Analysing the financial performance of commercial banks is done to meet the objectives of respective stakeholders. For instance, bank regulatory is interested in understanding the financial challenges facing commercial banks and the measures that have been put in place to counter them. Shareholders use financial performance analysis to determine whether or not to invest with a bank. Lastly, banks also evaluate their financial performance to develop sustainability goals and viable management decisions.
This report is divided into five sections. The first section analyses Keystone’s relative earning performance with its peers between 1989 and 1900 using financial profitability rations. The second section analyses the financial risks undertaken by the bank to attain its returns. The third section examines the Keystone’s interest- sensitivity. The fourth section evaluates Keystone’s liquidity needs over the first quarter of 1991. The fifth section provides specific recommendations to the management of the Keystone National Bank for improving the bank’s earnings performance and financial strength.
Earnings are also known as bottom line refers to a company’s net income after tax deduction. Earnings determine a company’s profitability and share price. Earnings is a mostly studied element of financial statements because it shows the profitability performance of a company relative to its peers in the market or based on the pre-established guidance. The earning performance of Keystone National Bank is indicated under Exhibit 3 on Key financial ratios. The key earnings ratios under study are Return on assets, Net profit margin, Asset yield, Return on equity, and leverage (Bailey, 2005).
Return on assets (ROA) is a profitability measure used to evaluate a company’s net income generated from its total assets. In a relative analysis between a company and its competitor(s) in the market, the one with the highest ROA is considered to be more profitable. Keystone’s ROA decreased from 0.95% in 1989 to 0.91% in 1990 compared to the Peer Group’s increase from 1.02% in 1989 to 1.04% in 1990 (Ghosh, 2012).
Net profit margin is a profitability ratio that indicates the percentage of a company’s net profit produced by its revenue during a specific period. Net profit margin ratio is calculated by dividing the net profit by total revenue then expressing the ratio as a percentage (English, 2011). In a relative analysis between a company and its competitor(s) in the market, the one with the highest Net profit margin is considered to be more profitable. Keystone’s net profit margin increased from 8.04% in 1989 to 8.36% in 1990 compared to the Peer Group’s increase from 8.80% in 1989 and 9.70% in 1990.
Asset yield indicates the amount of investment income and dividend that a company yield from investments and loans offered to its customers. The higher the yield on assets, the larger the income generated from loan and investment options offered to customers (Tracy, 2012). In a relative analysis between a company and its competitor(s), the one with the highest Net profit margin is considered to be more profitable. Keystone’s asset yield decreased from 11.81% in 1989 to 10.88% in 1990 compared to the Peer Group’s decrease from 11.59% in 1989 to 10.72% in 1990. Generally, Keystone performed better compared to its peers.
Return on Equity (ROE) is a profitability measure used to evaluate a company’s net income generated from shareholders’ equity. In a relative analysis between a company and its competitor(s) in the market, the one with the highest ROE is considered to be more profitable (Tracy, 2012). Keystone’s ROE decreased from 14.73% in 1989 to 13.82% in 1990 compared to the Peer Group’s increase from 14.41% in 1989 to 14.90% in 1990.
Leverage/ equity multiplier is a profitability ratio used to calculate a company’s leverage. The ratio is calculated by dividing a company’s total assets by its total equity. A high equity multiplier ratio shows that a company uses more debts compared to equity to finance its assets (English, 2011). Keystone’s equity multiplier decreased from 15.50x in 1989 to 15.20x in 1990 compared to the Peer Group’s increase from 14.12x in 1989 to 14.33x in 1990.
Commercial banks are associated with a number of risks. When the value of net leases and loans is huge compared to core deposits, a bank is considered to have poor utilisation of resources as well as low liquidity level. Banks consider both consumers and commercial loans when determining the degree of risks associated with their operations. Banks with high loan portfolio level is exposed to a high degree of default risks. In 1990, Keystone’s loan portfolio decreased by 10% which reduced its ability to maximise shareholders’ equity (Zagst, 2013).
Keystone National Bank held the higher provision for leases and loans when compared to the peer group. This shows that Keystone had anticipated an increased level of credit risks which would subsequently increase the degree of loan defaulters. However, the tangible amounts that the bank charged against the actual defaulted loans were lower compared to that of its peer group between 1989 and 1990 (Sierra, 2004). The analysis presents Keystone as a bank with the ability to maintain a low rate of loan default. Keystone uses its excellent ability to control its loans and leases accounts to improve its capital base and income generation. Nevertheless, maintaining higher provisions for losses on loans and leases shows that Keystone is more likely to incur loan losses compared to its peers which hinder its ability to effectively increase its capital and net incomes.
