Bank Performance Indicators
Profit is the
ultimate
goal
of commercial
banks.
All
the strategies designed and
activities
performed thereof are meant to realize this grand objective. However, this does not mean that
commercial banks have no other goals. Commercial banks could also have
additional social and economic goals. However, the
intention of this study is related to the
first objective, profitability. To
measure the profitability of commercial banks there are variety of ratios used of which Return on
Asset, Return on Equity and Net Interest Margin are the major ones (Murthy and Sree, 2003;
Alexandru et al., 2008).
2.1.1 Return on Equity
(ROE)
ROE is a financial ratio that refers to how much profit a company earned compared to the total amount
of shareholder equity invested or found on the
balance sheet.
ROE is what the shareholders look in
return for their investment. A business that has a high return on equity is more likely to be one that is
capable of generating cash internally. Thus, the higher the ROE the better the
company is in terms of profit generation.
It is further explained by Khrawish (2011)
that ROE is the
ratio of Net Income after Taxes divided by Total Equity Capital. It represents the
rate
of return earned on the
funds invested in
the bank by its stockholders. ROE reflects how effectively a bank management is using shareholders’ funds. Thus, it can be deduced from the above statement that the better the ROE the more effective the management in utilizing the shareholders capital.
2.1.2 Return on Asset (ROA)
ROA is also another major ratio that indicates the profitability of a bank. It is a ratio of Income to its
total asset (Khrawish, 2011).
It measures the ability of the
bank
management to generate income by
utilizing company assets at their disposal. In other words, it shows how efficiently the resources of the company
are
used to generate the income. It further indicates the efficiency of the management of a
company in generating net income from
all the resources of the institution (Khrawish, 2011). Wen (2010), state that a
higher ROA shows that the company is more efficient in using its resources.
2.1.3 Net Interest Margin (NIM)
NIM is a measure of the difference between the interest income generated by banks and the amount of
interest paid out to their lenders (for example, deposits), relative to the amount of their (interest- earning) assets. It is usually expressed as a percentage of what the financial institution earns on loans
in a specific time period and other assets minus the interest paid on borrowed funds divided by the average amount of the assets on which it earned income in that time period (the average earning assets). The
NIM
variable
is defined as the
net
interest income divided by total earnings assets (Gul et al.,
2011).
Net interest margin measures the gap between the interest income the bank receives on loans and
securities and interest cost of its borrowed funds. It reflects the cost of bank intermediation services
and the efficiency of the
bank. The higher the net interest margin, the higher the
bank's profit and the more stable the bank is. Thus, it is one of the key measures of bank profitability. However, a higher net
interest
margin could reflect
riskier lending
practices
associated with
substantial
loan loss provisions (Khrawish, 2011).
2.2 Determinants of Bank
Performance
The determinants
of bank
performances can be
classified into
bank specific (internal)
and
macroeconomic (external) factors (Al-Tamimi, 2010; Aburime, 2005). These are stochastic variables that determine the output. Internal factors are
individual bank characteristics which affect the banks performance. These factors are basically influenced by internal decisions of management and the board. The external factors are sector-wide or country-wide factors which are beyond the control of the company and affect the profitability of banks. The overall financial performance of banks in
Kenya in
the
last two decade has been
improving. However, this doesn't mean
that all banks are profitable, there are
banks declaring losses (Oloo, 2010).
Studies have
shown that bank specific and macroeconomic factors affect the performance of commercial banks (Flamini et al. 2009). In this regard, the
study of Olweny and Shipho (2011) in Kenya focused on sector-specific factors that affect
the performance of commercial banks. Yet, the effect of macroeconomic variables was not included. Moreover, to the
researcher's knowledge the
important element, the moderating role of ownership identity on the
performance of commercial banks in Kenya was not studied. Thus, this study was
conducted with the intention of filling this gap.
