204 206 E.N. Roussakis Assessing bank performance and determining strategy 205 Assessing bank performance and determining strategy Introduction Amal Galla is a graduate student in finance at Morocco’s HEM School of Business, Marrakesh campus. She has successfully completed all degree requirements except for the need to secure an internship (stage de fin d’études) in the area of her specialisation. This concern had preoccupied her for quite a while and had prompted her to pursue all available leads. As she was evaluating her next move, she received a call from the Head of Student Affairs office (Responsable Pédagogique) who informed her of an internship opportunity brought to his attention by his liaison at Florida International University, HEM’s academic partner in Miami. Essentially, a bank based in Coral Gables was offering a three-month paid internship that could develop into a permanent position if the senior management was satisfied with her performance. Amal followed through with this prospect and consented to an interview, via skype, with an officer of the bank’s human resources. A week later she received formal notification of the internship offer and in no time she arranged all trip details and arrived in Miami. Her first day at the bank she met various members of the management team starting with Mr. Felipe Battik, Vice President in charge of Human Resources, who defined the parameters of her internship assignment. Initially, Amal was to be rotated through the various units of the bank to gain additional insights into the scope of its activities. She was then to be placed at the office of the controller and treasurer to enable her access of the pertinent financial information for assessment of the bank’s performance. Based on her findings she was to identify a strategy to maximise the bank’s overall potential. Amal agreed to submit a written report of her review and recommendations and consented to make an oral presentation of the key issues before completion of her assignment. Her first day work impressions, combined with the prospect for a full-time employment, convinced Amal of the need to come up with a high quality written report on completion of her assignment. To better prepare for this challenge she thought appropriate to pursue a three step approach in the following order · revisit the pertinent chapters of her commercial banking textbook on the goal of management and the relevance of bank policies and strategies · research current literature on assessing bank performance and implementing strategy · review the bank’s background information (e.g., ownership, scope of operations, and financial condition) Hence, the sequence of the sections that follows. Literature review Assessing bank performance For a commercial bank, and other financial firms, performance refers to how effectively does an institution meets the needs of its stakeholders – shareholders (owners), employees, deposi.

1. 204
206 E.N. Roussakis
Assessing bank performance and determining strategy 205
Assessing bank performance and determining strategy
Introduction
Amal Galla is a graduate student in finance at Morocco’s HEM
School of Business, Marrakesh campus. She has successfully
completed all degree requirements except for the need to secure
an internship (stage de fin d’études) in the area of her
specialisation.
This concern had preoccupied her for quite a while and had

2. prompted her to pursue all available leads. As she was
evaluating her next move, she received a call from the Head of
Student Affairs office (Responsable Pédagogique) who informed
her of an internship opportunity brought to his attention by his
liaison at Florida International University, HEM’s academic
partner in Miami. Essentially, a bank based in Coral Gables was
offering a three-month paid internship that could develop into a
permanent position if the senior management was satisfied with
her performance.
Amal followed through with this prospect and consented to an
interview, via skype, with an officer of the bank’s human
resources. A week later she received formal notification of the
internship offer and in no time she arranged all trip details and
arrived in Miami. Her first day at the bank she met various
members of the management team starting with Mr. Felipe
Battik, Vice President in charge of Human Resources, who
defined the parameters of her internship assignment. Initially,
Amal was to be rotated through the various units of the bank to
gain additional insights into the scope of its activities. She was
then to be placed at the office of the controller and treasurer to
enable her access of the pertinent financial information for
assessment of the bank’s performance. Based on her findings
she was to identify a strategy to maximise the bank’s overall
potential. Amal agreed to submit a written report of her review
and recommendations and consented to make an oral
presentation of the key issues before completion of her
assignment.
Her first day work impressions, combined with the prospect for
a full-time employment, convinced Amal of the need to come up
with a high quality written report on completion of her
assignment. To better prepare for this challenge she thought
appropriate to pursue a three step approach in the following
order
· revisit the pertinent chapters of her commercial banking
textbook on the goal of management and the relevance of bank
policies and strategies

