Bank Performance Analysis: Methodology and Empirical Evidence (Estonian Banking System, 1994-2002)

Bank Performance Analysis: Methodology and Empirical
Evidence (Estonian Banking System, 1994-2002)

August Aarma, PhD, Assistant Professor
Depertment of Economics at Tallinn Technical University
101 Kopli Street, 11712 Tallinn, Estonia
Phone: + 372-6204051; fax: +372-6204051; e- mail: august@tv.ttu.ee
Jaan Vainu, PhD, Research Fellow

Phone: + 372-6204051; fax: +372-6204051; e- mail: jvainu@tv.ttu.ee
Contact person and presenter of the paper:

Vello Vensel, DSc, Professor of Statistics
Phone: + 372-6204051; fax: +372-6204051; e- mail: vvensel@tv.ttu.ee
Abstract
Banks and other financial institutions are a unique set of business firms whose assets and
liabilities, regulatory restrictions, economic functions and operating make them an important
subject of research, particularly in the conditions of the emerging financial sectors in the EU
accession countries from Central and Eastern Europe (CEE). Banks’ performance monitoring,
analysis and control needs special analysis in respect to their operation and performance
results from the viewpoint of different audiences, like investors/owners, regulators,
customers/clients, and management themselves. Some historical notes on the development of
the Estonian banking system and the capital structure of banks are presented in this article.
Different versions of financial ratio analysis are used for the bank performance analysis using
financial statement items as initial data sources. The usage of a modified versio n of DuPont
financial ratio analysis and a novel matrix approach is discussed in the article. Empirical
results of the Estonian commercial banking system performance analysis are also presented in
the article (1994-2002).
EFM classification codes: 510 – Depository Institutions - Management
Journal of Economic Literature Classification number: G21
Keywords: banks’ performance analysis, financial ratio analysis, DuPont model, matrix
approach and matrix model, banking system restructuring, production function.
Acknowledgement
This research was undertaken with joint support from the Göran Collert Foundation (Sweden)
and from the Estonian Science Foundation Program (contract no. 5185).
Estonian Banking Sector Performance
1. Introduction: Theoretical Background and Overview of Related Literature
The problem of banking and financial system soundness has become more important in all
countries over the recent years. The financial sector, and especially the banking system, is
vulnerable to systemic crises which has led to the creation of costly safety nets, as depositor
insurance schemes with well-known moral hazard problem. It is argued that there is
increasing evidence that banks are “black boxes” due to the week transparency and banks’
unwillingness to disclose information (Hyytinen and Takalo, 2002 and 2003). To measure
banks’ creditworthiness and risk exposures is a complicated issue and it is not easy to
interpret banks’ accounting data. Kaminsky and Reinhart (1999, p. 476) argued that
“Indicators of business failures and nonperforming loans are also usually available only at low
frequencies, if at all; the latter are also made less informative by banks desire to hide their
problems for as long as possible.” This means that it is needed to use as fully and complexly
as possible all available financial information from the official financial statements of banks
for making financial analysis of banks’ performance.
There are a lot of lessons to learn from earlier financial and banking crises in various
countries and recent crises in Asia. Kaminsky and Reinhart mentioned: “The cycle of over-
lending is exacerbated by implicit or explicit deposit guarantees, poor supervision, and moral-
hazard problems in the banking sector. Crises are accompanied by an overvaluation of the
currency, weakening exports, and the bursting of asset price bubbles” (Kaminsky and
Reinhart, 1998, p. 444). It seems that this has been written for characterizing the nowadays
situation in the EU accession countries It is noted that the most negative factor is the
extremely rapid domestic credit expansion during the last years, funded by massive borrowing
from abroad due to the sizeable interest rate differential (see, for example, Krzak, 1998).
Doubts about the soundness of the banking sector is also one of the greatest threats to the
credibility of a currency board arrangement in Estonia.
The contemporary banking crises can be classified mostly as “growth crises”, which are
characterized by economic deregulation and liberalization, removal of cross-border
restrictions on capital flows, and increased competition in the financial sector. Based on a
newly constructed cross-country database of financial liberalization, Abiad and Mody (2003)
examined the experience of 35 countries over the period 1973-1996 to analyze underlying
causes of financial sector reforms. They found that liberalization is a combination of discrete
changes in response to economic and political “shocks”, reinforced by a self-sustaining
dynamic (called this as “learning”). They draw five specific conclusions about what produce
changes (reform):
• Countries whose financial sectors are fully repressed (unliberalized) are the ones with the
strongest tendency to maintain their policy stance and hence remain closed and highly
regulated. But, initial reforms cause changes that make further reforms necessary.
• Regional diffusion effects appear to be important – the further a country’s stage of
liberalization is from that of the regional leader, the greater is the pressure to liberalize.
• Shocks to the economic environment (a new government; decline in US interest rates)
play an important role in weakening the status quo and making reforms possible.
• Crises do trigger action, but not always is the direction of reform – balance of payments
crises raise the likelihood of reform; banking crises have the opposite effect.
• Among variables representing ideology and structure, only trade openness appears related
to the pace of reform. Not important: presidential or parliamentary regimes, right- or left-
wing governments, and the legal system proves not to be influential as well.
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It is evident that to study results of financial sector reform and restructuring, a profound
performance analysis is needed. The traditional financial ratio analysis is mainly used for the
bank performance analysis. We can find different versions of this approach from various
textbooks about banking and financial institutions. Different versions of DuPont financial
ratio analysis (see Cole, 1973) seem to be more perspective for banks’ and other financial
institutions’ performance analysis (see, for example, Dietrich, 1996). Recent studies of banks’
efficiency and productivity analysis in different countries can be taken as lessons for the
Estonian case - see, for example, Hardy and di Patti, 2001 (Pakistan lessons); Spiegel, 1999
(Japaneze experience); Berger and Mester, 1999; Van Greuning and Bratanovic, 2000; and
Stiroh, 2000 (US experience); Rebelo and Mendes, 2000 (Portuguese experience); Hasan and
Marton, 2000 (Hungarian lessons); Andersen et al., 2000 (Finnish experience); ECB, 1999
and 2000 (EU banks’ experience); Kwan, 2002 and 2003 (Asian countries experience).
Different financial ratios are used as predictors of bank failures (Estrella et al., 2000). Berger
and Humphrey (1997) presented a review of 122 stud ies in 21 countries about the efficiency
and productivity of financial institutions. Mörttinen (2002) demonstrated how the banking
sector’s service production can be measured using aggregate financial statement and payment
transactions data; she computed banking sector labor productivity Tornqvist indices for six
countries (Finland, Sweden, UK, Germany, France and Italy).
The focus of financial analysis for the management of any bank (or the banking sector as a
whole) should be on the efficiency of performance of the bank measured from the viewpoint
of investors/owners’ income maximization. More widely, all stakeholders have to be
interested in the performance results of the banks. The concept of a “stakeholder monitor” is
useful to take into account in designing performance analysis of any bank. This concept was
developed by David Llewellyn – see Llewellyn 2002, Llewellyn and Mayes, 2003. We agree
with the suggestion that “Stakeholders, as the name implies, have something in stake in the
relative success or failure of the firm. Those who participate in the process of observing the
behavior of the firm and forming judgements in the light of it can be described as “monitors”.
Such monitors may have access to both market and private information. Combining these
ideas, “Stakeholder monitors” are all those agents who have an interest in the outcome of the
monitoring process” (Llewellyn and Mayes, 2003, p. 11). The incomplete list of “stakeholders
monitors” include: supervisory agencies, rating agencies, market traders, shareholders, board
of directors, debt-holders, depositors, managers, borrowers, employees.
In carrying out bank performance analysis, it is important to emphasize that banks differ in
their corporate governance from firms in other, less regula ted industries. These differences, in
turn, present their own challenges for bank managers, regulators, depositors, investors, and
other stakeholders. “Bank managers live in a more complex environment than their peers in
industry due to bank regulations. In addition to the demands placed on them by shareholders,
regulators have strong incentives to influence managerial action, and this may be in conflict
with shareholder demands” (Harm, 2002, p. 5). Governance is a set of mechanisms with
which the providers of capital and other stakeholders are defending their interests against the
firm. The firm is run by managers, and this a point where conflicts of interests starts. An
excellent survey of recent literature (both theoretical and empirical) is also presented by Harm
(op. cit., pp. 109-128).
Macey and O’Hara (2003) argue that bank officers and directors should be held to broader (if
not higher) set of standards than their counterparts in less regulated non- financial firms, and
banks pose special corporate governance problems. Kose and Qian (2003) consider another
important theme in the corporate governance of banks – the effect of the incentive features
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built into the compensation schemes of bank mangers. Adams and Mehran (2003) focus also
on the differences between the corporate governance of banks and manufacturing firms and
support the theory that governance structures are industry-specific. In general, the components
of firm’s governance structure are determined by various different factors, which all will
influence also performance analysis aims and techniques: the nature and structure of firm’s
assets and liabilities (leverage, share of financial assets, business risk, cash- flow patterns),
firm size, industry, regulations, etc.
Various measures of rates of return are used mainly for that purpose. We fully agree with the
opinion that “Relaying too heavily on just a few indicators of bank profitability can be
misleading. While ROA, ROE, and interest margin (and noninterest expenses) to gross
income remain the key measures, they should ideally be supplemented by the analysis of other
operating ratios” (Sundararajan, 2002, p.20). In this article, we present one of the possible
approaches to such financial analysis using the modified version of DuPont analysis (see
Cole, 1973), which is similar to Dietrich’s (1996) approach, and the novel matrix approach
which is was firstly presented in Vensel, 1997 (see also Vensel, 2001). We have selected the
following years for empirical analysis of the Estonian banking system performance:
1994 – the first year of macroeconomic stabilization after the currency reform in June 2002
and after resolution of the first banking crisis in Estonia;
1997 – extraordinary optimistic year, the first unsuccessful attempts of Estonian banks to
expand into Russian and Baltic countries’ markets, Bubble of the Tallinn Stock Exchange;
2000 – the second phase of macroeconomic stabilization and resolution of the second banking
crisis in Estonia;
2001-2002 – recent years before accession to the EU
The paper is organized as follows. The most important recent developments in the Estonian
banking system are presented in Section 2 (some historical notes; banking crises and banks’
rehabilitation; structural developments). DuPont financial ratio analysis modified
methodology and empirical results of the Estonian banking system performance are discussed
in Section 3. In Section 4, the methodology of a novel matrix model and the usage of this
methodological approach are presented. Construction of the Cobb-Douglas production
function is discussed in Chapter 5. The paper ends with some concluding remarks.
2. Development of the Estonian Banking System
2.1. Historical Notes
The first commercial bank (Tartu Commercial Bank) on the territory of the former Soviet
Union was established in Estonia in 1988. This bank went bankrupt and was liquidated in
1992-1993. So, since there was a great demand for banking services by the emerging private
sector, the maximum number of commercial banks operating simultaneously in the small
Estonian banking market was 42 in 1992. Some of them were liquidated during the banking
crises in 1992-1994 and in 1998-1999, and some of them were merged into larger commercial
banks. A short history of the Estonian contemporary banking system is presented in Table 1.
Up till 1997, the development of the Estonian banking sector was characterized by a rapid
nominal growth of total assets and loan portfolios. 1997 was also the beginning of a new stage
in the development of the Estonian financial sector, especially in the international context,
which is confirmed by investment grade credit ratings assigned to Estonia: Standard and
Poor’s BBB+ and Moody’s Investors Service’s Baa1. It has to be added that from 2001-2002
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Estonia has the fo llowing credit ratings by rating agencies (Leemets and Reedik, 2003, p. 49):
Moody’s foreign currency and kroon ratings both A1 (from 12.11.2002); Standard&Poor’s
rating both A- (from 20.11.2001); Fitch foreign currency rating A- and kroon rating A+ (from
30.08.2001). The rapidly growing economy (GDP growth rate in 1997 about 11%) boosted
credit demand, and also non-banking financial intermediation accelerated. However,
implementation of the expected Estonian banks expansion to the other Baltic countries and
Russia was only partly realised due to the tightened market situation both in Estonia and
internationally. Negative results of the over-optimistic and risky attitude towards the
opportunities of the Eastern market and consequences of the bursting of the 1997 stock
exchange bubble in Estonia became clearly evident during 1998-1999.
Table 1. History of the Estonian Banking Sector (Only Operating Banks, 2003)
No Bank Established Organizational Changes

