Valuate Banks

8/14/2019 Valuate Banks

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ALTERNATIVE MODELS OFBANK PERFORMANCE

Chapter 4

Bank Management Bank Management , 5th edition.5th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright 2003 by South-Western, a division of Thomson Learning


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Traditional bank performance analysiscarries three basic flaws

It ignores the wide diversity in strategiespursued by different institutionsA banks total assets no longer serve as ameaningful yardstick when banks engagein off-balance sheet activitiesThe analysis provides no directinformation concerning how or

which of the banks activitiescontribute to the creation of shareholder value


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Wide diversity in strategies pursued bydifferent institutions

When UBPRs were introduced, most banksdid similar things, which were reflected intheir balance sheet

They accepted deposits and made loans, andmany interest rates were regulatedThe primary differentiation of performancewas balance sheet composition

Today, banks may pursue sharply differentstrategies


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Banks total assets no longer serve as ameaningful yardstick when banks engage

in off-balance sheet activities

Consider the situation where two banks

report the same asset size, but one also hasan extensive mortgage-servicing operationthat generates servicing incomeIf the bank with mortgage-servicing makes aprofit on this activity, it will report a higher ROA, ceteris paribus, due to the higher noninterest income for mortgage-servicing

fees


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The analysis provides no direct informationconcerning how or which of the banksactivities contribute to the creation of shareholder value

It similarly ignores other performance

benchmarks that customer-focusedmanagers must consider to identifythe best strategies going forward


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Although ROA might be a biasedindicator of performance, return

on equity (ROE) doesnt sufferfrom the same weaknesses.

When considering the entire bank,stockholders equity must support allactivities, whether on- or off-balance

sheet.Thus, a comparison of net income toequity captures the returns to owners

contributions.


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A common starting point is to determinewhether the banks strategy is more loan-

driven or deposit-driven.

A loan-driven banks profitabilityis generally a function of net interest income (the margin)with loan volume a major factor.A deposit-driven banks profitability is

generally a function of noninterest incomewith franchise value and deposit volume amajor factor.


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A loan driven bank finds that:

asset size is determined by loan demandprofitability is determined by loaneconomics; i.e., loan yields versus cost of fundloan margin is high as well as noninterestexpensethe culture is typically our bank

underwrites loans better than other banksvalue is typically some multiple of coreearnings


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One way to construct ratios that avoid theproblems of off-balance sheet activities is to

calculate ratios tied to a banks totaloperating revenue (net interest income plusnoninterest income) -- (David Cates (1996))

Fundamentally this means calculateperformance measures using totaloperating revenue as the denominator rather than assets.

Here, total operating revenue equals the sumof net interest income and noninterest

income.


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Bank stock analysts follow a standard procedurewhen evaluating firm performance

Initially use GAAP-based financial information to calculateperformance measures

adjust the data to omit the impact of nonrecurring items, such asone-time asset sales and restructuring chargescompare these historical ratios with a carefully selected groupof peer institutions, matching each banks primary strategicfocus

Based on his or her own analysis and conversations withspecialists within the bank, the analyst then assesses thequality of earnings based on:

their sustainabilitythe banks market power in specific product or service areas

the banks franchise valueThe next step is to forecast earnings, cash flow, and marketvalue of equity over a three- to five-year time horizonFinally, the analyst makes a stock recommendation:

accumulate (buy)

neutral (hold)below-market performance (sell)


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It is extremely rare, however, to see anoutright sell recommendation becauseanalysts want to remain in the good gracesof the banks that they follow

Thus, they do not formally recommendselling the stock, but rather label it as likelyto exhibit below-market performance.A hold recommendation thus actually meanssell the stock for most analysts.

The recent failure of Enron is potentially anexample of the conflict of interest buy- side and sell-side analysts have.


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Investors in bank stocks are primarilyconcerned with whether the banksmanagement is creating value forstockholders.

When analysts compare performance over

some historical period, they are lessconcerned with ROE, ROA, and efficiencyratios rather the overall total return from

investing in the banks stock .Total return equals dividends received plusstock price appreciation/depreciation

relative to the initial investment.


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Return to stockholders= ( price + dividends) / price t-1

Earnings per share

Price to earnings (P/E) = stock price / EPS

Price to book value= stock price / book value per share

Market value (MV) of equit y

= MV of assets - MV of liabilities or = # share of common stock x stock rice

goutstandintockscommonof sharesof number stockpreferredondividendsandtaxesafter NI

=

Key stock market-based performancemeasures include


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Example: buy 100 shares of PNC Financial at the beginning of 2001 for $73.06. The bank paid $1.92 per share in dividends that generated reinvestment income of $.09. At the end of 2001,the price of stock was $56.20.

