Vous êtes sur la page 1sur 50

Bank Management,

Management 5th edition.

Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning


Chapter 4
Traditional bank performance analysis
carries three basic flaws
 It ignores the wide diversity in strategies
pursued by different institutions
 A bank’s total assets no longer serve as a
meaningful yardstick when banks engage
in off-balance sheet activities
 The analysis provides no direct
information concerning how or
which of the bank’s activities
contribute to the creation of
shareholder value
Wide diversity in strategies pursued by
different institutions
 When UBPRs were introduced, most banks
did similar things, which were reflected in
their balance sheet
 They accepted deposits and made loans, and
many interest rates were regulated
 The primary differentiation of performance
was balance sheet composition
 Today, banks may pursue sharply different
Bank’s total assets no longer serve as a
meaningful yardstick when banks engage
in off-balance sheet activities

 Consider the situation where two banks

report the same asset size, but one also has
an extensive mortgage-servicing operation
that generates servicing income
 If the bank with mortgage-servicing makes a
profit on this activity, it will report a higher
ROA, ceteris paribus, due to the higher
noninterest income for mortgage-servicing
The analysis provides no direct information
concerning how or which of the bank’s
activities contribute to the creation of
shareholder value

 It similarly ignores other performance

benchmarks that customer-focused
managers must consider to identify
the best strategies going forward
Although ROA might be a biased
indicator of performance, return
on equity (ROE) doesn’t suffer
from the same weaknesses.

 When considering the entire bank,

stockholders’ equity must support all
activities, whether on- or off-balance
 Thus, a comparison of net income to
equity captures the returns to owners’
The appropriate peer group
…as long as banks have a similar strategic focus
and offer similar products and services, asset size
and UBPR ratios can provide meaningful

 To identify the appropriate peer

institutions, management should consider
the following:
1. What is the bank’s strategic focus?
2. What are the traditional balance sheet and
off-balance sheet characteristics of firms
with this focus?
3. How do the bank’s activities affect its
operating revenue?
A common starting point is to determine
whether the bank’s strategy is more loan-
driven or deposit-driven.

 A loan-driven bank’s profitability

is generally a function of
net interest income (the margin)
with loan volume a major factor.
 A deposit-driven bank’s profitability is
generally a function of noninterest income
with franchise value and deposit volume a
major factor.
A loan driven bank finds that:
 asset size is determined by loan demand
 profitability is determined by loan
economics; i.e., loan yields versus cost of
 loan margin is high as well as noninterest
 the culture is typically “our bank
underwrites loans better than other banks”
 value is typically some multiple of core
A deposit driven bank typically finds that:

 asset size is determine by the growth

in core deposits
 value is determined by the bank’s
franchise value -- measured by the
market share of low-cost core
 lower interest income, interest
margins and noninterest expenses
 lower loan losses
Evaluating performance using GAAP-based
data and UBPR ratios
…a bank should compare its ratios with those from a
select sample of peer institutions that are similarly loan-
driven or deposit-driven.
 Peers should operate the same approximate
number of offices in the same metropolitan or non-
metropolitan markets and have the same product
and service mix.
 Asset-based ratios are thus directly comparable.
 Analysts can easily construct peer bank averages
by direct comparison to other similar bank’s
UBPR’s or by using the FDIC’s Statistics on
Depository Institutions (SDI) system at:
One way to construct ratios that avoid the
problems of off-balance sheet activities is to
calculate ratios tied to a bank’s total
operating revenue (net interest income plus
noninterest income)-- (David Cates (1996))

 Fundamentally this means calculate

performance measures using total
operating revenue as the denominator
rather than assets.
 Here, total operating revenue equals the sum
of net interest income and noninterest
The efficiency ratio
…measured as noninterest expense divided by
total operating revenue, is a popular measure used
by stock analysis based on operating revenue
rather than assets.
 Analysts strongly encourage banks, regardless
of size, to meet fairly specific targets in this ratio.
 Because operating revenue includes both
interest income and noninterest (fee-based)
income, it captures all activities.

