1
Evaluating Bank Performance
Oleg Deev
2
Contents
1. Bank balance sheet
2. Bank income statement
3. Profitability analysis
4. Expense ratio and asset utilization
5. Bank risks
6. Risk-adjusted performance analysis
7. Loan valuation
3
Performance Analysis
A high-performance firm is one that makes an exceptional
return to shareholders while maintaining an acceptable level
of risk.
̶ High performance is more than just high returns.
̶ Includes the ability to generate high returns while carefully
assessing and pricing the level of risk assumed.
4
Profitability
Euro area banks’ actual (2015-18) and expected (2019-21) return on equity (left panel);
median ratings for large global listed banks (right panel)
(left panel: 2015-21, annual percentages, median and interquartile range; right panel: Jan. 1995-Mar. 2019)
5
Bank Performance Analysis
̶ Most depository financial institutions own few fixed assets
and thus exhibit low operating leverage.
̶ Many bank liabilities carry short-term maturities.
̶ Interest expense changes create significant asset allocation and
pricing problems.
̶ Many commercial bank deposits are government insured
and carry below-market interest rates.
̶ Banks operate with less equity capital than nonfinancial
companies which increases financial leverage and volatility
of earnings.
6
Framework for Evaluating
Bank Performance
Internal Performance External Performance
Bank planning (policy formulation)
Goals, budgets, strategic planning
Market share
Technology
Data management, payments
Regulatory compliance
Capital, lending, securities, etc.
Personnel development
Challenges (personal selling and
geographic expansion)
Job satisfaction (training and
compensation)
Public confidence
Deposit insurance
Public image
7
Balance Sheet: Assets
Bank assets fall into four general categories:
1. Loans are the major asset and generate the greatest
amount of income before expenses and taxes.
2. Investment securities are held to earn interest, help
meet liquidity needs, speculate on interest rate
movements, meet pledging requirements and serve as
part of a bank’s dealer function.
3. Noninterest cash and due from banks consists of vault
cash, deposits held at the Central Bank and other
institutions and cash items in the process of collection.
4. Other assets are residual assets of relatively small
amounts (including fixed assets).
8
Balance Sheet: Assets
Accounting for investment securities:
̶ Held-to-maturity securities are recorded at amortized cost
reflecting the objective to hold until maturity.
̶ Trading account securities are actively bought and sold
and are reported at current market value on the balance
sheet. Unrealized gains and losses are reported on the
income statement.
̶ Available-for-sale securities are all other securities. They
are recorded at market value on the balance sheet with a
corresponding change to stockholders’ equity as unrealized
gains and losses.
9
Balance Sheet: Assets
Non-Interest Cash and Due From Banks
̶ Vault cash is held to meet customer withdrawals.
̶ Deposits held at the Central Bank are demand balances
used to meet legal reserve requirements, assist in check
clearing and wire transfers or effect the purchase and sale
of Treasury securities.
̶ Balances at other financial institutions are held primarily
to purchase services.
̶ Cash items in process of collection (CIPC) are generally
the largest component of cash, representing checks that
have been presented but not yet credited to accounts.
10
Balance Sheet: Assets
Other assets
Residual assets of small amounts including bank premises
and equipment, other real estate owned (OREO), investment
in unconsolidated subsidiaries and other assets.
̶ OREO is substantial for problem banks because it
represents collateral on unpaid loans.
̶ Commercial banks own relatively few fixed assets.
̶ Banker’s acceptances are negotiable instruments
guaranteeing payment to the owner that are often used in
trading goods.
11
B/S Analysis on Bloomberg
Constructing a Bank Balance Sheet
The following entries are from the actual balance sheet of a bank: Blank
Cash, including cash items in the process of collection 121
Non-interest-bearing deposits 275
Deposits with the central bank 190
Commercial loans 253
Long-term bonds (issued by the bank) 439
Real estate loans 460
Commercial paper and other short-term borrowing 70
Consumer loans 187
Securities 311
Interest-bearing deposits 717
Buildings and equipment 16
Other assets 685
Other liabilities 491
Note: Values are in billions. Blank
a. Use the entries to construct a balance sheet with assets on the left side of the balance sheet and
liabilities and bank capital on the right side.
b. The bank’s capital is what percentage of its assets?
