BANK'S PROFITABILITY

How profitable is a bank? This is not answered by saying, "Very profitable; it

made P1 billion in net income last year!" If that is how we measure a bank's profitability,
then just look at the bank's net income after taxes or NIAT, sometimes referred to as the
"bottom line" and if the number looks big, then it is very profitable. End of discussion.

Understanding how profitable a bank requires an analysis of the factors whose

impact flow all the way to the bottom line. The analysis becomes more meaningful if
ratios are used as these can be used to compare with other banks, which should give the
reader or analyst a deeper perspective of the banks' profitability far deeper than just
judging it based on NIAT or how much it made after taxes. This chapter presents a
number of indicators expressed in ratios that should tell us the key components
of this profitability or in which areas that management can focus on to increase the level of
its bottom line. Thus, not necessarily in the order of importance, the following
indicators could help the bank's Board of Directors and its management measure
how profitable their bank:

1. Ratio of net interest margin (NIM) to total operating expenses (TOE). Assume a bank
has 1 billion in NIM and also P1 billion in TOE. This means the other revenue streams of the
bank, i.e., foreign exchange income, fees and commissions, and earnings from
investment in fixed income securities will flow into the line called Core Earnings, from
which the bank would deduct provisions for loan losses to arrive at Earnings Before
Income Tax (EBIT) and finally Net Income After Tax (NIAT) after deducting the
applicable income tax rate.

This ratio puts pressure on Management to increase the NIM and/or reduce
the TOE. Ideally, there should be a strategy to reduce TOE by, say, 10% from the
previous year. Unless the bank has a large "excess fat" meaning it is
considerably overstaffed, this would be very difficult. To maintain the TOE
level compared to the previous year would be more reasonable.
 Management then concentrates on increasing the NIM. Almost
instinctively, the reaction is "let us do more loans." It is true that this would tend to
increase the NIM but it may also put pressure on fund sources and even in the
medium- or long-term,
loan portfolio quality. This "obsession" with
accelerated growth in loan booking could affect the quality
of the loan process.
2. Operating efficiency ratio. Management should
do its best to keep Total Operating Expenses down
and Net Income before TOE up so that the resulting line
(core earnings) i.e., Net Income before Loan Loss Provisions and
Income Tax can be maximized. So the formula is TOE
divided by Net Income before TOE. Generally, banks'
operating efficiency ratio is between 60% to 65%. Anything
lower than 60% would be very good.
3. Return on Equity (ROE). This is of course a very important
indicator to stockholders and the Board of Directors. In very
good times, particularly in a declining interest rate scenario,
some banks have achieved 15% or even higher. Normally, a double-
digit ROE is excellent while an ROE of less than 6% may not be
pleasing to the bank's shareholders too much.

4. Return on Assets or Return on Risk Assets (ROA or RORA). This

is the measure used in determining how profitable the assets and risk
assets (mostly loans) of the bank are. NIAT divided by total assets or
NIAT divided by total risk assets. RORA is often used as risk assets
having a direct bearing on the BSP Capital Adequacy Ratio (CAR).
Generally, the range of RORA is between 1.5% to 2%.

5. There are a few other ratios that could affect profitability like
deposits to loans ratio which gives an idea of the percentage of
loans funded by the lower cost deposits (and more stable funds)
compared to the higher cost "bought funds" or money market
sourced funds. The percentage of current account and saving account
(CASA) deposits can also be a good indicator as CASA is virtually zero
interest cost (zero for current accounts and .5% for savings accounts.)