Solution manual bank management and financial services 9th edition by rose, peter chap006

A bank's stock price is affected by all those factors affecting its profitability and risk exposure, particularly its rate of return on equity capital and risk to shareholder earnings..

CHAPTER 6 MEASURING AND EVALUATING THE PERFORMANCE OF BANKS AND THEIR

PRINCIPAL COMPETITORS

Goal of This Chapter: The purpose of this chapter is to discover what analytical tools can be applied to a bank’s financial statements so that management and the public can identify the most critical problems inside each bank and develop ways to deal with those problems

Key Topics in this Chapter

 Stock Values and Profitability Ratios

 Measuring Credit, Liquidity, and Other Risks

 Measuring Operating Efficiency

 Performance of Competing Financial Firms

 Size and Location Effects

 Appendix: Using Financial Ratios and Other Analytical Tools to Track Financial FirmPerformance—The UBPR and BHCPR

Chapter Outline

I Introduction:

II Evaluating Performance

A Determining Long-Range Objectives

B Maximizing the Value of the Firm: A Key Objective for Nearly All

Financial-Service Institutions

C Profitability Ratios: A Surrogate for Stock Values

1 Key Profitability Ratios

2 Interpreting Profitability Ratios

D Useful Profitability Formulas for Banks and Other Financial-Service Companies

E Return on Equity and Its Principal Components

F The Return on Assets and Its Principal Components

G What a Breakdown of Profitability Measures Can Tell Us

H Measuring Risk in Banking and Financial Services

1 Credit Risk

2 Liquidity Risk

3 Market Risk

a Price Risk

b Interest Rate Risk

4 Foreign Exchange and Sovereign Risk

5 Off-Balance-Sheet Risk

6 Operational (Transactional) Risk

7 Legal and Compliance Risks

8 Reputation Risk

9 Strategic Risk

10 Capital Risk

I Other Goals in Banking and Financial-Services Management

III Performance Indicators among Banking’s Key Competitors

IV The Impact of Size on Performance

A Size, Location, and Regulatory Bias in Analyzing the Performance of Banks andCompeting Financial Institutions

V Summary of the Chapter

Appendix to the Chapter - Using Financial Ratios and Other Analytical Tools to Track Firm Performance-The UBPR and BHCPR

profitability Bank stockholders, depositors, and bank examiners representing the regulatory community are all interested in the quality of bank performance The stockholders are primarily concerned with profitability as a key factor in determining their total return from holding bank stock, while depositors (especially large corporate depositors) and examiners typically focus on bank risk exposure

6-2 What individuals or groups are likely to be interested in these dimensions of performancefor a financial institution?

The individuals or groups likely to be interested in the dimensions i.e., profitability and risk are –other banks lending to a particular bank, borrowers, large depositors, holders of long-term debt capital issued by banks, bank stockholders, and bank examiners representing the regulatory community

6-3 What factors influence the stock price of a financial-service corporation?

A bank's stock price is affected by all those factors affecting its profitability and risk exposure, particularly its rate of return on equity capital and risk to shareholder earnings Research

evidence over the years has found that the stock prices of financial institutions is sensitive to changes in market interest rates, currency exchange rates, and the strength or weakness of the economy A bank can raise its stock price by working to achieve policies that increase future earnings, reduce risk, or pursue a combination of both actions

6-4 Suppose that a bank is expected to pay an annual dividend of $4 per share on its stock in the current period and dividends are expected to grow 5 percent a year every year, and the

minimum required return-to-equity capital based on the bank's perceived level of risk is 10 percent Can you estimate the current value of the bank's stock?

In this constant dividend growth rate problem, the current value of the bank's stock would be:

6-5 What is return on equity capital, and what aspect of performance is it supposed to

measure? Can you see how this performance measure might be useful to the managers of

financial firms?

