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MODULE 2
EVALUATING THE PERFORMANCE
OF BANKS

COMMERCIAL BANK MANAGEMENT

KEY TOPICS IN THIS MODULE

Measuring and
Financial
Evaluating
Statement of
Performance of
Banks
Banks

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I. Financial Statements of Banks

FINANCIAL STATEMENTS OF COMMERCIAL BANKS

Balance Sheet

Income Statement

Cashflow Statement

Financial Statement Notes

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BALANCE SHEET
The Balance Sheet, or The Report of Condition, for a bank shows the
amount and composition of funds sources (financial inputs) drawn upon
to finance lending and investing activities and how much has been
allocated to loans, securities, and other funds uses (financial outputs) at
any given point in time.

BALANCE SHEET
The Balance Sheet
Assets – Uses of Funds Liabilities and Equity – Sources of
• Cash (C) Funds
• Securities (S) • Deposits (D)
• Loans and Leases (L) • Non- deposit borrowings (NDB)
• Miscellaneous assets (buildings, • Equity capital (Stock, surplus, and
equipment, etc.) (MA) retained earnings) (EC)

The bank's balance sheet identity: C+S+L+MA = D + NDB + EC

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Balance Sheet for National City Corporation

(Note: Dollar figures in thousands)
Items 12/31/2004 12/31/2003 Items 12/31/2004 12/31/2003
Total assets 144,802,221 131,683,868 Total liabilities and capital 144,802,221 131,683,868
Cash and due from depository
8,744,393 12,098,574 Total liabilities 130,924,661 122,080,582
institutions
Investment securities 8,221,252 6,224,870 Total deposits 90,491,765 73,499,065
Federal funds sold and reverse Federal funds purchased and
2,474,898 8,393,385 8,127,367 14,956,262
repurchase agreements repurchase agreements
Gross loans and leases 113,181,843 96,223,410 Trading liabilities 0 0
(less) Loan loss allowance 1,187,909 1,125,330 Other borrowed funds 25,721,773 26,602,895
Trading account assets 268,983 216,154 Subordinated debt 2,306,409 2,079,955
Bank premises and fixed assets 1,254,640 1,045,266 All other liabilities 4,277,347 4,942,405
Other real estate owned 89,362 97,865 Total equity capital 13,877,560 9,603,286
Goodwill and other intangibles 5,051,313 2,264,972 Perpetual preferred stock 0 0
All other assets 6,703,446 6,244,702 Common stock 329,984 277,324
Surplus 7,269,528 3,375,913
Undivided profits 6,278,048 5,950,049

BALANCE SHEET
 Cash Assets
 Account is Called Cash and Deposits Due from Other Banks
 Includes:
• Vault Cash
• Deposits with Other Banks (Correspondent Deposits)
• Cash Items in Process of Collection
• Reserve Account with the Federal Reserve
 Sometimes Called Primary Reserves

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BALANCE SHEET
 Securities:
 Often Called Secondary Reserves
 Include:
• Short Term Government Securities
• Privately Issued Money Market Securities
Interest Bearing Time Deposits
Commercial Paper

BALANCE SHEET
 Investment Securities
 These are the Income Generating Portion of Securities
 Taxable Securities
• U.S. Government Notes
• Government Agency Securities
• Corporate Bonds
 Tax-Exempt Securities
• Municipal Bonds

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BALANCE SHEET
 Trading Account Assets
 Securities purchased to Provide Short-Term Profits from Short-Term Price
Movements
 When the Bank Acts as a Securities Dealer
 Valued at Market

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BALANCE SHEET
 Federal Funds Sold and Reverse Repurchase Agreements
 A Type of Loan Account
 Generally Overnight Loans
 Federal Funds Sold - Funds Come from the Deposits at the Federal Reserve
 Reverse Repurchase Agreements – Bank Takes Temporary Title to Securities
Owned by Borrower

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BALANCE SHEET
 Loan Accounts  Types of Loans
 The Major Asset • Commercial and Industrial Loans
 Gross Loans – Sum of All Loans • Consumer Loans (Loans to Individuals)
 Allowance for Possible Loan Losses • Real Estate Loans
• Contra Asset Account • Financial Institution Loans
• For Potential Future Loan Losses • Foreign Loans
 Net Loans • Agriculture Production Loans

