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Home > Capital Markets Best Practice > Analyzing a Bank’s Financial Performance

Capital Markets Best Practice

Analyzing a Bank’s Financial Performance

by Jyothi Manohar

Common Measures of Financial Performance

Capital Adequacy

How do banking regulators measure, evaluate, and rate the quality of a bank’s financial stability or, in industry parlance, the safety and soundness of a bank? Capital adequacy is a keystone. The Basel Committee on Banking Supervision of the Bank of International Settlements (BIS) has established minimum capital standards that are widely followed by banks across the world. (In September 2010 higher global minimum capital standards were announced that will be phased in over a period of time.) Capital adequacy is generally measured in the following categories.

  • Tier I capital generally consists of common equity, disclosed reserves, and retained earnings (excluding other comprehensive income) and is calculated as Tier I capital/Total risk-weighted assets. All assets on a bank’s balance sheet are risk-weighted based on the respective credit risk as defined by the respective central banks; for instance, cash on hand has a risk weight of 0, whereas a commercial advance may carry a risk weight of 100%. Tier I minimum capital ratios are generally established at 4%.

  • Total risk-based capital includes Tier I capital plus certain other eligible items up to limits specified by regulatory guidance. Minimum capital ratios are generally established at 8%.

  • Leverage ratio: Calculated as Tier I capital/Average total assets, with the minimum established at 4%.

Capital adequacy helps to sustain a bank’s growth and protect it from the consequences of the risks represented by its various lines of business. For instance, if a bank makes a strategic decision to expand its lending operations in a new geography, it will need to ensure that any impairment losses inherent in the new operations can be adequately absorbed by retained earnings while still maintaining healthy capital ratios.

These ratios are a necessary disclosure in any bank’s financial statements. Once a bank’s key capital ratios start to hover near or sink below the minimums required, alarm bells sound, hinting to analysts and regulators that the financial institution requires closer monitoring. In the United States, starting in 2009, peaking in 2010, and continuing today have been numerous bank failures that resulted in closure by the Federal Deposit Insurance Corporation (FDIC). A common thread among these failures is credit losses so excessive that they eroded retained earnings, and hence capital, to below the minimum or to such critically deficient levels as to threaten the very existence of the financial institution. Analyses of several of these bank failures can be read on the FDIC’s website (see More Info section at the end of the chapter).

Asset Quality

The asset quality measure largely addresses the quality of the loans and advances of a bank, although the quality of investment securities has also come into play. While all banks have credit policies that provide a framework within which the bank limits its lending operations, the varied nature of the loans made by a bank, the vast geographies over which they are spread, the varied nature, characteristics, and demographics of the borrowers, and the collateral underlying the loans present risks of nonperformance and collectability that are difficult to measure and quantify. Hence, credit risk is among the most critical risks that a financial institution must manage. Banks must necessarily have risk management systems in place to continuously monitor their loan portfolios.

The notes to a bank’s financial statements detail a bank’s credit risk management policies, the types of loans it makes, policies related to when nonperforming loans (NPLs) are placed on nonaccrual status (usually at 90 days of delinquency), charge-off (write-off as losses) policies, when loans are deemed impaired, policies related to the evaluation and measurement of impaired loans, and what factors are considered by the bank in establishing reserves (or allowances) for credit impairment and losses. Key asset quality ratios include the following.

  • Loan by type/Total loans and advances. Reflects the composition of the loan portfolio and growth rate of each in relation to total loans and advances, showing which sector of the portfolio is increasing rapidly and how credit risk might be impacted as a result.

  • Reserve (allowance) for credit losses/Total loans and advances. Presents the reserve for loan losses as a percentage of total loans.

  • NPL/Total loans and advances. Presents the proportion of the total loan portfolio that is nonperforming, i.e. no longer accruing interest since collection is in doubt.

  • Loans and advances charged off (written off)/Average total loans and advances. Represents actual losses incurred as a result of loans written off in proportion to average total loans.

  • Reserve for credit losses/NPL. Coverage represented by the reserve or allowance for credit losses to the existing level of nonperforming loans.