 Efficiency Ratio
= noninterest expense / net operating revenue
where net operating revenue
Bank stock analysts follow a standard procedure
when evaluating firm performance
 Initially use GAAP-based financial information to calculate
performance measures
 adjust the data to omit the impact of nonrecurring items, such as
one-time asset sales and restructuring charges
 compare these historical ratios with a carefully selected group
of peer institutions, matching each bank’s primary strategic
 Based on his or her own analysis and conversations with
specialists within the bank, the analyst then assesses the
quality of earnings based on:
 their sustainability
 the bank’s market power in specific product or service areas
 the bank’s franchise value
 The next step is to forecast earnings, cash flow, and market
value of equity over a three- to five-year time horizon
 Finally, the analyst makes a stock recommendation:
 accumulate (buy)
 neutral (hold)
 below-market performance (sell)
It is extremely rare, however, to see an
outright sell recommendation because
analysts want to remain in the good graces
of the banks that they follow
 Thus, they do not formally recommend
selling the stock, but rather label it as likely
to exhibit below-market performance.
 A hold recommendation thus actually means
“sell the stock” for most analysts.
 The recent failure of Enron is potentially an
example of the conflict of interest “buy-
side” and “sell-side” analysts have.
Investors in bank stocks are primarily
concerned with whether the bank’s
management is creating value for
 When analysts compare performance over
some historical period, they are less
concerned with ROE, ROA, and efficiency
ratios – rather the overall total return from
investing in the bank’s stock.
 Total return equals dividends received plus
stock price appreciation/depreciation
relative to the initial investment.
Key stock market-based performance
measures include
 Return to stockholders
= (∆price + dividends) / pricet-1
 Earnings per share
ΔNI after taxes and dividends on preferred stock
number of shares of common s tock outstanding

 Price to earnings (P/E) = stock price / EPS

 Price to book value
= stock price / book value per share
 Market value (MV) of equity
= MV of assets - MV of liabilities or
= # share of common stock x stock price
Example: buy 100 shares of PNC Financial at
the beginning of 2001 for $73.06. The bank paid
$1.92 per share in dividends that generated
reinvestment income of $.09. At the end of 2001,
the price of stock was $56.20.

 Return to stockholders in 2001 was -20.3%.

0.203 = [$56.20 - $73.06 + $2.01] ÷ $73.06
Balanced scorecard
…performance measures that look
beyond just financial measures
 The balanced scorecard is an attempt to balance
management decisions based on financial
measures with decisions based on a firm’s
relationships with its customers and the
effectiveness of support processes in designing
and delivering products and services
 The result is that line of business managers use
indicators such as:
 market share,
 customer retention and attrition,
 customer profitability, and
 service quality to evaluate performance
 Internally, they also track productivity and
employee satisfaction
Such nonfinancial indicators provide information regarding whether a
bank is truly customer-focused and whether its systems are appropriate
Operationalize the balanced scorecard

…divide the bank into a Customer Bank and

a House Bank
 Income derived from balance sheet
and income statement items that are
derived from bank customers
The Customer Bank
 Items that arise when the bank is its
own customer determines
The House Bank
Two banks in one house
 Traditional or Customer Bank, activities
 most loans, core deposits, payment services,
credit enhancements, asset management, and
financial advisory.
 Investment or House Bank, activities include:
 the investment portfolio, noncore, purchased
liabilities, loan participations, asset sales,
servicing, and bank-sponsored mutual funds.
 Items are assigned based on whether the
underlying activities pertain to bank
customers (Customer Bank) or the bank itself
(Investment Bank).
 Evaluate the returns on each Bank relative to
the risks and relevant benchmarks.
Line of business profitability analysis
…By allocate operating expenses to activities
that support bank customers and bank
management, banks can obtain at least a
rough estimate of segment net income.
 Leads to the reporting and use of both financial
and nonfinancial performance data, based on
specific customers.
 Many banks attempt to measure profitability by:
 type of loan customer (small business, middle
market, consumer installment, etc.)
 type of depositor; by characteristics of the
relationship (account longevity, cross-sell patterns,
profitability, etc.) and
 delivery system (branch, ATM, tele-phone, home
banking, etc.).
RAROC/RORAC analysis
…RAROC refers to risk-adjusted return on
capital, while RORAC refers to return on risk-
adjusted capital.
 In order to analyze profitability and risk precisely,
each line of business must have its own balance
sheet and income statement.
 These statements are difficult to construct because
many nontraditional activities, such as trust and
mortgage-servicing, do not explicitly require any direct
equity support.
 Even traditional activities, such as commercial lending
and consumer banking, complicate the issue because
these business units do not have equal amounts of
assets and liabilities generated by customers.
 The critical issue is to determine how much equity
capital to assign each unit.
Assigning equity capital to each unit
 Alternative capital allocation methods
 using regulatory risk-based capital
 assignment based on the size of assets
 benchmarking each unit to “pure-play”
peers that are stand-alone, publicly
held firms; and
 measures of each line of
business’s riskiness.
…often used interchangeably, but are formally
defined as follows:
 Risk adjust return on capital (RAROC)
 RAROC = Risk-adjusted income / Allocated capital
 Using this method, income is adjust for risk.
 Typically, income is adjusted for expected
 Return on risk adjusted capital (RORAC)
 RORAC = Net income / Allocated risk capital
 Using this method, capital is adjusted for risk.
 Typically, capital is adjusted for a maximum
potential loss based on the probability of future
returns or volatility of earnings.
Example: PNC reported results for seven
distinct lines of business
 Banking Businesses
1. Regional Community Banking
2. Corporate Banking
3. PNC Real Estate Finance
4. PNC Business Credit
 Asset Management and Processing
1. PNC Advisors
2. BlackRock
3. PFPC.
 The data were obtained from PNC’s management
accounting system based on internal assumptions
about revenue and expense allocations and
assignment of equity to each line of business.
PNC’s profitability analysis for 2000-2001
Two lines of business for PNC are detailed

