C H A P T E R 3 Analyzing Bank Performance 121
To account for the potential risk of off-balance sheet activities, risk-based
capital requirements oblige a bank to convert off-balance sheet activities to “on-
balance” sheet equivalents and hold capital against these activities. Appropriate
capital risk measures include all the risk measures discussed earlier, as well as
ratios measuring the following: Tier 1 capital and total risk-based capital to risk-
weighted assets, equity capital to total assets, dividend payout, and the growth
rate in Tier 1 capital. Tier 1 (or core) capital or Tier 1 leverage 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. See Chapter 12 for more details on the
calculation of required regulatory capital at banks. Importantly, a bank’s
dividend policy also affects its capital risk by influencing retained earnings.
Evaluating Bank Performance: An Application
A complete analysis of a financial firm is similar to that of any other industry
with a few exceptions. The analyst begins by gathering background information
on the firm’s operations, including specific characteristics of the business and
intensity of competition, organizational and business structure, management
character and quality, as well as the quality of reported data. Is the bank a
holding company or financial holding company with subsidiaries and branches,
or a single entity? Does it operate as a C-corporation or an S-corporation?42 Is
the firm privately held or publicly traded? When did the firm begin operations,
and in what geographic markets does it now compete? The evaluation should
also identify the products or services provided and the bank’s competitive
position in the marketplace as measured by market share, degree of product
differentiation, presence of economies of scale or scope in the cost structure,
and the bargaining power of customers with whom the bank deals. Much of this
discussion for PNC Bank was presented earlier in the chapter and hence the
following discussion focuses on the financial data of PNC introduced in
Exhibits 3.2, 3.4, and 3.7. It examines data for 2007 relative to peer banks and
summarizes trends from 2003 to 2007. Profitability is evaluated following the
ROE model presented in the chapter using data from PNC Bank’s UBPR data.
This evaluation is contrasted with the firm’s risk position using the risk
categories discussed in the “Managing Risk and Returns” section presented
previously.
PROFITABILITY ANALYSIS FOR PNC IN 2007
Profitability ratios are provided in Exhibit 3.8. The first three columns of data
are for 2006 and the next three columns are for 2007. The first column in 2006
and 2007 is labeled “CALC” and contains the ratios calculated using da.
APM Welcome, APM North West Network Conference, Synergies Across Sectors
C H A P T E R 3 Analyzing Bank Performance 121 To acc.docx
1. C H A P T E R 3 Analyzing Bank Performance 121
To account for the potential risk of off-balance sheet activities,
risk-based
capital requirements oblige a bank to convert off-balance sheet
activities to “on-
balance” sheet equivalents and hold capital against these
activities. Appropriate
capital risk measures include all the risk measures discussed
earlier, as well as
ratios measuring the following: Tier 1 capital and total risk-
based capital to risk-
weighted assets, equity capital to total assets, dividend payout,
and the growth
rate in Tier 1 capital. Tier 1 (or core) capital or Tier 1 leverage
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. See Chapter 12 for more
details on the
calculation of required regulatory capital at banks. Importantly,
a bank’s
dividend policy also affects its capital risk by influencing
retained earnings.
Evaluating Bank Performance: An Application
2. A complete analysis of a financial firm is similar to that of any
other industry
with a few exceptions. The analyst begins by gathering
background information
on the firm’s operations, including specific characteristics of
the business and
intensity of competition, organizational and business structure,
management
character and quality, as well as the quality of reported data. Is
the bank a
holding company or financial holding company with
subsidiaries and branches,
or a single entity? Does it operate as a C-corporation or an S-
corporation?42 Is
the firm privately held or publicly traded? When did the firm
begin operations,
and in what geographic markets does it now compete? The
evaluation should
also identify the products or services provided and the bank’s
competitive
position in the marketplace as measured by market share, degree
of product
differentiation, presence of economies of scale or scope in the
cost structure,
and the bargaining power of customers with whom the bank
deals. Much of this
discussion for PNC Bank was presented earlier in the chapter
and hence the
following discussion focuses on the financial data of PNC
introduced in
Exhibits 3.2, 3.4, and 3.7. It examines data for 2007 relative to
peer banks and
summarizes trends from 2003 to 2007. Profitability is evaluated
following the
ROE model presented in the chapter using data from PNC
Bank’s UBPR data.
