Sessions 3; June 20,

2020

Measuring and Evaluating the

Performance of Banks and Their
Principal Competitors
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 Slide 2 of 32

Recap
• Four Main items on the asset side of a bank
balance sheet:
1. Cash and bank balances
2. Investments in securities
3. Loans and advances
4. Miscellaneous assets
• Three main items on the liability side of a
bank balance sheet:
1. Deposits
2. Borrowings other than deposits
3. Equity capital and reserves
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Bank Management and Financial Services, 7/e 6-2
 Slide 3 of 32

Which is the best measure to evaluate the

performance of a bank?
• Share price of the bank is a powerful indicator of bank’s
performance.

• A bank which tries to maximize its share price can be

considered to be performing well.

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Bank Management and Financial Services, 7/e 6-3
 Slide 4 of 32

How to maximize the share price?

• 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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Bank Management and Financial Services, 7/e 6-4
 Slide 5 of 32

Maximizing share price – How to factor in

future growth in business?
• 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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Bank Management and Financial Services, 7/e 6-5
 Slide 6 of 32

How to arrive at share prices for a limited

time horizon?
• 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
• For an investor with limited time horizon, the price she is
willing to pay for a share is:

▫ 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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Bank Management and Financial Services, 7/e 6-6
 Slide 7 of 32

Importance of share price in evaluating firm

performance
• 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 which are not listed in a
stock exchange.
• For such firms evaluation can be done using key Profitability Ratios

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Bank2Management and Financial Services, 7/e
Total earning assets 6-7
 Slide 8 of 32

Some Key Performance Ratios

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Total earning assets 6-8
 Slide 9 of 32

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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Bank Management and Financial Services, 7/e 6-9
 Slide 10 of 32

Importance of Earnings Spread

• 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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Bank Management and Financial Services, 7/e 6-10
 Slide 11 of 32

Evaluating Performance (continued)

• Useful Profitability Formulas for Banks and Other Financial-
Service Companies

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 Slide 12 of 32

Evaluating Performance (continued)

or

where

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 Slide 13 of 32

How shareholders’ return for a bank can be maximized?

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 Slide 14 of 32

Components of Return on Equity (ROE) for All FDIC-

Insured Institutions (1992-2009)

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Bank Management and Financial Services, 7/e 6-14
 Slide 15 of 32

Evaluating Performance (continued)

• A slight variation of the simple ROE model produces an
efficiency equation useful for diagnosing problems in four
different areas in the management of financial-service firms

or

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Bank Management and Financial Services, 7/e 6-15
 Slide 16 of 32

ROE & ROA

• Suppose a bank is projected to achieve a 1.10 percent ROA
during the coming year. What must its ratio of total assets to
equity capital be if it is to achieve a target ROE of 12 percent?
If ROA unexpectedly fall to 0.80 percent what assets to
capital ratio it must have to maintain 12 percent ROE?

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