Keystone also suffered from liquidity risks. Liquidity examines the ability of an organisation to meet its short-term obligations using its most liquid financial instruments such as its current assets. Keystone was faced with the inability to raise adequate funds required to meet client credit and withdrawal requests as well as other financial needs. Such a situation would compel Keystone to obtain crisis reserves at a higher cost which reduces its profitability level. Keystone dealt with the risks associated with its operations effectively with an objective of meeting its end goals and objectives (Msindo, 2015).
Static GAP technique is used to examine changeability of interest rates changed on a bank’s assets and liability within a period of twelve months. Banks experience compression in net interest margin and reduction of net income when market interest rates keep on changing. Static GAP refers to the difference between the cumulative sensitive rate of assets and liabilities during the period (12 months). A larger static gap shows that a bank has been exposed to interest rate risks. The Keystone National Bank used the interest sensitivity report for a period of 12 months to establish how changes in the interest rates affect its financial performance and profitability (Stoica, Nucu, & Diaconasu, 2014).
Banks use a winning spread technique to determine their productivity relative to the changeability of interest rates. Therefore, the management should establish an effective spread that sustains an organisation’s overall financial performance goals. The administration of Keystone has not set out a percentage of profit quantified an acceptable interest charge over the period. Without establishing an acceptable percentage of chargeable interest rates, Keystone will become less attractive and with low proficiency. Companies with the ability to maintain low-interest charges on their assets and liabilities are associated with high proficiency, high profitability and administration productivity (Gray D., 2012).
The analysis showed that the Keystone extends the maturities of its assets without doing so on its corresponding liabilities which led to an increase in the interest rate. The Asset/Liability Management Committee (ALCO) provides tools used to measure exposure and impact of interest rate risk on banks. Moreover, banks are required to provide sufficient information used to establish sources of interest rate exposures and noncompliance with established risk limits. Keystone has not disclosed the information used to arrive at the interest sensitivity analysis as captured under exhibit 4 (Beccalli & Poli, 2015).
Keystone did not disclose its established risk rate limits which made it difficult to determine the degree at which the bank’s assets and liabilities have been exposed to risks, noncompliance with the risk limits as well as the impact of the interest rates on the financial performance. The bank has also not provided a detailed report to the board members with details of how interest rates would be controlled in the case where rates are higher than the set limits (Giovanni, 2013).
Keystone National Bank was faced with an unstable interest rate which affected its ability to fully realize its financial potentials. Changes in interest rates were caused by the trends in the economic environment. However, the 1990 interest sensitivity analysis report does not provide detailed information about the exposures and impact of risks arising from interest rates. Therefore, Keystone should develop an effective interest rate risk management program (Berger, 2015).
Liquidity is an important financial aspect in the banking sector because help to determine the ability of a bank to meet its short-term financial obligations such as maturing loans and securities. There are two ratios which are commonly used to assess the liquidity of a bank: the loans to Asset ratio and Loan/ deposit ratio (Mayes, 2013).
Banks which prefer to trade in risk-free securities tend to have higher liquidity ratios. On the other hand, banks that prefer to trade in liquid deposits have lower liquidity ratio. In the U.S, the recommended liquidity ratio is 20 percent (Tian, 2016).
Banks face liquidity risk when they cannot meet the financial obligations that come with an increase in assets or a reduction in the liabilities. Therefore, banks tend to avoid insolvency by trading in assets which can easily be converted into cash. However holding a high level of liquid asset causes a low rate of return which leads to low profitability level (Giovanni, 2013).
The liquidity ratio is obtained from dividing a bank’s loan by its current asset. The lower loan to asset ratio shows that a bank generates its income from noninterest and diversified investments such as trading. On the other hand, higher loan to asset ratio shows that a bank generates its income from loans (Giovanni, 2013).
In the first quarter of 1991, Keystone’s loans totaled to $ 39,571 while its current assets were $ 65,669. Dividing the loans by total current assets, a ratio of 0.60 which is the loan to asset ratio. Considering that the ratio is less than one, it can be concluded then that Keystone had a lower liquidity ratio. The bank relied more on diversified investment portfolios and noninterest investments to generate income. On advantage of maintaining a lower loan to the asset, the ratio is that Keystone could survive when the interest rate is high in the market as well as when the credit terms are not affordable (Lee & Lee, 2010).
Liquidity of a bank can also be assessed by calculating the loan/ deposit ratio. Banks are judged to be holding unproductive capital when the loan/ deposit ratio is low. On the other hand, banks can easily be negatively affected by the changes of the deposit base when the loan to deposit ratio is high (Tracy, 2012).
