Evaluating a Bank's Performance A. Determining Long-Range Objectives B. Maximizing the Value of the Firm C. Profitability Ratios: 1.

Key Profitability Ratios (ROE, ROA, NIM, NIMPLL, EPS, Efficiency Ratio, Fee Income Ratio) 2. Interpreting Profitability Ratios D. Measuring Risk in Banking and Financial Services (Credit Risk, Liquidity Risk, Market Risk, Interest-Rate Risk, Foreign Exchange & Sovereign Risk, Off-Balance Sheet Risk, Operational (Transactional) Risk, Legal and Compliance Risk, Reputation Risk, Strategic Risk, and Capital Risk) Key Performance Indicators among Bankings Key Competitors. ROE = return on equity = net income/average common equity A measure of the return to common stockholders on their investment. ROA = return on assets = net income/average (total) assets A measure of how well the assets are being managed. It does not take into account the level of debt and equity financing as reflected in ROE. NIM = net interest margin = net interest income/average (total) assets (an alternative version uses average earning assets as denominator) A good measure of traditional banking because it examines how well a bank gathers deposits and nondeposit funds and transforms them into loans and securities. NIMPLL = net interest margin after provision for loan losses = net interest income minus provision for loans losses/average (total) assets An alternative version of NIM that considers the higher risk that might be considered with higher earning assets or loans. This is better when comparing banks with products with different risks, e.g., credit card loans vs. other banks. When the provision for loan losses is less than net charge offs (charge offs less recoveries from previous charge offs) then the allowance for loan losses decreases and this is called releasing loan loss reserves and is usually associated with higher NIMPLL. Efficiency Ratio = noninterest expense/(net interest income + noninterest income) A lower value indicates the bank is producing its net operating revenue at a lower cost. A lower cost will allow the bank to increase its profits or lower prices and increase its market share. This ratio is more commonly used than net noninterest margin = (noninterest income noninterest expense)/average total assets. Fee Income Ratio = noninterest income/(net interest income + noninterest income) A higher value indicates the bank is producing more of its net operating revenue from noninterest income (fees). This is also considered a measure of modern banking because banks are trying to generate more of their income from fees. A historical analysis suggests that the NIM for banks is declining

over time due to greater competition for loans (lower interest rates and income) and deposits (higher interest rates and expenses). A higher ratio is usually considered positive. These fees also may be less volatile than interest rates. EPS = earnings per share = net income/# of outstanding shares Tax Management Efficiency = net income/pre-tax income Higher ratios indicate lower taxes.

NPM = net profit margin = net income/total operating revenues total operating revenues = total interest income + noninterest income AU = Asset Utilization = total operating revenues/average total assets Note that total operating revenues is similar to sales for a nonfinancial firm and this ratio is similar to Total Asset Turnover or Sales/Total Assets EM = Equity Multiplier = total assets/common equity The reciprocal of EM is the commonly used ratio of common equity/total assets. ROE = NPM X AU X EM = net income/common equity This is identical to the Du Pont analysis you learned in corporate finance. (pp. 174-179)

There are two ways to use financial ratios. (1) Examine the performance of a firm over time. (2) Compare the performance of one firm with another firm or peer group. The comparison to a peer group assumes the peer group is comparable to the firm. Analysts try to control for three major things when comparing banks. Size is usually the first basis of comparison because different size institutions have different characteristics. Location is the second basis of comparison because a banks performance is usually a reflection of the economy where it operates. Product composition is the third basis of comparison because a much heavier activity in one product than a peer group can affect the legitimacy of using the peer group for comparison purposes. Examples include banks with very high fee income ratios (State Street, Bank of New York Mellon, Northern Trust), banks with high credit card loans (Capital One, American Express), banks that are former investment banks (Goldman Sachs, Morgan Stanley), banks that are primarily insurance companies (MetLife), banks with high levels of real estate loans (Colonial (now part of BB&T), Washington Mutual (now part of JP Morgan Chase)). Of course these three bases can interact, e.g., bad real estate loans in Florida, California, Arizona, and Nevada.

Another factor that may be important for younger banks is the age of the bank because it usually takes two to three years for a bank to become profitable. The UBPR, which is discussed below, does provide some comparisons for similar sized banks established during the same year.

+ A good performance measurement framework comprises a number ofelements,including an effective organization that allows a clear allocation ofincome and expenses to business units related to different lines ofa banks business,products,or market segments;an internal transfer pricing system to measure the contribution ofvarious business units to the bottom line;and an effective and consistent means to incorporate the elements ofrisk into the performance measurement framework.Once the net contributions are known,by business lines,products,or markets, it can be clearly established which customer segments are the most promising and which products should be scrutinized concerning their revenue-generating capacity.A good performance measurement framework also allows analysis ofthe net contribution that a relationship with a large customer makes to the banks bottom line.