A bank health check is a comprehensive assessment of a bank’s financial condition, performance, and risk management practices. It is conducted by banking regulators or independent auditors and assesses a bank’s ability to withstand adverse economic conditions and potential risks such as credit, market, liquidity and funding risks.
A bank’s financial statements such as balance sheet, income statement, cash flow statement, and risk management methods are often scrutinized as part of a health check.
Here are nine basic metrics for analyzing bank health.
Why are health checks important?
Performing bank health checks is important because it allows regulators and stakeholders to assess the financial stability and operational effectiveness of banks. This enables rapid action to mitigate these risks and helps detect potential hazards and vulnerabilities that could impair a bank’s performance. In addition, it supports financial sector stability and maintains public confidence in the banking system.
During the 2007-2008 Global Financial Crisis (GFC), several poor practices led to the collapse of the global financial system. For example, banks and financial institutions offered loans to high-risk borrowers with poor credit histories, resulting in a significant number of loan defaults. These subprime mortgages were packaged into complex financial products and sold to investors as high-yield securities, ultimately leading to the collapse of the housing market.
The second-largest bank failure in U.S. history occurred on March 10, 2023, when the Silicon Valley Bank (SVB) collapsed following a bank run, surpassing the largest bank failure since the 2008 financial crisis. I was. During the period of near-zero interest rates, the SVB invested heavily in US government bonds, assuming it was a safe investment. But this strategy backfired when the Federal Reserve began raising interest rates aggressively to curb inflation. Bond prices fell as interest rates rose, resulting in the devaluation and eventual collapse of SVB’s bond portfolio.
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The lack of proper regulatory oversight allows financial institutions to engage in risky practices without proper checks and balances. Sound risk management practices are therefore key to good financial health of banks. , ultimately the effectiveness of the global financial system.
Key metrics for assessing bank health
Indicators that provide unique insight into a bank’s financial health and performance are discussed below.
Economic Value of Equity (EVE)
Economic value of equity is a measure of the long-term value of a financial institution’s equity, taking into account the present value of its assets and liabilities. It indicates the amount of capital remaining after liquidating all assets and liabilities and fulfilling all obligations. EVE is a frequently used measure in the calculation of interest rate risk in the banking book (IRRBB) and a bank should use this metric to measure his IRRBB.
Periodic evaluation of EVE is mandated by the US Federal Reserve. In addition, the Basel Committee on Banking Supervision recommends a plus or minus 2% stress test for all interest rates. The 2% stress test is a widely recognized measure of interest rate risk.
The formula for calculating EVE is:
For example, suppose the market value of a bank’s equity is $10 million, the present value of expected future cash flows from assets is $15 million, and the present value of expected future cash flows from liabilities is $12 million. increase. Using the EVE formula, we can calculate the economic value of a stock as follows:
A negative EVE indicates that the bank’s liabilities exceed its assets, so the bank needs more funds to meet its obligations. As a result, a bank’s long-term financial stability and ability to meet its obligations could be seriously threatened. It is therefore imperative that banks implement corrective actions to enhance economic equity values and reduce interest rate risk.
Net Interest Margin (NIM)
It represents the difference between the bank’s interest income and expenses. It indicates a bank’s ability to make a profit on its assets (loans, mortgages, etc.) in relation to its funding costs (deposits, borrowings, etc.).
Let’s take the example of a bank with the following financial data for a given year.
- Interest income from loans and securities: $10 million
- Interest expense paid to depositors and creditors: $5 million
- Total assets: $500 million
- Total liabilities: $400 million.
Using this information, you can calculate your bank’s NIM as follows:
This indicates that the bank earns 1 penny of net interest income for every dollar of assets it holds. A higher NIM indicates that the bank is more profitable because it is generating more income from its assets than it is spending on interest. In contrast, a low NIM indicates that the bank is less profitable because it earns less on its assets than it spends on interest.
This is the ratio of non-interest expenses to the bank’s income. A lower ratio indicates higher efficiency and profitability.
Let’s take the example of a bank with the following financial data for a given year.
- Net interest income: $20 million
- Non-interest income: $5 million
- Operating expenses: $12 million.