 Corporate Banking
…represents products and services provided
nationally in the areas of credit, equipment leasing,
treasury management, and capital markets
products to large and mid-sized corporations and
government entities.
 Community Banking
…encompasses the bank’s traditional deposit,
branch-based brokerage, electronic banking and
credit products to retail customers along with
products to small businesses such that it is
primarily a deposit-generating unit.
PNC’s Profitability Analysis for 2000-2001 (cont.)
Transfer pricing
…the interest rate at which a firm could buy or
sell funds in the external capital markets.

 When management creates balance sheets

for each line of business, it must allocate
capital as well as assets or liabilities to
make the balance sheet balance.
 It must then assign a cost or yield to each of
these components to produce income
statement for each line of business.
Transfer pricing systems
 Banks use internal funds transfer pricing
systems to assign asset yields and cost
of funds to different lines of business
and products.
 Most systems use a matched maturity
framework that assigns rates by
identifying the effective maturity of the
underlying assets or liabilities and
assigning a rate obtained from a money
or capital market instrument of the same
Example: Internal funds transfer pricing
2-year loan financed by a 3-month deposit
Bank Deposit-Gathering Division
Asset Liability Asset Liability
Receivable from Treasury Time dposit
Loan: 2 year Time deposit: 3 month 3-month 3-month
$1,000,000 @8.50% $1,000,000 @ 4.5% $1,000,000 @5.20% $1,000,000 @ 4.5%

Margin = 4.00% Margin = 0.70%

Interest Rate Risk: Liability sensitive Interest Rate Risk: None

Embedded Option: Prepayment risk on loan Option: None

Lending Division Treasury Division

Asset Liability Asset Liability
Loan: 2 year Transfer from Treasury: 2 Receivable from Lending: Transfer to Deposit-Gathering:
year 2-year 3-month
$1,000,000 @8.50% $1,000,000 @6.00% $1,000,000 @6.00% $1,000,000 @5.20%

