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  • How To Measure Bank Performance

    Although net income gives us an idea of how well a bank is doing, it suffers from one major drawback. It does not adjust for the bank's size, thus making it hard to compare how well one bank is doing relative to another. A basic measure of bank profitability that corrects for the size of the bank is the return on assets (ROA). Secondly, because the owners of a bank must know whether their bank is being managed well, ROA serves as a good method to identify it.

    ROA = Net profit after taxes / assets

    The return on assets provide information on how efficiently a bank is being run because it indicates how much profits are generated by each dollar of assets.

    However, what the bank's owners (equity holders) care about most is how much the bank is earning on their equity investment. This information is provided by the other basic measure of bank profitability, the return on equity (ROE).

    ROE = Net profit after taxes / equity capital

    There is a direct relationship between return on assets (which measures how efficiently the bank is run) and the return on equity (which measures how well the owners are doing on their investment). This relationship is determined by the equity multiplier (EM), the amount of assets per dollar of equity capital.

    EM = Assets / Equity capital

    ROE can also be expressed as a multiplication of ROA and EM

    ROE = ROA * EM

    This formula tells us what happens to the return on equity when a bank holds a smaller amount of capital (equity) for a given amount of assets. For example, X bank has $100 million of assets and $10 million of equity, which gives it an equity multiplier of 10 ( = $100 million / $10 million). The Y bank, in contrast, has only $4 million of equity and $100 million of assets, which gives it and equity multiplier of 25 ( = $100 million / $4million). 

    Suppose that these banks have been equally well run so that they have the same return on assets, 1%. The return on equity for the X bank equals to 1% * 10 = 10% , while the return on equity for the Y bank equals 1% * 25 = 25%. The equity holders in the Y bank are clearly a lot happier than the equity holders in the X bank because they are earning more than twice as high a return. We now can see why the owners of bank may not want it to hold a lot of capital. Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

    Another commonly used measure of bank performance is called the net interest margin (NIM). NIM is the difference between interest income and interest expenses as a percentage of total assets.

    NIM = (Interest income - Interest expenses) / Assets

    One of the bank's primary intermediation functions is to issue liabilities and use the proceeds to purchase income earnings assets. If a bank manager has done a good job of asset and liability management such that the bank earns substantial income on its assets and have low costs on its liability, profits will be high. How well a bank manages its asset and liabilities is affected by the spread between the interest earned on the bank's assets and the interest cost on its liabilities. This spread is exactly what net interest margin measures.

    If the bank is able to raise funds with liabilities that have low interest costs and is able to acquire assets with high interest income, the net interest margin will be high and the bank is likely to be highly profitable. If the interest cost of its liabilities rises relatively to the interest earned on its assets, the net interest margin will fall, and bank profitability will suffer.

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    Prem-Profile-PhotoAbout the Author

    I am Prem, the founder of TheFinanceConcept. I am an Investment Advisor and a part-time blogger. I hold PG degree in MBA (Finance) and pursuing CFA. Blogging has become my passion from April 2011. I enjoy writing articles on Securities Analysis and Financial Planning.
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    Falak
    said on January 23, 2012:

    I liked the article very much. It is really helpful for me.

    Prem said on January 23, 2012:

    @Falak Thanks Falak. Hope other articles are also useful to you and you get benefited from it.

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