Financial Soundness Indicators For Financial Sector Stability: A Discussion

The Retail Banking Industry

Discuss about the Financial Soundness Indicators For Financial Sector Stability.

All over the world, the retail banking industry is made up of those banks which provide direct financial services, such as savings accounts, checking accounts and investment facilities. Also offered are loan services for individual as well as corporate consumers. Hence, most of the retail banks have now taken up the role of commercial banks and they offer services to corporate as well as individual customers, asserts Birchall, (2014). However, all retail and commercial banks are different from investment banks, although with the repeal of the Glass-Steagall Act, all banks now offer retail, commercial and investment banking services. Basically, retail bankers, like the overall banking industry, derive their major revenue from the loans and services offered to their customer.

Analysis of banks’ operations and banking stocks has always been a challenge for the experts because operations of banks for generation of profits is fundamentally different from those other businesses, as per Sakata, (2013). While nearly all other businesses either manufacture or trade products for generating sales revenue, the banks’ primarily sell money. The key financial ratios, which investors and market analysts essentially use for evaluating institutions involved in retail banking are Net Interest Margin (NIM), Loan-to-Assets Ratio (LAR) and Return-on-Assets (ROA) Ratio, as stated by Beaver, Correia & McNichols, (2011). A detailed discussion about these and other important ratios has been carried out below in the section DISCUSSION.

In the developed nations, such as United States, retail banking industry has been divided into Nationwide Operators and Regional Operators. When an analysis is carried out for these retail banks, the investors show more interest in knowing about their profitability measures which can allow them to make a performance evaluation, as this is considered to be widely applicable to the complete banking industry, affirms Grier, (2007). As the financial statements of financial institutions are more complicated as compared to those of other businesses, investors and experts not only look at such traditional evaluation measures, such as price-to-book (P/B) ratio or price-to-earnings (P/E) ratio, as determined using CAMELS Methodology, they are also examining more accurate evaluations and investment potential of banks by using the EAGLES Methodology and both have been detailed hereunder, as per Chatterjee et al (eds), (2014).

Banking regulators, all across the world, have been regularly assessing the every bank’s financial condition and the specific risks being faced by them through the on-site examinations, assert Watanabe (ed), (2006). These examinations, although address the facets of the bank’s management, they also focus on making an assessment about the quality of the bank’s assets and also determine whether the management’s policies conform to the regulatory requirements. Regulators rate the banks using the CAMELS Rating Methodology which focusses mainly on the following six categories. Each letter refers to each rating category, explains Mayo, (2015).

Camels Ratings Methodology

C  Capital Adequacy

A  Asset Quality

M  Management Quality

E  Earnings Quality

L  Liquidity

S  Sensitivity to Market Risk

Evaluation of each bank is done on a scale of 1 to 5, where 1 denotes the Best Rating and 5 classifies the institution as the Worst Rating. Regulators also assign an Overall Rating by using the same range, as explained by Kumar, (2014). The discriminating nature of this rating methodology is that these six categories are not given equal weighting while determining the Overall Rating. Thus, an Overall Rating of 3 will indicate that the bank is facing certain problems which require immediate correction, while a rating of 4 or 5 will signify that the bank has a reasonable chance that it might fail in the near future because of the problems it is encountering, state Kovsted, Rand & Tarp, (2005).

This methodology also takes into consideration six factors while making an assessment of a bank’s performance, the categories defines have been changed post the global financial crisis of 2008, which originated from the USA banks and soon engulfed many other financial institutions all across the developed countries, as per Anh et al (eds), (2017).

In this section of EAGLES, the assessor will take into consideration three indicators – (i) Return on Assets (ROA); (ii) Return on Networth (RONW); (iii) Income / Overheads Ratio (IOR). Many analysts do not give importance to the IOR factor. They are of the opinion that income is dependent on external factors whereas overheads are influenced by internal factors, as per Anh et al (eds), (2017). Hence, as per this characterization, the bank must adjust the internal factor of overheads as per the external factor of income. Practically, this is not possible as neither the overheads can be reduced overnight not can income, which is dependent on the market demand for the bank’s products and services, be increased overnight, states ADB, (2015).

Asset quality of a bank can be assessed by an on-site inspection of its Loan Portfolio. It can also be measured by the level of its Bad and Doubtful Debts (BDD) as a percentage of the Total Loans. Analysts adopt a conservative approach by assessing that the percentage of the BDD’s to err should remain low, as per ADB, (2015).

