UNDERSTANDING

BANKING INDUSTRY
DR. Rajinder S. Aurora,
Professor in Finance,
IBS – Mumbai
 Pre-Provision Operating Profit(PPOP)

 The amount of income a bank or similar type of financial institution earns in a given time period before taking
into account funds set aside to provide for future bad debts.
 The PPOP will be reduced once the bank deducts amount of bad debt provisions it determines need to be set aside
to cover expected loan defaults, but this is not a cash outflow for the bank.
 The PPOP simply provides a reasonable estimate as to what the bank expects to have left for operating profit once
it eventually incurs cash outflows due to defaulted loans.
 A designation given to operating profit reports from banks and financial institutions to indicate that
the total includes funds reserved to accommodate future bad debts.
PPOP
 Since most banks have a large portfolio of loans outstanding to many different customers
at any one time.
 It is simply a matter of time before some of its customers default on their loans. As such,
it would be inaccurate for the bank to consider its entire operating profit as income that it
will be able to keep. Due to this reality, banks typically report their operating income as a
PPOP, to give investors insight into their operating profit, with the understanding that bad
debts will still be incurred and reduce the bottom line
 This is a reminder to investors that the institution anticipates actual operating profit
to decrease based upon loan default experience.
How to calculate PPOP
 PPOP= (Operating Profit / Interest X100)
Yield

 The income return on an investment.

 This refers to the interest or dividends received from a security and is usually expressed annually as a
percentage based on the investment's cost, its current market value or its face value.
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 For example, there are two stock dividend yields. If you buy a stock for $30 (cost basis) and its current
price and annual dividend is $33 and $1, respectively, the "cost yield" will be 3.3% ($1/$30) and the
"current yield" will be 3% ($1/$33).
Types of yield

 Bonds have four yields:

 Coupon yield
 the bond interest rate fixed at issuance
 Current yield
 the bond interest rate as a percentage of the current price of the bond
 Yield to maturity
 n estimate of what an investor will receive if the bond is held to its maturity date.
 Non-taxable municipal bonds will have a tax-equivalent (TE) yield determined by the investor's tax
bracket.
 Cost of Funds
 The interest rate paid by financial institutions for the funds that they deploy in their business.
 The cost of funds is one of the most important input costs for a financial institution, since a lower cost will
generate better returns
 when the funds are deployed in the form of short-term and long-term loans to borrowers.
 The spread between the cost of funds and the interest rate charged to borrowers represents one of the main
sources of profit for most financial institutions.
 cost of funds is determined by the interest rate paid to depositors on financial products including savings
accounts and time deposits.
 Although the term cost of funds usually refers to financial institutions, most corporations that rely on
borrowing are impacted by the costs they must incur to gain access to capital.
Amount Dividend / Average Owned funds x100 or
 Amount of interest / Average borrowed funds x100
 Spread

  The price an issuer pays above a benchmark fixed-income yield to borrow money.
  In the stock market, for example, the spread is the
difference between the highest price bid and the lowest price asked.
 With fixed income securities, such as bonds, the spread is the difference between the yields on securities
 having the same investment grade but different maturity dates. For example, if the yield on a long
term Treasury bond is 6%, and the yield on a Treasury bill is 4%, the 
Spread is 2%.
 Net Interest Income
 is the difference between interest earned and interest paid,
 is commonly tracked by banks and other institutions that lend money. As banks both pay interest (to other
banks or to individuals with deposits at the bank) and earn it (from loans), interest is both an expense and a
revenue stream.
 The difference between the revenue that is generated from a bank's assets and the expenses associated with
paying out its liabilities.
 A typical bank's assets consist of all forms of personal and commercial loans, mortgages and securities.
 The liabilities are, of course, the customer deposits. T
 he excess revenue that is generated from the spread between interest paid out on deposits and interest earned
on assets is the net interest income.
 Net Interest Income = Interest Received - Interest Paid
Net Interest Margin
 Net interest margin (NIM) is a measure of the difference between the interest income generated
by banks or other financial institutions and the amount of interest paid out to their lenders (for example,
deposits), relative to the amount of their (interest-earning) assets.
 A performance metric that examines how successful a bank’s investment decisions are compared to its
debt situations.
 A negative value denotes that the firm did not make an optimal decision, because interest expenses were
greater than the amount of returns generated by investments.

