Commercial Banking Answers

BFW2401: Commercial Banking &
Finance
Sem 2, 2016
Week 3
Analysis of Bank Performance
, 2005
Lecture 3: Analysis of Bank Performance Slide 2
May 5, 2017
References
Text: Gup et al (2007) Chapter 3
KPMG (2006) Financial Institutions Performance

Survey. http://www.fips.kpmg.com.au/
Optional reference for background unformation

Sharma, Rob and Wong, Kent (2004) The Adoption of
International Reporting Standards. Insight. APRA.
Second Quarter. Pp8-13. <www.apra.gov.au>

May 5, 2017
Learning Objectives
By the end of this lecture students should be able to
Identify internal and external aspects of bank
performance
Outline the main components of bank financial statements
Generate key return and risk measures from bank
financial statements
Put it all together to evaluate bank financial performance
using the Return on Equity model as a foundation
Explain the importance of supplementary data in addition
to financial analysis
Give two examples of modern risk-adjusted measures of
performance

May 5, 2017
Agenda
Introduction
A performance framework
Types of assessment
Data
Financial ratio analysis
New approaches to measuring performance
Conclusions

May 5, 2017
Bank Performance A Framework
Who cares?
Bank management
policy setting and strategy
Regulators
supervisory assessments
Shareholders/investors
investment decisions
Competitor financial institutions
merger and acquisition decisions, strategy

May 5, 2017
Objective: maximise shareholder wealth
Optimise risks and expected returns
Economic and political environment
Internal performance External performance

May 5, 2017
Internal performance
Does the bank have an effective planning process?
Setting objectives and planning to achieve them,
effective management
Is the bank making effective use of technology?
Contributes to improved service and lower costs
Does the bank have the staff it needs? (personnel)
Needs a skilled highly motivated workforce
What is the banks financial condition?
Reflected by financial accounts

May 5, 2017
External performance
Market share
Can the bank respond to changing demand as it moves
through the business cycle?
Is the bank growing its share of its chosen markets?
Regulatory compliance
Is the bank comfortably satisfying laws and regulations?
Is it able to respond to changes in requirements?
Public and investor confidence
Does the market perceive the bank as safe and reliable?
A bank cannot operate without public confidence

May 5, 2017
Types of Assessment
Quantitative (Financial) analysis
Share market data and ratings
Profitability & performance ratios, risk measures
From financial reports
e.g. ROE, ROA, Capital adequacy
Purpose for bank management:
Provides measures of past performance
Enables modeling for future planning periods

May 5, 2017
Types of Assessment
Qualitative (Non-financial)
Market perception
Range of products & services
Corporate citizenship or quality of management
Staff morale
Purpose for bank management:
Indicates non-financial performance
Validates financial analysis of performance
Contributes to modeling for future planning

May 5, 2017
Agenda
Introduction
Data
Sources of data
Absolute data and ratios
Data issues
Conclusions
May 5, 2017
Sources of Banking Information
Bank annual reports and half-yearly reports
Australian Bureau of Statistics (ABS)
RBA and APRA
Stockbrokers and large accounting firms eg KPMG
Ratings agencies eg Standard and Poors, Moodys,
Fitch-IBCA
Australasian Bankers Association (ABA)
Financial Services Institute of Australasia (FINSIA)
Financial press eg. Business Review Weekly,
Australian Financial Review
Australian Payments Clearing Association (APCA)
Data services eg CANNEX, Baycorp Advantage etc.
May 5, 2017
Basic Data from Bank Annual Reports
1. Balance sheet (statement of financial position)
Shows the banks financial state at a point in time,
Eg: Assets, liabilities and net worth
2. Income statement (statement of financial
performance)
Shows a banks major categories of revenue and
expenditures over a period of time
3. Statement of changes in equity
Shows items which impact on the banks equity,
Eg: Share transactions, changes in reserves, retained
profits and dividend payments
4. Cash flow statement
All cash inflows and outflows for a given period

May 5, 2017
Simplified Balance Sheet
(Statement of Financial Position)
Assets = Liabilities + Equity
Buffer against
Liquidity run on deposits
Loans Deposits
Funding
Buffer against
loan losses Capital