 Unearned Discount Income • Security Loans

• Leases
 Nonperforming Loans

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BALANCE SHEET
 Specific and General Reserves
 Specific Reserves
 Set Aside to Cover a Particular Loan
 Designate a Portion of ALL or
 Add More Reserves to ALL
 General Reserves
 Remaining ALL
 Determined by Management But Influenced by Taxes and Government
Regulation
 Loans to Lesser Developed Countries Require Allocated Transfer Reserves

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BALANCE SHEET
 Miscellaneous Assets
 Bank Premises and Fixed Assets
 Other Real Estate Owned (OREO)
 Goodwill and Other Intangibles

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BALANCE SHEET
 Deposit Accounts
 Noninterest-Bearing Demand Deposits
 Savings Deposits
 Now Accounts
 Money Market Deposit Accounts (MMDA)
 Time Deposits

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BALANCE SHEET
 Non-deposit Borrowings
 Fed Funds Purchased
 Securities Sold Under Agreement to Repurchase (Repurchase Agreements)
 Short-term borrowings: Reserves from the discount windows of Fed,
Eurocurrency Borrowings, commercial papers.
 Long-term debt.
 Subordinated Debt, including Limited Life Preferred Stock
 Other Liabilities

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BALANCE SHEET
 Equity Capital
 Preferred Stock
 Common Stock
Common Stock Outstanding
Capital Surplus
Retained Earnings (Undivided Profits)
Treasury Stock
Contingency Reserve

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BALANCE SHEET
 Off-Balance-Sheet Items
 Unused Commitments
 Standby Credit Agreements
 Derivative Contracts
• Futures Contracts
• Options
• Swaps
 OBS Transactions Exposure a Firm to Counterparty Risks

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Percentage of Total Assets for

The Composition of Balance Statements for All U.S. U.S. Banks with Less U.S. Banks with More
U.S. Banks with $100 Million
Different Size Banks Insured than $100 Million in than $1 Billion in Total
to $1 Billion in Total Assets
Banks Total Assets Assets
Total assets 100.00% 100.00% 100.00% 100.00%
Cash and due from depository institutions 4.61 5.29 3.75 4.7
Interest-bearing balances 2.63 1.67 0.85 1.96
Securities 18.44 24.74 22.08 17.8
Federal funds sold and reverse repurchase agreements 4.56 4.63 2.6 4.84
Net loans and leases 57.43 60.81 56.39 56.16
Loan loss allowance 0.87 0.89 0.94 0.87
Trading account assets 5.99 0.00* 0.01 6.93
Bank premises and fixed assets 1.03 1.86 1.84 0.9
Other real estate owned 0.05 0.15 0.12 0.03
Goodwill and other intangibles 3.27 0.34 0.72 3.68
All other assets 4.61 2.18 2.5 4.95
Total liabilities and capital 100.00% 100.00% 100.00% 100.00%
Total liabilities 89.89 88.48 90.01 89.92
Total deposits 66.48 83.69 80.85 64.14
Interest-bearing deposits 53.96 69.6 67.27 51.81
Federal funds purchased and repurchase agreements 6.87 0.91 2.53 7.59
Trading liabilities 3.33 0.00* 0.00* 3.86
Other borrowed funds 8.75 3.28 5.74 9.29
Subordinated debt 1.31 0.01 0.08 1.5
All other liabilities 3.15 0.6 0.79 3.52
Equity capital 10.11 11.52 9.99 10.08

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Total Off-Balance-Sheet Items Reported by U.S. Banks Arranged by Size Group

(in Billions of Dollars) on December 31, 2004
U.S. Insured
Total Volume in U.S. Insured U.S. Insured
Banks $100
Billions of Dollars Banks under Banks $1 Billion
Off-Balance-Sheet Items Million to $1
at All U.S. Insured $100 Million in or More in Total
Billion in
Banks Total Assets Assets
Total Assets
Total unused commitments $5,813.68 $69.88 $272.39 $5,471.41
Standby letters of credit and foreign office
409.9 0.51 6.98 402.5
guarantees
(Amount conveyed to others) -72.2 -0.01 -0.4 -71.79
Commercial letters of credit 28.37 0.08 0.88 27.41
Securities lent 1,165.31 0.05 0.88 1,164.38
Derivatives:
Notional amount of credit derivatives 2,346.69 0.00* 0.06 2,346.63
Interest rate contracts 75,518.57 -0.06 6.35 75,512.17
Foreign exchange rate contracts 9,925.42 0.00* 0.03 9,925.39
Contracts on other commodities and equities 1,400.81 0.03 0.26 1,400.52
All other off-balance sheet liabilities 49.34 0.19 1.57 47.58
Total off-balance-sheet items 95,685.90 70.8 288.91 95,326.20
Total assets (on-balance sheet) 8,413.08 189.04 953.4 7,270.64
Off-balance-sheet items ÷ On-balance sheet assets 1137.35% 37.45% 30.30% 1311.11%

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BALANCE SHEET
 Possible Issues
 The Problem of Book-Value Accounting
• Original (historical, book-value) cost
• Amortized cost
• Market-value
• Held-to-maturity and available-for-sale securities
 Auditing: Assuring Reliability of Financial Statements

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Quick Quiz
1) Which are the principal accounts that appear on a bank’s balance sheet (Report
of Condition)?
2) What are primary reserves and secondary reserves, and what are they supposed
to do?
3) What are off-balance-sheet items, and why are they important to some financial
firms?

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THE REPORT OF INCOME

 An income statement , or Report of Income, for a bank indicates the
amount of revenue received and expenses incurred over a specific
period of time.
 Bank revenue sources are from the interest incomes and fees charged
for specific services.
 Bank expenses include interest and non-interest expenses.

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THE INCOME STATEMENT

Revenues
• Interest income from loans and investments
• Noninterest income (fee income from miscellaneous sources)
Expenses
• Interest paid on deposits
• Interest paid on non-deposit borrowings
• Salaries and wages (employee compensation)
• Provision for loan losses (allocations to reserves for loan losses)
• Other expenses
Pretax net operating income (revenues – expenses listed above)
Taxes
Gains or losses from trading in securities
Net income (Pretax net operating income – taxes + securities gains – securities losses)

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THE INCOME STATEMENT

Report of Income
for National City
Corporation

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THE INCOME STATEMENT

 Interest income :
 Interest on loans
 Securities revenues
 Interest expense:
 Interest on deposits
 Interest owed on short-term borrowings in the money market
 Long-term borrowings
 Net interest Income = Interest Income – Interest Expense

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THE INCOME STATEMENT

 Loan-Loss Expense
 Provision for loan and lease losses (PLL) is an expense deducted from current
income.
 A non-cash accounting expense recorded through a bookkeeping entry.
 Builds reserves to absorb future loan losses (bad loans).

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THE INCOME STATEMENT

 Noninterest Income
 Service charges on deposit accounts
 Fees earned from fiduciary activities
 Trading account gains and fees
 Additional noninterest income
 Noninterest Expenses
 Wages, salaries, and employee benefits
 Premises and equipment expenses
 Other small expense such as legal fees, office supplies, and repair costs.

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THE INCOME STATEMENT

 Fees Earned from Fiduciary Activities  Trading Account Gains and Fees
o Fees for Managing Protecting a o Net Gains and Losses from trading cash
Customer’s Property instruments and Off-Balance Sheet Derivative
contracts that have been recognized during the
o Fees for Record Keeping for Corporate accounting period
Security Transactions and Dispensing
Interest and Dividend Payments  Additional Noninterest Income
o Fees for Managing Corporate and o Investment Banking, Advisory, Brokerage and
Individual Pension and Retirement Plans Underwriting
 Service Charges on Deposit Accounts o Venture Capital Revenue
o Checking Account Maintenance Fees o Net Servicing Fees
o Net Securitization Income
o Checking Account Overdraft Fees
o Insurance Commission Fees and Income
o Fees for Writing Excessive Checks
o Net Gains (Losses) on Sales of Loans
o Savings Account Overdraft Fees
o Net Gains (Losses) on sales of Real Estate
o Fees for Stopping Payment of Checks
o Net Gains (Losses) on the Sales of Other Assets

