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Evaluation of Banking Performance

Ratio Analysis technique is often used for evaluating banking performance.

Broadly speaking, there are two important performance dimensions, namely:

Profitability Risk

Prepared by: Mr. Amir Ikram 2

Profitability ratios: Return on Equity: Net Income after Taxes = Equity Capital Return on Assets: Net Income after Taxes = Total Assets Net Interest margin: Interest Revenue – Interest Expense = Total Assets


Profitability ratios: Net Non-Interest margin: Non-interest Revenue – Non-interest Expense = Total Assets Net bank operating margin: Total operating Revenues – Total operating Expenses = Total Assets Earning Per share of stock (EPS): Net Income after taxes = Common shares outstanding


Risk:Main Risks faced by banks:

Credit Risk Liquidity Risk Market Risk Interest-rate Risk Earning Risk Solvency Risk


Risk Analysis:

Credit risk:

“The danger of default by the borrower

to whom the bank has extended credit”


Credit risk_Indicators: Non-performing loans = Total loans & leases Net Charge-offs = Total loans & leases Provision for loan losses = Total loans & leases or Equity capital Allowance for loan losses = Total loans & leases or Equity capital


Credit risk_Indicators:Another popular credit risk measure:

Total loans = Total deposits


Liquidity risk:

‘The danger of having insufficient cash to meet obligations when due.’


Liquidity risk_indicators: Purchased funds = Total Assets

Net loans = Total Assets

The higher the ratio, the greater is the risk.


Liquidity risk_indicators: Cash & due from other banks = Total Assets Cash & Govt. Securities = Total Assets


Liquidity risk: How to reduce bank’s exposure to liquidity risk?

1) Increasing the proportion of bank funds committed to cash & marketable assets.

2) Use longer-term liabilities to fund the bank’s operations.


Market Risk:

“The danger of changing market values of bank assets, liabilities, and equity that may bring about loss.”


Market Risk:Main reasons:

Changes in market interest rates Changes in currency prices Shifting public demand for bank services Alteration in central bank policy

Bank’s perception in the eyes of investor.


Market Risk_indicators: Book value of Assets = Market value of Assets Book value of Equity Capital = Market value of Equity Capital


Market Risk_indicators: Book value of bonds & other fixed assets = Market value of bonds & other fixed assets Market value of common & preferred stock = Common & preferred shares outstanding


Interest Rate risk:

“The danger of shifting interest rates may adversely affect a bank’s net income, the value of its assets, or equity.”


Interest Rate risk:E.g, if a bank’s flexible-rate assets are greater than its

flexible-rate liabilities, i.e.,Flexible-rate assets/Flexible-rate liabilities > 1

And if interest-rate increases???

Here it will be beneficial for the bank…resulting in increased profit margin.


Interest Rate risk:Profit margin will be higher, if

Interest-rate falling Flexible-rate assets < Flexible-rate liabilities

Interest-rate rising Flexible-rate assets > Flexible-rate liabilities


Interest-rate risk_indicators: Interest-sensitive Assets = Interest-sensitive Liabilities


Interest-rate risk_indicators: Uninsured Deposits = Total Deposits

The higher the ratio, the greater is the risk.


Earnings risk:

“The danger that a bank’s rate of return on assets (ROA) or equity (ROE) or its net earnings may fall.”


Earnings risk_Indicators:

Standard deviation or Variance of net income (NI). Standard deviation or Variance of the bank’s

return on Assets (ROA) & return on equity (ROE).

The higher the standard deviations, the more risky the bank is.


Solvency risk:

“Risk to bank’s long-term survival is called solvency risk. The danger that a bank may

fail due to negative profitability and erosion of its capital.”


Solvency risk:Reasons: Excessive number of bad loans Decline in market value to the large portion of

bank’s security portfolio.

Market discipline: Increased chance of failing fall in stock’s market value

high interest rates on borrowings (to attract needed funds).


Solvency risk_indicators:

Yield on bank debt issues – Yield on Govt. securities **Govt. securities should be of the same maturity. Greater the difference, the higher is the risk.


Solvency risk_indicators: Bank’s Stock price = Annual earnings per share

Net-worth (equity capital) = Total Assets

Decline in ratio Greater risk exposure.


Solvency risk_indicators: Purchased funds = Total Liabilities Net-worth (equity capital) = Risky Assets** Risk assets mainly include loans and securities.


Other forms of risk:

Inflation Risk Currency or Exchange rate risk Political risk Crime risk


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