A. Large Banks
1. Hansapank 01.07.1991 Merged with the Estonian Savings Bank (which was
established 14.04.92 on the basis of former state-
owned savings offices and merged with the Estonian
Industrial Bank in 1996) in 1998
2. Union Bank of 15.12.1992 Established on the basis of 11 smaller regional banks,
Estonia merged with North-Estonia Bank in 1997 and with
the Bank of Tallinn (which was established 21.12.92)
in 1998
B. Medium-Sized Banks
3. Nordea Bank 20.06.1995 Established on the basis of merging KOP and SYP
Plc, branch (Finnish banks) offices
4. Sampo Bank 30.06.1992 Previous Optiva Pank, former Forexbank, merged
with Raepank in 1995 and with Estonian Investment
Bank (established 30.06.92) in 1998, Sampo-owned
since 2000
C. Small Banks
5. Estonian 10.04.1992 Small niche bank, majority owned by non-resident
Credit Bank legal persons
6. Tallinn 09.12.1991 Small niche bank, majority owned by Estonian legal
Business Bank persons
7. Preatoni Bank 23.09.1999 Oriented to foreign investments, real estate financing
and asset management
The rapid nominal growth both in the real and financial sectors, the deepening dependence on
international financial markets and financial problems in the emerging markets in South-East
Asia dictated several steps of precaution by the government and the central bank. The most
important long-term regulatory measures included raising of the banks’ minimum capital
adequacy ratio from 8% to 10%, increasing the risk-weight of local governments’ liabilities
from 50% to 100%, and a decision to introduce a market risk component to the capital
adequacy ratio. The intermediate steps included the introduction of reserve requirements to
the net liabilities of domestic banks vis-à-vis non-resident banks and additional liquidity
requirement to restrain capital inflow.
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Compared to previous years, the growth rate of nominal indicators in the banking sector
slowed down during 1998-2000, partly due to the changes in the external environment. With
the deterioration of the economic environment in 1998, wrong economic and management
decisions that had been made already earlier, surfaced in 1998 and resulted, for example, in
the dropout of three banks from the banking market in July-October. Some of the more
important interrelated systematic factors behind wrong management decisions were: the
expansive development in previous years, lack of experience in doing business in the
changing market conditions, insufficient transparency of the market, owners’ weak control
over the activities of executive management, tightened competition in the banking market,
insufficient risk hedging and management, and external shocks.
In 1998, a wave of mergers and restructuring took place in the Estonian banking sector. After
the completion of these mergers, Scandinavian banks started to show greater interest in the
Estonian banking market. As a result, Swedbank acquired 56% of Hansapank and
Skandinaviska Enskilda Banken (SEB) acquired 32% of the Union Bank of Estonia. We may
conclude that the Estonian banking sector became healthier when Swedish banks and other
Nordic investors joined the circle of bank owners, improving the future outlook of the
banking system. So that if during the first banking crises in 1992-1994, Estonia had to resolve
the problems by itself, then during the second banking crises in 1998-1999, foreign banks
also helped and supported to get over the crises.
Smaller banks in Estonia were affected also by the negative developments in Russia. The
liquidation of some banks continued in 1999, accompanied by the declaration of the
bankruptcy of EVEA Pank and ERA Pank. On the other hand, the first new banking licence
issued since 1993 was granted to the new Preatoni Pank in September 1999. Preatoni Pank
has focused mainly on intermediation of foreign capital into Estonian economy, real estate
financing and asset management. During 1999, Swedish banks - SEB and Swedbank -
increased their participation in the equity capital of the Union Bank of Estonia and in
Hansapank over 50%.
2.2. Banking Crises and Bank Rehabilitation
Estonia has experienced two serious banking crises during the about 12- years period of its
banking sector development and restructuring, the first crisis in 1992-1994 and the second in
1998-1999. The first banking crisis occurred during the hard period of starting drastic
economic reconstruction when production output was reducing dramatically and the country
underwent a period of hyperinflation. The characteristic feature of the first banking crisis in
Estonia was that it was caused by internal reasons and it was overcome with Estonia’s own
resources and management skills. The main causes of this banking crisis were severe
problems in the whole economy, poor bank management and lack of professional skills, weak
supervision both from the side of the central bank and owners. The depositors’ losses in the
banking crisis were large, the money supply decreased, many loans were depreciated, and the
trustworthiness of the banking system fell significantly.
The central bank acted quite quickly and resolutely to overcome the banking crisis. The Bank
of Estonia brought the prudential requirements into its operation on the basis of international
experience for protecting creditors’ and clients’ interests beginning from January 1993. In
April 1993, the Bank of Estonia announced a stabilization period in the banking system,
during what the issuance of new banking licenses was frozen and for the existing banks it
established a schedule of gradual rise in minimum equity capital. After that, the Bank of
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Estonia did not renew licenses of 8 banks, 10 banks merged into one bigger bank, a
moratorium was declared on 3 banks.
Looking back, it is possible to establish some signs of a future banking crisis in 1998-1999:
(1) Estonian banks took extraordinary high financial risks through investment companies and
their subsidiary companies to get big profits via speculating in securities market – rapid
fall in prices on the share market in autumn 1997 reduced significantly banks’ profits and
at the end of 1997 and in 1998 almost all banks operated in losses;
(2) Banks hold very high negative level of gap (interest rate sensitive liabilities exceeded
significantly rate-sensitive assets) for earning excessive profits in the environment were
interest rates steadily decreased during the previous years and they were not able to adjust
to changed environment with increasing interest rates from the second half- year of 1997;
(3) Commercial banks absorbed heavily into non-banking business – for example, later
bankrupted the Land Bank of Estonia owned seven subordinate establishments and related
companies, which dealt with leasing and investing, and with anything else but banking
(hotels, processing agricultural products, broadcasting etc), also other banks were
absorbed into risky non-banking business;
(4) The decision to expand to the Eastern market (Russia and other Baltic States), where the
interest rates and possible profitability seemed to be higher, was also too risky and
premature, especially in the framework of the Russian crisis in 1998;
(5) There were various disputes and conflicts if interests between the owners and
management which led to wrong (mismanagement) decisions Good examples should be
the Land Bank of Estonia and the Estonian Investment Bank – for example, the
shareholders of the Investment Bank intended to sell the bank to the German Schleswig-
Holstein Bank in autumn 1997, but the top executives threatened to hand in a collective
resignation and so the bank was sold to them.
(6) Sometimes there were inadvisable relations between the bank management and political
powers, and correspond ing political pressure – a typical “political” bank was the Land
Bank of Estonia where almost all financial risks were ignored and later the Government
lost its deposits in the bank amounting to more than 800 million Estonian crowns, EEK
(more than 50 million euros).
The occasion of starting the second banking crisis was the burst of a market bubble on the
Tallinn Stock Exchange in the Autumn 1997, caused partly by the impact of the financial
crises in the South-East Asia and supported lately by the Russian crisis in Autumn 1998. In
1998, a wave of mergers and restructuring took place in the Estonian banking sector. We may
conclude that Estonian banking sector became healthier when Swedish banks and other
Nordic investors joined the circle of owners of bank s, improving banking system’ future
outlook. So, if during the first banking crisis in 1992-1994 Estonia had to resolve the
problems by itself then during the second banking crisis in 1998-1999 foreign banks also
assisted and supported to get over the cris is.
The authors are on the opinion that the currency board arrangement helped in Estonia to
resolve banking crises rapidly and mostly effectively without remarkable rehabilitation costs.
The main instruments for anticipating banking crises are tightening of prudential requirements
and strengthening of banking supervision. Recent changes in the operational framework for
monetary policy and banks’ prudential ratios in Estonia were aimed at enhancing financial
stability and increasing the liquidity buffers of the financial system. In short-term, the priority
focused on restoring foreign investors’ confidence in Estonian economic viability.
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We may argue that the currency board arrangement practically did not help banks felt into
trouble because its resources are intended for guaranteeing the local currency and the central
bank is not acting as the lender of the last resort. The currency board is not able to avoid
banking crises and can not guarantee a “soft landing” and rehabilitation of banks felt into
trouble. At the same time, the currency board arrangement supported and strengthened the
discipline and responsibility of the main actors – banks, the central bank, depositors, and the
Government. A stable currency and presence of respective financial safety net compensated
the absence of classical lender-of- last resort facility and ensured development of in general
reliable banking sector.
Only Optiva Bank can be mentioned as a successful rehabilitation case in Estonian banking
market. Two banks in trouble, Estonian Investment Bank and Forexbank, merged in 1998, the
central bank obtained the ownership in merged new bank, re-capitalized the bank and sold it
to the Finnish Sampo Group in 2000. So as the bank was relatively small, the rehabilitation
costs were not very high.
2.3. Structural Developments
The structure of the Estonian banking sector has changed fundamentally during the last years.
Today, the banking system is highly concentrated and two Swedish-owned banks dominate in
the market (see also Table 1). The consolidation process continued throughout the second
banking crisis in 1998-1999 resulting in fundamental bank reorganizations. We can notice all
three world-wide trends in the financial consolidation process also in the Estonian market:
domestic consolidation, foreign entry and cross-border consolidation, and the formation of
financial conglomerates and bancassurances. Some characteristics of the development of the
Estonian financial market structure are presented in Table 2.
Some more interesting conclusions from Table 2:

