Bank Financial Analysis: Key Ratios & Metrics
Risk-Adjusted Return on Capital (RAROC)
RAROC is calculated as:
(Expected Income – Financial Costs – Provisions – Operating Expenses) / Risk Capital
- Expected Income: (Loan * Interest Rate)
- Financial Costs: (Loan * Cost of Financing)
- Provisions: (Loan * Loss Given Default * Probability of Default)
- Risk Capital: (Loan * Loss Given Default * Unexpected Default Rate)
A higher RAROC is better, and it should be greater than the bank’s capital cost to create value. Value creation occurs when RAROC exceeds the cost of bank capital.
Non-Performing Loans (NPL) Ratio
NPL Ratio = Non-Performing Loans / Total Gross Loans
A higher NPL ratio indicates more problems with debtors, potentially caused by the bankruptcy of other banks, higher risk tolerance, or lending to less creditworthy borrowers. It reflects a higher risk taken by the bank.
Coverage Ratio
Coverage Ratio = Loan Loss Reserves / NPL
A higher coverage ratio indicates a greater capacity to cover NPLs compared to competitors. As NPLs may increase in the future, a higher coverage ratio can impact ROA, as future earnings are tied to reserves. It shows awareness of the risk of the loans.
Return on Assets (ROA) and Return on Equity (ROE)
- ROA = Net Income / Total Assets
- ROE = Net Income / Total Equity
Interest Margin
Interest Margin = (Interest Income – Interest Expense) / Total Assets
A lower ROA suggests poorer asset management. A higher ROE suggests better leverage management, generating more income from equity. A higher interest margin indicates greater efficiency in earning interest from lending and investments.
To analyze these, use the income statement and compare ROA and interest margins.
Loan to Deposit Ratio
Loan to Deposit Ratio = Total Gross Loans / Customer Deposits
A ratio over 100% indicates that the bank is actively using its deposits for lending, suggesting higher liquidity and credit risk. Ensure sufficient capital adequacy.
Capital Ratio
Capital Ratio (Regulatory Capital) = (Tier 1 + Tier 2) / Risk-Weighted Assets (RWA)
This ratio measures a bank’s financial strength and stability against risk-weighted assets. It assesses a bank’s ability to absorb losses and protect depositors. A ratio above the minimum regulatory capital requirement (e.g., 8%) indicates strong capital adequacy and the capability to cover risk exposure.
Key Financial Ratios
Capital Adequacy (Regulatory Capital)
- Equity Ratio = Total Equity / Total Assets
- Tier 1 Leverage Ratio = Tier 1 Capital / Total Assets
Higher ratios indicate lower risk and greater loss-absorbing capacity, compliance with regulatory requirements, and more stability with less leverage (less reliance on debt).
- Tier 1 Risk-Based Capital Ratio = Tier 1 Capital / RWA
- Tier 2 Risk-Based Capital Ratio (Total Risk Capital Ratio) = Tier 2 Capital / RWA
These ratios measure a bank’s financial strength and stability against RWA, assessing its ability to absorb losses and protect depositors.
Asset Quality
- NPL Ratio (see above)
- Coverage Ratio (see above)
- Texas Ratio = (Delinquent Loans + NPL) / (Capital + Loan Loss Reserves)
- Loan Loss Reserve to Total Loans = Loan Loss Reserves / Total Loans
A higher loan loss reserve ratio indicates better loan coverage for losses; a higher portion will be covered by accounting provisions.
Management Efficiency
Efficiency Ratio = Operating Expenses / Gross Income
The lower the efficiency ratio, the more efficient the bank is.
Earnings
- Earnings Per Share (EPS) = Net Income / Number of Shares
- Price-to-Earnings Ratio (P/E) = Share Price / EPS
- Price-to-Book Ratio = (Share Price * Number of Shares) / (Assets – Liabilities)
Liquidity
Liquid Assets as % of Total Assets = (Cash + Deposits at Central Bank + Liquid Assets) / Total Assets
A higher percentage indicates greater liquidity. There’s a trade-off: a higher percentage helps meet liquidity needs, but highly liquid assets provide very low returns.
ROA Formula Example:
ROA = k = (f + (Br + Rp)) / (1 – (comp b(1 – res req))) + 1
Expected Return Formula Example:
E(r) = (Probability of Payment * (1 + k)) + (Probability of Default * Recovery Rate) -1
Repricing Gap
The difference between rate-sensitive assets (RSA) and rate-sensitive liabilities (RSL) that will be repriced or changed over a future period.
GAP = RSA – RSL
Net Interest Margin = GAP * Change in Interest Rate (Ri) = (RSA – RSL) * Change in Ri
Implications:
- Negative GAP (RSA < RSL): The bank is exposed to refinancing risk. A rise in market interest rates would decrease net interest income since interest expense would increase more.
- Positive GAP (RSA > RSL): The bank faces reinvestment risk. A drop in market interest rates would reduce net interest income as interest income would decrease more than interest expense.
- Spread Effect: When interest rate changes on RSA differ from those on RSL, affecting the net interest margin.
Credit Risk
The risk of loss due to a borrower’s failure to make payments as agreed. This risk can stem from different credit exposures, such as loans, bonds, and derivatives.
Components:
- Expected Loss: Represents the average loss a bank anticipates over a certain period due to defaults. Calculated based on exposure at default, probability of default, and loss given default. (Non-diversifiable)
- Unexpected Loss: Represents potential losses that exceed the expected loss. It accounts for the uncertainty and variability of losses due to default.
- Credit Risk Models: Used to quantify the level of credit risk and to manage and mitigate it efficiently.