How to Analyze Banks (part 2)
A deep dive into the earnings power of a bank.
15 minute read
This is part two of the series How to Analyze Banks. In this article, we explore how to analyze a bank’s earnings power and profitability.
Core Earnings
Earnings quality refers to how sustainable earnings are. This means that high-quality earnings are those that a bank can produce over time.Â
What constitutes a bank’s income statement can convey information about both risk and performance. Different sources of earnings mean different levels of risk. For example, earnings from fees and commissions are riskier than more recurrent revenue sources like interest income.
Considering the above, the process to evaluate earnings quality has two principal aspects. First, if aggressive accounting practices are used to show earnings better than they truly are, then understanding accounting rules and related laws is important to make proper adjustments. On the other hand, volatility can be a good starting point in understanding how sustainble earnings are.
What is the best way to know if a bank is using accounting mimics to improve profitability?
It is helpful to answer the following questions:
Are there any unusual features in the bank’s accounts?Â
What distinguishes this bank’s financial statements from those of its peers?
How do the elements of the financial statements fit together?
Are disclosures sufficient to understand the accounts?
Have there been any recent restatements of financial accounts that will make it hard to compare the financial accounts in different periods?
Volatility
We can take a look at the following numbers at different points in time: net-interest income, non-interest income, pre-provision income, loan-loss provisions, net operating profit after provisions, and pre-tax profit.
Questions to answer
How does the current figure compare with the previous period?
How does the percentage change compare with historical performance over the past two or three years?
Is this the continuation of a trend, or possibly the reversal or beginning of one?
How do these figures compare to the bank’s peers?
Depending upon whether the change is sector-wide or bank-specific, what might have caused the change?
Profitability
Because a bank’s earnings are closely linked to both capital and liquidity. Meaning that the more loans a bank advances, the more interest income it can generate. It is important to understand the profitability of these loaning activities. Good metrics that encompass this are return on equity and return on assets.Â
Questions to answer
How does net income compare to the amount invested by the owners? (ROE)
How does net interest income compare with the amount of principal advanced? (Net Interest Margin = net interest income / earning assets)
How does pre-tax income compare with total assets? (ROA)
In most markets, healthy banks generate an ROE between 10% and 20%. Likewise, the ROA of healthy banks tends to deviate between 1% and 2%. Very low industry ROA tends to be associated with highly taxed banks or policy lending obligations. High ROA could be the result of an oligopolistic market.
Also important is the Net Interest Margin, this ratio measures the profitability of a bank’s loan operations. It compares net interest income to total loans and is calculated as (interest income - interest expenses) / average earning assets. Where earnings assets equal loans and other assets that generate interest income.
By comparing the above with the historical and recent performances of competitors and its own, we can dive deeper into an earning analysis and understand why the bank can lend more profitably than another, or why performance has changed over time.