Banks, Thrifts and Credit Unions all are faced with low Return-on-Assets ratios. This fact makes it critical that management of these institutions manage their income and expenses very closely. Speak to this low ROA as it relates to the management of interest rate margin, noninterest income and expenses, and loan loss reserves. Your explanation should clarify why it is that these financial institutions must be conservative as they chose where to invest their funds. You may be helped in your answer by the following information provided by Investopedia.
What does the low Return-on-Assets mean to the bank manager and/or bank owner when reviewing the relationship between the ROA and ROE?
How does this affect the credit decision in the loan portfolio and the investment portfolio?
From the stand point of the FDIC, why is the capital position important?
How to Calculate Profitability Ratios for Banks
These three ratios can give you a good idea of how well a bank uses its resources to generate profits.
To determine the profitability of banks, simply looking at the earnings per share isn’t quite enough. It’s also important to know how efficiently a bank is using its assets and equity to generate profits. For this reason, three key profitability ratios to look at when evaluating a bank stock are:
Return on assets (ROA)
Return on equity (ROE)
Net interest margin (NIM)
Here’s how to calculate each one, as well as an example of each using 2015 data from Wells Fargo.
Return on assets
To calculate a bank’s return on assets, you need to know two pieces of information. First, you need to find the net income, which can be found on the bank’s income statement. Next, you need to find the bank’s assets (loans, securities, cash, etc.), which can be found on the bank’s balance sheet. To calculate return on assets, simply divide the net income by the total assets, then multiply by 100 to express it as a percentage.
ROA Formula – Return on Assets = Net Income / Total Assets X 100
As an example, Wells Fargo produced net income of just over $23 billion in 2015, and had total assets of $1.787 trillion at the end of the year. Dividing these two numbers and multiplying by 100 shows a ROA of 1.29%.
Now, we’re going to complicate things just a little. If you want the most accurate calculation possible for ROA (or ROE), you need to take an average of the assets or equity over the time period you’re considering. In the case of a bank’s annual ROE, the best practice is to take the average of the assets at the end of the last five quarters. For Wells Fargo, the five-quarter average assets were $1.737 trillion, which produces a slightly higher ROA of 1.32%.
Return on equity
For return on equity, you’ll need the net income as well as the total shareholders’ equity, which can be found on the balance sheet. The formula for ROE is similar to the ROA formula, except that you divide by equity instead.
ROE Formula – Return on equity = Net Income / equity X 100
Continuing our Wells Fargo example, we can determine that the bank’s five-quarter average equity is $189.8 billion. Using this, along with the bank’s $23 billion in net income shows a ROE of 12.1%.
Net interest margin
Finally, to calculate the net interest margin, you need to determine the bank’s net interest income. You can find this on the income statement, or you can subtract the bank’s interest expense from its interest income. Then, divide this by the bank’s assets. Similarly to the other two metrics, use a five-quarter average of assets in order to produce an accurate NIM.
NIM Formula – Net Interest Margin = Interest Income – Interest Expense / Total Assets X 100
For Wells Fargo, its income statement shows 2015 interest income of $49.28 billion, and interest expense of $3.98 billion. Therefore, we can calculate its net interest income as $45.3 billion, and its net interest margin as 2.6%.
So, what is “good” profitability?
In terms of ROA and ROE, 1% and 10%, respectively are generally considered to be good performance numbers. And, for the fourth quarter of 2015, the industry averages were 1.03% (ROA) and 9.21% (ROE). Net interest margin tends to fluctuate over time depending on the prevailing interest rates — that is, interest margins tend to be higher when market interest rates are up. In the fourth quarter of 2015, the industrywide average NIM was 3.02%, but was as high as 4.91% in the mid-1990s.
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The Industry Handbook: The Banking Industry
If there is one industry that has the stigma of being old and boring, it would have to be banking; however, a global trend of deregulation has opened up many new businesses to the banks. Coupling that with technological developments like internet banking and ATMs, the banking industry is obviously trying its hardest to shed its lackluster image.
There is no question that bank stocks are among the hardest to analyze. Many banks hold billions of dollars in assets and have several subsidiaries in different industries. A perfect example of what makes analyzing a bank stock so difficult is the length of their financials – they are typically well over 100 pages. While it would take an entire textbook to explain all the ins and outs of the banking industry, here we’ll shed some light on the more important areas to look at when analyzing a bank as an investment. (For background reading, seeAnalyzing A Bank’s Financial Statements.)
There are two major types of banks in North America:
Regional (and Thrift) Banks – These are the smaller financial institutions, which primarily focus on one geographical area within a country. In the U.S., there are six regions: Southeast, Northeast, Central, etc. Providing depository and lending services is the primary line of business for regional banks.
Major (Mega) Banks – While these banks might maintain local branches, their main scope is in financial centers like New York, where they get involved with international transactions and underwriting.
Could you imagine a world without banks? At first, this might sound like a great thought! But banks (and financial institutions) have become cornerstones of our economy for several reasons. They transfer risk, provide liquidity, facilitate both major and minor transactions and provide financial information for both individuals and businesses.
