank just charged off $21 million in loans Calculate as many of the risk measures as you can from the foregoing data Liquidity Risk: Net Loans and Leases $936 million = = 0.706949or 70.69 percent Total Assets $1,324 million Interest Rate Risk: Uninsured Deposits $243million = = 0.211304 or 21.13percent Total Deposits $1,150 million Capital Risk: Equity Capital $130 million = = 0.09009 or 9.01percent Risk Assets $1,443 million Stock Price $60   24 Earnings per Share $2.50 Book Value of Assets $1,324 million = = 0.917533or 91.75 percent Market Value of Assets $1,443 million Credit Risk: Nonperforming Assets $43million = = 0.04594or 4.59 percent Net Loans and Leases $936 million Charge-offs of Loans $21million = = 0.022436 or 2.24 percent Total Loans and Leases $936 million Price Risk: 6-9 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Book Value of Assets $1,324 million = = 0.917533or 91.75 percent Market Value of Assets $1,443 million Problems and Projects 6-1 An investor holds the stock of Last-But-Not-Least Financials and expects to receive a dividend of $4.75 per share at the end of the year Stock analysts recently predicted that the bank’s dividends will grow at approximately percent a year indefinitely into the future If this is true, and if the appropriate risk-adjusted cost of capital (discount rate) for the bank is 14 percent, what should be the current price per share of Last-But-Not-Least Financials’ stock? P0  D1 4.75   $43.18  r  g   0.14  0.03 6-2 Suppose that stockbrokers have projected that Jamestown Savings will pay a dividend of $2.50 per share on its common stock at the end of the year; a dividend of $3.25 per share is expected for the next year, and $4.00 per share in the following two years The risk-adjusted cost of capital for banks in Jamestown’s risk class is 15 percent If an investor holding Jamestown’s stock plans to hold that stock for only four years and hopes to sell it at a price of $50 per share, what should the value of the bank’s stock be in today’s market? P0  2.50 3.25 4 50       0.15   0.15   0.15    0.15   0.15 P0 = $38.14 per share 6-3 Oriole Savings Association has a ratio of equity capital to total assets of percent In contrast, Cardinal Savings reports an equity-capital-to-asset ratio of percent What is the value of the equity multiplier for each of these institutions? Suppose that both institutions have an ROA of 0.67 percent What must each institution’s return on equity capital be? What your calculations tell you about the benefits of having as little equity capital as regulations or the marketplace will allow? Oriole Savings Association has an equity-to-asset ratio of percent which means its equity multiplier must be: 1 = = 11.11X 0.09  Equity Capital    Assets   6-10 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors In contrast, Cardinal Savings has an equity-to-asset ratio of percent which means it has an equity multiplier of: 1 = = 14.29X 0.07  Equity Capital    Assets   With an ROA of 0.67 percent Oriole Savings Association would have an ROE of: ROE = 0.67 × 11.11x = 7.44 percent With an ROA of 0.67 percent Cardinal Savings would have an ROE of: ROE = 0.67 × 14.29x = 9.57 percent In this case Cardinal Savings is making greater use of financial leverage and is generating a higher return on equity capital as compared to Oriole Savings Association 6-4 The latest report of condition and income and expense statement for Smiling Merchants National Bank are as shown in the following tables: Smiling Merchants National Bank (complete) Income and Expense Statement (Report of Income) Interest and fees on loans $50 Interest and dividends on securities Total interest income 56 Interest paid on deposits Interest on nondeposit borrowings Total interest expense 40 46 Net interest income Provision for loan losses Noninterest income and fees Noninterest expenses: Salaries and employee benefits Overhead expenses Other noninterest expenses Total noninterest expenses Net noninterest income 10 20 Pretax operating income Securities gains (or losses) Pretax net operating income Taxes Net operating income Net extraordinary income 6-11 10* 17 -2 10 -1 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Net income *Note: the bank currently has 40 FTE employees Smiling Merchants National Bank Report of Condition Assets Liabilities Cash and deposits due from banks $100 Demand deposits Investment securities 150 Savings deposits Federal funds sold 10 Time deposits Net loans 700 Federal funds purchased (Allowance for loan losses = 25) Total liabilities (Unearned income on loans = 5) Equity capital Net Fixed Assets 50 Common stock Surplus Total assets 980 Retained earnings Total Capital Total earnings assets 860 Interest-bearing deposits $190 180 470 80 920 20 35 35 80 650 Fill in the missing items on the income and expense statement Using these statements, calculate the following performance measures: ROE ROA Net interest margin Net noninterest margin Net operating margin Earnings spread Net profit margin Asset utilization Equity multiplier Tax management efficiency Expense control efficiency Asset management efficiency Funds management efficiency Operating efficiency ratio What strengths and weaknesses are you able to detect in Smiling Merchants’ performance? ROE = ROA = Net income $7 = = 0.0778 or 7.78 percent Total equity capital $90 Net income $7 = = 0.00714 or 0.71 percent Total assets $980 Net interest income $10 Net interest margin = = = 0.0120 or 1.02 percent Total assets $980 Net noninterest margin = Net noninterest income -$2 = = -0.00204 or -0.20 percent Total assets $980 6-12 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Net operating margin = = $8 = 0.008163 or 0.82 percent $980 Earnings spread = = Total operating revenues - Total operating expenses Total assets Totalinterest income Totalinterest expenses Total earnings assets Totalinterest-bearing liabilities $56 $46 = 0.002103 or 0.21 percent $860 $650 Net profit margin = Net income $7 = = 0.092105 or 9.21 percent Total operating revenues $54 Asset utilization = Total operating revenues $76 = = 0.077551 or 7.76 percent Total assets $980 Equity multiplier = Total assets $980 = = 10.89x Total equity capital $90 10 Tax Management = 11 Expense control effeciency = 12 Asset managment effeciency ratio = = Net income $7 = = 0.7 or 70 percent Pretax net operating income $10 Pretax net operating income $10 = = 0.131579 or 13.16 percent Total operating revenue $76 Total operating revenues Total assets $76 = 0.07755 or 7.76 percent $980 13 Funds Managment Effeciency Ratio = 14 Operating effeciency ratio = Total assets $980 = = 10.89x Total equity capital $90 Total operating expenses $68 = = 0.894737 or 89.47 percent Total operating revenues $76 Strengths: ROE: Positive value reflects a high rate of return flowing to shareholders Net profit margin: Positive value reflects effectiveness of management in controlling cost and service pricing policies 6-13 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Asset utilization: Positive value reflects a good portfolio management policies and yield on assets Equity multiplier: Positive value reflects efficient financial policies Expense control efficiency, asset management efficiency ratio, funds management efficiency ratio, operating efficiency ratio also reflects a high operating efficiency and expense control Tax-management efficiency ratio: Positive ratio reflecting the use of security gains or losses and other tax-management tools (such as buying tax-exempt bonds) to minimize tax exposure etc Weaknesses: ROA: Positive value (0.714%) reflects managerial efficiency and how successful management has been in converting assets into net earnings Since the positive value is only 0.714% it acts as a weakness for Smiling Merchants National Bank Net noninterest margin: Negative value (−0.2%) reflects that net noninterest income is inline with noninterest cost Net interest margin: Positive value (1.02%) reflects that management is not successful in achieving close control over earning assets and in utilizing the cheapest sources of funding Since the positive value is only 1.02% it acts as a weakness for Smiling Merchants National Bank Earnings spread: Positive value (0.21%) reflects a high competition, forcing management to try and find other ways to make up for an eroding earnings spread 6-5 The following information is for Rainbow National Bank: Interest income Interest expense Total assets Securities losses or gains Earning assets Total liabilities Taxes paid Shares of common stock outstanding Noninterest income Noninterest expense Provision for loan losses $2,250.00 1,500.00 45,000.00 21.00 40,000.00 38,000.00 16.00 5,000 $800.00 900.00 250.00 Please calculate: ROE ROA Net interest margin Earnings per share 6-14 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Net noninterest margin Net operating margin ROE = Net income $405 = = 0.058or 5.8 percent Total equity capital $45,000 - $38,000 ROA = Net income $405 = = 0.009or 0.90 percent Total assets $45,000 Net interest income $750 = = 0.01667 or1.67 percent Total assets $45,000 Net interest margin = Earnings per share = Net income $405 = = $0.081per share Common equity shares outstanding 5,000 Net noninterest margin = Net noninterest income -$350 = = -0.0078or -0.78percent Total assets $45,000 Total operating revenues-Total operating expenses $400 = Total assets $45,000 = 0.00889 or 0.89 percent Net operating margin = Alternative Scenarios: a Suppose interest income, interest expenses, noninterest income, and noninterest expenses each increase by percent while all other revenue and expense items shown in the preceding table remain unchanged What will happen to Rainbow ROE, ROA, and earnings per share? Interest income Interest expense Total assets Securities losses or gains Earning assets Total liabilities Taxes paid Shares of Common Stock outstanding Noninterest income Noninterest expense Provision for loan losses ROE = $2,317.50 $1,545.00 $45,000.00 $21.00 $40,000.00 $38,000.00 $16.00 5,000 $824.00 $927.00 $250.00 Net income $425 = = 0.06064 or 6.06 percent Total equity capital $45,000 - $38,000 6-15 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors ROA = Net income $425 = = 0.00943or 0.943percent Total assets $45,000 Earnings per share = Net income $425 = = $0.0849 per share Common equityshares outstanding 5,000 b On the other hand, suppose Rainbow interest income and expenses as well as its noninterest income and expenses decline by percent, again with all other factors held constant How would the bank’s ROE, ROA, and per-share earnings change? Interest income Interest expense Total assets Securities losses or gains Earning assets Total liabilities Taxes paid Shares of common stock outstanding Noninterest income Noninterest expense Provision for loan losses $2,182.50 $1,455.00 $45,000.00 $21.00 $40,000.00 $38,000.00 $16.00 5,000 $776.00 $873.00 $250.00 ROE = Net income $386 = = 0.05507 or 5.51percent Total equity capital $45,000 - $38,000 ROA = Net income $386 = = 0.00857 or 0.857 percent Total assets $45,000 Earnings per share = Net income $386 = = $0.0771per share Common equityshares outstanding 5,000 6-6 Zebra Group holds total assets of $25 billion and equity capital of $2 billion and has just posted an ROA of 0.95 percent What is the financial firm’s ROE? ROE = ROA ×  Total assets $25 = 0.95 percent × = 0.11875 or 11.875 percent Total equity capital $2 Alternative Scenarios: a Suppose Zebra Group finds its ROA climbing by 25 percent, with assets and equity capital unchanged What will happen to its ROE? Why? ROA increases by 25 percent, with no change in assets or equity capital Therefore, the new ROA = 0.95 × 1.25 = 0.01188 or 1.188 percent 6-16 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors $25 = 0.14844 or 14.84 percent $2 This represents a 25 percent increase in ROE With no changes in assets or equity, the investors' funds are more effectively utilized, generating additional income and making the bank more profitable New ROE = 1.188 percent × b: On the other hand, suppose the bank’s ROA drops by 25 percent If total assets and equity capital hold their present positions, what change will occur in ROE? ROA decreases by 25 percent, with no change in equity or assets Therefore, the new ROA = 0.95 × 0.75 = 0.007125 or 0.7125 percent New ROE = 0.7125 percent × $25 = 0.08906 or 8.91 percent $2 This represents a 25% decrease in ROE The bank's management has been less efficient, in this case, in managing their lending and/or investing functions or their operating costs c If ROA at Zebra Group remains fixed at 0.95 percent but both total assets and equity double, how does ROE change? Why? ROA is constant at 0.95 percent, and Total assets double in size to $50 billion and equity capital doubles in size to $4 billion Therefore, the equity multiplier (i.e total assets ÷ equity capital) remains the same (E.M = $50 ÷ $4 = 12.5X) As a result, ROE does not changes from the original situation (0.95 percent × 12.5 = 11.875 percent) This represents no change in ROE The bank's management has been efficient, in this case, in managing their lending and/or investing functions or their operating costs d How would a decline in total assets and equity by half (with ROA still at 0.95 percent) affect the bank’s ROE? This, of course, is just the reverse of scenario c Since the changes in both assets and equity capital are the same, the ratio of the two (i.e., the equity multiplier) remains constant As a result, there is again no change in ROE 6-7 OK State Bank reports total operating revenues of $150 million, with total operating expenses of $125 million, and owes taxes of $5 million It has total assets of $1.00 billion and total liabilities of $850 million What is the bank’s ROE? Net income after taxes = $150 million − $125 million − $5 million = $20 million Equity capital = $1.00 billion − $850 million = $150 million 6-17 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors ROE = Net income after taxes $20 million = = 0.133 or 13.33 percent Equity capital $150 million Alternative Scenarios: a How will the ROE for OK State Bank change if total operating expenses, taxes, and total operating revenues each grow by 10 percent while assets and liabilities remain fixed? Total operating revenues = $150 million × 1.10 = $165 million Total operating expenses = $125 million × 1.10 = $137.5million Tax liability = $5 million × 1.10 = $5.5 million Net income after taxes = $165 - $137.5 - $5.50 = $22 million ROE = $22 million = 0.1467 or 14.67 percent $150 million Change in ROE =  14.67 percent - 13.33 percent  13.33 percent = 10 percent b Suppose OK State’s total assets and total liabilities increase by 10 percent, but its revenues and expenses (including taxes) are unchanged How will the bank’s ROE change? Total assets increase by 10% (Total assets = $ 1.0 × 1.10 = $1.1 billion) Total liabilities increase by 10% (Total liabilities = $850 million × 1.10 = $935 Revenues and expenses (including taxes) remain unchanged Equity capital = $1.1 billion − $935 million = $165 million ROE = $20 million = 0.1212 or 12.12 percent $165 million Change in ROE =  12.12 percent - 13.33 percent  13.33 percent = -9.09 percent c Can you determine what will happen to ROE if both operating revenues and expenses (including taxes) decline by 10 percent, with the bank’s total assets and liabilities held constant? Total revenues decline by 10% (Total revenues = $150 million × 0.90 = $135million) Total expenses decline by 10% (Total expenses = $125 million × 0.90 = $112.5 million) Tax liability declines by 10% (Tax liability = $5 × 0.9 = $4.5 million) Assets and liabilities remain unchanged (Therefore, equity remains unchanged) Net income after tax = $135 million – 112.5 million − $4.5 million = $18 6-18 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors $18 million = 0.12 or 12 percent $150 million  12 percent - 13.33 percent  = -10 percent Change in ROE = 13.33 percent ROE = d What does ROE become if OK State’s assets and liabilities decrease by 10 percent, while its operating revenues, taxes, and operating expenses not change? Total assets = $1.0 billion × 0.9 = $900 million Total liabilities = $850 million × 0.9 =$765 million Equity capital = $900 million − $765 million = $135 million ROE = $20 million = 0.1481 or 14.81 percent $135 million Change in ROE =  14.81 percent - 13.33 percent  13.33 percent = 11.11 percent 6-8 Suppose a stockholder-owned thrift institution is projected to achieve a 0.90 percent ROA during the coming year What must its ratio of total assets to equity capital be if it is to achieve its target ROE of 12 percent? If ROA unexpectedly falls to 0.80 percent, what assets-to-capital ratio must it then have to reach a 12 percent ROE? ROE  ROA  Total assets Total equity capital Total assets ROE 12 percent = = = 13.33x Total equity capital ROA 0.90 percent If ROA unexpectedly falls to 0.80 percent and target ROE remains 12 percent: 12 percent  0.8 percent  Total assets Total equity capital Total assets 12 percent = = 15x Total equity capital 0.80 percent 6-9 Conway 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 Total operating revenues Total assets $ 30.00 135.00 1,750.00 6-19 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Total equity capital accounts 170.00 Net income $30 million = = 0.2222 or 22.22 percent Total operating revenue $135 million a Net profit margin = b Asset utilization = Total operating revenue $135 million = = 0.0771 or 7.71 percent Total assets $1, 750 million c Equity multiplier = Total assets $1,750 million = = 10.29x Total equity capital $170 million d Net profit margin = Net income $30 million = = 0.1765 or 17.65 percent Total equity capital $170 million 6-10 Runnals National Bank has experienced the following trends over the past five years (all figures in millions of dollars): Year Net Income After-Tax $2.65 2.75 3.25 3.65 4.00 Total Operating Revenues $26.50 30.10 39.80 47.50 55.90 Total Assets $300.00 315.00 331.00 347.00 365.00 Total Liabilitie s $273.00 288.00 301.00 314.00 329.00 Determine the figures for ROE, profit margin, asset utilization, and equity multiplier for this bank Are any adverse trends evident? Where would you recommend that management look to deal with the bank’s emerging problem(s)? Year Profit Margin 10.00% 9.14% 8.17% 7.68% 7.16% Asset Utilization 8.83% 9.56% 12.02% 13.69% 15.32% Equity Multiplier 11.11x 11.67x 11.03x 10.52x 10.14x ROA 0.88% 0.87% 0.98% 1.05% 1.10% ROE 9.81% 10.19% 10.83% 11.06% 11.11% If we look at the entire five-year period, Runnal's profit margin has declined constantly This can be viewed as troublesome when we note that net income and total operating revenues have nearly doubled during the five-year period Two potential areas that management should investigate are (1) the mix of funding sources and (2) non-interest expenses Runnal’s asset utilization has shown a constant growth trend over the five years due to careful allocation of assets towards the highest yielding loans and investments while avoiding excessive 6-20 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors risk The bank’s equity multiplier increased in the first year and started reducing the subsequent years as its equity capital increased in all the years Runnal experiences an increase in ROE over the years as the expanding asset utilization offsets decreases in net profit margin and equity multiplier Since ROE has grown much more rapidly than ROA, we should be concerned that Runnal is increasing its liability sources of funding, thereby increasing its leverage to keep its ROE growing This can cause serious problems with its income as interest rates rise, driving up its cost of funds With regard to its noninterest expenses, if these are growing faster than the bank's noninterest income, then there is greater pressure on the bank's net interest margin to offset the increasing negative spread between noninterest income and noninterest expenses 6-11 Paintbrush Valley State Bank has just submitted its Report of Condition and Report of Income to its principal supervisory agency The bank reported net income before taxes and securities transactions of $37 million and taxes of $8 million If its total operating revenues were $950 million, its total assets $2.7 billion, and its equity capital $250 million, determine the following for Paintbrush Valley: a Tax management efficiency ratio b Expense control efficiency ratio c Asset management efficiency ratio d Funds management efficiency ratio e ROE a = Tax management efficiency = Net income Pretax net operating income $37 million - $8 million $29 million = = 0.7838 or 78.38 percent $37 million $37 million Pretax net operating income Total operating revenue b Expense control efficiency = = $37 million = 0.0389 or 3.89 percent $950 million Total operating revenue Total assets c Asset management efficiency = = $950 million = 0.3519 or 35.19 percent $2,700 million d Fund management efficiency = Total assets $2,700 million = = 10.8x Total equity capital $250 million 6-21 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors e ROE = Net income $29 million = = 0.116 or 11.6 percent Total equity capital $250 million Alternative Scenarios: a Suppose Paintbrush Valley State Bank experienced a 20 percent rise in net before-tax income, with its tax obligation, operating revenues, assets, and equity unchanged What would happen to ROE and its components? ROE = ROA × Total assets Net income Total assets or × Total equity Total assets Total equity [  $37 × 1.20  - $8 $2,700 × $2,700 $44.4 - $8 $2,700 or × = 0.1456 or 14.56 percent $250 $2,700 $250 This represents a 25 percent increase in ROE, from 11.60 percent to 14.56 percent Since the equity multiplier did not change, this increase in ROE is due to the increase in ROA, from 1.07 percent to 1.35 percent b If total assets climb by 20 percent, what will happen to Paintbrush’s efficiency ratio and ROE? Asset management efficiency ratio = $950 $950 =  0.2932 or 29.32 percent $2,700 × 1.2 $3, 240 This represents a decrease of 16.67 percent Fund management efficiency = $3,240 million = 12.96x $250 million This represents a 20% increase ROE would not change since the decrease in the asset management efficiency ratio is offset by the increase in the funds management efficiency ratio c What effect would a 20 percent higher level of equity capital have upon Paintbrush’s ROE and its components? Fund management efficiency = $2,700 = 9x $250  1.2 The fund management efficiency ratio decreases from 10.8x to 9x 6-22 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors ROE = Tax management efficiency ratio × Expense control efficiency ratio × Asset management efficiency ratio × Funds management efficiency ratio = 78.38% × 3.89% × 35.19% × 9x = 0.097 or 9.7 percent A 20 percent increase in equity will decrease the ROE by 16.67 percent from 11.6 percent to 9.7 percent 6-12 Using this information for Eagle Bank and Trust Company (all figures in millions), calculate the