ComBank 090728 Handout

7/27/2009

1

COMMERCIAL BANKING

Girish Naravane

[email protected]

1

ANALYZING BANK PERFORMANCE

2

Return to the Bank

ROA = NI / TA

Bank Performance Model

Returns to

ShareholdersROE = NI / TE

Degree of Leverage

1/EM = 1 / (TA / TE) 3

INCOME

Return to the Bank

ROA = NI / TA

EXPENSES

Bank Performance ModelReturns to


Degree of Leverage

1/EM = 1 / (TA / TE)

4

INCOME

Return to the Bank

ROA = NI / TA

EXPENSES

Interest

Overhead

Prov. for LL

Taxes

Interest

Non Interest


Returns to


Degree of Leverage

1/EM = 1 / (TA / TE)

5

INCOME

Return to the Bank

ROA = NI / TA

EXPENSES

Rate

Composition (mix)

Volume

Interest

Overhead

Prov. for LL

Taxes

Fees and Serv Charge

Trust

Other

Rate

Composition (mix)

Volume

Interest

Non Interest

Salaries and Benefits

Occupancy

Other


Returns to


Degree of Leverage

1/EM = 1 / (TA / TE)

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Banking ratios

• Profitability Ratios

• Asset Quality Ratios

• Capital Adequacy Ratios

• Liquidity Ratios

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PROFITABILITY RATIOS

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Aggregate profitability measures

• Net interest margin

• Spread

• Earnings base

• Burden

• Efficiency ratio

9 10

Profitability Ratios

• Key Measures of Aggregate Bank Profitability:

• Return on Equity (ROE):

• Annualized net income after taxes and extraordinary items

as a percent of average total equity capital.

• Measures the return on each Rupee of stockholders’ equity.

• ROE = ROA * Earnings Multiplier (EM)

• EM: a measure of leverage. Large values indicate large

amounts of debt financing

EquityTotal

sTotalAsset

sTotalAsset

IncomeNetROE

×=

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• Return on Assets (ROA):

• Annualized net income after taxes and extraordinary items

as a percent of average total assets.

• Net income generated per Rupee of average assets

invested during period.

• As a rule of thumb, an ROA of 1% is considered acceptable

for most banks.

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Profitability

• ROA Decomposition:

• ROA= Profit Margin (PM)*Asset Utilization (AU)

• Profit Margin: measures a bank’s ability to control

expenses and reduce taxes.

• Asset Utilization: represents the gross yield on

assets.

tsTotal Asse

meating IncoTotal Oper

IncomeOperatingTotal

IncomeNetROA ×=

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Profitability Ratios• Net Interest Income = Interest Income – Interest Expense

• Yield on Earning Assets:

• This ratio measures how much a bank is earning on its interest-

earning assets.

• Cost of Funding Earning Assets:

• This ratio attempts to measure how much a bank is paying for its

deposits and borrowings.

• Net Interest Margin

• Measures the difference between what a bank earns on its loans

and investments (yield on earning assets) and what it pays on

deposits and borrowings (cost of funding earning assets).

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• Noninterest income to earning assets:

• This ratio is a measure of a bank’s other income sources (from

fees, etc.).

• Noninterest expense to earning assets:

• This ratio is a measure of bank’s operating expenses. For most

banks, noninterest expenses far exceed noninterest income.

• Net operating income to assets:

• Net operating income as a percent of average assets

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Efficiency Ratio

• This ratio evaluates the overhead structure of the bank.

It is an overall indicator of how well the bank is

managing its expenses.

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• Net charge-offs to loans:

• Gross loan and lease financing receivable charge-offs, less

gross recoveries, (annualized) as a percent of average total

loans and lease financing receivables.

ASSET QUALITY RATIOS

17 18

• Loss allowance to loans

• This measures whether the loan loss allowance is adequate

to cover potential loan losses.

• Loss allowance to noncurrent loans

• This is another measure of the adequacy of the loan loss

allowance.

Asset Quality Ratios

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• Noncurrent assets plus other real estate owned to

assets

• This ratio attempts to measure the percent of non-

performing assets.

• Noncurrent loans to loans

• This ratio is an indicator of the percentage of problems loans

in the bank’s portfolio.