The Rate of Growth of the bank’s loans in comparison to its Core Deposits are taken into consideration as these two are important indicators as to how the bank wants to maintain a favorable position of itself among its customers, as confirmed by ADB, (2014).

Eagles Ratings Methodology

Analysts define Liquidity as the bank’s ability of having sufficient funds for meeting the demands of its customers for loans, general withdrawals, withdrawal of deposits and operational expenses. The management has to maintain a requisite balance between the bank’s deposits and the loans extended. In EAGLES Methodology, the Credit-to-Deposit Ratio (CD Ratio) is taken as the indicator, state Harker & Zenios (ed), (2000).

Equity level is the bank’s adequate capital maintenance and it has immense impact on the bank’s survival. Financial industry’s international guidelines (Basel II) have set this requirement at 8% of the bank’s Risk Adjusted Assets at the minimum, as stated by Beaver, Correia & McNichols, (2011).

Strategic Response Quotient (SRQ) is considered to be the most effective management tool of a bank’s strategy, asserts Hilb, (2016). This factor assesses the bank management’s capability of lending, garnering deposits, generating higher fee-based incomes and manage within limits the bank’s operating cost. Analysts obtain SRQ by dividing the bank’s interest margin by its net operating cost which is calculated by deducting the total operating cost from the bank’s fee income according to USA-IBP, (2007).

After the explanation of both CAMELS and EAGLES Methodologies, we move towards discussing their implementation, effects and results. This will finally lead this report to their Critical Analysis in the penultimate section of this report. We have shown above the criteria behind the naming of these methodologies, says ADB, (2014). But the actual purpose of this discussion is to see their implementation. So let us first see how CAMELS is implemented by analysts when making decisions of strategic management by the results obtained from the financial ratios which are derived from the annual financial statements and data of the concerned banks, which in the case of this report are Techcombank and Sacombank, as described by Watanabe (ed), (2006).

We have explained in the Introduction Section about the letters used in CAMELS. Let us discuss them one-by-one, as explained by Sakata, (2013).

Analysts determine this factor on the basis of Loans to Assets Ratio (LAR) of the bank. This ratio is calculated by dividing the loans advanced by the bank with the amount of assets (deposits) which the bank holds, as per Mayo, (2015). In this methodology, emphasis was only on the data under these two heads, without taking into consideration the factors which can lead to a downfall of any one of these factors. The analyst was not concerned about the Bad Loans and was also not taking into consideration the ownership of the assets held by the bank, asserts Mayo, (2015).

Discussion

While conducting the analysis of this factor, the analyst had a very broad spectrum to consider. Commonly termed as Tier-1 Capital Ratio, this is the most primary yardstick which an analyst applies for measuring the bank’s asset quality (commonly named as capital strength). The first requirement here is to calculate the amount of ‘tier 1 capital’.

This, according to the analysts and the regulators, are the highest quality asset, which are in the form of shareholders’ fund, reserves and hybrid securities, states Kumar, (2014). This amount, upon division by the ‘risk-weighted assets’ gives the ratio in percentage points. The analysis does not take into account whole of the assets owned by the bank, as per ADB, (2015). This functionality, which was based purely on theoretical assumption, was the biggest factor which led to the Global Financial Crisis of 2008 (GFC 2008).

Here again, the theoretical assumptions are taken more into consideration instead of conducting a realistic analysis on the basis of available data about the financial institution. Technically, there are no available formulae which can be used on the basis of the available data and measure the quality of management of a bank or its work-force or its management, state Chatterjee et al (eds), (2014).

In simple words, this ratio is about the earnings which an investor can earn on its share of investment in the bank, as explained by Harker & Zenios (ed), (2000). The Price to Earnings Ratio (P/E Ratio) has been considered as the benchmark of the earnings of a bank and this is calculated by dividing the share price of the bank by the earning per share. There is no criteria to evaluate how the bank can improve its earnings as both the factors in the formula shown above are dependent on external conditions, as discussed by Anh et al (eds), (2017).

Ratios used for determining the Liquidity of a bank are those ratios which help in the assessment of an analyst in knowing whether the bank will be able to honour its short-term liabilities and has the viability to survive in short-term future, explains Kovsted, Rand & Tarp, (2005). The most important ratio which was used for this assessment is the Current Ratio. This ratio, which is calculated by using the formula shown below, helps the analyst in knowing whether the bank has enough cash as well as cash-equivalents for fulfilling its short-term liabilities, assert Beaver, Correia & McNichols, (2011).

