Bank Performance Analysis: ROA, ROE, and How to Evaluate Banks
Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2
Chapter 20 wraps up the commercial banking section by asking a simple question: how do you know if a bank is doing well? Regulators need to spot problems early. Shareholders need to know if their investment is paying off. And bank managers need feedback on whether their strategies are working.
How to Value a Bank
The value of a commercial bank is the present value of its expected future cash flows. That is the same formula used to value any business.
V = Sum of [E(CFt) / (1 + k)^t]
Where E(CFt) is the expected cash flow in period t and k is the required rate of return for investors. The value changes when either the expected cash flows change or the required return changes.
What Affects Cash Flows
Four factors drive a bank’s cash flows.
Economic growth. When the economy is strong, more people and businesses want loans. Loan demand goes up. Default rates go down. Demand for other bank services like brokerage and financial planning also increases.
Interest rates. This one is counterintuitive. Lower interest rates are generally good for banks. Their deposit costs fall faster than their loan income shrinks (because loans tend to be less rate-sensitive than deposits). Higher rates squeeze the net interest margin.
Industry conditions. Regulation matters a lot. When regulators removed geographic restrictions, banks could expand into new markets. When they allowed banks to offer securities and insurance services, new revenue streams opened up. Technology and competition levels also play a role.
Management abilities. This is the only factor the bank can control. Good managers figure out how to position the balance sheet to take advantage of whatever economic and regulatory environment they face. They find efficiencies. They diversify wisely.
What Affects the Required Return
The required return has two pieces: the risk-free rate and the risk premium.
The risk-free rate is driven by inflation, economic growth, money supply, and the budget deficit. The risk premium depends on economic conditions (less risk in good times), industry characteristics (capital requirements reduce risk, but looser regulation might increase it), and management quality.
During the 2008-2009 credit crisis, bank valuations crashed. Many publicly traded banks lost over 70% of their value. Only 11 banks failed in the 2003-2007 period before the crisis. Then 140 failed in 2009 and 157 in 2010. The reasons were clear: weak economy hurt cash flows, and investors demanded higher risk premiums.
Breaking Down Bank Performance
The standard approach is to express every income statement item as a percentage of total assets. This lets you compare banks of different sizes and track trends over time.
Here is the basic framework:
- Gross interest income (what the bank earns on loans and securities)
- Gross interest expenses (what the bank pays on deposits and borrowed funds)
- Net interest income (the difference, also called net interest margin)
- Noninterest income (fees from services)
- Loan loss provision (reserves set aside for expected defaults)
- Noninterest expenses (salaries, rent, equipment, overhead)
- Securities gains or losses
- Income before tax
- Taxes
- Net income (this is your ROA when expressed as % of assets)
The Federal Reserve groups banks into four size categories: money center banks (top 10), large banks (11-100), medium banks (101-1,000), and small banks (below 1,000). Performance varies across these groups.
Small banks tend to earn higher gross interest income because they can charge higher rates to local businesses that have fewer alternatives. But large banks generate more noninterest income because they offer more fee-based services.
Net Interest Margin
This is the most watched number in banking. It is gross interest income minus gross interest expenses, expressed as a percentage of assets. It tells you how effectively the bank is earning money from its core business of taking deposits and making loans.
A bank’s net interest margin is driven partly by its own decisions (what rates to charge, what deposits to attract) and partly by the interest rate environment. When rates fall, deposit costs often drop faster than loan rates, widening the margin. When rates rise, the opposite tends to happen.
Loan Loss Provisions
This is where things get tricky. Banks have to estimate how many of their current loans will eventually default and set aside reserves accordingly. During the 2008 crisis, the average loan loss provision jumped to 1.95% of total assets, up from 0.27% just two years earlier. That increase alone was enough to wipe out all other profits for most banks.
There is room for manipulation here. Conservative banks set aside larger reserves early, which reduces reported earnings now but avoids nasty surprises later. Aggressive banks understate likely losses, making earnings look better in the short term. If manager bonuses are tied to current earnings or stock price, the incentive to understate losses is real.
Noninterest Income and Expenses
Noninterest income comes from service fees, lockbox services, foreign exchange transactions, and other services. Larger banks tend to generate more of this income because they offer a wider range of services.
Noninterest expenses cover salaries, equipment, office space, and compliance costs. Banks with more loans tend to have higher personnel costs because loan assessment requires human judgment. Banks with lots of small deposits also face higher costs because small accounts are more labor-intensive to manage.
Return on Assets (ROA)
ROA = Net income / Total assets
This is the single most important number for assessing a bank’s efficiency. If ROA is low, you need to figure out why. Possible causes include:
- Excessive interest expenses (paying too much for deposits)
- Low interest income (too conservative with assets, or locked into low fixed rates)
- Insufficient noninterest income (not enough fee-based services)
- Heavy loan losses (took on too much credit risk)
- High noninterest expenses (operational inefficiency)
Each diagnosis points to a different fix. That is why ROA alone is not enough. You need to break it apart and examine the components.
Return on Equity (ROE)
ROE = ROA x Leverage measure
Where the leverage measure = Total assets / Equity capital
This is what shareholders care about most. A bank can boost its ROE by increasing leverage (holding less capital relative to assets). But regulators set minimum capital requirements precisely to prevent excessive leverage.
During 2005-2007, the average ROE for U.S. banks was relatively high, around 12-15%. It crashed to negative territory in 2009 during the worst of the crisis, then gradually recovered.
A Real-World Comparison
The chapter includes a detailed example comparing a fictional bank called Zager Bank to industry averages over five years. Zager pursued an aggressive strategy of lending to risky borrowers at high rates.
During Years 1 and 2, when the economy was strong, Zager’s strategy was brilliant. High net interest margin. High noninterest income. Low loan losses. Its performance beat the industry average.
When the economy weakened in Year 3, Zager’s world fell apart. Risky borrowers started defaulting. Loan losses spiked. Net income went negative while the industry average just dipped slightly. In Years 4 and 5, as the economy recovered, Zager bounced back but never fully recovered its earlier advantage.
This is the risk-return trade-off in action. Aggressive strategies pay off handsomely in good times and punish you severely in bad times. The question every bank has to answer is: how much risk are we comfortable with?
The Key Policy Decisions
Madura provides a useful table linking each income statement item to the bank decisions that affect it and the uncontrollable factors at play.
Gross interest income depends on the bank’s asset composition, loan quality, maturity and rate sensitivity, and pricing policy. But it also depends on economic conditions and market interest rates.
Gross interest expenses depend on the liability composition and maturity structure. But market rates heavily influence these too.
Loan losses depend on asset quality and the bank’s collection capabilities. But they are also at the mercy of the business cycle.
The bottom line: bank managers control some things but not everything. The best they can do is make smart decisions about what they can control and position the bank to survive whatever they cannot.
My Take
This chapter ties the entire banking section together nicely. The valuation framework at the beginning is useful because it reminds you that every decision a bank makes ultimately affects either its expected cash flows or the risk investors perceive. That is what drives the stock price.
The Zager Bank example is the highlight. It shows in concrete numbers what happens when a bank bets heavily on one strategy and the environment shifts. The temptation during good times is always to take more risk because the extra returns look so easy. But the losses during the downturn can more than offset years of above-average profits.
If I had to summarize what I learned from these five chapters on commercial banking, it would be this: banking looks simple on the surface (take deposits, make loans, keep the difference) but underneath it is a constant balancing act between profitability and survival. The banks that last are the ones that resist the urge to bet the house when times are good.