Asset Quality Ratios

CAPITAL ADEQUACY RATIO

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Capital Adequacy Ratios

• Equity capital to assets

• Total equity capital as a percent of total assets.

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• Core capital (leverage) ratio

• Tier 1 (core) capital as a percent of average total assets

minus ineligible intangibles.

• Tier 1 (core) capital includes: common equity plus

noncumulative perpetual preferred stock plus minority

interests in consolidated subsidiaries less goodwill and

other ineligible intangible assets.

• Total Capital = Tier 1 capital + Tier 2 capital. Tier 2 capital

includes loan loss reserves, preferred stock, and

mandatory convertible debt.

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• Tier 1 Risk-Based Capital Ratio

• Tier 1 (core) capital as a percent of risk-weighted assets as

defined by the appropriate regulator for prompt corrective

action during that time period.

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• Total Risk-Based Capital Ratio

• Total risk based capital as a percent of risk-weighted

assets as defined by the appropriate regulator for prompt

corrective action during that time period.

• Banks must meet minimum ratio of capital to risk-

weighted assets of 9%, with at least 4.5% taking the form

of Tier (1) capital.

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LIQUIDITY RATIO

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Liquidity Ratios

• Asset Liquidity Ratios:

• Current Ratio

• Current assets / current liabilities

• Liability Liquidity Ratios:

• Net Loans and leases to deposits

• Loans and lease financing receivables net of unearned

income, allowances and reserves, as a percent of total

deposits.

• This ratio is an indicator of a bank’s ability to support loan

growth with deposits.

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Liquidity Ratios

• Net loan and leases to core deposits:

• Loan and lease financing receivables, net of allowances

and reserves, as a percent of total domestic deposits, less

time deposits of Rs.100,000 or more.

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Liquidity Ratios

• Net noncore funding dependence ratio

• (Noncore Liabilities – Short-term investments)/Long-term

assets.

• This ratio highlights how dependent a bank is on volatile

funding sources; the ratio attempts to measure a bank’s

ability to withstand the sudden loss of its noncore

liabilities.

Fundamental risks

• Credit risk

• Liquidity risk

• Market risk

• Operational risk

• Capital or solvency risk

• Legal risk

• Reputational risk

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Areas of Concentration

• Credit Risk Loans and Secs quality & type

• Liquidity Risk S/T to L/T composition of Assets and

Liabs

• Market Risk Int Rate sensitivity of Assets & Liabs

(GAP)

• Operating Risk Employee usage and efficiency

• Legal Risk Lawsuits, Contract Exposure, negative

publicity

• Capital/Solvency Risk Eq Capital used and avail vs.

Risk categories of usage 30

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CREDIT RISK

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Credit risk

• It is the potential variation in net income and market

value of equity resulting from nonpayment or delayed

payment.

• Three Question need to be addressed:

1. What has been the loss experience?

2. What amount of losses do we expect?

3. How prepared is the bank?

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Credit ratios to consider

• What has been the loss experience?

• Net loss to average total LN&LS

• Gross losses to average total LN&LS

• Recoveries to avg tot LN&LS

• Recoveries to prior period losses.

• Net losses by type of LN&LS

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• What amount of losses do we expect?

• Non-current LN&LS to total loans

• Total Past Due LN&LS - incl nonaccrual

• Non-current restructured LN&LS / GR LN&LS

• Past due by loan type

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• How prepared are we?

• Loss Provision to: average assets and avg total LN&LS

• LN&LS Allowance to: net losses and total LN&LS

• Earnings coverage of net loss

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Leverage/Credit Risk

• Asset Quality

• Provision for Loan Losses / Loans (<.2%)

• Non-Accruals / Loans (< 1%)

• Charge-Offs / Loans (Hopefully < PLL)

• Loan Ratios

• Loans / Assets (60-80%)

• Loans / Deposits (70% Small, 100+%

Big)

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LIQUIDITY RISK

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Liquidity risk

• It 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:

1. By liquidation of assets.

• Composition of investments

• Maturity of investments

2. By borrowing.

• Core deposits

• Volatile deposits

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Liquidity

• Temporary Investments:

Government Bonds + Government Bills<1yr/ Assets

• Volatile Liability Dependency:

• 1) Non-core Deposits –Temporary Investments / Loans

• 2) Non-core Deposits + Government Bonds / Assets

• 3) Non-core Deposits + Government Bonds / Total Liabilities

(% of funding)

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MARKET RISK

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Market risk

• It is the risk to a financial institution’s 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

• It is 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.