• The banking market concentration (the share of three largest banks’ assets in total banks’
assets) achieved more than 90% already in 1998; it was 90.4% at the end of 2002;
• foreign banks’ share in total assets of Estonian commercial banks increased dramatically
and was 97.5% at the end of 2002;
• the Estonian financial sector is clearly bank-oriented – the bank assets to GDP ratio was
75.6% and the banks assets share in total financial assets was 45.2% at the end of 2002;
• private credits by banks and other financial institutions increased considerably during the
analyzed period – private credits by banks to GDP ratio was 46.2% and overall private
credits to GDP ratio 62% in 2002;
• relatively rapidly have grown leasing and factoring portfolio (about four times during
1997-2002) and stock market capitalization (about 5.5 times); total financial assets ratio to
GDP has risen to 167% at the end of 2002.
Table 2. Some Indicators of the Estonian Banking and Financial Sector Development
Indicator 1997 1998 1999 2000 2001 2002 02/97

Number of commercial banks 11 6 7 7 7 7 0.636
Number of private banks 11 5 6 7 7 7 0.636
Number of foreign banks 1 2 2 4 4 4 4.000
Concentration index C3, % 69.7 93.0 92.4 91.1 91.1 90.4 1.297
Concentration index C5, % 83.4 99.4 98.9 98.8 98.9 99.1 1.188
Total assets, EUR m 2594 2620 3008 3695 4372 5221 2.013
8
Total assets/GDP, % 63.4 55.7 61.7 67.7 71.8 75.6 1.192

Foreign ownership in share capital, % 44.2 60.7 61.6 83.6 85.4 86.7 1.962
Foreign ownership in total assets, % 2.3 90.2 89.8 97.4 97.5 97.5 42.39
Private credit by banks, EUR m 1362 1527 1704 2189 2601 3193 2.344
Private credit by banks/GDP, % 33.2 32.6 35.4 40.1 42.7 46.2 1.392
Leasing and factoring portfolio, EUR m 315 399 433 644 893 1232 3.911
Leasing and factoring/GDP, % 8 8 9 12 15 18 2.250
Debt market capitalization, EUR m 258 235 204 231 279 211 0.818
Debt market capitalization/GDP, % 6 5 4 4 5 3 0.500
Stock market capitalization, EUR m 837 531 1913 2095 1999 4570 5.460
Stock market capitalization/GDP, % 20 11 39.8 38.4 32.8 66.2 3.310
Insurance gross collected premiums 70 81 83 98 112 134 1.914
Gross collected premiums/GDP, % 1.7 1.7 1.7 1.8 1.8 1.9 1.118
Investment funds’ assets, EUR m 97 23 73 95 193 280 1.887
Investment funds’ assets/GDP, % 2.4 0.5 1.5 1.7 3.2 4.1 1.708
Total financial assets, EUR m 2458 2912 5550 6727 7748 11551 4.699
Total financial assets/GDP, % 60 62 115 123 127 167 2.783
Total private credit, EUR m n.a. 1902 2106 2777 3395 4308 2.265
Total private credit/GDP, % n.a. 40 43 50 55 62 1.550
GDP, EUR m 4110 4685 4813 5458 6089 6904 1.680
GDP real growth, % 10.6 4.7 -1.1 6.4 5.3 4.7 n.a.
Source: Bank of Estonia
Notes: (1) Total financial assets consist of the assets of the central bank and other financial
institutions, debt securities market, stock market, leasing and factoring portfolio, and insurance gross
premiums from; (2) Foreign banks consist of foreign banks’ branches in Estonia and the banks
majority owned by foreign banks.
At the end of 2002, there were six credit institutions operating in the Estonian banking
market, a branch of a non-resident credit institution (Nordea Bank Finland Plc, Estonian
Branch) and representative offices of six non-resident financial institutions (Landesbank
Schleswig-Holstein and Norddeutsche Landesbank Girozentrales, Svenska Handelsbanken,
OKO Osuuspankkien Keskuspanki OYJ, Parekss Banka, Vereins- und Westbank AG,). The
ownership structure of Estonian banks is presented in Table 3. The dependence of the
Estonian banking system on the developments in international financial markets and on
foreign investors’ preferences deepened from year to year. In the course of the restructuring
process, foreign banks increased their share in equity capital from 10.3% in 1996 to 79% at
the end of 2002. The total share of non-resident owners has risen to 86.7% at the end of 2002.
Table 3. Ownership Structure of Estonian Banks, %
Year Estonian Owners Non-Resident Owners

Public Legal Individuals Total Banks Legal Individuals Total
Sector Persons Persons
1996 12.0 NA NA 62.8 10.3 NA NA 37.2
1997 4.2 41.6 11.3 57.1 22.7 19.6 0.6 42.9
1998 13.6 22.3 8.6 44.5 45.5 9.5 0.5 55.5
1999 11.6 15.2 11.0 37.6 52.6 8.9 0.7 62.2
2000 0.0 6.8 9.3 16.1 67.0 16.7 0.2 83.9
2001 0.0 5.6 8.5 14.1 63.3 22.3 0.3 85.9
2002 0.0 5.2 8.1 13.3 79.0 7.6 0.1 86.7
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Equity investments by Swedish banks in two largest Estonian banks (Hansapank and Union
bank of Estonia) in 1998 and by Finnish insurance company Sampo Group in Optiva Pank in
2000, increased the share of all non-resident owners from 37.2% to 85.9% during 1996-2001.
The public sector (mostly the Bank of Estonia) share in the ownership structure increased in
1998 due to the rescue operation of two smaller banks (the central bank was the core
shareholder of the newly established Optiva Pank ), and decreased to zero already at the end of
2000 due to the sale of Optiva Pank to Sampo Group.
3. DuPont Financial Ratio Analysis
3.1. Methodology
The starting point of the bank performance analysis is to calculate the book rate of return on
equity, ROE
Earnings After Taxes, EAT
ROE = (1)
Book Value of Equity, BVE
which consists of three components:
• pull- through, U
U = (2)
Earnings Before Taxes, EBT
• financial leverage, LEV
Total Assets, TA
LEV = (3)
Book Value of Equity, BVE
• return on total assets, ROA
Earnings Before Taxes, EBT
ROA = (4)
Total Assets, TA
These financial ratios form the multiple factor system
EAT TA EBT EAT
ROE = × × = (5)
EBT BVE TA BVE
All these financial ratios are widely used for a bank performance analysis. Pull-through (U)
shows success of the bank tax management policy as it may be interpreted as one minus the
average corporate tax rate. The financial leverage ratio (LEV) measures how many Estonian
crowns (EEK) of assets the bank has per EEK of equity and may be interpreted as a bank’s
“gearing”. Return on total assets (ROA) is one of the most frequently used financial ratios by
financial analysts. ROA measures the ability of bank management to generate income after all
financial and non- financial costs and expenses for owners.
Changes in ROA are usually the cause of the most important changes in banks’ performance
and need a more detailed analysis. The other financial ratios such as components of ROE,
pull- through (U) and financial leverage (LEV), reflect tax treatment and capitalization rate,
and they usually change less. ROA may be divided into the following components:
• bank burden, B
Net Non - Interest Revenue, NNIR NIR − NIE
B= =
Total Assets, TA TA
(6)
where NIR - non- interest revenue;
NIE - non- interest expense;
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• earning assets ratio, EAR

