Bank efficiency ratio

From CEOpedia | Management online

The bank efficiency ratio is tools used to measure profitability and economic efficiency, i.e. the overall efficiency of a bank's operations, both of a qualitative and quantitative nature. One of the simplest techniques of effectiveness measurement is the indicator analysis based on data from financial statements [1]. Although these measures are often criticized because of their low information value and lack of links with microeconomic theory, they are most often used, mainly because of their simplicity and clarity. The most useful is the classification of indicators from their origin, including [2]:

  • balance sheet indicators,
  • indicators of the profit and loss account,
  • mixed indicators, where one component comes from the balance sheet and the other from the profit and loss account.

Efficiency

Efficiency is a state where a change in the satisfaction of one entity will not negatively affect the level of satisfaction of another holder. Also, efficiency is achieved when the incremental costs of meeting a particular objective are equated with the incremental benefits of meeting that objective. The higher the relationship is, in other words, the greater the difference between the effects and the inputs, the higher the efficiency of the facility is considered to be. Effectiveness can be identified with profitability. Efficiency is the result of two factors, i.e. efficiency and economy [3]. What is effective, however, is an action that produces a result - a result equal to the assumed one. On the other hand, economic is an action that allows achieving the assumed result at the lowest cost [4].

Types of bank efficiency

The effectiveness of banks is measured using tools of the following nature both qualitative and quantitative. One of the simplest techniques for measuring effectiveness is indicator analysis. Three types of bank effectiveness can be distinguished, namely [5]:

  • Organizational effectiveness about the organization's objectives, its resources, and conditions inside and outside the organization and the time at which the concept is evaluated.
  • Financial effectiveness, which relates to the assessment of the financial performance and financial position of a bank based on financial statements, and is based on financial ratios.
  • Cost-effectiveness, which is the assessment of whether a given production volume was achieved with an appropriate volume and structure of inputs.

The efficiency of banks is measured using the following indicators [6]:

  • NIM (Net Interest Margin)
  • COR(Cost Of Risk)
  • ROA (Return On Assets)
  • ROE (Return On Equity)
  • ROI (Return On Investment)

NIM (net interest margin)

One of the most important measures for banks is the net interest margin (NIM). Jet is the ratio of the net interest margin to the average assets less the interest accrued on non-performing receivables. It is obtained by dividing the interest income (the most important source of the sector's earnings, accounting for two-thirds of its revenues) by the average value of interest assets in a given period. The NIM is determined by how much interest income the bank manages to "squeeze out" at a given size of assets (interest income is the difference between interest income and interest expenses, to put it simply - it is the difference between interest collected and paid by the bank). NIM measures the bank's profitability obtained from its core business, which is - in simpler terms - financial market intermediation. The level of this ratio depends on many factors, including the level of interest rates, the bank's willingness to finance more risky customers (then it hedges itself with a higher margin), the structure of its loan portfolio or liquidity in the sector, the demand for money and the degree of consolidation and competition in the banking sector [7].

COR (cost of risk)

The COR is the resultant of the bank's vulnerability to risk and its ability to properly assess the risk. The COR is calculated by dividing the result on loan write-offs by the average value of the net loan portfolio in a given period [8].

ROA (return on assets)

Return on Assets (ROA) is the ratio of a company's net profit to the value of its assets; it can also be calculated as the product of return on sales and the ratio of turnover in assets [9]. It indicates the company's ability to generate profits and the effectiveness of managing its assets. The higher the ROA, the better the financial condition of the company. This indicator is important, among others, for financial institutions that are considering granting a loan and studying the possibility of its repayment.

ROE (return on equity)

Return on Equity (ROE) is a profitability indicator which means how much profit the company managed to generate from the contributed equity. When calculating ROE, the profit for a given period counts towards the equity at the beginning of the given period.

Net profit through equity expressed in % = ROE

The higher the value of this indicator, the more favorable the situation of the company. Higher efficiency of equity capital is connected with the possibility of obtaining a higher financial surplus and, consequently, higher dividends [10].

ROI (return on investment)

Return on Investment (ROI) is a profitability indicator used to measure the efficiency of a company, regardless of the structure of its assets or extraordinary factors [11]. ROI method is used to measure absolute profitability for all providers of capital and can be interpreted economically as a rate of return on investment incurred for the implementation of the investment. It belongs to a group of simple methods, which assume that the excess net benefit from the investment is measured by the accrual profit and the time value of money is constant [12]. The method is often used to assess the profitability of IT, marketing and training projects. It is also used to assess the social profitability of projects. In the last example, ROI is referred to as SROI, i.e. Social Return on Investment.