3. This evaluation is contrasted with the firm’s risk position using
the risk
categories discussed in the “Managing Risk and Returns”
section presented
previously.
PROFITABILITY ANALYSIS FOR PNC IN 2007
Profitability ratios are provided in Exhibit 3.8. The first three
columns of data
are for 2006 and the next three columns are for 2007. The first
column in 2006
and 2007 is labeled “CALC” and contains the ratios calculated
using data listed
in Exhibits 3.2, 3.4, and 3.7. The second column, “BANK,”
provides profitability
42 It is important to know if a bank operates as an S-
corporation. S-corporations do not pay taxes at the bank level;
rather these tax
obligations are passed on to shareholders. This means that net
income is “overstated” relative to a C-corporation because it
does not
consider the taxes that must be paid by shareholders on behalf
of the bank. Analysts should adjust all after-tax figures for S-
corporation
banks to compare to C-corporation banks.
Copyright 2009 Cengage Learning, Inc. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part.
122 C H A P T E R 3 Analyzing Bank Performance
4. ratios taken directly from the UBPR. The third column, titled
“PG 1,”
represents peer group comparative figures obtained from the
UBPR for other
U.S. banks with more than $3 billion in assets.43 The equations
provided in the
chapter apply to data in the column labeled “CALC.” Because
the UBPR uses
several different methods of averaging balance sheet data, the
calculated ratios
will not always equal the UBPR ratios. Quarterly average
balance sheet data are
not published in the UBPR except for average total assets and
average total
loans. When other average balance sheet data are needed to
calculate a ratio, the
average value is obtained by using an average of year-end data.
The calculated
values are provided as a reference for applying the formulas and
equations
presented earlier in the chapter. Because the use of quarterly
average balance
sheet data will generally provide more accurate ratios, the
following analysis will
use ratios obtained directly from the UBPR and compare these
with the listed
peer group figures.44
PNC’s profitability fell dramatically in 2007, such that the
return on equity
(ROE) was only 8.80 percent, 96 basis points below that of
peers for the year, as
well as 463 basis points below returns for 2006.45 ROE was
generated by an ROA
of 0.93 percent and an equity multiplier of 9.69x. Profitability
5. at the bank was 5
basis points below that of peers according to ROA, while its
financial leverage
was slightly higher than that of peers (EM of 9.61x). The bank’s
lower ROE was
a result of lower return on assets, rather than less leverage. In
fact, PNC’s higher
equity multiplier signals slightly lower equity to assets. The
bank’s lower
returns, combined with higher risk (greater leverage), is a
potential sign that the
bank is currently a lower-performance institution.
One of the greatest challenges of evaluating performance is that
a company
that assumes a higher degree of risk typically also reports
higher profits at first,
and only later—when those higher-risk activities create
problems—does the
bank report higher charge-offs or additional provisions for loan
losses.
PNC’s lower ROA is a result of lower income rather than an
inability to
control expenses. The bank’s lower income, as indicated by an
asset utilization
of 6.77 percent (versus 7.39 percent for peers) indicates that
PNC generates less
revenue per dollar of assets. By contrast, the bank’s lower
expense ratio of 5.38
percent (versus 5.88 percent for peers) indicates that PNC was
more efficient
than its peers in controlling total expenses. By breaking down
asset utilization
into interest income and noninterest income and the expense
ratio into interest
6. and noninterest expense and provisions for loan losses, we can
better determine
the operational strengths and weaknesses of PNC’s profitability.
PNC’s lower overall expenses are attributed to significantly
lower interest
expense and lower provisions for loan losses rather than lower
non-interest
expense. PNC actually paid 0.53 percent less in interest expense
relative to average
43 There are actually 27 bank peer groups. Peer group 1 is for
banks over $3 billion.
44 Although the following analysis will directly compare PNC’s
ratio to the peer group, it is important to recognize that the peer
group may or may not be the appropriate comparison. To say a
bank is doing better than the peer means it is doing better than
average and does not always indicate that the bank is “doing
well.”
45 The following analysis will use ratios reported in the UBPR
rather than those calculated. For example, the ROE reported in
the UBPR
under the column “BANK,” and listed in the second column
under Dec-07 of Exhibit 3.8, is 8.8 percent. The ROE calculated
from 2007
data presented in Exhibits 3.2 and 3.4 is 11.45 percent. Ratios
reported in the UBPR use one of three types of averages of
quarterly
figures from balance sheet data and the use of quarterly
averages generally produces ratios that are more accurate.