May 5, 2017
Profit & Loss (Statement of Financial Performance)
Interest revenue
- Interest expense
= Net interest income
Non-interest revenue
- Non-interest expense
= Net non-interest cost
Net operating income
- Tax (30%)
= Net income
- Dividends
= Retained Earnings
May 5, 2017
Financial reports provide absolute data (dollar
values)
Some examples
Total assets and total liabilities
Liquid assets
Loans and Deposits
Level of equity
Net income, Interest revenue, Interest expense
Bad debts
etc

May 5, 2017
Supplementary information
Other items that can be calculated, or may
be provided in notes to the accounts
Earning assets (those earning an explicit interest

return)
Risk weighted capital adequacy
Maturities of investment securities
Net write-offs (loan write-offs less recoveries)
Past-due loans (late or delinquent loans)

May 5, 2017
Off balance sheet information
OBS transactions are significant,

They affect bank revenues, expenses and risks
Important to look at level and breakdown of
different types of OBS
Direct credit substitutes e.g standby letter of credit
Trade and performance-related items
Commitments
Market rate-related transactions
May 5, 2017
Share market data
share prices
dividend payments
Credit ratings
Analysts recommendations
Market Shares
May 5, 2017
Non-financial information
Non-financial information may indicate bank
performance (or risk)
Examples
Significant management changes?
Maybe there was bad management and hence
management was dismissed?
Recent change of auditors?
Approach to corporate governance?
Conservative method (low estimates) for defining
non-performing loans?
etc
May 5, 2017
Agenda
Introduction
Data
Financial ratios
ROE model
Example
Other key ratios
Conclusion
May 5, 2017
Financial ratios
Many different ratios
Common size ratios
balance sheet items as a percentage of total assets or
income items as a percentage of total revenue
Profitability ratios based on revenue and cost
indicators
Risk measures

May 5, 2017
Financial ratios
Benefits of Financial Ratios
Allows valid comparisons (reduced impact of
differences in size of institutions)
Effective performance measurement relies on

accurate data and
intelligent interpretation

May 5, 2017
Financial ratios
Financial ratio analysis relies on intelligent
interpretation based on comparisons with
Trends
Comparison relative to a banks own past
performance
Targets
Comparison with the banks stated
targets/objectives
Peers
Comparison with other similar banks
May 5, 2017
Difficulties with financial analysis
Problems with raw data
Inaccurate data can give false inputs
Creative accounting can distort measures
Accounting data does not always accurately reflect
true market values
Changing accounting standards make trend analysis
difficult
Example: under the new International Financial Accounting
Standards (IFRS) introduced in 2005, banks report higher
levels of return on equity (ROE) because some items are no
longer counted as equity, so reported equity has tended to
fall and reported ROE has tended to rise
continues
May 5, 2017
Problems with ratios
Averages/aggregates hide detail
Ratios are backward looking, reflect past
performance
Ratios tend to compartmentalize financial analysis
so it is important to consider linkages, e.g.
increase in net interest income may reflect
increase in credit risk
continues

May 5, 2017
Omissions
Off-balance sheet transactions omitted or not
comparable
Qualitative factors omitted
Conclusion on financial analysis:

Valuable tool, but cannot be used in isolation it
needs to be validated by other measures such as
share market data, off balance sheet data and
qualitative measures

May 5, 2017
Financial Analysis
Key question for financial analysis:

Is the bank achieving its long run objective of
maximising shareholder value?
Are returns to shareholders high?
Are risks low?
Is each business unit contributing?
If not why?

May 5, 2017
Financial Analysis
Effective analysis of bank performance must

look at:
Other key indicators
Off-balance sheet indicators
Share market data
Indicators of qualitative performance
Indicators of business unit performance

May 5, 2017
Dupont model = ROE model
Financial analysis using the ROE model

Uses return to shareholders as the starting
point
Based on ratios
Plus detailed data to explain observed changes in
financial ratios and look for linkages
Structured discussion
Starts with ROE (Return on Equity).

May 5, 2017
Financial Analysis
Dupont Model:
Breaks down ROE performance into its component
parts
An increase in any ratio contributes to an increase
in ROE
It is important to investigate risks too i.e. how
has a higher ROE been achieved?

