FINC 4320

1
FINC 4320

• Evaluating Bank Performance, Part One Measuring
  Returns and Assessing Risks
• Fall 2004

2
Measuring Performance the ROE Model

• Return on Equity Capital - ROE
• Return on Assets - ROA
• and

3
Breaking Down ROE
4
ROE Depends On

• Equity Multiplier
• Expense Ratio
• Asset Utilization

• Leverage or Financing Policies
• Effectiveness of Expense Management
• Portfolio Management Policies

5
Factors Affecting the Expense Ratio

• Interest Expense Ratio
• Provision for Loan Losses Ratio
• Non-interest Expense Ratio
• Note that each can be further analyzed!

6
Factors Affecting Asset Utilization

• Interest Income/TA
• what are the components, by income contribution
  or dollars invested?
• what are the risks?
• Non-Interest Income/TA
• what are the sources of fees? deposit accounts?
  OBSAs?
• what are the risks?

7
Other Often-used Measures of Profitability

• NIM
• Spread
• Burden ratio
• Efficiency ratio

8
Whats a Manager to do?

• Toward what measure of performance should bank
  managers aim?
• What are the profitability, liquidity, and
  solvency tradeoffs?

9
Assessing Credit Risk

• Credit Risk the potential variation in net
  income and market value of equity resulting from
  nonpayment or delayed payment.
• Three questions need to be addressed
• What amount of losses do we expect?
• How prepared is the bank?
• What has been the loss experience?

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Credit ratios to consider

• What has been the loss experience?
• Net loss to average total LNLS
• Gross losses to average total LNLS
• Recoveries to avg tot LNLS
• Recoveries to prior period losses.
• Net losses by type of LNLS
• What amount of losses do we expect?
• Non-current LNLS to tot loans
• Total P/D LNLS - incl nonaccural
• Non-curr restruc LNLS / GR LNLS
• Curr-Non-curr restruct / GR LNLS
• Past due by loan type

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Credit ratios to consider (continued)

• How prepared are we?
• Loss Provision to average assets and avg tot
  LNLS
• LNLS Allowance to net losses and total LNLS
• Earnings coverage of net loss

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Assessing Liquidity risk

• Liquidity Risk is the variation in net income and
  market value of equity caused by a bank's
  difficulty in obtaining cash at a reasonable cost
  from either the sale of assets or new
  borrowings.
• Banks can acquire liquidity in two distinct ways
• By liquidation of assets.
• Composition of investments
• Maturity of investments
• By borrowing.
• Core deposits
• Volatile deposits

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Liquidity Risk Measures

• Volatile Liabilities/Total Assets
• Core deposits/Total Assets
• Net Loans/Total Assets
• Cash and Due from Banks/Total Assets
• Cash and Govt. Securities/Total Assets
• Securities maturing less than 1 year/Total Assets

14
Assessing Market risk

• Market risk is the risk to a financial
  institutions condition resulting from adverse
  movements in market rates or prices .
• Market risk arises from changes in
• Interest rates
• Foreign exchange rates
• Equity and security prices.

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Interest rate risk

• the potential variability in a bank's net
  interest income and market value of equity due to
  changes in the level of market interest rates.
• Example 10,000 Car loan 4 year Car loan
  at 8.5 1 year CD at 4.5 Spread 4.0
• But for How long?
• Funding GAP
• GAP RSA - RSL,
• where RSA amount of assets which will
  mature or reprice in a give period of time.
  Suppose the CD rate re-sets every 3 months.
• In this example
• GAP3m 0.00 - 10,000 - 10,000
• This is a negative GAP.

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Foreign exchange risk

• the risk to a financial institutions condition
  resulting from adverse movements in foreign
  exchange rates.
• Foreign exchange risk arises from changes in
  foreign exchange rates that affect the values of
  assets, liabilities, and off-balance sheet
  activities denominated in currencies different
  from the banks domestic (home) currency.
• This risk is often found in off-balance sheet
  loan commitments and guarantees denominated in
  foreign currencies foreign currency translation
  risk.

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Equity and security price risk

• change in market prices, interest rates and
  foreign exchange rates affect the market values
  of equities, fixed income securities, foreign
  currency holdings, and associated derivative and
  other off-balance sheet contracts.
• Large banks must conduct value-at-risk analysis
  to assess the risk of loss with their trading
  account portfolios.

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Operational risk

• measures the cost efficiency of the bank's
  activities i.e., expense control or
  productivity.
• Typical ratios focus on
• total assets per employee
• total personnel expense per employee
• noninterest expense ratio
• There is no meaningful way to estimate the
  likelihood of fraud or other contingencies from
  published data
• A banks operating risk is closely related to its
  operating policies and processes and whether is
  has adequate controls

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Capital or Solvency risk

• closely tied to asset quality and a bank's
  overall risk profile
• The more risk taken, the greater is the amount of
  capital required.
• Appropriate risk measures include all the risk
  measures discussed earlier as well as ratios
  measuring the ratio of
• Tier 1 capital and total risk based capital to
  risk weighted assets,
• equity capital to total assets,
• dividend payout, and growth rate in tier 1
  capital.
• Spread Between Bank Jumbo CDs and Treasury
  Securities of Same Maturity

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Definitions of capital

• Tier 1 capital is
• total common equity capital plus noncumulative
  preferred stock, plus minority interest in
  unconsolidated subsidiaries, less ineligible
  intangibles.
• Risk weighted assets are
• the total of risk adjusted assets where the risk
  weights are based on four risk classes of assets.
  
• Importantly, a bank's dividend policy affects its
  capital risk by influencing retained earnings.