Indicators That Allow Us to Know Whether a Highly Profitable Bank is Really Healthy

Posted on November 28, 2015

Net income is one of the oft-used figures for banks. However, we should distinguish between non-interest and interest income. In a sophisticated, dynamic and open credit market, the bank’s income from interest differentials must be minimal. In some countries, like Russia and Japan, government provides subsidies by lending banks money at low interest. It means that they can reap sizable interest income, even with moderate interest rate for average lenders. Incomes obtained from government securities should be tax free in many countries. This is also a kind of subsidy that is provided by the government. However, we should know that high interest income is actually a sign of financial weakness. Banks can obtain profit only when they are helped by external forces, such as the government.

It is only of the more important ratios that we need to observe. This is another reason why a bank should be accredited by International banking firms. It can be quite complex for average bank consumers to understand regulatory requirement and any of the essential defined ratios. However, minimum compliance with common standards should be considered as a potentially risky situation. One of the essential ratios is the ROE or the return on the equity of the bank. The value can be obtained by dividing net income with average equity. ROA or return on the assets of the bank can be obtained by dividing net income with average assets. Finally, we should consider the ratio between common stocks and total assets.

We should be aware that the above ratios should be considered as cure-alls. Like any figure and number, they can be distorted and manipulated. For these three ratios, it is better to have higher values than low ones. High ratios indicate that the bank has a better underlying strength of provisions and financial reserves. Banks with good ratios will always expand their business and they participate in various financial or social programs. The bank’s resilience to credit risks and ratios should be better if much of the earnings are not distributed to shareholders and retained mostly in the bank’s financial system. Not even the asset utilization coefficient and profit margin can be relied upon to accurately assess the health of the bank. These two factors could look good because the government and other external forces are giving banks subsidies and other financial helps.

In order to elaborate the above points better, we should know that the Central Bank may lend money cheaply to local banks with low interest. This allows banks to get more than modest interest income rather unhealthily from consumers who lend the money. The end result is that the bank’s profitability and income could be caused by non-productive sources. The bank’s financial records should also show us the amount of poor loans that are carried. It means that simple values of bank’s net profit are a poor guide to help us know about the real profitability of the bank.

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