MONASH

BUSINESS
SCHOOL

Lecture 2
ANALYSIS OF BANK PERFORMANCE

BFF2401 Commercial banking and finance

LEARNING OBJECTIVES

Identify internal & external aspects of bank performance

Outline the main components of bank financial statements
Generate key return and risk measures from bank financial
statements
Put it all together to evaluate bank financial performance
using the Dupont (Return on Equity) model as a foundation
Explain the importance of supplementary data in addition to
financial analysis
Give two examples of modern risk-adjusted measures of
performance

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REFERENCES

Text:
Gup et al (2007), Commercial Banking: The Management of Risk,
Milton, John Wiley & Sons, Chapter 3

Other references
KPMG (2014) Financial Institutions Performance Survey.
http://www.fips.kpmg.com.au/
KPMG (2015) Major Australian banks: Full year results 2015.
Robert A. Eisenbeis (2008) The Sub Prime Debacle and Financial
Turmoil, Presentation at the 13th FINSIA and Melbourne Centre
for Financial Studies Banking and Finance Conference.

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LECTURE OUTLINE

Introduction
A performance framework
Types of assessment
Data
Financial ratio analysis
New approaches to measuring performance
Conclusions

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BANK PERFORMANCE A FRAMEWORK

Why do we need to evaluate bank performance?

Bank management Competitor financial institutions

Policy setting and strategy Merger and acquisition decisions,
strategy

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BANK PERFORMANCE A FRAMEWORK

Why do we need to evaluate bank performance?

Shareholders/investors Regulators and the community

Investment decisions Supervisory assessments

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BANK PERFORMANCE A FRAMEWORK

Objective: maximise shareholder wealth

Optimise risks and expected returns

Economic and political environment

Internal performance External performance

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INTERNAL PERFORMANCE

Bank planning
Setting objectives and planning to achieve them,
effective management
Technology
Contributes to improved service and lower costs
Personnel development
Needs a skilled highly motivated workforce
Banks financial condition
Reflected by financial accounts
Measures of profitability and risk

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EXTERNAL PERFORMANCE

Market share
Can the bank respond to changing demand as it moves
through the business cycle?
Is the bank growing its share of its chosen markets?
Regulatory compliance
Is the bank comfortably satisfying laws and regulations?
Is it able to respond to changes in requirements?
Public and investor confidence
Does the market perceive the bank as safe and reliable?
A bank cannot operate without public confidence.

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QUANTITATIVE ASSESSMENT

Financial analysis
Profitability & performance ratios, risk measures
From financial reports e.g. ROE, ROA, Capital adequacy
Share market data and ratings
Purpose for bank management
Provides measures of past performance
Enables modeling for future planning periods

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QUALITATIVE ASSESSMENT

Non-financial analysis
Market perception
Range of products & services
Corporate citizenship or quality of management
Staff morale

Purpose for bank management

Indicates non-financial performance
Validates financial analysis of performance
Contributes to modeling for future planning

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LECTURE OUTLINE

Introduction
Data
Sources of data
Absolute data and ratios
Data issues
Financial ratio analysis
New approaches to measuring performance
Conclusions

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SOURCES OF BANKING INFORMATION

Bank annual reports and half-yearly reports

Australian Bureau of Statistics (ABS)
RBA and APRA
Stockbrokers and large accounting firms e.g. KPMG
Ratings agencies e.g. Standard and Poors, Moodys,
Fitch
Australian Bankers Association (ABA)
Financial Services Institute of Australasia (FINSIA)
Financial press e.g. Australian Financial Review
Australian Payments Clearing Association (APCA)
Data services e.g. CANSTAR CANNEX

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BANK ANNUAL REPORT DATA

1. Balance sheet (statement of financial position)

Shows the banks financial state at a point in time,
E.g. Assets, liabilities and net worth
2. Income statement (statement of financial performance)
Shows a banks major categories of revenue and expenses over
a period of time
3. Statement of changes in equity
Shows items which impact on the banks equity
E.g. Share transactions, changes in reserves, retained profits and
dividend payments
4. Cash flow statement
All cash inflows and outflows for a given period

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BANK ANNUAL REPORT DATA

Simplified Balance Sheet

Assets = Liabilities + Equity

Liquidity Buffer against

run on deposits

Loans Deposits
Funding

Buffer against
loan losses Capital

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BANK ANNUAL REPORT DATA

Profit & Loss

Interest revenue
- Interest expense
= Net interest income
Non-interest revenue
- Non-interest expense
= Net non-interest cost
Net operating income
- Tax (30%)
= Net income
- Dividends
= Retained Earnings

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WHICH BANK IS MORE PROFITABLE?