May 5, 2017
Financial Analysis
Dupont Model
Leverage Measures leverage and dividend

Multiplier policies (financing effectiveness)
Total Assets Asset
Equity Measures
ROE Utilisation asset portfolio
Net Income = x Revenue management
Equity Total Assets (mix and yield)
ROA
Net Income = x
Measures return
to shareholders Total Assets Net (Profit)
Measures
Margin effectiveness of
Measures overall Net Income cost controls
operating efficiency Revenue

May 5, 2017

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Financial Analysis
Risk versus return:
Return Credit Risk? Capital Risk?

Important to investigate risks too

May 5, 2017
Financial Analysis: Process
1. Collect absolute data

2. Calculate ratios
3. Identify initial meaning of each ratio
4. Look for linkages consider other key ratios
Then to complete the performance assessment :

Look for at share market data, credit ratings, non
financial indicators and other measures of performance
Calculate growth rates and market share
See hypothetical example of financial analysis...

May 5, 2017
Example: 1. Collect Absolute Data
Sample balance sheet $
Assets 2006 2007 Liabilities 2006 2007
Cash/liquidity 8,000,000 10,000,000 Current debt 63,000,000 65,000,000
Loans etc 120,000,000 121,500,000 Long term debt 57,000,000 58,000,000
Premises etc 2,000,000 2,000,000 Equity 10,000,000 10,500,000
Total 130,000,000 133,500,000 Total 130,000,000 133,500,000
Sample Income Statement $ 2006 2007

Interest revenue 4,000,000 4,200,000
Interest expense (1,500,000) (1,677,419)
Net interest income 2,500,000 2,522,581
Non-interest income 1,000,000 1,100,000
Non-interest expense (1,500,000) (1,500,000)
Net non-interest cost (500,000) (400,000)
Net operating income 2,000,000 2,122,581
Tax (30%) (600,000) (636,774)
Net income 1,400,000 1,485,806

May 5, 2017
3. Calculate ratios
Dupont model: Data Using 2006 data from
required example
Revenue = (Interest Revenue = 4,000,000 +
revenue) + (Non-interest 1,000,000 = 5,000,000
income)
Net income = (Interest Net Income = 4,000,000
revenue) (Interest 1,500,000 500,000
expense) (Net non- 600,000 = 1,400,000
interest cost) - Taxes
Total assets (average*) Assets = 130,000,000
Equity (average*) Equity = 10,000,000
* Assets for 2005 not provided, so
use year end

May 5, 2017
4. Identify initial meaning of ratio
Industry
Peer comparison 2006 2006 average
ROE 14.0% 13.89%
Leverage multiplier 13.0x 13.97x
ROA 1.08% 0.99%
Asset utilisation 3.85% 3.50%
Net margin 28.0% 28.40%

May 5, 2017
Peer comparison for 2006:
Ratios compared with other peer banks (or industry average)
Leverage
multiplier Lower: Why?
Above Big 5: 13.0 Big 5, 2006: 13.97
Why?
Asset Greater: Why?
ROE Utilisation
= x
14.0% 3.85% Big 5, 2006: 3.50%
Big 5, 2006: 13.89% ROA

= x
1.08%
Big 5, 2006: 0.99% Net margin Lower: Why?
Above Big 5: 28.0% Big 5, 2006: 28.40%
Why?
Note: Big 5 = Weighted average of 2006 global results of ANZ, CBA, NAB, St.George, Westpac (different from KPMG figures earlier)

May 5, 2017
Trend comparison 2006 to 2007:
2006 2007
ROE 14.0% 14.2%
Leverage multiplier 13.0x 12.7x
ROA 1.08% 1.11%
Asset utilisation 3.85% 3.97%
Net margin 28.0% 28.03%

May 5, 2017
5. Look for linkages
Trend comparison 2006 to 2007:

Fall of 0.3 points
(Slightly lower
Leverage Increase of 0.12
capital risk)
multiplier percentage points.
Have asset interest rates
13.0->12.7
Asset risen?
ROE Has mix of assets moved
= x Utilisation
14.0->14.2% to higher credit risk?
3.85->3.97% Has non-interest income
ROA increased?
= x
1.08->1.11%
Increase of 0.2 Increase of 0.03
percentage points Net margin percentage points.
Have costs decreased?
28.0->28.03% Have non-interest costs
Increase of 0.03 fallen?
percentage points Lower taxes?