Critical Analysis

Current Ratio = Total Current Assets / Total Current Liabilities

Analysis of this ratio is associated with the analysis of the asset quality of the bank. This is determined by making an analysis between the Cumulative Provision Balances of the bank with the amount of the bank’s Gross NPAs which are taken on a particular date, as stated by Hilb, (2016). Through this measure, the analysts are able to indicate the level at which the management of the bank has made provisions for the non-performing portion of its loan portfolio. A higher ratio suggests that the management is required to make provision of additional amounts in its Cumulative Reserves in the coming years, explain Chatterjee et al (eds), (2014). The formula used is: Provision Coverage Ratio = Cumulative Provisions / Gross NPAs.

After the huge capital losses which many of the world’s largest financial institutions had to bear during the Global Financial Crisis of 2008, the banking industry all over the world came together to cover the many loopholes that were there in the security and critical analysis of the banking industry, as detailed by Watanabe (ed), (2006). The theoretical assessment factors were quickly replaced with more practical and result-oriented factors and controls. The factors for assessment remained the same 6 as were under CAMELS. But these new analysis factors, now named as EAGLES (Earning; Asset; Growth; Liquidity; Equity; Strategy) had more teeth, were based on realistic and current data of the bank and took into consideration facts which could be used for controlling, at a quicker pace, any anomalies found in the bank’s working or management or asset deployment, assert Kovsted, Rand & Tarp, (2005).

Although Earnings were covered under CAMELS also, but in EAGLES, their assessment process was widened and more ratios were included for conducting a fair, fast and control-oriented analysis, says Birchall, (2014).

• Return-On-Assets (ROA)

This ratio, although being in use by nearly all businesses, was strictly included for arriving at an accurate assessment of the earnings of the bank, as is explained by Beaver, Correia & McNichols, (2011). The formula to be used is:

ROA = Earnings Before Interest and Tax (EBIT) / Total Assets.

• Return-On-Equity (ROE)

This, again, is a ratio which was being implemented for analysis in all businesses across the world. This could give the performance of the capital induced into the bank by shareholders (investment), asserts Hilb, (2016). The formula for assessing this ratio is:

ROE = Earnings Before Interest and Tax (EBIT) / Average Shareholder Equity

• Net Interest Margin (NIM)

This ratio was based on factors which included the net interest income of the bank divided by its Earning Assets. Both the factors to be used for calculating this ratio were given a wider perspective, explains ADB, (2014). The interest income would be determined after reducing the expenses incurred by the bank on earning this income. This factor will also include any other income which the bank earns and which is similar in nature to interest income, as per Anh et al (eds), (2017). The Earning Assets factor will include all the assets which provide an earning opportunity to the bank and would include – Balance with the State Bank of Vietnam + Loan and other Credits + Trading Securities + Loans extended to Customers. The formula is:

NIM = Net Interest and Similar Incomes / Earning Assets.

• Total Cost / Total Income

The purpose of this ratio is to know how much is the bank spending on earning the income, explains ADB, (2015).

• Total Staff Cost / Total Operating Cost

This ratio has been introduces with the purpose of knowing the cost bank is incurring on manpower to make an assessment of the efficiency of its workforce, says Hilb, (2016).

In this factor, a more realistic approach has been allowed by including the data related to the Bad Debts of a bank (commonly known as Nor-Performing Assets-NPA). The formula is: Assets Ratio = Total Non-Performing Loans / Total Assets.

More emphasis has been placed on this ratio as it can be accurately used for knowing the future standing of the bank. Here, three different ratios have been incorporated under this section, namely (i) Growth of Loans; (ii) Growth of Deposits; (iii) Growth of NPL, as detailed by Beaver, Correia & McNichols, (2011). So instead of just limiting the analysis to loans, the analysts makes a comparative analysis of these three ratios so that the growth can be understood on all parameters. The formulae used is:

• Growth of Loans Ratio = Loans to Customers / Deposits
• Growth of Deposits Ratio = (Current Year Deposits – Previous Year Deposits) / Total Deposits
• Growth of Non-Performing Loans Ratio = (Current Year NPLs – Previous Year NPLs) / Total NPLs

Liquidity Ratio here refers to the Net Ratio of the Total Loans to the Total Deposits of the bank, as detailed by Harker & Zenios (ed), (2000). The formula used is:

Liquidity-to-Deposit Ratio (LDR) = Total Loans / Total Deposits.

