20 Bank Performance

Financial Markets and Institutions
13th Edition
by Jeff Madura
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20 Bank Performance
Chapter Objectives
• Identify the factors that affect the valuation of a

commercial bank.
• Compare the performance of banks in different
size classifications over recent years.
• Explain how to evaluate the performance of a
particular bank based on financial statement data.
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2
Valuation of a Commercial Bank (1 of 4)
A commercial bank’s value is the present value of its future

cash flows
n
e(CFt )
V =å
t =1 (1 + k )t
DV = f ( DE (CF ), Dk )
where E(CFt) represents the expected cash flow to be

generated in period t, and k represents the required rate of
return.
3 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
Factors That Affect Cash Flows

• Change in Economic Growth
• Can enhance a commercial bank’s cash flows by increasing
the household or business demand for loans.
• Change in the Risk-Free Interest Rate
• If the risk-free interest rate decreases, other market rates
may also decline, which may result in a stronger demand
for the commercial bank’s loans.
• Commercial banks rely heavily on short-term deposits as a
source of funds, and the rates paid on these deposits are
typically revised in accordance with other interest rate
movements.
Factors That Affect Cash Flows (Continued)

• Change in Industry Conditions
• One of the most important industry characteristics that can
affect a commercial bank’s cash flows is regulation.
• Another important industry characteristic that can affect a
bank’s cash flows is technological innovation, which can
improve efficiencies and thereby enhance cash flows.
• Management Abilities
• The only one of the four characteristics over which the bank
has control.
• The bank can select its managers and its organizational
structure.
Factors That Affect the Required Rate of Return by

Investors
• Change in the Risk-Free Rate
• When the risk-free rate increases, so does the return
required by investors.
• Change in the Risk Premium
• If the risk premium on a commercial bank rises, so will the
required rate of return by investors who invest in the bank.
(Exhibit 20.1)
• Impact of the Credit Crisis on Bank Valuations
• Bank valuations overall were affected during the credit
crisis.
Exhibit 20.1 Framework for Valuing a
Commercial Bank
• A stronger economy leads to an increased demand for loans (interest income) and other
services provided by the commercial bank (noninterest income), fewer loan defaults, and better
cash flows.
• A lower risk-free rate enhances the valuation of bank assets that do not have an adjustable
interest rate, such as some Consumer and mortgage loans. It also increases the valuations of
bonds. Commercial banks that have a higher proportion of these types of assets will benefit
more from a decline in the risk-free rate; conversely, they will be adversely affected to a greater
degree by an increase in the risk-free rate.
• The valuation is also influenced by industry conditions and the commercial bank’s management
(not shown in the diagram). These factors affect the risk premium (and therefore investors’
required return) and the expected cash flows to be generated by the commercial bank.
Assessing Bank Performance (1 of 4)
Interest Income and Expenses

• Gross interest income is interest income generated from
all assets. Gross interest income tends to increase when
interest rates rise and to decrease when interest rates
decline. (Exhibit 20.2)
• Gross interest expenses represent interest paid on
deposits and on other borrowed funds. Gross interest
expenses will normally be higher when market interest
rates are higher.
• Net interest income is the difference between gross
interest income and interest expenses and is measured
as a percentage of assets (See Exhibit 20.3).
Exhibit 20.2 Example of Performance
Summary of Canyon Bank 2012
ITEM 2019
1. Gross interest income 5.3%
2. Gross interest expenses 2.3
3. Net interest income 3.0
4. Noninterest income 2.0
5. Loan loss provision 0.6
6. Noninterest expenses 3.0
7. Securities gains (losses) 0.0
8. Income before tax 1.4
9. Taxes 0.4
10. Net income 1.0
11. Cash dividends provided 0.3
12. Retained earnings 0.7
Note: All items in the exhibit are estimated as a proportion of total assets.
Noninterest Income and Expenses