Using this information, a bank’s efficiency ratio can be calculated as follows:
This means that for every $1 of revenue the bank generates, it spends $0.50 on operating costs. High efficiency rates can be a warning sign for banks, suggesting they may struggle to generate revenue and have difficulty staying competitive.
Efficiency above 60% is generally considered a high-cost structure and may lead to lower profitability, requiring banks to take steps to improve operational efficiency, such as streamlining operations. may indicate . Reduce costs associated with overhead or enhance your ability to generate revenue.
Return on Assets (ROA)
It measures how much profit a bank makes on its assets. Higher ROA means better performance.
Suppose Bank A has net income of $5 million and total assets of $100 million. Now that her ROA looks like this:
A high ROA (e.g. 1% or higher) indicates that the bank is generating sufficient returns on its assets and is efficiently generating profits, or vice versa.
Return on Equity (RoE)
It measures a bank’s profitability in relation to shareholders’ equity. Higher ROE indicates better performance.
Suppose Bank B has a net profit of $4 million and a shareholders’ equity of $20 million. Now, her ROE will be:
Bad debt (NPL)
This is the ratio of bad loans to total bank lending. A high non-performing loan ratio indicates high credit risk and the potential for bad debt losses. Let’s say the bank has a $1 billion loan portfolio. The borrower has defaulted on his payments for over 90 days, so $100 million (or 10%) of that is classified as bad debt.
If the bank has to hold a 50% reserve for these bad loans, it has to allocate $50 million to the reserve. This means the bank’s net loan portfolio will be his $950 million.
Now imagine that the bank is unable to recover $20 million from these bad debts and has to write them off. As a result, the bank’s loan portfolio will be reduced to $930 million, impacting the bank’s profitability and capital adequacy.
This example shows the impact of bad debt on a bank’s financial position and why it is important for a bank to effectively manage its loan portfolio to minimize the risk of bad debt.
This is the ratio of operating expenses to the bank’s operating profit. A lower ratio indicates higher efficiency and profitability.
For example, a bank has total operating expenses of $500 million and total operating income of $1 billion. The cost-to-income ratio for this bank is:
This means that for every dollar of operational income a bank generates, it spends $0.50 on operational costs. In general, lower cost-to-income ratios are preferable because they indicate that banks are more profitable and efficient, as they are able to generate more income with less expense.
Bad debt reserve ratio
This is the ratio of a bank’s loan loss reserves to bad debts. This reflects a bank’s ability to cover potential credit losses with provisions.
For example, a bank has $100 million in bad debt reserves and $50 million in bad debt. The loan loss reserve coverage ratio for this bank is:
Capital adequacy ratio (CAR)
Capital adequacy measures a bank’s ability to pay its debts and handle credit and operational risks. A good CAR indicates that the bank has sufficient capital to absorb losses, avoid bankruptcy, and protect depositors’ funds.
The formula for calculating capital adequacy ratio is as follows.
The Bank for International Settlements divides its capital into Tier 1 and Tier 2. Tier 1 is the primary measure of financial health, including shareholders’ equity and retained earnings. Tier 2 is supplemental capital, which includes revalued private reserves and hybrid securities.
Risk-weighted assets are bank assets that are weighted by risk, with each asset class assigned a risk level based on the likelihood of a decline in value. Risk weights determine the bank’s total assets and vary by asset class such as cash, corporate bonds, and fixed income.
For example, if a bank has $1 billion in Tier 1 capital, $500 million in Tier 2 capital, and $10 billion in risk-weighted assets, the CAR would be:
In this case, the bank’s CAR is 15%, indicating that it has sufficient capital to cover potential losses from its lending and investment activities.
Why do we need decentralization?
Decentralized Finance (DeFi) enables a financial system that is transparent, secure, and accessible to all. Bitcoin (BTC) introduced a decentralized currency to the world and challenged the centralized banking system. The collapse of the GFC and SVB has highlighted the risks of a centralized financial system and increased interest in decentralizing banking.
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However, DeFi also presents risks that should not be ignored. For example, cryptocurrency market volatility can pose significant risks to those investing in DeFi platforms. Therefore, it is imperative that investors carefully consider such risks and conduct due diligence before investing in any DeFi project.