Measuring And Evaluating A Banks Performance Finance Essay
Banks are an integral part of the whole financial system and are linked to the growth of the economy as it provides the function of financial intermediation whereby linking surplus units with deficit units. This function along with the banks function of making different investments is known as the ‘Portfolio Function.’ According to the theory of finance there is one other function of banks and that is known as the ‘Transaction Function’, which means that banks help in the transfer of wealth between different generations. So to be able to perform all these functions with ease and with certain standard a bank must perform well and in simpler words, it should be efficient.
Also it means that the financial sector, especially banks, along with its growth and development, plays a vital role in the development and the growth of the country’s economy as it helps in credit creation due to which more investments are made into the economy.
But when we look at the case of Pakistan we see that at the time of independence Pakistan was at the losing end as it inherited a not fully functional financial sector and even after that the development in this finance sector was not up to the mark which then led to a further downfall in the performance of the financial sector of Pakistan. It was not up to the mark because at the time of independence Pakistan had only one bank which was Habib Bank and then after that not many banks opened. But the few which did open were initially state owned and the massive privatization in the 1970’s also meant that the new banks which had opened were under more scrutiny now as now there were high regulations and the government and regulatory authorities were now intervening more. As a result the efficiency of the still under developed financial mainly banking sector was low which meant that growth of the economy was also low and this had a negative effect on the savings and investment of the country as they too decreased. All these unhealthy signs were the outcome of less creativity and innovation, a decreased range of financial products, higher tax rates, customer dissatisfaction etc.
It was at this point in time that the ‘Banking Sector Reforms’ were introduced in 1991. They were introduced so as to give a new sort of life to the banking sector which was further falling into trouble as either it was completely being ignored or there were high political pressures due to which decisions were made not in favor of the banking sector but so as to favor a handful of individuals. Other factors which led to high inefficiency in the banking sector included overstaffing, poor customer services, waste of resources etc and all these factors were a direct effect of the banks being state owned.
The banking reforms came in two phases. In the first phase which was in 1991 there was huge liberalization and financial sector deregulation. Due to these reforms new banks started to open up and instead of the government intervening, the SBP now decided it wanted to play more of a regulatory role and that’s what they pushed to do, advising all banks to review themselves and then send in reports. So now the government was intent on focusing to improve the banking sector and was trying to remove the inefficiencies pertaining in the banking sector as much as they could.
The second phase which was in 1997 saw total control being given to SBP who introduced two new systems for the evaluation of the banking sector and its efficiency. These systems were the CAMELS (further explained below) and the CAELS (capital adequacy, asset quality, earnings, liquidity and sensitivity) system. With these systems the SBP now had a new way of looking at the efficiency of the banks.
Relevance of the Topic and Research Title
Banks today are under great pressure to perform so that they can meet the objectives of their stockholder, depositors and borrowers and at the same time they need to keep government regulators satisfied about their policies, loans and investments. Also since they play such a vital role in the development of the economy it only makes sense that the banks will try their best to be efficient and profitable.
Bank performance must be in balance with the specific objectives that have been set out, so a just evaluation of any banks performance should start by evaluating whether it has been able to achieve the objectives of its management and stockholders have chosen. Different banks have their own set of objectives. Some banks would like to grow as quick as possible, even if it means taking high levels of risk, while others want to minimize risk and become a sound bank in the long run, but with modest rewards for their shareholders.
The objective of maximum profitability with a level of risk acceptable to the banks shareholders is not easy to achieve and this is the problem at hand. It is important to know the variables which influence the profitability of a bank and to see how changes can be made in these variables so as to maintain the required level of profitability without taking on more risk.
The research title is very important as banks make up the largest chunk in the financial sector. Efficient banks with high profitability will largely mean that the banking sector is doing well and hence developing which in turn will mean that the financial sector overall is developing. Financial sector development is important as it can spur economic growth whereas a lack of development can harm this growth and cause economic chaos.
Background Information and Evolution
Over the years many different methods have been used to evaluate the performance of banks. With time new methods were introduced and over all there was development in these measuring techniques.