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Foreign exchange risk

• It is the risk to a financial institution’s 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 bank’s domestic

(home) currency.

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Foreign exchange risk

• 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

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Operational risk

• It 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

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Operational risk

• There is no meaningful way to estimate the likelihood

of fraud or other contingencies from published data

• A bank’s operating risk is closely related to its

operating policies and processes and whether it has

adequate controls

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CAPITAL RISK

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Capital 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.

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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.

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OTHER RISKS

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Trading Risk

• If the price at which an instrument is purchased differs

from the price at which it is sold, the risk is that the

instrument may go down in value rather than up.

• This type of risk is called trading risk

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Legal risk

• The potential that unenforceable contracts, lawsuits,

or adverse judgments can disrupt or otherwise

negatively affect the operations or condition of

banking organization

• Legal risk include:

• Compliance risks

• Strategic risks

• General liability issues

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Reputational risk

• Reputational risk is the potential that negative publicity

regarding an institution’s business practices, whether

true or not, will cause a decline in the customer base,

costly litigation, or revenue reductions.

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Other Risks

• Foreign exchange risk comes from holding assets

denominated in one currency and liabilities

denominated in another

• Sovereign risk arises from the fact that some foreign

borrowers may not repay their loans, not because

they are unwilling to, but because their government

prohibits them from doing so.

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Risks CAMELS Ratings

• C - Capital Adequacy

• A - Asset Quality

• M - Mgmt Quality, Mgmt & BoD ability and systems

(policies & procedures)

• E - Earnings, not just quantity, but quality,

sustainability

• L - Liquidity

• S - Sensitivity to market fluctuations, Int. rates, FX,

Commodity prices (thru loans)58

The “Evaluation 8”

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Earnings and Profitability

• Net interest income/average assets

• Provision for loan loss/average assets

• Net realized securities gains and losses/average assets

• Net income/average assets


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Asset Quality

• Noncurrent loans/total loans

• Allowance for loan and lease losses /noncurrent loans

Capitalization

• Cash dividends/net income

• Tier 1 capital/average assets

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Tier 1 Capital is

adjusted equity capital

+ minority interest in consolidated subsidiaries

– other identified intangibles

– net unrealized loss in market equity securities


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Average assets used in the Tier 1 Capital ratio is average

assets less all intangibles and net unrealized loss on

market equity securities.

Problem assets = noncurrent loans + restructured loans


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Basic Guidelines

• Be aware of Rupee changes in the ratio’s numerator

and denominator.

• Ratio changes can occasionally give a misleading

performance picture.

• Let’s say a bank’s noncurrent loans to total loans ratio

shows a decline, indicating improved asset quality.

However, examining the numbers used to generate the

ratio might give you a different picture of asset quality.


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Basic Guidelines

• For example, assume the bank’s loan portfolio grew

rapidly.

• The large loan growth may disguise the fact that

noncurrent loans are rising as well, but just not as fast,

causing the ratio to fall.

• Analysis of ratio values alone would not have revealed

this problem.


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• Be aware of levels and trends.

• Levels tell you where your bank stands at a given point

in time and can be used to judge matters pertaining to

adequacy.

• For instance, the level of your bank’s leverage ratio can

be compared to capital guidelines to help determine

capital adequacy.


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• Trends tell you about direction and help you determine

where your bank’s performance is headed based on

past performance.

• It can take several years worth of information to

determine a trend.

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• Reconcile differences in the time periods reported.

• Because income statement amount occur for a period

of time, it is reasonable to expect that values on a mid-

year income statement should be less than those for a

full year.

• When comparing income statement values, you want

the time periods to be the same. To do this, annualize

data to correct time differences.


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• Reduce possible distortions in ratio calculations from

statement time reference differences by following some

of these basic guidelines:

• When all ratio components are taken from the same type of

statement such as balance sheets or income statements,

simply form the ratio and divide.