• Noninterest income results from fees charged on
services provided, such as lockbox services, banker’s
acceptances, cashier’s checks, and foreign exchange
transactions.(Row 4 of Exhibit 20.2)
• The loan loss provision is a reserve account established
by the bank in anticipation of loan losses in the future.
(Row 5 of Exhibit 20.2)
• Noninterest expenses include salaries, office equipment,
and other expenses not related to the payment of interest
on deposits. (Row 6 of Exhibit 20.2)
Noninterest Income and Expenses (continued)

• Securities gains and losses result from the bank’s sale of
securities. (Row 7 of Exhibit 20.2)
• Income before tax is net interest income, noninterest
income, and securities gains less the provision for loan
losses and noninterest expenses. (Row 8 of Exhibit 20.2)
• The key income statement item is net income, which
accounts for any taxes paid. (Row 10 of Exhibit 20.2)
Reliance on the Bank’s Financial Information

• Analysts and investors alike rely heavily on the bank’s
financial statements to evaluate a bank’s performance.
• The subjectivity in accounting causes a lack of
transparency and can create much uncertainty when
assessing banks. During weak economic periods,
investors may not know whether they can trust that
banks have fully acknowledged the reduced valuations of
their assets. Thus investors may avoid investing in bank
stocks during such periods, which creates even more
fear about banks, whether justified or not.
Evaluation of a Bank’s ROA (1 of 2)
Return on Assets — The ROA is influenced by all income

statement items and the policies that affect those items.
(Exhibit 20.3)
Reasons for a Low ROA (Exhibit 20.4)
• Incurring excessive interest expenses
• Low interest received on loans and securities
• Insufficient non-interest income
• Heavy loan losses
• Excessive non-interest expenses
Exhibit 20.3 Influence of Bank Policies and Other
Factors on a Bank’s Income Statement (1 of 2)
INCOME STATEMENT BANK POLICY DECISIONS UNCONT ROLLABLE

ITEM AS A AFFECTING THE INCOME FACTORS AFFECTING
PERCENTAGE OF STATEMENT ITEM THE INCOME STATEMENT
ASSETS ITEM
(1) Gross interest income • Composition of assets • Economic conditions
• Quality of assets • Market interest rate
• Maturity and rate sensitivity movements
of assets
• Loan pricing policy
(2) Gross interest • Composition of liabilities • Market interest rate
expenses • Maturities and rate movements
sensitivity of liabilities
(3) Net interest
income5(1)−(2)
(4) Noninterest income • Service charges • Regulatory provisions
• Nontraditional activities
Exhibit 20.3 Influence of Bank Policies and Other
Factors on a Bank’s Income Statement (2 of 2)
INCOME STATEMENT ITEM AS A BANK POLICY DECISIONS UNCONTROLLABLE

PERCENTAGE OF ASSETS AFFECTING THE INCOME FACTORS AFFECTING THE
STATEMENT ITEM INCOME STATEMENT ITEM
(5) Noninterest expenses • Composition of assets • Inflation
• Composition of liabilities
• Nontraditional activities
• Efficiency of personnel
• Costs of office space and equipment
• Marketing costs
• Other costs
(6) Loan losses • Composition of assets • Economic conditions
• Quality of assets • Market interest rate
• Collection department capabilities movements
(7) Pretax return on assets5(3)+(4) −
(5)−(6)
(8) Taxes • Tax planning • Tax laws
(9) After-tax return on assets =(7) −(8)
(10) Financial leverage, measured • Capital structure policies • Capital structure regulations
here as (assets/equity)
(11) Return on equity=(9)×(10)
Exhibit 20.4 Breakdown of Performance
Measures
MEASURES OF FINANCIAL BANK DECISIONS
BANK CHARACTERISTICS AFFECTING
PERFORMANCE INFLUENCING FINANCIAL
PERFORMANCE CHARACTERISTICS
(1) Return on assets Net interest margin Deposit rate decisions
(ROA) Noninterest revenues Loan rate decisions
Noninterest expenses Loan losses
Loan losses Bank services offered
Overhead requirements
Efficiency
Advertising
Risk level of loans
provided
(2) Return on equity ROA Leverage measure Same as for ROA
(ROE) Capital structure decision
Evaluation of a Bank’s ROA (2 of 2)
Converting ROA to ROE (Exhibit 20.5)