Net Interest Margin = (Investment Returns- Interest Expenses) / Average Earning Assets
 CASA Ratio

 CASA stands for current and savings account. 

 The CASA ratio shows how much deposit a bank has in the form of current and saving account deposits in the
total deposit. 
 A higher CASA ratio means higher portion of the deposits of the bank has come from current and savings
deposit, which is generally a cheaper source of fund.
 Many banks don't pay interest on the current account deposits and money lying in the savings accounts attracts
a mere 3.5% interest rate. Hence, higher the CASA ratio better the net interest margin, which means better
operating efficiency of the bank. 
 Higher income from CASA will improve the net interest margin as the cost of this fund is relatively lower. For
instance, most banks lend at over 10%, whereas, the rate of interest that they pay on saving deposit is just 3.5%.
However, actual realisation depends on other expenditure, too. 
 Higher income from CASA will improve the net interest margin as the cost of this fund is relatively
lower. For instance, most banks lend at over 10%, whereas, the rate of interest that they pay on saving
deposit is just 3.5%. However, actual realisation depends on other expenditure, too. 
CASA ratio= CASA deposits/ Total Deposits
 Cost-efficiency Ratio
 The bank efficiency ratio is a quick and easy measure of a bank's ability to turn resources into revenue.
 The lower the percent, the better the bank is doing.
 An increase in your bank's efficiency ratio either means an increase in costs to run your bank or a decrease in
revenue
 The efficiency ratio, a ratio that typically applies to banks, in simple terms is defined as expenses as a percentage
of revenue (expenses / revenue), with a few variations.
 A lower percentage is better since that means expenses are low and earnings are high. It relates to operating
leverage, which measures the ratio between fixed costs and variable costs.
 Efficiency Ratio = Expenses* / Revenue
 *not including interest expense
 Loan-loss Provisions/Pre-provision operating profit

 Allowance for Loan Losses is calculated as the sum of any specific, generic and other types of Allowances
for Loan Losses, which might also include those that have been temporarily created in addition to generic
and specific.
 Interest-Earning Assets consist of Liquid Assets (mainly Cash and Balances with Central Bank, Due from
Banks, Trading and Available-for-Sale Securities), Non-Liquid Assets (mainly Other Financial Assets
Designated at Fair Value, Held-to-Maturity Investments and Gross Loans) and the interest-earning
components of Other Assets.
 Core Deposits are those deposits that are not sourced from Institutional Depositors. In the absence of more
accurate information, Core Deposits is calculated as Due to Customers less Foreign Deposits and less large-
ticket deposits (jumbo cities).
 Loan Loss Provisions are calculated by adding Provisions for Credit Losses, Releases of Provisions and
Recoveries, Direct Write-Off of Loans and Advances and Other Loan Loss Provisions.
 = Loan Loss Provisions / Pre-provision operating Profit
 Net Interest Income is equal to Interest Income minus Interest Expense
Other Ratios
 Net Interest Margin =
Net Interest income/ Earning Assets

 Reserve as a percentage of loans:

(Reserve/ Total loans )

 Charge offs as percentage of loans:

(Charge-offs/ Total Loans )
Other Ratios
 Return on Average Assets =
( Net Operating Income/ Total Assets )

 Return on Equity =
( Net Income/Stockholder Equity )

 Rate Paid on Funds =

Total Interest Expense / Total Earning Assets
Long Term Debt to Total Liabilities and Equity

 The higher this figure, the more difficult it would be for a bank to borrow more
funds. This figure is determined as follows:
 Long Term Debt to Total Liabilities and Equity = ( Long Term Debt / Total
Liabilities plus Equity
Loans to Assets

 The loans to assets ratio measures the total loans outstanding as a percentage of total
assets. The higher this ratio indicates a bank is loaned up and its liquidity is low. The
higher the ratio, the more risky a bank may be to higher defaults.

