A bank health check is a comprehensive assessment of a bank’s financial condition, performance and risk management practices. It is conducted by bank regulators or independent auditors to assess a bank’s ability to withstand adverse economic conditions and potential risks, including credit risk, market risk, liquidity risk, and funding risk.
A bank’s financial statements, including the balance sheet, income statement, and statement of cash flows, as well as risk management methods, are often examined as part of a health check.
Here are nine key metrics for analyzing the health of a bank.
Why is a health check important?
Conducting a bank health check is important because it enables regulators and stakeholders to assess the bank’s financial stability and operational effectiveness. This enables immediate measures to be taken to reduce these risks and helps to detect potential risks and vulnerabilities that could impair the Bank’s performance. In addition, it supports the stability of the financial sector and maintains public confidence in the banking system.
During the 2007-2008 global financial crisis (GFC), many bad practices contributed to the collapse of the global financial system. For example, banks and financial institutions were giving loans to high-risk borrowers with poor credit history, which led to a large number of loan defaults. These subprime mortgages were bundled into complex financial instruments and sold to investors as high-yield securities, which eventually led to the housing market crash.
The second largest bank failure in US history occurred on March 10, 2023, when the Silicon Valley Bank (SVB) collapsed after the bank ran, surpassing the largest bank failure since the 2008 financial crisis. During a period of near-zero interest rates, SVB invested heavily in government bonds American, assuming it was a safe investment. However, this strategy backfired when the Federal Reserve began aggressively raising interest rates to curb inflation. As interest rates rose, bond prices fell, leading to a decline in the value and eventual collapse of SVB’s bond portfolio.
Related: Silicon Valley Bank Crash: How SVB’s Share Price Has Performed in 5 Years
The lack of proper regulatory oversight allows financial institutions to engage in risky practices without proper checks and balances. Therefore, sound risk management practices are key to the positive financial health of a bank and, ultimately, to the effectiveness of the global financial system.
Key metrics for assessing bank health
Below we discuss metrics that provide unique insight into a bank’s financial condition and performance.
Economic Value of Equity (EVE)
The 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 equity that will be left after all assets and liabilities are liquidated and all liabilities are fulfilled. EVE is a metric frequently used in calculating interest rate risk on the bank book (IRRBB), and banks should measure IRRBB using this metric.
Regular evaluation of EVE is required by the US Federal Reserve. In addition, the Basel Committee on Banking Supervision recommends a stress test of plus or minus 2% on all interest rates. The 2% stress test is a widely recognized measure used to check interest rate risk.
The formula for calculating EVE is as follows:
For example, suppose a bank has a market value of equity of $10 million, and the present value of expected future cash flows from assets is $15 million, while the present value of expected future cash flows from liabilities is $12 million. Using the EVE formula, one can calculate the economic value of equity as follows:
A negative EVE indicates that the bank needs more money to meet its liabilities because its liabilities exceed its assets. As a result, the long-term financial stability and ability of the bank to meet its obligations could be seriously compromised. Thus, it is necessary for the bank to implement corrective measures to enhance the value of economic equity and reduce interest rate risks.
net interest margin (NIM)
This represents the difference between interest income and expenses of the bank. It shows the bank’s ability to make money from its assets (loans, mortgages, etc.) in relation to financing costs (deposits, borrowings, etc.).
Let’s take an example of a bank with the following financial statements for a given year:
- Interest income earned on loans and securities: $10 million
- Interest expenses paid to depositors and creditors: $5 million
- Total assets: $500 million
- Total liabilities: $400 million.
With this information, one can calculate NIM for the bank as follows:
This indicates that the bank is making a net interest income of one penny for every dollar of assets it owns. A higher NIM shows that the bank is more profitable because it generates more income from its assets than it spends on interest. In contrast, a lower NIM shows that the bank is less profitable because it earns less money on its assets than it spends on interest.
efficiency ratio
This is the ratio of the bank’s non-interest expenses to its revenue. A lower ratio indicates higher efficiency and profitability.
Let’s take an example of a bank with the following financial statements for a given year:
- Net interest income: $20 million
- Non-interest income: $5 million
- Operating expenses: $12 million.
Using this information, the bank efficiency ratio can be calculated as follows:
This indicates that for every $1 of income the bank generates, it spends $0.50 on operating costs. A high efficiency ratio may be a warning sign for a bank, indicating that it may struggle to make money and may find it difficult to stay competitive.
