How to Evaluate the Performance of Banks

How to Evaluate the Performance of Banks
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Banking is a highly regulated industry, which makes it easier for you to evaluate each bank's relative performance, and also the industry as a whole. Regulatory bodies such as the Federal Deposit Insurance Corporation and the Federal Reserve Bank, among others, publish large amounts of banking data on their websites.

Financial Performance

Some of the key financial ratios investors use to analyze banks include return on assets, return on equity, efficiency ratio and the net interest margin. Use these ratios to look for trends in the bank's own performance, and also to compare financial performance with competitors. The efficiency ratio is a measure of non-interest expenses relative to income, and a lower efficiency ratio indicates stronger performance. The FDIC's website is user-friendly, allowing you to download financial data for specific banks and their peers.

Loan Portfolio

Most banks derive the bulk of their income from their loan portfolios. This makes growth and the composition of a bank's loan portfolio an important metric for analysis. The notes to a financial statement contains a breakdown of the bank's loan portfolio between residential mortgage, commercial, industrial, automotive, installment and miscellaneous loans. Also consider overall loan growth, and differentiate between organic growth and loans generated by new branches. Pay attention for any trends in uncollectible loans. An increase may indicate weaknesses in the bank's lending capabilities or economic environment.

Capital Adequacy

Since the collapse of several high-profile banks -- including investment banks Lehman Brothers and Bear Stearns -- capital adequacy has been a hot topic. Banks must have sufficient capital in order to absorb losses and any potential liquidity declines stemming from customers withdrawing funds. Banks with higher risk tolerances are potentially at risk for incurring losses, but also may violate regulatory requirements if insufficient funds are set aside as reserves. The reason banks do not maximize reserves is that they prefer to use the funds to generate additional revenues.

Gap Analysis

Balance sheet items for banks tend to more closely approximate market value than for non-financial companies.
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Gap analysis is used to measure a bank's exposure to interest rate risk. Banks try to match the durations of their assets and liabilities. This way, when a certain amount must be paid to a customer, the bank will have adequate cash on hand and will not have to use valuable earnings assets to make the payment. As interest rates move, the nature of the stream of payments changes. The degree to which there is an imbalance between the durations of assets and liabilities will dictate the magnitude of the effect this will have on the bank's financial results.