Part 8
Dear Clients, Friends and Neighbors,
As I continue to write this monthly Q&A column (the 8th in our series) I hope you are finding it insightful to help you
through these uncertain economic times. Here is some information I hope you will find helpful:
Question: So much is in the news today regarding bank profitability. How do you measure a bank’s profitability and how can you compare one bank to another?
Answer: There are several methods for measuring bank profitability over and above just giving the raw dollar amount of earnings. The banking industry is very analytical in that there is a method of measuring all aspects of profitability. The most common measurements are Return on Average Assets (ROAA) and Return on Equity (ROE). ROAA is a measurement of the earnings generated off of the asset base of the bank. It is calculated by net income for a period divided by the average assets for that same period. To annualize the number, it is then multiplied by 12 months if you are measuring monthly earnings. ROE is similar except that net income is divided by average equity for the period. Both measurements are standardized in the industry, so it is easy to compare bank to bank.
To get an even better picture of a bank’s earnings, you can look at earnings per share if it is a public company. This measures the earnings each shareholder earns for each share they own. This can also produce a yield on the investor’s investment. The list of ratios used to measure earnings is extensive, but one additional measure management uses to measure performance is called the efficiency ratio. This ratio measures the percentage of pre tax income that falls to the bottom line out of every dollar of revenue.
No single measurement is looked upon as a complete indicator of performance, rather the entire range of performance measures is looked at each month and compared to prior months as well as to peer banks.
Question: Banking is a very competitive industry. How does a bank measure its success against other banks in the same market?
Answer: Each year a bank’s Board of Directors, along with the senior management team meet to create a strategic plan document. This document extends out several years but also speaks to the current year as it generally includes the annual budget. Strategic planning is the process at which the management and board agree on the overall strategy of the company, be it a focus on asset growth, profitability or a combination of both. If the focus is on aggressive asset growth, the offset is usually a reduction in earnings. On the reverse is a bank that develops an aggressive earnings strategy, which means that growth will not be emphasized. The third and most common strategy is a blend of the above two.
Throughout the year, actual results are measured against budgeted projections. Banks also look at their peer banks throughout the state as well as market share for deposits within their market. A strategy may be to increase market share by 5% in a given time period while at the same time increasing loans outstanding by 8%. These figures must fit within the bank’s overall capital structure and outside factors such as the economy plan an integral part in the process.
Question: Is running a bank that much different than running, say, a manufacturing company?
Answer: The easy answer is no. We have a balance sheet and income statement like every company in the country. For a bank, loans are the single largest group of assets. We also have investments, cash and fixed assets on the asset side of the balance sheet. Most banks like to minimize the level of fixed assets just because we do not generate any revenue from them. For this reason, most banks will have over 90% of their assets classified as earning assets, which are loans and investments.
The liability side of the balance sheet consists of deposits and capital. Regulatory agencies are requiring banks to maintain higher capital levels, so it is not uncommon to see banks today with capital levels of about 12%-15% of total assets. Deposits are classified as liabilities on a bank's balance sheet. The mix and level of deposits is what determines the value of a bank in today's world. Banks with solid core deposits and an overall low cost of funds are generally more profitable and therefore generally carry a higher stock price than banks with large levels of wholesale deposits or who rely on CDs for their primary funding.
The income statement of a bank looks just like the income statement for any company. Our cost of goods is the cost we pay on deposits. Gross margin is reflected on a bank’s income statement as net interest margin. Our largest cost on a monthly basis is our human resource – payroll - costs.
Banks today are running on very thin margins with interest rates being as low as they are. It is therefore critical to run our company as efficiently as possible. Like every other company in the country, during times of a recession, we look to operate very efficiently and cut excess expenses were we can.
Question: Is it difficult to change the strategy of the bank in a short period of time if something like a recession dictates change mid-stream?
Answer: Again, like any company, a bank must have some degree of flexibility. Prevailing interest rates dictate much of what we do and when we do it. Therefore, we attempt to manage the difference between what we earn on our asset portfolio and our cost of deposits for a given period. If we are successful in this endeavor, it does not matter if interest rates rise or fall, our margin should remain the same and profitability should remain constant for a given level of assets. If this is the case, growth in assets will be a major determining factor in profit growth. Add to this the flexibility we need to maintain with respect to our operating costs and you will see that we are constantly working to maintain the greatest level of efficiency we can.
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