What are the bank-specific ratios
Bank-specific ratios such as net interest margin (NIM), provision for credit losses (PCL), and efficiency ratio are unique to the banking industry. Much like companies in other sectors, banks have specific ratios to measure profitability and efficiency to suit unique business operations. Also, since financial strength is especially important for banks, there are also ratios to measure solvency.
Ratios for profitability
1. Net interest margin
The net interest margin measures the difference between the interest income generated and interest expense. Unlike most other companies, a majority of a bank’s income and expenses is created by interest. Since the bank funds a majority of their operations through customer’s deposits, they pay a large amount in interest expense. Also, a large portion of their business involves the lending of money, so a majority of revenue is based on collecting interest on loans.
The formula for the net interest margin (NIM) is:
Net Interest Margin = (Interest Income – Interest Expense) / Total Assets
Ratios for efficiency
1. Efficiency ratio
The efficiency ratio assesses the efficiency of a bank’s operation by dividing non-interest expenses by revenue.
The formula for the efficiency ratio is:
Efficiency Ratio = Non-Interest Expense / Revenue
This ratio does not include interest expense as that is naturally occurring when the deposits within a bank grow. However, non-interest expense such as marketing expense or operational expense can be controlled by a company. A lower efficiency ratio shows that there is less non-interest expense per dollar of revenue.
2. Operating leverage
Operating leverage is another measure of efficiency. It compares the growth of revenue with the growth of non-interest expense.
The formula for the operating leverage is:
Operating Leverage = Growth Rate of Revenue – Growth Rate of Non-Interest Expense
A positive ratio shows that revenue is growing faster than expenses. On the other hand, if the operating leverage ratio is negative, then the bank is accumulating expenses faster than revenue. This suggests inefficiencies in operations.
Ratios for financial strength
1. Liquidity coverage ratio
As the name suggests, the liquidity coverage ratio measures the liquidity of a bank. This particular ratio measures the ability of a bank to meet short term obligations without any inflow of outside cash for 30 days.
The formula for the liquidity coverage ratio is:
Liquidity coverage ratio = High-Quality Liquid Asset Amount / Total Net Cash Flow Amount
This period of 30 days was chosen as that is the estimated amount of time it takes for the government to step in and help a bank during a financial crisis. Thus, if a bank is capable of fund cash outflows for 30 days, it would not fall.
2. Leverage Ratio
The leverage ratio measures the ability of a bank to cover its exposures with tier 1 capital. As tier 1 capital is the core capital of a bank, it is also very liquid. This allows it to be converted to cover exposures easily and ensure the solvency of a bank.
The formula for the leverage ratio is:
Leverage Ratio: Tier 1 Capital / Total Assets (Exposure)
3. CET1 ratio
The CET1 ratio is similar to the leverage ratio and measures the ability of a bank to cover its exposures. However, the CET1 ratio is a more stringent measurement as it only considers the common equity tier 1 capital, which is less than the tier 1 capital. Also, for this calculation, the risk of the exposure (asset) is considered as well. A higher risk asset is given a higher weighting of risk, which lowers the CET1 ratio.
The formula for the CET1 ratio is:
CET1 Ratio = Common Equity Tier 1 Capital / Risk Weighted Assets
Other bank-specific ratios
1. Provision for Credit Losses (PCL) Ratio
The provision for credit losses is an amount a bank sets aside to cover loans they believe will not be collectable. By having an amount set aside, the bank is more protected from insolvency. The PCL ratio measures the provision for credit losses as a percentage of net loans and acceptances. This allows for investors or regulators to gauge the riskiness of loans the bank has written in comparison to peers. As risky loans lead to higher PCL and a higher PCL ratio
The formula for provision for credit losses ratio is:
Provision for Credit Losses Ratio = Provision for Credit Losses / Net Loans and Acceptances
Thank you for reading CFI’s article on bank-specific ratios. To keep learning and developing your knowledge as a financial analyst, we recommend these resources: