Profitability of Commercial Banks: Presented By:-Ruchika Singh (MBA/10046/18) Nikhil Mishra (MBA/10051/18)

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PROFITABILITY OF

COMMERCIAL BANKS
Presented By:-
Ruchika Singh (MBA/10046/18)
Nikhil Mishra (MBA/10051/18)
COMMERCIAL BANKS
• A bank which undertakes all kinds of ordinary banking business is
known as a commercial bank. It is so called because it provides
money and credit for commercial and trade activities.
• Commercial banks in India are organised as joint stock companies
and known as banking companies.
• These banks are primarily classified as scheduled and non scheduled
banks.
FUNCTIONS OF COMMERCIAL BANKS
• They receive short and medium term deposits from the public and
grant short term loans and advances.
• They supply working capital to the industries and enable them to
carry on production and manufacturing activities.
• They grant loans and advances on the stocks of agricultural
commodities, industrial goods, etc.
• They discount internal and foreign bills and thereby finance the
international trade.
• They also perform certain agency services such as collection of
cheques, dividends, interest on investments, letter of credit, etc.
TYPES OF COMMERCIAL BANKS

COMMERCIAL
BANKS

NON-
SCHEDULED NATIONALISED
SCHEDULED
PROFITABILITY OF COMMERCIAL BANKS
• Like all businesses, banks profit by earning more money than what
they pay in expenses.
• The major portion of a bank's profit comes from the fees that it
charges for its services and the interest that it earns on its assets (its
loans to individuals, businesses, and other organizations and the
securities that it holds) .
• Its major expense is the interest paid on its liabilities (deposits and
the money that it borrows, either from other banks or by selling
commercial paper in the money market) .
HOW DO BANKS EARN PROFIT?
1. Loans:
• Lending loans to borrowers from the public is a major way for commercial
banks to earn money. These could be personal loan, home loan, car loan
and other type of mortgages.
• The money lent to a person comes from the money deposits of other
customers. Banks generally restrict the amount of withdrawals to remain
solvent, especially for forwarding loans. This ensures that the money
remains within the bank.
• The amount is lent to a person at a higher interest rate for a fixed period of
time. As the loan amount starts getting recovered, the bank pays a portion
of the interest value to other depositors and keeps the remaining as its
“earning”.
• Issuance of loans creates money.
EXAMPLE
How Do Banks Make Money from Loans