• If the ratio components come from a mix of balance sheet and

income statements, use average values for the balance sheet

components to get a more accurate ratio result.

Individual Assignment• With respect to Evaluation 8 revenue ratios (net interest income and

net income) is your bank above or below peer?

• Are expense ratios (provision for loan losses, overhead (noninterest

expenses) expenses) at your bank above or below peer?

• Where does loan quality rank?

• Are the bank’s ratios of noncurrent loans/total loans (Noncurrent loans and

leases (LN&LS) to gross LN&LS) and net loan losses/total loans (Net loss to

average total LN&LS) above or below peer?

• Where does capital stand?

• Is Tier 1 capital/average assets (Tier 1 Leverage capital) above or below

peer?

• Where do dividends rank?

• Is cash dividends/net income (Cash dividends to net income) above or

below peer? 69

Individual Assignment

• If your bank meets the following criteria:

• Your bank’s revenue ratios are above peer

• Its expense and asset quality ratios are below peer

• Its capital is above peer

• Dividend payout is at or below peer

• Then it is likely that your bank’s performance is relatively

good.

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ALTERNATIVE MODELS OF BANK

PERFORMANCE

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Key Profitability Ratios in Banking

Assets Total

Expenses Operating Total

- Revenues Operating Total

Margin OperatingBank Net =

gOutstandin SharesEquity Common

TaxesAfter IncomeNet (EPS) SharePer Earnings =

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Value of the Bank’s Stock

∑∞

= +=

0ttr) (1

)E(D P

t

0

73

Value of a Bank’s Stock

• Value of a Bank’s Stock Rises When:

• Expected Dividends Increase

• Risk of the Bank Falls

• Combination of Expected Dividend Increase and Risk Decline

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Value of Bank’s Stock if Earnings Growth is Constant

g -r

D P

1

0 =

75

3 basic flaws

Traditional bank performance analysis carries three

basic flaws

1. It ignores the wide diversity in strategies pursued by

different institutions

2. A bank’s total assets no longer serve as a meaningful

yardstick when banks engage in off-balance sheet

activities

3. The analysis provides no direct information concerning

how or which of the bank’s activities contribute to the

creation of shareholder value

76

Wide diversity in strategies

• Wide diversity in strategies pursued by different

institutions

• Most banks did similar things, which were reflected in

their balance sheet

• They accepted deposits and made loans, and many

interest rates were regulated

• The primary differentiation of performance was balance

sheet composition

• Today, banks may pursue sharply different strategies

77

Bank’s total assets

• Bank’s total assets no longer serve as a meaningful

yardstick when banks engage in off-balance sheet

activities

• Consider the situation where two banks report the

same asset size, but one also has an extensive servicing

income

• If the bank with service income makes a profit on this

activity, it will report a higher ROA, due to the higher

noninterest income due to servicing fees

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No direct information

• The analysis provides no direct information concerning

how or which of the bank’s activities contribute to the

creation of shareholder value

• It similarly ignores other performance benchmarks that

customer-focused managers must consider to identify

the best strategies going forward

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ROA weaknesses.

• Although ROA might be a biased indicator of

performance, return on equity (ROE) doesn’t suffer

from the same weaknesses.

• When considering the entire bank, stockholders’ equity

must support all activities, whether on- or off-balance

sheet.

• Thus, a comparison of net income to equity captures

the returns to owners’ contributions.

80

The appropriate peer group

• As long as banks have a similar strategic focus and

offer similar products and services, asset size and

ratios can provide meaningful comparisons.

• To identify the appropriate peer institutions,

management should consider the following:

1. What is the bank’s strategic focus?

2. What are the traditional balance sheet and off-balance

sheet characteristics of firms with this focus?

3. How do the bank’s activities affect its operating

revenue?

81

Common starting point

• A common starting point is to determine whether the

bank’s strategy is more loan-driven or deposit-driven.

A loan-driven bank’s profitability is generally a function

of net interest income (the margin) with loan volume a

major factor.

• A deposit-driven bank’s profitability is generally a

function of noninterest income with franchise value and

deposit volume a major factor.