3. · research current literature on assessing bank performance and
implementing strategy
· review the bank’s background information (e.g., ownership,
scope of operations, and financial condition)
Hence, the sequence of the sections that follows. Literature
review
Assessing bank performance
For a commercial bank, and other financial firms, performance
refers to how effectively does an institution meets the needs of
its stakeholders – shareholders (owners), employees, depositors
and other creditors, and borrowing customers – in the
framework of regulatory pronouncements. Key ratios and their
interpretation
As with all profit-seeking organizations, the single most
important indicator of bank performance has been profitability.
After all, banks and other financial institutions are simply
businesses organised to maximise the value of the shareholders’
wealth invested in the firm. With profitability, the most
important dimension of performance,
1- Two financial ratios that apply equally well for measuring
the performance of both banks
Rate ofreturn on equity (ROE) is, in the accounting sense, The
ratio tells a bank’s shareholders how much the institution is
earning on their investment. The ratio is especially important
because the key objective of a bank is to maximise the return to
shareholders.
The second profitability measure, ROA, This measure gauges
how well management is using a bank’s assets to generate net
earnings. A low rate may reflect excessive operating expenses
or conservative lending and investment policies, while a high
rate may denote operational efficiency or aggressive lending
and investment policies. If the latter is the case, the bank may
be assuming increased risk in order to attain higher returns on
assets.

4. 2 - other key indicators of bank profitability as well as
efficiency are the net interest margin and the net non-interest
margin.
The net interest margin expresses management’s effectiveness
to boost interest income and control interest expense (funding
costs).
Although increasingly in recent years banks have been
emphasising non-interest income, for many institutions this
ratio may be negative as a result of high non-interest costs.
An alternative expression of both of these ratios is in terms of
earning assets (investments securities and loans and leases).
Many authorities prefer to measure the net interest and non-
interest margins by comparing them to earning assets as these
constitute the principal contributors to a bank’s income and rate
of return.
3- The spread is another traditional indicator of return on a
bank’s assets by measuring the difference between the average
yield on earning assets and the average cost of interest-bearing
liabilities. It is defined as:
Figure 1 Decomposition process
4- This decomposition process helps narrow down the causes of
bank earnings problems and suggests where the management
needs to look for possible cures.
As shown in Figure 1, the decomposition process focuses on the
ROE and its key components, ROA and the equity multiplier

5. (also known as leverage multiplier for signifying extent of bank
reliance on leverage or debt in the financing of its assets).
Together the two component ratios indicate that a higher ROE
can be attained by increasing either ROA or financial leverage.
The ROA, in turn, may be broken down into its key components,
profit margin and asset utilisation. The profit margin and asset
utilisation may each be decomposed further. The former would
reflect the relative importance of four ratios each of which
measures the individual weight of specific types of expenses
and taxes (interest expense, non-interest expense, provision for
loan losses, and income taxes) in relation to total operating
income; asset utilisation would itself be broken down into
interest income relative to total assets, and non-interest income
to total assets.
Additional ratios may be used to measure performance in other
aspects of banking activity, such as operating efficiency (total
operating expenses in relation to total operating income),
employee productivity (net operating income relative to full-
time equivalent employees), off-balance sheet items (relative to
total assets), and capital adequacy based on the internationally
imposed standards of the Basel agreement – e.g., ratio of core
capital (Tier 1) to total risk-weighted assets, and ratio of total
capital (Tier 1 plus Tier 2) to total risk-weighted assets.
5-With lending the dominant activity of commercial banks and
the key source of revenue income, the relevance and quality of
the loan portfolio is measured by such indicators as:
The first ratio has been a traditional gauge of a bank’s exposure
to credit risk (debtors’ failure to perform as agreed). With loans
among the riskiest of all assets, growth of this ratio increases a
bank’s loss potential and undermines the safety of its deposits.
The next four ratios evaluate critical aspects of loan portfolio
soundness.

