FINC 4320 Alternative Models for Evaluating Bank Performance Fall 2007
The Need for Alternative Models <ul><li>Traditional bank performance analysis carries three basic flaws </li></ul><ul><li>...
Can ROE be “rescued”? <ul><li>Although ROA might be a biased indicator of performance, return on equity (ROE) doesn’t suff...
The Key to UBPR Use <ul><li>As long as banks have a similar strategic focus and offer similar products and services, asset...
What kind of bank? <ul><li>A common starting point is to determine whether the bank’s strategy is more loan-driven or depo...
Operating Income Measures <ul><li>One way to construct ratios that avoid the problems of off-balance sheet activities is t...
Operating Income Measures <ul><li>The  efficiency ratio , measured as noninterest expense divided by total operating reven...
How does “the market” assess performance? <ul><li>Bank stock analysts follow a standard procedure when evaluating firm per...
Total Return Measures <ul><li>Investors in bank stocks are primarily concerned with whether the bank’s management is creat...
<ul><li>Return to stockholders  = (  price + dividends) / price t-1 </li></ul><ul><li>Earnings per share </li></ul><ul><l...
Line of Business Profitability Analysis <ul><li>By allocating operating expenses to activities that support bank customers...
Line of Business Profitability Analysis <ul><li>There are several key ideas to be careful about when using this type analy...
Using RAROC/RORAC Measures <ul><li>RAROC refers to risk-adjusted return on capital, while RORAC refers to return on risk-a...
Using RAROC/RORAC Measures <ul><li>In order to analyze profitability and risk precisely, each line of business must have i...
Funds Transfer Pricing <ul><li>When management creates balance sheets for each line of business, it must allocate capital ...
Funds Transfer Pricing <ul><li>Example :   2-year loan financed by a 3-month deposit </li></ul>
Risk-adjusted income and economic income <ul><li>Two adjustments are frequently made to income in line of business profita...
Allocated Capital <ul><li>The objective of RAROC analysis is to assist in risk management and the evaluation of line of bu...
Bank Performance and EVA <ul><li>Some analysts criticize traditional earnings measures such as ROE, ROA, and EPS because t...
Bank Performance and EVA <ul><li>Stern Stewart and Company measures economic profit with EVA, which is equal to a firm's o...
The Balanced Scorecard <ul><li>The balanced scorecard is an attempt to balance management decisions based on financial mea...
The Balanced Scorecard <ul><li>Think of the bank as being two banks in one house: </li></ul><ul><ul><li>Traditional or Cus...
Using the Balanced Scorecard <ul><li>Financial Performance:  </li></ul><ul><ul><li>How Do Stockholders View Our Risk and R...
Using the Balanced Scorecard: Scorecard measures
Upcoming SlideShare
Loading in …5
×

Alternative Models of Performance Measurement

1,370 views

Published on

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
1,370
On SlideShare
0
From Embeds
0
Number of Embeds
2
Actions
Shares
0
Downloads
34
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide
  • When UBPRs were introduced, 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 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 mortgage-servicing operation that generates servicing income If the bank with mortgage-servicing makes a profit on this activity, it will report a higher ROA, ceteris paribus, due to the higher noninterest income for mortgage-servicing fees It similarly ignores other performance benchmarks that customer-focused managers must consider to identify the best strategies going forward
  • A loan driven bank typically 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 the culture is typically “our bank underwrites loans better than other banks” value is typically some multiple of core earnings 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
  • Using GAAP-based 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 Qualitative adjustments to earnings: their sustainability the bank’s market power in specific product or service areas the bank’s franchise value
  • NOTE: We will cover customer focused measures like the BALANCED SCORECARD at the end of this set of notes!
  • 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. DISCUSS THE PNC EXAMPLE FROM THE TEXT.
  • 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.
  • 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.
  • 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.
  • It is often difficult to obtain an accurate measure of a firm&apos;s cost of capital. The amount of bank capital includes not just stockholders&apos; 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.
  • Customer Bank: most loans, core deposits, payment services, credit enhancements, asset management, and financial advisory. House Bank:the investment portfolio, noncore, purchased liabilities, loan participations, asset sales, servicing, and bank-sponsored mutual funds.
  • Alternative Models of Performance Measurement

