FIG09104: Financial Markets and Institutions

DR. Dionis J. Ndolage

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 COST AND PROFITABILITY MANAGEMENT & BANK
PERFORMANCE

TOPIC TOBE COVERED

1. Profitability – as an essential objective of a Bank.
2. Revenue/ Income structure of the Bank.
3. Cost/Expense Structure of the Bank.
4. Managing Return and Expenses/Cost of the Bank.
5. Key Return and expense control Ratios.
6. Evaluating Bank performance.
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1.Profitability – as an essential objective of a
Bank.
 Strong profit are necessary to:
1)Pay shareholders dividends
2)Build shareholders equity/ capital
3)Offset loan losses
4)Pay on going operating expenses
5)Expand products and services – encourage
investors to provide capital for new bank
product and services.
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 Key measures of profitability are: ROA, ROE &
EPS.
 Adequate accumulation of capital and Profitability
is essential as it:
a)Increases the banks share prices.
b)Increases capital gains for existing shareholders
when they liquidate their holdings.
c) Increases the extent of dividends to be issued/
received.
d)Increases the marketability and value of bank
share and overall value of the bank.
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e) Reduces the cost of raising further capital funds
in the future through new or right issue.
f) Increases the borrowing capacity of the bank as
the capital / equity base of the bank increases.

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 In order to generate profit, the bank needs to:
1) Seek profitable opportunities, with adequate spread
between asset yield and cost of funds and other
operating costs ( including salaries & wages,
defaults/provisions on loan losses (PLL)
2) Need to hold a well-diversified portfolios of loans and
investment (funded business ) to generate adequate
income ( careful selection, structuring and management
of assets)
3) Need to diversify into financial & financial related
services (including OBS services ) – non-funded services
that generate non-interest fees & commissions/charges.

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 Five Primary Areas for Potential Margin
Improvement
1)Increase interest revenue (+)
2)Decrease interest expenses (-)
3)Decease provision for loan losses (PLL) (by
increasing the quality of loans (-) = increase of
interest margin (=)
4)Increase non-interest income ( by diversifying
into profitable financial products / services (+)

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5) Decrease non-interest expenses(-) ( e.g.,
operating expenses by increasing efficiency and
productivity of assets/people & equipments,
through automation/ ICT improvement, etc. =
Increase of net margin (+)

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Concluding Remarks:
 Improvements in any of the 5 key margin areas
must be approached carefully with
consideration to risk implications of any
earnings improvements e.g., interest revenue
may be improved by taking on more credit risks,
interest rate risks or liquidity risk.
 Therefore, there is a need for making a trade-off
between return and risk in any decision made to
enhance the profitability of a bank.

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 Profitability can also be enhanced by increasing
Asset (+ Resources) Utilization and Leverage –
Multiplier of the bank.

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2. Revenue/Income Structure on the bank
1)Interest Income (Rate, Composition mix and
Volume)
2)Dividend Income
3)Non-interest Income.
 Sources of Interest Income.
1)Loan and Leases
2)Securities (Short and Long-term)
3)Interest bearing deposits/Balances with other
banks.
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4) Trading Account/Securities
5) Dividends on Equity Stakes
 Sources of Non-interest Income:
1) Fees, Commissions and Service Charges
2) Investment Securities gain (or Losses)
3) Fiduciary and Trust Services/Income
4) Correspondent Services
5) Trading account gain
6) Other charges on Banking and other allied services e.g.,
Advisory services, OBS services, brokerage services, etc.

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3.Cost/Expense Structure of the Bank.
 Key Types of Banking Expenses:
1)Interest Expenses (Rate, Composition (Mix) and
Volume)
2)Overhead/ Operating Expenses
3)Provision for Loan Losses (PLL)
4)Losses from securities
5)Depreciation and Amortization
6)Taxes.