Earning Assets,EA
EAR = (7)
Total Assets,TA
• net interest margin, NIM
Net Interest Revenue, NIR IR − IE
NIM = = (8)
Earning Assets,EA EA
where IR - interest revenue;
IE - interest expense,
Financial ratios (6-8) form a factor system
NNIR EA NIR NNIR + NIR EBT
ROA = + × = = (9)
TA TA EA TA TA
Burden (B) measures a bank management’s control of operating expenses. The burden for
banks is negative to show the fact that non- interest revenue (fees, earned commissions, other
operating income) does not cover labor and other administrative or non- interest expenses.
Earning assets ratio (EAR) is usually not an important factor of changes in ROA but it may be
interesting to make comparisons between various banks because EAR characterizes different
development strategies. Net interest margin (NIM) is a more important and widely used
financial ratio in the factor system (9). NIM reflects the interest spread between assets and
liabilities, it focuses on the net earnings from investing through borrowed funds and is the
major source of profitability for the bank.
For a more detailed analysis, NIM may be divided into three following components:
• return on earning assets, REA
Interest Revenue, IR
REA = (10)
Earning Assets,EA
• cost of liabilities, COL
Interest Expense, IE
COL = (11)
Liabilitie s, L
• liabilities to earning assets ratio, LEA
Liabilitie s, L
LEA = (12)
Earning Assets,EA
which form the factor system
IR IE L IR − IE NIR
NIM = − × = = (13)
EA L EA EA EA
Return on earning assets (REA) connects directly earning assets and interest revenue
generated by them. Thus, REA characterizes the average rate of lent funds and earned
dividends. The cost of liabilities (COL) may be interpreted as the average price of borrowed
capital. Liabilities to earning assets ratio (LEA) measures the intensity of bank investment
activity.
3.2. Banking Sector Performance and Profitability - DuPont Analysis
It is argued that internationalization, adoption of new banking technologies, deregulation,

banking market consolidation and other recent trends in financial intermediation should result
in increasing efficiency. On the other hand, since banks are no longer monopoly suppliers of
financial services and products and markets are more contestable (increased competition
11
between banks and new competition from non-bank financial institutions and markets),
intermediation margins, net interest income and other income should result in decreasing
profitability and efficiency. In any case, elimination of inefficiencies and reducing costs
would be a challenge for banks’ survival in the rapidly changing market environment.
Initial financial information for Estonian banking sector performance analysis (1994-2002) is
presented in Tables 4-5 on the basis aggregated consolidated financial statements published
by the Bank of Estonia (see Bank of Estonia, Annual Reports).
Table 4. Aggregated Consolidated Balance Sheet of Estonian Commercial Banks

(end of the Year, EEK m)
Item 1994 1997 2000 2001 2002 02/94 02/01

Assets
1. Cash and reserves 1421.0 4247.7 7046.2 5378.3 4954.0 3.486 0.921
Cash 649.2 1212.4 1335.2 1596.4 1394.1 2.147 0.873
Claims on central bank 771.8 3035.3 5711.0 3781.9 3559.9 4.612 0.941
2. Earning Assets 7905.9 32995.4 47102.8 59985.2 73669.9 9.318 1.228
Claims in credit institutions 2681.5 3582.8 5057.6 9040.9 10109.8 3.770 1.118
Claims on customers 4526.6 21315.6 34253.1 40714.9 49976.4 11.04 1.227
Uncollectible claims (-) -154.8 -423.1 -532.2 -598.6 -522.2 3.373 0.872
Securities 852.6 8520.1 8324.3 10828.0 14105.9 16.54 1.303
3. Tangible and other assets 1059.0 3339.4 3670.0 3047.5 3062.3 2.892 1.005
Tangible assets 626.1 1378.1 1226.0 1064.5 1040.4 1.662 0.977
Other assets 432.9 1961.3 2444.0 1983.0 2021.9 4.671 1.020
Total assets (1+2+3) 10385.9 40582.5 57819.0 68411.0 81686.2 7.865 1.194
Liabilities and capital
1. Liabilities 9618.8 36411.6 50540.1 59331.8 71766.8 7.461 1.210
Liabilities to customers 6943.7 21400.7 34774.3 42698.5 48802.2 7.028 1.143
Liabilities to credit
institutions and central bank 920.9 6743.4 6271.6 6449.0 11878.6 12.90 1.842
Other liabilities 1754.2 8267.5 9494.2 10184.3 11086.0 6.320 1.089
2. Equity 767,1 4170.9 7278.9 9079.2 9919.4 12.93 1.093
Share capital 712.0 2551.5 5927.9 6149.8 6237.5 8.761 1.014
Reserves 115.6 518.5 730.9 731.7 734.3 6.352 1.004
Profit or loss retained -60.5 1100.9 620.1 2197.7 2947.6 - 1.341
Total liabilities (1+2) 10385.9 40582.5 57819.0 68411.0 81686.2 7.865 1.194
(Source: Bank of Estonia, Annual Reports)
The Estonian bank ing system has grown rapidly in nominal terms. The respective growth
rates for 2001/1994 and 2001/2000 are also presented in Tables 4-5. In general, we can see
high growth rates in almost all balance sheet and income statement items during 1994-2001:
for example, both earnings before taxes and after taxes have risen more than 20 times, banks’
equity has risen 14 times, share capital 10 times and total assets about 7 times, etc. A financial
ratio analysis is needed for analyzing profitability and efficiency changes in the banking
system, using a modified version of DuPont financial ratio analysis technique (see Dietrich,
1996; Vensel, 2001). Initial financial information in the form of simplified consolidated
financial statements of the Estonian commercial banking system as a whole in 1994-20012 is
presented in Table 6. The respective growth rates for 2002/1994 and 2002/2001 are also
presented.
12
Table 5. Aggregated Consolidated Income Statement of Estonian Commercial Banks
Indicator 1994 1997 2000 2001 2002 02/94 02/01

1. Interest revenue (IR) 943.6 2658.5 3744.2 4308.1 4253.5 4.508 0.987
Loans 780.2 1956.9 2816.8 3308.2 3309.9 4.242 1.001
Other interest income 163.4 701.6 927.4 999.9 943.6 5.775 0.944
2. Interest expense (IE) 312.8 1217.2 1811.9 2125.7 1883.0 6.020 0.886
Deposits 248.5 690.3 1065.0 1269.8 913.1 3.674 0.719
Other interest expense 64.3 526.9 746.9 855.9 969.9 15.08 1.133
3. Net interest revenue (1-2) 630.8 1441.3 1932.3 2182.4 2370.5 3.758 1.086
4. Non-interest revenue 457.0 3272.0 2065.6 2895.1 2613.4 5.719 0.903
Commission income 217.3 799.1 965.1 1062.6 1202.6 5.534 1.132
Financial operations 115.4 715.1 755.0 690.7 1031.4 8.938 1.493
Other income 124.3 1757.8 345.5 1141.8 379.4 3.052 0.332
5. Non-interest expense 1019.8 3644.4 3384.8 3373.7 3769.1 3.696 1.117
Commission expense 76.2 250.8 255.9 282.9 333.4 4.375 1.179
Administrative expenses 611.5 1244.0 1373.6 1583.9 1757.8 2.875 1.110
Other expenses, losses 332.1 2149.6 1755.3 1506.9 1677.9 5.052 1.113
6. Net non-interest revenue -562.8 -372.4 -1319.2 -478.6 -1155.7 2.053 2.415
(4-5)
7. Earnings before taxes (3+6) 68.0 1068.9 613.1 1703.8 1214.8 17.86 0.713
8. Tax expense 27.1 105.8 - 20.4 61.6 2.273 3.020
9. Earnings after taxes (7-8) 40.9 963.1 613.1 1683.4 1153.2 28.20 0.685
(Source: Bank of Estonia, Annual Reports)
Table 6. Simplified Consolidated Financial Statements of the Estonian Banking System

(1994-2002, million kroons)
Items 1994 1997 2000 2001 2002 02/94 02/01

Income Statement Data
Interest Revenue, IR 943.6 2658.5 3744.2 4308.1 4253.5 4.508 0.987
Interest Expense, IE 312.8 1217.5 1811.9 2125.7 1883.0 6.020 0.886
Net Interest Revenue,
NIR = IR – IE 630.8 1444.1 1932.3 2182.4 2370.5 3.758 1.086
Non-Interest Revenue, NOIR 457.0 3272.0 2065.6 2895.1 2613.4 5.719 0.903
Non-Interest Expense, NOIE 1019.8 3644.4 3384.8 3373.7 3769.1 3.696 1.117
Net Non-Interest Revenue,
NNIR = NOIR – NOIE -562.8 -372.4 -1319.2 -478.6 -1155.7 2.053 2.415
Earnings Before Taxes,
EBT = NIR + NNIR 68.0 1068.9 613.1 1703.8 1214.8 17.86 0.713
Earnings After Taxes, EAT 40.9 963.1 613.1 1683.4 1153.2 28.20 0.685
Balance Sheet Data
Cash and Reserves, R 1527,8 3203.8 6578.0 6212.3 5166.2 3.381 0.832
Earning Assets, EA 6117.8 25817.0 42019.6 53544.0 66827.5 10.92 1.248
Fixed and Other Assets, FA 742.9 2743.1 3847.3 3358.7 3054.9 4.112 0.910
Total Assets, TA = 8388.5 31763.9 52444.9 63115.0 75048.6 8.947 1.189
R+EA+FA
Liabilities, L 7667.3 28562.7 45164.2 54936.0 65549.2 8.549 1.193
Book Value of Equity, BVE 721.2 3201.2 7280.7 8179.0 9499.4 13.17 1.161
Source: The Bank of Estonia Statistical Datasheets and Bulletins
13
Using initial data from Table 6 (the balance sheet data are averaged), results of DuPont
financial ratio analysis are presented in Table 7. These results need some comments, focusing
on the growth rates of 2002/1994.
Table 7. Financial Ratio Analysis of Estonian Commercial Banks (1994-2002)
Financial Ratio 1994 1997 2000 2001 2002 02/94 02/01

Book Rate of Return, %,ROE = EAT/BVE 5.671 30.09 8.59 20.58 12.14 2.141 0.590
Components of ROE, ROE = U×LEV×ROTA
Pull-through, %, U = EAT/EBT 60.15 90.10 100.0 98.80 94.93 1.578 0.961
Financial Leverage, LEV = TA/BE 11.63 9.92 7.203 7.717 7.90 0.679 1.024
Return on Total Assets, ROTA = EBT/TA 0.811 3.365 1.192 2.700 1.619 1.996 0.600
Components of ROTA,
ROTA = B + EAR×NIM
Burden, %, B = NNIR/TA -6.709 -1.172 -2.493 -0.755 -1.540 0.230 2.040
Earning Assets Ratio, %, EAR = EA/TA 72.93 81.28 80.12 84.84 89.05 1.221 1.050
Net Interest Margin, %, NIM = NIR/EA 10.31 5.594 4.599 4.076 3.547 0.344 0.870
Components of NIM,
NIM = REA – COL×LEA
Return on Earning Assets, REA = IR/EA 15.42 10.30 8.921 8.046 6.365 0.413 0.791
Cost of Liabilities, %, COL = IE/L 4.080 4.263 4.012 3.869 2.873 0.704 0.743
Liabilities to Earning Assets Ratio, LEA =
L/EA 1.253 1.106 1.075 1.026 0.981 0.783 0.956
Source: Authors’ calculations
• The book rate of return on equity (ROE), which is the most widely used and popular
measure of the bank performance results from the viewpoint of owners/investors,
increased during the analysed period from 5.67% in 1994 to 12.14% in 2002, i.e. more
than two times. We can also mention very high volatility of profitability ratios (both ROE
and ROA) during the analysed period. Banks after-tax earnings to earnings before taxes
ratio (pull-through, U), which characterises the banks tax management policy efficiency
because (1 - U) = t (t - the average tax rate), also increased during this period. Ba nks were
more skilful at finding various “tax shelters” in 1997 compared with 1994, also later.
Banks’ financial leverage ratio (LEV) decreased substantially due to the central bank’s
new equity requirements, which forced banks to raise equity or to merge. Financial
leverage rose again in 2001 and 2002. The main factor of ROE change is the increase of
the return on total assets (ROTA), which needs a more detailed analysis.
• ROTA rose from 0.81% to 1.62% between 1994 and 2002 was caused by the significant
decrease of the Estonian banks’ burden (B) due to the improvement of the banks’ cost
control and services pricing, also due to the substantial increase in the share of interest-
earning assets in total assets. However, the net interest margin level (NIM), which reflects
the interest rate spread between assets and liabilities for deposit-taking financial
institutions and is the major source for the profitability of banks, has decreased
substantially, from 10.31% to 3.55 %, i.e. about three times. This phenomenon also needs
further analysis.
• We may draw some important and interesting conclusions from the component analysis of
the substantial decrease of the NIM level:
14
(a) The average return on earning assets (REA) has fallen substantially over the recent years
due to the overall falling of interest rates in the Estonian banking market, the average cost
of liabilities (COL) increased slightly and fell in 2001 and in 2002 compared with 2000;
(b) REA has fallen much faster than COL, i.e. the interest spread decreased considerably over
the analysed period ((15.42% - 4.08%) - (6.37% - 2.87%) = 11.34% - 3.50% = 7.84%), -
this change reflects the sharpened competition between banks themselves and with other
financial institutions, as for example insurance and investment funds;
(c) liabilities to earning assets ratio (LEA) has also fallen substantially, i.e. Estonian
commercial banks intensified their lending and investment activities, and almost all
available resources (in 2002, also a part of the equity) have been invested in the earning
assets.
4. Matrix approach for banks’ performance analysis
4.1. Methodology
It is possible to use the matrix model to present and analyse interrelations between various
economic and financial indicators. On the basis of n quantitative indicators Yi (i = 1, 2, …, n;
n - the number on initial quantitative financial indicators) it is possible to define n(n - 1)
qualitative indicators, for example financial ratios
Yi
xij = ( i, j = 1, 2, ..., n; i ≠ j) (14)
Yj
which form the (n × n) square matrix
{ }
x11 x12 x1n
X = x21 x 22 x 2n = xij (15)
x n1 xn 2 x nn
and which we call the matrix model of the studied phenomenon.
We can draw two important conclusions from these features of the matrix model (15): (1) as
the symmetric square matrix (15) consists of two triangular matrices which are “mirror
reflections” of each other (contain elements which are reciprocal to each other), the financial
(or other economic) information needed for the analysis is presented only in one triangular
matrix; (2) as the square matrix (15) consists of row and column vectors in linear dependence,
it is sufficient for a generalized estimate of the studied phenomenon, to take into consideration
only one vector.
The first of these conclusions is important for the component or decomposition analysis of
bank performance, and we take under observation only one triangular matrix focusing on the
study and analysis of interrelations between the elements/financial ratios of the matrix model.
Further steps of analysis depend on how many and which initial quantitative indicators from
the balance sheet and income statements of the bank to choose for the formation of the matrix
model, and which sequence to follow when including the initial indicators into the model. If
we choose to start with the output or results indicators according to their degree of “finality”,
and to end with the input or resource indicators by their “preliminarity”, we receive the matrix
model which consists of two triangular matrices:
• matrix of effectiveness, where the elements/financial ratios reflect various aspects of the
efficiency of the bank performance;
• inverse matrix of effectiveness, which consists of the reciprocals of the efficiency
indicators/financial ratios.
15
A financial analysis of any bank starts with obtaining the financial data. If to follow the
principles discussed here, we get the following sequence of the most important initial
quantitative financial indicators:
(1) Y1 - earnings after taxes, EAT;
(2) Y2 - earnings before taxes, EBT;
(3) Y3 - net interest revenue, NIR;
(4) Y4 - interest revenue, IR;
(5) Y5 - total operating income, TOI;
(6) Y6 - earning assets, EA;
(7) Y7 - book value of equity, BE;
(8) Y8 - total assets, TA.
The matrix model for a bank performance analysis is presented in Table 8.
Table 8. The Matrix Model for Banks Performance Analysis
Earnings Earnings Net Interest Interest Total Earning Book

After Before Revenue, Revenue, Operating Assets, Y6, Value of
Taxes, Y1 , Taxes, Y2, Y3, NIR Y4, IR Income, EA Equity, Y7
EAT EBT Y5, TOI
Earnings x21=Y1/Y2
Before Net
Taxes, Y2, Earnings to
EBT Earnings,
NEER *
Net Interest X31=Y1/Y3 x32=Y2/Y3
Revenue, Net Ear- Earnings to
Y3, NIR nings to Net Interest
Net Interest Ratio,
NENIR ENIR
Interest x41=Y1/Y4 x42=Y2/Y4 x43=Y3/Y4
Revenue, Net Earnings to Net Interest
Y4, IR Earnings to Interest to Interest
Interest, Ratio, EIR Ratio, NIIR
NEIR
Total x51=Y1/Y5 x52=Y2/Y5 x53=Y3/Y5 x54=Y4/Y5
Operating Net Earnings to Net Interest Interest to
Income, Y5 Earnings to Total to Total Total
TOI Total Inco- Income Income Income
me Ratio, Ratio, Ratio, Ratio, ITIR
NETIR * ETIR NITIR
Earning x61=Y1/Y6 x62=Y2/Y6 x63=Y3/Y6 x64=Y4/Y6 x65=Y5/Y6
Assets, Y6, Net Return Return on Net Interest Interest on Total
EA on Earning Earning on Earning Earning Income on
Assets, Assets, Assets, Assets,IEA Earning
NREA REA NIEA (Return on Assets,
(NIM) * EA) * TIEA
Book x71=Y1/Y7 x72=Y2/Y7 x73=Y3/Y7 x74=Y4/Y7 x75=Y5/Y7 x76=Y6/Y7
Value of Net Return Return on Net Interest Interest on Total Earning
Equity, Y7, on Equity, Equity, on Equity, Equity, Income on Assets to
BE NROE * ROE * NIOE IOE Equity, Equity
TIOE Ratio,EAER
Total x81=Y1/Y8 x82=Y2/Y8 x83=Y3/Y8 x84=Y4/Y8 x85=Y5/Y8 x86=Y6/Y8 X87=Y7/Y8
Assets, Y8, Net Return Return on Net Interest Interest on Total Earning Equity
TA on Assets, Assets, on Assets, Assets, Income on Assets Multiplier,
NREA * ROA * NIOA IOA Assets, Ratio, EM =
TIOA * EAR * 1/LEV *
16
We have to say some words about the terminology. The fact is that different authors use
different definitions and terms of financial ratios for banks’ (or firms) performance analysis.
Some of the most frequently used and well-known ratios are exceptions, for example, return
on assets (ROA), return on equity (ROE), net interest margin (NIM). But even ROA and ROE
may be calculated using the net income/earnings after taxes (EAT) or earnings before taxes
(EAT). For organizing the terminology, we used the following terminological principles:
(1) all qualitative indicators/financial ratios which reflect proportions among the output
quantitative indicators are defined as (net) earnings or (net) interest ratios to another
corresponding quantitative input indicator, for example, net interest to interest ratio, NIIR
Net Interest Revenue, NIR
NIIR = (16)
(2) all qualitative indicators/financial ratios which reflect proportions between output and
input quantitative indicators, and are traditional indicators of the efficiency, are defined as
(net) return, (net) interest or total income to corresponding input quantitative indicator, for
example, interest on earning assets, IEA
IEA = (17)
Earning Assets,EA
(3) qualitative indicators/financial ratios which reflect proportions among input quantitative
indicators are defined more traditionally, for example, as equity multiplier (EM) and earning
assets ratios.
More widely used financial ratios in Table 8 are marked with asterisk (*) and some of the
traditionally used terms are also presented in parentheses, for example,
x51 = = NETIR = PM (18)
Total Operating Income, TOI
4.2. General Results of Using the Matrix Model
The initial quantitative financial indicators of the Estonian commercial banking system
needed for using the matrix model are presented in Table 9. The effectiveness matrix of
Estonian commercial banks with all the above-described financial ratios is presented in Table
10. Actually, six different matrixes are presented in Table 10. The key for reading the
financial information in Table 10 is as follows:
(1) acronym of the corresponding financial ratio;
(2) - (4) levels of respective financial ratios in 1994, in 2001 and in 2002;
(4) relative changes in the corresponding financial ratio as the growth rates 2002/1994 and
2002/2001;
Table 9. Initial Financial Indicators for the Matrix Model (EEK m)
Financial Indicators 1994 1997 2000 2001 2002 02/94 02/01

