1. Evaluating Bank Performance
• Outline
– A Framework for Evaluating Bank Performance
Internal Performance
External Performance
Presentation of Bank Financial Statements
– Analyzing Bank Performance with Financial Ratios
Profit Ratios
Risk Ratios
– Internal Performance Evaluations Based on Economic Profit
RAROC (Risk-Adjusted Return on Capital)
EVA (Economic Value Added)

2. A Framework for Evaluating
Bank Performance
• Internal Performance
– Bank planning (policy formulation)
Goals, budgets, strategic planning
– Technology
Computers, communications, payments
– Personnel development
Challenges (personal selling and geographic expansion)
Job satisfaction (training and compensation)

3. A Framework for Evaluating
Bank Performance
• External Performance
– Market share
Earnings effects
Role of technology
– Regulatory compliance
Capital
Lending
Securities
Other
– Public confidence
Deposit insurance
Public image

4. A Framework for Evaluating
Bank Performance
• Presentation of Bank Financial Statements
– Balance sheet (Report of Condition)
Assets: cash assets, loans, and securities
Liabilities: deposit funds and nondeposit funds
Capital: equity capital, subordinated notes and debentures, loan
loss reserves
– Income Statement (Report of Income)
Interest income
Noninterest income
Interest expenses
Noninterest expenses (including provision for loan losses)
Net profit

5. A Framework for Evaluating
Bank Performance
Table 3.1 Balance Sheet for State Bank ($Thousands)
ASSETS DEC. 31, 2000 DEC. 31, 1999
Cash assets $ 9,039 $ 10,522
Interest bearing bank balances 0 1,000
Federal funds sold 10,500 1,500
U.S. Treasury and agency securities 54,082 44,848
Municipal securities 32,789 34,616
All other securities 0 0
Net loans and leases 90,101 81,857
Real estate loans 50,393 38.975
Commercial loans 9,615 11,381
Individual loans 8,824 10,640
Agricultural loans 20,680 19,654
Other loans and leases-domestic 3,684 4,025
Gross loans and leases 93,196 84,675
Less: unearned income reserves 89 282
Reserve for loan and lease losses 3,006 2,356
Premises, fixed assets, and capitalized leases 2,229 2,398
Other real estate 2,282 3,012
Other assets 4,951 4,014
Total assets $205,973 $183,767

6. A Framework for Evaluating
Bank Performance
Table 3.1 Balance Sheet for State Bank ($Thousands)
LIABILITIES & CAPITAL DEC. 31, 2000 DEC. 31, 2001
Demand deposits $ 23,063 $ 22,528
All NOW and ATS accounts 6,021 5,322
MMDA accounts 41,402 49,797
Other savings deposits 3,097 2,992
Time deposits<$100K 31,707 28,954
Time deposits>$100K 83,009 57,665
Total deposits 188,299 167,258
Fed funds purchase and resale 0 0
Other borrowings 0 0
Bankers’ acceptance and other liabilities 3,546 3,101
Total liabilities 191,845 170,359
Subordinated notes and debentures 0 0
All common and preferred equity 14,128 13,408
Total liabilities and capital $205,973 $183,767

7. Analyzing Bank Performance with
Financial Ratios
• Profit ratios
– Rate of return on equity
ROE = NI/TE (net income after taxes/total equity)
– Rate of return on assets
ROA = NI/TA (net income after taxes/total assets)
– Other profit measures
Net interest margin
NIM = (Total interest income - Total interest expense)/Total assets
Note: municipal bond interest is not taxable, such that it must be
grossed up to a pre-tax equivalent basis by dividing munis interest
earned by the factor (1 - tax rate of bank).

8. Analyzing Bank Performance with
Financial Ratios
• Profit ratios
– Unraveling profit ratios
ROE = ROA x TA/TE (total assets/total equity or equity
multiplier).
Thus, by decreasing equity, a bank can increase ROE based on any
given level of ROA.
ROE = NI/OR x OR/TA x TA/TE (where OR is operating
revenue).
The NI/OR ratio is the profit margin, while OR/TA reflects asset
utilization. By using this breakdown, one can make inferences
concerning the reason for say increases in ROE. If asset utilization
and equity multiplier did not change, the profit margin must
have increased due to cost savings pushing this ratio up.

9. Analyzing Bank Performance with
Financial Ratios
• Risk ratios
– Capitalization
Leverage ratio
Total equity/Total assets
Total capital ratio
(Total equity + Long-term debt + Reserve for loan
losses)/Total assets
Note: book values and market values likely are different and
yield different results.

10. Analyzing Bank Performance with
Financial Ratios
• Risk ratios
Asset quality
Provision for loan loss ratio
= PLL/TL (provision for loan losses/total loans and leases)
Loan ratio
= Net loans/Total assets
Loss ratio
= Net charge-offs on loans (gross charge-offs minus
recoveries)/Total loans and leases
Reserve ratio
= Reserve for loan losses (reserve for loan losses last year
minus gross charge-offs plus PLL and recoveries)/Total
loans and leases
Nonperforming ratio
= Nonperforming assets (nonaccrual loans and
restructured

11. Analyzing Bank Performance with
Financial Ratios
• Risk ratios
– Operating efficiency (cost control)
Wages and salaries/Total expenses
Fixed occupancy expenses/Total expenses
– Liquidity
Temporary investments ratio
= (Fed funds sold, short-term securities, cash, trading account
securities)/Total assets
Volatile liability dependency ratio
= (Total volatile liabilities - Temporary investments)/Net loans
and leases
Note: This ratio gives an indication of the extent to which “hot”
money is being used to fund the riskiest assets of the bank.

12. Analyzing Bank Performance with
Financial Ratios
• Other financial ratios
– Tax rate = Total taxes paid/Net income before taxes
– Dollar gap ratio
= Interest rate sensitive assets - Interest-rate sensitive liabilities
Total assets
where rate-sensitive means short-term with maturities of less than
one year (or repriced in less than one year).

13. Internal Performance Evaluations
Based on Economic Profit
• RAROC (Risk-adjusted return on capital)
– Example
Cost of funds 5.00%
Provision for loan losses 1.00
Direct expense 0.50
Indirect expense 0.25
Overhead 0.25
Total charges before capital charge 7.00%
Capital charge* 2.29
Total required loan rate 9.29%
*Note: The capital charge is determined by multiplying the equity capital allocated to the loan times
the opportunity cost of equity and then converting to a pre-tax level. Assume that the allocated
equity to loan ratio is 10% and the opportunity cost of equity is 16%, such that the after-tax capital charge is
1.6%. If the tax rate for the bank is 0.3, the pre-tax capital charge is 1.6/(1.0-0.3), or 2.29.
In this example, if the loan rate is 9.29%, the bank will earn the target return on
equity of 16%. Of course, if the bank can price the loan at a rate higher than 9.29%,
it will earn profit over the target level of equity returns. In this case an economic
profit is earned in that the value of equity is increased.

14. Internal Performance Evaluations
Based on Economic Profit
• EVA (Economic value added)
= Adjusted earnings – Opportunity cost of capital,
where adjusted earnings is net income after taxes, and the opportunity
cost of capital equals the cost of equity times equity capital.
• RAROC and EVA
– Both methods are beneficial in assessing managerial performance
and developing incentive compensation schemes compatible with
shareholder wealth goals.
– RAROC has a short-run perspective (i.e., business unit profit is
compared to the unit’s capital at risk)
– EVA has a long-run perspective (i.e., business unit profit is
compared to the cost of capital of the bank)