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Income Statement for National City Corporation

Item 2004 2003
Total interest income $6,317,502 $6,193,817
Total interest expense 1,848,517 1,777,250
Net interest income 4,468,985 4,416,567
Provision for loan and lease losses 322,920 638,183
Total noninterest income 3,950,662 3,187,461
Fiduciary activities 258,113 250,551
Service charges on deposit accounts 642,961 557,751
Trading account gains and fees 3,586 37,993
Additional noninterest income 3,056,002 2,341,166
Total noninterest expense 4,278,510 3,683,345
Salaries and employee benefits 2,214,989 1,926,225
Premises and equipment expense 551,965 375,746
Additional noninterest expense 1,511,556 1,381,374
Pretax net operating income 3,828,217 3,282,499
Securities gains (losses) 15,365 7,713
Applicable income taxes 1,384,300 1,148,490
Income before extraordinary items 2,459,282 2,141,713
Extraordinary gains—net 0 0
Net income 2,459,282 2,141,713

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All U.S. Insured Less than $100 $100 Million $1 Billion

Income and Expense Items
Banks Million to $1 Billion or More
1. Total interest income 4.13% 4.99% 5.00% 3.99%
Domestic office loans 2.86 3.98 4.16 2.67
Foreign office loans 0.25 0.00* 0.00* 0.29
Lease financing receivables 0.09 0.01 0.02 0.1
Balances due from depository institutions 0.04 0.04 0.02 0.04
Securities 0.68 0.88 0.8 0.66
Trading accounts 0.12 0.00* 0.00* 0.13
Federal funds sold 0.06 0.06 0.03 0.09
Other interest income 0.04 0.02 0.03 0.04
2. Total interest expense 1.16 1.3 1.32 1.14
Domestic office deposits 0.59 1.17 1.1 0.5
Foreign office deposits 0.16 0.00* 0.00* 0.18
Federal funds purchased 0.11 0.01 0.03 0.13
Trading liabilities and other borrowed money 0.25 0.11 0.18 0.26
Subordinated notes and debentures 0.06 0.00* 0.01 0.08
3. Net interest income 2.97 3.69 3.68 2.85
Provision for loan and lease losses 0.31 0.21 0.25 0.32

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All U.S. Insured Less than $100 $100 Million $1 Billion

Income and Expense Items
Banks Million to $1 Billion or More
4 Total noninterest income 2.19 0.91 1.34 2.33
Fiduciary activities 0.27 0.08 0.19 0.28
Service charges on deposit accounts 0.38 0.41 0.42 0.37
Trading account gains and fees 0.11 0.00* 0.00* 0.13
Additional noninterest income 1.42 0.42 0.74 1.54
5. Total noninterest expenses 3.06 3.21 3.15 3.05
Salaries and employee benefits 1.32 1.73 1.59 1.27
Premises and equipment expense 0.38 0.43 0.4 0.38
Additional noninterest expenses 1.36 1.05 1.16 1.4
6. Pretax net operating income 1.78 1.18 1.62 1.82
Securities gains (losses) 0.04 0.01 0.01 0.05
Applicable income taxes 0.58 0.24 0.42 0.61
7. Income before extraordinary items 1.24 0.95 1.22 1.25
Extraordinary gains—net 0.00* 0.00* 0.00* 0.00*
8. Net income 1.24 0.95 1.22 1.25

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Features of the Financial Statements of Banks Consequences for the Managers of Banks

• Heavy dependence on borrowed funds supplied by • The earnings and the very existence of financial institutions are
others (including deposits and nondeposit exposed to significant risk if those borrowings cannot be repaid
borrowings); thus, many financial firms make heavy when due. Thus, financial firms must hold a significant
use of financial leverage (debt) in an effort to boost proportion of high-quality and readily marketable assets to meet
their stockholders’ earnings. their debt obligations.

