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
Evaluating performance using GAAP-based data and UBPR 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 bank’s UBPR’s or by using the FDIC’s Statistics on Depository Institutions (SDI) system at: http://www3.fdic.gov/sdi/
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) - - (David Cates (1996))
Fundamentally this means calculate performance measures using total operating revenue as the denominator rather than assets.
Here, total operating revenue equals the sum of net interest income and noninterest income.
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.
= noninterest expense / net operating revenue
where net operating revenue
= the sum of net interest income + noninterest income.
Bank stock analysts follow a standard procedure when evaluating firm performance
Initially use GAAP-based 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
Based on his or her own analysis and conversations with specialists within the bank, the analyst then assesses the quality of earnings based on:
the bank’s market power in specific product or service areas
the bank’s franchise value
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:
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
Thus, 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.
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.
Price to book value = stock price / book value per share
Market value (MV) of equit y = MV of assets - MV of liabilities or = # share of common stock x stock price
Key stock market-based performance measures include
Example: buy 100 shares of PNC Financial at the beginning of 2001 for $73.06. The bank paid $1.92 per share in dividends that generated reinvestment income of $.09. At the end of 2001, the price of stock was $56.20.
Return to stockholders in 2001 was -20.3%.
0.203 = [$56.20 - $73.06 + $2.01] ÷ $73.06
Balanced scorecard …performance measures that look beyond just financial measures
The balanced scorecard is 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
The result is that line of business managers use indicators such as:
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
Operationalize the balanced scorecard …divide the bank into a Customer Bank and a House Bank
Income derived from balance sheet and income statement items that are derived from bank customers determines The Customer Bank
Items that arise when the bank is its own customer determines The House Bank
most loans, core deposits, payment services, credit enhancements, asset management, and financial advisory.
Investment or House Bank, activities include:
the investment portfolio, noncore, purchased liabilities, loan participations, asset sales, servicing, and bank-sponsored mutual funds.
Items are assigned based on whether the underlying activities pertain to bank customers (Customer Bank) or the bank itself (Investment Bank).
Evaluate the returns on each Bank relative to the risks and relevant benchmarks.
Line of business profitability analysis … By allocate 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.
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, tele-phone, home banking, etc.).
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.
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.
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.
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.
PNC’s Profitability Analysis for 2000-2001 (cont.)
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.
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.
Example : I nternal funds transfer pricing 2-year loan financed by a 3-month deposit
Two adjustments are frequently made to income in line of business profitability analysis:
The return is adjusted for risk by subtracting expected losses
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.
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:
Regulatory risk-based capital standards
Benchmarking versus “pure-play” stand-alone businesses
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.
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.
Assuming a hurdle rate of 12% annually, economic income net of the capital charge:
$6.4 - (.12/12) $160.364 = $4.796 million
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.
In January 1998, bank regulators imposed capital requirements against the market risk associated with large banks’ trading positions.
The requirements apply to any U.S. bank or bank holding company that has a trading account in excess of $1 billion or accounts for 10 percent or more of bank assets.
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.
Value-at-risk estimate for foreign exchange Identify the maximum expected loss given the bank’s recent history of daily returns on the trading portfolio. Empirical distribution approach to value-at-risk involves: 1. Identify the lowest 1 % of daily price moves. 2. Assuming that the value of the 1% lowest price move is 7.54 percent, 99 percent of the daily returns exceed this figure.
Value-at-risk estimates for market risk associated with the trading portfolios at Credit Suisse First Boston (CSFB) in 1999 and 2000.
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.
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.
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.
MVA represents the increment to market value and is determined by the present value of current and expected economic profit:
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:
where the capital charge equals the product of the firm’s value of capital and the associated cost of capital.
MVA = Mkt Value of Capital - Hist. Amt of Invested Capital EVA = Net Operating Profit After Tax (NOPAT) - Capital Charge
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 GAAP-based accounting data, which distort true profits, must be modified to obtain estimates of economic profit.