Return on equity capital is the ratio of net income over total equity capital It represents the rate

of return earned on the funds invested in the bank by its stockholders They expect to earn a suitable profit over the risk of their investment

Return on equity capital can also be calculated using the return on assets as follows:

Total assetsROE = ROA

Total equity capital



This ROE–ROA relationship illustrates the fundamental trade-off between risk and return This equation reminds us that the return to a financial firm’s shareholders is highly sensitive to how itsassets are financed—the proportion of debt and owner’s capital used Constructing a risk-return trade-off table can help the managers understand how much leverage (debt relative to equity) must be used to achieve a financial institution’s desired rate of return to its stockholders

6-6 Suppose a bank reports that its net income for the current year is $51 million, its assets total $1,144 million, and its liabilities amount to $926 million What is its return on equity capital? Is the ROE you have calculated good or bad? What information do you need to answer this last question?

The bank's return on equity capital should be:

Net incomeROE

Total equity capital

Return on assets is the ratio of net income over total assets The rate of return secured on a bank'stotal assets indicates the efficiency of its management in generating net income from all of the resources (assets) committed to the institution This would be important to banks and their major competitors.

6-8 A bank estimates that its total revenues will amount to $155 million and its total expenses(including taxes) will equal $107 million this year Its liabilities total $4,960 million while its equity capital amounts to $52 million What is the bank's return on assets? Is this ROA high or low? How could you find out?

The bank's return on assets would be:

In contrast, the noninterest margin reflects the banks spread between its noninterest income (such

as service fees on deposits) and its noninterest expenses (especially salaries and wages and overhead expenses) For most banks the noninterest margin is negative Management will usuallyattempt to expand fee income, while controlling closely the growth of noninterest expenses in order to make a negative noninterest margin less negative

The earnings spread measures the effectiveness of the bank's intermediation function of

borrowing and lending money, which, of course, is the bank's primary way of generating

earnings As competition increases, the spread between the average yields on assets and the average cost of liabilities will be squeezed, forcing the bank's management to search for

alternative sources of income, such as fees from various services the bank offers

6-10 Suppose a banker tells you that his bank in the year just completed had total interest expenses on all borrowings of $12 million and noninterest expenses of $5 million, while interest income from earning assets totaled $16 million and noninterest revenues totaled $2 million

Suppose further that assets amounted to $480 million, of which earning assets represented 85 percent of that total while total interest-bearing liabilities amounted to 75 percent of total assets See if you can determine this bank's net interest and noninterest margins and its earnings base and earnings spread for the most recent year.

The bank's net interest and noninterest margins must be:

Interest income - Interest expense

Net interest margin =

The bank's earnings spread and earnings base are:

Totalinterest income Total interestexpenseEarningsspread = -

Total earning assets Total interest-bearing liablities

The principal components of ROE are:

a The net profit margin or the Net after-tax income to Total operating revenues which reflects the effectiveness of a bank's expense control program and service pricing policies;

b The degree of asset utilization or the ratio of Total operating revenues to Total assets which measures the effectiveness of the bank's portfolio management policies, especially the mix and yield on assets; and,

c The equity multiplier or the ratio of Total assets to Total equity capital which measures a bank's use of leverage in funding its operations: the sources chosen to fund the financial

institution (debt or equity)

6-12 Suppose a bank has an ROA of 0.80 percent and an equity multiplier of 12X What is itsROE? Suppose this bank's ROA falls to 0.60 percent What size equity multiplier must it have tohold its ROE unchanged?

The bank's ROE is:

ROE = 0.80 percent ×12 = 9.60 percent

If ROA falls to 0.60 percent, the bank's ROE and equity multiplier can be determined from:

ROE = 9.60 percent = 0.60 percent × Equity multiplier

9.60 percentEquity Multiplier 16X

0.60 percent

6-13 Suppose a bank reports net income of $12, pre-tax net income of $15, operating revenues

of $100, assets of $600, and $50 in equity capital What is the bank's ROE? Tax-managementefficiency indicator? Expense control efficiency indicator? Asset management efficiencyindicator? Funds management efficiency indicator?