14
Income Statement
̶ Interest income (II) is the sum of interest and fees earned
on all assets.
̶ Estimated tax benefit for loan and lease financing and tax-exempt
securities income is the estimated dollar tax benefit from not paying
taxes on these items.
̶ Interest expense (IE) is the sum of interest paid on all
interest bearing liabilities.
̶ Gross interest income minus gross interest expense is labeled net
interest income (NII).
15
Income Statement
Non-Interest Income (OI) includes:
̶ Fiduciary activities
̶ Deposit service charges
̶ Trading, venture capital and
securitization income
̶ Investment banking, advisory,
brokerage and underwriting fees
and commissions
̶ Insurance commission fees and
income
̶ Net servicing fees
̶ Net gains (losses) on sales of
loans
̶ Other net gains (losses)
16
Income Statement
̶ Non-Interest Expense (OE) consists of:
̶ Personnel, occupancy and other operating expenses
̶ Intangible amortizations and goodwill impairment
̶ Provision for loan and lease losses (PLL)
̶ Realized securities gains or losses (SG)
̶ Applicable income taxes (T)
̶ Net income (NI):
̶ Operating profit less all taxes +/- extraordinary items
̶ Total Revenue (TR):
̶ Total interest income, noninterest income and realized securities gains
(losses)
̶ Total Expense (EXP):
̶ Interest expense, noninterest expense and provision for loan losses
NI	 = 	NII	– 	Burden	– 	PLL	 + 	SG	 − 	T
17
I/S Analysis on Bloomberg
18
Relationship Between the Balance
Sheet and Income Statement
yi average pretax yield on the ith
asset
cj average interest cost of the jth
liability
quals the number of assets and m equals the number of liabilities. The
ntity in Equation 3.1 can be restated as:
n
i 1
Ai
m
j 1
Lj NW
arned on each asset equals the product of the average yield yi and the
estment Ai . Thus:
Interest income
n
i 1
yiAi
interest paid on each liability equals the product of the average inte
he average dollar funding Lj from that source, so that:
Interest expense
m
cjLj
cj average interest cost of the jth
liability
mber of assets and m equals the number of liabilities. The balance
on 3.1 can be restated as:
n
i 1
Ai
m
j 1
Lj NW (3.3)
asset equals the product of the average yield yi and the average
Thus:
Interest income
n
i 1
yiAi (3.4)
on each liability equals the product of the average interest cost
lar funding Lj from that source, so that:
Interest expense
m
j 1
cjLj (3.5)
(NII) equals the difference:
i 1
Ai
j 1
Lj NW
Interest earned on each asset equals the product of the average yield
dollar investment Ai . Thus:
Interest income
n
i 1
yiAi
Similarly, interest paid on each liability equals the product of the
cj and the average dollar funding Lj from that source, so that:
Interest expense
m
j 1
cjLj
Net interest income (NII) equals the difference:
NII
n
i 1
yiAi −
m
j 1
cjLj
age Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may b
ed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content
arned on each asset equals the product of the average yield yi and the
estment Ai . Thus:
Interest income
n
i 1
yiAi
interest paid on each liability equals the product of the average inte
he average dollar funding Lj from that source, so that:
Interest expense
m
j 1
cjLj
terest income (NII) equals the difference:
NII
n
i 1
yiAi −
m
j 1
cjLj
y not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBo
t materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent r
19
Relationship Between the Balance
Sheet and Income Statement
̶ Net interest income changes when the:
̶ composition or mix of assets change.
̶ rate earned on assets or paid on liabilities changes.
̶ volume of interest earning assets or interest bearing liabilities
change.
̶ Net income varies with the magnitude of assets and
liabilities and the associated cash flows:
ties cj . Larger loans are often transactions driven, with smaller mar
ans are relationship driven and typically associated with larger margin
nterest income, noninterest expense, and provisions for loan losses
he same balance sheet composition. The greater the loan portfolio,
ating overhead and provision for loan losses. Likewise, institutions th
nsumer loans operate with more noninterest expense (overhead). T
more in branch systems and equipment to attract consumer deposits a
multiple-payment consumer loans. Bank holding companies with
ries, on the other hand, generate more fee income.
ncome thus varies with the magnitudes of assets and liabilities and the
ws:
NI
n
i 1
yiAi −
m
j 1
cjLj − Βurden − PLL SG − Τ
ome in excess of dividend payments to shareholders increases retaine
s, total stockholders equity.