• Person A does a fixed deposit worth 100,000 with a bank @8% annual
interest for 5 years. Person B requests a personal loan worth 100,000
with the same bank.
• After checking person B’s credentials, the bank decides to extend the
personal loan @13% annual interest for 5 years. The 5-year loan
fetches 136,518 to the bank. At the same time, the fixed deposit
matures and the bank pays 121,658 to person A.
• The difference between the two (– 14,860) is the bank’s income.
2.Credit Cards:
• Credit cards are unsecured loans extended by a commercial bank with
the sole intention of earning heavy interest.
• Availing a credit card, limited or unlimited value, gives the person
access to immediate funds and the person is charged premium fees
by the bank for extending this facility.
• Initially, credit card issuing bank offer low late payment fees for the
first year but from second-year onwards, the interest rates vary
anywhere between 15% and 30%.
• Often, mismanagement of credit cards by the user leads to a huge
debt, which ends up in a high windfall for the bank.
3) Public Deposits
• Money kept by the public in various types of savings and checking accounts
is the largest source of funds for commercial banks.
• The amount accountholders entrust the bank with safekeeping earns them
a very basic interest amount. These deposits are pooled together and
loaned out to other individuals or invested elsewhere.
• The banks earn interest money and share the basic percentage with the
savings or checking accountholder.
4) Debt Issuance
• Commercial banks often issue debts to raise capital. This is done to
maintain smooth banking operations and when the need arise; the banks
will use sources like repurchasing agreements to access debt funding.
• The issuance of bank bonds isn’t unusual but they aren’t a common source
of issuing bank capital also; the bank bonds are either convertible or
callable in nature. The ‘debt’ forms a small percentage of total loans in
commercial banks and they aren’t major loanable funds either.
• 5) Service Fees
• Commercial banks levy service fees on its customers and even though
the service fees are marginal, it forms a large chunk of commercial
bank earning medium.
• Commercial banks charge service fees for ATM’s, overdrafts, operating
a simple savings account, issuing debit cards, renewing debit cards,
accessing internet banking and mobile banking, issuing checks,
maintaining bank lockers and more.
• These fees are unavoidable since every commercial bank charges
them.
METHODS OF CALCULATION OF PROFITABIITY
0F COMMERCIAL BANKS
Parent name name derivation purpose
ROA Return on assets Net profit after Asset management
tax/assets without risk impact
RAROA Risk adjusted return on Economic profit/assets Asset management with
assets mitigated risk
Adjustment
ROE Return on equity Net profit after GL return on equity
tax/equity without risk impact
RAROE Risk adjusted return on Economic profit/equity Return on equity with
equity mitigated risk impact
RAROC Risk adjusted return on Economic Fully risk based
capital profit/economic cost profitability
EVA Economic value added Economic profit-net Fully risk based
cost of economic capital profit
RETURN ON ASSETS
• Calculate the bank's net income. This is its total income (or "gross" income)
minus its expenses such as provision for loan losses and non-interest
expenses. For instance, if a bank has a gross income of $50 million and
expenses totalling $8 million, you would subtract $8 million from $50
million to get a net income of $42 million.
• Add the bank's assets, such as loans, securities and cash. For this example,
assume that the bank has assets totalling $75 million.
• Divide the bank's net income by its assets to find the Return on Assets. This
is the ratio one compares. In this example, we would divide $42 million by
$75 million to get 0.56. To state this as a percent, multiply times 100, to
equal 56 percent
• A firm with higher ROA is better at converting its investment into profits
than a firm with lower ROA.
RISK ADJUSTED RETURNON CAPITAL (RAROA)
• Risk-adjusted return on capital (RAROC) is a modified return on investment
(ROI) figure that takes elements of risk into account. The formula used to
calculate RAROC is:
Risk Adjusted Return on Capital (RAROC)=(Revenue-expenses-expected
loss+income from capital)/capital
• Where:
Income from capital = (capital charges) x (risk-free rate)
Expected loss = average loss expected over a specified period of time
• In financial analysis, projects and investments with greater risk levels must
be evaluated differently; RAROC accounts for changes in an investment’s
profile by discounting risky cash flows against less-risky cash flows.
RETURN ON EQUITY