The bank's ROE must be:

$15

$15ExpenseControl Effeciency Indicator = = 0.15or15percent

$100

$100Asset Management Effeciency Indicator = = 0.1667 or16.67 percent

$600

$600 Fund Management Effeciency Indicator = = 12x

$50

Alternative calculation for ROE:

= 0.8 × 0.15 × 0.1667 × 12

= 0.24 or 24 percent

6-14 What are the most important components of ROA, and what aspects of a financial

institution’s performance do they reflect?

The principal components of ROA are:

a Total Interest Income less Total Interest Expense divided by Total Assets, measuring a bank's success at intermediating funds between borrowers and lenders

b Provision for Loan Losses divided by Total Assets, which measures management's ability to control loan losses and manage a bank's accrual expense

c Noninterest Income less Noninterest Expenses divided by Total Assets, which indicates the ability of management to control salaries and wages, other noninterest costs of operations and generate income from handling customer transactions

d Applicable Taxes divided by Total Assets, which is an index of tax management effectiveness, measures the financial firm’s share of the cost of government securities

6-15 If a bank has a net interest margin of 2.50%, a noninterest margin of −1.85%, and a ratio

of provision for loan losses, taxes, security gains, and extraordinary items of −0.47%, what is itsROA?

The bank's ROA must be:

ROA = Net interest margin + Noninterest margin – Ratio of provision for loan

losses, taxes, security gains, and extraordinary itemsROA = 2.5 percent + (−1.85 percent) – (−0.47 percent) = 1.12 percent6-16 To what different kinds of risk are banks and their financial-service competitors subjectedtoday?

a Credit Risk: the probability that the loans and securities the bank holds will not pay out as promised

b Liquidity Risk: the probability that the bank will not have sufficient cash on hand in the volume needed precisely when cash demands arise

c Market Risk: the probability that the market value of assets held by the bank will decline due

to falling market prices Market risk is composed of both price risk and interest rate risk

Price Risk: the probability or possibility that the value of bond portfolios and

stockholders’ equity may decline due to market prices movement against the financial firm

Interest-Rate Risk: the possibility or probability that the interest rates will change,

subjecting the bank to incur a lower margin of profit or a lower value for the firm’s capital

d Foreign Exchange and Sovereign Risk: the uncertainty that due to fluctuation in currency prices, assets denominated in foreign currencies may fall, forcing the write-down of these assets

on its Balance Sheet

e Off-Balance-Sheet Risk: the probability that the volume of off-balance-sheet commitments far exceeds the volume of conventional assets

f Operational (Transactional) Risk: the uncertainty regarding a financial firm’s earnings due to failures in computer systems, employee misconduct, floods, lightening strikes and other similar events

g Legal and Compliance Risk: the uncertainty regarding a financial firm’s earnings due to actions taken by our legal system or due to a violation of rules and regulations

h Reputation Risk: the uncertainty due to public opinion or the variability in earnings due to positive or negative publicity about the financial firm

i Strategic Risk: the uncertainty in earnings due to adverse business decisions, lack of

responsiveness to industry changes, and other poor decisions by management

j Capital Risk: the risk that the value of the assets will decline below the value of the liabilities All of the other risks listed above can affect earnings and the value of the assets and liabilities and therefore can have an effect on the capital position of the firm

6-17 What items on a bank's balance sheet and income statement can be used to measure its risk exposure? To what other financial institutions do these risk measures seem to apply?

There are several alternative measures of risk in banking and financial service firms Capital risk

is often measured by bank capital ratios, such as the ratio of total capital to total assets or total capital to risk assets Credit risk can be tracked by such ratios as net loan losses to total loans or relative to total capital Liquidity risk can be followed by using such ratios as cash assets and government securities to total assets or by purchased funds to total assets Interest-rate risk may

be indicated by such ratios as interest-sensitive assets to interest-sensitive liabilities or the ratio

of money-market assets to money-market borrowings

These risk measures also apply to those nonbank financial institutions that are private, profit making corporations, including stockholder-owned thrift institutions, insurance companies,

finance and credit card companies, security broker and dealer firms, mutual funds, and hedge funds.