 This figure is determined as follows:

Loans to Assets = ( Loans / Total Assets )
Equity to Loans

 Equity to Loans reflects the degree of equity coverage to outstanding loans. This
figure is determined as follows:

 Equity to Loans =
 ( Average Common Equity / Average Total Assets
Tier I

Tier I
 Banks must maintain a ratio which is within the guidelines set by the FDIC
guidelines. This figure is determined as follows:

 Tier 1 Capital =
( Stockholder Equity/ Risk-Adjusted Assets )
Total Capital includes Tier I and the reserve for loan losses ( up to 1.25 % of Risk
Adjusted Capital) plus subordinated notes (to 50 percent of Tier I capital). This
figure is also set by FDIC guidelines
Bank Profitability

Bank Profitability: The net after tax income or net earning of a bank
(usually divided by a measure of bank size).
Some of key ratios are given below

Net Income After Taxes

Return on Equity Capital (ROE) 
Total Equity Capital

Net Income After Taxes

Return on Assets (ROA) 
Total Assets

Net Interest Income

Net Interest Margin 
Total Assets
 Net Non interest Income
Net Non interest Margin 
Total Assets
Total Operating Revenues -
Total Operating Expenses
Net Bank Operating Margin 
Total Assets

Net Income After Taxes

Earnings Per Share (EPS) 
Common Equity Shares Outstandin g
 Banks normally borrow from savers and lend to the investors. A key
measure of the success of this intermediation function is certainly the
spread between the yield on average earning assets to the cost rate on
interest-bearing sources of funds. That is, to measure the true cost of
intermediation, we must look at:
 Yield Spread = (Percent yield on average earning assets - Percent cost on interest-
earning sources of funds)
Profitability Ratios

 Are ROA and ROE equal good proxies for the return of
ownership of a financial institution? Does it matter which
earnings ratio we use?
 The answer is yes, because ROA and ROE reveal different

information about a bank or other financial institution.

 ROA is a measure of efficiency. It conveys information on

how well the institution’s resources are being used in order to

generate income.
Profitability Ratios

 ROE is a more direct measure of returns to the shareholders. Since the reward to the
owners are a key goal for the whole organization, ROE is generally superior to ROA
as a measure of profitability.
 One point should be obvious here: ROE is strongly influenced by the capital
structure of a financial institution, in particular, how much use it makes of equity
financing
 Management may be able to boost ROE simply by greater use of financial leverage-
that is, increasing the ratio of debt to equity capital. This can be seen clearly if we
note that
ROE = ROA x (total assets/total equity capital)
or equivalently,
ROE=ROA x ((total equity + total debt) / total equity)
 The elements which make up ROE can be derived by multiplying together three other financial
ratios:
 Ratio of net income to total operating income (revenue). This is known as the profit margin.

 Ratio of operating income to total assets--known as asset utilization ratio.

 Ratio of total assets to equity capital--known as equity multiplier.

 ROE=(NI/TE) = (NI/OI) x (OI/TA) x (TA/TE)

 ROE = (Profit margin x Asset utilization x Equity multiplier)

 The importance of the above formula is that it can aid management in pinpointing where the
problem lies if a financial institution’s ROE is lower or falling.
 For example, if the profit margin is falling, this implies that less net income is being recovered
from each dollar of operating revenue
 The causes of this problem would be due to:
 lack of adequate expense control
 below-par tax management practices

 inappropriate pricing of services

 ineffective marketing strategies

 However, if ROE, is low or declining due to a decreasing asset utilization ratio, we need
to review the institution’s asset management policies-particularly the yield and mix of its
loans and security investment and the size of its cash or liquidity
 Finally, the equity multiplier sheds light on the financing mix of the institution --
what proportion of assets are supported by owner’s equity (particularly stock and
retained earnings) as opposed to debt capital.
Breakdown Analysis of ROE:

ROE = Tax management efficiency x Expense control efficiency x Asset

management efficiency x Funds management efficiency

Net income after tax

ROE  x
Net income before taxes and securities gain (losses)
Net income before taxes and securities gain (losses)
x
Total opeerating revenues
Total operating revenues
x
Total assets
Total assets
Total equity capital accounts
Breakdown Analysis of Bank’s ROA