82

Loans

• A loan driven bank finds that:

• asset size is determined by loan demand

• profitability is determined by loan economics; i.e., loan yields

versus cost of fund

• loan margin is high as well as noninterest expense

• value is typically some multiple of core earnings

83

Deposits

• A deposit driven bank typically finds that:

• asset size is determine by the growth in core deposits

• value is determined by the bank’s franchise value - measured

by the market share of low-cost core deposits

• lower interest income, interest margins and noninterest

expenses

• lower loan losses

84

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Evaluating performance using Accounting data and ratios

• A bank should compare its ratios with those from a

select sample of peer institutions that are similarly

loan-driven or deposit-driven.

• Peers should operate the same approximate number of

offices in the same metropolitan or non-metropolitan

markets and have the same product and service mix.

• Asset-based ratios are thus directly comparable.

• Analysts can easily construct peer bank averages by

direct comparison to other similar Banks

85

Ratios

• One way to construct ratios that avoid the problems of

off-balance sheet activities is to calculate ratios tied to

a bank’s total operating revenue (net interest income

plus noninterest income)

86

The efficiency ratio

• Measured as noninterest expense divided by total operating

revenue, is a popular measure used by stock analysis based on

operating revenue rather than assets.

• Analysts strongly encourage banks, regardless of size, to meet

fairly specific targets in this ratio.

• Because operating revenue includes both interest income and

noninterest (fee-based) income, it captures all activities.

• Efficiency Ratio

= noninterest expense / net operating revenue

where net operating revenue

= the sum of net interest income + noninterest income.87

Bank stock analysts follow a standard procedure when evaluating firm performance

• Initially use financial information to calculate

performance measures

• adjust the data to omit the impact of nonrecurring items,

such as one-time asset sales and restructuring charges

• compare these historical ratios with a carefully selected

group of peer institutions, matching each bank’s primary

strategic focus

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• Based on his or her own analysis and conversations

with specialists within the bank, the analyst then

assesses the quality of earnings based on:

• their sustainability

• the bank’s market power in specific product or service areas

• the bank’s franchise value

89


• The next step is to forecast earnings, cash flow, and

market value of equity over a three- to five-year time

horizon

• Finally, the analyst makes a stock recommendation:

• accumulate (buy)

• neutral (hold)

• below-market performance (sell)

• It is extremely rare, however, to see an outright sell

recommendation because analysts want to remain in

the good graces of the banks that they follow

90

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• They do not formally recommend selling the stock, but

rather label it as likely to exhibit below-market

performance.

• A hold recommendation thus actually means “sell the

stock” for most analysts.

• The recent failure of Enron is potentially an example of

the conflict of interest “buy-side” and “sell-side”

analysts have.

91


• Investors in bank stocks are primarily concerned with

whether the bank’s management is creating value for

stockholders.

• When analysts compare performance over some

historical period, they are less concerned with ROE,

ROA, and efficiency ratios – rather the overall total

return from investing in the bank’s stock.

• Total return equals dividends received plus stock price

appreciation/depreciation relative to the initial

investment.

92

Key stock market-based performance

measures include

• Return to stockholders

= (∆price + dividends) / pricet-1

• Earnings per share

• Price to earnings (P/E) = stock price / EPS

• Price to book value

= stock price / book value per share

• Market value (MV) of equity

= MV of assets - MV of liabilities or

= # share of common stock x stock price

goutstandintock s common of shares of number

stock preferred on dividends and taxes after ∆NI=

93

Example:

• Buy 100 shares of ABC Bank at the beginning of 2006

for Rs.73.06. The bank paid Rs.1.92 per share in

dividends that generated reinvestment income of

Rs.09. At the end of 2006, the price of stock was

Rs.56.20.

• Return to stockholders in 2006 was -20.3%.

-0.203 = [56.20 - 73.06 + 2.01] 73.06

94

Line of business profitability analysis

• By allocating operating expenses to activities that

support bank customers and bank management, banks

can obtain at least a rough estimate of segment net

income.

• Leads to the reporting and use of both financial and

nonfinancial performance data, based on specific

customers.

95

Line of business profitability analysis

• Many banks attempt to measure profitability by:

• type of loan customer (small business, middle market,

consumer installment, etc.)

