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CHAPTER 5

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CHAPTER 5

ACCOUNTING AND ECONOMIC MODELS OF BANK PERFORMANCE AND VALUATION

Chapter 5

TO UNDERSTAND ...

- The Return-On-Equity Model and its Decomposition Analysis
- Variability of Return as a Measure of Risk
- Modern Finance in the Real World
- Accounting and Economic Models of Bank Valuation
- The Notion of “Hidden Capital” in Banks

Chapter 5

- Stamp bank financial statements: “Once upon a time”
- Why? Because they are “fairy tales” of the risks embodies in them!
- For many banks, however, only these statements are available for performance analysis
- ROE Model and Decomposition Analysis

Chapter 5

- Third Quarter, 2000
- 1. Industry earnings rebound
- 2. Net income of $19.3 billion (3rd highest)
- 3. Troubled commercial loans continue to rise
- 4. PLL absorbs a growing share of revenues
- 5. Assets surpass $6-trillion level

Chapter 5

- Asset sizeROA (%, annualized)
- < $100 million1.16
- $100-$1,0001.30
- $1B-$10B1.36
- > $10B1.16
- All banks1.20
- ROE (all banks) = 14.25% = 1.2% x 11.87

Chapter 5

- Asset sizeNumber of banks
- < $100 million4,922
- $100-$1,0003,070
- “Community banks”7,992 (95%)
- $1B-$10B 301
- > $10B 82
- “Large banks” 383 (5%)

Chapter 5

- Description based on 25 asset-size groups
- Number of banking offices (1, 2, 3+)
- Location (SMA or non-SMA)
- Number of banks in peer group
- Example: As of 12-31-00, there 830 banks with two or fewer banking offices and total assets between $50-$100 million located in non-SMAs

Chapter 5

- 521 FDIC-insured savings banks
- 57 credit-card specialty banks
- 5,109 BHCs across four size groups
- > $10 billion 64
- $1B-$10B 246
- $150M-$1B1,407
- < $150 million3,392

Chapter 5

EM

ROE<NonControllable Factors

ROA<

Overall BankControllable Factors

Performance <

Risk VariabilityCredit Risk

Balance Sheet Risk <Interest-Rate Risk

Regulatory RiskLiquidity Risk

Technological RiskExchange-Rate Risk

Affiliation Risk

Operating-Efficiency Risk

Strategic Risk

Chapter 5

ROE

ROA x EM

ROA

Net Income / Assets or PM x AU

Profit Margin (PM)

Net Income / Revenue

Asset Utilization (AU)

Revenue / Average Total Assets

Chapter 5

- Stage One: ROE = ROA x EM
- Stage Two: ROA = PM x AU
- Substituting:ROE = PM x AU x EM
- Stage Three: Figure 5-2, p. 135
- Conduct a Sherlock-Holmes-type investigation to determine strengths and weaknesses

Chapter 5

- Trend or time-series analysis
- Peer-group or cross-sectional analysis
- Potential “control variables” include:
- Bank size
- Location
- Type of business
- Organizational structure

Chapter 5

Factors Contributing to Improved

Bank Profitability Since 1992

- Improved Loan Quality
- Lower and More Stable Interest Rates
- Enhanced Generation of Fees and Other NonInterest Income
- Improved Operating Efficiency

Chapter 5

- The bad news of over 6,000 innocent deaths overwhelmed the following good news
- The banks and securities firms affected had secondary and tertiary backup systems
- The Fed provided ample liquidity to ease the financial aftermath of the market crash in the week that followed and continued its policy of “easy money” to attempt to stimulate the economy

