Chapter 20

Bank Performance

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

Chapter Outline
Valuation of a commercial bank  Performance evaluation of banks  Risk evaluation of banks  How to evaluate a banks performance  Bank failures


Valuation of a Commercial Bank



The value of a commercial bank is the present value of its future cash flows:
V!

E (CFt ) t t !1 (1  k )

The value should change in response to changes in its expected cash flows and to changes in the required rate of return:
(V ! f ? E (CF ), (k A (  3

Valuation of a Commercial Bank (contd)



Factors that affect cash flows

(E (CF ) ! f ( (ECON, (Rf , (INDUS, (MANAB ) 


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

Valuation of a Commercial Bank (contd)



Factors that affect cash flows (contd)

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 banks loans Banks cost of funds decreases when the risk-free rate decreases 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 banks volume of business or reduce the prices it can charge for its services

Change in industry conditions



Valuation of a Commercial Bank (contd)



Factors that affect cash flows (contd)

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 banks assets and liabilities to capitalize on existing economic or regulatory conditions


Valuation of a Commercial Bank (contd)



Factors that affect the required rate of return by investors

(k ! f ( (Rf , (RP ) 


Change in the risk-free rate

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

(Rf ! f ( (INF , (ECON, (MS, (DEF )   

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Valuation of a Commercial Bank (contd)



Factors that affect the required rate of return by investors (contd)

Change in the risk premium


When the risk premium increases, so does the return required by investors:

(RP ! f ( (ECON, (INDUS, (MANAB ) ? 

Impact of the September 11 Crisis on commercial bank values

Commercial bank valuations declined as a result because economic conditions were weakened and the volume of bank loans 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


Performance Evaluation of Banks (contd)



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 is typically higher than that of other banks

Gross interest expenses represent interest paid on deposit and on other borrowed funds


Affected by market rates and the composition of the banks liabilities In recent years, gross interest expenses have been similar among banks
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Performance Evaluation of Banks (contd)



Interest income and expenses (contd)

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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Performance Evaluation of Banks (contd)



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 banks than for small banks because larger banks provide more services

The loan loss provision is a reserve account established in anticipation of future loan losses
 

Should increase in recessionary periods Was high for most banks during the early 1990s recession but declined for the next several years
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Performance Evaluation of Banks (contd)



Noninterest income and expenses (contd)

Noninterest expenses include salaries, office equipment, and other expenses


Generally increased over time

Securities gains and losses result from a banks sale of securities



Have been negligible in the aggregate

Income before tax is obtained by summing net interest income, noninterest income, and securities gains and subtracting the provision for loan losses and noninterest expenses


In recent years, bank income was enhanced by the increase in noninterest income and in net interest margins
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Performance Evaluation of Banks (contd)



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 because of the increase in noninterest income  Has been high for medium and large banks recently  Depends on the banks policy decisions as well as uncontrollable factors relating to the economy and government regulations

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Performance Evaluation of Banks (contd)



Net income (contd)

Return on equity (ROE)


ROE is affected by the same income statement items that affect ROA as well as the banks degree of financial leverage:

ROE ! Return on assets (ROA) v Leverage measure Net profit after taxes Assets ! v Assets Equity
 

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 degree of capital
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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:

R j ,t ! B0  B1Rm,t  ut
The regression model is applied to quarterly historical data The coefficient is an estimate of beta because it measures the sensitivity 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 Banks Performance

 

Analysts often need to evaluate an individual banks performance Examination of return on assets
ROA usually reveals when a banks 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 Banks Performance (contd)

Measures of Financial Characteristics Bank Performance Influencing Performance Return on assets (ROA) Net interest margin Bank Decisions Affecting Financial Characteristics Deposit rate decisions Loan rate decisions Loan losses Bank services offered Overhead requirements Efficiency Advertising Risk level of loans provided See above Capital structure decision
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Noninterest revenues Noninterest expenses

Loan losses Return on equity (ROE) ROA Leverage measure

Bank Failures
   

From 1940 to 1980, there were generally fewer than 20 bank failures per year In the late 1980s, there were about 200 failures per year Failures declined in the early 1990s In the mid and late 1990s, the number of bank failures declined substantially

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Bank Failures (contd)



Reasons for bank failure

The bank may have experienced fraud


Includes embezzlement of funds No matter how well a bank diversifies its loans, it is still subject to a recessionary cycle Rumors may cause depositors to withdraw funds and the bank may be unable to attract new deposits Deregulation has made the banking industry more competitive A reduced net interest margin could lead to failure
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The bank may have a high loan default percentage



The bank may experience a liquidity crisis



The bank may face increased competition



Bank Failures (contd)



Reasons for bank failure (contd)

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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