Hence, some of
the ratios calculated using data from Exhibits 3.2 and 3.4 will
not equal those reported in the UBPR that appears in the
appendix. See
the Contemporary Issues box: “Interpreting Financial Ratios
7. and the Use of Average Balance Sheet Data.”
Copyright 2009 Cengage Learning, Inc. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part.
C H A P T E R 3 Analyzing Bank Performance 123
Exhibit 3.8
Profitability Measures for PNC Bank and Community National
Bank,
2006–2007
PNC Bank, National Association
Dec-06 Dec-07
Profitability Ratios Pg # CALC BANK PG 1 CALC BANK PG 1
ROE 11 13.46% 13.43% 12.89% 11.45% 8.80% 9.76%
ROA 1 1.02% 1.02% 1.23% 0.93% 0.93% 0.98%
EM = 1 / (Total equity / TA) 11 (Calc) 13.25 13.18 9.99 11.09
9.69 9.61
AU (income) *sum 7.41% 7.40% 7.21% 6.77% 6.77% 7.40%
*Interest income / aTA 1 5.08% 5.08% 5.95% 4.92% 4.92%
6.16%
Average loans / aTA 6 57.57% 58.21% 63.82% 55.14% 55.06%
66.71%
Rate: Loans 3 6.42% 6.42% 7.15% 6.30% 6.30% 7.32%
9. Time deposits over $100M / aTA 6 6.08% 6.15% 12.54% 5.06%
4.26% 11.68%
Cost: Time deposits over $100M 3 4.96% 4.97% 4.38% 4.25%
4.26% 4.78%
*Noninterest expense / aTA 1 3.00% 3.00% 2.54% 2.72% 2.72%
2.62%
*PLL / aTA 1 0.14% 0.14% 0.13% 0.21% 0.21% 0.28%
Avg. interest-bearing debt / aTA 1 77.41% 77.35% 81.67%
68.85% 76.50% 81.77%
Cost of interest-bearing funds 3 3.06% 3.29% 3.36% 3.31%
3.20% 3.68%
Efficiency Ratio 3 61.63% 61.63% 55.31% 62.88% 62.88%
57.60%
*When income statement numbers are used in the numerator,
aTA is average total assets from Exhibit 3.7. For consistency,
however, all “mix” or
composition values use averages of current and prior period.
For example, numerator and denominator averages for “Total
deposits (avg.) / aTA” are
both calculated using end-of-period annual average data.
Note: Short-term noncore funding is defined in the UBPR as
certificates of deposit of $100,000 or more, brokered deposits of
less than $100,000, other
borrowings (of less than one year), deposits in foreign offices,
securities sold under agreements to repurchase, and federal
funds purchased with
maturities of less than one year. Due to the lack of detailed
data, calculated volatile liabilities does not include brokered
deposits.
10. Copyright 2009 Cengage Learning, Inc. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part.
124 C H A P T E R 3 Analyzing Bank Performance
Exhibit 3.8
(continued)
Community National Bank
Dec-06 Dec-07
Profitability Ratios Pg # CALC BANK PG 4 CALC BANK PG 4
ROE 11 25.39% 25.41% 11.56% 20.75% 20.68% 9.43%
ROA 1 2.27% 2.27% 1.10% 1.89% 1.89% 0.93%
EM = 1 / (Total equity / TA) 11 (Calc) 11.06x 11.25x 10.32x
10.75x 10.88x 10.07x
AU (income) *sum 8.06% 8.06% 7.40% 8.23% 8.24% 7.59%
*Interest income / aTA 1 7.04% 7.04% 6.62% 7.44% 7.44%
6.84%
Average loans / aTA 6 76.05% 73.59% 69.78% 79.25% 77.98%
70.75%
12. Short-term noncore / aTA 6 17.66% 14.19% 16.38% 19.95%
16.47% 17.64%
Time deposits over $100M / aTA 6 17.66% 17.49% 15.49%
19.95% 19.26% 16.59%
Cost: Time deposits over $100M 3 4.16% 4.07% 4.27% 4.60%
4.67% 4.84%
*Noninterest expense / aTA 1 3.39% 3.39% 3.21% 3.59% 3.59%
3.22%
*PLL / aTA 1 0.19% 0.19% 0.16% 0.19% 0.19% 0.20%
Avg. interest-bearing debt / aTA 1 68.75% 69.39% 74.95%
68.57% 70.20% 75.90%
Cost of interest-bearing funds 3 3.17% 3.16% 3.32% 3.67%
3.62% 3.84%
Efficiency Ratio 3 57.70% 57.70% 65.39% 63.04% 63.04%
68.74%
Source: Tim Koch and Scott MacDonald; from FFIEC, Uniform
Bank Performance Report,
www2.fdic.gov/ubpr/UbprReport/SearchEngine/Default.asp
assets than peers did (2.45 percent versus 2.98 percent). This
difference suggests
that PNC operates differently than peers do in at least one of the
areas of rates
paid, liability composition, or volume of interest-bearing
liabilities. The
significantly lower volume of interest-bearing debt of 76.5
percent versus 81.8
percent of average assets signals an operational advantage.