Chapter 5

Standard Deviation

The Square Root of the Sum of Squared Deviations from the Mean

Coefficient of Variation

The Ratio of the Standard Deviation to the Mean

Chapter 5

RI = [E(ROA) + CAP] / sROA

Where

E(ROA) = Expected Return on Assets

CAP = The Inverse of the EM, or the

bank’s ratio of equity capital to

total assets

SROA = The Standard Deviation of ROA

Chapter 5

- The risk index (RI) is a distance measure in terms of the number of standard deviations that a bank is away from book-value insolvency
- Given an RI, we can compute (an upper bound) probability of book-value insolvency as Pr(BV<0) = 1/2[(RI)2]

Chapter 5

- ComponentStrong bankWeak bank
- E(ROA)0.02-0.02
- CAP0.10 0.03
- sROA0.001 0.007
- RI120.01.43
- Pr(BV<0)0.0035%24.5%

Chapter 5

- When a bank has too many bad loans what happens?
- It has to take such a large PLL that E(ROA) < 0 and it wipes out CAP such that NW < 0. In terms of RI, the numerator < 0.

Chapter 5

Itemization Principles

Procedures that Govern what Entries do or do not Need to be Recognized in the Body of Each Financial Statement

Valuation Principles

Procedures that Determine the Worth or Value Assigned to Itemized Entries

Chapter 5

ECONOMICS

Market-Value Analysis

ACCOUNTING

Book-Value Analysis

Chapter 5

- Balance sheet:
$100,000 = $90,000 + $10,000

- Income-expense statement:
100,000 x .075 – 90,000 x 0.6 = 2,100

- Asset is a five-year, fixed-rate bond with an annual coupon of 7.5% funded by a one-year CD at 6%

Chapter 5

- Assume interest rates double immediately after the balance sheet is set
- Net income in the second year is:
7,500 – 90,000 x 0.12 = -3,300

- Immediately after the shock, MVE = PV(A) – PV(L) = 74,859 – 85,178 =
-10,319

Chapter 5

- A + G = L + NW
- G, the government guarantee, is an unbooked intangible asset
- As a bank’s NW => 0, G becomes more important
- Since an unbooked intangible asset must have an offsetting entry, what is it and where is it booked?

Chapter 5

- Acquisition and Funding of Assets
- Risks: Credit, Liquidity, Prepayment, Interest Rate, Sovereign, and Foreign Exchange
- Stock Price = EPS x P/E

Chapter 5

- Economic, Real, and Market Value
- PV = CF1/(1+r)+CF2/(1+r)2+...+CFn/(1+r)n
- Risk/Return Tradeoffs

Chapter 5

P = EPS* x P/E x K

Where:

EPS* = current economic or real earnings

and

K = an adjustment factor that marks the industry P/E ratio either up or down to reflect the firm’s unique risk profile

Chapter 5

- Capital Asset Pricing Model (CAPM) = provides a method for determining asset prices based on the asset’s contribution to portfolio risk
r = rf + beta(rM + rf)

- Beta = index of systematic risk

Chapter 5

- Market-To-Book Ratio
- Price-Earnings Ratio
- Constant-Growth Model

- Dividend-Payout Ratio
- Dividend Yield

Chapter 5

Two Sources of Hidden Capital

1. Differences Between the Market Values (MV) and Book Values (BV) of on-balance-sheet items

2. Neglect off-balance-sheet items that Generally Accepted Accounting Principles do not Permit to be Formally Booked

Chapter 5

- Statistical Market Value Accounting Model (SMVAM)
- MVE = a + b (BVE) + e
- Joint hypothesis: [a = 0, b = 1]
- If so, MVE = BE
- Do we expect this to hold?
- How do we interpret the rejection of the null hypothesis?

Chapter 5

- SampleIntercept (a)Slope (b)
- 28 BHCs- 2.603.03*
- 9 largest-24.13.66*
- 19 large 1.02.91*
*Significantly different from 1.0 at the 1% level of significance

Chapter 5

- Accounting and economic models can be used to measure bank performance
- Economic models are more realistic but accounting frameworks are the only game in town for many banks
- ROE = PM x AU x EM
- Credit risk has caused the greatest fluctuations in bank earnings

Chapter 5