Banking Regulation and Risks Table of Contents Table of Contents 2 Answer 1. 3 Answer 2. 5 References 7 Answer 1. Return on Equity (ROE) is regularly used by banks as a means of measuring performance, potential growth, profitability and managerial compensation, on the basis of comparison of realized ROE with the level of ROE of competing banks…
One of the reasons for increased leverage generating value for banks is that increased leverage increases the savings from cost of capital obtained from debt funds due to the tax code and subsidized government guarantees. ROE= Net Income/Shareholders Equity ROE can be decomposed to classify the financial drivers of value creation in a company. This is known as DuPont analysis. ROE= Return on assets*leverage Or, ROE= (Net Income/assets)*(assets/shareholders equity) Or, ROE= (Net Income/Revenue)*(Revenue/assets)*(Assets/Shareholders’ Equity) Or, ROE= Net Profit Margin*Asset Turnover*Leverage Thus the three components of ROE is net profit margin, asset turnover ratio and gearing ratio or leverage. The profit margin states the amount of profit made by a bank from its operations. The asset turnover ratio states that how efficient a bank is in using the assets it owns and determines the revenue generated by the bank from its assets. Asset turnover ratio has an inverse relationship with net profit margin. The gearing ratio measures the financial leverage and states that how the bank finances the assets it holds, i.e. the amount of assets per pound of shareholders’ equity investment in the bank. Assets are financed by shareholders’ equity and by creditors, and a higher ratio indicates that the bank is getting more finance from the creditors. Thus greater gearing ratio leads to rise in ROE. Illustration: Consider the following data- Revenue= ?29,261millions Net Income= ?4,212millions Assets= ?27,987millions Shareholders’ Equity= ?13,572millions Net profit margin= Net Income/Revenue= ?4,212millions/?29,261millions= 0.1439=14.39% Asset Turnover= Revenue/Assets= ?29,261millions/?27,987millions=1.0455 Leverage=Assets/Shareholders’ equity= ?27,987millions/?13,572millions= 2.0621 ROE= 0.1439*1.0455*2.0621= 0.3102 = 31.02% ROE of 31.02% to a bank is a good indicator of growth. Still, if a bank decides to not to take leverage so as to become debt-free, then the ROE drop to 15.04%. Even if a bank decides to assume less leverage than the current, ROE will decrease. Thus, from the above illustration it can be said that ROE can be improved through leverage, i.e. leverage is important for the rise and improvement of ROE. Answer 2. Northern Rock, the UK Bank was the most high-profile casualty of the credit crisis of 2007, as in September 2007 the bank suffered run from its depositors. Northern Rock Building Society, a British Bank was formed in 1997 when the society floated on the London Stock Exchange. The bank specialized in mortgage business, and 90% of the assets of the bank were residential mortgages. Rise in growth, profitability and market value was noticed in the bank’s performance since 2001. The shareholders of the bank were benefitted and the management informed that the business model of the bank was effective in bringing about cost control, high quality asset growth, and competitive products with innovative products and transparency. The following graph summarizes the key growth rates for the years 2001-2006. Source: suerf.org, 2009. The huge gap between risk-weighted assets and total assets made by the extensive regulatory arbitrage raised questions in respect to the quality of assets held by the bank. Due to the aggressive policy of Northern Rock, the bank ended up with a leverage to be the highest in the European sector but the capital that was to serve as a cushion against ...
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