In theory it is thought that behavior of a stock price and its movements is the best indicator of a business firm’s or a bank’s performance because it reflects the markets evaluation of the firm’s performance. But in reality this is not the best indicator for the banking sector as most bank stock is not actively traded in international or national markets.
Here come in profitability ratios, which are a surrogate for stock values. Among the most important ratio measures of bank profitability used now a days are the following:
Return on Equity Capital
Rate of turn to stockholders
Return on Assets
Net Interest Margin
Profitability and efficiency
Net non-interest Margin
Profitability and efficiency
Net Bank Operating Margin
Profitability and efficiency
Earnings per share of stock
The U.S federal regulators made good use of these financial ratios along with other analytical tools to track bank performance when in the 1980’s they came up with the ‘Uniform Bank Performance Report’ so that analysts can compare the performance of one bank against another.
Moving on another way of measuring a bank’s performance is by measuring inputs and outputs in the banking industry. (This is the same approach that will be used in this research). There are two approaches to gauge this input-output process:
The Production or Service Provision Approach:
This is also known as the “Value Added Approach”. In this approach banks provide their clients with services by administering client’s financial transactions, keeping client deposits, issuing loans and managing other financial assets.
The Asset or Intermediation Approach:
Under this, bank accepts deposits from customers and transforms these deposits into loans for other clients. This approach can further be divided into two categories:
The Profit Approach:
Also known as “The User Cost Approach”. This approach determines whether a financial product is an input or an output based on its net contribution to bank revenue.
The Risk-Management Approach:
This approach is used to evaluate risks attached to various forms of assets in banks.
There are two major estimation techniques:
Parametric Approach: In this the efficient frontiers are calculated by using stochastic techniques.
Non-Parametric Approach: It is when efficient units are used to create the efficient frontiers.
The basic difference in both these approaches is that in non-parametric approach there is possibility of output expansion as well as a possibility of its contraction while determining the efficiency frontiers.
These estimation techniques can be classified as follows:
Data Envelopment Analysis (DEA)
Free Disposal Hull (FDH)
Stochastic Frontier Approach (SFA)
Thick Frontier Approach (TFA)
Distribution of Free Approach (DFA)
Below is a hypothetical framework which will just give a general overview of how the input-output model works:
Another way of checking the financial performance of a bank is by using the CAMELS approach. On www.investopedia.com it says that CAMELS:
An international bank-rating system where bank supervisory authority’s rate institutions according to six factors. The six factors are represented by the acronym "CAMELS." The six factors examined are as follows:
C - Capital adequacy
A - Asset quality
M - Management quality
E – Earnings
L - Liquidity
S - Sensitivity to Market Risk
CAMELS.bmp Source: www.sbp.org.pk
Managerial concerns pertaining to Research
The managerial value of this thesis is high as it will help managers to get to know about the different factors that affect the profitability and the efficiency of the bank and how these all are related to each other; as in how they link together that is how different inputs are converted to outputs. Plus it will also help them determine how important each input is for the bank and what effect it has on the outputs of the bank and whether more time should be spent on that input or some other input should be incorporated. Once they know this then it will be easy for them as they would now know where they should focus more so as to increase the profitability and efficiency and hence the overall performance of the bank.
Academic concerns pertaining to Research
The first and foremost academic concern of this research, as is of any research, is that it will help future students who decide to do their research in the same area. It will provide them with some sort of guidance as to the different methods that are available for the measurement of the efficiency of the banking industry and then they can choose whatever method suited them well.
Apart from this this research will have academic value as it will help the graduating students who are interested in the banking sector know what factors determine the banks efficiency and profitability and then they could talk about that in their job interviews and this will help them get the job.
Keywords and Definitions
Efficiency: Ability to produce a desired effect, product, etc. with a minimum of effort, expense, or waste; quality or fact of being efficient.
Profitability: Ability of a firm to generate net income on a consistent basis.