ROA = Interest margin + Non-interest margin – Special income margin

(Where special income and expense items = Provision for loan losses +
taxes + securities gain or losses + extraordinary income or losses

Net inte re st inc ome Ne t non - intere st inc ome

ROA   -
Total a ssets Total a ssets
Spe cia l inc ome and e xpense ite ms
Total a ssets
 Credit Risk

 The Probability that Some of the Bank’s Assets Will Decline in Value and Perhaps Become
WorthlessTotal loans to total deposits: As this ratio grow, banks examiners may become
more concerned because they may endanger the interest of depositors.
 Non-performing loans to total loans and leases: The rise in this ratio signals that bank’s
credit risk is increasing. If this ratio persistently rise, then bank’s failure may be just
around the corner.
 Annual provision for loan losses/Total loans and leases: The increase in this ratio signals
that the management is having enough funds to control the bad loans. More is better.
 Credit Risk Measures:
 Non-performing Loans/Total Loans
 Net Charge-Offs (Written Off Loans)/Total Loans
 Provision for Loan Losses/Total Loans
 Provision for Loan Losses/Equity Capital
 Total Loans/Total Deposits
Liquidity Risk:

 Probability the Bank Will Not Have Sufficient Cash and Borrowing Capacity to
Meet Deposit Withdrawals and Other Cash NeedsNet loans to total assets: Higher
the value of the ratio, lower cash available and higher chance to liquidity crunch.
 Cash and due to total assets: The higher the value higher the liquidity. More is better.
 Cash asset and government securities to total assets: Higher the value, more easily
the bank can convert these securities into cash. More is better.
 Purchased funds to total assets: Higher use of purchased funds increase the chances
of liquidity crunch
 Liquidity Risk Measures:
 Purchased Funds (Eurodollars, federal funds, large value certificate of deposits
(CDs) and commercial papers)/Total Assets
 Net Loans/Total Assets
 Cash assets and Due from Banks/Total Assets
 Cash assets and Government Securities/Total Assets
Market Risk

 Probability of the Market Value of the Bank’s Investment Portfolio Declining in

Value Due to a Rise in Interest Rates

 Market Risk Measures:

 Book-Value of Assets/ Estimated Market Value of Assets

 Book-Value of Equity/ Market Value of Equity
 Market Value of Bonds/Book-Value of Bonds
 Market Value of Preferred Stock and Common Stock
Interest Rate Risk

 The Danger that Shifting Interest Rates May Adversely Affect a Bank’s Net Income,
the Value of its Assets or EquityRatio of interest sensitive assets to interest sensitive
liabilities: When interest sensitive assets exceeds interest sensitive liabilities in a
particular maturity range, a bank is vulnerable to falling interest rate. Same is the
case for opposite.

 Interest Rate Risk Measures:

 Interest Sensitive Assets/Interest Sensitive Liabilities
 Uninsured Deposits/Total Deposits
Earnings Risk

 The Risk to the Bank’s Bottom Line – Its Net Income After All Expenses

 Earnings Risk Measures:

 Standard Deviation of Net Income

 Standard Deviation of ROE
 Standard Deviation of ROA

 Standard Deviation: The higher the standard deviation or variance of bank income,
the more risky the banks earning picture is
Solvency or Default Risk

 Probability of the Value of the Bank’s Assets Declining Below the Level of its Total
Liabilities. The Probability of the Bank’s Long Run Survival
 Solvency Risk Measures:
 Stock Price/Earnings Per Share
 Equity Capital/Total Assets
 Purchased Funds/Total Liabilities
 Equity Capital/Risk Assets
 PE: This ratio often falls if investors come to believe that a bank is undercapitalised
relative to the risks it has taken on.
 Ratio of equity capital to assets: A decline in equity funding relative to assets may
indicate increased risk exposure for the banks shareholders and debt holders.
 Ratio of equity capital to risk assets: It reflects how well current bank capital covers
potential losses from these assets most likely to decline in value.
Loans to Deposits Ratio