Professional Documents
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ALTERNATIVE MODELS OF
BANK PERFORMANCE
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
strategies
Bank’s total assets no longer serve as a
meaningful yardstick when banks engage
in off-balance sheet 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
focus
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
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.
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
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.
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
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 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
businesses
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.
Earnings-at-risk
…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.
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
positions.
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
assets.
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
positions.
The new capital requirements address market risk
associated with a bank’s trading activities.
Value-at-risk estimate for foreign
exchange
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
moves.
2. Assuming that the
value of the 1%
lowest price move is
7.54 percent, 99
percent of the daily
returns exceed this
figure.
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
B. Income Statement
Change
Interest income: .065($800) + .09($2,000) + .10($900) $322 -$100
$1 billion in credit card loans
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
nonfinancial.
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
ALTERNATIVE MODELS OF
BANK PERFORMANCE
Chapter 4