Return to stockholders in 2001 was -20.3%.0.203 = [$56.20 - $73.06 + $2.01] $73.06

B l d d


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Balanced scorecardperformance measures that look beyond just financial measures

The balanced scorecard is an attempt to balancemanagement decisions based on financialmeasures with decisions based on a firmsrelationships with its customers and theeffectiveness of support processes in designingand delivering products and servicesThe result is that line of business managers useindicators such as:

market share,customer retention and attrition,customer profitability, andservice quality to evaluate performance

Internally, they also track productivity andemployee satisfaction

Such nonfinancial indicators provide information regarding whether abank is truly customer-focused and whether its systems are appropriate


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Operationalize the balanced scorecard

divide the bank into a Customer Bank and a House Bank

Income derived from balance sheetand income statement items that arederived from bank customersdetermines

The Customer Bank

Items that arise when the bank is itsown customer determinesThe House Bank


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Two banks in one houseTraditional or Customer Bank, activitiesinclude:

most loans, core deposits, payment services,credit enhancements, asset management, andfinancial advisory.

Investment or House Bank, activities include:the investment portfolio, noncore, purchasedliabilities, loan participations, asset sales,servicing, and bank-sponsored mutual funds.

Items are assigned based on whether theunderlying activities pertain to bankcustomers (Customer Bank) or the bank itself (Investment Bank).Evaluate the returns on each Bank relative tothe risks and relevant benchmarks.


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Assigning equity capital to each unit

Alternative capital allocation methodsinclude:using regulatory risk-based capitalstandardsassignment based on the size of assetsbenchmarking each unit to pure-playpeers that are stand-alone, publicly

held firms; andmeasures of each line of businesss riskiness.


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Example: PNC reported results for sevendistinct lines of business

Banking Businesses1. Regional Community Banking2. Corporate Banking3. PNC Real Estate Finance

4. PNC Business CreditAsset Management and Processing

1. PNC Advisors2. BlackRock3. PFPC.

The data were obtained from PNCs managementaccounting system based on internal assumptionsabout revenue and expense allocations andassignment of equity to each line of business.


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PNCs profitability analysis for 2000-2001


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Two lines of business for PNC are detailed

Corporate Bankingrepresents products and services provided nationally in the areas of credit, equipment leasing,treasury management, and capital markets

products to large and mid-sized corporations and government entities.

Community Bankingencompasses the banks traditional deposit,branch-based brokerage, electronic banking and credit products to retail customers along with

products to small businesses such that it is primarily a deposit-generating unit.


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Transfer pricingthe interest rate at which a firm could buy or

sell funds in the external capital markets.

When management creates balance sheetsfor each line of business, it must allocatecapital as well as assets or liabilities tomake the balance sheet balance.It must then assign a cost or yield to each of

these components to produce incomestatement for each line of business.


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Bank Asset Liability

Loan: 2 year Time deposit: 3 month$1,000,000 @8.50% $1,000,000 @ 4.5%

Margin = 4.00%

Interest Rate Risk: Liability sensitiveEmbedded Option: Prepayment risk on loan

Lending DivisionAsset LiabilityLoan: 2 year Transfer from Treasury: 2

year$1,000,000 @8.50% $1,000,000 @6.00%

Margin = 2.50%

Interest Rate Risk: NoneOption : Sold prepayment option to loan customer on balance sheet;buy an option from Treasury for 0.20%.NIM after option cost = 2.50% - 0.20% = 2.30%

Deposit-Gathering DivisionAsset LiabilityReceivable from Treasury Time dposit3-month 3-month$1,000,000 @5.20% $1,000,000 @ 4.5%

Margin = 0.70%

Interest Rate Risk: NoneOption: None

Treasury DivisionAsset LiabilityReceivable from Lending: Transfer to Deposit-Gathering:2-year 3-month$1,000,000 @6.00% $1,000,000 @5.20%

Margin = 0.80%

Interest Rate Risk: Liability sensitiveOption : Sell option to lending division for 0.20%;NIM after option sale = 0.80% + 0.20% = 1.00%.Treasury has interest rate and loan prepayment risk.