• Most revenues come from interest and dividends on • Management must choose loans and investments carefully to
loans and securities. The largest expense item is often avoid a high proportion of earning assets that fail to pay out as
the interest cost of borrowed funds, followed by planned, damaging expected revenue flows. Because revenues
personnel costs. and expenses are sensitive to changing interest rates,
management must be competent at protecting against losses due
to interest-rate movements by using interest-rate hedging
techniques.
• The greatest proportion of assets is devoted to • With only limited resources devoted to fixed assets and,
financial assets (principally loans and securities). A therefore, few fixed costs stemming from plant and equipment,
relatively small proportion of assets is devoted to plant financial firms’ earnings are less sensitive to fluctuations in sales
and equipment (fixed assets); thus, financial volume (operating revenues) than those of many other
institutions tend to make very limited use of operating businesses, but this also limits potential earnings. (Banking, for
leverage example, tends to be a moderately profitable industry.)

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II. Measuring and Evaluating the

Performance of Commercial banks

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 Purposes:
 Meeting the needs of stakeholders
Performance (stockholders, employees, customers) as
well as Regulatory Compliance.
Evaluation  Heavy dependence upon the open market
of Banks in raising money.
 Dramatically competition for traditional
loan and deposit customers.

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Information sources and analytical

methods

 Information sources:
 Financial Statements
 Other sources
 Analytical methods:
 Structural analysis
 Trend analysis
 Comparative analysis

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Maximizing the Value of the Bank

 A bank’s stock price is a function of the:

Where:
• E(Dt) : Stockholders dividends expected to be paid in future periods.
• r : a minimum acceptable rate of return or cost of capital

 Question: In what situations will the value of the Bank tend to rise?
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Maximizing the Value of the Bank

 The stock price equation can be in the form:
𝐏𝟎 = 𝐃𝟏 ⁄(𝐫 − 𝐠)
Where:
D1: the expected dividends on stock in period 1
r : cost of capital, or the rate of discount
g: the expected constant growth rate of stock dividends.

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Profitability Ratios
Key Ratios Measurement
Net Income
𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐞𝐪𝐮𝐢𝐭𝐲 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 (𝐑𝐎𝐄)
Total equity capital
Net Income
𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐀𝐬𝐬𝐞𝐭𝐬 (𝐑𝐎𝐀)
Total assets
(Interest income − Interest expense)
𝐍𝐞𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 (NIM)
Total assets
Noninterest revenues−Noninterest expenses
Net noninterest margin
Total assets
Total operaating revenues −Total operating expenses
Net Operating margin
Total assets
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Profitability Ratios

Key Ratios Measurement

Earning per share of Net income
stock (EPS) Common equity shares outstanding
Total interest income Total interest expense
Earnings spread −
Total earning assets Total interest − bearing liabilities

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Useful Profitability Formulas

 Relationships between ROE and ROA
Total assets
ROE = ROA ×
Total equity capital
In other words:
Net income Net income Total assets
= ×
Total equity capital Total assets Total equity capital

Total revenues − Total operating expenses − Taxes Total assets

ROE = ×
Total assets Total equity capital

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Useful Profitability Formulas

 Relationships between ROE and ROA

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Useful Profitability Formulas

 Components of the ROE formula
Net income Total operating revenue Total assets
𝐑𝐎𝐄 = × ×
Total operating revenue Total assets Total equity capital

𝐑𝐎𝐄 = 𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 𝐍𝐏𝐌 × 𝐀𝐬𝐬𝐞𝐭 𝐮𝐭𝐢𝐥𝐢𝐳𝐚𝐭𝐢𝐨𝐧 𝐫𝐚𝐭𝐢𝐨(𝐀𝐔) × 𝐄𝐪𝐮𝐢𝐭𝐲 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫(𝐄𝐌)

NPM AU AU
Effectiveness of Porfolio management Leverage or financial
expense management policies, especially the policies (debt or
and service pricing mix and yield on assets equity)
policies

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Useful Profitability Formulas

Exhibit…Elements that Determine the
Rate of Return earned on the
Stockholders’ Investment (ROE)

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Return on Equity  Table 2.1. Components of Return on Equity (ROE) for

Decomposition All FDIC-Insured Institutions (1992-2005)

