Measuring & Evaluating the Performance of

Banks & their Principal Competitors

L5: Contact hours 9 & 10
(content ref 2.2,chapter 6 of R&H )

BITS Pilani 1st February 2020 FIN ZG 513

Pilani|Dubai|Goa|Hyderabad
Introduction
Banks, like others, are under pressure to PERFORM.
Several stakeholders: owners, employees, depositors, borrowers, regulators ….

Performance: success or failure: whether met expectations of stakeholders

Performance: objectively revealed w r to FINANCIAL STATEMENTS

 
Performance evaluation: Why / Who

BFSI need Financial Market for funds: Shares, bonds, ….. incl deposits
Investors / analysts/ rating agencies# analyse PLBS with a ‘fine tooth comb’
Huge competition for deposits & credit business
 
Agenda: Look at indicators of performance: of banks and its competitors
 
Most important dimensions of performance: Profitability & Risk: why these:
Because, BFSI players are organised to maximise value of shareholders’ wealth,
at an acceptable level of risk
# CRISIL, ICRA, CARE, India Ratings ( previously FITCH)

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Evaluating performance : Market price
of the shares
Actuals vs objectives 
Objectives:fast growth, minimise risk, balanced growth (moderate rewards & low risk) 
Maximise value of firm: key objective of most BFSI players
Maximise value of shares
If share price not rising (or falls): current investors may sell shares, price may fall
⇒ difficult to raise resources.
Determinants of share prices: pls refer equation (6-1) of R&H Minimum expected rate
Price depends on stream of future dividends (also EPS), of return for the firm’s
level of risk:
discounted by the Cost of Capital
Two components :
GORDAN’s ‘Growth Model’
--Risk fee rate of interest
P0 = D1 /(r-g) ; (r >g) …. equation (6-2) of R&H
(govt securities)
P0 : Price of share at time t=0 ; D1 : Dividend expected in the year 1 --Risk premium, based on
r: rate of discount; g: expected rate of growth in dividends the perceived level of risks
Generally, dividends are quite stable, with some growth. (NPA’s, diversified markets/

portfolios)

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Gordon’s growth model: Illustration &
limitations
Illustration: P0 = D1 /(r-g) D1=5,r=0.10, g=0.06
XYZ Bank is expected to pay dividend @ Rs 5 /share after one year, dividends are
expected to grow @6% p.a. for all future years, appropriate discount rate @ 10% p.a.
⇒Market price now P0 = Rs 5 / (0.10-0.06) = Rs 125.

Disadvantages of Gordon’s model:

Assumes:
The company’s dividend will indefinitely grow at the same rate
The investor will never sell his/her share.
The investors have limited time horizon after which they will sell their shares

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Modified growth model
Share price for evaluation: pros & cons
 = + + . . . ++

Illustration:
An investor expects a bank to pay a $5 dividend after one year, $10 after two years,
and then plan to sell the share for $150 per share.
If the relevant discount rate to capture the risk is 10% p.a.,
the current price of the share should approach :
= + + = $ 140.91 (Eqn 6-3 OF R&H )
Share price as a measure of evaluation: Pros and cons
Pros : Market’s evaluation of firm, best measure being the main objective of biz
Cons: No market price for the shares of unlisted companies,
Affected by several / extraneous factors, fluctuations & manipulations
Therefore, Profitability ratios are taken as a surrogate for the share prices for
evaluation of performance

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Profitabililty ratios
Ratios Explanations
Return on Equity Capital ( ‘ROE’)= PAT
  ROE : Rate of Returns flowing to the Shareholders
Return on Assets (‘ROA’) =

Net Interest Margin ( ‘NIM’)= = ROA : Measures the management’s efficiency to convert
the assets into returns
Only the Paid-up Capital
 
Degree of Asset Utilisation(‘AU’)= NOT the Authorised Capital
Equity Multiplier (‘EM’)= NIM : Shows profitability i.e. SPREAD between
Earning per Share (‘EPS’)=
Net Profit Margin (‘NPM’)= Interest INCOME and Interest COST
AU : Portfolio policies, mix and yield on assets
# Net Interest Income