If based on
absolute dollar
Large bank Small bank values of net
income, then
Net Income $200 million $20 million large bank
Total assets $10 billion $500 million performs better
since $200m >
ROA 2% 4% $20m BUT

In fact, small bank is

more profitable than
large bank since its
return on assets
(ROA) is higher

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SUPPLEMENTARY INFORMATION

Other items that can be calculated, or may be provided

in Notes to the Accounts
Earning assets (those earning an explicit interest income)
Risk weighted capital adequacy (Basel 3)
Maturities of investment securities
Net write-offs (loan write-offs less recoveries)
Past-due loans (late or delinquent loans)

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OFF BALANCE SHEET INFORMATION

OBS transactions are significant.

They affect bank revenues, expenses and risks.
Important to look at the level and breakdown of different
types of OBS.
Financial guarantees
Direct credit substitutes eg. standby letters of credit
Trade and performance-related items
Commitments
E.g. liquidity facilities

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SUPPLEMENTARY INFORMATION

Share market data

share prices
dividend payments
Credit ratings
Analystsrecommendations
Market shares

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NON-FINANCIAL INFORMATION

Non-financial information may indicate bank performance

(or risk):
Significant management changes?
Maybe there was bad management and hence management was
dismissed?
Recent change of auditors?
Approach to corporate governance?
Conservative method (low estimates) for defining non-
performing loans?

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LECTURE OUTLINE

Introduction
Data
Financial ratio analysis
Financial ratios
ROE model
Example
Other key ratios
New approaches to measuring performance
Conclusions

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FINANCIAL RATIOS

Common size ratios

Balance sheet items as a percentage of total assets or
income items as a percentage of total revenue

Profitability ratios based on revenue and cost indicators

Risk measures

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FINANCIAL RATIOS

Benefits of Financial Ratios

Allow valid comparisons (reduced impact of differences in size of
institutions)

Effective performance measurement relies on

Accurate data
Intelligent interpretation

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FINANCIAL RATIOS

Financial ratio analysis relies on intelligent interpretation

based on comparisons with

Trends
Comparison relative to a banks own past performance
Targets
Comparison with the banks stated targets/objectives
Peers
Comparison with other similar banks

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PROBLEMS WITH RAW DATA

Inaccurate data can give false inputs.

Creative accounting can distort measures.
Accounting data does not always accurately reflect
true market values.
Changing accounting standards make trend analysis
difficult.
Example: under the new International Financial Reporting
Standards (IFRS) of 2005, banks report higher levels of
return on equity (ROE) because some items are no longer
counted as equity. So reported equity tended to fall and
reported ROE tended to rise.

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PROBLEMS WITH RATIOS

Averages/aggregates hide the details.

Ratios are backward looking, reflect past
performance.
Ratios tend to compartmentalize financial analysis,
so it is important to consider linkages, e.g. increase in
net interest income may reflect increase in credit risk.
Omissions
Off-balance sheet transactions may be omitted or not
comparable.
Qualitative factors are omitted.

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LIMITS ON FINANCIAL ANALYSIS

Valuable tool, but cannot be used in isolation

It needs to be validated by other measures such as

share market data, off-balance sheet data and
qualitative measures etc.

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EFFECTIVE FINANCIAL ANALYSIS

Effective analysis of bank performance includes:

Financial ratio analysis
Other key indicators
Off-balance sheet indicators
Share market data
Indicators of qualitative performance
Indicators of business unit performance

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ROE (DUPONT) MODEL

Financial analysis using the ROE model

Uses return to shareholders as the starting point
Based on ratios
Plus detailed data to explain observed changes in financial
ratios and their linkages
Structured discussion
Starts with ROE (Return on Equity).

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MAJOR AUSTRALIAN BANKS - ROE

Operating profit after taxes

Return on Equity (ROE) =
Shareholdersfunds

Source: BANKSCOPE

Is this cash?
Is ROE related to the share price on the stock exchange?