PNC’s large amount
of demand deposits (8.35 percent versus 4.83 percent of average
total assets),
which are business checking accounts that do not pay interest,
are a significant
13. contributor to the lower interest costs. Interestingly, the interest
cost of some
liabilities was actually higher versus peers. For example, at 2.65
percent versus
1.85 percent, the cost of MMDAs was 80 basis points higher
than for peers, as
was the cost of CDs under $100,000, which was 16 basis points
higher. In terms
of funding composition, PNC’s core deposits contributed almost
1.5 percent
less in total funding while short-term noncore funding
comprised 3.24 percent
less. This is a clear indicator that PNC relied relatively more on
other (generally
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C H A P T E R 3 Analyzing Bank Performance 125
more expensive) borrowings such as federal funds purchased,
Federal Home
Loan Bank borrowings, and subordinated debt.
The dependence on borrowed funds would normally lead to a
higher overall
interest expense, but the flat yield curve and low interest rates
of 2007 kept the
relative cost of these funds closer to other deposits. Thus,
PNC’s lower overall
interest expense was a result of more non-interest-bearing funds
(demand
deposits), which indicates a favorable mix of lower-cost
14. liabilities and a lower
volume of interest-bearing liabilities. The benefits were offset
somewhat by the
higher rate paid some of these funds.
Profitability for PNC was lowered by the bank’s higher
noninterest expense
to assets (2.72 percent versus 2.62 percent for peers). Although
personnel
expenses were lower, occupancy and other expenses were higher
versus peers.
PNC delivers banking services through an extensive branching
network,
including some foreign branches, and focuses on funding the
bank with core
deposits. PNC has successfully lowered its noninterest expense
over the past
several years, going from a higher level of noninterest expense
relative to peers
to lower expenses. There is often an expense tradeoff between
the lower interest
cost of a large volume of core deposits (particularly demand
deposits) and a
higher noninterest cost due to additional branch facilities and
people needed to
support these accounts. PNC benefits from both lower
noninterest expense and
lower interest expense. Its larger retail network of branches and
services also
produces more noninterest income such that PNC’s noninterest
income is
substantially higher than that of peers.
Consider the components of asset utilization. PNC’s AU, which
was 62 basis
points lower than that of peers, was a result of its lower interest
15. income (4.92
percent versus 6.16 percent for peers) rather than its higher
noninterest income
(1.85 percent versus 1.24 percent for peers). In general, lower
interest income might
be due to lower yields on assets, fewer loans, a smaller volume
of earning assets, or
a combination of these factors. Examining the yield on earning
assets, we find that
PNC earned 107 basis points less (5.67 percent versus 6.74
percent for peers) and
invested almost 6 percent less in earning assets.46 PNC also
earned much lower
yields on both loans and investments and operated with fewer
total loans and leases
(55.66 percent of average assets versus 66.71 percent for peers),
but had 7.04
percent more investments. Generally, loans offer the highest
yields, but in 2007,
PNC’s average loan yield was actually below its average
investment yield. The fact
that PNC held fewer assets in loans, that the yield on these
loans was low, and that
PNC invested less in earning assets, resulted in lower interest
income. Rate, mix,
and volume effects thus contributed to PNC’s lower interest
income.
