Overview of Banking

Profitability of Bank

How Do Banks Earn Profits?

The majority of revenue comes from accepting deposits from consumers and then lending that money, with interest, out to individuals and businesses in the form of bank loans. You are most likely very familiar with the fact that banks also make money by charging fees. Additionally, banks even earn returns on investments

Bank Earnings
Interest and fees on loans is traditionally the major source of income for commercial banks. Earnings from the Money market Return on Equity(ROE) Return on Assets(ROA) Interest Margin

Bank Earnings: Non Interest

Non-interest income is earned by providing a variety of services, such as trading of securities, assisting companies to issue new equity financing, securities commissions and wealth management, sale of land, building, profit and loss on revaluation of assets etc. Ex:- Fees ,Service charges

Profitability Analysis
It decomposes cost management and revenue management into narrower categories of cost and revenue to evaluate the source of profits. It includes: Assets utilization

Determination of net interest income.

Efficiency ratio

Analysis of non interest expense.

Determination of net interest expense. Profit vs. risk

Return on Asset (ROA)

Return on Asset = (Free income + Net interest income

operating cost)/ Average total assets

Or Return on Asset = Net income/Average total asset It tells that what an bank is earning on its total asset.

Net Interest Income

Net Interest Income = Interest Received on Assets - Interest Paid on Liabilities Or Net Interest income =Interest Earned on Securities & LoansInterest Paid on Deposits and Borrowings

High net interest income and margin indicates a well managed bank and also indicates future profitability.

Net Interest Margin

It shows how well the bank is earning income on its assets.

Net Interest Margin = Net Interest Income / Average total assets

Where, Average Total Assets =(Total Assets at End of Fiscal Year - Total Assets at Start of Fiscal Year) /2

Return on Equity(ROE)
The Return on equity is what the bank's owners are primarily interest in because that is the return that they earn on their investment. When a bank increases its liabilities to pay for assets, it is using leverage otherwise a bank's profit would be limited by the fees that it can charge and its interest rate spread. Interest rate spreads are not wide and so a bank can only earn more net interest income by increasing the number of loans that it makes compared with the amount of its bank capital which it does by using leverage.

Profit v/s Risk

Earning high profits in good or even normal times will be easier if the bank is willing to take on some risk. This risk may be more problematic in bad times. Important to measure the risk of the banking system as well as the profits.

Banking Dilemma: Profitability Versus Safety

One way for a bank to increase expected profits is to take on more risk. For a bank to survive, it must balance the demands of three constituencies: shareholders, depositors, and regulators, each with their own interest in profitability and safety. The bank has to be concerned with shareholder wealth maximization.

(Cont)

Contd.
Banks supply liquidity to customers. Depositors store their liquidity in banks; loan customers come to the bank to borrow liquidity. The bank supplies liquidity from two sources: sale of assets and borrowing.

The Dilemma
A bank must successfully balance profitability on one hand and liquidity and solvency on the other. Bank failure can result from the depletion of capital caused by losses on loans or securities -- from over-aggressive profit seeking. But a bank that only invests in high-quality assets may not be profitable. Failure can also occur if a bank cannot meet the liquidity demands of its depositors -- a run on the bank occurs. If assets are profitable, but illiquid, the bank also has a problem.

Profitability of Banks in India: Current Scenario

According to a Credit Rating and Information Services of India (Crisil) study, Lower operating expenses including rationalisation of employee costs have improved the profitability of banks, contrary to the popular perception that only trading profits helped the banking sector shore up their bottom lines. The reduction in operating expenses was achieved through largescale voluntary retirement schemes implemented by public sector banks. Since this reduction in operating expenses seems sustainable, it promises a brighter future for the banking sector. The efficiency profitability models adopted at various branches of banks which help in enhancing and profitability of banks.