The how and how not of Bank Financial Performance Analysis

" How, and How Not, to Analyse Bank Financial Performance : Uncluttering the Clutter "
By VK Sharma,
 Former Executive Director,
                                 Reserve Bank of India                                    

                        Come quarterly/annual bank financial results and investors and readers of business and financial newspapers are all agog over some analyst gushing ‘ Bank A’s net profit rises 35%, and some other analyst emoting ‘ Bank B’s NIM is highest at 5 or 6 % ! And all these are taken by readers and investors as holy grail  suggesting that banks concerned  have been exceptionally efficient and profitable ! This need, and may, not at all be so. But before seeing why, it would only be instructive and value-adding to consider the business model of a typical competitive , efficient, safe, and sound bank.  A bank is typically characterized by relatively high financial leverage, which, in turn, is measured by what is known as Equity Multiplier (EM), which, in turn, is nothing but total assets of a bank divided by its common equity/ shareholder funds. Multiplying this leverage (EM) by what is called Return on Assets (ROA) gives Return on Equity (ROE) for a bank. Typically,competitive, efficient, safe and sound banks have had historically an average ROA of about 1% and a reasonably safe EM of about 15, implying an average market-competitive equilibrium ROE of about 15%. In the recent period, the Indian Banking System has had leverage of about 13 to 14 times. Significantly, and hearteningly, to the credit of RBI and the Indian banking sector, this corresponds to an average leverage ratio ( inverse of EM) of 7%+ which,  at about 2.5 times, is way higher than 3% mandated by new Basel 3 capital rules to be complied with only in 2018 ! In other words, the Indian banking sector is already more than 2.5 times compliant on this critical Basel 3 parameter !! In this context, another key financial parameter is what is known as Net Interest Margin (NIM) which is the difference between interest earned and interest expended as a percentage of a bank’s assets. Collectively for Indian Banks in the recent period, NIM has varied between 2.5% to 3%. If we deduct ROA from NIM, we get what can be called Non Interest cost of Intermediation. In fact, it is this critical parameter/ objective function viz (NIM-ROA) which, for a given ROA derived, in turn, from a given ROE and EM, it must be the dharma/mantra of a role model bank management to minimize for maximizing returns to depositors and/or minimizing costs to borrowers . Thus, either way, constrained minimization of the objective function (NIM-ROA) delivers value to all stakeholdergs viz, shareholders, insured & uninsured depositors, borrowers, taxpayers, in particular, and the real economy, in general. To recapitulate,  " the business model of a competitive, efficient, safe and sound bank is one which, while  by minimizing the objective function (NIM-ROA) subject to the constraint of a given ROA, derived, in turn, from a given market-competitive equilibrium ROE, maximizes value for all stakeholders viz, depositors, borrowers, shareholders and public policy institutions, and allows it to grow sustainably by helping the real sector grow consistent with 'financial sector-real sector balance ' where the financial sector is ever a means to the real sector end !! "
           