The production approach: Banks provide service to customers by administering customers financial transactions, keeping customer deposits, issuing loans, cashing cheques and managing other financial assets.
The asset approach: Banks accepts deposits from customers and transforms them into loans to clients.
The profit approach: Banks manager’s purpose is to maximize the bank’s profit function.
The risk-management approach: Evaluate risks attached to various forms of assets in a bank.
(Mlima, A. P., & Hjalmarsson, L. (2002). Measurement of inputs and outputs in the banking industry. Tanzanet Journal .)
Technical Efficiency: Investigates how well the production process converts inputs into outputs.
Cost Efficiency: The ratio of the minimum production cost observed in the sample to the actual production cost of the DMU investigated.
Allocative Efficiency: The effective choice of inputs and inputs prices with the objective of minimizing production costs, which is a selection of an effective production plan. Thus it can be residually calculated as the ratio of cost efficiency to technical efficiency.
(Source: Avkiran, N. K. (2006). Developing foreign bank efficiency models for DEA grounded in finance theory. Socio- Economic Planning Sciences , 275-296.)
The study objectives are to highlight the various determinants of the profitability of a bank and how they can be used by managers to achieve the highest amount of profitability with the least risk while policy makers can use them as a tool to influence the growth of the economy by bringing in new and improved banking regulations.
This is important as profitability leads to revenues and profits which in turn means greater marketability of that bank and as a result the market value and returns to investors increase thereby keeping them happy too.
Also banks are the backbone of the whole economy as it borrows and lends to businessmen who invest this money and overall economy grows. So if banks are not profitable or not peforming well then they will receive no deposit and hence will have no money to lend out and as a result the whole economic system might collapse.
Chapter 2 Literature Review
2.1 Efficiency and Profitability: The Link between the two.
2.2 The Estimation Technique: The Parametric and Non- Parametric approach.
2.3 Data Envelopment Analysis
2.4 Choice of Inputs and Outputs
2.5 Selection of Decision Making Units (DMU’s)
2.6 Different DEA software programs
2.7 Further Analysis: The Sensitivity Analysis
CHAPTER 3: Methodology & Analytical Choice
3.1: Framework of Analysis
For this thesis the Intermediation Approach will be used under the DEA analysis. Several different types of inputs and outputs can be used which are shown below:
Capital Related operating expenses
Labor (employee expenses)
Loans and Advances
(Price of input:
Interest paid to Depositors/Deposit)
(Price of input: Profit before Tax/Net capital)
But for this thesis the output oriented model has been used in which
“…...the efficiency is estimated by the output of the firm relative to the best practice level for a given level of inputs.”
The inputs and outputs that have been chosen under this model are as follows:
When talking about the output oriented model we determine a bank’s maximum potential output from its input provided that it is operating efficiently.
When we look at these inputs and outputs we can see that they all are very detrimental when it comes to the efficiency or the profitability of the bank.
When talking about deposits, we know that the main source of funds for any banks is the deposits which the customers bring in. These deposits are the funds from the surplus units and then bank can now use them further e.g in the form of loans which are given out to deficit unit. Since this is the chunk of business done by the bank especially as financial intermediaries, it is not possible to ignore deposits as in input. Without deposits the banks would not be functional as they would not be able to serve their main purpose of intermediation. We cannot ignore the fact that the biggest liability on the banks balance sheet is deposits and hence its proper management is needed in order for banks to perform well. Deposits are the backbone of any bank and are a must when it comes to the banks operations in a well manner.
Labor too is an important input for any bank as its labor that is the employees of the banks are the ones who actually handle the day to day transactions of the people and deal with them and help them out if they have any problems relating to their account. Customer relations are a very important now a days for any company who wants to prosper. In the same way the banks need this labor to form strong bonds with the customer so that the customer brings in more deposits and as a result the bank now has more funds to use. Another important aspect of the labor component as an input is that the owners of the bank don’t usually take much interest in the running of the bank as long as they get their profits. It is this labor in the form of the board of directors and management of the bank who are responsible to take care of the running of the bank and make sure that all the banks functions are being served and it is running as smoothly as possible and at the same time profits are being generated in an efficient way. It is also the same labor who is responsible for making up rules for the running of the bank and to see where to invest or not and to keep checks on all those people under them to see if all are working in accordance with the objectives of the bank and its owners.