• type of depositor; by characteristics of the relationship

(account longevity, cross-sell patterns, profitability, etc.) and

• delivery system (branch, ATM, telephone, home banking,

etc.).

96

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RAROC/RORAC analysis

• RAROC refers to risk-adjusted return on capital, while

RORAC refers to return on risk-adjusted capital

• In order to analyze profitability and risk precisely, each

line of business must have its own balance sheet and

income statement.

97

RAROC/RORAC analysis

• These statements are difficult to construct because many

nontraditional activities, such as trust and mortgage-servicing,

do not explicitly require any direct equity support.

• Even traditional activities, such as commercial lending and

consumer banking, complicate the issue because these

business units do not have equal amounts of assets and

liabilities generated by customers.

• The critical issue is to determine how much equity capital to

assign each unit.

98

Assigning equity capital to each unit

• Alternative capital allocation methods include:

• using regulatory risk-based capital standards

• assignment based on the size of assets

• benchmarking each unit to “pure-play” peers that are stand-

alone, publicly held firms; and

• measures of each line of business’s riskiness.

99

RAROC/RORAC

• Risk adjust return on capital (RAROC)

• RAROC = Risk-adjusted income / Allocated capital

• Using this method, income is adjust for risk.

• Typically, income is adjusted for expected losses.

• Return on risk adjusted capital (RORAC)

• RORAC = Net income / Allocated risk capital

• Using this method, capital is adjusted for risk.

• Typically, capital is adjusted for a maximum potential loss based on

the probability of future returns or volatility of earnings.

100

Example:

• Banking Businesses

1. Regional Community Banking

2. Corporate Banking

3. Real Estate Finance

4. Business Credit

• Asset Management and Processing

5. Advisory

• The data is obtained from Bank’s management accounting

system based on internal assumptions about revenue and

expense allocations and assignment of equity to each line of

business.

101

PNC’s profitability analysis for 2000-2001

102

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Two lines of business

1. Corporate Banking

…represents products and services provided nationally in the

areas of credit, equipment leasing, treasury management, and

capital markets products to large and mid-sized corporations and

government entities.

2. Community Banking

…encompasses the bank’s traditional deposit, branch-based

brokerage, electronic banking and credit products to retail

customers along with products to small businesses such that it is

primarily a deposit-generating unit.

103

PN

C’s

Pro

fita

bili

ty A

na

lysi

s fo

r 2

00

0-2

00

1 (

con

t.)

104

Transfer pricing

• The interest rate at which a firm could buy or sell funds

in the external capital markets

• When management creates balance sheets for each line

of business, it must allocate capital as well as assets or

liabilities to make the balance sheet balance.

• It must then assign a cost or yield to each of these

components to produce income statement for each line

of business.

105

Transfer pricing systems• Banks use internal funds transfer pricing systems to

assign asset yields and cost of funds to different lines of

business and products.

• Most systems use a matched maturity framework that

assigns rates by identifying the effective maturity of the

underlying assets or liabilities and assigning a rate

obtained from a money or capital market instrument of

the same maturity.

106

Risk-adjusted income and economic income

• Two adjustments are frequently made to income in

line of business profitability analysis:

1. The return is adjusted for risk by subtracting expected

losses

2. The return nets out required returns expected by

stockholders.

• This minimum required return, or cost of equity,

represents a hurdle rate, or stockholders’ minimum

required rate of return.

• The specific concern is whether RAROC is greater

than the firm’s cost of equity.

107

Allocated risk capital

• The objective of RAROC analysis is to assist in risk management

and the evaluation of line of business performance. As part of

this, it is necessary to assign capital to each line of business

• Banks allocate risk capital by:

1. Regulatory risk-based capital standards

2. Asset size

3. Benchmarking versus “pure-play” stand-alone businesses

4. Perceived riskiness of the business unit

Unfortunately, most lines of business do not have market value

balance sheets. Hence, many banks focus on the volatility in

economic earnings (earnings-at-risk) or estimate a value-at-risk

figure.

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Earnings-at-risk

• The volatility of earnings from a line of business

• Securities underwriting and letters of credit

(guarantees) against customer exposures at a large

bank do not require much capital to support day-to-day

operations.

