What are the Key Ratios for the Banking Industry?

1. Introduction

The banking industry, more specifically the retail side of the banking industry is the most complex part of the already highly complex industry to analyze. Because of many different factors involved in the retail industry, it is extremely difficult to measure the performance of the banking industry, especially the retail banking industry.

The reason that it is such a complex task to analyze the retail banking industry is that even a single small bank may have tens of thousands and even 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 of the clients would also have a credit card, and each client pays a different interest on their credit card depending upon their FICO scores, and their credit history.

Some banks would also issue mortgages, how do they assess the creditworthiness of the client, what is the chance that the client would be able to pay his/ her mortgage. These are all metrics that 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 certain metrics which analyze the bank performance and which have made it incredibly simple to gauge how a bank is performing. These performance metrics are known as key ratios for the banking industry. The key ratios are also known as banking financial ratios.

2. The key ratios for the banking industry

The key ratios for the banking industry are shown below in figure one:

Figure 1: The three key ratios for the Banking Industry

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The three key ratios for the banking industry shown in figure 1are net interest margin, the loan to assets ratio, and the return on assets ratio. All three of these play a very important 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 in order 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 is paying to the depositors versus the interest that the bank is charging 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.

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2.2 The loan to assets ratio

The loan to asset ratio is another one of the key ratios that are 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 is using its deposits to earn money.

Basically, it is a metric that tells us from which sources a bank is deriving its revenues and profits. Is the income being generated is derived from loans or is the bank diversifying and investing in some other products.

The higher the loan to assets ratio, the more the income that particular bank is deriving from making new loans, the lower the loan to asset ratio, the less the income that particular bank is deriving from making new loans, and instead it is diversifying into new and different financial products.

How a bank’s performance is impacted by the loan to asset ratio depends upon the interest rate set by the central bank of that particular country. If the interest rates are high, then it makes sense that the banks with higher loan to assets ratios are performing well, but when compared to a low-interest-rate environment the banks with high loan to asset ratios are seen as performing less well than those banks which hold 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 extremely difficult to measure the cash flow of a bank as compared to any other business.

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The majority of assets a bank has are the loan it makes. By calculating the return on assets or ROA for these loans, it makes it relatively easy to gauge a bank’s performance. The higher the return on asset ratio a bank has, the more profitable it is. The return on assets ratio is calculated by income earned by the bank after taxes.

Another major advantage of return on assets measurement is that it is highly predictable, unlike a cash flow. The cash flow can be extremely volatile, and that is why cash flow is not considered a good measurement metric for the banking industry because it is extremely difficult to predict from quarter to quarter.

3. Conclusion

There are three key ratios that are used to measure a bank’s financial performance. Each one of these key ratios measures a specific part of the banking industry. When all three of these are combined, they provide a clear picture of how well a bank is actually performing in the market.