As one of the most critical institutions in the global economy, banks have to be healthy and thriving to serve their customers and stakeholders efficiently.
The bank’s financial statements, including the balance sheet, income statement, and cash flow statement, as well as its risk management methods, are often thoroughly examined as part of the health check.
As such, there are several metrics that analysts use during this performance of the overall health of a bank, and it is good to know them.
In this article, we will look at nine key metrics that analysts use to evaluate the health of a bank.
1.) Economic Value of Equality
Economic Value of Equity (EVE) is a financial metric that measures the long-term value of a company’s equity, taking into account the net present value of its expected future cash flows. It is commonly used in the banking industry to measure the sensitivity of a bank’s equity to changes in interest rates.
To calculate EVE, a bank forecasts its expected cash flows over a certain period, typically several years into the future, based on its current assets and liabilities. These cash flows are then discounted to their net present value using an appropriate discount rate, which takes into account the time value of money and the risk associated with the bank’s cash flows.
The resulting net present value of the bank’s future cash flows is subtracted from the bank’s current book value of equity to arrive at the economic value of equity.
EVE = Market Value of equity – Present value of expected future cash flows of assets – Present value of expected future cash flows of liabilities
EVE is useful for measuring a bank’s sensitivity to interest rate changes because changes in interest rates can have a significant impact on a bank’s net interest income, which is a major source of revenue for banks. If interest rates increase, a bank’s net interest income may increase, but the value of its assets and liabilities may decline, which could negatively impact its EVE. Conversely, if interest rates decrease, a bank’s net interest income may decline, but the value of its assets and liabilities may increase, which could positively impact its EVE.
EVE is also useful for evaluating a bank’s risk management strategies, as it can help identify potential risks to the bank’s equity value and inform decisions about capital allocation and risk management practices. By monitoring changes in EVE over time, a bank can identify potential areas of concern and take proactive measures to mitigate risks and protect its equity value.
2.) Net Interest Margin (NIM)
Net interest margin (NIM) is a financial metric that represents the difference between a bank’s interest income and expenses. This metric provides insight into a bank’s ability to generate profit from its assets, such as loans and mortgages, in relation to its funding costs, such as deposits and borrowing.
We can take the case of a bank that realizes the following financial performance in a given year:
- Interest income earned on loans and securities: $10 million
- Interest expense paid to depositors and creditors: $5 million
- Total assets: $500 million
- Total liabilities: $400 million.
3.) Efficiency Ratio
The efficiency ratio is a financial metric that represents the ratio of a bank’s non-interest expenses to its revenue. A lower efficiency ratio indicates higher efficiency and profitability, as the bank is able to manage its expenses more effectively in relation to its revenue.
Similar to the previous point, we can look at a bank with the following financial data:
- Net interest income: $20 million
- Non-interest income: $5 million
- Operating expenses: $12 million.
To find the efficiency ratio from this data, one would need to use the formula of Efficiency Ratio = Operating Expenses / (Net Income + Non – Interest Income).
Efficiency Ratio = $12 million / ($20 million + $5 million) = 50%
Based on this Efficiency ratio, it can be said that out of every $1 of income the bank generates, it spends $0.50 on operating costs.
A high efficiency ratio may be considered a warning sign for a bank, indicating that the bank may struggle to generate profits and maintain competitiveness in the market. This suggests that the bank may have higher expenses relative to its revenue, which can negatively impact its profitability and efficiency.
At the same time, an efficiency ratio of more than 60% is generally considered to indicate a high-cost structure for a bank. This may lead to decreased profitability and could be a sign that the bank needs to take action to improve its operational efficiency.
Such actions could include streamlining its operations, cutting costs associated with overhead or enhancing its capacity to generate revenue. By improving its efficiency ratio, the bank may be able to increase its profitability and maintain its competitiveness in the market.
4.) Return on assets (ROA)
The ROA is a measure of a bank’s profitability and reflects the amount of profit generated by the bank for each dollar of assets it holds. It is calculated by dividing the bank’s net income by its total assets. A high ROA indicates that the bank is generating a high return on its assets, which is positive for its profitability.
For example, let’s say a certain Bank A has a net income of $5 million and total assets of $100 million. To measure its ROA we can use the following formula:
ROA = (Net Income / Total Assets) * 100 = $5 million / $100 million = 5%
5.) Return on Equity
The ROE is a measure of a bank’s profitability and reflects the amount of profit generated by the bank for each dollar of equity (i.e., the amount of money invested by shareholders).
It is calculated by dividing the bank’s net income by its total equity. A high ROE indicates that the bank is generating a high return on its shareholders’ investments, which is positive for its profitability.