20
Return on Equity Model
EXHIBIT 3.6 Decomposition of Return on Equity: The Nature of Bank Profits
Cost of each liab.
Int. exp. on liab. j/$ amt. of liab. j
Interest Expense
aTA
Composition of liab.
$ amount of liab. j/aTA
Vol. of interest-bearing liab.
Tot. Int.-bearing liabilities/aTA
Salaries and empl. benefits/aTA
Occupancy expenses/aTANoninterest Expense
aTA Other expenses/aTA
Return on Assets
Net Income
aTA
Provisions for Loan losses
aTA
Tax Ratio
Income Taxes
aTA
Yield on each asset
Int. inc. on asset i/$ amt. of asset i
Composition of assets
$ amount of asset i/aTA
Interest Income
aTA
Volume of earning assets
Total earning assets/aTA
Asset Utilization
Total Revenue
aTA
Fiduciary Income/aTA
Service Charges and fees/aTANoninterest Income
aTA Trading Revenue/aTA
Other Noninterest income/aTA
Expense Ratio
Total Expenses
aTA
Return on Equity
Net Income
aTE
Equity Multiplier
aTA
aTE
Note: aTA = average total assets and aTE = average total equity.
21
Profitability Analysis
̶ Return on Equity (ROE)
̶ Net income/Average total equity
̶ Return on Assets (ROA)
̶ Net income/Average total assets
̶ ROE is linked to ROA by an equity multiplier (EM)
Rule 1: Use Average Balance Sheet Data when Comparing
Income Statement Data with Balance Sheet Data
Rule 2: Compare Individual Ratios over Time
Rule 3: Accounting Data May Not Reflect Accepted
Accounting Procedures and May Be Manipulated
ratios to determine why performance varies from peers.
Aggregate bank profitability is measured and compared in terms of return on equity
and return on assets. The ROE model simply relates ROE to ROA and financial leverage,
then decomposes ROA into its contributing elements. By definition:
ROE Net income Average total equity19
ROE equals net income divided by average total stockholders equity and measures the
percentage return on each dollar of stockholders equity.20
It is the aggregate return to
stockholders before paying cash dividends.
ROA equals net income divided by average total assets and thus measures net income
per dollar of average assets owned during the period. ROE is linked to ROA by the
equity multiplier (EM), which equals average total assets divided by total equity, via
the following accounting identity:
ROE
Net income
Average total assets
Average total assets
Average total equity
ROA EM
(3.8)
A larger equity multiplier indicates a larger amount of debt financing relative to
stockholders equity. As such, EM measures financial leverage and represents both a
profit and risk measure. Consider two competing banks, each holding $100 million in
assets with the identical composition. Asset quality is the same. One bank is financed
with $90 million in debt and $10 million in total equity, while the other bank is financed
with $95 million in debt and just $5 million in total equity. In this example, EM equals
10× for the first bank and 20× for the second bank.
EM 10 $100 $10 for the bank with $10 million in equity
EM 20 $100 $5 for the bank with $5 million in equity
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Expense Ratio and Asset
Utilization
̶ Net Income = Total Revenue – Total Operating Expenses – Taxes
̶ Asset Utilization (AU) = Total Revenue/Average Total Assets
̶ Expense Ratio (ER) = Total Operating Expenses/Average Total
Assets
̶ Tax Ratio (TAX) = Taxes/Average Total Assets
The greater the AU and the lower the ER and TAX, the higher the
ROA.