• But before a bank can actively engage in this business, it

must have a strong credit and bond rating, which

requires a substantial amount of risk capital.

• One way to measure the required risk capital is to relate

it to the volatility of earnings from this line of business;

i.e., earnings-at-risk.

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Earnings-at-risk applied to loans1. Using historical data for each of the past 30 months,

estimate revenues obtained directly from these loans.

2. Using historical data for each of the past 30 months,

estimate direct expenses from offering these services and

expected losses.

3. Using the 60 observations for revenues minus expenses

and losses, estimate one standard deviation of earnings.

This is earnings-at-risk.

4. Estimate risk capital as one (or two) standard deviation of

earnings, divided by the risk-free interest rate.

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Management of market risk

• Market risk is the risk of loss to earnings and capital

related to changes in the market values of bank assets,

liabilities, and off-balance sheet positions

• RBI imposed capital requirements against the market

risk associated with large banks’ trading positions.

• The requirements apply to any bank or bank holding

company that has a trading account in excess of Rs.100

crores or accounts for 10 percent or more of bank assets.

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Management of market risk

• Typically, market risk arises from taking positions and

dealing in foreign exchange, equity, interest rate, and

commodity markets, and the items affected are the

securities trading account, derivatives positions, and

foreign exchange positions.

• The new capital requirements address market risk

associated with a bank’s trading activities.

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ROE, ROA, and EPS

• Some analysts criticize traditional earnings measures

such as ROE, ROA, and EPS because they provide no

information about how a bank’s management is adding

to shareholder value.

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ROE, ROA, and EPS

• If the objective of the firm is to maximize stockholders’

wealth, such measures do not indicate whether

stockholder wealth has increased over time, let alone

whether it has been maximized.

• Stern, Stewart & Company has introduced the concepts

of market value added (MVA) and its associated

economic value added (EVA) in an attempt to directly

link performance to shareholder wealth creation.

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Economic value added (EVA)

• An approach to measuring performance that compares

a bank’s (or line of business) net operating profit after-

tax (NOPAT) with a capital charge

• Economic Value Added (EVA) is the capital charge

which represents the required return to stockholders

assuming a specific allocated risk capital amount.

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Market and economic value added

• MVA represents the increment to market value and is

determined by the present value of current and expected

economic profit:

MVA = Mkt Value of Capital - Hist. Amt of Invested Capital

• Stern Stewart and Company measures economic profit with

EVA, which is equal to a firm's operating profit minus the

charge for the cost of capital:

EVA = Net Operating Profit After Tax (NOPAT) - Capital

Charge

where the capital charge equals the product of the firm’s value

of capital and the associated cost of capital

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Difficulties in measuring EVA for the entire bank

• It is often difficult to obtain an accurate measure of a firm's

cost of capital.

• The amount of bank capital includes not just stockholders'

equity, but also includes loan loss reserves, deferred (net)

tax credits, non-recurring items such as restructuring

charges and unamortized securities gains.

• NOPAT should reflect operating profit associated with the

current economics of the firm. Thus, traditional accounting

data, which distort true profits, must be modified to obtain

estimates of economic profit.

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A. Balance Sheet Assets $Millions Rate Liabilities & Equity $Millions Rate Cash $150 0 Demand deposits $800 Securities $800 6.5% MMDAs $1800 3% Commercial loans $2000 9.0% CDs $1300 5.5% Credit card loans $1900 10.0% Small time deposits $680 4.5% -Loss reserve -$100 Deferred tax credits $100 Other assets -$250 Equity - $320 Total assets $5,000 Liabilities + equity $5,000 Risk-weighted assets: .50($800) + 1($2,000) + 1($1,900) + 1($250) = $4,550 Tier 1 capital = $320 Tier I ratio: $320/$4,550 = 7.03% Total capital = $420 Total capital ratio: $420/$4,550 = 9.23% B. Income Statement Interest income: .065($800) + .090($2,000) + .10($1,900) = $422 Interest expense: .03($1,800) + .055($1,300) + .045($680) = -$156.1 Net interest income $265.9 Provision for loan losses -$25 Noninterest income $60 Noninterest expense -$190 Pre tax Income $110.90 Taxes @ 40% $44.36 Net income $66.54 C. Profit Measures ROE = (66.54 / 320 ) = 20.8% ROA = (66.54 / 5,000) = 1.33% Assuming that net charge-offs $22, cash taxes pai, = $39, and allocated risk capital $550 with a capital charge of 12%: NOPAT = $110.90 + $25 - $22 - $39 = $74.9 EVA = $74.9 - 0.12($550) = $8.9 E