May 5, 2017
Financial Analysis: Other Key Ratios
Other key ratios can:
Help answer some of the questions raised during
the ROE analysis
Give additional information
Examples
Bank efficiency
Interest differentials
Risk measures interest rate risk, credit risk,
liquidity risk, capital risk

May 5, 2017
Bank Efficiency
Operating income per employee
Net operating income
Number of employees (FTE)
Cost to assets ratio:
Operating expenses
Total Assets
Efficiency ratio, or cost to income ratio
Operating expenses
Operating income
May 5, 2017
Interest differentials
Net interest income (dollar interest margin)
Interest earned - Interest expense
Percentage interest spread
average interest earned on interest earning assets less
average interest paid on interest bearing liabilities
Interest earnings - Interest expense
Interest earning assets Interest bearing liabilities
Percentage interest margin (net interest margin)
Interest earned - Interest expense
Earning assets
May 5, 2017
Risk Measurement - Interest rate risk
Interest sensitivity ratio (a sample measure)
Interest sensitive assets(RSA$)
Interest Sensitive liabilities (RSL$)
Interpretation:
If ratio = 1 i.e. RSA =RSL
Change in interest rates will affect both income and expense
Two effects will tend to offset each other
NET interest income will remain largely unchanged
Interest rate risk (repricing risk) will be minimised

May 5, 2017
Risk Measurement - Credit risk (asset quality)
Ratios reflecting losses - example:
Net write-offs
Total assets
Ratios reflecting the level of diversification

Exposure ratios - example: Loans to farmers (or other
industry segment) as a percentage of total assets

May 5, 2017
Risk Measurement - Liquidity risk

Liquidity ratios e.g.
Liquid assets
Total assets
Liquid assets
Deposits

May 5, 2017
Risk Measurement - Capital risk

Simple capital ratio
Shareholders funds
Total assets
Risk weighted capital ratio
Qualifying capital
Total risk-weighted assets

May 5, 2017
Financial Analysis: Off-Balance Sheet Indicators
Examples:
1. Ratios such as:
Off-balance sheet business
Total balance sheet assets
Off-balance sheet credit risk exposures
Total risk-weighted assets
2. Value-at-Risk of off-balance sheet items
Modern statistical measure of risk
VaR = how much bank might lose over a given time with
a given probability

May 5, 2017
Financial Analysis: Share Market data
Shareholders returns
Price/earning ratio (P/E ratio)
Share price divided by bank earnings per share
If the P/E ratio is higher than average this reflects

market expectations that the bank will have higher
than average performance rates in the future

May 5, 2017
Single period shareholder returns:

Dividend yield = dividend as a % of the share
price at the beginning of the period
Capital gain = change in the share price as a % of
the share price at the beginning of the period
Shareholders rate of return = the dividend plus
the change in share price expressed as a % of the
share price at the beginning of the period

May 5, 2017
Single period shareholder returns: Example:
Share price at beginning of period = $21

Share price at end of period = $25
Dividend paid during period = $1.20
Dividend yield = ($1.20/$21) x 100 = 5.7%

Capital gain = [($25 - $21)/$21] x 100 = 19.0%
Shareholders rate of return
= {[$1.20 + ($25 - $21)]/$21} x 100 = $24.8%
May 5, 2017
Calculate growth rate, market share
Asset growth rate e.g for 2007:
$133.5 M $130 M x 100 = 2.7%

$130M 1
How does this compare to GDP growth (economy)?

How does this compare to previous year?
How does this compare to other peer banks growth rates?
If high (low)growth: does this reflect more (less) risk
taking? Does it reflect more (less) market shares?

May 5, 2017
Calculate growth rate, market share
Market share movements e.g. in 2007:
$133.5 M x 100 = ???%
Total assets of all banks 1
If gained or lost market share, why? If gain, has it

bought market share (sacrificed margins)?
Can do similar assessments of markets share of

loan segments, deposits, etc.

