Evaluation and Supervision of Banks in Deregulated Real and Financial Markets

[Draft for Discussion – not to be quoted]




Nachiket Mor and Basant Maheshwari[1]





While there is a great deal of continuing debate about what are the comprehensive determinants of growth and development, there is broad “consensus about what facilitates long-term growth: transparent financial markets; well-capitalized, well-regulated banks; free trade; educated workers; a reliable but not inflexible legal system; taxes and welfare benefits low enough to avoid disincentives to work”[2].  Given the gradual deregulation of financial markets as well as markets for goods and services in India, in this paper we attempt to discuss what is meant by a well-regulated and well-capitalised bank taking the Indian context as an example.  Specifically we seek to articulate a simple framework, which could serve as a guide to evaluating the performance of a bank and provide some pointers how best such a bank may be supervised using this framework. 


We also attempt to show that evaluation frameworks that focus on distinct parameters such as Non Performance Asset Ratios and provisioning levels determined using fixed rules such as number of days of overdues; standardised Liquidity Gap rules; adequacy of Investment Fluctuation Reserves and Fixed Capital Adequacy Ratios not only reveal very little about the “soundness” of a bank but actually end up “requiring” even well-intentioned bank managements to run the bank in a less than optimal manner.  In addition, supervisory frameworks that seek to limit the risk exposure of banks by restricting the participation of banks in unsecured paper, equity markets, commodity markets, derivatives markets, futures markets, foreign exchange markets, external commercial borrowings and bond markets combined with severe branch licensing restrictions, a variety of interest rate caps both on the assets and the liabilities side, and regulation driven directed lending, actually end up increasing the risk exposure of banks and leave the banks very vulnerable to shocks with very little ability to either enhance returns or reduce risks. 





Scarce Resources


Any evaluation framework seeks to evaluate the performance of an entity essentially in terms of how it uses its scarce resources.  For a Bank the two key scarce resources generally are:


  1. