EVALUATING BANK

PERFORMANCE
A Course for Bank Directors

October 5, 2004

3:30p.m. 4:45p.m.

2004 ABA Annual Convention October 3-6, 2004 Marriott Marquis New York, NY

EVALUATING BANK PERFORMANCE 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

EVALUATING BANK PERFORMANCE A Course for Bank Directors

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 as quantitative perspective

EVALUATING BANK PERFORMANCE A Course for Bank Directors

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 constructive criticism

Senior Management
Develop strategies and execute day-to-day, be transparent and candid with Board, encourage inquiry

Other Issues to Consider:

Appropriate policies, procedures and limits, including new product/business processes Effective infrastructure for measuring and monitoring performance Comprehensive internal controls and audit

EVALUATING BANK PERFORMANCE A Course for Bank Directors

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?

EVALUATING BANK PERFORMANCE A Course for Bank Directors

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

Are there any patterns or themes of control weakness / noncompliance? 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 independent risk managers (including compliance and audit) with requisite authority and competence?

EVALUATING BANK PERFORMANCE 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 have we actually put a jet engine on a tricycle we are planning to sell to a fiveyear old? Is a limit that is never breached effective?

EVALUATING BANK PERFORMANCE A Course for Bank Directors

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

Market Liquidity

Credit Reputational

Risks

Operational Business

EVALUATING BANK PERFORMANCE A Course for Bank Directors

Bank Performance Metrics: Commercial Banking

Financial Metrics

Earnings/Profitability
Net Interest Margin, Return on Assets, Loan Growth, Fee Income, Operating Efficiency Write-offs, Loan Loss Reserves, Non-Performing Ratio, Concentrations (Industry, Obligor, Country, Rating) Leverage Ratio, Regulatory Capital

Non-Financial Metrics
Market Share Agent Portfolio

Asset Quality

Capital

Interest Rate Sensitivity

Market

Credit

Risks

Operational

Reputational

EVALUATING BANK PERFORMANCE A Course for Bank Directors

Bank Performance Metrics: Retail Banking

Financial Metrics

Earnings / Profitability
Net Interest Margin, Return on Assets, Loan Growth, Fee Income, Operating Efficiency Ratio FICO bands, Loss Rates, Loan Loss Reserves, Liquidity Ratio, Non-Performing Ratio, Concentrations Leverage Ratio, Regulatory Capital

Non-Financial Metrics
Market Share Reputation Compliance Controls Branch Network Core Deposits

Asset Quality

Capital

Interest Rate Sensitivity

Market

Credit

Risks

Operational

Reputational

EVALUATING BANK PERFORMANCE A Course for Bank Directors

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

Market

Risks
Credit Operational

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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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

Reputational

Risks
Business Operational

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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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

Business

Risks
Reputational

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EVALUATING BANK PERFORMANCE A Course for Bank Directors

Evaluating Overall Bank Performance: Risk-Adjusted Measures

Measuring a banks performance across the enterprise:
Risk-Adjusted Return on Capital (RAROC) and Economic Profit (EP)
RAROC Economic Profit
Return

-[

Economic Capital

Return

Economic Capital

Hurdle Rate

Shareholder Value Added (SVA)

SVA
Net Operating Profit After Tax

-[

Capital

Cost of Capital

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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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 by product or business line Because it is risk-adjusted, it can be used to compare different types of businesses (trading book vs. banking book, asset vs. liability products) It can be used to evaluate existing performance, and also to boost performance through the proper allocation of capital among product or business line In some ways, it is a short-run perspective (business unit profit is compared to the units current capital at risk) According to a 2002 survey sponsored by ISDA and the RMA, 78% of the banks surveyed used RAROC. Regulatory drivers include SR 99-18 and Basel II, Pillar 2
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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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 to the cost of capital of the bank.

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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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)

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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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 financial objectives 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
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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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

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EVALUATING BANK PERFORMANCE 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 performance indicators (financial, customer, internal business processes, and learning and growth) Argues that return-on-investment, market share, and earnings-per-share do not provide the full perspective of an organizations performance Must balance internal and process measures with results and financial measures (i.e. balanced scorecard) Also balances short-term and long-term goals

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EVALUATING BANK PERFORMANCE 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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EVALUATING BANK PERFORMANCE 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, and management purposes Comes from the Federal Financial Institutions Examination Council (FFIEC), an inter-agency body for the Federal Reserve (FRB), Federal Deposit Insurance 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 liability management, and growth management Is produced quarterly using bank call reports

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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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 is supervised 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 percentile rankings)

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EVALUATING BANK PERFORMANCE A Course for Bank Directors

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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EVALUATING BANK PERFORMANCE A Course for Bank Directors

Contacts
Donald Vangel Office of the Chairman Advisor, Regulatory Compliance Hank Prybylski Practice Leader Financial Services Advisory Risk Management Samir Nangea Senior Manager Financial Services Advisory Risk Management (212) 773-2129 donald.vangel@ey.com (212) 773-2823 lawrence.prybylski@ey.com

(212) 773-6742 samir.nangea@ey.com

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