bank's net interest margin, noninterest margin, and ROA Interest income Interest expense Provision for loan losses Security gains (or losses) Noninterest expense Noninterest income Extraordinary net gains Total assets a Net interest margin = = $ 75 61 1,000 Interest income - Interest expenses Total assets $75 - $61 $14 =  0.014 or 1.40% $1,000 $1,000 b Net noninterest margin = = Noninterest income - Noninterest expenses Total assets $5 - $8 -$3 =   0.003 or -0.3% $1,000 $1,000 c ROA = Net income $8 = = 0.008 or 0.80 percent Total assets $1,000 6-13 Mountain Savings reported these figures (in millions) on its income statement for the past five years Calculate the institution’s ROA in each year Are there any adverse trends? Any favorable trends? What seems to be happening to this institution? Gross interest income Interest expenses Current Year $40 24 6-23 One Year Ago $41 25 Two Years Ago $42 26 Three Years Ago $43 27 Four Years Ago $44 28 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Net interest income Provision for loan losses Net interest income after Loan loss provision Noninterest income Noninterest expense Net noninterest income Income before taxes Income taxes owed Net income after taxes but before gains (losses) Net securities gains (losses) Net income Total assets ROA 16 14 16 15 16 15 16 16 16 16 (4) 10 (3) 12 11 (4) 11 11 (4) 12 11 (4) 12 12 11 885 1.24% 13 880 1.48% 12 875 1.37% 11 860 1.28% 12 850 1.41% Mountain's ROA has remained consistent, in the range of 1.24 percent to 1.48 percent, over the last five years The gross interest income has consistently declined over the last five years However, the company has also managed to decrease interest expenses at the same rate A similar trend is seen in the movement of noninterest income and noninterest expense, offsetting the effects of each other Thus, the company has been able to maintain a constant level of net income from operations Growth in interest and noninterest income has been in level with the growth in interest and noninterest expense, as well as a reduction in the allowance for loan losses, resulting in a constant level of net income from operations 6-14 An analysis of the BHCPR reports on BB&T is presented in this chapter’s appendix We examined a wide variety of profitability measures for that bank, including ROA, ROE, net profit margin, net interest and operating margins, and asset utilization However, the various measures of earnings risk, credit risk, liquidity risk, market risk (price risk and interest rate risk), and capital risk were not discussed in detail Using the data in Tables 6-5 through 6-9, calculate each of these dimensions of risk for BB&T for the most recent two years and discuss how the bank’s risk exposure appears to be changing over time What steps would you recommend to management to deal with any risk exposure problems you observe? Note to instructors: The Bank Holding Performance Report (BHCPR) is provided to each bank by the Federal Financial Institutions Examination Council The BHCPR is prepared from the call reports of condition and income that are filed quarterly by all banks It (the BHCPR) is for the use of regulators and management to assess how well the bank is performing relative to its internal goals and its peer group The user's guide to the BHCPR is available from the FFIEC for a nominal fee and details the various ratios and comparative data contained in the BHCPR The actual BHCPR is much more 6-24 Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors detailed than the example provided in the text as Tables 6-5 through 6-9 These exhibits are for illustrative purposes and not contain all the information that is necessary to calculate all the risk measures described in the text The instructor may find it helpful to use BHCPRs provided by a few local banks in class discussions Those actual BHCPRs allow the students to calculate the full range of risk and return measures and expand discussion of the concepts and ratios considerably 6-25 ...Chapter 06 - Measuring and Evaluating the Performance of Banks and Their Principal Competitors Strategic Risk 10 Capital Risk I Other Goals in Banking and Financial- Services Management III Performance... the Chapter - Using Financial Ratios and Other Analytical Tools to Track FinancialFirm Performance-The UBPR and BHCPR Concept Checks 6-1 Why should banks and other corporate financial firms be... capital issued by banks, bank stockholders, and bank examiners representing the regulatory community 6-3 What factors influence the stock price of a financial- service corporation? A bank' s stock