CHAPTER SIX Measuring and Evaluating the Performance of Banks and Their Principal Competitors

Key Topics  Stock Values and Profitability Ratios  Measuring Credit, Liquidity, and Other Risks  Measuring Operating Efficiency  Performance of Competing Financial Firms  Size and Location Effects 6-2

Evaluating Bank Performance  Performance refer to how adequately a financial firm meets the needs of  Stockholder  Employee  Depositors and creditors  Borrowing customers  Performance are under heavy scrutiny: Banks depend heavily upon the open market to raise funds  In 2002 J.P.Morgan Chase’s credit rating came under review  In 2007, Citigroup,Countrywide and Washington Mutual 6-3

Evaluating Bank Performance  Two important dimensions of performance:  Profitability  Risk  Objective: to maximize the value of the shareholders’ wealth at an acceptable level of risk. 6-4

Value of the Bank’s Stock 6-5

Value of a Bank’s Stock Rises When:  Expected Dividends Increase  Risk of the Bank Falls  Market Interest Rates Decrease  Combination of Expected Dividend Increase and Risk Decline 6-6

Value of Bank’s Stock if Earnings Growth is Constant 6-7  A stock whose dividends are expected to grow forever at a constant rate, g. D 1 = D 0 (1+g) 1 D 2 = D 1 (1+g) =D 0 (1+g) 2 D t = D t-1 (1+g) =D 0 (1+g) t  If g is constant, the discounted dividend formula converges to:   g r D g r g D P      1 0 0 1

Value of Bank’s Stock if Earnings Growth is Constant 6-8  For example, a bank is expected to pay a dividend of $5 per share in period 1, and dividends are expected to grow at 6% forever, and the discount rate to reflect risk is 10%, then the stock price could be valued at:

Value of Bank’s Stock if Earnings Growth is Constant 6-9  However, most capital-market investors have a limited time horizon and plan to sell the stock at the end of their investment horizon:  Suppose investors expect a bank to pay dividend of $5 at the end of period 1, $10 at the end of period 2 and sell the stock for a price of $150 per share:

Key Profitability Ratios in Banking Assets Total Income Interest Net Assets Total expense) Interest - income (Interest Margin Interest Net   Assets Total Income t Noninteres Net Assets Total expenses t Noninteres - PLLL - revenue t Noninteres Margin t Noninteres Net   Net Income Return on Equity Capital (ROE) = Total Equity Capital Net Income Return on Assets (ROA) = Total Assets 6-10