The return on
bank's equity (ROE) is net income divided by its average equity. The return on bank's assets (ROA) is its net income divided by its average assets. The (tier 1 or total) capital divided by bank's risk weighted assets – a measure of bank's capital adequacy. Most banks follow provisions of Basel Accord as set by Basel Committee of Bank Supervision (also known as G10). This could be misleading because Accord is ill equipped to deal with risks associated with emerging markets, where default rates of 33% and more are norm. Finally, there is common stock to total assets ratio. But ratios are not cure-alls. Inasmuch as quantities that comprise them can be toyed with – they can be subject to manipulation and distortion. It is true that it is better to have high ratios than low ones. High ratios are indicative of a bank's underlying strength, reserves, and provisions and, therefore, of its ability to expand its business. A strong bank can also participate in various programs, offerings and auctions of Central Bank or of Ministry of Finance. The larger share of bank's earnings that is retained in bank and not distributed as profits to its shareholders – better these ratios and bank's resilience to credit risks.Still, these ratios should be taken with more than a grain of salt. Not even bank's profit margin (the ratio of net income to total income) or its asset utilization coefficient (the ratio of income to average assets) should be relied upon. They could be result of hidden subsidies by government and management misjudgement or understatement of credit risks.
To elaborate on last two points:
A bank can borrow cheap money from Central Bank (or pay low interest to its depositors and savers) and invest it in secure government bonds, earning a much higher interest income from bonds' coupon payments. The end result: a rise in bank's income and profitability due to a non-productive, non-lasting arbitrage operation. Otherwise, bank's management can understate amounts of bad loans carried on bank's books, thus decreasing necessary set-asides and increasing profitability. The financial statements of banks largely reflect management's appraisal of business. This has proven to be a poor guide.
In main financial results page of a bank's books, special attention should be paid to provisions for devaluation of securities and to unrealized difference in currency position. This is especially true if bank is holding a major part of assets (in form of financial investments or of loans) and equity is invested in securities or in foreign exchange denominated instruments.
Separately, a bank can be trading for its own position (the Nostro), either as a market maker or as a trader. The profit (or loss) on securities trading has to be discounted because it is conjectural and incidental to bank's main activities: deposit taking and loan making.
Most banks deposit some of their assets with other banks. This is normally considered to be a way of spreading risk. But in highly volatile economies with sickly, underdeveloped financial sectors, all institutions in sector are likely to move in tandem (a highly correlated market). Cross deposits among banks only serve to increase risk of depositing bank (as recent affair with Toko Bank in Russia and banking crisis in South Korea have demonstrated).
Further closer to bottom line are bank's operating expenses: salaries, depreciation, fixed or capital assets (real estate and equipment) and administrative expenses. The rule of thumb is: higher these expenses, weaker bank. The great historian Toynbee once said that great civilizations collapse immediately after they bequeath to us most impressive buildings. This is doubly true with banks. If you see a bank fervently engaged in construction of palatial branches – stay away from it.
Banks are risk arbitrageurs. They live off mismatch between assets and liabilities. To best of their ability, they try to second guess markets and reduce such a mismatch by assuming part of risks and by engaging in portfolio management. For this they charge fees and commissions, interest and profits – which constitute their sources of income.
If any expertise is imputed to banking system, it is risk management. Banks are supposed to adequately assess, control and minimize credit risks. They are required to implement credit rating mechanisms (credit analysis and value at risk – VAR - models), efficient and exclusive information-gathering systems, and to put in place right lending policies and procedures.
Just in case they misread market risks and these turned into credit risks (which happens only too often), banks are supposed to put aside amounts of money which could realistically offset loans gone sour or future non-performing assets. These are loan loss reserves and provisions. Loans are supposed to be constantly monitored, reclassified and charges made against them as applicable. If you see a bank with zero reclassifications, charge offs and recoveries – either bank is lying through its teeth, or it is not taking business of banking too seriously, or its management is no less than divine in its prescience. What is important to look at is rate of provision for loan losses as a percentage of loans outstanding. Then it should be compared to percentage of non-performing loans out of loans outstanding. If two figures are out of kilter, either someone is pulling your leg – or management is incompetent or lying to you. The first thing new owners of a bank do is, usually, improve placed asset quality (a polite way of saying that they get rid of bad, non-performing loans, whether declared as such or not). They do this by classifying loans. Most central banks in world have in place regulations for loan classification and if acted upon, these yield rather more reliable results than any management's "appraisal", no matter how well intentioned.
In some countries Central Bank (or Supervision of Banks) forces banks to set aside provisions against loans at highest risk categories, even if they are performing. This, by far, should be preferable method.