Y1, Earnings After Taxes, EAT 40.9 963.1 613.1 1683.4 1153.2 28.20 0.685
Y2, Earnings Before Taxes, EBT 68.0 1068.9 613.1 1703.8 1214.8 17.86 0.713
Y3, Net Interest Revenue, NIR 630.8 1444.1 1932.3 2182.4 2370.5 3.758 1.086
Y4, Interest Revenue, IR 943.6 2658.5 3744.2 4308.1 4253.5 4.508 0.987
Y5, Total Operating Income, TOI 1401.4 5930.5 5809.8 7203.1 6866.9 5.229 1.226
Y6, Earning Assets, EA 6117.8 25817.0 42019.6 53544.0 66827.5 10.92 1.248
Y7, Book Value of Equity, BVE 721.2 3201.2 7280.7 8179.0 9499.4 13.17 1.161
Y8, Total Assets, TA 8388.5 31763.9 52444.9 63115.0 75048.6 8.947 1.189
17
The most important element/financial ratio of the effectiveness matrix is x 81 , which forms the
following multiple factor system:
x81 = x 21 × x32 × x 43 × x54 × x65 × x76 × x87 (19)
or substituting with the definitions of corresponding financial ratios
NROA = U × ENIR × NIIR × ITIR × TIEA × EAER × EM =

EAT EBT NIR IR TOI EA BVE EAT (20)
= × × × × × × =
EBT NIR IR TOI EA BVE TA TA
So far, we have demonstrated only one possibility of using the matrix model for the banks
performance analysis. There are a number of other possibilities to develop various other factor
systems, to determine the absolute influence of changes in the respective financial ratios on
the change of different quantitative financial indicators, to compose multi- factor aggregate
index-numbers in the case of de-aggregated initial information, etc.
The initial quant itative financial indicators needed for the development of the banks
performance efficiency matrix, may be divided into two groups by their economic substance:
• results or output indicators of the bank activities, which one may take from the income
statement: earnings after taxes (EAT), earnings before taxes (EBT), net interest revenue
(NIR), interest revenue (IR), total operating income (TOI);
• resource or input indicators of the bank operating, which one may take from the balance
sheet: earning assets (EA), book value of equity (BVE), total assets (TA).
We may compare the bank with any other business firm, which uses available
resources/production factors/inputs (equity and borrowed external funds) for producing
something useful, i.e. during the bank operating, certain inputs are transformed into certain
outputs. The bank’s operating result is a production of specific financial services during the
financial intermediation: credit services, securities services, transaction proceeding services,
asset management services, information and financial advice offering services. All these
financial services in money terms are expressed in the bank management revenues and
income.
Analogously with the classification of the initial financial indicators into two groups, the
efficiency matrix of the bank performance analysis consists of three partial matrices:
• triangular matrix, where the elements are financial ratios characterising proportions
among the quantitative output indicators, and which are by their nature co-ordination
ratios: NEER, NENIR, ENIR, NEIR, EIR, NIIR, NETIR, ETIR, NITIR, and ITIR - we
named this triangular matrix as “output matrix”;
• triangular matrix, where the elements are financial ratios reflecting proportions among the
quantitative input indicators, and which are also typical co-ordination ratios: EAER, EAR,
EM - we named this matrix as “input matrix”;
• Quadrate matrix, where the elements are financial ratios characterising proportions among
different quantitative output and input indicators, i.e. these are typical intensity ratios, or
traditional output/input-type efficiency indicators: NREA, REA, NIEA, IEA, TIEA,
NROE, ROE, NIOE, IOE, TIOE, NROA, ROA, NIOA, IOA, and TIOA - we named this
matrix as “output- input matrix” (do not confuse with Leontieff input-output type
matrices).
18
Table 10. The Effectiveness Matrix of the Estonian Commercial Banking System (1994-02)
EAT EBT NIR IR TOI EA BVE

40.9 68.0 630.8 943.6 1401.4 6117.8 721.2
1683.4 1703.8 2182.4 4308.1 7203.1 53544.0 8179.0
1153.2 1214.8 2370.5 4253.5 6866.9 66827.5 9499.4
28.20 17.86 3.758 4.508 4.900 10.92 13.17
0.685 0.713 1.086 0.987 0.953 1.248 1.161
EBT NEER
68.0 0.6015
1703.8 0.9880
1214.8 0.9493
17.86 1.578
0.713 0.961
NIR NENIR ENIR
630.6 0.0648 0.1078
2182.4 0.7714 0.7807
2370.5 0.4865 0.5125
3.758 7.507 4.754
1.086 0.6307 0.6565
IR NEIR EIR NIIR
943.6 0.0433 0.0721 0.6685
4308.1 0.3907 0.3955 0.5066
4253.5 0.2711 0.2856 0.5573
4.508 6.261 3.961 0.8337
0.987 0.6829 0.7221 1.1001
TOI NETIR ETIR NITIR ITIR
1401.4 0.0291 0.0485 0.4501 0.6733
7203.1 0.2337 0.2365 0.3029 0.5981
6866.9 0.1679 0.1769 0.3452 0.6194
4.900 5.771 3.648 0.7670 0.9200
0.953 0.7184 0.7480 1.1387 1.0356
EA NREA REA NIEA IEA TIEA
6117.8 0.0067 0.0111 0.1031 0.1542 0.2291
53544.0 0.0314 0.0318 0.04076 0.08046 0.1345
66827.5 0.0173 0.0182 0.03547 0.06365 0.1028
10.92 2.5756 1.6396 0.3441 0.4128 0.4485
1.248 0.5510 0.5723 0.8702 0.7911 0.7643
BE NROE ROE NIOE IOE TIOE EAER
721.2 0.0567 0.0943 0.8747 1.3084 1.9432 8.4828
8179.0 0.2058 0.2083 0.2668 0.5267 0.8807 6.5465
9499.4 0.1214 0.1279 0.2495 0.4478 0.7229 7.0349
13.17 2.141 1.3561 0.2853 0.3422 0.3720 0.8293
1.161 0.5889 0.6140 0.9352 0.8502 0.8208 1.0746
TA NROA ROA NIOA IOA TIOA EAR EM
8388.5 0.00488 0.00811 0.07520 0.11249 0.1671 0.7293 0.0860
63115.0 0.02667 0.02700 0.03458 0.06826 0.1141 0.8484 0.1296
75048.6 0.01537 0.01619 0.03159 0.05668 0.0915 0.8905 0.1266
8.947 3.1488 1.9963 0.4200 0.5038 0.5476 1.2210 1.4723
1.189 0.5763 0.5996 0.9135 0.8304 0.8019 1.0496 0.9769
Source: Authors' calculations
19
4.3. Analysis of the Partial Matrices
Output Matrix:
Initial quantitative financial indicators, needed for building up the output matrix, are
sequenced by the degree of their “finality”. The most ultimate output indicator of the bank
operating is earnings after taxes (EAT) which is also the ultimate indicator in the income
statement because it reflects disposable for owners generated by the bank management
income. Then follows earnings before taxes (EBT), then net interest revenue (NIR), interest
revenue (IR), and total operating income (TOI).
Net earnings to total income ratio (NETIR = EAT/TOI) is the leading element in the output
matrix. All other elements/financial ratios of the output matrix reflect in this ratio. These other
financial ratios form various multiple factor systems, as for example
NETIR = NEER × ENIR × NIIR × ITIR =
EAT EBT NIR IR EAT (21)
= × × × =
EBT NIR IR TOI TOI
NETIR = NEER × ETIR = NEIR × ITIR = NENIR × NITIR =
or EAT EBT EAT IR EAT NIR EAT (22)
= × = × = × =
EBT TOI IR TOI NIR TOI TOI
One may check these and other interrelations between corresponding financial ratios. For
example, using data from Table 7, growth rates (2002/1994) of financial ratios of the factor
system (21) are related as follows,
5.771 = 1.578 × 4.754 × 0.834 × 0.920,
i.e. earnings to net interest revenue (ENIR = EBT/NIR) very significant increase was the
major factor of the level of NETIR substantial growth. It needs more exact explanation.
ENIR may be expressed as