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1) Sources of Interest Expenses:
(a) Short-term borrowing
(b) Long-term borrowing
(c) Deposit Mobilization
Key Ratios:
(i) Net Interest Income (NII) = Interest revenue
(earned from assets)- Interest expenses (Paid
on liabilities)
(ii) Interest Margin (IM) = NII / Earning Assets

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2)Sources of Overheads/ Operating Expenses:
(a)Salaries and Benefits
(b)Occupancy expenses eg., Rent , Depreciation.
(c)Cost of Outsourcing services
(d)Cost of providing deposit and payment services
(e)Managing customers investments and own
investments.
(f)Legal, Regulatory and accounting fees.
(g)Insurance Policies
(h)Promotional and Advertising expenses
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(i)Other expenditure: BODs and meetings, Data
processing costs, Auditors fees, Communication,
postage, stationery and printing, etc.

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 Measures to Ensure Profitability and Cost Mgt in
Banks
1)Ensure a healthy spread between interest income
and interest expenses by effectively managing the
bank interest margin (IM) by:
(a)Coordinate and balance the maturity of bank
assets and liabilities (Matching assets and
liabilities)
(b)Coordinate the rate structure of bank assets and
liabilities. This is because rate structure and
maturities determine the sensitivity
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of assets and liabilities. Thus, fixed rate assets
should be funded by fixed rate liabilities and
VRAs by VRLs, respectively.
(c) Coordinate credit quality of assets and liabilities
as they influence return on assets and funding
costs- thus affecting the profitability of the bank.
2) Ensure good spread between Non-Interest Income and
Non-Interest Expenses.
3)Proper Credit Mgt to reduce Credit Risk and Non-
performing loan (NPL) and thus provisions for loan
losses (PLLs).

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4)Proper Tax Mgt and Planning – to reduce Tax burden
5) Gap Mgt ( Matching Assets and Liabilities).
6) Interest forecasting and interest sensitivity analysis.
7) Adequate use of technology to reduce costs and
increase productivity.
8) Taking advantages of economies of scale and
scope- to ensure synergistic advantages and cost
synergy/reduction.

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9) Proper cost accounting, management and
control systems and procedures.
10)Outsourcing some services
11) Proper pricing of Assets and services,
including loan pricing to ensure that cost of
funding and operations are covered and there is
a healthy spread or profit margin.
12) Proper forecasting of the bank outlook,
economic and coupled with effective bank
planning (strategic, tactical and operational).

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13) Effective and proper customer and business
profitability analysis and profit planning.
14) Recruitment, Retaining and Development of
skilled, qualified and experienced bank
managers and officers.

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 Strategies to Manage Non-Interest Expenses
1)Effective budgeting aimed at controlling
expenses.
2)Ensure that Return on Investment (ROI)
/Business lines exceed the bank’s weighted cost
of capital/ Funding.
3)Other strategies for cost management
(a) Expense Reduction – Identify the expenses that can
be reduced or eliminated without affecting the
business of the bank and OUTSOURCING .

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3. Other strategies for cost management Cont…
(b) Increase operating efficiencies or productivity
– by (i) Reducing costs, but maintaining the
existing level of products and services, eg.,
retrenchment of staff.
(ii) Increase output, but maintaining the level of
current expenses.
Note that:
(i) and (ii) above imply that the bank is able to deliver
products and services at a lower unit cost. This means
that there should be economies of scale and scope.
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3. Other strategies for cost management Cont…
Also Note that:
(i)Economies of Scale – Operating on large scale –
exist when the bank average cost decreases as
output increases.
(ii)Economies of Scope – Implies reduction in
joint costs – by offering jointly several products
(eg., cross-selling) rather than offering them
independently.

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3. Other strategies for cost management Cont…
(c) Revenue Enhancement – involve changing the
pricing of specific products and services, but
maintaining a sufficiently high volume of
business – so that total revenue increases,
especially for products whose demand is
inelastic OR expand volume and quality while
keeping price constant or minimal (by target
marketing)

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3. Other strategies for cost management Cont…
(d) Contribution Growth – Mgt of the bank
allocates resources to improve overall long -
term profitability of the bank, eg., investing in
new computer system and technology to
provide better customer services at reduced
unit costs once a large volume of operation can
be attained.

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AIMS OF COST MANAGEMENT STRATEGIES
1)To make the bank more cost-effective and
learner and thus become low-cost competitor.
2)And at the same time, to enhance long-term
productivity and survival prospects of the bank.
 Always ensure that there is a continuous cost
analysis, evaluation and comparisons with the
peer banks.

