A bank health check is a comprehensive assessment of a bank’s financial condition, performance and risk management practices. It is conducted by banking regulators or independent auditors to evaluate the bank’s ability to withstand adverse economic conditions and potential risks, including credit risk, market risk, liquidity risk and funding risk.
The bank’s financial statements, including the balance sheet, income statement and cash flow statement, as well as its risk management methods, are often thoroughly examined as part of the health check.
Here are nine fundamental metrics to analyze the health of a bank.
Why is a health check important?
It is important to perform a bank health check because it enables regulators and stakeholders to assess a bank’s financial stability and operational effectiveness. This enables prompt measures to reduce these risks and helps detect potential hazards and vulnerabilities that could impair the bank’s performance. Additionally, it supports financial sector stability and maintains public confidence in the banking system.
During the 2007–2008 global financial crisis (GFC), several poor practices contributed to the collapse of the global financial system. For instance, banks and financial institutions were providing loans to high-risk borrowers with poor credit histories, which resulted in a significant number of loan defaults. These subprime mortgages were packaged into complex financial instruments and sold to investors as high-yielding securities, ultimately leading to a collapse in the housing market.
The second-largest bank failure in United States history occurred on March 10, 2023, when Silicon Valley Bank (SVB) collapsed following a bank run, surpassing the largest bank failure since the 2008 financial crisis. During a period of near-zero interest rates, SVB invested heavily in U.S. government bonds, assuming they were a safe investment. However, this strategy backfired when the Federal Reserve began aggressively raising interest rates to curb inflation. As interest rates climbed, bond prices fell, resulting in a decline in the value of SVB’s bond portfolio and ultimately its collapse.
Related: Silicon Valley Bank collapse: How SVB stock price performed in 5 years
A lack of proper regulatory oversight allows financial institutions to engage in risky practices without proper checks and balances. Therefore, sound risk management practices are the key to a bank’s positive financial health and, ultimately, the effectiveness of the global financial system.
Key metrics to assess the health of a bank
The metrics that provide a unique insight into the bank’s financial health and performance 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 present value of its assets and liabilities. It indicates the amount of equity that would be left after liquidating all assets and liabilities and meeting all obligations. EVE is a frequently used measure in the computation of interest rate risk in the banking book (IRRBB), and banks must gauge IRRBB using this metric.
Regular appraisal of the EVE is required by the U.S. 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 recognized yardstick utilized for ascertaining interest rate risk.
The formula for calculating EVE is as follows:
For example, suppose a bank has a market value of equity of $10 million, and the present value of expected future cash flows from assets is $15 million, while the present value of expected future cash flows from liabilities is $12 million. Using the EVE formula, one can calculate the economic value of equity as follows:
Negative EVE indicates that the bank needs more money to meet its obligations because its liabilities exceed its assets. As a result, the long-term financial stability and ability of the bank to fulfill its obligations could be seriously jeopardized. Thus, it is essential that the bank implement corrective measures to enhance its economic equity value and lower its interest rate risk.
Net interest margin (NIM)
This represents the difference between interest income and expenses for a bank. It illustrates the bank’s ability to make money from its assets (loans, mortgages, etc.) in relation to its funding costs (deposits, borrowing, etc.).
Let’s take an example of a bank with the following financial data for a given year:
- Interest income earned on loans and securities: $10 million
- Interest expense paid to depositors and creditors: $5 million
- Total assets: $500 million
- Total liabilities: $400 million.
Using this information, one can calculate the NIM of the bank as follows:
This indicates that the bank makes a net interest income of one penny for every dollar of assets it holds. A higher NIM shows that the bank is more profitable since it is generating more income from its assets than it is spending on interest. In contrast, a lower NIM shows that the bank is less profitable because it is making less money off of its assets than it is spending on interest.
Efficiency ratio
This is the ratio of a bank’s non-interest expense to its revenue. A lower ratio indicates higher efficiency and profitability.