Also known as Capital Adequacy Ratio (CAR) is used for making an assessment of the bank’s ratio by using data related to Non-Cash Tier-1 Capital added with Non-Cash Tier-2 Capital and divided by the Risk Weighted Assets of the bank for the year, asserts Kumar, (2014). The formula is: Capital Adequacy Ratio (CAR) = [(Tier-1 Capital LESS Cash & Cash-Equivalents) + (Tier-2 Capital LESS Cash)] / Risk Weighted Asset.

Under this section, the analyst has started analysing the following factors – (i) Interest Margin Ratio; (ii) Net Non-Interest Cost Ratio; (iii) Interest Burden Ratio. The formulae for these ratios are:

• Interest Margin Ratio = Net Interest Income / Total Loans
• Net Non-Interest Cost Ratio = Service Income / Loans

A benchmark limit of 0.05% has been set for this ratio.

• Interest Burden Ratio = Interest Margin / Net Non-Interest Cost

Apart from these ratios, the regulating authorities have also fixed certain benchmarks, especially with respect to the loans given by the banks.

• Interest Margin / Total Loans factor should be below 6%.
• Operation Cost / Total Loans factor should be below 2%.
• Non Performing Loans / Total Loans factor should also be below 2%.
• ROA / Total Loans factor should also be below 2%.

A thorough discussion has been carried out in the DISCUSSION section about the factors which are of importance while carrying out an analysis for a bank using the EAGLES Methodology. In this section, we shall carry out a critical analysis of the ratios using the EAGLES Methodology for the two banks, namely TECHCOMBANK and SACOMBANK, explains Kovsted, Rand & Tarp, (2005). The data used for this analysis is available in TABLE-2 (for TECHCOMBANK) and in TABLE-3 (for SACOMBANK) and the ratios have been calculated and results shown in TABLE-1. The tables have been appended in Annexure below and Excel Spreadsheets have been attached separately, as detailed by Chatterjee et al (eds), (2014).  

1. Earning

• ROA

Against the banking industry’s benchmark figure of 0.51%, the performance of SACOMBANK was satisfactory during 2015 at 0.50% during this year. But in 2016, the bank slipped far behind the industry average, and at 0.05% it was touching just a fraction of even its own achievement of the previous year, asserts ADB, (2014). On the other hand, TECHCOMBANK maintained a very high percentage in both years, at 1.10% in 2015 and at 1.70% in 2016 against the banking industry benchmark of 0.51%.

• ROE

Against the banking industry’s benchmark figure of 5.49%, the performance of SACOMBANK at 4.00% in 2015 and at 0.70% was well below the satisfactory levels during both the years, as per Watanabe (ed), (2006). On the other hand, TECHCOMBANK maintained a very high percentage in both years, at 9.30% in 2015 and at 15.60% in 2016 against the banking industry benchmark of 5.49%.

• NIM

Against the banking industry’s benchmark figure of 3.50%, the performance of SACOMBANK was satisfactory during 2015 at 3.40% but it was much below the benchmark in 2016, when the bank slipped far behind the industry average, and maintained it at 1.93%, touching just a fraction of even its own achievement of the previous year, as detailed by ADB, (2015). On the other hand, TECHCOMBANK maintained a very high percentage in both years, at 5.50% in 2015 and at 4.70% in 2016 against the banking industry benchmark of 3.50%.

• OTHERS
• Total Cost to Total Income Ratio

Against the banking industry’s benchmark figure of 49.00%, the performance of SACOMBANK at 42.10% in 2015 was high as compared to 15.66% in 2016, although it remained below the industry average in both years. On the other hand, TECHCOMBANK maintained a very high percentage in both years, at 63.30% in 2015 and at 57.90% in 2016 against the banking industry benchmark of 49.00%.

• Total Staff Cost to Total Operating Cost

Against the banking industry’s benchmark figure of 49.00%, the performance of SACOMBANK was satisfactory during 2015 and 2016 at 55.40% and 54.78% respectively. TECHCOMBANK also maintained a high percentage in both years, at 58.30% in 2015 and at 51.00% in 2016 against the banking industry benchmark of 49.00%.

