FINC 4320

Alternative Models for Evaluating Bank Performance

Fall 2007

The Need for Alternative ModelsTraditional bank performance analysis carries three basic flaws

1. It ignores the wide diversity in strategies pursued by different institutions

2. A bank’s total assets no longer serve as a meaningful yardstick when banks engage in off-balance sheet activities

3. The analysis provides no directinformation concerning how or which of the bank’s activities contribute to the creation of shareholder value

Can ROE be “rescued”?

• 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 sheet.

– Thus, a comparison of net income to equity captures the returns to owners’ contributions.

The Key to UBPR Use

• As long as banks have a similar strategic focus and offer similar products and services, asset size and UBPR ratios can provide meaningful comparisons.

• 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?

What kind of bank?

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.

Operating Income Measures

• 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.

Operating Income Measures

• 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.

How does “the market” assess performance?• Bank stock analysts follow a standard procedure when

evaluating firm performance– Initially use GAAP-based financial information to calculate

performance measures

– Based on his or her own analysis and conversations with specialists within the bank, the analyst then assesses the quality of earnings based on:

– 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:

Total Return Measures

• Investors in bank stocks are primarily concerned with whether the bank’s management is creating value for stockholders– 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.

• Return to stockholders = (price + dividends) / pricet-1

• Earnings per share

• 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

goutstandintock s common of shares of number

stock preferred on dividends and taxes after ΔNI

Total Returns and other Market Measures

Line of Business Profitability Analysis

• By allocating 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.).

Line of Business Profitability Analysis

• There are several key ideas to be careful about when using this type analysis– RAROC/RORAC– Transfer Pricing– Risk-adjusted Income– Allocated Risk Capital

Using RAROC/RORAC Measures

• RAROC refers to risk-adjusted return on capital, while RORAC refers to return on risk-adjusted capital.– RAROC = Risk-adjusted income / Allocated capital

• Using this method, income is adjust for risk.

• Typically, income is adjusted for expected losses.

– 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.

Using RAROC/RORAC Measures

• In order to analyze profitability and risk precisely, each line of business must have its own balance sheet and income statement. – The critical issue is to determine how much equity

capital to assign each unit. Alternative capital allocation methods include:

• using regulatory risk-based capital standards

• 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.

• The results provide useful information in helping management decide where to allocate resources.

Funds Transfer Pricing

• 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.

• The transfer price is the interest rate at which a firm could buy or sell funds in the external capital markets.

Funds Transfer Pricing

Example: 2-year loan financed by a 3-month deposit

Bank Asset Liability Loan: 2 year Time deposit: 3 month $1,000,000 @8.50% $1,000,000 @ 4.5%

Margin = 4.00% Interest Rate Risk: Liability sensitive Embedded Option: Prepayment risk on loan

Lending Division Asset Liability Loan: 2 year Transfer from Treasury: 2

year $1,000,000 @8.50% $1,000,000 @6.00%

Margin = 2.50% Interest Rate Risk: None Option: Sold prepayment option to loan customer on balance sheet; buy an option from Treasury for 0.20%. NIM after option cost = 2.50% - 0.20% = 2.30%

Deposit-Gathering Division Asset Liability Receivable from Treasury Time dposit 3-month 3-month $1,000,000 @5.20% $1,000,000 @ 4.5%

Margin = 0.70% Interest Rate Risk: None Option: None

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

Margin = 0.80% Interest Rate Risk: Liability sensitive Option: Sell option to lending division for 0.20%; NIM after option sale = 0.80% + 0.20% = 1.00%. Treasury has interest rate and loan prepayment risk.

Risk-adjusted income and economic income

• Two adjustments are frequently made to income in line of business profitability analysis: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 return.

• The specific concern is whether RAROC is greater than the firm’s cost of equity.

Allocated 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.

• 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.

Bank Performance and EVA

• 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.

• Stern, Stewart & Company has introduced the concepts of economic value added (EVA) in an attempt to directly link performance to shareholder wealth creation.

Bank Performance and EVA

• 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.

• What are the concerns with applying this approach?

The Balanced Scorecard• 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

The Balanced Scorecard

• Think of the bank as being two banks in one house:– Traditional or Customer Bank

– Investment or House Bank

• 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.

Using the Balanced Scorecard

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?

Using the Balanced Scorecard: Scorecard measures