2.            We  are now ready to unclutter the clutter in bank financial performance analysis and evaluation. As regards the myth of NIM being a key measure of profitability, let it be said that  NIM by, and in, itself conveys nothing more than what it apparently does viz, as we have seen before, it is just the difference between interest earned, and interest expended, as a percentage of a bank’s assets. It is just a means to an end and not an end in itself ! For it,therefore, to make any sense, it needs to be analysed further beyond what it is by considering (NIM-ROA). For if NIM be 6%, and ROA be zero, then automatically ROE will also be zero and it is no brainer to see that this nominally very high NIM only establishes that the bank is neither competitive, efficient, safe nor sound ! Even if  ROA be, say 2%, then ( NIM-ROA) will be (6%-2%) i.e 4%. And this bank will be far less efficient and competitive  than a bank whose NIM  is, say 3%, and ROA , say 1% , and, therefore, (NIM-ROA)  2% ! This is because non-interest cost of intermediation of the higher- NIM bank is twice that of the lower- NIM bank and it is precisely this twice as large (NIM-ROA) and its reasons through its granular analysis and dissection that should engage the attention of bank analysts and investors !  For it is this (NIM – ROA) that subsumes all non- interest expenses such as taxes, salaries /wages /compensation, operational expenses, loan loss provisions, marked-to-market provisions, write-offs etc. And this (NIM –ROA) becomes even more significant, if the reported gross NPAs (non performing assets) are unusually low ! Therefore, in the above example, the bank with lower (NIM-ROA) will be twice as efficient and competitive  as the one with higher (NIM-ROA) because the former maximizes value for all stakeholders viz, depositors by way of higher deposit interest rates, borrowers by way of lower borrowing costs, shareholders by way of given ROA and market - competitive equilibrium ROE ! And significantly, there is no effect on the rigour, applicability and  generality of the above analytical framework even if non-interest income is not insignificant for all that need be done is just add this income, as a percentage of assets , to NIM- ROA , and only refer to this, if you will, as Net Income Margin rather than Net Interest Margin  ! This would, for a given ROA and ROE , only make NIM even  wider and , as stated before , in combination with the unusually low gross NPAs for such banks  , would make NIM- ROA look , if anything, even more questionable in the sense that what is absent in the unusually low Gross NPAs is very likely present in the unusually wide NIM - ROA !
3.                 Finally , coming to too much being made of, say 25% to 35% growth in net profits, this too needs to be regarded with circumspection for these numbers need to be adjusted for the growth in balance sheet / assets and not just considered in isolation and on a stand- alone basis. For if net profit grows at 35%, on a yoy ,or a CAGR, basis and  assets/ balance sheet also grow by, say 35%, then there is really nothing to write home , or to feel gung ho, about for the bank in question has been no more, and no less, efficient and profitable than before ! Another equally insightful way to see this is in terms of change in ROA . For example, if previous ROA be, say 1%, then there is no change in ROA as the ROA also remains unchanged at 1% for 35% growth both in net profits and assets/balance sheet ! On the other hand, if for a 35% growth in net profit, assets/ balance sheet grow by, say 25%, then the bank has been more efficient and profitable only to the extent of (1.35/1.25-1)*100 i.e.+ 8%, and not 35%, as bank analysts would unwittingly have readers and investors believe !! In this case, ROA increases fom 1% to 1*1.08 i.e 1.08% only ! Also, significantly, and equally, if assets/ balance sheet grow by 40%, then the so-called nominal profit growth of 35% will translate into a less efficient and less profitable performance of (1.35/1.40-1)*100 i.e - 3.5% and not 35% as ROA will decline to 0.96% from 1% previously although absolute net profit increased by 35% !!  This then is the conceptually robust and technically rigorous nuts-and-bolts way of  how bank analysts and investors must dissect  bank financial performance and judge true and fair value of banking stocks  for value investing/buying  !

4.              While on the how-and-how-not  of bank financial performance anaysis and evaluation, a tailpiece on banks' reporting of ' total business ' will not be out of place and context. Typically, in India, it is routine for banks to report total business as the sum of deposits and loans to give analysts and investors a sense of growth in banks' business. But this is not only at variance with the international practice but also intellectually and conceptually flawed and vitiated for  all  ' business ' is about generating revenues and returns for shareholders and it is ' total assets'  that precisely do that and it is tautological and axiomatic that there is no way revenue generating assets can exist and grow without corresponding  expense contributing liabilities ! That is also precisely why, as sources and uses of funds, liabilities and assets appear opposite each other on a balance sheet . Significantly, the so called total business of banks has typically exceeded total assets/ balance sheet size by about 50% !
5.              Therefore, while bank analyts and investors will do well to go that extra mile to have a true and fair sense of banks' business growth, with a view to aligning with the international practice , RBI may also consider mandating banks  reporting total assets/ balance sheet size rather than the so called ' total business ' adding deposit liabilities and loan assets.
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