Net Profit Asset Equity

Year ROE (%) Margin (NPM) × Utilization × Multiplier
= (%) (AU) (%) (EM)
2005* 12.68 = 18.89 × 6.93 × 9.63
2004 13.27 = 19.81 × 6.51 × 9.72
2003 15.04 = 19.86 × 6.95 × 10.93
2002 14.10 = 17.10 × 7.60 × 10.87
2000 13.53 = 12.02 × 9.48 × 11.78
1998 13.51 = 12.73 × 9.11 × 11.74
1996 13.31 = 12.21 × 9.01 × 12.17
1994 13.33 = 12.59 × 8.34 × 12.80
1992 12.21 = 9.55 × 9.31 × 13.42 46

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Useful Profitability Formulas

 Components of the ROE formula

Pretax Total
Net income net operating income operating revenue Total assets
ROE = × × ×
Pretax Total Total assets Total
net operating income operating revenue equity capital

Tax management Expense control asset management Fund

ROE = × × ×
efficiency efficiency efficiency management

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Useful Profitability Formulas

Components of the ROE formula
Example: Suppose a bank’s Balance sheet and Income statement show the
following figures:
• Net income = $10 million
• Pretax net operating income = $1.3 million
• Total operating revenue = $39.3 million

The result for its ROE:

$1.0 𝐦𝐢𝐥 $1.3 𝐦𝐢𝐥 $39.3 𝐦𝐢𝐥 $122.0 𝐦𝐢𝐥
ROE = × × ×
1.3 𝐦𝐢𝐥 39.3 𝐦𝐢𝐥 122.0 𝐦𝐢𝐥 7.3 𝐦𝐢𝐥
ROE = 0.769 x 0.033 x 0.322 x 16.71 = 0.137 𝐨𝐫 13.7%

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Components of Return on Assets (ROA)

Calculation Return on Assets (ROA)
Gross interest income ÷Total assets Income from holding assets
- Interest expense ÷Total assets Supply cost of funds for holding assets
= Net interest margin ÷Total assets Return earned because the lending institutions’ credit
quality is better than its customers’ credit quality

+ Noninterest income ÷Total assets Income from handling customer transactions

- Noninterest expense ÷Total assets Cost of operations
- Provision for loan losses ÷ Total assets Accrual expense
= Pretax net operating income ÷Total assets Return asset before taxes
- Income tax ÷Total assets The bank’s share of the cost of government services
= Income before extraordinary items ÷Total assets Net income from recurring sources of revenue
+ Extraordinary items ÷Total assets Nonrecurring source of income or loss
= Net income ÷Total assets (ROA) Earnings left over for the stockholders after all cost met
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Components of Return on Assets (ROA)

Interest income − Interest expense
Net interest margin
Total assets
PLUS
Noninterest Income − Noninterest expense
Net noninterest margin
Total assets
LESS
Provisions for loan losses
Special transactions ± securities gain or losses
+taxes − extraodinary net gains
affecting its net income
Total assets

EQUALS
Net income
Return on assets (ROA)
Total assets
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Components of Return on Assets

 Example:
Components of ROA for all US FDIC Insured Depository Institutions (1992-2005)
Income Statement Items (unit: %) 2005 2003 2002 2000 1998 1996 1994 1992
Total interest income / Total assets 4.79 4.63 5.32 7.17 6.97 7.14 6.64 7.49
− Total interest expense / Total assets 1.73 1.40 1.90 3.87 3.55 3.56 2.99 3.77
= Net interest income / Total assets 3.06 3.22 3.43 3.30 3.41 3.58 3.65 3.72
− Provision for loan and lease losses / Total assets 0.25 0.43 0.64 0.45 0.39 0.35 0.28 0.70
+ Total noninterest income / Total assets 2.13 2.32 2.27 2.32 2.14 1.87 1.70 1.62
− Total noninterest expense / Total assets 3.05 3.20 3.27 3.39 3.51 3.45 3.46 3.51
= Pretax net operating income / Total assets 1.89 1.92 1.80 1.77 1.66 1.64 1.61 1.12
+ Securities gains (losses) / Total assets 0.06 0.13 0.15 -0.02 0.09 0.04 -0.01 0.14
− Applicable income taxes / Total assets 0.64 0.67 0.64 0.61 0.60 0.58 0.54 0.41
= Income before extraordinary items / Total assets 1.31 1.37 1.30 1.14 1.15 1.10 1.06 0.85
+ Extraordinary gains (net) / Total assets 0.00** 0.00** 0.00** 0.00** 0.01 0.00** -0.01 0.02
= Net income / Total assets 1.31 1.38 1.30 1.14 1.16 1.10 1.05 0.87
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MEASURING RISK IN BANKS