Let’s take an 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 efficiency ratio of the bank can be calculated as follows:
This indicates that for every $1 of income the bank generates, it spends $0.50 on operating costs. A high-efficiency ratio might be a warning sign for a bank, suggesting that it might struggle to make money and might find it difficult to stay competitive.
An efficiency ratio of more than 60% is generally regarded as having a high-cost structure, which may result in decreased profitability and may be a sign that the bank needs to take action to increase its operational efficiency, such as by streamlining its operations, cutting costs associated with overhead or enhancing its capacity to generate revenue.
Return on assets (ROA)
This measures how successfully a bank is turning a profit from its assets. Better performance is indicated by a higher ROA.
Suppose that Bank A has a net income of $5 million and total assets of $100 million. Now, its ROA will be:
A high ROA — e.g., over 1% — indicates that the bank is earning a good return on its assets and is efficient in generating profits or vice versa.
Return on equity (RoE)
This measures the profitability of a bank in relation to shareholder equity. A higher ROE indicates better performance.
Suppose that Bank B has a net income of $4 million and shareholders’ equity of $20 million. Now, its ROE will be:
Non-performing loans (NPLs)
This is the ratio of the bank’s non-performing loans to its total loans. A high NPL ratio indicates higher credit risk and potential loan losses. Let’s say a bank has a $1-billion loan portfolio. Because the borrowers have missed payments for more than 90 days, $100 million (or 10%) of these are classified as non-performing loans.
If the bank has to set aside a provision of 50% for these non-performing loans, it would need to allocate $50 million toward provisions. This means that the bank’s net loan portfolio would be $950 million.
Let’s now imagine that the bank must write off these non-performing loans because it will not be able to recover $20 million from them. As a result, the bank’s loan portfolio would drop to $930 million, which would have an effect on the bank’s profitability and capital adequacy ratios.
This example illustrates how non-performing loans can have significant implications for a bank’s financial position, and why it is crucial for banks to manage their loan portfolios effectively to minimize the risk of such loans.
Cost-to-income ratio
This is the ratio of a bank’s operating costs to its operating income. A lower ratio indicates higher efficiency and profitability.
For example, let’s say a bank has total operating expenses of $500 million and a total operating income of $1 billion. The cost-to-income ratio for this bank would be:
This means that the bank spends $0.50 on operating costs for every dollar of operational income it generates. In general, a lower cost-to-income ratio is preferable since it shows that the bank is more profitable and efficient because it can generate more income with fewer expenses.
Loan loss provisions coverage ratio
This is the ratio of a bank’s loan loss provisions to its non-performing loans. It reflects the bank’s ability to cover potential loan losses with its provisions.
For example, let’s say a bank has loan loss provisions of $100 million and nonperforming loans of $50 million. The loan loss provisions coverage ratio for this bank would be:
Capital adequacy ratio (CAR)
The capital adequacy ratio assesses a bank’s ability to pay liabilities and handle credit and operational risks. A good CAR indicates that a bank has enough capital to absorb losses and avoid insolvency, protecting depositors’ funds.
Here is the formula to calculate 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 shareholder equity and retained earnings. Tier 2 is supplementary capital, including revalued and undisclosed reserves and hybrid securities.
Risk-weighted assets are a bank’s assets weighted by risk, with each asset class assigned a risk level based on its likelihood to decrease in value. The risk weighting determines the sum of the bank’s assets and varies for each asset class, such as cash, debentures 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 would be:
In this case, the bank’s CAR is 15%, which indicates that it has sufficient capital to cover its potential losses from its lending and investment activities.
Why is decentralization necessary?
Decentralized finance (DeFi) enables financial systems that are 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 centralized financial systems, leading to an increased interest in the decentralization of banking.
Related: Banks down? That is why Bitcoin was created, crypto community says
However, DeFi also has its share of risks that should not be neglected. For instance, the market volatility of cryptocurrencies can create significant risks for those investing in DeFi platforms. Therefore, it is essential for investors to carefully consider such risks and conduct their due diligence before investing in any DeFi project.