2.2.1 Bank Specific Factors/Internal Factors
As explained above, the
internal factors are bank specific variables which influence the
profitability of
specific bank. These factors are within the scope of the bank to manipulate them and that they differ
from bank to bank. These include capital size, size of deposit liabilities, size and composition of credit
portfolio, interest rate policy, labor productivity, and state of information technology, risk level,
management quality, bank size, ownership and the like. CAMEL framework often used by scholars to
proxy the bank specific factors (Dang, 2011). CAMEL stands for Capital Adequacy, Asset Quality,
Management Efficiency, Earnings Ability and Liquidity. Each of these indicators are further discussed below.
2.2.1.1 Capital Adequacy
Capital is one of the bank specific factors that influence the level of bank profitability. Capital is the
amount of own fund available
to support the
bank's business and act as a buffer in case of adverse situation (Athanasoglou et al. 2005). Banks capital creates liquidity for the
bank
due to the
fact that deposits are most fragile and prone to bank runs. Moreover, greater bank capital reduces the
chance of distress (Diamond, 2000). However, it is not without drawbacks that it induce weak demand for liability, the cheapest sources of fund Capital
adequacy is the level of capital
required by the banks to enable them withstand the risks such as credit, market and operational risks they are exposed to in order to absorb the
potential loses and protect the bank's debtors. According to Dang (2011), the
adequacy of capital is judged on the basis of capital adequacy ratio (CAR). Capital adequacy ratio
shows the internal strength of the bank to withstand losses during
crisis. Capital adequacy
ratio is directly proportional to the resilience of the bank
to crisis situations. It has also
a direct effect on the profitability of banks by determining its expansion to risky but profitable ventures or areas (Sangmi and Nazir, 2010).
2.2.1.2 Asset Quality
The bank's asset is another bank specific variable that affects the profitability of a bank. The bank
asset includes among others current asset, credit portfolio, fixed asset, and other investments. Often
a growing asset (size) related to the
age of the bank (Athanasoglou et al., 2005). More often than not the
loan of a bank is the major asset that generates the major share of the
banks income. Loan is the major
asset of commercial
banks from which they generate income. The quality of loan portfolio determines
the profitability of banks. The
loan portfolio quality has A direct bearing on bank profitability. The highest risk facing a bank is the
losses derived from delinquent loans (Dang, 2011). Thus,
nonperforming loan ratios are the best proxies for asset quality. Different types of financial ratios used
to study the performances of banks by different scholars. It is the major concern of all commercial
banks to keep the
amount of nonperforming loans to low level. This is so because high nonperforming loan affects the
profitability of the bank. Thus, low nonperforming loans to total loans shows that the good health of the
portfolio a bank. The
lower the ratio the
better the bank performing (Sangmi and Nazir, 2010).
2.2.1.3 Management Efficiency
Management Efficiency is one of the key internal factors that determine
the bank profitability. It is
represented by different financial ratios like total asset growth, loan growth rate and earnings growth
rate. Yet, it is one of the complexes subject to capture
with financial ratios. Moreover, operational efficiency in managing
the
operating expenses is another dimension
for management quality. The
performance
of management
is often expressed
qualitatively
through subjective evaluation of
management systems, organizational discipline, control systems, quality of staff,
and others. Yet, some
financial ratios of the financial statements act as a proxy for management efficiency.
The capability of the management to deploy its resources efficiently, income maximization, reducing operating costs
can be measured by financial ratios. One of this ratios used to measure management quality is
operating profit to income ratio (Rahman et al. in Ilhomovich, 2009; Sangmi and
Nazir, 2010). The
higher the operating profits to total income (revenue) the more the efficient management is in terms of operational efficiency and income generation. The other important ratio
is
that proxy management quality is expense
to asset ratio. The ratio of operating expenses to total asset is expected to be negatively associated with
profitability. Management quality in this regard, determines the level of
operating expenses and in turn affects profitability (Athanasoglou et al. 2005).