    1. 1. FINC 4320 Alternative Models for Evaluating Bank Performance Fall 2007
    2. 2. The Need for Alternative Models <ul><li>Traditional bank performance analysis carries three basic flaws </li></ul><ul><li>It ignores the wide diversity in strategies pursued by different institutions </li></ul><ul><li>A bank’s total assets no longer serve as a meaningful yardstick when banks engage in off-balance sheet activities </li></ul><ul><li>The analysis provides no direct information concerning how or which of the bank’s activities contribute to the creation of shareholder value </li></ul>
    3. 3. Can ROE be “rescued”? <ul><li>Although ROA might be a biased indicator of performance, return on equity (ROE) doesn’t suffer from the same weaknesses. </li></ul><ul><ul><li>When considering the entire bank, stockholders’ equity must support all activities, whether on- or off-balance sheet. </li></ul></ul><ul><ul><li>Thus, a comparison of net income to equity captures the returns to owners’ contributions. </li></ul></ul>
    4. 4. The Key to UBPR Use <ul><li>As long as banks have a similar strategic focus and offer similar products and services, asset size and UBPR ratios can provide meaningful comparisons. </li></ul><ul><li>To identify the appropriate peer institutions, management should consider the following: </li></ul><ul><ul><li>What is the bank’s strategic focus? </li></ul></ul><ul><ul><li>What are the traditional balance sheet and off-balance sheet characteristics of firms with this focus? </li></ul></ul><ul><ul><li>How do the bank’s activities affect its operating revenue? </li></ul></ul>
    5. 5. What kind of bank? <ul><li>A common starting point is to determine whether the bank’s strategy is more loan-driven or deposit-driven. </li></ul><ul><ul><li>A loan-driven bank’s profitability is generally a function of net interest income (the margin) with loan volume a major factor. </li></ul></ul><ul><ul><li>A deposit-driven bank’s profitability is generally a function of noninterest income with franchise value and deposit volume a major factor. </li></ul></ul>
    6. 6. Operating Income Measures <ul><li>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)) </li></ul><ul><li>Fundamentally this means calculate performance measures using total operating revenue as the denominator rather than assets. </li></ul>
    7. 7. Operating Income Measures <ul><li>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. </li></ul><ul><ul><li>Analysts strongly encourage banks, regardless of size, to meet fairly specific targets in this ratio. </li></ul></ul><ul><ul><li>Because operating revenue includes both interest income and noninterest (fee-based) income, it captures all activities. </li></ul></ul>
    8. 8. How does “the market” assess performance? <ul><li>Bank stock analysts follow a standard procedure when evaluating firm performance </li></ul><ul><ul><li>Initially use GAAP-based financial information to calculate performance measures </li></ul></ul><ul><ul><li>Based on his or her own analysis and conversations with specialists within the bank, the analyst then assesses the quality of earnings based on: </li></ul></ul><ul><ul><li>The next step is to forecast earnings, cash flow, and market value of equity over a three- to five-year time horizon </li></ul></ul><ul><ul><li>Finally, the analyst makes a stock recommendation: </li></ul></ul>
    9. 9. Total Return Measures <ul><li>Investors in bank stocks are primarily concerned with whether the bank’s management is creating value for stockholders </li></ul><ul><ul><li>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 . </li></ul></ul><ul><ul><li>Total return equals dividends received plus stock price appreciation/depreciation relative to the initial investment. </li></ul></ul>
    10. 10. <ul><li>Return to stockholders = (  price + dividends) / price t-1 </li></ul><ul><li>Earnings per share </li></ul><ul><li>Price to earnings (P/E) = stock price / EPS </li></ul><ul><li>Price to book value = stock price / book value per share </li></ul><ul><li>Market value (MV) of equit y = MV of assets - MV of liabilities or = # share of common stock x stock price </li></ul>Total Returns and other Market Measures
    11. 11. Line of Business Profitability Analysis <ul><li>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. </li></ul><ul><li>Leads to the reporting and use of both financial and nonfinancial performance data, based on specific customers. </li></ul><ul><li>Many banks attempt to measure profitability by: </li></ul><ul><ul><li>type of loan customer (small business, middle market, consumer installment, etc.) </li></ul></ul><ul><ul><li>type of depositor; by characteristics of the relationship (account longevity, cross-sell patterns, profitability, etc.) and </li></ul></ul><ul><ul><li>delivery system (branch, ATM, tele-phone, home banking, etc.). </li></ul></ul>
    12. 12. Line of Business Profitability Analysis <ul><li>There are several key ideas to be careful about when using this type analysis </li></ul><ul><ul><li>RAROC/RORAC </li></ul></ul><ul><ul><li>Transfer Pricing </li></ul></ul><ul><ul><li>Risk-adjusted Income </li></ul></ul><ul><ul><li>Allocated Risk Capital </li></ul></ul>
