Recently, the 3 local banks reported a better set of results than expected. Banks have a unique set of operating and financial metrics that are different from other industries and their financial statements cannot be analysed based on the usual metrics. This blog post attempts to explain the various metrics used in banks' financial statements. I will use DBS' financial statements as examples for the metrics, but they are applicable to the other 2 banks.

Net Interest Income

At the core of a bank's operations is its business of taking short-term deposits and making long-term loans. Banks charge higher interest rates for the loans and pay lower interest rates for the deposits, thereby profiting from the difference in interest rates. This difference is known as the Net Interest Margin (NIM). The higher the NIM, the more profits the bank generates from its lending operations. In the last 6 months, the NIM of banks have come off steeply as the US Federal Reserve lowered interest rates sharply to stave off an impending recession caused by the COVID-19 pandemic. For DBS, its NIM has dropped from 1.86% in Dec 2019 to 1.53% in Sep 2020.

Many factors affect the NIM. One of them is the Loan-to-Deposit Ratio (LDR). This ratio indicates how much deposits are lent out as loans. The higher the LDR, the more loans are made from the deposits. However, it is never a good idea to lend out 100% of the deposits, because if depositors were to withdraw money from the bank at short notices, the bank would have to find other sources of funds to replace them. These alternative sources of funds are usually more expensive than customers' deposits. Due to the COVID-19 recession, depositors have flocked back to the safety of the 3 major banks. For DBS, its LDR has dropped from 89% in Dec 2019 to 83% in Sep 2020 as it receives more deposits than it could loan out.

Another factor is the Current Account Savings Account (CASA) Ratio. Banks obtain their funds from current accounts, savings accounts, fixed deposits, bank bonds, shareholder equity, etc. This ratio describes the percentage of deposits that are from current and savings accounts, which have the lowest cost of funds among all funding sources.Thus, the higher the CASA ratio, the lower the interest rate paid to depositors and the higher the NIM would be. For DBS, the CASA ratio went up from 58.9% in Dec 2019 to 69.5% in Sep 2020. This is likely due to the low interest rates offered on fixed deposits, which discourage depositors from renewing their fixed deposits. 

Credit Costs

Although banks profit from the Net Interest Income, there are also loans that might potentially go bad and have to be written off, which reduces the lending profits. The key metric is the Non-Performing Loan (NPL) Ratio. This ratio describes the percentage of loans that might potentially go bad. Note that this ratio reflects the total amount of outstanding NPLs at a snapshot in time and not new NPLs incurred during the reporting period. For DBS, the NPL ratio has largely stayed constant, from 1.5% in Dec 2019 to 1.6% in Sep 2020.

How banks deduct losses from bad loans is by setting aside allowances in the income statement. Note that these allowances do not necessarily mean that the bad loans are irrecoverable. If the economy recovers and the companies do well again, the bank could write-back the past allowances made, thereby increasing the profit in future reporting periods.

There are 2 types of allowances -- general provisions and specific provisions. General Provisions (GP) are for potential bad loans in the industry as a whole, while Specific Provisions (SP) are for bad loans of specific companies. For example, retailers are facing significant challenges from e-commerce and COVID-19. Banks might set aside more general provisions for loans to retailers. On the other hand, Robinsons' closure means that banks that are exposed to it have to set aside more specific provisions for loans to Robinsons.

In recent years, banks have adopted the Expected Credit Loss (ECL) model, which requires banks to estimate the expected amount of credit losses from the loans. There are 3 stages in the ECL model. ECL Stages 1 and 2 correspond to GP while ECL Stage 3 corresponds to SP.

For 3Q2020, DBS set aside $236M in GP and $318M in SP. As a percentage of total loans on an annualised basis, the SP credit cost is 0.31% or 31 basis points. The GP credit cost works out to be 23 basis points.

Thus, for 3Q2020, DBS made NIM of 1.53%, but had to set aside credit costs of 0.31% in SP and 0.23% in GP. After deducting the credit costs, DBS made 0.99% from its lending operations.

From another perspective, DBS' NPL ratio is 1.6%, which is close to the NIM of 1.53%. In other words, the Net Interest Income that DBS makes in 1 year is nearly sufficient to write off all the existing NPLs.

Allowance Reserves

The GP and SP set aside in each reporting period go to the allowance reserves. When the loan eventually cannot be recovered, the loan amount is deducted from the reserves. There is no further impact on the income statement.

