I have always maintained that at a fundamental level commercial banking, as the name itself suggests, is a business and has the core values and principles of a commercial enterprise - that of Liquidity, Solvency and Profitability. Safety, Stability plus
Social and Economic relevance are as critical given that banks are powerful economic instruments. It is this special position that requires banks to increase “Stakeholder Value” as opposed to just “Shareholder Value”.
“Transaction Volumes, in the recent times, are down by 30% plus” bemoaned my friend, a senior member of a global bank. “ We are grappling with the rippling effect this will have on our already strained P & L – any thoughts?” he
asked. That got me thinking and we spoke. On reflection I realized this is the challenge almost all banks are facing - the result of that reflection is this blog series. Idea is to explore profitability paradigm as its different hues and colors, the myriad
of shades across the financial and economic canvass demand response. The series aims to cover this theme from different perspectives symbolically pegged to yesterday, today and tomorrow. a)
Context Setting- the fundamentals (The “Yesterday”) , the
Margin Compression Story (The “Today”) and Lens on Profitability and Value Creation (The “Tomorrow”).
Will start off with the first theme – the fundamentals. I remember till recently almost all conversations of financial services used to place its history into two distinct phases -
before and after the 2007/8 financial crisis which I refer to as BC and AD periods (Short for Before Crisis and After Disaster). Interestingly the two periods- the before and after were as dramatic.
As a response to the crisis and with an aim to strengthen banking system, regulators stipulated substantial Capital and Liquidity buffers so the banks can survive dramatic adverse situations. While banks did initially demur at the buffer buckets, over time
realized (Or were made to realize by regulators 😊)that the buffers were good for them and the system. For good measure regulators also required banks to do annual stress tests (In addition to building the buffers) to gauge their capability to withstand a
“Black Swan event” Worst case economic scenario prescribed for stress testing was GDP fall by 5% to 7% considered quite extreme.
With all the above guidelines, banks were on their way to building resilient organizations given the liquidity and capital buffer build. Profitability was another story though. Different banks and different regions had different stories to tell. In 2019.
American banks as an example, turned in a good year, by reportedly bringing in a record $180 billion profit in the first three quarters while their peers, the big banks in Europe lagged significantly and their JAPAC (Japan & Asia pacific) contemporaries somewhere
By end 2019 banking system, globally, was settling into BAU (business as usual) with efforts to strengthen their balance sheets with buffers and grappling, less successfully, with steadying and growing their P & L dealing with Issues like business model
related challenges, balance sheet structures and concentration of assets (example Top 100 of US 5000 banks are reported to have about $14.4 trillion in assets – a concentration of almost 81%) all of which have a direct bearing on profitability.
Coming back to the basics , at the very fundamental level four ratios reflect the profitability canvas of a bank ROE (Return on equity); ROA (Return on Assets); NIM (Net Interest Margin) and RAROC (Risk Adjusted Return on Capital), the last being my favorite
as it captures risk adjusted profit which is a more realistic reflection of profit (the two fundamental drivers for arriving at RAROC are Risk & Profitability).
The four ratios :-
Return On Equity (ROE) - Net Profit after Tax/Average equity
Return On Assets (ROA) - Net Profit after Tax/Average Assets
Net Interest Margin (NIM) -Net Interest Income/Average earning assets
Risk Adjusted Return On Capital (RAROC) - Economic Profit/Economic Cost
A closer look reveals that the critical underlying components of all the above computations are :-
- Net Income = Net Interest Income + Net Non-Interest Income
- Credit Losses
- Assets – Volume, Mix and risk profile
- Equity/ Capital
For the purpose of this analysis, will consider the last two viz. Equity and Taxes as constant and explore the
impact of shrunken transactions, the economic environment that prompted such a shrinking on the first three aspects viz. Net Profit, Credit Losses and Provisions in the next blog “Margin Compression Story” . In the third blog will
expand to include the mix and volume of Assets on net profit as we look forward to a strong tomorrow with a “Lens on Profitability and Value Creation”
Next Blog - “Margin Compression Story” .