A bank health check is a comprehensive assessment of a bank’s financial condition, performance and risk management practices. This is done by banking regulators or independent auditors to evaluate the bank’s ability to withstand economic conditions and potential risks, including credit risk, market risk, liquidity risk and funding risk.
Bank financial statements, including balance sheets, income statements and cash flow statements, as well as risk management methods, are often scrutinized as part of health checks.
Here are nine basic metrics for analyzing a bank’s health.
Why is a health check important?
It is important to conduct a bank health check because it allows regulators and stakeholders to assess the financial stability and operational effectiveness of the bank. This enables quick steps to mitigate these risks and helps detect potential hazards and vulnerabilities that could harm the bank’s performance. In addition, it supports the stability of the financial sector and maintains public confidence in the banking system.
During the global financial crisis (GFC) of 2007-2008, several bad practices led to the collapse of the global financial system. For example, banks and financial institutions provide loans to high-risk borrowers with poor credit history, which leads to many defaults. These subprime mortgages were packaged into complex financial instruments and sold to investors as high-yielding securities, which ultimately led to the collapse of the housing market.
The second largest bank failure in the history of the United States occurred on March 10, 2023, when Silicon Valley Bank (SVB) collapsed after a bank run, surpassing the largest bank failure since the financial crisis of 2008. During the period of near-zero interest rates, SVB invested heavily very much in US government bonds, assuming they are a safe investment. However, this strategy backfired when the Federal Reserve began aggressively raising interest rates to curb inflation. As interest rates rise, bond prices fall, leading to a decline in the value of SVB’s bond portfolio and its eventual collapse.
Related: Silicon Valley Bank collapse: How SVB stock price performed in 5 years
Lack of proper regulatory oversight allows financial institutions to engage in risky practices without proper checks and balances. Therefore, good risk management practices are key to positive financial health and, ultimately, the effectiveness of the global financial system.
Key metrics to assess bank health
Metrics that provide unique insight into the health and financial performance of the bank 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 current value of its assets and liabilities. It shows the amount of equity that will be left after eliminating all assets and liabilities and settling all liabilities. EVE is a measure often used to calculate interest rate risk in the banking book (IRRBB), and banks should measure IRRBB using this metric.
Regular evaluation of EVE is required by the US Federal Reserve. In addition, a stress test of plus or minus 2% on all interest rates is recommended by the Basel Committee on Banking Supervision. The 2% stress test is a widely accepted measure used to determine interest rate risk.
The formula for calculating EVE is as follows:
For example, suppose a bank has an equity market value of $10 million, and the present value of future cash flows from assets is $15 million, while the present value of 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 liabilities exceed assets. As a result, the long-term financial stability and ability of the bank to meet its obligations can be seriously jeopardized. Thus, it is very important that banks implement corrective measures to improve the value of economic equity and reduce interest rate risk.
Net interest margin (NIM)
This represents the difference between interest income and costs for the bank. It describes the bank’s ability to make money from its assets (loans, mortgages, etc.) in relation to the cost of financing (deposits, loans, etc.).
Consider the example of a bank with the following financial data for a given year:
- Interest income received from loans and securities: $10 million
- Interest expense paid to depositors and creditors: $5 million
- Total assets: $500 million
- Total liability: $400 million.
Using this information, one can calculate the bank’s NIM as follows:
This shows that the bank makes one cent of net interest income for every dollar of assets it holds. A higher NIM indicates that the bank is more profitable because it earns more from its assets than it spends on interest. In contrast, a lower NIM indicates that the bank is less profitable because it earns less money from assets than it spends on interest.
Efficiency ratio
This is the ratio of the bank’s non-interest expenses to revenue. A lower ratio indicates higher efficiency and profitability.
Consider 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, the bank’s efficiency ratio can be calculated as follows:
This shows that for every $1 of income the bank generates, it spends $0.50 on operating costs. A high efficiency ratio can 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 of more than 60% is generally considered to have a high cost structure, which can lead to a decrease in profits and can be a sign that the bank should act to increase operational efficiency, such as by speeding up operations, cutting overhead costs or increasing capacity to generate revenue.
return on assets (ROA)
It measures how successful the bank is in turning profits from its assets. Better performance is indicated by higher ROA.
Suppose Bank A has net income of $5 million and total assets of $100 million. Now, the ROA will be:
A high ROA – for example, more than 1% – indicates that the bank generates a good return on assets and is efficient in generating profits or vice versa.
Return on equity (RoE)
It measures a bank’s profitability in relation to its shareholders’ equity. Higher ROE indicates better performance.
Suppose Bank B has net income of $4 million and stockholders’ equity of $20 million. Now, the ROE will be:
Non Performing Loan (NPL)
This is the ratio of bad bank loans to total loans. A high NPL ratio indicates higher credit risk and potential loan losses. For example, if a bank has a loan portfolio of $1 billion. Because the borrower has missed payments for more than 90 days, $100 million (or 10%) is classified as a non-performing loan.
If the bank has to set aside a 50% provision for these non-performing loans, the bank must set aside $50 million for the provision. This means that the bank’s net loan portfolio will be $950 million.
Now let’s imagine that the bank has to write off a bad loan because it will never be able to recover $20 million. As a result, the bank’s loan portfolio will decrease to $930 million, which will have an impact on the bank’s profitability ratio and capital adequacy.
This example illustrates how non-performing loans can have significant implications for a bank’s financial position, and why it is important for banks to effectively manage their loan portfolios to reduce the risk of these loans.
Cost-to-income ratio
This is the ratio of a bank’s operating expenses to 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 is:
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 preferable because it indicates that the bank is more profitable and efficient because it can generate more with less expense.
Loan loss provision coverage ratio
This is the ratio of bank loan loss provisions to bad loans. It reflects the bank’s ability to cover potential loan losses with its provisions.
For example, suppose a bank has a loan loss provision of $100 million and a non-performing loan of $50 million. The loan loss provision coverage ratio for this bank is:
Capital Adequacy Ratio (CAR)
The capital adequacy ratio assesses the bank’s ability to pay its obligations and handle credit and operational risks. A good CAR indicates that the bank has sufficient capital to absorb losses and prevent insolvency, protecting depositors’ funds.
Here is the formula for calculating the capital adequacy ratio:
The Bank of International Settlements separates capital into Tier 1 and Tier 2, with Tier 1 being the primary measure of financial health, including shareholders’ equity and retained earnings. Tier 2 is additional capital, including revalued and undisclosed reserves and hybrid securities.
Risk-weighted assets are the bank’s assets weighted by risk, with each asset class assigned a risk level based on the likelihood of a decline in value. The risk weight determines the amount of bank 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 will be:
In this case, the bank’s CAR is 15%, which indicates that it has enough capital to cover potential losses from credit and investment activities.
Why is decentralization necessary?
Decentralized finance (DeFi) enables a financial system that is 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 SVB highlighted the risks of a centralized financial system, leading to increased interest in decentralizing banking.
Related: Bank down? That’s why Bitcoin was created, the crypto community says
However, DeFi also has risks that should not be overlooked. For example, the volatility of the cryptocurrencies market can create significant risks for those investing in DeFi platforms. Therefore, it is important for investors to consider these risks carefully and do their due diligence before investing in DeFi projects.