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Profitability of Banks

Group-6SIIB-ABM 2011-13

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Asset & Liability for bank is defined as:

Major Asset: Loans to individuals, business and other organizations

The securities that it holds

Major Liability:

Deposits

Money that it borrows, either from other banks or by selling commercial

paper in the money market

Asset & Liability

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Interest and fees on loans is traditionally the major source of

income for commercial banks.

Interest paid on deposits is one of the largest expense items.

Both of the above follow market rates of interest.

Net interest income represents the difference between gross

interest income and gross interest expense

Bank Earnings

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Noninterest income includes fees and service charges.

This source of revenue has grown significantly in importance.

Non interest expense includes salary expenditures.

These expenses have also grown in recent years

Bank Earnings: Non Interest

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Trends in profitability can be assessed by examining Return on

Assets(ROA) over time.

Another measure of profitability is Return on Equity.

Other measures that are widely used are Risk Adjusted Return on

Capital (RAROC) and Economic Profit (Economic Value Added).

Bank Performance

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Return on Asset =

(Free income + Net interest income

operating cost)/ Average total assets

Or

Return on Asset =

Net income/Average total asset

It tells that what an bank is earning on its total asset.

Return on Asset (ROA)

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Net Interest Income =

Interest Received on Assets - Interest Paid on Liabilities

Or

Net Interest income =

Interest Earned on Securities & Loans- Interest Paid on Deposits and Borrowings

High net interest income and margin indicates a well managed bank and

also indicates future profitability.

Net Interest Income

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Net interest income depends partly on the interest rate spread

Interest Rate Spread =

Average Interest Rate Received on Assets Average Interest Rate Paid on Liabilities

Interest rate spread is difference between the average yield a

financial institution receives from loans and other interest-accruing

activities and the average rate it pays on deposits and borrowings.

Greater the interest rate the more profitable the bank will be.

Interest Rate Spread

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It shows how well the bank is earning income on its assets.

Net Interest Margin =

Net Interest Income / Average total assets

Where,

Average Total Assets =

(Total Assets at End of Fiscal Year - Total Assets at Start of Fiscal Year) /2

Net Interest Margin

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ROE= Return on Assets x Leverage Ratio

Or

ROE= Net Income/Bank capital

Where,

Leverage Ratio = Bank assets/ Bank capital

Return on Equity(ROE)

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The Return on equity is what the bank's owners are primarily interest in

because that is the return that they earn on their investment.

When a bank increases its liabilities to pay for assets, it is using leverage

otherwise a bank's profit would be limited by the fees that it can charge

and its interest rate spread.

Interest rate spreads are not wide and so a bank can only earn more net

interest income by increasing the number of loans that it makes compared

with the amount of its bank capital which it does by using leverage.

Return on Equity(ROE)

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It decomposes cost management and revenue management into narrower categories of cost and

revenue to evaluate the source of profits. It includes:

Assets utilization

Determination of net interest income.

Efficiency ratio

Analysis of non interest expense.

Determination of net interest expense.

Profit vs. risk

Profitability Analysis

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Asset utilization =

(non interest revenue/assets ) + (interest revenue/assets)

It Involves:

Rate

Composition

Volume effect

Asset Utilization

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It involves Interest Earning assets as a share of assets which

include:

Volume Effects = earning assets/total assets

Composition/Mix Effects: Types of interest earning assets.

Determination of Net Interest Income

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It include:

Personnel Expenses

Total Expenses

Burden

Analysis of Non Interest Expense

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Earning high profits in good or even normal times

will be easier if the bank is willing to take onsome risk.

This risk may be more problematic in bad times.

Important to measure the risk of the banking

system as well as the profits.

Profit v/s Risk

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Profit for Financial Reporting

Profit to Raise Tier I Capital

Profit to Create a favorable market Image

Profit for Continuous Up gradation of IT Systems

Profit for Organic Growth

Profit for Inorganic Growth

Commercial Role of Profit

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One way for a bank to increase expected profits is to take on more risk.

However, this can jeopardize bank safety.

For a bank to survive, it must balance the demands of three

constituencies:

shareholders, depositors, and regulators, each with their own interest in

profitability and safety.

The bank has to be concerned with shareholder wealth maximization.

Banking Dilemma:

Profitability Versus Safety(1/3)

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Bank Solvency -- Maintaining the momentum of a going concern,

attracting customers and financing in the market.

A firm is insolvent when the value of its liabilities exceeds the value of

its assets.

Banks have relatively low capital/asset positions and high quality

assets.

Bank Liquidity -- the ability to accommodate deposit withdrawals,

loan requests, and pay off other liabilities as they come due.

Banking Dilemma:


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Banks supply liquidity to customers.

Depositors store their liquidity in banks; loan

customers come to the bank to borrow liquidity.

The bank supplies liquidity from two sources: sale

of assets and borrowing.

Banking Dilemma:


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A bank must successfully balance profitability on one hand and liquidity and

solvency on the other.