EBT NIR + NNIR NNIR
ENIR = = = 1+ (23)
NIR NIR NIR
The ratio NNIR/NIR is negative and thus ENIR shows the bank management success in the
management of bank’s non- interest activities, which is in general a burden for banks
operating: effectiveness of the bank cost control, success designing the price policy, success
of various other financial transactions. Growth of ENIR about five times in Estonian
commercial banking system was the main factor of the rising of ROA, ROE, and other rate of
return indicators. One may check that the negative ratio NNIR/NIR decreased substantially
during analyzed years, from 89.2% in 1994 to 48.8% in 2002. It means, that if in 1994 the
most of earned net interest revenue was spent to cover net non- interest revenue, then in 2002
remarkable part of generated net interest revenue (NIR) remained also for growing
shareholders profits.
It is also possible to carry out component analysis of NETIR on the basis of an additive factor
system. So as
EAT EBT − T NIR + NNIR − T NNIR T
NETIR = = = = NITIR + − (24)
TOI TOI TOI TOI TOI
and NNIR = EBT - NIR, and T = EBT - EAT. From Tables 4 and 7 we can obtain the
absolute change of NETIR under the influence of these three factors:
1994: 0.0291 = 0.4501 + (-0.4016) - 0.0194
2002: 0.1679 = 0.3452 + (-0.1683) - 0.0090
20
absolute change: 0.1388 = -0.1049 + 0.2333 + 0.0104
And so, net earnings (earnings after taxes, EAT) have grown 13.89 cents from every
generated kroon of total operating income under the influence of the following factors:
(1) negative influence of the decrease of net interest revenue to total income ratio (NITIR),
- 10.49 cents;
(2) substantial decrease of the negative net non- interest revenue to total income ratio
(NNIR/TOI), + 23.33 cents;
(3) decrease of the tax to total income ratio (T/TOI), +1.04 cents.
Expense indicators (interest expense, IE, non- interest expense, NOIE) may also be included
into the factor system (24)
EAT ( IR − IE ) + ( NOIR − NOIE ) − T
NETITR = = =
TOI TOI
(25)
IE NOIR NOIE T
= ITIR − + − −
TOI TOI TOI TOI
All elements/financial ratios of the efficiency matrix (or the inverse matrix of efficiency) are
interrelated with each other. There exist eight different possibilities depending on the location
of related financial ratios (left, right, above, or below of each other, or one ratio is in the
inverse matrix of efficiency). For example, if the question is, how net interest to interest ratio
(NIIR = NIR/IR) from the output matrix, and earning assets ratio (EAR = EA/TA) from the
input matrix, are related, we may build up the following multiple factor system
NIR EA TA NIR EAR × NIEA
NIIR = = × × = (26)
IR TA IR EA IOA
and using the factual data from Table 7:
1994: 0.6685 = 0.7293 × 0.1031 : 0.1125
2002: 0.5573 = 0.8905 × 0.03547 : 0.05668
growth rates: 0.8337 = 1.2210 × 0.3441 : 0.5038
What can we conclude from these numbers? The rise of earning assets ratio (EAR) and the
decline of interest on total assets ratio (IOA) influenced positively to the relative change of
net interest to interest ratio, but substantial negative relative change of net interest to earning
assets ratio (NIEA) level had more relevant negative influence.
Input Matrix:
Only three financial ratios (earning assets to equity ratio, EAER = EA/BVE; equity multiplier,
EM = BVE/TA; earning assets ratio, EAR = EA/TA) are presented in the output matrix of our
example, see Table 10. All these financial ratios characterize proportions between input
quantitative indicators. Total assets are the “bottom” of that matrix, and others characterize
the structure of the bank’s balance sheet: earning assets from the assets side, and book value
of equity from the liabilities’ side. One may discuss the sequence of including earning assets
(EA) and equity (BVE) into the matrix model, but if the main task is to study and analyze
efficiency of banks performance, then earning assets to equity ratio (EAER) is just the one of
the efficiency partial indicators.
Earning assets ratio is the leading element of the output matrix, as this is the final indicator of
the multiple factor system
21
EA EA BVE
EAR = = × = EAER × EM (27)
TA BVE TA
Using data from Tables 7 we may obtain
1994: 0.7293 = 8.4828 × 0.0860
2002: 0.8905 = 7.0349 × 0.1266
growth rates: 1.2210 = 0.8293 × 1.4723
It is possible to develop other factor systems using quantitative financial indicators from
Table 7. For example
TA − R − FA R FA
EAR = = 1− − (28)
TA TA TA
where R - cash and reserves in the bank assets;
FA - fixed and other assets.
Using data from Table 7 we may study influence of these factors (cash and reserves ratio to
total assets, and fixed and other assets ratio to total assets) to the absolute change of EAR
level
1994: 0.7293 = 1 - 0.1821 - 0.0886
2002: 0.8905 = 1 - 0.0688 - 0.0407
absolute changes: 0.1612 = 0.1133 + 0.0479
It means that the increase of EAR level was achieved due to the decrease of the share of cash
and reserves in total assets (+ 0.075), and also due to decrease of the share of fixed and other
assets in the total assets (+ 0.002).
We may once more call the readers’ attention to the fact that the development and usage of
concrete financial analysis methods depend on posted tasks of the analysis. For example, if
one must study the structure of the bank balance sheet assets side, analysis methods depend
on, what is actually needed to study, where these weak sides of the bank activities and
operating which need more detailed analysis are, etc. For example:
(1) if the main task is to study general efficiency of the banks performance and the banks
management income generation possibilities, one may use approach discussed in this
paper to study the structure of banks assets and liabilities, emphasizing the role of EAER,
EAR, and EM;
(2) if the bank has liquidity problems and the main task of the financial analyst is to study
bank’s liquidity position and related with this problems, one may start from calculating the
ratio R/TA, and thereupon to develop corresponding analysis scheme/factor system for
detailed analysis of factors influencing bank’s liquidity position;
(3) if credibility and confidence in the bank’s activities is weak and hurt, or the “brand name”
of the bank is unknown, among other issues it may be useful to study the share of fixed and
other assets in the total assets, etc.
Output-Input Matrix:
The quadratic output- input matrix is the most important partial matrix of the bank
performance matrix model because elements of that matrix are typical output/input-type
financial ratios, i.e. efficiency indicators. There are at all 3×5=15 financial ratios (from which
almost half are frequently used) in the output-input matrix presented in Table 10.
22
Net return on assets (NROA = EAT/TA) is the leading element of the whole efficiency
matrix, which forms the following multiple factor system from all elements of the main
diagonal
NROA = NEER × ENIR × NIIR × ITIR × TIEA × EAER × EM =
EAT EBT NIR IR TOI EA BVE EAT (29)
= × × × × × × =
EBT NIR IR TOI EA BVE TA TA
We may check easily the factor system (29)
1994: 0.6015 × 0.1078 × 0.6685 × 0.6733 × 0.2291 × 8.4828 × 0.0860 = 0.0048
2002: 0.9493 × 0.5125 × 0.5573 × 0.6194 × 0.1028 × 7.0349 × 0.1266 = 0.0154
growth rates: 1.578 × 4.574 × 0.8337 × 0.920 × 0.4485 × 0.8293 × 1.4723 = 3.15
Naturally, it is possible to aggregate or de-aggregate elements/financial ratios included in the

multiple factor system (29), to include elements from the inverse matrix of efficiency etc. I.e.
in principle it is possible to develop a number of different factor systems depending on posted
tasks of analysis and established bottlenecks in the bank activities, operating and
performance. It is also possible to start with the analysis of other financial ratios in the output-
input matrix. For example, from Table 10 we can see that net interest on assets ratio (NIOA =
NIR/TA) in Estonian commercial banking system is fallen substantially (more than twice)
during the analysed period, which phenomenon needs further analysis. We may develop the
following factor system from the elements of the main diagonal of the matrix model
NIOA = NIIR × ITIR × TIEA × EAER × EM =
NIR IR TOI EA BVE NIR (30)
= × × × × =
IR TOI EA BVE TA TA
Using data from Table 7 we may obtain

1994: 0.07520 = 0.6685 × 0.6733 × 0.2291 × 8.4828 × 0.0860
2002: 0.03159 = 0.5573 × 0.6194 × 0.1028 × 7.0349 × 0.1266
growth rate. 0.4200 = 0.8337 × 0.9200 × 0.4485 × 0.8293 × 1.4723
Consequently, all factors from the output matrix and from the output-input matrix negatively
influenced the change of NIOA: net interest to interest ratio (NIIR=NIR/IR) decreased
16.63%, interest to total income ratio (ITIR = IR/TOI) decreased 8.00%, and total income to
earning assets ratio (TIEA = TOI/EA) decreased 55.15%. Financial ratios, which characterize
proportions between input indicators, changed as follows: earning assets to equity ratio
(EAER = EA/BE) decreased 17.07%, and only equity multiplier (EM = BVE/TA) increased
substantially, 47.23%.
It is suitable to aggregate some financial ratios. For example, as NIIR × ITIR × TIEA = NIEA
=NIR/EA, and EAER × EM = EAR = EA/TA, we receive the following factor system:
NIR EA NIR
NIOA = NIEA × EAR = × = (31)
EA TA TA
Using data from Table 10:
1994: 0.0752 = 0.1031 × 0.7293
2002: 0.03159 = 0.03547 × 0.8905
growth rates: 0.4200 = 0.3441 × 1.2210
23
Consequently, efficiency of Estonian commercial banking system from the point of view
earned interests has fallen substantially during the last four years. Positive changes in the
proportions of input indicators slowed down this falling a little.
Now we turn back to the analysis of the leading element of the output-input matrix, i.e. to the
analysis of NROA dynamics. It is suitable to aggregate financial ratios from the output matrix
and from the input matrix correspondingly to formulae (21) and (27)
EAT TOI EA EAT
NROA = NETIR × TIEA × EAR = × × = (32)
TOI EA TA TA
Only one output/input-type traditional efficiency indicator, TIEA = TOI/EA, is added to the
leading elements of the output matrix and input matrix. Results are as follows:
1994: 0.0049 = 0.0291 × 0.2291 × 0.7293
2002: 0.0154 = 0.1679 × 0.1028 × 0.8905
growth rates: 3.15 = 5.771 × 0.4485 × 1.221
Hence, the growth of net return on assets (NROA = EAT/TA) more than three times was
caused by the influence of following changes:
(1) favorable changes in the proportions of banks output indicators, which are expressed in the
5.771 times rise of the level of NETIR, were the main “engine” of the very substantial rise
of NROA;
(2) there was also small positive change in the proportions of banks input indicators, which
became apparent in the 22.1% rise of EAR;
(3) the only typical and traditional output/input-type efficiency indicator, TIEA = TOI/EA, in
the factor system (42), decreased substantially (growth rate 0.4485).
Rise of the general level of the efficiency of Estonian commercial banking system
performance during the analyzed period (1994-2002) seems at first very efficacious. This
reflects in the increase of NROA, but it was mainly caused by changes in the proportions of
output indicators (mainly ENIR about 4.75 times rise). We are of the opinion that such
phenomenon is not relevant in the long-term perspective. Traditional output/input-type
efficiency ratios, as NIEA, IEA, NIOA and others, have been decreased substantially and
there are other major sources for rising banks operating efficiency in the future.
Now we present the analysis of the absolute change of NROA from entirely other aspect. It is
possible to develop the following additive factor system
EAT EBT − T ( NIR + NNIR ) − T ( IR − IE ) + NNIR − T
NROA = = = = =
TA TA TA TA
(33)
IE NNIR T
= IOA − + −
TA TA TA
Using data from Tables 6 and 10 we may find:
1994: 0.00488 = 0.11249 - 0.03729 + (-0.06709) - 0.00323
2002: 0.01537 = 0.05668 - 0.02509 + (-0.01540) - 0.00082
absolute changes: 0.01049 = -0.05581 + 0.01220 + 0.05169 + 0.00241
Expressing these results in Cents for one Estonian crown (EEK) of total assets and rounding
these results a little, we get the absolute change of NROA to 1.05 cents from every EEK of
assets in the result of following changes:
(1) decrease of interests on assets ratio (IOA = IR/TA), - 5.58 cents;
24
(2) decrease of interest expense to total assets ratio (IE/TA), + 1.22 cents;
(3) decrease of net non- interest revenue to total assets ratio (NNIR/TA), + 5.17 cents;
(4) decrease of taxes to total assets ratio (T/TA), + 0.24 cents.
As it was mentioned already earlier, the main source of the rise of net return on assets was
decrease of banks burden. The burden for banks is their non-interest activities what has
always negative results. The measure of banks burden was in the last discussed case expressed
as net non-interest revenue to total assets ratio, NNIR/TA. Estonian commercial banks major
activities (lending and investing) results have been worsen during the last two years.
Now let us look how traditional financial ratio analysis indicators are represented in the
matrix model. First of all, more widely used rate of return type financial ratios, as return on
assets (ROA) and return on equity (ROE), also related with them financial leverage (LEV)
and equity multiplier (EM), are directly presented there (LEV = 1/EM). There is also all
needed information for the usage of DuPont financial ratio analysis different versions.
ROE decomposition analysis indicators are all directly in the matrix model, see formulae (1)-
(5). There is also informa tion for carrying out component analysis of ROTA, see formulae
(6)-(9). As net non- interest revenue NNIR = EBT - NIR, it is possible to calculate banks
burden, B = NNIR/TA. Also it is not difficult to carry out NIM component analysis, see
formulae (10)-(13) because all needed initial information is in the efficiency matrix. As
interest expense IE = NIR - IR and liabilities L = TA - BE, we may calculate cost of liabilities
COL = IE/L and liabilities to earning assets ratio LEA = L/EA.
We may conclude that the list of initial quantitative financial indicators in Table 9 and the
efficiency matrix in Table 10 contain enough information for carrying out different versions
of traditional financial ratio analysis, including DuPont analysis versions. But, in addition,
there is much more information for making more profound bank performance analysis, from
which possibilities we illustrated in this paper only partly. And so, most important financial
information, which is possible to obtain from the balance sheet and the income statement of
the bank, is in more complex and aggregated form presented in the matrix model (Table 10).
5. Production functions of the Estonian banking
It is possible to use the existing information to construct production functions of

