Profitability of Banks

Group-6 SIIB-ABM 2011-13

Asset & Liability

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

Bank Earnings
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: Non Interest

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 Performance
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).

Return on Asset (ROA)

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.

Net Interest Income

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.

Interest Rate Spread

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.

Net Interest Margin

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

Return on Equity(ROE)
ROE= Return on Assets x Leverage Ratio Or ROE= Net Income/Bank capital Where,

Leverage Ratio = Bank assets/ Bank capital

Return on Equity(ROE)
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.

Profitability Analysis
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

Asset Utilization
Asset utilization =
(non interest revenue/assets ) + (interest revenue/assets)
It Involves:

Rate
Composition Volume effect

Determination of Net Interest Income

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.

Analysis of Non Interest Expense

It include: Personnel Expenses Total Expenses Burden

Profit v/s Risk

Earning high profits in good or even normal times

will be easier if the bank is willing to take on

some risk.

This risk may be more problematic in bad times.

Important to measure the risk of the banking system as well as the profits.

Commercial Role of Profit

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

Banking Dilemma: Profitability Versus Safety(1/3)

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(2/3)

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: Profitability Versus Safety(3/3)

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.

The Dilemma
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.

Profitability Goal Versus Liquidity and Solvency

Indian Banking Scenario

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

Profitability of Banks in India: Current Scenario

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.

Case:
Profitability Of study of SBI for period 2003-2008

Profitability Performance Analysis

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

Spread as Percentage of Working Funds

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.

YEAR

Interest Earned as % of working funds 9.10

Interest Paid as % of working funds

Spread as % of working funds

2003

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

Analysis
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.

Burden as Percentage of Working Funds

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

YEAR

Non-Interest Expenditure as % of working funds 2.32

Non-Interest income as % of working funds

Burden as % of working funds

2003

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

Analysis
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.

Conclusion
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

Thank You!
Anadi Seth Arpit Agarwal Harbar Kamaljot Singh Dhindsa Kamal Preet Kaur Samuel Cherian Shailedra Singh Dandotiya