In the first quarter of 1991, Keystone’s loans totalled to $ 39,571 while its total deposits were $ 33,237. Dividing the loans by total current assets, a ratio of 1.19 which is the loan to deposit ratio. Keystone can use $1.19 of its current assets (loans) to repay $ 1 of its current liabilities (customer deposits).
Generally, Keystone had a lower liquidity ratio because it held more unproductive asset items which cause a low rate of income. Therefore, the banks should dispose-off its unproductive assets for more productive ones.
The demand for loans was expected to increase in 1991 because of the growth in the three leading sectors in the market. The economic recession was expected to lead to recovery. Moreover, business activities remained stronger than the expectations. The interest rate was expected to fall in the short term before raising in the long term. However, if a recession or weak economic recovery continues in the long run then the interest rate would further drop. To remain competitive in the market, Keystone National Bank opted to provide high rate on core deposits (CD) to increase its customer base (Gray D., 2012).
High-interest rates are associated with higher revenue on loans and other investments in the banking sector. However, the cost of funding the investments are also high when the interest rates are high. Banks use debts such as deposits from customers and other securities to finance loans and other investments. Therefore, high-interest rates have a negative impact on banks’ profitability level if not maintained effectively.
Keystone is likely to face low financial performance and profitability when the interest rate falls. The deposits from customers are also expected to increase with the growth in the three market sectors. The attempt by the bank to provide higher rates on deposits, to expand the market base, is likely to fail because of its inability to fund such expenses from low performing loans and investments (Zagst, 2013).
Keystone should, therefore;
Improve its liquidity level which would improve its ability to meet the financial obligations associated with customer deposits and other securities. The banks should improve its liquidity level by investing more in risk-free government securities instead of over-relying on liquid deposits from customers (Berger, 2015).
Partially discharge its unproductive capital and assets and acquire productive ones. With the fall of the interest rates, the bank should hold assets which can easily be converted into liquid cash. It would take a lot of time before unproductive assets are turned into cash compared to the productive ones. Holding more productive loans and other investments improve the financial position of Keystone during the low economic recovery period which directly leads to improved returns (Ghosh, 2012).
References
Bailey, R. (2005). The Economics of Financial Markets. New York: Cambridge University Press.
Beccalli, E., & Poli, F. (2015). Bank Risk, Governance and Regulation. New York: Springer.
Berger, A. N. (2015). he Oxford Handbook of Banking. Washington DC: Oxford University Press.
English, P. (2011). Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects (1 ed.). New York: John Wiley & Sons.
Ghosh, A. (2012). Managing Risks in Commercial and Retail Banking. New Jersey: John Wiley & Sons.
Giovanni, D. A. (2013). Bank Leverage and Monetary Policy’s Risk-Taking Channel: Evidence from the United States. New York: International Monetary Fund.
Gray, D. (2012). Interest Rate Risk Management at Community Banks. Community Banking Connections. Retrieved from www.cbcfrs.org/articles/2012/Q3/Interest-Rate-Risk-Management
Gray, D., & Malone, S. (2008). Macrofinancial Risk Analysis. New York: John Wiley & Sons.
Lee, C.-F., & Lee, J. (2010). Handbook of Quantitative Finance and Risk Management. London: Springer Science & Business Media.
Mayes, D. G. (2013). Reforming the Governance of the Financial Sector. London: Routledge.
Msindo, Z. H. (2015). THE IMPACT OF INTEREST RATES ON STOCK RETURNS: EMPIRICAL EVIDENCE FROM THE JSE SECURITIES EXCHANGE. Sculpting Global Leaders. Retrieved from wiredspace.wits.ac.za/jspui/bitstream/…/1/Zethu’sFinal%20Researchpaper14Sept.pdf
Sierra, G. E. (2004). What Does the Federal Reserve’s Economic Value Model Tell Us About Interest Rate Risk at U.S. Community Banks? Federal Reserve Bank of St. Louis Review, pp. 45-60.
Stoica, O., Nucu, A. E., & Diaconasu, D.-E. (2014). Interest Rates and Stock Prices: Evidence from Central and Eastern European Markets. Emerging Markets Finance and Trade. Retrieved from https://www.tandfonline.com/doi/abs/10.2753/REE1540-496X5004S403
Tian, W. (2016). Commercial Banking Risk Management: Regulation in the Wake of the Financial Crisis. New York: Palgrave Macmillan US.
Tracy, A. (2012). Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet. London, UK: Bidi Capital Pty Ltd.
Zagst, R. (2013). Interest-Rate Management. New York: Springer Science & Business Media.
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