Bank failure can result from the depletion of capital caused by losses on loans or

securities -- from over-aggressive profit seeking. But a bank that only invests in

high-quality assets may not be profitable.

Failure can also occur if a bank cannot meet the liquidity demands of its depositors

-- a run on the bank occurs. If assets are profitable, but illiquid, the bank also has a

problem.

Bank insolvency very often leads to bank illiquidity.

The Dilemma

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Profitability Goal Versus

Liquidity and Solvency

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1970-90 Social Banking

Narasimham Era: Liberalising the Banking Atmosphere (CRR, SLR and

Interest Rates)

1994 Onwards: Financial Sector Reforms putting Pressure on Banking

Sector

Basel Norms & Tier I Capital

Post 2000: Shorter Settlement Cycles in Stock Market, More Pressure on

Banking Sector

Indian Banking Scenario

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According to a Credit Rating and Information Services of India (Crisil) study, Lower operating

expenses including rationalisation of employee costs have improved the profitability of banks,

contrary to the popular perception that only trading profits helped the banking sector shore up

their bottom lines.

The reduction in operating expenses was achieved through large-scale voluntary retirement

schemes implemented by public sector banks. Since this reduction in operating expenses seems

sustainable, it promises a brighter future for the banking sector.

The efficiency profitability models adopted at various branches of banks which help in enhancing

and profitability of banks.

Profitability of Banks in India:

Current Scenario

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Case:

Profitability Of study of SBI for period 2003-2008

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Profitability performance analysis of the bank

has been performed using two sets of ratios.

They are as under:

Spread as percentage of Working Funds

Burden as percentage of Working Funds

Profitability Performance Analysis

Spread as Percentage of

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Spread is the difference between the interest received and

the interest paid.

It is the net amount, which a bank utilizes in meeting its

operating, administrative and management expenditures.

Spread as percentage of working fund=interest earned as

percentage of working fund interest paid as percentage of

working fund.

Spread as Percentage of

Working Funds

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YEAR Interest Earned as %

of

working funds

Interest Paid as %

of working funds

Spread as % of

working funds

2003 9.10 6.18 2.92

2004 7.97 5.04 2.93

2005 7.10 4.39 3.31

2006 7.19 4.05 3.14

2007 7.34 4.36 2.98

2008 7.32 4.77 2.55

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It shows that in the last six years, the ratio of SBI has registered a decrease

The range of the ratio lies between 2.55% to 3.31%.

By analysing trend from 2003 to 2008 s that an increase has been observed in the first three

years only, whereas a consistent decrease has been observed in the last three years. It

indicates that the performance of SBI in terms of spread ratio has been deteriorated.

Statistical analysis shows that the average ratio of spread as percentage of working funds for

SBI is 2.97%, with a S.D. and dispersion (C.V.) of 0.23 and 7.74% respectively indicating a high

consistency in the ratio.

Analysis

B d P t f

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Burden is the difference between non-interest expenditure and the non-

interest income of a bank.

It is the amount of non-interest expenditure not covered by non-interest

income. It can be calculated by taking the difference between non-interest

expenditure as percentage of working funds and non-interest income as

percentage of working funds

Burden as percentage of working funds = non interest expenditure as

percentage of working capital non interest income as percentage of

working capital.

Burden as Percentage of

Working Funds

YEAR Non-Interest Non-Interest Burden as % of

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YEAR Non Interest

Expenditure as

% of working

funds

Non Interest

income as % of

working funds

Burden as % of

working

funds

2003 2.32 1.68 0.64

2004 2.42 1.99 0.43

2005 2.39 1.69 0.70

2006 2.36 1.48 0.88

2007 2.20 1.07 1.13

2008 1.89 1.30 0.59

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It shows that in the last six years, the ratio of SBI has registered a continuous

increase, except the last year.

It lies between the range of 0.43% and 1.13%.

By analysing the trend from 2003 to 2008 reflects the inefficiency of the bank in

managing its non-interest expenses and non-interest income.

Statistical analysis shows that the average burden ratio of SBI is 0.73%, with a S.D.

and dispersion (C.V.) of 0.22 and 30.14% respectively, which reflects that there is a

high variability, or in other words less consistency, in the ratio of the bank.

Analysis

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After going through the spread ratios and the burden ratios of SBI, it can be inferred that in

terms of both the ratios, the bank has not performed in a satisfactory manner.

The decrease in the ratio of interest earned as the % of working funds has caused a decline in

the spread ratio, whereas the decline in the ratio of non-interest income as % of working

funds has resulted in an increase in burden ratio.

A decreasing spread ratio and an increasing burden ratio is not a healthy sign for the

profitability of a bank.

Therefore, there is a need of taking some appropriate and corrective measures to increase

the income, and restrict the increase in the expenditures and burden of the bank

Conclusion

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Thank You!

Anadi Seth

Arpit Agarwal

Harbar Kamaljot Singh Dhindsa

Kamal Preet Kaur

Samuel Cherian

Shailedra Singh Dandotiya

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