EM : LEVERAGE, sources chosen to fund the assets

EPS : Net income accruing to each share

NPM : Effectiveness of Pricing & Expense Ratio

(‘ER’)
 

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Breaking ratios into key components
ROE and ROA : closely related
To evaluate BFSI: often useful to break down ratios ROE = ROA x EM
into key components. (%) (%)
ROE & ROA: popular profitability ratios, are closely related +2.5 = +0.5 x 5.0
(same numerator i.e. the NI) +5.0 = +0.5 x 10.0
ROE = ROA X EM -5.0 = -0.5 x 10.0
Revenue
-10.0 = -0.5 x 20.0
NI = NI X TA ▬
Cost ER#
SC TA SC +16.0 = +0.8 x 20.0

T.O.R. Total Operating Revenue

= NI X T.O.R X TA Why high Leverage ?
T.O.R TA SC + Debt cheaper than
Equity
ROE = NPM X AU X EM +Tax deductible
- Higher RISK
ROA = NPM X AU
EM : Usually high ( ≥ 10) . High EM means high debt, high risk
# Expense Ratio
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ROE calculation & evaluation

 
ROE = Net Income / Total Equity NI
Illustration : XYZ Bank reports that its net income for the current year is $15 million,
its total assets and total liabilities amount to $1,144 million & $926 million
respectively# TA TL

What is its return on equity capital? Evaluate XYZ Bank’s performance.

ROE= 0.0688 or 6.9% TA = SC+TL⇒ SC=TA-TL

Evaluation: We need to compare the ROE of XYZ Bank with the ROE of some
comparable bank/BFSI player to be able to evaluate the performance

# Year average data for the assets, liabilities & share capital

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ROE: Banks in India

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ROA calculation for banks

ROA = Net Income / Average Total Assets

Illustration :
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 average liabilities are $4,960 million while its average equity capital amounts to
$52 million.
What is the bank's return on assets?
Evaluate the bank’s performance in terms of the ROA
• Total assets = Equity capital + total liabilities = 52 +4960
• Net ROAincome
= = Revenues
Net Income –
= expenses
$155 mill. - $107 mill. ==0.0096
155-107
or 0.96 percent
Total Assets $4,960 mill. + $52 mill.

This bank's ROA should be compared with the ROA's of other comparable banks
(size, location, nature of services) to draw meaningful evaluation.

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Breaking ROA ratio

Return on assets: ROA = NI / ATA

but NI = TR@ – TE# , ⇒ ROA can be broken into two parts:
ROA* = NI / ATA = (TR — TE) / ATA
= TR/ATA — TE/ATA
= AU — ER
SG : Security
Asset Utilization (AU) → income generation
Gains /(Loss)
Expense Ratio (ER) → expense control

@ TR: total revenue or total operating income

= Interest income + Non-interest income & SG Provision for
LOAN LOSSES

# TE: total expenses

= Interest expenses + Non-interest expenses + PLL
* ROA: before taxes; TE: excludes taxes

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Breaking ROA ratio

ROA is driven by the bank’s ability to:

…generate income (AU) and control expenses (ER)

 Income generation (AU)

Int. Inc. Non. int. Inc. Sec gains (losses)
AU   
TA TA TA
 Expense Control (ER)
Int. Exp. Non  int . Exp. PLL
ER 
*
 
TA TA TA

*
Expense Ratio (‘ER’) does not include taxes, TA & TL should be Average figures
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ROA: Banks in India

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Significance of EM: illustration
TA = 100
Let us consider two banks, both with $100 million in asset values with identical asset qualities but
with different liability compositions.
Bank X has a liability composition with $90 million in debt and $10 million in equity.
Bank Y has a liability composition of $95 million in debt and $5 million in equity.
EM (Bank X) = 100/10 =10 EM =TA/SC
EM (Bank Y) = 100/5 = 20
Case 1: both the banks have an ROA of +1, then
ROE (Bank X) = 1*10% = 10% ROE = ROA x EM
ROE (Bank Y) = 1*20% = 20%
Case 2: both the banks have ROA = ▬ 1 then
ROE (Bank X)= ▬1*10% = --10%
ROE (Bank Y)= ▬ 1*20% = --20%
Interpretation:
• First, Bank Y is able to earn BETTER ROE as it has a higher EM.
• However, if there is a loss, Bank Y will show a WORSE ROE as compared to Bank Y.
• So, a higher financial leverage works to the firm’s advantage by boosting ROE when earnings
are positive.
• It is, however, a double-edged sword: when the firm records a SLOW GROWTH / negative
earnings, the fall in ROE is also bigger.