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INTERNATIONAL COMPARISONS 2013

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DUPONT MODEL

Breaks down ROE performance into component

parts

An increase in any ratio contributes to an increase

in ROE

It is important to investigate risks too i.e. how has a

higher ROE been achieved?

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REDUCED DUPONT MODEL

It is called the reduced Dupont Model or reduced

ROE model as we will only look at the first 5 ratios

Leverage Measures leverage and dividend

Multiplier policies (financing effectiveness)
Total Assets Asset
Equity Measures
ROE Utilisation asset portfolio
Net Income = x Revenue management (mix
Equity Total Assets and yield)
ROA
Net Income = x
Measures return to
shareholders
Total Assets Net (Profit)
Measures
Margin effectiveness of
Measures overall Net Income cost controls
operating efficiency Revenue

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EXAMPLE OF DUPONT MODEL

Bank A Bank B Bank A Bank B

Assets 10 10 Liabilities 7 3
Equities 3 7
Total Assets 10 10 Total Liabilities & 10 10
Equities

Which bank is riskier and why?

Leverage multiplier:
Bank A = 10/3 = 3.33x
Bank B = 10/7 = 1.33x
Bank A is riskier as it has more debt.

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Source: Robert A. Eisenbeis (2008) The Sub Prime Debacle and Financial Turmoil

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FINANCIAL ANALYSIS DUPONT MODEL

Risk versus return:

=

+
=


= 1+

Return Credit Risk? Capital Risk?

Important to investigate risks too
Westpac

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FINANCIAL ANALYSIS: PROCESS

1. Collect the absolute data

2. Calculate the ratios
3. Identify the initial meaning of each ratio
4. Look for the linkages and consider other key ratios

Then to complete performance assessment:

Look at share market data, credit ratings, non-financial indicators
and other measures of performance
Calculate growth rates and market share
See hypothetical example of financial analysis...

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 1. COLLECT ABSOLUTE DATA

Sample balance sheet $

Assets 2014 2015 Liabilities 2014 2015
Cash/liquidity 8,000,000 10,000,000 Current debt 63,000,000 65,000,000
Loans etc 120,000,000 121,500,000 Long term debt 57,000,000 58,000,000
Premises etc 2,000,000 2,000,000 Equity 10,000,000 10,500,000
Total 130,000,000 133,500,000 Total 130,000,000 133,500,000
Sample Income Statement $ 2014 2015
Interest revenue 4,000,000 4,200,000
Interest expense (1,500,000) (1,677,419)
Net interest income 2,500,000 2,522,581
Non-interest income 1,000,000 1,100,000
Non-interest expense (1,500,000) (1,500,000)
Net non-interest cost (500,000) (400,000)
Net operating income 2,000,000 2,122,581
Tax (30%) (600,000) (636,774)
Net income 1,400,000 1,485,806

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2. CALCULATE RATIOS

Dupont model: Data required Using 2014 data from

Revenue = (Interest revenue) + example, calculate:
(Non-interest income) Revenue
Net income = (Revenue) -
(Interest expense) (Non-
Net Income
interest expense) Taxes
Total assets
Assets
Equity

Equity

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3. INDENTIFY INITIAL MEANING OF RATIOS

Peer comparison for 2014 2014 Majors

ROE ? 13.83%
Leverage multiplier ? 13.97x
ROA ? 0.99%
Asset utilisation ? 3.50%
Net margin ? 28.40%

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3. INDENTIFY INITIAL MEANING OF RATIOS

Peer comparison for 2014:

Ratios compared with other peer banks (or industry average)

Leverage
multiplier Lower: Why?
Above Majors: 13.0 Majors, 2014: 13.97
Why?
Asset Greater: Why?
ROE Utilisation
= x
14.0% 3.85% Majors, 2014: 3.50%

Majors, 2014: ROA

13.83% = x
1.08%
Majors, 2014: 0.99% Net margin Lower: Why?
Above Majors: 28.0% Majors, 2014: 28.40%
Why?