 Credit Risk  Legal and Compliance Risk
 Liquidity Risk  Reputation Risk
 Market Risk  Strategic Risk
 Interest Rate Risk  Capital Risk
 Operational Risk

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MEASURING RISK IN BANKS

 Risk for a bank means the perceived uncertainty associated with a
particular event.
 Earnings may decline unexpectedly and the possibility of a decline in
their earnings per share of stock, eroding its resources for future
growth.
 Measures of Overall risk for a bank: Standard deviation () or
variance (2) of stock prices, net income, return on equity and return
on assets.

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MEASURING RISK IN BANKS

 Credit Risk
 The probability that some of the bank’s assets, especially its loans, will decline
in value and perhaps become worthless.
 Indicators of credit risk:
• Nonperforming assets to total loans and leases
• Net charge-offs of loans to total loans and leases
• Annual provision for loan losses to total loans and leases (or to equity capital)
• Allowance for loan losses to total loans and leases (or to equity capital)
• Nonperforming assets to equity capital
 Additional Indicator:
• Total loans to total deposits
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MEASURING RISK IN BANKS

 Liquidity Risk
 Probability the bank will not have sufficient cash and borrowing capacity to
meet deposit withdrawals, loan demand and other cash needs
 Liquidity Risk Measures
• Purchased Funds/Total Assets
• Cash and Due from Banks/Total Assets
• Cash and Government Securities/Total Assets

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MEASURING RISK IN BANKS

 Market Risk
 Interest Rate Risk: The impact of changing interest rates on a financial
institution’s margin of profit.
• The ratio of interest-sensitive assets to interest-sensitive liabilities
• The ratio of uninsured deposits to total deposits
 Price risk: is the potential for financial loss due to adverse movements in
market prices, specifically affecting the value of on- and off-balance sheet
trading portfolios.
• Book-Value of Assets/ Market Value of Assets
• Book-Value of Equity/ Market Value of Equity
• Book-Value of Bonds/Market Value of Bonds
• Market Value of Preferred Stock and Common Stock
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MEASURING RISK IN BANKS

 Operational Risk
 Operational risk refers to uncertainty regarding a financial firm’s earnings due to
failures in computer systems, errors, misconduct by employees, lightning strikes,
and similar events.
 The risk of loss resulting from inadequate or failed internal processes, people, and
systems, or from external events

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MEASURING RISK IN BANKS

 Other Bank Risks
 Legal risk creates variability in earnings due to actions taken by the legal system. It
includes unenforceable contracts, lawsuits, or adverse judgments.
 Compliance risk includes violations of rules and regulations.
 Reputation Risk: is the uncertainty associated with public opinion.
 Strategic Risk is variations in earnings due to adverse business decisions, improper
implementation of decisions, or lack of responsiveness ton industry changes.
 Capital Risk is the impact of all the risks examined above can affected a financial firm’s
long-run survival.
 Off-Balance Sheet Risk: The volatility in net income and market value of bank equity
that may arise from unanticipated losses due to these off-balance sheet liabilities.

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Other Goals in Banking Management

 Operation efficiency

Total operating expenses

𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐞𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐜𝐲 𝐫𝐚𝐭𝐢𝐨 =
Total operating revenues

Net operating income

𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐞 𝐩𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐯𝐢𝐭𝐲 𝐫𝐚𝐭𝐢𝐨 =
Number of full − time − equivalent employees

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The impact of Size on Performance

Table: Important Performance Indicators Related to the Size and Location of FDIC-Insured Banks (2005)

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Size, Location, and Regulatory Bias

 It is best to compare the performance among financial firms that are of similar
size, serving the same or similar areas, and subject to similar regulations and
regulatory agencies.
 The Uniform Bank Performance Report (The UBPR) Provided by U.S. Federal
Regulators so that Analysts Can Compare the Performance of One Bank Against
Another.

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