6-18 A bank reports that the total amount of its net loans and leases outstanding is $936 million, its assets total $1,324 million, its equity capital amounts to $110 million, and it holds

$1,150 million in deposits, all expressed in book value The estimated market values of the bank's total assets and equity capital are $1,443 million and $130 million, respectively The bank's stock is currently valued at $60 per share with annual per-share earnings of $2.50 Uninsured deposits amount to $243 million and money-market borrowings total $132 million, while nonperforming loans currently amount to $43 million and the bank just charged off $21 million in loans Calculate as many of the risk measures as you can from the foregoing data

1 Liquidity Risk:

Net Loans and Leases $936 million

= = 0.706949or 70.69 percentTotal Assets $1,324 million

2 Interest Rate Risk:

Uninsured Deposits $243million

= = 0.211304or 21.13percentTotal Deposits $1,150 million

3 Capital Risk:

Equity Capital $130 million

= = 0.09009or 9.01percentRisk Assets $1,443 million

Stock Price $60

24Earnings per Share $2.50 

Book Value of Assets $1,324 million

= = 0.917533or 91.75percentMarket Value of Assets $1,443 million

4 Credit Risk:

Nonperforming Assets $43million

= = 0.04594or 4.59 percentNet Loans and Leases $936 million

Charge-offs of Loans $21million

= = 0.022436or 2.24 percentTotal Loans and Leases $936 million

5 Price Risk:

Book Value of Assets $1,324 million

= = 0.917533or 91.75percentMarket Value of Assets $1,443 million

Problems and Projects

6-1 An investor holds the stock of Last-But-Not-Least Financials and expects to receive a dividend of $4.75 per share at the end of the year Stock analysts recently predicted that the bank’s dividends will grow at approximately 3 percent a year indefinitely into the future If this

is true, and if the appropriate risk-adjusted cost of capital (discount rate) for the bank is 14 percent, what should be the current price per share of Last-But-Not-Least Financials’ stock?

0

4.75

$43.180.14 0.03

6-2 Suppose that stockbrokers have projected that Jamestown Savings will pay a dividend of

$2.50 per share on its common stock at the end of the year; a dividend of $3.25 per share is expected for the next year, and $4.00 per share in the following two years The risk-adjusted cost

of capital for banks in Jamestown’s risk class is 15 percent If an investor holding Jamestown’s stock plans to hold that stock for only four years and hopes to sell it at a price of $50 per share, what should the value of the bank’s stock be in today’s market?

Oriole Savings Association has an equity-to-asset ratio of 9 percent which means its equity multiplier must be:

= = 11.11XEquity Capital 0.09

Assets

In contrast, Cardinal Savings has an equity-to-asset ratio of 7 percent which means it has an equity multiplier of:

= = 14.29XEquity Capital 0.07

Interest on nondeposit borrowings 6

Total interest expense 46

Noninterest income and fees 20Noninterest expenses:

Salaries and employee benefits 10*

Other noninterest expenses 2Total noninterest expenses 17

Net noninterest income -2

Securities gains (or losses) 2Pretax net operating income 10

Net income 7

*Note: the bank currently has 40 FTE employees

Smiling Merchants National Bank

Report of Condition

Cash and deposits due from banks $100 Demand deposits $190

Investment securities 150 Savings deposits 180

Net loans 700 Federal funds purchased 80

(Allowance for loan losses = 25) Total liabilities 920

(Unearned income on loans = 5) Equity capital

Total earnings assets 860 Interest-bearing deposits 650

Fill in the missing items on the income and expense statement Using these statements, calculate the following performance measures:

Net interest margin Tax management efficiency

Net noninterest margin Expense control efficiency

Net operating margin Asset management efficiency

Earnings spread Funds management efficiency

Net profit margin Operating efficiency ratio

What strengths and weaknesses are you able to detect in Smiling Merchants’ performance?

1 ROE = Total equity capitalNet income = $90$7 = 0.0778 or 7.78 percent

2 ROA = Net income = $7 = 0.00714 or 0.71 percent