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3. INDENTIFY INITIAL MEANING OF RATIOS

Trend comparison 2014 to 2015

2014 2015
ROE 14.0% 14.2%
Leverage multiplier 13.0x 12.7x
ROA 1.08% 1.11%
Asset utilisation 3.85% 3.97%
Net margin 28.0% 28.03%

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4. LOOK FOR LINKAGES

Trend comparison 2014 to 2015:

Fall of 0.3 points
Leverage (Slightly lower capital risk)
Increase of 0.12 percentage
multiplier
points.
13.0->12.7 Have asset interest rates
ROE Asset risen?
= x Utilisation Has mix of assets moved
14.0->14.2% to higher credit risk?
3.85->3.97% Has non-interest income
ROA increased?
= x
1.08->1.11%
Increase of 0.2 Increase of 0.03
percentage points Net margin percentage points.
Have costs decreased?
Increase of 0.03
28.0->28.03% Have non-interest costs
percentage points fallen?
Lower taxes?

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Source: SNL Financial, July 2014
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OTHER KEY FINANCIAL RATIOS

Other key ratios such as:

Bank efficiency
Interest differentials
Risk measures interest rate risk, credit risk, liquidity risk,
capital risk

These ratios can

Help answer some of the questions raised during the ROE
analysis
Give additional information

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OTHER KEY EFFICIENCY RATIOS

Operating income per employee

Net operating income
Number of employees (FTE)
Cost to assets ratio:
Operating expenses
Total Assets
Efficiency ratio, or cost to income ratio
Operating expenses
Operating income

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KEY INTEREST DIFFERENTIAL RATIOS

Net interest income (dollar interest margin)

Interest earned - Interest expense
Percentage interest spread
average interest earned on interest earning assets less average
interest paid on interest bearing liabilities
Interest earnings Interest expense
Interest earning assets Interest bearing liabilities
Percentage interest margin (net interest margin)
Interest earned - Interest expense
Earning assets

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INTEREST DIFFERENTIALS EXAMPLE

Example 3.4 (page 83): Interest margin ratios

Interest income $500 million
Interest expense $280 million
Total earning assets at 1 July 2005 $8.1 billion
Total earning assets at 30 June 2006 $9.5 billion
Interest-bearing liabilities at 1 July 2005 $6.5 billion
Interest-bearing liabilities at 30 June 2006 $7.5 billion
What are its interest differentials?
Solution:
Net interest income/margin = $500m - $280m = $220m
% net interest margin = $220m/{($8.1b+$9.5b)/2} = 2.5%
% interest spread = $500m/{($8.1b+$9.5b)/2} - $280m/{($6.5b+$7.5b)/2}
= 5.68% - 4% = 1.68%
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MAJOR BANKS NET INTEREST MARGINS

Source: KPMG (2015), Major Australian banks: Full year results 2015, p.12

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KEY RISK RATIOS

Risk Measurement - Interest rate risk

Interest sensitivity ratio - a sample measure
Interest sensitive assets ($RSA)
Interest sensitive liabilities ($RSL)
Interpretation:
If ratio = 1 i.e. RSA = RSL
Change in interest rates will affect both income and
expense
Two effects will tend to offset each other
NET interest income will remain largely unchanged
Interest rate risk (repricing risk) will be minimised

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KEY RISK RATIOS

Risk Measurement - Credit risk (asset quality)

Ratios reflecting losses - a sample measure:
Net write-offs
Total assets
Ratios reflecting the level of diversification
Exposure ratios - example: Loans to farmers (or other
industry segment) as a percentage of total assets

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KEY RISK RATIOS

Risk Measurement - Liquidity risk

Liquidity ratios - sample measures:

Liquid assets
Total assets

Liquid assets
Deposits

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KEY RISK RATIOS

Risk Measurement - Capital risk

Simple capital ratio
Shareholders funds
Total assets
Capital adequacy ratio (CAR)
Total regulatory capital
Total risk-adjusted assets

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OFF-BALANCE SHEET INDICATORS

Ratios such as:

Off-balance sheet business (nominal values)
Total balance sheet assets

Off-balance sheet credit risk exposures

Total risk-weighted assets
Value-at-Risk of off-balance sheet items
Modern statistical measure of risk
VaR = how much a bank might lose over a given time with a
given probability

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SHARE MARKET DATA

Share value
Price/earning ratio (P/E ratio) is the share price
divided by bank earnings per share
If the P/E ratio is higher than average, the market
expects that the bank will perform better in the
future

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SHAREHOLDERS RETURNS

Single period shareholder returns:

1
Dividend yield =
0

Capital gain rate = 1 0
0
Shareholders total return = dividend yield + capital
gain rate

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EXAMPLE OF SHAREHOLDERS RETURNS

Single period shareholder returns:

Example:
Share price at beginning of period = $21
Share price at end of period = $25
Dividend paid during period = $1.20
Solution:
Dividend yield = ($1.20/$21) x 100 = 5.7%
Capital gain = [($25 - $21)/$21] x 100 = 19.0%
Shareholderstotal return
= {[$1.20 + ($25 - $21)]/$21} x 100 = 24.8%

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GROWTH RATES & MARKET SHARE

Asset growth rate e.g. for 2015:

$133.5 $130 100
= 2.7%
130 1

How does this compare to GDP growth (economy)?