The lower yield on loans might suggest lower risk, but PNC’s
history has
shown loan problems in the past. For example, PNC’s loan rates
were also lower
in 2000 yet its loan problems of 2001 indicated a greater-risk
loan portfolio.47
PNC pursued a lower credit-risk strategy after their loan
problems of 2001,
16. which is reflected in its lower returns. PNC’s changing business
model is one of
the many reasons an analyst should carefully examine the
bank’s credit risk.
46 The UBPR reports “Average earning assets/Average assets”
on page 1 and “Total earning assets” on page 6. The first
measure
reported on page 1 includes total loans (rather than net loans)
and a five period average of interest-only strips and equity
securities.
Hence, we use the measure on page 6 for the analysis.
47 See the Contemporary Issues box: “The Fall of Enron and Its
Impact on PNC Bank.”
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126 C H A P T E R 3 Analyzing Bank Performance
The relationship between interest income and interest expense is
expressed in
terms of net interest margin (NIM). PNC’s lower net interest
margin (2.84
percent versus 3.48 percent for peers) indicates that PNC’s
lower interest
income is not offset by its lower interest expense. PNC’s net
interest margin is
lower than that of peers, in part, because it has fewer earning
assets and fewer
loans and because of the fact that the yield on these loans was
less than for
17. peers. An aggregate measure of the trade-off between interest
and noninterest
income and expense is the efficiency ratio, which equals
noninterest expense
divided by net operating income. PNC’s efficiency ratio is
higher than that of
peers at 62.88 percent versus 57.60 percent. The ratio indicates
that PNC spends
almost 63 cents to generate one dollar in net operating income,
about 5.3 cents
more than peers do.
Although interest income was much lower at PNC, noninterest
income was
much higher than for peers. Like other large banking
organizations, PNC
recently restructured its business model to rely proportionately
more on
noninterest income and less on loan income, particularly asset
management
and the custody business. In order to reduce overall credit risk,
management
stated an objective to become more selective in the types of
loans made. Many
large banks generally encourage loans to larger businesses with
more easily
verifiable credit qualities, hence lower loan rates. This assists
the bank in
keeping overhead costs down and in cross-selling other
products, thus
producing more fee income.
Peer group data presented in Exhibit 3.3, however, masks some
important
differences between PNC’s performance and that of its peers.
The peer data in
18. Exhibit 3.3 are for banks with total assets of more than $3
billion because larger
banks typically generate higher levels of noninterest income
than smaller banks
do. Exhibit 3.10 provides additional detail on noninterest
income and compares
PNC against banks with assets of more than $10 billion.
Consistent with the sale
of more products, PNC’s noninterest income is from multiple
sources:
investment banking, advisory, brokerage, and underwriting fees
and
commissions; fiduciary activities; service charges; and net gains
on loan sales.
PNC’s noninterest income position appears to be better than that
of the average
peer bank presented in the UBPR and Exhibit 3.3, but when
compared with
banks with more than $10 billion in assets, PNC generates 26
basis points less in
noninterest income.
In summary, PNC returns in 2007 are below those of a high-
performance
bank. Returns to the entire banking industry were down
significantly in 2007
but PNC’s were down even more. PNC’s lower returns and
slightly higher
financial leverage indicates more financial risk but lower
returns. Its lower ROA
is a direct result of lower interest income and slightly higher
noninterest
expenses. PNC produces less interest income due to lower rates
on loans and
investments, a smaller loan portfolio, and fewer earning assets.
PNC’s primary
19. profitability strengths are its lower interest expense and higher
noninterest
income. A lower proportion of interest-bearing liabilities (more
demand
deposits) is the primary driver of PNC’s lower interest expense.
Although its
noninterest expense is somewhat higher than that of peers,
noninterest expense
control has improved over the past five years.
Copyright 2009 Cengage Learning, Inc. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part.
Critical Viewing Form
BA 3102
Instructions: Please address each item below for each movie.
The total length of your critical viewing form responses should
be approximately one-half to one page, single spaced. This
form will be graded on a pass/fail basis. To pass, you need to
provide reasonably detailed and insightful answers to the items
below.
1. Briefly summarize the basic plot, or issue that the movie
addresses.
2. What do you think is the most interesting point in the
movie?
3. What is the most controversial statement you’ve heard?
4. What is the most important ethical issue that the movie is
addressing? Please explain.