1. Assets

The industry standard for this ratio was fixed at 3.00%. SACOMBANK remained well below the benchmark at 1.18% in 2015 and at 0.73% in 2016 which was not a good sign of management strategy. TECHCOMBANK fared more badly in both the years, when it was not even able to show positive figures for both the years. Its figure for 2015 stood at (-)2.50% and at (-)2.19% in 2016.

1. Growth

Although Growth contained three ratio factors, (i) Growth of Loans; (ii) Growth of Deposits; (iii) Growth of NPL, both the banks did not register any growth under (ii) and (iii) in both years, as explained by Birchall, (2014). In the year 2015 and 2016, growth of loans was reported as 70.40% and 67.30% respectively by SACOMBANK. TECHCOMBANK did better in comparison to SACOMBANK by registering growth in Loans At 77.70 % In 2015 And 81.80% In 2016.

1. Liquidity

In this ratio factor, both banks faired quite well in both years. Against the industry benchmark of 60%, SACOMBANK reported Liquidity-to-Deposit ratio at 70.40% and at 66.60% in 2015 and 2016 respectively, asserts Mayo, (2015). TECHCOMBANK also reported healthy figures of 77.00% and 81.80 % for 2015 and 2016 respectively. It is imperative here to point out that in 2015 SACOMBANK reported the same quantum of 70.40%, both for Growth as well as Liquidity. ON the other hand, in 2016 TECHCOMBANK had reported the same quantum of 81.80%, in its Growth and Liquidity ratios.

1. Capital Adequacy Ratio (Car)

This ratio was fixed at 12.75% by the banking industry regulators. Against this, SACOMBANK reported 10.96% in 2015 and 9.61% in 2016, which was low in comparison to industry standards but was satisfactory. However, TECHCOMBANK was more robust in its performance by reporting 14.70% in 2015 and 13.10% in 2016, well above the industry standard in both the years.

1. Strategy

Two ratios were considered under this heading by both the banks as detailed below.

• Interest Margin

Against the banking industry’s benchmark figure of 6.00%, the performance of SACOMBANK at 3.50% in 2015 was good as compared to 2.02% in 2016, although it remained below the industry average in both years. On the other hand, TECHCOMBANK maintained a good percentage in both years, at 5.80% in 2015 and at 5.00% in 2016 against the banking industry benchmark of 6.00%.

• Net Non-Interest Cost

Against the banking industry’s benchmark figure of 2.00%, the performance of SACOMBANK was satisfactory during 2015 and 2016 at 0.01%. TECHCOMBANK also maintained a satisfactory percentage in both years, at 0.39% in 2015 and at 0.42% in 2016 against the banking industry benchmark of 2.00%.

Conclusion

On the basis of the Critical Analysis carried out above with the help of EAGLES Methodology, this report suggests the following for improving the various factors connected with TECHCOMBANK and SACOMBANK, asserts Grier, (2007).

1. For enhancing effectiveness and efficiency of the management

This report suggests the following aspects to be improved –

• Strengthen the bank’s strategic management policy
• Develop responsible Risk Management procedures and system
• Improve the quality of bank’s loan information
• Improving the quality of bank’s credit control activities
• Improve the appraisal & approval process of loans

1. Solutions for enhancing bank’s operating capability

This report suggests the following aspects to be improved –

• Improving the process of resolving outstanding debts
• Improving the process of dealing with bank’s bad loans
• Reducing bank’s operating expenses
• Selecting customer segments for risk factors
• Continued cooperation with multilateral institutions such as World Bank, ADB, JICA, SECO, IFC
• Increase investments in innovation and modernize bank’s business activities

1. Solutions for improving quality of bank’s products and services

This report suggests the following aspects to be improved –

• Classification of customer base for loan purposes
• Develop credit policies suitable for corporate customers
• Improve and diversify lending products for consumers
• Improve and standardize latest product range to increase service fee income
• Invest and upgrade software for avoiding clogging of network
• Improve quality of the existing service infrastructure
• Strengthen customer communication activities and plan long-term marketing

1. Solutions for developing high-quality human resources

This report suggests the following aspects to be improved –

• Provide to staff professional training and skills
• Develop a standardized process for job titles
• Provide professional level training to all new cadres
• Improve and enhance human quality structure and international cooperation

References

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