Then is capital which is the 2nd largest source of funds for banks and it is the money which is gained by the selling of shares. It includes paid up capital and share premium. This capital is very important too as it can also be used to give out loans or to make investments and hence it helps banks to fulfill its intermediation function.
Coming to the output side we first have loans or advances. These make up the largest chunk of the asset side of the bank’s balance sheet and return from these loans is a source of income for the bank. These loans are made possible by the large amounts of deposits the banks get from their account holders who are the surplus units and then they are given out to the deficit units. So this business of getting deposits and making loans is the core business of the bank and how well it manages its loans and how well it can recover the loan amount is a significant determinant of any banks efficiency. The return from the loans is a source of income and the return banks give on the deposits to their deposit holder is an expense for the bank. The difference between these two rates is the banks spread and managing it properly will lead to an efficient and profitable bank. But in order to manage it properly, the deposits and loans have to be managed properly.
Then are the investments which the banks make in forms of investment bonds, treasury bills and shares of other companies etc. Investments are the second largest asset of the bank as the banks again receive income from the investments they make in the form of the return. So managing these investments and making investments at the proper place and proper time is very important too and is also the function of the labor (that is the management of the bank).
So when we look at it this we can see that all these inputs and outputs are related to each other in the sense that a lack of attention in one area might lead to the collapse of the banks entire operations. For example if the banks labor doesn’t make a proper enquiry about a potential borrower and gives them a loan and the borrower then defaults on his payment it might lead to problems for the bank in the sense that they might not be able to pay back a depositor. If this happens then this certain depositor might go tell others and hence people might be either not willing to deposit their money in that bank or current depositors might rush to withdraw their money and as a result the bank will be short on funds. When they are short of funds the bank will not be able to give out loans and as a result the system will start to crumble and eventually collapse.
3.2: Statement of research hypotheses
For this analysis the focus will be on the DEA approach which is a linear programming technique that calculates a comparative ratio, the relative efficiency score, of multiple outputs to multiple inputs for each decision making unit, which in this case will be banks. This efficiency score is either expressed as a number between 0% to 100% or between 0 and 1. A DMU with a score of 1 or 100% is a fully efficient bank. Banks getting a 1 will then be compared to banks which didn’t get a 1 and then conclusions will be drawn so as to what component of the efficient bank makes it get a 1 while the other bank fails to do so.
3.3: Elements of research design
Type of Research
I would be primarily focusing on conducting Applied Research
This study is conducted in Natural Settings as it is likely to be conducted in real settings.
Nature of Data
The nature of Data that is likely to be used for the purpose is Time series.
Unit of Analysis
Unit of Analysis that has been selected for this research are banks.
The year 2009
Comment on data reliability
The data that was collected for the efficiency analysis is secondary in nature and hence is assumed to be reliable in nature as it will be taken from reliable sources.
3.4: Data collection preferences
The data collected is just for the year 2009 and it is for the following decision making units:
Since the data is secondary it is thought to be reliable but there is always a chance of some error. In secondary data sources this chance of error stems from the measurement bias which comes into data for two reasons:
Deliberate distortion of data.
This is when someone intentionally records the data inaccurately in order to either deceive people or for no advantage what so ever.
Changes in the way data are collected.
If the data collection procedures and the people collecting the data remain the same then so will the measurement bias. A change in either of the two factors will cause the measurement bias to change.
But these measurement biases are something over which no secondary data source user has any control over and hence this can be seen as a limitation.
3.5: Data collection and related procedures
The data source for this research is the annual reports of the respective DMU’s under consideration. Since the data is being collected from the annual reports, this too is a reason why the data collected is considered to be reliable. Another reason is that these reports are audited and are public for everyone so the chance that the bank management will give the wrong or misleading information in these reports is low.
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