Margin = 0.80%
Margin = 2.50%
Interest Rate Risk: Liability sensitive
Interest Rate Risk: None Option: Sell option to lending division for 0.20%;
Option: Sold prepayment option to loan customer on balance sheet; NIM after option sale = 0.80% + 0.20% = 1.00%.
buy an option from Treasury for 0.20%. Treasury has interest rate and loan prepayment risk.
NIM after option cost = 2.50% - 0.20% = 2.30%
Risk-adjusted income and economic
 Two adjustments are frequently made to
income in line of business profitability
1. The return is adjusted for risk by subtracting
expected losses
2. The return nets out required returns
expected by stockholders.
 This minimum required return, or cost of
equity, represents a hurdle rate, or
stockholders’ minimum required rate of
 The specific concern is whether RAROC is
greater than the firm’s cost of equity.
Allocated risk capital
…The objective of RAROC analysis is to assist in
risk management and the evaluation of line of
business performance. As part of this, it is necessary
to assign capital to each line of business.
 Banks allocate risk capital by:
1. Regulatory risk-based capital standards
2. Asset size
3. Benchmarking versus “pure-play” stand-alone
4. Perceived riskiness of the business unit
Unfortunately, most lines of business do not have market value
balance sheets. Hence, many banks focus on the volatility in
economic earnings (earnings-at-risk) or estimate a value-at-risk figure.
…the volatility of earnings from a line of business.
 Securities underwriting and letters of credit
(guarantees) against customer exposures at
a large bank do not require much capital to
support day-to-day operations.
 But before a bank can actively engage in this
business, it must have a strong credit and
bond rating, which requires a substantial
amount of risk capital.
 One way to measure the required risk
capital is to relate it to the volatility of
earnings from this line of business; i.e.,
Earnings-at-risk applied to loans
 Using historical data for each of the past 30
months, estimate revenues obtained directly
from these loans.
 Using historical data for each of the past 30
months, estimate direct expenses from
offering these services and expected losses.
 Using the 60 observations for revenues minus
expenses and losses, estimate one standard
deviation of earnings. This is earnings-at-risk.
 Estimate risk capital as one (or two) standard
deviation of earnings, divided by the risk-free
interest rate.
Allocating risk capital based on earnings
volatility: Securities underwriting and
letters of credit division
A. Monthly Revenue Less Expenses (in millions of $)
 Most Recent 30 Months Observations:
4, 3, 4.5, 5, 5.2, 4.6, 3.9, 4.3, 5, 4.7, 5.1, 5.4, 5, 4.5, 4.4,
4.8, 5, 5.5, 5.3, 5.1, 5, 5.4, 5.7, 6.3, 6, 5.8, 5.5, 5.9, 5.5, 6.4
 Mean: $5.06 million
Standard Deviation: $0.735 million
B. Allocated Risk Capital
 Assuming a risk-free rate of 5.5% (annual):
(0.055 / 12) x Risk Capital = $ 0.735 million
Risk Capital = $160.364 million
C. RORAC for the Most Recent Month
1. Revenue minus expense of $6.4 million
RORAC = 6.4 / 160.364 = 0.0399 monthly,
or 47.89% annually
3. Economic Income
Assuming a hurdle rate of 12% annually, economic income
net of the capital charge:
$6.4 - (.12/12) $160.364 = $4.796 million
Management of market risk
…market risk is the risk of loss to earnings and
capital related to changes in the market values of
bank assets, liabilities, and off-balance sheet
 In January 1998, bank regulators imposed capital
requirements against the market risk associated
with large banks’ trading positions.
 The requirements apply to any U.S. bank or bank
holding company that has a trading account in excess
of $1 billion or accounts for 10 percent or more of bank
 Typically, market risk arises from taking positions
and dealing in foreign exchange, equity, interest
rate, and commodity markets, and the items
affected are the securities trading account,
derivatives positions, and foreign exchange
 The new capital requirements address market risk
associated with a bank’s trading activities.
Value-at-risk estimate for foreign
Identify the maximum expected loss given the bank’s recent
history of daily returns on the trading portfolio.
Empirical distribution
approach to value-at-
risk involves:
1. Identify the lowest 1
% of daily price
2. Assuming that the
value of the 1%
lowest price move is
7.54 percent, 99
percent of the daily
returns exceed this
Value-at-risk estimates for market risk associated with the trading
portfolios at Credit Suisse First Boston (CSFB) in 1999 and 2000.
Some analysts criticize traditional earnings
measures such as ROE, ROA, and EPS because
they provide no information about how a bank’s
management is adding to shareholder value.
 If the objective of the firm is to maximize
stockholders’ wealth, such measures do not
indicate whether stockholder wealth has
increased over time, let alone whether it has
been maximized.
 Stern, Stewart & Company has introduced
the concepts of market value added (MVA)
and its associated economic value added
(EVA) in an attempt to directly link
performance to shareholder wealth creation.
Economic value added (EVA)
…an approach to measuring performance
that compares a bank’s (or line of business)
net operating profit after-tax (NOPAT) with
a capital charge.
 Economic Value Added (EVA) is the
capital charge which represents the
required return to stockholders
assuming a specific allocated risk
capital amount.
Market and economic value added
 MVA represents the increment to market
value and is determined by the present value
of current and expected economic profit:
MVA = Mkt Value of Capital - Hist. Amt of Invested Capital
 Stern Stewart and Company measures
economic profit with EVA, which is equal to a
firm's operating profit minus the charge for
the cost of capital:
EVA = Net Operating Profit After Tax (NOPAT) - Capital Charge
where the capital charge equals the product
of the firm’s value of capital and the
associated cost of capital.
Difficulties in measuring EVA for the
entire bank
 It is often difficult to obtain an accurate
measure of a firm's cost of capital.
 The amount of bank capital includes not just
stockholders' equity, but also includes loan
loss reserves, deferred (net) tax credits, non-
recurring items such as restructuring charges
and unamortized securities gains.
 NOPAT should reflect operating profit
associated with the current economics of the
firm. Thus, traditional GAAP-based accounting
data, which distort true profits, must be
modified to obtain estimates of economic
A. Balance Sheet
Assets $Millions Rate Liabilities & Equity $Millions Rate
Cash $150 0 Demand deposits $800
Securities $800 6.5% MMDAs $1800 3%
Commercial loans $2000 9.0% CDs $1300 5.5%
Credit card loans $1900 10.0% Small time deposits $680 4.5%
-Loss reserve -$100 Deferred tax credits $100
Other assets -$250 Equity - $320
Total assets $5,000 Liabilities + equity $5,000
Risk-weighted assets: .50($800) + 1($2,000) + 1($1,900) + 1($250) = $4,550