6. Inability to meet normal operating requirements on a day-to-day
basis exposes a bank to liquidity risk (lack of sufficient cash
and borrowing capacity to meet customer demands). Key
measures of this risk, expressed as a percent of total assets, are
the following ratios:
Management challenges
Ponce de Leon Bank was not immune to the effects of the
financial crisis owing to its loan portfolio concentration in real
estate loans and the somewhat aggressive lending practices it
used to expand it – granting loans at higher than normal loan-to-
value (LTV) ratios, and using lax structuring of loan repayment
terms and conditions (many loans were granted with interest
only payment provisions and no significant principal
amortisations). As the financial crisis began to unfold, the bank
started to experience an increase in its non-current loans and
repossessed properties to a level beyond what could be
supported by its total capital and loan loss reserves. Regulatory
concerns prompted the bank to seek out private investors who
contributed $2.0 million of additional capital in early 2009.
This move, however, turned out to offer only temporary relief;
continued deterioration in asset quality caused additional losses,
poor earnings, and return to capital deficiency. The extent of
the bank’s exposure may be sensed by the fact that at the end of
the first quarter of 2010, commercial real estate loans were
valued at $34.7 million and represented 604% of its capital
base, while its gas station loans amounted to $12.2 million and
represented 211% of its capital. In addition, the bank’s OREO
(other real estate owned portfolio-foreclosed loans) surged by
more than double – from $3.185 million in 2009 to $7.38

7. million in 2010 – representing a 120% of its capital.
Addressing the additional loan portfolio exposure (e.g.,
increasing loan loss reserves for $6.1 million in non-current
loans) and meeting regulatory capital requirements was a
challenging task for the bank. Yet its management felt confident
that as the two-year old government financial rescue plan
worked its way through the economy, recovery and growth
would soon take hold. Continuing highly stimulative US
monetary and fiscal policies had already caused the gradual
improvement in the 2010 quarterly GDP data and the drop in the
unemployment rate (9.4%). Management reasoned that these
policies would prompt real estate to rebound and help restore
the bank to a safe and financially sound condition.
The immediate attention of management was directed on
boosting the bank’s non-interest income. Its rational was that
this source of income diversified earnings from traditional lines
of business and contributed significantly to the bank’s long-
term potential. A prime favourite was entry into the fiduciary
business (trust services). Trust services (e.g., managing
customer assets such as securities, land, and buildings) offered
the advantage of generating income without utilising bank
funds. Bank fees, monthly service charges on deposits, and
special charges for special services were viewed as additional
favourites for boosting non-interest income.
The size and relative importance of bank operations may be
sensed from Tables 4 through 6 which depict the financial
condition of the institution in 2009 and 2010. Financial
statements were audited by a major US accounting firm.
Table 4 Balance sheets, Ponce de Leon Bank, Coral Gables,
Florida (thousands of dollars)
2010
2009
Total assets
$106,908
$98,054

8. Cash and due from depository institutions
10,569
7,219
Interest-bearing balances
4,431
5,537
Securities
12,844
16,190
Federal funds sold and reverse repurchase agreements
279
0
Net loans and leases
72,936
68,024
Loan loss allowance
1,562
1,223
Trading account assets
0
0
Bank premises and fixed assets
1,265
1,380
Other real estate owned
7,380
3,185
Goodwill and other intangibles
0
0
All other assets
1,635
2,056
Life insurance assets
0
0

9. Total liabilities and capital
$106,908
$98,054
Total liabilities
100,787
86,726
Total deposits
94,656
82,187
Interest-bearing deposits
90,308
75,556
Deposits held in domestic offices
94,656
82,187
Percentage of insured
84.56%
84.28%
Federal funds purchased and repurchase agreements
0
0
Trading liabilities
0
0
Other borrowed funds
1,292
1,318
Subordinated debt
3,000
3,000
All other liabilities
1,839
221
Total equity capital
6,121
11,328

10. Total bank equity capital
6,121
11,328
Common stock
3,720
3,720
Surplus
9,902
8,607
Undivided profits
–7,501
–999
Source: Supplied by the management of the bank
Table 4 Balance sheets, Ponce de Leon Bank, Coral Gables,
Florida (thousands of dollars) (continued)
2010
2009
Memoranda:
Non-current loans and leases
4,242
5,298
Income earned, not collected on loans
540
555
Earning assets
90,490
89,751
Long-term assets (5+ years)
13,390
10,244
Average assets, year-to-date
102,906
99,319