How does this compare to previous years?
How does this compare to other peer banks growth rates?
If high (low) growth: does this reflect more (less) risk taking?
Does it reflect more (less) market share?

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GROWTH RATES & MARKET SHARE

Market-share movements e.g. in 2015:

$133.5 100
= %
1

If gained or lost market share, why? If gain, has the bank

bought market share (sacrificed margins)?
Can do similar assessments of the banks share of the loan
market, the deposit market, etc.

KPMG

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Source: KPMG (2015), Major Australian banks: Full year results 2015, p.14

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Source: KPMG (2015), Major Australian banks: Full year results 2015, p.15

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LECTURE OUTLINE

Introduction
Data
Financial ratio analysis
New approaches to measuring performance
Conclusions

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MEASURING PERFORMANCE

Modern analytic techniques also assess performance

on a risk-adjusted basis.
Share prices relate to risk AND return so
risk-adjusted returns relate to share prices.
Uses:
to assess performance of different product lines
for management incentives & compensation (bonuses)

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MEASURING PERFORMANCE

Two examples:

(1) RAROC = Risk Adjusted Return On Capital

(2) EVA = Economic Value added

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MEASURING PERFORMANCE

(1) Risk-adjusted return on capital (RAROC)

Applied to pricing loans, RAROC allocates equity
capital depending on risk of loss, calculates a
required rate of return on equity and then uses this
information in pricing loans.
If loan rate > RAROC (i.e. required loan rate) then
the bank is earning Economic Profit and increasing
shareholder value.

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MEASURING PERFORMANCE

(1) Risk-adjusted return on capital (RAROC)

This can be extended to product lines that divide the
bank into business units.
Example: a large bank will typically have consumer
banking, wholesale banking and securities components.
One potential drawback of applying RAROC to
product lines is that it may not be possible to
separate the economic costs and revenues of the
different products.

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 MEASURING PERFORMANCE

(2) Economic value added (EVA)

EVA = Adjusted earnings Opportunity cost of capital
Where: Adjusted earnings = profit after taxes
Opportunity cost of capital = cost of equity x equity capital
EVA is a measure of the value added in any given
period by a banks operations in excess of the cost of
capital used in those operations.
Managers can apply EVA to loans, projects, product
lines and so on.
New investments should be undertaken until the
marginal contribution of the last investment is zero (i.e.
EVA = 0)
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RAROC and EVA

Similarities:
Both RAROC and EVA are beneficial in assessing managerial
performance and developing incentive compensation schemes
compatible with shareholder wealth goals (e.g. reducing agency
costs).
Both methods present some difficult challenges in allocation
costs, revenues and equity when applied to lines of business,
divisions, products and so on that are not separate from one
another.
Difference:
RAROC has a short run perspective (i.e. compares business unit
profit with the units capital-at risk) whereas EVA has a long run
perspective (i.e. compares business unit profit with the cost of
capital of the bank).

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 PERFORMANCE ANALYSIS - CONCLUSION

Fundamental question is whether shareholder value has

been maximised?

Good financial analysis requires:

(1) Quality inputs (data)
Verify the data quality e.g. look at notes to accounts
Ratio analysis focused on ROE
Share market indicators of performance
Other measures of returns and risks
Off-balance sheet indicators
Qualitative indicators and external economic and political factors

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PERFORMANCE ANALYSIS - CONCLUSION

Good financial analysis requires:

(2) Comparative analysis i.e. comparisons
Between planning periods (to identify trends)
With competitors/peers
With forecasts/objectives/targets
(3) An understanding of the strategic context
Current business/economic climate
(4) Drilling down to discover WHY ratios change
Look at linkages
Look at risk-adjusted analysis of business units

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LECTURE SUMMARY

Introduction
Data
Financial ratio analysis
New approaches to measuring performance
Conclusions

KPMG

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