There is another reserve known as Regulatory Loss Allowance Reserve (RLAR). Allowances for RLAR are set aside from retained earnings instead of from the income statement, i.e. profits are not reduced by the amount set aside for RLAR, unlike GP and SP. However, there is no free lunch. When the loan eventually cannot be recovered, the loan amount is deducted from RLAR and from the income statement.

Together, the GP and SP reserves and RLAR form a pool of allowance reserves to cover Non-Performing Assets (NPA). NPAs are similar to NPLs, but include other NPAs in the banks' non-lending businesses, such as wealth management, brokerage, etc.. The (Total Allowance & RLAR)/NPA Ratio indicates the percentage of NPAs which is covered by the total allowance reserves. For DBS, this ratio is 107% in Sep 2020, which means that all NPAs are fully covered by the reserves. If this ratio is less than 100% and if all NPAs were to be irrecoverable, any shortfall will have to be deducted from the income statement. If this results in a loss, it will reduce the bank's capital, which might affect the stability and liquidity of the bank (see next section). Thus, the total allowance reserves provide a cushion for bad loans before the income statement and bank's capital are impacted. Having said the above, there is no requirement for the ratio to be above 100%, since not all NPAs will end up being irrecoverable.

Some NPAs are secured by collaterals. For these loans, banks could take over and sell the collaterals to recover the loans. Hence, there is a corresponding ratio that considers only unsecured NPAs. This is the (Total Allowance & RLAR)/Unsecured NPA Ratio. For DBS, this ratio is 200% in Sep 2020, which means that the allowance reserves are sufficient to cover unsecured NPAs by 2 times. The high ratio helps to cushion instances whereby the collaterals are worth less than the loan amount.

Stability & Liquidity

Banks are systematically important to the economy and failure of a bank could lead to disastrous consequences. To guard against such scenarios, banks are required to have sufficient capital reserves to absorb loan losses. This is measured by Capital Adequacy Ratios (CAR). Capital can be classified as Tier 1 or Tier 2, with Tier 1 being more reliable than Tier 2. Tier 1 capital comprises share capital and audited retained earnings, while Tier 2 capital comprises unaudited retained earnings and general loss reserves. CARs are measured by dividing the specific tier of capital over Risk-Weighted Assets (RWA). Different types of loans have different risks (e.g. secured/ unsecured), and RWA considers the likelihood of the assets going bad.

The most important CAR is the Common Equity Tier 1 (CET1) Ratio. This ratio is most keenly watched by investors, as it has implications on the amount of dividends the bank can declare. If the CET1 ratio is too low for regulators' comfort, regulators could ask the bank to stop dividends so that earnings could be retained to build up the CET1 capital. Similarly, banks could also raise capital via rights issues.

In Sep 2020, DBS' CET1 ratio is 13.9%, which is above the bank's target ratio of 12.5% to 13.5%. For reference, the last time DBS carried out a rights issue was in Dec 2008, at the height of the Global Financial Crisis (GFC). Its Tier 1 CAR then was 10.1%. Post-issuance, the Tier 1 CAR rose to 12.5% in Mar 2009.

The GFC saw governments stepping in to rescue major banks that were at risks of failing. Since then, regulators have introduced 2 additional measures to ensure that banks would not fail again. The Liquidity Coverage Ratio (LCR) measures how much High Quality Liquid Assets the bank has to meet estimated total net cash outflows over a 30-day stress scenario. The Net Stable Funding Ratio (NSFR) measures the amount of available stable funding relative to the amount of required stable fuinding. The LCR and NSFR measure the short-term and mid/long-term resilience of the banks respectively and must be above 100%. For DBS, the LCR and NSFR are 135% and 123% respectively in Sep 2020.

The Leverage Ratio measures the amount of loans relative to the bank's equity. It is similar to the Debt-to-Equity ratio for other industries. For DBS, the leverage ratio is 6.9 times in Sep 2020.

Other Ratios

Other ratios include Return on Assets (ROA) and Return on Equity (ROE). These ratios should be familiar with investors since they also apply to other industries. Another ratio is the Cost-to-Income Ratio, which measures how efficient the bank is in controlling costs relative to income. Some banks also report the Non-Interest Income to Total Income Ratio, which measures how much income the bank generates outside its lending business. A higher ratio means that there is great diversity in the income sources.

Conclusion

This blog post explains the operating and financial metrics that are relevant to banks. With this information, hopefully investors will be able to understand the financial performance of banks better.

See related blog posts:

• A Comparison of the 3 Local Banks (2016)