11. Average assets, quarterly
106,679
98,021
Volatile liabilities
49,800
39,223
Insider loans
645
848
FHLB advances
1,292
1,318
Loans and leases held for sale
0
0
Unused loan commitments
3,263
3,849
Tier 1 (core) risk-based capital
5,935
10,988
Tier 2 risk-based capital
3,902
3,926
Total risk weighted assets
71,709
73,837
Total unused commitments
3,263
3,849
Restructured Loans and leases
220
6,066
Source: Supplied by the management of the bank
Table 5 Income statements, Ponce de Leon Bank, Coral
Gables, Florida (thousands of dollars)

12. 2010
2009
Total interest income
3,152
3,761
Total interest expense
1,223
1,717
Net interest income
1,929
2,044
Provision for loan and lease losses
987
1,162
Total non-interest income
–124
138
Fiduciary activities
0
0
Service charges on deposit accounts
77
96
Trading account gains and fees
0
0
Additional non-interest income
–201
42
Total non-interest expense
4,288
2,852
Salaries and employee benefits
1,345
1,394

13. Premises and equipment expense
419
509
Additional non-interest expense
2,524
949
Pre-tax net operating income
–3,470
–1,832
Securities gains (losses)
135
138
Applicable income taxes
0
–668
Income before extraordinary items
–3,335
–1,026
Extraordinary gains – net
0
0
Net charge-offs
1,039
553
Cash dividends
0
0
Sale, conversion, retirement of capital stock, net
1,295
2,060
Net operating income
–3,470
–1,114
Source: Supplied by the management of the bank
Table 6 Performance ratios, Ponce de Leon Bank, Coral
Gables, Florida

14. 2010
2009
Yield on earning assets
4.68%
5.35%
Cost of funding earning assets
1.81%
2.44%
Net interest margin
2.86%
2.91%
Non-interest income to earning assets
–0.18%
0.20%
Non-interest expense to earning assets
6.36%
4.06%
Net charge-offs to loans
2.01%
1.02%
Credit loss provision to net charge-offs
95.00%
210.13%
Earnings coverage of net loan charge-offs (x)
–2.39
–1.21
Efficiency ratio
237.56%
130.71%
Assets per employee ($ millions)
4.11
4.26
Cash dividends to net income (YTD only)
0.00%
0.00%

15. Condition ratios
Loss allowance to loans
2.10%
1.77%
Loss allowance to non-current loans
36.82%
23.08%
Non-current assets plus other real estate owned to assets
10.87%
8.65%
Non-current loans to loans
5.69%
7.65%
Net loans and leases to deposits
77.05%
82.77%
Net loans and leases to core deposits
162.60%
158.33%
Equity capital to assets
5.73%
11.55%
Core capital (leverage) ratio
5.49%
11.20%
Tier 1 risk-based capital ratio
8.28%
14.88%
Total risk-based capital ratio
13.72%
20.20%
Memoranda:
Average assets

16. $102,906
$99,319
Average earning assets
$89,851
$93,757
Average equity
$7,010
$10,325
Average loans
$68,930
$72,570
20092010
Net income/ total operating income60.81%100.00%
Interest expense / total operating income-93.72%-35.24%
Noninterest expenses / TOI-155.68%-123.57%
provision for loan losses / TOI-63.43%-28.44%
Income tax paid / TOI
Total operating income / total asset-1.87%-3.25%
Interest income / total asset3.84%2.95%
Noninterest income / total asset0.14%-0.12%

17. Profit margin
Asset Utilization
20092010
Dept ratio88.45%94.27%
Leverage Ratio11.20%5.49%
Loss allowance to loans1.77%2.10%
Leverage Ratio
Cashandbalancesduefromotherdepository
institutions/Total assets7.36%9.88%improving
Cashassetsandshorttermgovernment
securities (one year or less) / Total assets5.65%4.14%falling
Purchased funds / Total assets00
Liquidty Ratio
20092010
ROA-1.14%-3.25%
ROE-10%-57%
20092010
Net interest margin 2.91%2.86%
Net non-interest margin -2.77%-4.13%
20092010
spread-27%-24.00%