Example: Internal funds transfer pricing2-year loan financed by a 3-month deposit

Ri k dj d i d i


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Risk-adjusted income and economicincome

Two adjustments are frequently made toincome in line of business profitabilityanalysis:

1. The return is adjusted for risk by subtracting

expected losses2. The return nets out required returns

expected by stockholders.This minimum required return, or cost of

equity, represents a hurdle rate, or stockholders minimum required rate of return.The specific concern is whether RAROC is

greater than the firms cost of equity.


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Allocated risk capitalThe objective of RAROC analysis is to assist inrisk management and the evaluation of line of business performance. As part of this, it is necessaryto assign capital to each line of business.

Banks allocate risk capital by:1. Regulatory risk-based capital standards2. Asset size3. Benchmarking versus pure-play stand-alone

businesses4. Perceived riskiness of the business unit

Unfortunately, most lines of business do not have market valuebalance sheets. Hence, many banks focus on the volatility in

economic earnings ( earnings-at-risk ) or estimate a value-at-risk figure.


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Earnings-at-risk the volatility of earnings from a line of business.

Securities underwriting and letters of credit(guarantees) against customer exposures ata large bank do not require much capital tosupport day-to-day operations.

But before a bank can actively engage in thisbusiness, it must have a strong credit andbond rating, which requires a substantialamount of risk capital.

One way to measure the required riskcapital is to relate it to the volatility of earnings from this line of business; i.e.,

earnings-at-risk.


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Earnings-at-risk applied to loans

Using historical data for each of the past 30months, estimate revenues obtained directlyfrom these loans.Using historical data for each of the past 30months, estimate direct expenses fromoffering these services and expected losses.Using the 60 observations for revenues minus

expenses and losses, estimate one standarddeviation of earnings. This is earnings-at-risk.Estimate risk capital as one (or two) standarddeviation of earnings, divided by the risk-freeinterest rate.


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Allocating risk capital based on earningsvolatility: Securities underwriting and

letters of credit divisionA. Monthly Revenue Less Expenses (in millions of $)Most Recent 30 Months Observations:4, 3, 4.5, 5, 5.2, 4.6, 3.9, 4.3, 5, 4.7, 5.1, 5.4, 5, 4.5, 4.4,4.8, 5, 5.5, 5.3, 5.1, 5, 5.4, 5.7, 6.3, 6, 5.8, 5.5, 5.9, 5.5, 6.4Mean: $5.06 millionStandard Deviation: $0.735 million

B. Allocated Risk CapitalAssuming a risk-free rate of 5.5% (annual):(0.055 / 12) x Risk Capital = $ 0.735 million

Risk Capital = $160.364 millionC. RORAC for the Most Recent Month

1. Revenue minus expense of $6.4 millionRORAC = 6.4 / 160.364 = 0.0399 monthly,

or 47.89% annually3. Economic Income

Assuming a hurdle rate of 12% annually, economic incomenet of the capital charge:

$6.4 - (.12/12) $160.364 = $4.796 million

Management of market risk


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Management of market risk market risk is the risk of loss to earnings and capital related to changes in the market values of bank assets, liabilities, and off-balance sheet

positions.In January 1998, bank regulators imposed capitalrequirements against the market risk associatedwith large banks trading positions.

The requirements apply to any U.S. bank or bankholding company that has a trading account in excessof $1 billion or accounts for 10 percent or more of bankassets.

Typically, market risk arises from taking positions

and dealing in foreign exchange, equity, interestrate, and commodity markets, and the itemsaffected are the securities trading account,derivatives positions, and foreign exchangepositions.

The new capital requirements address market riskassociated with a banks trading activities.

V l i k i f f i


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Value-at-risk estimate for foreignexchangeIdentify the maximum expected loss given the banks recenthistory of daily returns on the trading portfolio.

Empirical distributionapproach to value-at-risk involves:1. Identify the lowest 1

% of daily pricemoves.

2. Assuming that thevalue of the 1%lowest price move is7.54 percent, 99percent of the dailyreturns exceed thisfigure.

g


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Some analysts criticize traditional earningsmeasures such as ROE, ROA, and EPS becausethey provide no information about how a banksmanagement is adding to shareholder value.

If the objective of the firm is to maximizestockholders wealth, such measures do notindicate whether stockholder wealth hasincreased over time, let alone whether it hasbeen maximized.

Stern, Stewart & Company has introducedthe concepts of market value added (MVA)and its associated economic value added(EVA) in an attempt to directly link

performance to shareholder wealth creation.


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Economic value added (EVA)an approach to measuring performancethat compares a banks (or line of business)net operating profit after-tax (NOPAT) witha capital charge.