Running a bank is just as difficult as analyzing it for investment purposes. A bank’s management must look at the following criteria before it decides how many loans to extend, to whom the loans can be given, what rates to set, and so on:
Capital Adequacy and the Role of Capital
Asset and Liability Management – There is a happy medium between banks overextending themselves (lending too much) and lending enough to make a profit.
Interest Rate Risk – This indicates how changes in interest rates affect profitability.
Liquidity – This is formulated as the proportion of outstanding loans to total assets. If more than 60-70% of total assets are loaned out, the bank is considered to be highly illiquid.
Asset Quality – What is the likelihood of default?
Profitability – This is earnings and revenue growth.
Perhaps the biggest distinction that sets the banking industry apart from others is the government’s heavy involvement in it. Besides setting restrictions on borrowing limits and the amount of deposits that a bank must hold in the vault, the government (mainly the Federal Reserve) has a huge influence on a bank’s profitability. (To learn more about the Fed, read the Federal Reserve Tutorial.)
Interest Rates: In the U.S., the Federal Reserve decides the interest rates. Because interest rates directly affect the credit market (loans), banks constantly try to predict the next interest rate moves, so they can adjust their own rates. A bad prediction on the movement of interest rates can cost millions. (To learn more, read HYPERLINK “http://www.investopedia.com/articles/03/122203.asp” Trying To Predict Interest Rates.)
Gap: This refers to the difference, over time, between the assets and liabilities of a financial institution. A “negative gap” occurs when liabilities are higher than assets. Conversely, when there are more assets than liabilities, there is a positive gap. When interest rates are going up, banks with a positive gap will profit. The opposite is true when interest rates are falling.
Capital Adequacy: A bank’s capital, or equity, is the margin by which creditors are covered if the bank has to liquidate assets. A good measure of a bank’s health is its capital/asset ratio, which, by law, is required to be above a prescribed minimum.
The following are the current minimum capital adequacy ratios:
Tier 1 capital to total risk weighted credit (see below) must not be less than 4%.
Total capital (Tier 1 plus Tier 2 less certain deductions) to total risk weighted credit exposures must not be less than 8%. (For more on this, read How Do Banks Determine Risk?)
The risk weighting is prescribed by the Bank for International Settlements. For example, cash and government securities are said to have zero risk, whereas mortgages have a risk weight of 0.5. Multiplying the assets by their risk weights gives the total risk-weighted assets, which is then used to determine the capital adequacy.
Tier 1 Capital: In relation to the capital adequacy ratio, Tier 1 capital can absorb losses without a bank being required to cease trading. This is core capital, and includes equity capital and disclosed reserves.
Tier 2 Capital: In relation to the capital adequacy ratio, Tier 2 capital can absorb losses in the event of a winding up, so it provides less protection to depositors. It includes items such as undisclosed reserves, general loss reserves and subordinated term debt.
Gross Yield on Earning Assets (GYEA) = Total Interest Income
Total Earning Assets
This tells you what yields were generated from invested capital (assets).
Rates Paid on Funds (RPF) = Total Interest Expense
Total Earning Assets
This tells you the average interest rate that the bank is paying on borrowed funds.
Net Interest Margin (NIM) = (Total Interest Income – Total Interest Expense)
Total Earning Assets
This tells you the average interest margin that the bank is receiving by borrowing and lending funds
Interest rate fluctuations play a huge role in the profitability of a bank. Banks are, therefore, trying to get away from this dependency by generating more revenue on fee-based services. Many bank financial statements will break up the revenue figures into fee-based (or non interest) and non-fee (interest) generated revenue. Make sure you take a close look at the fee-based revenue: firms with a higher fee-based revenue will typically earn a higher return on assets than competitors.
Evaluating management can be difficult because so many aspects of the job are intangible. One key figure for evaluating management is the net interest margin (NIM) (defined above). Look at the past NIM across several years to determine its trends. Ideally, you want to see an even or upward trend. Most banks will have NIMs in the 2-5% range; this might appear low, but don’t be fooled – a .01% change from the previous year means big changes in profits.
Another good metric for evaluating management performance is a bank’s return on assets (ROA). When calculating ROA, remember that banks are highly leveraged, so a 1% ROA indicates huge profits. This is one area that catches a lot of investors: technology companies might have an ROA of 5% or more, but these figures cannot be directly compared to banks. (To learn more, read ROA On The Way.)
As with other industries, you want to know that a bank has costs under control, and that things are being run efficiently. Closely analyze the bank’s operating expenses. Ideally, you want to see operating expenses remain the same as previous years or to decrease. This isn’t to say that an increase in operating expenses is a bad thing, as long as revenues are also increasing.
As we mentioned in the above section, a measure of a bank’s financial health is its capital adequacy. If a bank is having difficulty meeting the capital ratio requirements, it can use a number of ways to increase the ratio. If it is publicly traded, it can issue new stock or sell moresubordinated debt. That, however, may be costly if the bank is in a weak financial position. Small banks, most of which are not publicly traded, generally do not have the option of selling new stock. If the bank cannot increase its equity, it can reduce its assets to improve the capital ratio. Shrinking the balance sheet, however, is not attractive because it hurts profitability. The last option is to seek a merger with a stronger bank.