revenue is analogous to net sales plus other income at a nonfinancial co
equals the sum of interest income, noninterest income, and securities
s).22
Total operating expense (EXP) equals the sum of interest expense, non
se, and provisions for loan and lease losses. Dividing both sides by averag
(aTA) “decomposes” ROA into its components:23
ROA
NI
aTA
TR
aTA
EXP
aTA
Taxes
aTA
ROA AU ER TAX
:
AU Total revenue aTA
ER Total operating expenses aTA
TAX Applicable income taxes aTA
e, a bank’s ROA is composed of asset utilization (AU), the expense ratio (ER
x ratio (TAX). The greater the AU and the lower the ER and TAX, the hig
23
Expense Ratio and Asset
Utilization
̶ Interest expense ratio = Interest Expense/Average Total
Assets
̶ Noninterest expense ratio = Noninterest Expense/Average
Total Assets
̶ PLL ratio = Provision for Loan Losses/Average Total Assets
tive interpretation. For example, an ER of 5 percent indicates that
rating expenses equal 5 percent of total assets. Thus, the lower (gr
ore (less) efficient a bank will be in controlling expenses. The deco
ears at the top of Exhibit 3.6. Three additional ratios isolate the impa
of operating expenses:
nterest expense ratio Interest expense IE aTA
Noninterest expense ratio Noninterest expense OE aTA
Provision for loan loss ratio Provisions for loan losses PLL aTA
m of these ratios equals the expense ratio.24
ER
EXP
aTA
IE
aTA
OE
aTA
PLL
aTA
ary income and expense are included in the definitions of total revenue and total expe
-time occurrences, they should be excluded when evaluating operating performance a
s over time and versus peers. We assume that extraordinary income and expense a
24
Expense Ratio and Asset
Utilization
Interest expense may vary for three reasons:
1. Rate effects means interest costs differ between banks.
̶ Banks pay different risk premiums indicating how the market perceives
their asset quality and overall risk.
̶ Banks time their borrowings differently which impacts rates.
̶ Banks use different maturities which impacts rates.
2. Composite effects because the mix of liabilities differ.
3. Volume effects recognizes that interest expense is based
on the amount of liabilities.
25
Expense Ratio and Asset
Utilization
Noninterest Expense
̶ Measures of personnel, occupancy and other operating
expenses as a percentage of total overhead indicate cost
efficiencies or comparative disadvantages.
̶ Ratios are constructed to allow comparisons between different
sized banks.
̶ May also vary based on composition of liabilities
̶ Banks with large amounts of transaction deposits have greater
relative overhead costs.
26
Expense Ratio and Asset
Utilization
̶ Asset utilization (AU) is a measure of the institution’s ability to
generate total revenue.
̶ The greater the AU, the greater the bank’s ability to generate
income from the assets it owns.
̶ Interest income differs between banks for the same three reasons
as interest expense: rate, composition and volume.
̶ Noninterest Income (OI)
̶ Fees, fiduciary activities, service charges, trading revenues and
other noninterest income.
̶ May be skewed by substantial nonrecurring items.
̶ Tax payments also impact ROA.
rate total revenue. The greater the AU, the greater the bank’s ability to generate incom
rom the assets it owns. For example, if a bank’s AU equals 7 percent, its gross retur
before expenses and taxes) on average total assets equals 7 percent. A higher figure ind
ates greater profits, everything else held constant. If the same bank’s ER is 5 percent, th
bank’s net return on investment (assets) before taxes is 2 percent. Total revenue (TR
an be divided into three components:
TR Interest income II Noninterest income OI
Realized securities gains or losses SG
Dividing both sides by average total assets produces:28
AU
TR
aTA
II
aTA
OI
aTA
SG
aTA
(3.13
This indicates how much of a bank’s gross yield on assets results from intere
ncome, noninterest income, and realized securities gains (losses). Interest income ma
differ between banks for the same three reasons discussed with interest expense: rat
omposition, and volume effects. For the rate effect, an examination of pretax (gross
ields per asset, yi from Equation 3.4, allows the bank to compare realized interest yield
with those of peer banks. Differences may reflect different maturities, the timing of pur
hases relative to the interest rate cycle, or a different composition of holdings (henc
isk of the assets) within each asset category. For example, a bank that invests heavil
n new construction loans should initially earn higher gross yields on loans than a ban
27
Aggregate Profitability Measures
̶ Net Interest Margin (NIM) is a summary measure of the net interest
return on income-producing assets:
̶ Net Interest Income / Average Earning Assets
̶ Spread (SPRD) is a measure of the rate spread or funding
differential on balance sheet items that earn or pay interest.