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5. KEY RATIOS FOR ENSURING PROFITABILITY
AND EXPENSES CONTROL.
1)Key profitability/ Return Ratio: ROE, ROA and
EPS.
2)Expense Control Ratio (ER): Ability to control
expenses.
ER = (Interest Expenses / TA) + (Non-Interest
Expenses / TA) + (Provision for Loan Losses
(PLLs)/ TA ) + ( Taxes / TA)

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 Components of Expense Control Ratio (ER):
(i)Interest Expenses / TA
(ii)Non-Interest expenses / TA
(iii)Provision for Loan Losses (PLLs) / TA
(iv)Taxes / TA

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5.Key Ratios For Ensuring Profitability And Expenses
Control Cont…
3) Efficiency Ratios:
(i)Operating efficiency ratio = Total Operating
Expenses / Total Operating Revenue
(ii)Employee Productivity Ratio = Net Operating
Income / Number of Full Time Employees.
4) Efficiency Ratio for boosting ROE are:
(i)Tax Mgt Efficiency = NIAT / NIBT and security gain (or
losses).
(ii)
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5.Key Ratios For Ensuring Profitability And
Expenses Control Cont…
4) Efficiency Ratio for boosting ROE Cont…
(ii) Expense control efficiency = NIBT & Securities
Gain (or Loss) / Total Operating Revenues.
(iii) Asset Mgt Efficiency = Total Operating Revenue /
Total Assets
(iv) Fund Mgt Efficiency (Leverage Multiplier) = Total
Assets / Total Equity Capital.
(v) ROE = Tax Mgt Efficiency x Expense Mgt Efficiency x
Asset Mgt Efficient x Fund Mgt Efficiency.
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6.EVALUATING BANK PERFORMANCE
(i)CAMELS – Used by bank regulators
 C = Capital Adequacy
 A = Assets Quality
 M = Management Capability
 E = Earning capacity & Adequacy
 L = Liquidity Adequacy
 S = Sensitivity to (Market) Risks
Component and Composite Ratings: Scale of 1
(best) to 5 (Worst).
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(2) PATROL – Capital Adequacy, Profitability,
Credit Quality, Organization and Liquidity.
Component and Composite Ratings: Scale of 1
(best) to 5 (Worst).
Bank of Italy uses annual PATROL rating system
as an off-site supervision tool to measure
financial health of individual banks and provide
support to conduct and prioritize on –site
examinations.

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(3) RATE Framework by Bank of England (FSA)- a
formal risk assessment of significant business units of a
bank using nine (9) evaluation factors: CAMELS –
B/COM: That is Capital, Assets, Market Risk, Earnings,
Liabilities, Business, Controls, Organization and
Management.
 Rating: four-point scale with 1 representing a low risk or
a strong control(best) and 4 representing high risk or
weak controls (worst).
 Overall outcome of the risk assessment is compared to
bank’s financial strength in the terms of solvency and
profitability and is used to plan the supervisory review
process for each bank.
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(4) Bank Performance and Key Ratios:
(i)Liquidity Risk Ratios: Liquidity adequacy.
(ii)Interest Rate Risk Ratios – on Assets & Liabilities &
OBS.
(iii)Credit Risk Ratios – Asset Quality (Loans &
Investment)
(iv)Capital/Solvency Risk Ratios – Capital Adequacy.
(v)Forex Risk Exposure Ratios (eg., NOPFE /Capital
(measures of foreign currency mismatch): Foreign
exposure / Core capital ; Forex loans /Forex Deposits;
Forex Assets/ Forex Liabilities.

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(vi)Return/ Profitability Ratios – (ROE Model –
include five (5) components: Net Margin x Asset
utilization = ROA x Leverage Multiplier = ROE)
and EPS
(vii) Cost Efficiency and Expense Control Ratios.

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 Following Lecture Sessions on Bank
Management are:
1)Asset-Liability Management (ALM)
2)Lending Mgt
3)Investment Mgt
4)Risk Mgt

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THANK YOU FOR LISTERNING

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