May 5, 2017
Agenda
Introduction
Data
Conclusions

May 5, 2017
New Approaches to measuring performance
Modern analytic techniques also assess
performance on a risk-adjusted basis
Share prices relate to risk AND return so risk-

adjusted returns relate to share prices
Uses:
to assess performance of different product lines
for management incentives & compensation
(bonuses)
May 5, 2017
Two examples
(1) EP = Economic profit
(2) RAROC = Risk Adjusted Return On Capital

May 5, 2017
(1) Economic profit
Definition:
Economic Profit (EP) is profit earned after the
deduction of all costs including the return to
capital
If a bank earns economic profit this means
the value of the banks equity has increased
and shareholder value is increased

May 5, 2017
A measure of economic profit is economic
value added (EVA)
Example: EVA for a loan portfolio

EVA =
[Net income expected loan losses] [$ cost of capital]
This is a risk-adjusted measure as

the amount of allocated capital depends on the risk
more risky business must be allocated more capital
expected loan losses are deducted from net income

May 5, 2017
Example: Compare two $100 loans,
Assume
the banks (pre-tax) cost of capital = 30%
Loan A is risky and needs $8 of capital
Loan B is low risk and needs $4 of capital
Then:
Loan A cost of capital = $2.40 (30% of $8)
Loan Bs cost of capital is $1.20 (30% of $4)
Loan A will add to shareholder value if its net income minus

expected loan losses is > $2.40
Loan B will add to shareholder value if its net income minus
expected loan losses is > $1.20
May 5, 2017
(2) Risk-adjusted return on capital (RAROC)
example: RAROC for a loan portfolio =
Net income expected loan losses
Allocated capital
If RAROC > required rate of return on capital then the
bank is earning Economic Profit and increasing
shareholder value
Note: again this is risk adjusted as

the allocated capital depends on the risk level and
expected loan losses are deducted from net income

May 5, 2017
Performance Analysis: Conclusion
Fundamental question:
Has shareholder value been maximised?

May 5, 2017
Good financial analysis requires:
1.Quality inputs (data)
Verify the data quality eg look at notes to accounts
Ratio analysis focussed on ROE
Share market indicators of performance
Other measures of returns and risks
Off-balance sheet indicators
Qualitative indicators and external economic and
political factors

May 5, 2017
Good financial analysis requires:
2. Comparative analysis i.e. comparison
Between planning periods (to identify trends)
With competitors/peers
With forecasts/objectives/targets
3. An understanding of the strategic context
Current business/economic climate
4. Drilling down to discover WHY ratios change
Look at linkages
Look at risk adjusted analysis of business units

May 5, 2017
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May 5, 2017
END

May 5, 2017
Interest Rate Margins - Example
Interest Rate
5 Year Loan
7.5%
Credit (asset) spread = 1.5%
6.0% Net interest
C urve
margin = 4.0% e Yie
l d
Risk
Fr e Interest rate risk (maturity)
4.5%
spread = 3.0%
1 Year
3.5% CD
3.0% Funding (liability) spread = -0.5%
1.5% Fig 3.9 (Adjusted)
0.0%
0 1 2 3 4 5 Maturity (Years)

May 5, 2017
Financial Analysis
Return on Equity (ROE):

Operating profit after taxes
Shareholders funds
Source: KPMG FIPS (2004)

Note: ANZ is after significant items, NAB and St.George are before, CBA is calculated
Use caution with comparisons! on a cash basis, Westpac on underlying cash earnings, St.George is before goodwill

May 5, 2017
Agenda
Introduction
Data
ROE model
Example
Other key ratios
Conclusions

May 5, 2017
Financial Analysis
Return on Equity (ROE):
Operating profit after taxes
Shareholders funds
In 2006
For the major
Australian banks:
Average ROE =
21%
Source: KPMG Financial Institutions Performance Survey
http://www.fips.kpmg.com.au

May 5, 2017
Financial Analysis
Return on Equity (ROE)
. 2004 2005 2006
ANZ 17.8% 17.5% 20.1%
CBA 12.7% 16.9% 21.3%
NAB 15.8% 15.0% 16.9%
StG 21.4% 22.6% 23.0%
WBC 20.7% 21.4% 22.9%
Average 17.7% 18.5% 22.8%
Source: KPMG Financial Performance Survey
May 5, 2017
2. Calculate growth rate, market share
Asset growth rate e.g for 2007:
$133.5 M $130 M x 100 = 2.7%

$130M 1
How does this compare to GDP growth (economy)?