̶ Interest Income/Average Earning Assets - Interest Expense /
Average Interest-Bearing Liabilities
̶ Burden ratio measure the amount of noninterest expense covered
by fees, service charges, securities gains and other income as a
fraction of total assets.
̶ (Non-Interest Expense – Non-Interest Income) / Average Earning
Assets
̶ Cost-income ratio
̶ Efficiency ratio measures a bank’s ability to control noninterest
expense relative to total revenue net of interest expense.
̶ Non-Interest Expense/(Net Interest Income + Non-Interest Income)
28
Stylized B/S and I/S
ASSETS LIABILITIES
Cash 100 Demand Deposits 3000
Loans 6000 Time Deposits 2500
Fixed Assets 200 Bonds 1000
Liquid Assets 1000 Equity 800
7300 7300
Interest Income 700
+ Fee income 600
- interest expenses 600
- op. expenses 500
= gross profit 200
Tax = 20%
Net profit = 160
30
Stylized B/S and I/S
ASSETS LIABILITIES
Loans 1200 Deposits 1080
Equity 100
Retained profits 20
Interest Income 700
Fees and services 65
Interest expense 90
Op. expenses 60
Loss provisions 12
Taxes 4.6
Profit after tax 18.4
32
Leverage and Bank Profits
̶ A high ratio of assets to capital (high leverage) is a twoedged
sword: Leverage can magnify relatively small ROAs
into large ROEs, but it can do the same for losses.
̶ Moral hazard can contribute to high bank leverage.
̶ If managers are compensated for a high ROE, they may
take on more risk than shareholders would prefer.
̶ Deposit insurance has increased moral hazard by reducing
the incentive depositors have to monitor the behavior of
bank managers.
̶ To deal with this risk, government regulations called capital
requirements have placed limits on the value of the assets
commercial banks can acquire relative to their capital.
33
Performance Characteristics
of Banks by Size
Commercial banks of different sizes exhibit sharply different
operating characteristics:
̶ Some reflect government regulations.
̶ Some are associated with differences in markets served.
̶ Larger banks hold a larger % of assets in loans relative to deposits
but a smaller % of earning assets.
̶ Smaller banks operate with proportionately more core deposits and
fewer volatile liabilities.
̶ Lower earnings base of largest banks reflect de-emphasis of
lending and increased emphasis on products and services and the
generation of fee income.
34
Cost Management Strategies
̶ Expense Reduction
̶ Employee reduction, temporary workers and outsourcing
̶ Operating Efficiencies
̶ Reduce costs while maintaining the existing level of products and
services
̶ Increase output but maintain current expenses
̶ Improve workflow
̶ Economies of scale exist when average costs decrease
as output increases.
35
Revenue Enhancement
̶ Involves changing the pricing of specific products and
services but maintaining a sufficiently high volume of
business so that total revenue increases.
̶ Closely linked to the concept of price elasticity.
̶ Identify products with price-inelastic demand.
̶ Price increase lowers demand but the decrease in demand is less
than the increase in price.
̶ Contribution growth allocates resources to best improve
overall long-term profitability.
36
Credit Risk
̶ Potential variation in net income from loan nonpayment or
deferred payment.
̶ Net losses = gross losses (charge-offs) – recoveries
(loans that were previously written off and collected).
̶ Expected future losses:
̶ Past-due loans are still accruing interest.
̶ Nonperforming loans are more than 90 days past due.
̶ Nonaccrual loans are not currently accruing interest.
̶ Restructured loans have modified payments or interest.
̶ Classified loans have reserves for recognized losses.
37
Liquidity Risk
̶ Risk to earnings and equity from the bank’s inability to
timely meet payments or obligations.
̶ Funding liquidity risk is the inability to liquidate assets or raise
required funding.
̶ Market liquidity risk is the inability of the institution to easily unwind
or offset specific exposures without significant losses from
inadequate market depth or market disturbances.
̶ Liquid assets are costly to hold because they pay very
low rates of interest.
̶ consist of unpledged, marketable short-term securities classified as
available for sale plus federal funds sold and securities purchased
under agreement to resell.
38
Market Risk
̶ Risk to earnings and equity from adverse movements in
market rates or prices.
̶ Interest rate risk is the potential variability in an
institution’s net interest income and market value of
equity due to changes in market interest rates.