Similar to the previous example, lets say a bank has a net income of $4 million and shareholders’ equity of $20 million. Now, its ROE will be:
ROE = (Net Income / Shareholder’s equity)*100= $4 million/$20 million = 20%
6.) Non-Performing Loans
The NPL ratio measures the percentage of a bank’s loans that are not being re-paid. A high NPL ratio indicates that the bank is at risk of incurring losses from defaulting loans, which can negatively impact its profitability and solvency. Banks with high NPL ratios may need to increase their provisions for loan losses, which can impact their earnings.
Suppose a bank has a loan portfolio of $1 billion. If the borrowers have missed payments for more than 90 days, $100 million (or 10%) of these loans are classified as non-performing loans.
Assuming the bank has to set aside a provision of 50% for these non-performing loans, it would need to allocate $50 million towards provisions. As a result, the bank’s net loan portfolio would decrease by $50 million, bringing it down to $950 million.
If it came to be that the bank must write off $20 million from the non-performing loans, the loan portfolio would decrease from $1 billion to $980 million. This write-off would result in a reduction of the bank’s profitability and capital adequacy ratios, which are key metrics used to measure a bank’s financial health.
The reduction in profitability is due to the fact that the bank is no longer receiving interest income from these loans. Moreover, the write-off would also impact the bank’s capital adequacy ratios, which measure the bank’s ability to absorb potential losses.
Specifically, the bank’s Tier 1 capital ratio, which measures its core capital relative to risk-weighted assets, would decrease since the bank’s core capital remains the same, but the risk-weighted assets have increased. The bank’s total capital ratio, which measures its total capital relative to risk-weighted assets, would also decrease due to the write-off. The decrease in capital adequacy ratios could lead to regulatory concerns and potentially limit the bank’s ability to lend.
7.) Loan Loss Provisions Coverage Ratio
The loan loss provisions coverage ratio is a financial metric used to assess a bank’s ability to absorb potential losses from its loan portfolio. It is calculated by dividing the amount of loan loss provisions set aside by the bank by the total amount of non-performing loans (NPLs) in its portfolio.
A higher ratio indicates that the bank has set aside more provisions to cover potential losses from its NPLs, which suggests that it is better positioned to manage credit risks and maintain profitability. A lower ratio may indicate that the bank is exposed to higher levels of credit risk and may struggle to absorb potential loss.
8.) Capital Adequacy Ratio (CAR)
The CAR is a measure of a bank’s ability to absorb losses without becoming insolvent. It is calculated by dividing the bank’s total capital by its risk-weighted assets, which takes into account the level of risk associated with each asset.
A high CAR indicates that the bank has sufficient capital to cover any losses it may incur, while a low CAR may indicate that the bank is at risk of becoming insolvent. Regulatory authorities set minimum CAR requirements for banks to ensure that they have sufficient capital to absorb losses.
Below is the formula to calculate capital adequacy ratio:
CAR = (Tier 1 Capital + Tier 2 Capital ) / Risk-Weighted Assets
In banking, Tier 1 and Tier 2 capital are measures of a bank’s financial health and regulatory compliance. Tier 1 capital represents the bank’s core capital and is the primary measure of financial health. It includes shareholder equity and retained earnings, which are considered the most reliable forms of capital.
Tier 2 capital, on the other hand, is considered supplementary capital and includes revalued and undisclosed reserves, as well as hybrid securities that can be converted into equity. Tier 2 capital is considered less reliable than Tier 1 capital and is subject to more stringent regulatory requirements.
Say, if a bank has Tier 1 capital of $1 billion, Tier 2 capital of $500 million and risk-weighted assets of $10 billion, the CAR would be:
CAR = ($1 billion + $500 million)/$10 billion = 15%
9.) Cost to Income Ratio
The cost-to-income ratio measures a bank’s expenses against its operating income, which includes interest income as well as non-interest income such as fees and commissions. A lower ratio indicates that a bank is able to operate more efficiently and generate more income for every dollar spent on operating costs.
For example, if a bank has operating expenses of $500 million and operating income of $1 billion, its cost-to-income ratio would be 50% ($500 million divided by $1 billion). A lower cost-to-income ratio would indicate that the bank is operating more efficiently, whereas a higher ratio would suggest that the bank is spending too much on operating costs relative to the income it is generating.
Similar to the efficiency ratio, a high cost-to-income ratio may be a warning sign for a bank that it needs to take action to increase its operational efficiency and control its costs in order to maintain profitability and competitiveness.
Analyzing these key metrics can provide valuable insights into a bank’s financial health which can help investors and stakeholders make informed decisions about investing in or working with the bank. This is particularly useful at a time of volatility in the banking sector and can be of great assistance to help you have your finger on the pulse of the trajectory of a bank.
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