If high growth, how? High credit risk? Gained
market share? If low growth, lost market share?

May 5, 2017
2. Calculate growth rate, market share
Market share movements e.g. in 2007:
$133.5 M x 100 = ???%
Total assets of all banks 1
If gained or lost market share, why? If gain, has it

bought market share (sacrificed margins)?
Can do similar assessments of markets share of

loan segments, deposits, etc.

May 5, 2017
Efficiency ratio (cost to income ratio) Source: KPMG (2006)

May 5, 2017

Commercial Banking Answers

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BFW2401: Commercial Banking &

Text: Gup et al (2007) Chapter 3

KPMG (2006) Financial Institutions Performance

Optional reference for background unformation

Lecture 3: Analysis of Bank Performance Slide 3

Lecture 3: Analysis of Bank Performance Slide 4

Lecture 3: Analysis of Bank Performance Slide 5

Lecture 3: Analysis of Bank Performance Slide 6

Objective: maximise shareholder wealth

Optimise risks and expected returns

Economic and political environment

Internal performance External performance

Lecture 3: Analysis of Bank Performance Slide 7

Lecture 3: Analysis of Bank Performance Slide 8

Lecture 3: Analysis of Bank Performance Slide 9

Lecture 3: Analysis of Bank Performance Slide 10

Lecture 3: Analysis of Bank Performance Slide 11

Lecture 3: Analysis of Bank Performance Slide 14

Lecture 3: Analysis of Bank Performance Slide 15

Lecture 3: Analysis of Bank Performance Slide 17

Earning assets (those earning an explicit interest

Lecture 3: Analysis of Bank Performance Slide 18

OBS transactions are significant,

Lecture 3: Analysis of Bank Performance Slide 23

Effective performance measurement relies on

Lecture 3: Analysis of Bank Performance Slide 24

Lecture 3: Analysis of Bank Performance Slide 27

Conclusion on financial analysis:

Lecture 3: Analysis of Bank Performance Slide 28

Key question for financial analysis:

Lecture 3: Analysis of Bank Performance Slide 29

Effective analysis of bank performance must

Lecture 3: Analysis of Bank Performance Slide 30

Financial analysis using the ROE model

Lecture 3: Analysis of Bank Performance Slide 31

Lecture 3: Analysis of Bank Performance Slide 32

Leverage Measures leverage and dividend

Lecture 3: Analysis of Bank Performance Slide 33

Return Credit Risk? Capital Risk?

Lecture 3: Analysis of Bank Performance Slide 34

1. Collect absolute data

Then to complete the performance assessment :

See hypothetical example of financial analysis...

Sample Income Statement $ 2006 2007

Lecture 3: Analysis of Bank Performance Slide 36

Lecture 3: Analysis of Bank Performance Slide 37

Lecture 3: Analysis of Bank Performance Slide 38

Big 5, 2006: 13.89% ROA

Lecture 3: Analysis of Bank Performance Slide 39

Trend comparison 2006 to 2007:

Lecture 3: Analysis of Bank Performance Slide 40

Trend comparison 2006 to 2007:

Lecture 3: Analysis of Bank Performance Slide 41

Lecture 3: Analysis of Bank Performance Slide 42

Lecture 3: Analysis of Bank Performance Slide 45

Ratios reflecting the level of diversification

Lecture 3: Analysis of Bank Performance Slide 46

Risk Measurement - Liquidity risk

Lecture 3: Analysis of Bank Performance Slide 47

Risk Measurement - Capital risk

Lecture 3: Analysis of Bank Performance Slide 48

Lecture 3: Analysis of Bank Performance Slide 49

If the P/E ratio is higher than average this reflects