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