Calculation:-
• Subtract the bank's expenses from its gross income to find the net income.
• Divide the bank's net income by its capital. A bank's capital consists of
items including the equity of shareholders, reserves and retained earnings.
Consider an example in which a bank has $100 million of net income and
$800 million of capital. Divide $100 million by $800 million to get 0.125.
• Convert the ratio of income to assets to a percentage by multiplying your
answer from step two times 100. In this example, we would multiply 0.125
times 100 to get 12.5 percent.
FACTORS AFFECTING PROFITABILITY OF
COMMERCIAL BANKS
Bank Specific Variables
• The bank-specific variables are selected by using some key drivers of
profitability like earnings, efficiency, risk taking and leverage.
Profitability is driven by the ability of a bank in generating sufficient
earnings or in lowering operational cost, implying being more
efficient.
• Furthermore, due to the special nature of banks, risk taking and
leverage are also very important drivers for profitability.
• Some bank specific variable are:-
• Capital strength- The equity-to-asset ratio measures how much of bank’s
assets are funded with owner’s funds and is a proxy for the capital
adequacy of a bank by estimating the ability to absorb losses.
• Operational efficiency: Cost to income ratio shows the overheads or costs
of running the bank, including staff salaries and benefits, occupancy
expenses and other expenses such as office supplies, as percentage of
income.
• Income diversification: The concept of revenue diversifications follows the
concept of portfolio theory which states that banks can reduce firm-
specific risk by diversifying their portfolios. Moreover, the decline in
interest margins during the last decade has changed the traditional role of
banks and forced them to search for new sources of revenue.
• Liquidity risk: Liquidity risk is one of the types of risk for banks; when banks
hold a lower amount of liquid assets they are more vulnerable to large
deposit withdrawals. Therefore, liquidity risk is estimated by the ratio of
liquid assets to total assets.
5. Size: There is consensus in academic literature that economies of scale and
synergies arise up to a certain level of size. Beyond that level, financial
organizations become too complex to manage and diseconomies of scale arise.
The effect of size could therefore be nonlinear; meaning that profitability is likely
to increase up to a certain level by achieving economies of scale and decline from
a certain level in which banks become too complex and bureaucratic. Hence, the
expected sign of the coefficient of bank size is unpredictable based on academic
literature.
6.Asset Quality: There appears to be a consensus that bank profitability is directly
related to the quality of the assets on its balance sheet; that is, poor credit quality
has a negative effect on bank profitability and vice versa.
This relationship exists because an increase in the doubtful assets, which do not
accrue income, requires a bank to allocate a significant portion of its gross margin
to provisions to cover expected credit losses; thus, profitability will be lower. This
was in line with the theory that increased exposure to credit risk is normally
associated with decreased firm profitability. Indicating that banks would improve
profitability by improving screening and monitoring of credit risk.
Industry-specific variables
• It discusses the industry concentration variable separately from bank-
specific variables as far as this variable is to some extent external.
That means managers cannot change the variable immediately like
that of bank-specific variables.
Industry Concentration Level
• A more concentrated sector favours bank profitability motivated by
the benefits of greater market power. There is a positive relationship
between concentration and profitability as an indirect consequence
of efficiency.
Macroeconomic variables
• The macroeconomic control variables are external for banks and are
uncontrollable. The growth of real gross domestic product and the inflation
rate are selected as possible macro-economic variables that can affect bank
profitability.
1. Real GDP growth: Poor economic conditions can worsen the quality of
the loan portfolio, generating credit losses and increasing the provisions
that banks need to hold, thereby reducing bank profitability.
2. Inflation: Another important macro-economic condition which may
affect both the costs and revenues of banks is the inflation rate (INFL).
OTHER FACTORS INFLUENCING BAKING
PROFITABILITY
• Mergers-merged banks enjoy an increase on profit efficiency
compared to other banks due to the range of factors including shifting
outputs from securities to loans and improvements on higher value
product range.
• Managerial efficiency-managerial efficiency not only raises profits,
but also assists in increased concentration and greater market share
gains.
• Liquidity-there lies a positive relationship between bank’s liquidity
and banking profitability.
WAYS OF IMPROVING COMMERCIAL BANKING
PROFITABILITY
1.Achieving balance sheet efficiencies-
Banks will have to revamp their deposits and assets mixes , so that they are in
conformity with compliance regulations and at the same time do not compromise
on increasing profitability. In order to retain deposits, banks will have to boost their
customer relationship programs and increase cross-selling efforts.
2.Driving mergers and acquisitions-Mergers can generate a number of advantages:
• Firms that merge can take advantage of a range of economies of scale, such as
cost savings associated with marketing and technology.
• In the case of vertical integration there are savings in terms of not having to pay
‘3rd party’ profits. For example, if a tour operator owns its own hotels it will not
need to pay profits to the hotel, and will be able to keeps costs and prices down.
• Economies of scope are also available to firms that merger and are benefits
associated with using the fixed assets of one firm to produce output for the other
firm.
• Unexpected synergies are unpredicted benefits that arise when firms merge or
undertake a joint venture, such as when two pharmaceutical companies merge,
and create a new drug.
3.Pursuing growth-banks will have to invest in customer analytics as
well as digital technology in order to develop better cross-selling
strategies and also generate more interest of the customers.
4.Transforming payments-Banks have replaced their traditional cards
with the EMV standard of chip and PIN cards. With the introduction of
Apple Pay, google pay ,etc. contactless payments are also becoming
quite popular. And as contactless payments become more accepted,
banks will have to look for ways to distinguish their way of delivering
customer experience.
5.Strengthening compliance management -as the compliance
regulations have been bolstered, banks need to integrate compliance
and risk management fully into the culture of the banks rather than
concentrating on specific processes. It should be enforced in the
performance management systems as well, through employee training.
6. Managing data and analytics-Banks need to move toward a central
Regulatory Management Office (RMO) in order to monitor the data
management processes. Besides that, the Chief Data Officers should
also extend their responsibilities and help in collaborating with new
business lines and functional groups, which will help in value creation.
7.Enhancing cyber security-To improve cybersecurity efforts, banks
must add advanced features to their existing systems. New methods
like Wargaming, attracting specialized talent etc. will prove to be quite
helpful. Enhancing the existing intelligence systems to detect new
threats or attacks on a regular basis could also be very helpful.
As the economy improves, banks need to invest more into technology
for most of their concerns whether it is compliance or customer
relations or cybersecurity.
THANK YOU!

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