An efficiency ratio greater than 60% is generally considered to have a high cost structure, which may lead to lower profitability and may be a sign that the bank needs to take actions to increase its operational efficiency, such as streamlining its operations, reducing costs associated with overheads or enhancing its generation capacity. Revenues.
return on assets (ROA)
This measures how well the bank is making a profit on its assets. Better performance is indicated by an increase in return on assets.
Let’s say Bank A has net income of $5 million and total assets of $100 million. Now, the return on assets will be:
A high return on assets – for example, more than 1% – indicates that the bank is making a good return on its assets and is effective in making profits or vice versa.
return on equity (RoE)
This measures the bank’s profitability in relation to shareholders’ equity. A higher return on equity indicates better performance.
Let’s say Bank B has net income of $4 million and equity of $20 million. Now, the return on equity will be:
Non-performing loans
This is the ratio of the bank’s non-performing loans to its total loans. A higher non-performing loan ratio indicates higher credit risk and potential loan losses. Let’s say a bank has a loan portfolio of $1 billion. Because the borrowers were behind in payments for more than 90 days, $100 million (or 10%) of them were classified as non-performing loans.
If the bank had to make a 50% provision for these non-performing loans, it would need to make $50 million in provisions. This means that the bank’s net loan portfolio will be $950 million.
Now let’s imagine that the bank has to write off these non-performing loans because it will not be able to recover $20 million of them. As a result, the bank’s loan portfolio will drop to $930 million, which will have an impact on the bank’s profitability and capital adequacy ratios.
This example shows how non-performing loans can have significant effects on a bank’s financial position, and why it is critical that banks manage their loan portfolios effectively to reduce the risk of such loans.
cost-to-income ratio
This is the ratio of a bank’s operating costs to its operating income. A lower ratio indicates higher efficiency and profitability.
For example, suppose a bank has total operating expenses of $500 million and total operating income of $1 billion. The cost-to-income ratio for this bank will be:
This means that the bank spends $0.50 on operating costs for every dollar of operating income it generates. In general, a lower cost-to-income ratio is preferred because it shows that the bank is more profitable and efficient because it can generate more income with fewer expenses.
Loan loss provision coverage ratio
This is the ratio of the bank’s loan loss provisions to its non-performing loans. It reflects the bank’s ability to cover potential loan losses with its provisions.
For example, suppose a bank has loan loss provisions of $100 million and non-performing loans of $50 million. The loan loss provision coverage ratio for this bank will be as follows:
Capital Adequacy Ratio (CAR)
The capital adequacy ratio assesses the bank’s ability to meet obligations and deal with credit and operational risks. A good performance ratio indicates that the bank has sufficient capital to absorb losses, avoid bankruptcy, and protect depositors’ funds.
This is the formula for calculating the capital adequacy ratio:
The BIS divides capital into Tier 1 and Tier 2, with Tier 1 being the primary measure of financial health, including equity and retained earnings. Tier 2 is supplementary capital, including revalued and undisclosed reserves and hybrid securities.
Risk-weighted assets are the bank’s risk-weighted assets, with each asset class assigned a risk level based on its probability of depreciation. Risk weighting determines the bank’s total assets and is different for each asset class, such as cash, bonds, and bonds.
For example, if a bank has Tier 1 capital of $1 billion, Tier 2 capital of $500 million and risk weighted assets of $10 billion, the CAR would be:
In this case, the bank’s capital adequacy ratio is 15%, which indicates that it has sufficient capital to cover its potential losses from lending and investment activities.
Why is decentralization necessary?
Decentralized finance (DeFi) enables financial systems that are transparent, secure, and accessible to all. Bitcoin (BTC) introduced the world to decentralized currency and challenged the centralized banking system. The GFC and the collapse of the SVB highlighted the dangers of centralized financial systems, which led to an increased interest in decentralizing banking.
Related: Banks Declining? The crypto community says this is why Bitcoin was created
However, DeFi also has its share of risks that should not be neglected. For example, market volatility in cryptocurrencies can create significant risks for those who invest in DeFi platforms. Therefore, it is imperative for investors to carefully consider these risks and conduct due diligence before investing in any DeFi project.
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