At any given point in time, a bank must have the necessary funds to make loans and advances to borrowers, meet the demands of customers for deposit withdrawals, and pay other obligations. Although a bank can project some of these requirements based on loan commitments in the pipeline, upcoming maturities of loans and deposits, and known obligations, unanticipated demands and contingencies must be met as well. A necessary byproduct of asset liability management processes is liquidity management. All banks have liquidity policies that allow them to meet known and unexpected liquidity requirements. Sources of liquidity are:

  • cash and cash equivalents;

  • core deposits;

  • reserve balances;

  • assets available for sale that can be disposed of quickly and converted to cash;

  • borrowing sources that include lines of credit that can be drawn on.

Essential to this analysis is that a bank has access to diverse sources of liquidity and can answer the following questions.

  • Is there a stable base of core deposits, or is it shrinking?

  • Is there reliance on short-term, volatile sources of funds to meet long-term obligations, or vice-versa?

  • Is there ready access to money and capital markets in the event that additional funds must be raised?

  • Does the bank have enough diversification among assets on its balance sheet that can be quickly converted to cash?

  • Does management have enough policies and processes in place to evaluate its liquidity position funds management and contingency funding strategies on an ongoing basis?

  • What picture is the cash flow statement presenting that will impact the bank’s liquidity position?

  • Is the loan-to-deposit ratio satisfactory? Calculated as Total loans and advances/Total deposits, this is a measure for assessing a bank’s liquidity.

If the ratio is too high, the bank might not have enough liquidity to cover unanticipated funding requirements; if the ratio is too low, the bank may not be earning as much as it could be.


How Does a Bank Generate Net Income?

Banks lend money and accept deposits, invest excess funds, generate fee income, and pay bills. On the face of it, and through a quick perusal of a bank’s income statement, the concept appears straightforward enough—generate a healthy net interest income and enough noninterest income to cover all noninterest expenses and then some. It is easier said than done, however.

The next sections describe the different components that go into the calculation of a bank’s net income.

Net Interest Income

Managing and monitoring a large variety of interest-bearing assets and interest-bearing liabilities in a constantly changing interest rate environment is no easy task. When one thinks of the variety of interest-bearing assets (primarily investment securities and loans and advances) that carry a multitude of interest rates (fixed rate or variable rates tied to indices such as Libor, Treasury rates, prime rates, bank rates) and a multitude of maturities and the variety of interest-bearing liabilities (primarily customer and bank deposits and borrowings) that also carry a plethora of interest rates and span maturities from “on demand” to 10 years or more and everything in between, managing the balance sheet and interest rate risk is a challenging, complex, ongoing exercise.

The proportion of noninterest income to total income speaks volumes as to the sources of revenues for a bank and its reliance on ancillary services versus traditional banking services.

Throw into the mix the vagaries of consumer and business demand for funds, national and world events that impact the financial markets and economies locally, nationally, and internationally, and a bank’s ability to meet all of those demands while still generating income for its shareholders, and it becomes obvious that remaining financially healthy is a highwire act. Asset liability management, liquidity management, interest rate risk and sensitivity analysis, duration and maturity gap analysis are all inextricably intertwined.

The interest rate environment has been at historical lows these past few years. It has been especially challenging for banks to maintain consistently healthy net interest margins (NIM, measured by net interest income as a percentage of average interest-earning assets). Ideally, banks will strive for a NIM better than 3%.

It has been especially challenging for banks to maintain consistently healthy net interest margins (measured by net interest income as a percentage of average interest earning assets).

Noninterest Income

To meet the objective of consistent net income and earnings per share (EPS), the other alternatives for banks have been either to generate as much noninterest revenue as possible through fees, service charges, and gains on sale of assets or to reduce operating expenses. Reducing provisions for losses and asset impairments is not a prudent option, particularly in a troubled world economy. To augment revenues from traditional banking services, more and more banks are generating fee and service revenue from private banking, trust and wealth management, financial advice, sale of nondeposit investment vehicles, insurance products, and other such ancillary services. The proportion of noninterest income to total income speaks volumes as to the sources of revenues for a bank and its reliance on ancillary services versus traditional banking services. It should help to focus an analyst’s attention on the viability of these revenue sources for the bank.