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EM: Banks in India

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Breaking ROE: items of PLBS & control points

Rate Control assets:

Mix/ pricing
Composition (mix) Low liquid & idle
Interest
Returns
Returnstoto Volume assets
Shareholders
Shareholders
ROE INCOME Max returns from
ROE==NI
NI/ /TE
TE Fees & Serv Charges assets, manage/
Non Interest Trust optimise risks
Maximise revenue
Other for the given
Returns to the Bank
ROA = NI / TA expenses
Rate
Interest Control liabilities:
Composition (mix)
Mix/ rates
Volume
EXPENSES
Salaries Control expenses
Overhead Optimise /
Other manage risks
Degree of Leverage
Prov. for LL Fin leverage
EM = TA/TE
Taxes
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Performance Evaluation using CAMELS
rating

 Capital Adequacy
 Asset Quality
 Management Quality
 Earnings
 Liquidity
 Sensitivity to market risk
Regulators assign:
a rating of 1(best) to 5 (worst) in each of the six categories,
and an overall composite rating of:
• 1 to 2 indicating fundamentally sound bank,
• 3 indicating that bank shows some underlying weakness needing correction,
• 4 to 5 indicating that the bank has problems.

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 BITS Pilani

Risk analysis in BFSI industry

Risk analysis

What: the perceived uncertainties associated with a particular event

Uncertainties (within or outside the BFSI’s control)
Examples: loan repayment, deposit growth, stock prices, earnings growth,
fluctuation in interest rates - - , competition, economic conditions, regulations,
international factors

Goal: maximise share price, PAT, revenue growth . . . , minimize losses.

But, can not ignore the risks

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Risks faced by BFSI players

Credit# risk
Probability that some assets, esp. loans, will decline in value or may become worthless
With EM of 10: one out of 9 of loans going bad will wipe out the equity
Indicators of Credit Risk (ratios)
NPA*/ total loans, Annual provision for loan losses (‘PLL’)^/ Equity Capital
NPA/ Equity Capital, Total loans/total deposits

Liquidity risk
Risk of not having sufficient cash (& borrowing capacity) to meet:
customer withdrawals, demand for the loans
Low liquidity ⇒ borrowing of emergency funds at high cost
Strategy: keep cash, short dated govt securities, long term liabilities

# Borrowing capacity advanced by bank to a borrower

*NPA: (Non Performing Assets): Income generating assets that are past due for ≥ 90 days.
^ Also called Provision for Doubtful Debt

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Risks faced by BFSI players ( contd)

Market risks
Price risk: fluctuation in prices of shares/ investments, bonds
  Interest rate risk: deposits, advances, marketable securities
Will see risk management later

Foreign Exchange risks: fluctuations in FX affects FX assets, liabilities

Off balance sheet risk: Financial guarantees (‘standby credit’), loan commitments,
Financial options and futures
 
Operational risks: Failure of computer system, error/ misconduct by employees, flood

Legal risk: Lawsuits

Reputation risk: Negative publicity can affect clientele

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Performance indicators for BFSI
competitors
Most of the ratios / indicators are equally applicable to other BFSI competitors
Some performance indicators may be unique in other BFSI cases:
 
• Insurance:
 Growth of insurance premium
 Value of ‘life’ or pension reserves (main liabilities)/ total assets

• Mutual funds:
 Value of AUM# (& growth), Service fee/ Total AUM, Rate of return

• NBFC:
 Total loans disbursed (& growth)
 
 # Assets under management

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Performance evaluation for BFSI players

Analysis of performance

• Compare with the comparables (Don’t compare apples with oranges !)

• Best to compare with BFSI’s of similar: size, service, locations, markets, . . . .

Exact comparables may be difficult/ impossible

Best to compare with the closest comparables, make adjustments for the differences

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 BITS Pilani

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