Economic Value Added (EVA) is thecapital charge which represents therequired return to stockholdersassuming a specific allocated riskcapital amount.


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Market and economic value added

MVA represents the increment to marketvalue and is determined by the present valueof current and expected economic profit:

Stern Stewart and Company measureseconomic profit with EVA, which is equal to afirm's operating profit minus the charge for the cost of capital:

where the capital charge equals the productof the firms value of capital and theassociated cost of capital.

MVA = Mkt Value of Capital - Hist. Amt of Invested Capital

EVA = Net Operating Profit After Tax (NOPAT) - Capital Charge

Diffi lti i i g EVA f th


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Difficulties in measuring EVA for theentire bank

It is often difficult to obtain an accuratemeasure of a firm's cost of capital.The amount of bank capital includes not juststockholders' equity, but also includes loanloss reserves, deferred (net) tax credits, non-recurring items such as restructuring chargesand unamortized securities gains.

NOPAT should reflect operating profitassociated with the current economics of thefirm. Thus, traditional GAAP-based accountingdata, which distort true profits, must be

modified to obtain estimates of economic

A. Balance Sheet $ $


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Assets $Millions Rate Liabilities & Equity $Millions RateCash $150 0 Demand deposits $800Securities $800 6.5% MMDAs $1800 3%Commercial loans $2000 9.0% CDs $1300 5.5%Credit card loans $1900 10.0% Small time deposits $680 4.5%-Loss reserve -$100 Deferred tax credits $100

Other assets -$250 Equity - $320Total assets $5,000 Liabilities + equity $5,000

Risk-weighted assets: .50($800) + 1($2,000) + 1($1,900) + 1($250) = $4,550

Tier 1 capital = $320 Tier I ratio: $320/$4,550 = 7.03%Total capital = $420 Total capital ratio: $420/$4,550 = 9.23%

B. Income Statement Interest income: .065($800) + .090($2,000) + .10($1,900) = $422Interest expense: .03($1,800) + .055($1,300) + .045($680) = -$156.1

Net interest income $265.9Provision for loan losses -$25Noninterest income $60Noninterest expense -$190

Pre tax Income $110.90Taxes @ 40% $44.36

Net income $66.54

C. Profit MeasuresROE = (66.54 / 320 ) = 20.8% ROA = (66.54 / 5,000) = 1.33%Assuming that net charge-offs $22, cash taxes pai, = $39,and allocated risk capital $550 with a capital charge of 12%:

NOPAT = $110.90 + $25 - $22 - $39 = $74.9EVA = $74.9 - 0.12($550) = $8.9 E V A c a

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A. Change In Balance Sheet itemsAssets Amount Liablilties AmountCredit card loans -$1,000 CDs -$940Loan loss reserve +$30 Equity -$30

Total assets -$970 Total -$970

B. Income Statement Change

Interest income: . 065($800) + .09($2,000) + .10($900) $322 -$100Interest expense: .03($1,800) + .055($460) + .045($680) -$109.9 -$46.2 Net interest income: $212.1 -$53.8

Provision for loan losses: +$5 +$30.0 Noninterest income: $72 +$12 Noninterest expense: -$195 -$5

Pre tax income: $94.1 -$16.8Taxes @ 40%: $37.64 -6.72

Net income: $56.46 -10.08

C. Profit Measures: Actual net charge-oft $14, cash taxes paid = $31,and risk capital falls to $500.ROE = $56.46/$290 = 19.47%ROA = $56.46/$4,030 = 1.40%EVA = [$94.1 - $5 - $14 - $31] - $60 = -$15.9Risk-weighted assets: .50($800) + 1($2,000) + 1($900) + 1($250) = $3,550

Tier 1 capital = $290 Tier I ratio: $290/$3,550 = 8.17%Tier 2 capital = $420 Total capital ratio: $420/$3,550 = 11.83% E V

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Balanced scorecard framework with


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Balanced scorecard framework withfour blocks

1. Financial Performance:How Do Stockholders View Our Risk andReturn Profile?

2. Customer Performance:How Do Customers See Us?

3. Internal Process Management:At What Must We Excel?

4. Innovation and Learning:How Can We Continue to Improve andCreate Value?


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Scorecard measures

Bank ManagementBank Management 5th edition5th edition


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ALTERNATIVE MODELS OFBANK PERFORMANCE

Chapter 4

Bank Management Bank Management , 5th edition.5th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright 2003 by South-Western, a division of Thomson Learning

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Valuate Banks