1. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-1 Chapter 6 Depository Institution Performance

2. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-2 Objectives and Guidelines It is often helpful to analyze decision areas which affect an institution’s risk and return. Differences in regulatory and accounting standards for reporting financial data leave some discretion to managers in reporting performance. Trend analysis reveals long-term patterns in financial measures.

3. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-3 Common size financial statements are helpful for peer/industry analysis. Government and private companies provide data for peer comparisons. However, publishers of data often use different definitions for particular ratios, and comparison firms are often from different states with different regional economies and state banking regulations.

4. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-4 ROE EM AU NPM Noninterest Revenue to Assets Interest Revenue to Assets NIM Burden Provision for Loan Losses ROA Dupont Analysis for a Depository Institution

5. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-5 Asset Utilization (AU) reflects revenue management. Net Profit Margin (NPM) reflects cost management. NIM can be analyzed by examining the relative changes in interest revenue to assets and interest expense to assets. NPM includes any securities gains or losses or extraordinary items. The burden can be analyzed by considering the different types of operating expenses and sources of noninterest revenue.

6. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-6 What Determines Changes in NIM? Changes in the mix of bank assets and liabilities. Changes in the volume of assets and liabilities. Changes in the rates earned and paid on individual assets and liabilities.

7. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-7 Liquidity Management To manage liquidity risk, depository institutions can: hold short term securities; and borrow purchased funds which are very interest- sensitive. The cost of holding short-term assets is lower interest income. The cost of borrowing purchased funds is increasing cost of funds when rates rise.

8. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-8 Liquidity Measures

9. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-9 Loan Management and Credit Risk Increasingly risky loans should pay progressively higher rates to compensate for risk. Some loan types have more credit risk than others by their very nature. For example, commercial real estate loans are riskier than home mortgages. Consumer loans often expose banks to higher bad debt losses on average than other types of loans.

10. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-10 Credit Risk Measures

11. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-11 Interest Rate Risk Management The bank’s repricing gap as a percentage of assets measures the likelihood that the bank’s NIM will change with a change in market interest rates. Market value risk is the threat that the market value of assets will fall more rapidly than the market value of liabilities with a rise in rates, reducing the market value of equity.

12. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-12 Interest Rate Risk Measures

13. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-13 Capital Management Depository institutions have high financial leverage. High leverage translates into high insolvency risk. The higher the other types of risks that a bank has the higher the capital ratio should be.

14. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-14 Capital Risk Measures

15. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-15 Operational Efficiency A bank’s burden is a measure of the effectiveness of its expense control relative to its productivity in producing noninterest revenues. The most popular efficiency ratio is

16. Copyright © by 2000 Harcourt, Inc. All rights reserved. 6-16 Volatility of Earnings Volatility as measured by the standard deviation is also a measure of risk. The standard deviation over time can be calculated for: NIM; ROA; and ROE.