Measuring and Evaluating Bank Performance

Measuring and Evaluating Bank Performance

Julie M. Cannady

October 25, 2012

Abstract

After the most recent financial crisis, most banks, regulators and clients were inclined to review the standards for measuring and evaluating each bank's own performance. This is not an easy task with so many factors to consider and with changes in banking as a whole. However, it is very critical to the survival of each individual bank that they have their own systems in place to safeguard against decline and ultimate failure of their institution. Without proper guidelines and measurements in place, they have no accurate way of knowing how their bank is performing and whether or not it is on the right track. This paper looks at various ways to measure and evaluate bank performance to the best of one's ability.

Introduction

The objective of this assignment is to discover the various techniques of measuring financial performance by defining and analyzing key performance ratios. As previously stated, this is a difficult task and generally requires the efforts of multiple individuals, each with their own assigned role of keeping records within the bank. All banks use a measure of performance as an indication of whether or not they are succeeding at what they do or struggling. Of course, we would all like to think that our bank is right on track and that there will never be any danger of it shutting down. Sadly this is not the case, as discovered in recent years with so many bank failures, mergers and acquisitions. Using various methods, which will be explained, most banks can use numbers and reports to determine their safety and soundness during this continuing time of change.

I. For each pair below, indicate which asset exhibits the greatest credit risk, or another risk, if applicable and describe why.

A. A 10 year U.S. government bond vs. a 91 day T-bill

A 10 year U.S. government bond exhibits the greatest risk. However it exhibits Interest Rate Risk and not Credit Risk. With knowledge that most government issued investments are backed by the full faith and credit of the U.S. government, you would think these would both be equally sound investments. However, after taking a deeper look, one would discover that securities are backed by the government, but the funds themselves are not. There is always potential for rate and yield changes. Most research indicates that while the American economy is in such an unsettled state, longer term bonds have a higher amount of risk, as well as a higher return potential, because of the possibility of changes to rate and yield. Therefore, the 91 day T-bill would be the most conservative approach. Although it is shorter in term, it has the potential to make money and has less time for a risk of changes in rate or yield. With a 91 day T-bill, you purchase it at a discount from par, but at maturity, it is paid back at the agreed upon amount over par. Unlike a 10 year U.S. government bond, you wouldn't be taking interest distributions during the term, but you would receive it all in one lump sum at maturity.

B. Commercial loans to two businesses in the same industry: one collateralized by accounts receivables and the other by inventory as work-in-process

When evaluating accounts receivable as collateral, there are always numerous factors to consider, such as the length of time the receivables have been on the books, the effectiveness of the company's collection department, trade terms, dilution, etc. On the other hand, evaluating inventory as collateral can be difficult. Banks have to consider whether or not the company that sold the inventory to the borrower has an automatic prior lien even though they may not have filed a UCC. Advance rates vary for most banks and should always be established at their liquidation value and not the higher market value. From past experience, a bank will never receive full value of what the inventory is worth to that company if they foreclose and have to sell the inventory. Furthermore, work-in-process inventory has extremely limited liquidation value since it requires additional production cost to be converted to salable merchandise. It is my conclusion that out of these two scenarios, the bank assumes a greater credit risk by taking inventory as a work-in-process as collateral, than what it would by taking accounts receivable as collateral.

C. Five year State of Illinois municipal bond or a five year GSE agency bond issued by the Federal Home Loan Bank system

Both of these types of bonds are government related, but very different from each other. A municipal bond is a bond issued by a state, city or local government or its agencies, whereas an agency bond is debt issued by government-sponsored enterprises (GSEs), such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Municipal bonds are usually not taxable making them quite attractive to those looking to purchase bonds. State and local governments often borrow money by issuing these municipal bonds. There are some exceptions, but most municipal bonds are considered one of the safest investments available with very low default rates (around 0.13%). The State of Illinois would be one of those exceptions to the norm. Illinois is one of two states with the lowest credit rating. The other is California. This is related to large unfunded pension plans and inadequate state contributions to the plans. GSE agency bonds on the other hand are considered low risk investments, although they are not always backed by the federal government. However, it is believed that since the government corporations such as Fannie Mae and Freddie Mac play such a vital role in the economy, the government would be unlikely to allow a GSE to default on a payment. Therefore, it would be safe to say that the GSE agency bond is a much safer investment, making the Illinois municipal bond the greatest credit risk.

D. A loan to a local professional group (doctors or lawyers) vs. a loan participation

Both of these ideas would seem appealing to most any bank, especially in times where growth is a must. However, the loan participation would have to be the greatest credit risk. Even though there does not appear to be enough information to come to an accurate conclusion, when it all boils down to it, each bank would rather have full control over