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ROE DECOMPOSITION

Sterne Agees Strategies group recently introduced a detailed ROE decomposition model coined

IDEAS. The report allows the analyst and bank management to gain a strong understanding

of what is driving net income and the return on shareholders equity. It also allows the managers

to compare their institution to a group of up to 18 peers, along with its size based peer group. A

detailed understanding of this report highlights Sterne Agees holistic approach to helping our

clients maximize income for a given level of risk that is considered prudent for the institutions

size. The Strategies Team uses the report extensively in developing client specific

recommendations. The report and its components will be discussed in detail below. A sample of

the information that can be extracted from this report includes:

What is driving the institutions profitability?

How much leverage is being utilized across the balance sheet?

What is the mix of liabilities? How confidence sensitive is this funding mix? And how

competitive is the local deposit market?

What is the mix of assets? Is the institution earning an adequate return on this risk?

How diversified is the institutions revenue base? And how rate sensitive is the revenue

mix?

How efficiently is the institution managing expenses?

Is the mix of assets in the securities portfolio generating an adequate return and is the risk

in this portfolio balanced with the risk taken elsewhere on the balance sheet?

These are just a few of the questions that a thorough understanding of the ROE Decomposition

report can address. Banking more so than most industries is a numbers driven business. Balance

sheets are highly leveraged and small changes in interest rates and spreads can have a magnified

impact on performance. It is also a highly fragmented and homogenous business - which means

that there are always competitors in the marketplace that will exhibit irrational pricing both onthe deposit and asset gathering side of the balance sheet. If management strays from the

numbers and begins to chase an irrational competitor the results can be terminal. This is evident

from the increased number of bank failures that inevitably follow the bursting of an asset bubble,

such as the real estate crisis that we are currently experiencing. A clear understanding of the

numbers and how an institution is managing its balance sheet will lead to better investment


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decisions and will allow management teams to avoid chasing business that is not generating an

adequate risk adjusted return on capital.

How is the report structured?

There are 9 sections to the report which cover the main earning asset and interest bearing liability

categories, including Loans, Investments, Deposits, Wholesale Funding, Net Interest Spread

Drivers, Earning Asset and Liability mix, Drivers of ROAA, and the Derivation of ROE. The

following illustration is the main page of the report. This is where everything comes together.

At first glance, it looks a little busy but once you understand the flow you will see that this page

provides a wealth of information.

This page flows from the bottom up and revolves around the 4 main asset and liability categories

which we call the foundation. On the asset side, the allocation to loans and investments and the

yields on these assets is displayed. On the liability side, (right side) we start with the deposit and


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wholesale funding allocations and the corresponding costs. The model includes a

balance/counterbalance type of mechanism whereby several levers can be pulled to improve the

resulting ROE, however; one should be cognizant of the potential ripple effect of a lever to other

parts of the model (balance sheet). For example, the Net Interest Spread on Earning Assets is

impacted by several variables, i.e. the allocation or yield on any or all of the foundation

categories. The remainder of the report drives off of this flow chart by taking each section and

exploring it in more detail.

What is the information contained in each of the individual boxes on this page?

Each of the boxes on this page contains the same category of information. For example, the

Return on Equity box includes the actual ratio and it allows the viewer to see how this ratio

compares to the peer average inblue. On the left side of the box, highlighted in yellow, is the


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ranking of the institution within the peer group and the number in red, is the page number that

provides details of the calculated ratio. In this example, the subject institution is outperforming

its peer group with a 19.87% ROE versus a 5.47% average for the peers. This institution ranks 2

out of 20 for this metric. Wait a minute - I thought you mentioned earlier that there were only 18

peers? Thats correct, however the size based peer average is included in this calculation as well

so the comparison is to the 18 chosen peer institutions and to the average for the size based peer

group. It is important to point out that the rankings are simply ordered from highest to lowest for

each metric. Therefore for measures where a lower number implies better performance such as

the Cost of Interest Bearing Liabilities, a higher number ranking would be preferred, i.e. 20 out

of 20 would be consider best in class.

Following the arrows from the bottom of the pyramid up, one sees that the information flows

very logically. The product of each foundation categorys asset allocation times its yield results

in the weighted average yield for each category. These numbers roll up to the next level whichshows the Yield on Earning Assets and the Cost of Interest Bearing Liabilities. The difference

between these two numbers is the Net Interest Spread on Earning Assets, which is found in the

middle of the page. In the example above, this number is 3.65% for the subject institution. From

this information one can see that the subject institutions Net Interest Spread is slightly above

average relative to its peer group. They are generating modest yields on the loan portfolio and

the allocation to loans is relatively low. However, the weighted average yield on the investment

portfolio is slightly above the peer average and the allocation to this asset class is also above

average at 38.95% relative to the peer average of 25.17%. Questions management and/or

analysts may ask at this point might include; Why is the allocation to loans so low and the

investment allocation so high? Is loan demand weak in their core market? Or could this be an

underwriting or competitive pricing decision? What types of loans are being put on the books?