banking, treating banking as a separate sector with its own inputs and outputs. We selected
total income of the banks (y) as the output variable, and used fixed assets ( x1 ), earning assets
( x 2 ), liabilities ( x3 ), and equity ( x 4 ) as factors. We used financial statements’ quarterly data
for individual Estonian banks, from the fist quarter 1995 to the second quarter 2003, as these
were published in the Bulletins of the Bank of Estonia. The strength of the relationships
between the selected variables is presented in Table 11, mainly due to existing of trends in all
observed variables. We chose the Cobb-Douglas function as the type of the production
function.
y = axα z β , α + β ≠ 1. (34)
To estimate the parameters α and β of the function (34), using ordinary least square
method (OLSM) estimators, it is first necessary to find logarithms of the primary data.
Thereafter we analyzed the trends of the logarithms. The following proved to be the best.
25
Table 11. The strength of the relationships between the selected variables
Y X1 X2 X3 X4
Y 1
X1 0.460073 1
X2 0.771868 0.70662 1
X3 0.76014 0.73396 0.998335 1
X4 0.694385 0.843456 0.951603 0.95453 1
Source: The authors’ calculations
ln y = 6,1515 + 0,054t ; (35)

ln x1 = 7,1060 + 0,3461ln t; (36)
ln x 2 = 9,3456 + 0,0632t; (37)
ln x3 = 9, 4188 + 0,0676t ; (38)
ln x 4 = 6,2014 + 0,8623t. (39)
Deviations from the trends were used as new primary data in constructing production
functions. The parameters of the production functions were found applying Kramer’s method.
The following results were obtained:
y = 0,4025 x10,9628 x30, 0392e ( 0, 0279t− 0,3332ln t ) ; (40)

y = 0,0427 x20, 9324 x30, 0176e −0, 0092t ; (41)
0 , 5376 0 , 4624 (0 ,0034t − 0 ,3987 ln t )
y = 0,1801x 2 x4 e ; (42)
0 ,1689 0 ,8381 (0 , 0427t − 0 ,7227 ln t )
y = 0,5029 x 3 x4 e . (43)
All equations are statistically significant according to the F-criterion; however, we

regard equation (42) as the best as it has the smallest standard error. As the models show,
earning assets are the most important factor for the total income. This is quite logical as the
earning assets are the resource for lending, and that is from which the banks earn their
income. The exponential functions in the models indicate that the growth rate of incomes is
decelerating. The above analysis shows that it is possible to treat banking as an independent
sector of the economy of a country and that econometric modeling yields interesting results
(possible combinations of factors).
6. Conclusions
(1) The development of the Estonian banking sector can be described by a quite rapid
nominal growth of total assets, loan portfolios, net income and other quantitative financial
indicators. Although the Estonian banking market was already quite concentrated, the
consolidation process continued. The capitalization of Estonian banks improved, and the
share of non-residents in the share capital increased significantly.
(2) The banks performance analysis is an important issue in the conditions of transition
economies in the Central and Eastern European countries because the financial sector
could play the key role in a successful transition. The balance sheet and income statement
of the bank is the major source for carrying out the bank performance analysis. A
modified version of the DuPont financial ratio analysis and the matrix approach, which
enable to follow interrelations between different financial indicators, seem to be more
perspective.
26
(3) Some empirical results of the usage of both the DuPont financial ratio analysis and the
matrix model for the Estonian commercial banking system in 1994-2002 are presented in
the article. As the Estonian banking system is developing rapidly, both input and output
quantitative financial indicators have increased substantially during the recent years.
There was an overall falling of the market-determined interest rates in the Estonian
banking market, the interest spread decreased substantially, which influenced the
dynamics of various discussed financial ratios.
(4) The rise of the Estonian commercial banking system performance efficiency, which is
revealed in the increase of the rate of return indicators such as return on assets (ROA) and
return on equity (ROE), was caused mainly by the changes in the proportions between
output indicators (for example, the banks’ burden has decreased substantially). The
traditional output/input-type efficiency ratios (interest or income on assets or on equity
ratios) however, decreased substantially during the analyzed period.
(5) The initial quantitative financial indicators and the respective matrix model used in this
article contain all relevant information for carrying out different versions and
modifications of the traditional financial ratio analysis, including DuPont financial ratio
analysis. In addition, there is much more information for carrying out a more profound
banks performance analysis, the possibilities of which we partly illustrated in this article.
(6) Application of econometric models (production functions) in the analysis of banking
information provides new opportunities to combine factors in analyzing and forecasting
output variables.
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28

Bank Performance Analysis: Methodology and Empirical Evidence (Estonian Banking System, 1994-2002)

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Bank Performance Analysis: Methodology and Empirical

Evidence (Estonian Banking System, 1994-2002)

Jaan Vainu, PhD, Research Fellow

Contact person and presenter of the paper:

EFM classification codes: 510 – Depository Institutions - Management

Journal of Economic Literature Classification number: G21

1. Introduction: Theoretical Background and Overview of Related Literature

2. Development of the Estonian Banking System

2.1. Historical Notes

No Bank Established Organizational Changes

2.2. Banking Crises and Bank Rehabilitation

2.3. Structural Developments

Some more interesting conclusions from Table 2:

Indicator 1997 1998 1999 2000 2001 2002 02/97

Total assets/GDP, % 63.4 55.7 61.7 67.7 71.8 75.6 1.192

Table 3. Ownership Structure of Estonian Banks, %

Year Estonian Owners Non-Resident Owners

3. DuPont Financial Ratio Analysis

• earning assets ratio, EAR

3.2. Banking Sector Performance and Profitability - DuPont Analysis

It is argued that internationalization, adoption of new banking technologies, deregulation,

Table 4. Aggregated Consolidated Balance Sheet of Estonian Commercial Banks

Item 1994 1997 2000 2001 2002 02/94 02/01

Table 5. Aggregated Consolidated Income Statement of Estonian Commercial Banks

Indicator 1994 1997 2000 2001 2002 02/94 02/01

Table 6. Simplified Consolidated Financial Statements of the Estonian Banking System

Items 1994 1997 2000 2001 2002 02/94 02/01

Table 7. Financial Ratio Analysis of Estonian Commercial Banks (1994-2002)

Financial Ratio 1994 1997 2000 2001 2002 02/94 02/01

4. Matrix approach for banks’ performance analysis

Table 8. The Matrix Model for Banks Performance Analysis

Earnings Earnings Net Interest Interest Total Earning Book

4.2. General Results of Using the Matrix Model

Table 9. Initial Financial Indicators for the Matrix Model (EEK m)

Financial Indicators 1994 1997 2000 2001 2002 02/94 02/01

NROA = U × ENIR × NIIR × ITIR × TIEA × EAER × EM =

EAT EBT NIR IR TOI EA BVE

4.3. Analysis of the Partial Matrices

ENIR may be expressed as

absolute change: 0.1388 = -0.1049 + 0.2333 + 0.0104

Naturally, it is possible to aggregate or de-aggregate elements/financial ratios included in the

Using data from Table 7 we may obtain

5. Production functions of the Estonian banking

It is possible to use the existing information to construct production functions of

ln y = 6,1515 + 0,054t ; (35)

y = 0,4025 x10,9628 x30, 0392e ( 0, 0279t− 0,3332ln t ) ; (40)

All equations are statistically significant according to the F-criterion; however, we

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