• Return on Equity
• ROE (Return on Equity) is affected by the same income
statement items that affect ROA and by the bank’s degree
of financial leverage.
• The leverage measure is the inverse of the capital ratio
(when only equity counts as capital).
ROE = ROA ´ Leverage Measure

Net Income Net Income Total Assets
= ´
Equity Capital Total Assets Equity Capital
Exhibit 20.5 Average ROE among
Banks Over Time
How to Evaluate a Bank’s Performance
Application:
Example of Zager Bank (Exhibit 20.6)
• Zager bank is a medium-size bank.
• Aggressive management style can be viewed as risky due
to limited collateral and cash flow situation.
• The bank charges high interest rates on loans because the
borrowers do not have alternative lenders.
• Strategy was successful during strong economic conditions.
• When economy weakened in 2008, borrowers had trouble
repaying their loans.
Exhibit 20.6 Comparison of Zager Bank’s
Expenses and Income to the Industry
SUMMARY (1 of 3)
• A bank’s value depends on its expected future cash flows

and the required rate of return by investors who invest in
the bank. The bank’s expected cash flows are influenced
by economic growth, interest rate movements, regulatory
constraints, and the abilities of the bank’s managers. The
required rate of return by investors who invest in the
bank is influenced by the prevailing interest rate (which is
affected by other economic conditions) and the risk
premium (which is affected by economic growth,
regulatory constraints, and the management abilities of
the bank). In general, the value of commercial banks is
favorably affected by strong economic growth, declining
interest rates, and strong management abilities.
SUMMARY (2 of 3)
• A bank’s performance can be evaluated by comparing its income

statement items (as a percentage of total assets) to a control group
of other banks with a similar size classification. The performance of
the bank may be compared to the performance of a control group of
banks. Any difference in performance between the bank and the
control group is typically because of differences in net interest
margin, loan loss reserves, noninterest income, or noninterest
expenses. If the bank’s net interest margin is relatively low, it either
is relying too heavily on deposits with higher interest rates or is not
earning adequate interest on its loans. If the bank is forced to boost
loan loss reserves, this suggests that its loan portfolio may be too
risky. If its noninterest income is relatively low, the bank is not
providing enough services that generate fee income. If the bank’s
noninterest expenses are relatively high, its cost of operations is
excessive. There may be other specific details that make the
assessment more complex, but the key problems of a bank can
usually be detected with the approach described here.
SUMMARY (3 of 3)
• A common measure of a bank’s overall performance is

its return on assets (ROA). The ROA of a bank is partially
determined by movements in market interest rates, as
many banks benefit from lower interest rates. In addition,
the ROA is highly dependent on economic conditions,
because banks can extend more loans to creditworthy
customers and may also experience a higher demand for
their services.
• Another useful measure of a bank’s overall performance
is return on equity (ROE). A bank can increase its ROE
by increasing its financial leverage, but its leverage is
constrained by capital requirements.

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20 Bank Performance

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Financial Markets and Institutions

• Identify the factors that affect the valuation of a

A commercial bank’s value is the present value of its future

where E(CFt) represents the expected cash flow to be

Factors That Affect Cash Flows

Factors That Affect Cash Flows (Continued)

Factors That Affect the Required Rate of Return by

Interest Income and Expenses

Noninterest Income and Expenses

Noninterest Income and Expenses (continued)

Reliance on the Bank’s Financial Information

Return on Assets — The ROA is influenced by all income

INCOME STATEMENT BANK POLICY DECISIONS UNCONT ROLLABLE

INCOME STATEMENT ITEM AS A BANK POLICY DECISIONS UNCONTROLLABLE

(9) After-tax return on assets =(7) −(8)

Converting ROA to ROE (Exhibit 20.5)

ROE = ROA ´ Leverage Measure

• A bank’s value depends on its expected future cash flows

• A bank’s performance can be evaluated by comparing its income

• A common measure of a bank’s overall performance is

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