Examples of Bank efficiency ratio

  • Return on Assets (ROA): This measures the bank's ability to generate profit from its total assets. It is calculated by dividing the net income (after taxes) by the total assets.
  • Return on Equity (ROE): This measures the bank's ability to generate profits from its shareholders' equity. It is calculated by dividing the net income (after taxes) by the total shareholders' equity.
  • Net Interest Margin (NIM): This measures the bank's profitability on its lending activities. It is calculated by dividing the net interest income by the average interest-earning assets.
  • Operating Expense Ratio (OER): This measures the bank's efficiency in managing expenses. It is calculated by dividing the total operating expenses by total income (before taxes).
  • Efficiency Ratio (ER): This measures the amount of expenses associated with generating income. It is calculated by dividing the total expenses (before taxes) by total income (before taxes).
  • Cost to Income Ratio (CIR): This measures the cost of generating income. It is calculated by dividing the total operating expenses by total income (before taxes).

Advantages of Bank efficiency ratio

The Bank Efficiency Ratio is a useful tool used to measure both the profitability and economic efficiency of a bank's operations. It provides a comprehensive assessment of the performance of a given bank and can be used to compare against the performance of other banks. Here are some advantages of using the Bank Efficiency Ratio:

  • It is a quantitative measure, which helps with decision making and evaluating performance.
  • It measures different aspects of a bank’s performance such as total assets, total liabilities, net income, and various other financial metrics.
  • It is a good indicator of a bank’s overall efficiency and profitability, and can be used to benchmark performance against other similar banks.
  • It helps to identify areas where a bank can improve its performance and increase efficiency.
  • It can help to identify potential cost savings and streamline processes to increase profitability.

Limitations of Bank efficiency ratio

The Bank efficiency ratio is an effective tool for measuring profitability and economic efficiency, however there are certain limitations to be considered when using it. These include:

  • It does not factor in external market conditions and economic cycles, which can influence the performance of a bank.
  • It does not account for off-balance sheet activities, such as derivatives and other transactions that are not included in financial statements.
  • It does not consider the risk associated with certain activities, such as credit risk and liquidity risk.
  • It cannot be used to compare the performance of different banks, as the ratio is based on the performance of a single bank.
  • It does not take into account the cost of capital, which can have a significant impact on profitability.
  • The accuracy of the ratio is dependent on the accuracy of the data used in the calculations, which can be subject to errors.

Other approaches related to Bank efficiency ratio

One of the most commonly used methods of measuring a bank's efficiency is the Bank Efficiency Ratio. This method looks at the overall performance of the bank, both quantitatively and qualitatively, to determine its efficiency. Below are some of the other approaches related to Bank Efficiency Ratio:

  • Cost-Income Ratio (CIR): This ratio measures the cost of running a bank against the income it generates. It indicates how well a bank is managing its costs and how much profit the bank is generating.
  • Asset Utilization Ratio: This ratio measures how efficiently a bank is utilizing its assets to generate income. It is calculated by dividing the bank’s total assets by its total income.
  • Return on Assets (ROA): The return on assets ratio measures how efficiently a bank is using its assets to generate income. It is calculated by dividing a bank’s net income by its total assets.
  • Return on Equity (ROE): This ratio measures the return on a bank’s equity investment. It is calculated by dividing a bank’s net income by its total equity.

In summary, Bank Efficiency Ratio is a tool used to measure the overall efficiency of a bank's operations. Other approaches related to Bank Efficiency Ratio are Cost-Income Ratio, Asset Utilization Ratio, Return on Assets and Return on Equity.

Footnotes

  1. S.A. Jamil, F. Alshubiri, I. Fattouh 2016, pp. 15-17
  2. B.M.S. Sillah, I. Khokhar, N. Khan 2014, pp. 233-234
  3. B.M.S. Sillah, I. Khokhar, N. Khan 2014, pp. 233-234
  4. D. Memić, S. Škaljić-Memić 2013, pp. 126-128
  5. D. Memić, S. Škaljić-Memić 2013, pp. 132
  6. D. Memić, S. Škaljić-Memić 2013, pp. 132
  7. I. Akomea-Frimpong 2017, pp. 21-23
  8. J. P. Hughes, J. Jagtiani, L. J. Mester 2016, pp. 12-14
  9. K. Ohene-Asare, M. Asmild 2012, pp. 146
  10. K. Ohene-Asare, M. Asmild 2012, p. 171
  11. J. W. Bos, C. J. Kool 2006, p. 1953
  12. J. W. Bos, C. J. Kool 2006, pp. 1953-1955


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References

Author: Hubert Olech