Provisions for Impairment and Other Losses

Though all banks have lending and investment policies that purport to be prudent and establish parameters as to the types of loans, advances, and investments they will make and their relative concentrations, both as a proportion of the respective totals and of equity, it is difficult for any bank to accurately anticipate economic downturns and financial meltdowns (as have been experienced since 2007 and are continuing to impact several countries across the globe). These events are, to a fair degree, outside a bank’s control, yet they have an adverse impact on the collateral value of loans and advances and the quality and collectability of its assets. Many banks across the world have experienced losses as a result of nonperforming loans, toxic investments, and other asset write-downs, particularly during the trough year 2009. Analyzing the carrying value of its assets is an ongoing risk management activity for every bank. This includes the valuation of goodwill and intangibles as well, some of which have suffered in the recent crises and been written down or charged off through profit and loss as being impaired.

Noninterest Expense

Most operating costs, with the exception of discretionary spending such as marketing and advertising, represent fixed costs that a bank must incur to operate its business efficiently. Depending on how internal and external factors impact other components of the financial statements, a bank may make strategic decisions to cut costs by divesting poorly performing branches, businesses, and subsidiaries and by outsourcing certain types of operation such as data processing, loan servicing, human resources, etc. Risk management techniques that include close monitoring of planned (budgeted) performance against actual results are another tool used by a bank to manage its financial performance. The efficiency ratio is a measure of how well a bank is controlling its operating costs. While there are variations in how banks compute the efficiency ratio, it is generally calculated as:

Noninterest expense ÷ (Net interest income + Noninterest income − Gains on investment securities)

The lower the efficiency ratio, the better the bank’s performance. Ideally, banks will strive for efficiency ratios of 50–55% or less.

The efficiency ratio is a good measure of how well a bank is controlling its operating costs. The lower the efficiency ratio, the better the bank’s performance.

Net Income and Earnings Per Share

Sustained positive earnings and earnings per share are among the planned primary objectives for any company’s business plan—and no less so for a bank. Net income helps to build retained earnings, which in turn sustains healthy capital ratios. For a bank, maintaining better than minimum capital ratios (as we have already seen in this chapter) is the lifeblood for survival. Net income keeps stockholders happy by providing a source of continued dividends on their investment. EPS is a common measure of a company’s profitability and is well known to anyone who invests in company stock.

In analyzing net income, however, it is important to understand which components of the income statement are major contributors to the net income or net loss—whether these be core operations, ancillary services, gains from investment securities sales or other asset disposals, or increases in noninterest expenses or provisions for loan losses or other asset impairments. Is net income or loss being generated by a one-time event that will not recur? Looking at the cause of changes in net income or loss over a period of time will help an analyst to focus on what events are shaping a bank’s financial performance.

No one measure by itself is an indicator of the financial health of a bank. It is important to understand each, and the interplay among all or many of these measures, to properly evaluate a bank’s financial performance.


In summary, analyses of a bank’s earnings encompass:

  • the consistency, quality, and adequacy of earnings;

  • sources and levels of earnings;

  • the ability to bolster retained earnings and capital through earnings;

  • levels of provision required for impaired loans and assets;

  • net interest margins;

  • the return on assets (ROA): Net income/Average assets;

  • the return on equity (ROE): Net income/Average equity;

  • the dividend payout ratio: Dividends/Net income.

In analyzing net income, it is important to understand which components of the income statement are major contributors to the net income or net loss.

Management Capability

This intangible measure encompasses the qualifications of board members, the level of participation of each, the level of collective oversight provided by board committees and the board over the critical operating, accounting, and financial reporting policies of the bank, as well as the qualifications of key members of management, their experience and capability in executing board-approved policies, and their oversight of the day-to-day operations of the bank.

Although it is difficult to quantify this measure, the annual reports of all public banks include discussion and disclosures related to board members, executive management, the level of shareholdings of each, the remuneration received, the qualifications, and the specific position each holds in relation to the bank. In addition, significant related party transactions—i.e. transactions that board members, executive management, or their affiliated interests have with the bank—will be disclosed. All of these disclosures point an analyst to the potential for conflicts of interest and the level of objectivity with which board members and executive management execute their responsibilities in protecting the interests of the bank, its customers, and its stockholders.