And is this risk reflective of the average loan yields being generated? For those outside the

bank, the report will not provide answers to all of these questions, but it can lead to some

interesting discussions among management that will enhance the knowledge about bank, the

markets in which they are operating, and the performance relative to their strategic plans. This

also allows Sterne Agees Strategies Team to gain a better understanding of how the institution is

managed and the areas in which to focus to help maximize the return on equity. Thus begins the

collaboration between Sterne Agee and its clients to develop strategy and implement necessary

actions to move the bank closer to reaching their goals.

Moving further up the page, the net interest margin on earning assets is shown at 3.86%, which is

calculated as the (yield on earning assets cost of interest bearing liabilities) + gain on net

interest position. The net interest position is the difference between total earning assets and total

interest bearing liabilities as a percentage of average earning assets. The net interest margin on


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earning assets is multiplied by the percentage of earning assets/total assets to derive the net

interest margin. In the example, the net interest margin is calculated as (3.86% * 96.26%) =

3.72%. The net interest margin plus the non-operating margin (fee income) equals total

revenue. Subtracting taxes and non-interest expenses from this number leads you to the ROAA

(1.85%). Finally, the ROAA multiplied by the leverage ratio equals the Return on Equity at the

top of the pyramid.

Exploring the numbers in more detail

The picture on the following page illustrates the layout for presenting the quarterly loan yield

data for the subject institution and the corresponding peer group. From the loan yield box on the

main page we know that this information is found on page 12 of the report. The first line item on

this page shows the average quarterly loan yields for the size based peer group. This is followed

by the quarterly loan yields for the chosen peer group and the subject institutions information.Below the loan yield for the subject institution, is the rank within the peer group, including the

size based peer average along with some basic statistics around the numbers. The bottom of the

page shows this same information graphically. The numbers in the bar chart highlight the

difference between the peer group mean and the subject institutions loan yield for the

corresponding period. This breakout information is presented consistently for all of the

foundation categories and is provided quarterly for 10 periods and annually for 5 periods.

As noted earlier, the loan yield for the subject institution is modest at 6.12% ranking 13 among

the 20 peers. However, the risk adjusted loan yield (loan yield adjusted for provision charges

and the allocation to loans) is 6.07% ranking 13 out of 20. This information is helpful as it

suggests that the bank is pricing the product appropriately to capture the risk and that the

expected loss in the loan portfolio is relatively low. To confirm these conclusions, a deeper

analysis is required, but the numbers suggest that the bank is probably making relatively low risk

residential real estate loans with modest LTVs and decent borrower credit profiles. This would

further suggest that the bank is exposed to a high degree of option risk due to the borrowers

prepayment option. The prepayment risk should be taken into consideration when making

strategic or investment recommendations for this institution. For example, one would most likely

want to minimize the exposure to MBS in the investment portfolio and instead focus on non-amortizing product or CMO type structures with tight payment windows and limited extension

risk.


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What if analysis

The model is a static, point-in-time snapshot of the institutions performance relative to the

chosen peer group, however there are a few pages that allows for some simple What If

Analysis. Page 9 of the report, shown below, highlights several of the key drivers of ROE.

Each metric is isolated and set equal to the peer average, while all other metrics are held constant

to gauge the impact that reversion to the mean would have on the institutions ROE. This

analysis is best shown versus a high performing peer group so that the reversion to the mean is

reflective of the best in class performance. This is a key area for management to focus on as

one of the main goals is to maximize shareholder value and this page provides a good roadmap

of the areas to address that will have the biggest impact on this metric. The ROE Mean

Reversion analysis is also a key focus of the Sterne Agee Strategies team as we analyze aninstitutions performance and offer strategies that may improve risk adjusted returns.


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The column labeled Variance From Actual, suggests the biggest improvement to ROE would

come from an increase in the allocation to loans that is closer to the peer group average

allocation. If this metric was set to the peer group average, with everything else held constant,

the institutions ROE would improve by 424 bps to 24.11% from 19.87%.

On the far right of this page, the chart that shows the improvement in ROE that would be

generated from a 100bp increase in each ratio, holding all other variables constant. The number

at the top of the box is the adjusted ROE and the number below is basis point change from the

base case ROE. From this information, it is apparent that an increase in the yield on the loan

portfolio would have the biggest impact on ROE.

Conclusion

ROE Decomposition is not a new concept. Equity analysts have been using this analysis for

years to review a companys performance and identify the key drivers of return on equity and

shareholder value. However, the concept is not as broadly used by fixed income investors and is

also not as broadly used internally by a companys management team. We believe this is a


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cornerstone report to understand how an institution is being managed, the challenges that it is

facing, and the key financial metrics to focus on in order to improve profitability.

As a broker/dealer, Sterne Agee is in the business of buying and selling securities on behalf ofour customers. However, knowing what to buy or sell should really be viewed in the context of

an institutions entire balance sheet and its particular risk profile. Banking is a homogenous

business, but there are clearly some broad differences in each institutions willingness to accept

risk and its ability to manage risk. These factors need to be taken into consideration in designing

a strategic plan.

We take this responsibility seriously and would welcome the opportunity to work with your

institution to develop a customized plan to improve return on equity and maximize shareholder

value. Contact your Sterne Agee Representative to request an ROE Decomposition Analysis for

your institution. A specific list of peers to be included in the report would be useful to customize

the analysis.

Larry Meding, CFA

Managing Director

Fixed Income Strategies

[email protected]

901-761-6990
mailto:[email protected]:[email protected]

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