Understanding Key Bank Ratios: A Comprehensive Guide

Bank-specific ratios, such as net interest margin (NIM), provision for credit losses (PCL), and efficiency ratio are unique to the banking industry. Similar to companies in other sectors, banks have specific ratios to measure profitabilityProfitability RatiosProfitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific period of time. They show how well a company utilizes its assets to produce profit and efficiency that are designed to suit their unique business operations. Also, since financial strength is especially important for banks, there are also several ratios to measure solvencySolvencySolvency is the ability of a company to meet its long-term financial obligations. When analysts wish to know more about the solvency of a company, they look at the total value of its assets compared to the total liabilities held..

Ratios for Profitability

1. Net Interest Margin

Net interest margin measures the difference between interest income generated and interest expenses. Unlike most other companies, the bulk of a bank’s income and expenses is created by interest. Since the bank funds a majority of their operations through customer deposits, they pay out a large total amount in interest expense. The majority of a bank’s revenue is derived from collecting interest on loans.

The formula for net interest margin is:

Net Interest Margin = (Interest Income – Interest Expense) / Total Assets

Ratios for Efficiency

1. Efficiency Ratio

The efficiency ratio assesses the efficiency of a bank’s operation by dividing non-interest expenses by revenue.

The formula for the efficiency ratio is:

Efficiency Ratio = Non-Interest Expense / Revenue

The efficiency ratio does not include interest expenses, as the latter is naturally occurring when the deposits within a bank grow. However, non-interest expenses, such as marketing or operational expenses, can be controlled by the bank. A lower efficiency ratio shows that there is less non-interest expense per dollar of revenue.

2. Operating Leverage

Operating leverage is another measure of efficiency. It compares the growth of revenue with the growth of non-interest expenses.

The formula for calculating operating leverage is:

Operating Leverage = Growth Rate of Revenue – Growth Rate of Non-Interest Expense

A positive ratio shows that revenue is growing faster than expenses. On the other hand, if the operating leverage ratio is negative, then the bank is accumulating expenses faster than revenue. That would suggest inefficiencies in operations.

Ratios for Financial Strength

1. Liquidity Coverage Ratio

As the name suggests, the liquidity coverage ratio measures the liquidity of a bank. Specifically, it measures the ability of a bank to meet short-term (within 30 days) obligations without having to access any outside cash.

The formula for the liquidity coverage ratio is:

Liquidity Coverage Ratio = High-Quality Liquid Asset Amount / Total Net Cash Flow Amount 

The 30-day period was chosen as it is the estimated amount of time it takes for the government to step in and help a bank during a financial crisis. Thus, if a bank is capable of fund cash outflows for 30 days, it will not fall.

2. Leverage Ratio

The leverage ratio measures the ability of a bank to cover its exposures with tier 1 capital. As tier 1 capital is the core capital of a bank, it is also very liquid. Tier 1 capital can be readily converted to cash to cover exposures easily and ensure the solvency of the bank.

The formula for the leverage ratio is:

Leverage Ratio: Tier 1 Capital / Total Assets (Exposure)

3. CET1 Ratio

The CET1 ratio is similar to the leverage ratio. It measures the ability of a bank to cover its exposures. However, the CET1 ratio is a more stringent measurement, as it only considers the common equity tier 1 capital, which is less than the total tier 1 capital. Also, for the ratio’s calculation, the risk level of the exposure (asset) is considered as well. A higher risk asset is given a higher weighting of risk, which lowers the CET1 ratio.

The formula for the CET1 ratio is:

CET1 Ratio = Common Equity Tier 1 Capital / Risk-Weighted Assets

Other Bank-specific Ratios

1. Provision for Credit Losses (PCL) Ratio

The provision for credit losses (PCL) is an amount that a bank sets aside to cover loans they believe will not be collectible. By having such an amount set aside, the bank is more protected from insolvency. The PCL ratio measures the provision for credit losses as a percentage of net loans and acceptances. Looking at it enables investors or regulators to assess the riskiness of loans written by the bank in comparison to their peers. Risky loans lead to a higher PCL and, thus, a higher PCL ratio.

The formula for the provision for credit losses ratio is:

Provision for Credit Losses Ratio = Provision for Credit Losses / Net Loans and Acceptances

Additional Resources

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