Risk Management

In this chapter we have alluded to varied risks in several aspects that must be managed in order to achieve positive financial performance. The typical risks listed below have direct or indirect effects on a bank’s financial performance and should be addressed by all banks. Banks’ annual reports detail the risk management activities that are applicable to the organization.

  • Credit risk: Credit risk is addressed in the section “Asset quality” above and encompasses more than the traditional definition associated with lending activities. Credit risk is found in all activities where success depends on counterparty, issuer, or borrower performance.

  • Interest rate and market risk: Interest rate risk is addressed under “Net interest income” above. Market risk is the risk to a bank’s financial condition resulting from adverse movements in market rates or prices, such as interest rates, foreign exchange rates, or equity prices. Changes in interest rates may have a significant effect on other areas of risk. For example, market risk can impair the bank’s liquidity position.

  • Liquidity risk: This is addressed under “Liquidity” above.

  • Operational and transaction risk: Operational risk arises from the potential that inadequate information systems, operational problems, breaches in internal controls, fraud, or unforeseen catastrophes will result in unexpected losses. Transaction risk is pervasive to an organization. It is the risk to earnings or capital arising from problems with service or product delivery and may include potential financial losses from human error or fraud, incomplete information, and related decision-making or operational disruption.

  • Compliance and legal risk: All banks must operate in compliance with a myriad of laws, rules, and regulations. Compliance risk arises from potential violations of or nonconformance with those laws, regulations, or prescribed practices which govern the bank’s activities. Legal risk arises from the potential that unenforceable contracts, lawsuits, or adverse judgments can adversely affect the operations and financial performance of the bank.

  • Strategic risk: Strategic risk results from adverse business decisions or the improper implementation of those decisions. Examples include the misalignment of business and technology strategic plans, improper market positioning (e.g. retail delivery strategies, geographic positioning, etc.) and pricing of products and services.

  • Reputation risk: Reputation risk is the potential that negative publicity regarding a bank’s business practices will cause a decline in the customer base, costly litigation, or revenue reductions, often as a result of poor earnings, regulatory censure, significant fraud or litigation, or failure to provide services or products in conformity with the local market. Reputation risk exposure is driven to a large extent by the bank’s actions to manage other categories of risks.

  • Foreign exchange risk: Tied to market risk above.

  • Technology risk: Technology risk is the potential that the bank has an inadequate technology infrastructure and related technical support to properly process daily transactions, keep customer information private, provide timely and accurate board and management information for key decision-making, thereby disabling the bank in the event of a catastrophe.

Critical Key Ratios: Risk-Adjusted Performance Measures (RAPMs)

We have seen that the safety and soundness of banks and the banking system are reliant on maintaining levels of capital that will see a financial institution through adverse periods and sustain it over the long run. Given the many tangible and intangible risks facing the banking industry today, protecting capital through risk-adjusted performance measures is of increasing importance. The most common RAPM is risk-adjusted return on risk-adjusted capital (RARORAC), which goes beyond the earnings measures represented by return on assets (ROA) and return on equity (ROE). RARORAC takes into consideration anticipated returns adjusted for expected future losses (credit losses, declines in interest income or noninterest income, contingencies, etc.). In addition, capital-at-risk represents not just equity (the difference between total assets and total liabilities) but the estimated funds required to protect against expected losses as well as unexpected losses—i.e. losses that could result from each of the risks identified in “Risk management” above. Hence, RARORAC is a marked change from traditional measures of return on equity not only with respect to computation, but also to measurement and complexity. RARORAC is measured as:

Risk-adjusted return ÷ Capital-at-risk

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Further reading


  • Golin, Jonathan. The Bank Credit Analysis Handbook: A Guide for Analysts, Bankers and Investors. Singapore: Wiley, 2001.


  • Basel Committee on Banking Supervision. “Basel III: A global regulatory framework for more resilient banks and banking systems.” Bank of International Settlements. Updated June 2011. Online at:


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