The banking industry, specifically the retail side, is the most complex part of the already highly complex industry to analyze.
Because of the many different factors involved in the retail industry, it is challenging to measure the performance of the banking industry, especially the retail banking industry.
It is a complex task to analyze the retail banking industry because even a small bank may have tens of thousands and hundreds of thousands of clients.
Many of these clients would have different types of bank accounts with the bank, such as savings or current accounts.
Many clients would also have a credit card, and each pays a different interest on their credit card depending on their FICO scores and credit history.
Some banks would also issue mortgages.
How do they assess the creditworthiness of the client? What is the chance that the client could pay their mortgage?
These metrics make it almost impossible or, at the least, very difficult to analyze how a bank is performing relative to any other industry.
As a result, analysts have created specific metrics that analyze the bank’s performance and have made it incredibly simple to gauge how a bank is performing.
These performance metrics are known as critical ratios for the banking industry. The key ratios are also known as financial banking ratios.
2. The critical ratios for the banking industry
The key ratios for the banking industry are shown below in figure one:
Figure 1: The three critical ratios for the Banking Industry
The three critical ratios for the banking industry shown in figure 1 are the net interest margin, the loan-to-assets ratio, and the return on assets ratio.
All three of these play a vital role in the measurement of the financial performance of a bank. All three of the key ratios are explained in great detail below:
2.1 Net Interest Margin
A simple version of how banks work is they get money from their depositors and pay them interest on their deposits.
To pay interest and make profits, Banks loan out these deposits to other people or businesses for mortgages or consumer loans, or so on; the interest that banks charge on these loans should be higher than the interest the bank is paying to depositors.
The bank must do this to meet expenses and make profits. This is where the net interest margin comes in.
The net interest margin can be defined as the percentage difference between the interest the bank pays to the depositors and the interest it charges on its loans.
For example, suppose a bank pays 2 percent interest to a depositor while the bank asks for a 3 percent interest rate on the loan it makes to consumers.
The net interest margin of this bank is only one percent. Similarly, if instead of 3 percent, the bank charged four percent on its loan, the net interest margin would be 2 percent.
Analysts use this metric to judge the profitability of a bank. The higher the interest rate margin is, the more profitable the bank is. So, banks try to keep the interest rate margin as high as possible.
2.2 The loan to assets ratio
The loan-to-asset ratio is another critical ratio specific only to the banking industry and, even more specifically, the retail banking industry. The loan-to-asset ratio is used to judge how a bank uses its deposits to earn money.
It is a metric that tells us from which sources a bank derives its revenues and profits. Is the income generated from loans, or is the bank diversifying and investing in other products?
The higher the loan-to-assets ratio, the more income that particular bank derives from making new loans.
The lower the loan-to-asset ratio, the less income a particular bank derives from making new loans. Instead, it is diversifying into new and different financial products.
How the loan-to-asset ratio impacts a bank’s performance depends upon the interest rate set by the central bank of that particular country.
If the interest rates are high, it makes sense that the banks with higher loan-to-assets ratios are performing well.
Still, compared to a low-interest-rate environment, banks with high loan-to-asset ratios are seen as performing less than those with a diversified portfolio.
2.3 The return on asset ratio
This is the final of the key ratios. Although this ratio is not banking-specific, this helps a lot in evaluating a bank’s performance.
The return on assets ratio is used because it is tough to measure the cash flow of a bank as compared to any other business.
The majority of assets a bank has are the loan it makes. Calculating the return on assets or ROA for these loans makes it relatively easy to gauge a bank’s performance.
The higher the return on asset ratio, the more profitable a bank is. The return on assets ratio is calculated by income earned by the bank after taxes.
Another significant advantage of return on assets measurement is that it is highly predictable, unlike cash flow.
The cash flow can be highly volatile, which is why it is not considered a good measurement metric for the banking industry because it is tough to predict from quarter to quarter.
2.4 Return on Equity Important to Assess Bank
Return on equity (ROE) is an important tool for assessing a bank’s financial performance. ROE measures the profitability of a business in comparison to its equity and helps investors gauge the return they can expect from their investments.
It measures how much profit the owners of the bank are generating relative to the money invested by shareholders.
By comparing ROE values with peers and industry averages, investors can better understand how well their investments in a particular bank will perform over time.
The higher the ROE, the more profitable and efficient a bank will likely be.
2.5 Risk-Adjusted Return on Capital
Risk-adjusted return on capital (RAROC) is a key tool for assessing a bank’s financial performance.
RAROC measures the profitability of a business relative to the risks taken by investors and helps investors understand how their investments will perform in different economic circumstances.
By comparing RAROC values with peers and industry averages, investors can determine if their investments in a particular bank provide an adequate return adjusted for risk.
The higher the RAROC, the more attractive that bank’s investments are likely to be.
2.6 Efficiency Ratio
An efficiency ratio is an important tool to assess a bank’s financial performance. It measures how efficiently a bank can convert its assets into income and helps investors understand how their investments will fare in different economic conditions.
By comparing efficiency ratios with peers and industry averages, investors can determine if their investments in a particular bank provide the expected returns over time.
A higher efficiency ratio indicates that the bank can generate more revenues from its assets and improve profitability for shareholders.
2.7 Loans to Deposits Ratio
The loans to deposits ratio is an important tool to assess a bank’s financial performance. It measures the amount of money a bank lends out compared to the amount it holds in deposits from customers and other sources.
By comparing loans to deposits ratios with peers and industry averages, investors can determine if their investments in a particular bank provide adequate returns over time.
A higher loans to deposits ratio indicates that the bank has more money available for lending, ultimately increasing shareholders’ profits.
2.8 Yield on Loans
A loan yield is an important tool to assess a bank’s financial performance. It measures the return a bank earns from its loan portfolio and helps investors understand how their investments will fare in different economic conditions.
By comparing yields on loans with peers and industry averages, investors can determine if their investments in a particular bank provide adequate returns over time.
A higher yield indicates that the bank can generate more income from the same level of risk and opportunities for greater profitability for shareholders.
2.9 Allowance for Loan and Lease Losses to Loans
The allowance for loan and lease losses to loans is an important tool for assessing a bank’s financial performance.
It measures the amount of money a bank sets aside from its cash flow to cover potential loan defaults.
By comparing allowances for loan and lease losses with peers and industry averages, investors can determine if their investments in a particular bank are safe from unforeseen losses due to borrower default.
A lower ratio can signify better risk management practices, improving profitability and shareholder returns.
2. 10 Cost of Total Deposits
The cost of total deposits is an important tool to assess a bank’s financial performance. It measures the average rate at which a bank pays interest on its deposit accounts.
By comparing its cost of total deposits with peers and industry averages, investors can determine if their investments provide competitive returns relative to other banks.
A higher cost of total deposits could signal that the bank is paying more than necessary for deposit funds, resulting in reduced profitability and lower shareholder returns.
Three key ratios are used to measure a bank’s financial performance. Each one of these critical ratios measures a specific part of the banking industry.
When all three of these are combined, they clearly show how well a bank performs in the market.