Chapter Six

Measuring and Evaluating the

Performance of Banks and Their
Principal Competitors
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 Key Topics

• Stock Values and Profitability Ratios

• Liquidity, and Other Risks

• Measuring Operating Efficiency

• Performance of Competing Financial Firms

• Size and Location Effects

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 Introduction
• This chapter focuses on the most widely used indicators of the
quality and quantity of bank performance and their principal
competitors
• Focus on the most important dimensions of performance –
profitability and risk
• Financial institutions are simply businesses organized to maximize
the value of the shareholders’ wealth invested in the firm at an
acceptable level of risk
• Most continually be on the lookout for new opportunities for revenue
growth, greater efficiency, and more effective planning and control.
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 Evaluating Performance
• Performance must be directed toward specific objectives
• A fair evaluation of any financial firm’s performance should start by
evaluating whether it has been able to achieve the objectives its
management and stockholders have chosen.
• A key objective is to maximize the value of the firm

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 Evaluating Performance (continued)
• The minimum acceptable rate of return, r, is sometimes referred to as an
institution’s cost of capital
▫ Two main components
▫ The risk-free rate of interest
▫ The equity risk premium
• The value of the financial firm’s stock will tend to rise in any of the
following situations
1. The value of the stream of future stockholder dividends is expected to
increase
2. The financial organization’s perceived level of risk falls
3. Market interest rates decrease, reducing shareholders’ acceptable rates of
return via the risk-free rate of interest component of all market interest rates
4. Expected dividend increases are combined with declining risk, as perceived
by investors

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 Evaluating Performance (continued)
• The stock values of financial institutions are sensitive to changes in market
interest rates, currency exchange rates, and the strength or weakness of the
economy
• Equation (6–1) assumes that the stock may pay dividends of varying
amounts over time
• If the dividends paid to stockholders are expected to grow at a constant
rate over time, perhaps reflecting steady growth in earnings, the stock
price equation can be greatly simplified into

▫ D1 is the expected dividend in period 1

▫ r is the rate of discount reflecting the perceived level of risk
▫ g is the expected constant growth rate at which all future stock dividends
will grow each year
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 Evaluating Performance (continued)
• The previous two stock price formulas assume the financial firm
will pay dividends indefinitely into the future
• Most capital market investors have a limited time horizon

▫ where we assume an investor will hold the stock for n periods,

receiving the stream of dividends D1, D2, . . . , Dn and sell the stock
for price Pn at the end of the planned investment horizon

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 Evaluating Performance (continued)
• The behavior of a stock’s price is, in theory, the best indicator of a
financial firm’s performance because it reflects the market’s evaluation of
that firm
• This indicator is often not available for smaller banks and other relatively
small financial-service corporations
• Key Profitability Ratios

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 Evaluating Performance (continued)

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 Evaluating Performance (continued)
• Return on assets (ROA) is primarily an indicator of managerial efficiency
▫ Indicates how capable management has been in converting assets into
net earnings
• Return on equity (ROE) is a measure of the rate of return flowing to
shareholders
• Approximates the net benefit that the stockholders have received from
investing their capital in the financial firm
• The net operating margin, net interest margin, and net noninterest
margin are efficiency measures as well as profitability measures
▫ The net interest margin measures how large a spread between interest
revenues and interest costs management has been able to achieve
▫ The net noninterest margin measures the amount of noninterest
revenues stemming from service fees the financial firm has been able to
collect relative to the amount of noninterest costs incurred
▫ Typically, the net noninterest margin is negative
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 Evaluating Performance (continued)
• Another traditional measure of earnings efficiency is the earnings spread

▫ Measures the effectiveness of a financial firm’s intermediation function in

borrowing and lending money and also the intensity of competition in the
firm’s market area
▫ Greater competition tends to squeeze the difference between average asset
yields and average liability costs
▫ If other factors are held constant, the spread will decline as competition
increases
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 Evaluating Performance (continued)
• Achieving superior profitability for a financial institution depends upon
several crucial factors
1. Careful use of financial leverage (or the proportion of assets financed by debt as
opposed to equity capital)
2. Careful use of operating leverage from fixed assets (or the proportion of fixed-
cost inputs used to boost operating earnings as output grows)
3. Careful control of operating expenses so that more dollars of sales revenue
become net income
4. Careful management of the asset portfolio to meet liquidity needs while seeking
the highest returns from any assets acquired
5. Careful control of exposure to risk so that losses don’t overwhelm income and
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 Evaluating Performance (continued)
• Risk to the manager of a financial institution or to a regulator
supervising financial institutions means the perceived uncertainty
associated with a particular event
• Among the more popular measures of overall risk for a financial firm
are the following
▫ Standard deviation (σ) or variance (σ2) of stock prices
▫ Standard deviation or variance of net income
▫ Standard deviation or variance of return on equity (ROE) and
return on assets (ROA)
• The higher the standard deviation or variance of the above
measures, the greater the overall
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Evaluating Performance (continued)
• Bank Risks
▫ Credit Risk
▫ Liquidity Risk
▫ Market Risk
▫ Interest Rate Risk
▫ Operational Risk
▫ Legal and Compliance Risk
▫ Reputation Risk
▫ Strategic Risk
▫ Capital Risk
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 Evaluating Performance (continued)
• Other Goals in Banking and Financial-Services Management

▫ A rise in the value of the operating efficiency ratio often indicates an

expense control problem or a falloff in revenues, perhaps due to
declining market demand
▫ In contrast, a rise in the employee productivity ratio suggests
management and staff are generating more operating revenue and/or
reducing operating expenses per employee, helping to squeeze out
more product with a given employee base
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 Performance Indicators among Banking’s
Key Competitors
• Among the key bank performance indicators that often are
equally applicable to privately owned, profit-making nonbank
financial firms are
Prices on common and preferred stock Return on equity capital (ROE)
Return on assets (ROA) Net operating margin
Net interest margin Equity multiplier
Asset utilization ratio Cash accounts to total assets
Nonperforming assets to equity capital Interest-sensitive assets to interest-
ratio sensitive liabilities
Book-value assets to market-value assets Equity capital to risk-exposed assets
Interest-rate spread between yields on Earnings per share of stock
the financial firm’s debt and market
yields on government securities
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 The Impact of Size on Performance
• When the performance of one financial firm is compared to that
of another, size becomes a critical factor
▫ Size is often measured by total assets or, in the case of a depository
institution, total deposits
• Most performance ratios are highly sensitive to the size group in
which a financial institution finds itself
• The best performance comparison is to choose institutions of
similar size serving the same market area
• Also, compare financial institutions subject to similar regulations
and regulatory agencies
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 Quick Quiz
1. What individuals or groups are likely to be interested in the banks’ level
of profitability and exposure to risk?
2. What are the principal components of ROE, and what does each of the
these components measure?
3. What are the most important components of ROA and what aspects of a
financial institution’s performance do they reflect?
4. Why do the managers of financial firms often pay close attention today
to the net interest margin and noninterest margin? To the earnings
spread?
5. To what different kinds of risk are banks and their financial-service
competitors subjected today?
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 • END

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