Tier 1 capital = $320 Tier I ratio: $320/$4,550 = 7.03%

EVA calculation For Ameribank

Total capital = $420 Total capital ratio: $420/$4,550 = 9.23%

B. Income Statement
Interest income: .065($800) + .090($2,000) + .10($1,900) = $422
Interest expense: .03($1,800) + .055($1,300) + .045($680) = -$156.1
Net interest income $265.9
Provision for loan losses -$25
Noninterest income $60
Noninterest expense -$190
Pre tax Income $110.90
Taxes @ 40% $44.36
Net income $66.54
C. Profit Measures
ROE = (66.54 / 320 ) = 20.8% ROA = (66.54 / 5,000) = 1.33%
Assuming that net charge-offs $22, cash taxes pai, = $39,
and allocated risk capital $550 with a capital charge of 12%:
NOPAT = $110.90 + $25 - $22 - $39 = $74.9
EVA = $74.9 - 0.12($550) = $8.9
EVA calculation for ameribank after sale of A. Change In Balance Sheet items
Assets ∆ Amount Liablilties ∆ Amount
Credit card loans -$1,000 CDs -$940
Loan loss reserve +$30 Equity -$30
Total assets -$970 Total -$970

B. Income Statement
Interest income: .065($800) + .09($2,000) + .10($900) $322 -$100
$1 billion in credit card loans

Interest expense: .03($1,800) + .055($460) + .045($680) -$109.9 -$46.2

Net interest income: $212.1 -$53.8
Provision for loan losses: +$5 +$30.0
Noninterest income: $72 +$12
Noninterest expense: -$195 -$5
Pre tax income: $94.1 -$16.8
Taxes @ 40%: $37.64 -6.72
Net income: $56.46 -10.08

C. Profit Measures: Actual net charge-oft $14, cash taxes paid = $31,
and risk capital falls to $500.
ROE = $56.46/$290 = 19.47%
ROA = $56.46/$4,030 = 1.40%
EVA = [$94.1 - $5 - $14 - $31] - $60 = -$15.9
Risk-weighted assets: .50($800) + 1($2,000) + 1($900) + 1($250) = $3,550
Tier 1 capital = $290 Tier I ratio: $290/$3,550 = 8.17%
Tier 2 capital = $420 Total capital ratio: $420/$3,550 = 11.83%
Balanced scorecard
 One of the recent dramatic shifts in strategic thinking by
management has recently produced a new approach to
performance measurement at many firms, both financial and
 The primary catalyst is an appreciation that financial measures
alone do not provide sufficient information regarding a firm’s
overall performance.
 In addition to profit and risk measures, managers need
benchmarks and targets for efforts and activities related to:
 customer satisfaction,
 employee satisfaction,
 organizational innovation, and
 the development of business processes.
 This is particularly true if a bank is customer-focused.
 Should management target and measure performance along the
lines of:
 market share,
 service quality,
 customer profitability,
 sales performance, and
 customer satisfaction?
Balanced scorecard framework with
four blocks
1. Financial Performance:
 How Do Stockholders View Our Risk and
Return Profile?
2. Customer Performance:
 How Do Customers See Us?
3. Internal Process Management:
 At What Must We Excel?
4. Innovation and Learning:
 How Can We Continue to Improve and
Create Value?
Scorecard measures
Bank Management,
Management 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning


Chapter 4