    13. 13. Using RAROC/RORAC Measures <ul><li>RAROC refers to risk-adjusted return on capital, while RORAC refers to return on risk-adjusted capital. </li></ul><ul><ul><li>RAROC = Risk-adjusted income / Allocated capital </li></ul></ul><ul><ul><ul><li>Using this method, income is adjust for risk. </li></ul></ul></ul><ul><ul><ul><li>Typically, income is adjusted for expected losses. </li></ul></ul></ul><ul><ul><li>RORAC = Net income / Allocated risk capital </li></ul></ul><ul><ul><ul><li>Using this method, capital is adjusted for risk. </li></ul></ul></ul><ul><ul><ul><li>Typically, capital is adjusted for a maximum potential loss based on the probability of future returns or volatility of earnings. </li></ul></ul></ul>
    14. 14. Using RAROC/RORAC Measures <ul><li>In order to analyze profitability and risk precisely, each line of business must have its own balance sheet and income statement. </li></ul><ul><ul><li>The critical issue is to determine how much equity capital to assign each unit. Alternative capital allocation methods include: </li></ul></ul><ul><ul><ul><li>using regulatory risk-based capital standards </li></ul></ul></ul><ul><ul><ul><li>assignment based on the size of assets </li></ul></ul></ul><ul><ul><ul><li>benchmarking each unit to “pure-play” peers that are stand-alone, publicly held firms; and </li></ul></ul></ul><ul><ul><ul><li>measures of each line of business’s riskiness. </li></ul></ul></ul><ul><li>The results provide useful information in helping management decide where to allocate resources. </li></ul>
    15. 15. Funds Transfer Pricing <ul><li>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. </li></ul><ul><li>It must then assign a cost or yield to each of these components to produce income statement for each line of business. </li></ul><ul><li>The transfer price is the interest rate at which a firm could buy or sell funds in the external capital markets. </li></ul>
    16. 16. Funds Transfer Pricing <ul><li>Example : 2-year loan financed by a 3-month deposit </li></ul>
    17. 17. Risk-adjusted income and economic income <ul><li>Two adjustments are frequently made to income in line of business profitability analysis: </li></ul><ul><ul><li>The return is adjusted for risk by subtracting expected losses </li></ul></ul><ul><ul><li>The return nets out required returns expected by stockholders. </li></ul></ul><ul><li>This minimum required return, or cost of equity, represents a hurdle rate, or stockholders’ minimum required rate of return. </li></ul><ul><li>The specific concern is whether RAROC is greater than the firm’s cost of equity. </li></ul>
    18. 18. Allocated Capital <ul><li>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. </li></ul><ul><li>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. </li></ul>
    19. 19. Bank Performance and EVA <ul><li>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. </li></ul><ul><li>Stern, Stewart & Company has introduced the concepts of economic value added (EVA) in an attempt to directly link performance to shareholder wealth creation. </li></ul>
    20. 20. Bank Performance and EVA <ul><li>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: </li></ul><ul><li>EVA = Net Operating Profit After Tax (NOPAT) – Capital Charge </li></ul><ul><li>where the capital charge equals the product of the firm’s value of capital and the associated cost of capital. </li></ul><ul><li>What are the concerns with applying this approach? </li></ul>
    21. 21. The Balanced Scorecard <ul><li>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 </li></ul><ul><li>The result is that line of business managers use indicators such as: </li></ul><ul><ul><li>market share, </li></ul></ul><ul><ul><li>customer retention and attrition, </li></ul></ul><ul><ul><li>customer profitability, and </li></ul></ul><ul><ul><li>service quality to evaluate performance </li></ul></ul><ul><li>Internally, they also track productivity and employee satisfaction </li></ul>
    22. 22. The Balanced Scorecard <ul><li>Think of the bank as being two banks in one house: </li></ul><ul><ul><li>Traditional or Customer Bank </li></ul></ul><ul><ul><li>Investment or House Bank </li></ul></ul><ul><li>Items are assigned based on whether the underlying activities pertain to bank customers (Customer Bank) or the bank itself (Investment Bank). </li></ul><ul><li>Evaluate the returns on each Bank relative to the risks and relevant benchmarks. </li></ul>
    23. 23. Using the Balanced Scorecard <ul><li>Financial Performance: </li></ul><ul><ul><li>How Do Stockholders View Our Risk and Return Profile? </li></ul></ul><ul><li>Customer Performance: </li></ul><ul><ul><li>How Do Customers See Us? </li></ul></ul><ul><li>Internal Process Management: </li></ul><ul><ul><li>At What Must We Excel? </li></ul></ul><ul><li>Innovation and Learning: </li></ul><ul><ul><li>How Can We Continue to Improve and Create Value? </li></ul></ul>
    24. 24. Using the Balanced Scorecard: Scorecard measures

    ×