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A. Change In Balance Sheet items Assets ∆∆∆∆ Amount Liablilties ∆∆∆∆ Amount Credit card loans -$1,000 CDs -$940 Loan loss reserve +$30 Equity -$30 Total assets -$970 Total -$970

B. Income Statement Change Interest income: .065($800) + .09($2,000) + .10($900) $322 -$100 Interest expense: .03($1,800) + .055($460) + .045($680) -$109.9 -$46.2 Net interest income: $212.1 -$53.8 Provision for loan losses: +$5 +$30.0 Noninterest income: $72 +$12 Noninterest expense: -$195 -$5 Pre tax income: $94.1 -$16.8 Taxes @ 40%: $37.64 -6.72 Net income: $56.46 -10.08 C. Profit Measures: Actual net charge-oft $14, cash taxes paid = $31,

and risk capital falls to $500. ROE = $56.46/$290 = 19.47% ROA = $56.46/$4,030 = 1.40% EVA = [$94.1 - $5 - $14 - $31] - $60 = -$15.9 Risk-weighted assets: .50($800) + 1($2,000) + 1($900) + 1($250) = $3,550 Tier 1 capital = $290 Tier I ratio: $290/$3,550 = 8.17% Tier 2 capital = $420 Total capital ratio: $420/$3,550 = 11.83% E

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Balanced scorecard

• Performance measures that look beyond just financial

measures

• An attempt to balance management decisions based

on financial measures with decisions based on a

firm’s relationships with its customers and the

effectiveness of support processes in designing and

delivering products and services

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Balanced scorecard

• The result is that line of business managers use

indicators such as:

• market share,

• customer retention and attrition,

• customer profitability, and

• service quality to evaluate performance

• Internally, they also track productivity and employee

satisfaction

Such nonfinancial indicators provide information regarding

whether a bank is truly customer-focused and whether its

systems are appropriate

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Balanced scorecard

Balanced scorecard framework with four blocks

1. Financial Performance:

• How Do Stockholders View Our Risk and Return Profile?

2. Customer Performance:

• How Do Customers See Us?

3. Internal Process Management:

• At What Must We Excel?

4. Innovation and Learning:

• How Can We Continue to Improve and Create Value?

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Financial Measures Customer Measures Internal Measures Learning Measures

Customer profitability Life cycle segment market share Channel usage Skill competency

Lifestyle segment profitability Customer satisfaction Product usage Sales productivity

Product profitability Customer retention Percentage of revenue from new products

Employer satisfaction

Delivery channel cost Market share Percentage of revenue from product promotions

Employee retention

Return on investment Customer acquisition Product development cycle Employee satisfaction

Revenue growth Customer profitability Hours with customer Employee productivity

Deposit service cost change Share of segment New product revenue Strategic job coverage ratio

Revenue mix Depth of relationship Cross-sale ration Strategic information availability ratio

Sales growth and target markets Brand name rating Channel mix change Personal goals alignment

Dollars past due divided by total dollar loans

Number of customer complaints Service error rate Revenue per employee

Fee revenue divided by total revenue Closed accounts by reason Request fulfillment time Sales force average length of service

Net income Share of wallet Loss ratio Turnover

Return on risk-adjusted equity Percent of target accounts Underwriting quality audit Training hours divided by FTE

Net income after capital charge Overhead ratio Number of training programs offered

Cost of capital Ratio of branch to on-call transactions—ATM transactions

Turnover ratio

Efficiency Sales per sales call Turbulence

Economic value added Sales per referral

Assets per employee New sales divided by banker

Productivity

Efficiency ratio

New product revenue as percent of total

Scorecard measures

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ANY QUESTIONS???

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THANK YOU

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ComBank 090728 Handout

Documents

Transcript of ComBank 090728 Handout