̶ Analyzed using GAP and earnings sensitivity analysis.
̶ More comprehensive approach uses duration gap and economic
value of equity sensitivity analysis.
̶ An asset or liability is rate sensitive if management expects it to be
repriced (rate change) within a certain time period.
39
Market Risk
̶ Equity and security price risk is the potential risk of loss
associated with trading account portfolios.
̶ Large banks often conduct value-at-risk analyses to assess risk.
Small banks conduct sensitivity analysis.
̶ Foreign exchange risk is the risk to an institution from
adverse movements in foreign exchange rates.
̶ Most banks measure this risk by calculating measures of net
exposure by each currency.
̶ Net exposure is the amount of assets minus the amount of
liabilities denominated in the same currency.
40
Operational Risk
̶ Possibility that operating expenses might vary
significantly from what was expected.
̶ May occur as the result of:
̶ Business interruptions
̶ Transaction processing
̶ Inadequate information systems
̶ Breaches in internal controls
̶ Client liability
̶ Reputation risk:
̶ Risk that negative publicity, true or untrue, can adversely affect a
bank’s customer base or bring forth costly litigation that negatively
affects profitability.
41
Risk-adjusted performance
analysis
̶ Banks have to increase their capital at the same time as they aim to
improve their returns on capital
̶ RoE might be boosted by taking more risk
̶ Risk-adjusted return on capital (RAROC) takes risk into account
RAROC =
Revenues − Operating	costs	 − Expected	loss
Risk	based	required	capital
1. incorporates the expected loss associated with lending, rather than
the actual loan impairments that are included in the income
statement of the bank (calculated on the basis of long-term
average default rates and recovery rates associated with the
bank’s actual loan portfolio)
2. relates the adjusted income to risk-based required capital
(available regulatory capital)
42
Risk-adjusted performance
analysis
Asset
productivity
R/EA
Asset
efficiency
EA/TA
Tax
efficiency
PAT/PBT
ROA
PBTI/EA
(PBTI-EL)
/EA
RAROC
(PBTI-EL)
/RRC
PBT/RRC RoE
(1 – C/R)
Cost-
efficiency
EL/EA
Asset
quality
TA/RRC
Risk-normed
leverage
(Imp – EL)
/RRC
Unexpected
loss
RRC/Equity
Capital
buffer
X
X
X
X
X– –
Figure 1: The performance scheme
R (revenues)
C (costs)
EA (earning assets)
PBTI (profit before taxes
and interest (= R — C)
EL (expected loss)
TA (total assets)
RRC (risk- required
capital), Imp
(impairment)
UL (unexpected loss (=
Imp — EL)
PBT (profit before tax)
PAT (profit after tax)
43
Risk-adjusted performance
analysis
1. Calculation of RoA
RoA =
R − C
EA
=
R
EA
1 −
R
C
2. Derivation of RAROC from RoA
RAROC =
R − C − EL
RRC
= RoA −
EL
EA
EA
TA
G
TA
RRC
3. Derivation of RoE from RAROC
RoE = RAROC −
UL
RRC
RRC
Equity
G
PAT
PBT
44
Loan valuation
Loan maturity = 2 years (annual interest)
Customer deposit pay rate = 5% (fixed for two years)
Target ROE = 10%
Corporate tax rate = 20%
Loan default probability (Year 1) = 0%
Loan default probability (Year 2) = 5%
Recovery rate = 40%
Loan interest rate X%
ASSET LIABILITY
Loan 100 Deposit 90
Equity 10
!"#$%&! = (
"#$
%
![*+&]
(1 + 01!)&
45
Literature
̶ KOCH, T.W. and S.S. MacDONALD (2015). Bank Management.
Chapters 3-4.
̶ CHOUDRY M. (2022). The Principles of Banking, 2nd ed. – Ch. 1,
pp.19-48.
̶ HORVÁTOVÁ, Eva. Ekonomika a riadenie bánk. S. 60-82.
̶ KLAASSEN, P. and I. van EEGHEN (2015). Analyzing bank
performance – linking RoE, RoA and RAROC: U.S. commercial
banks 1992-2014. Journal of Financial Perspectives, 3(2).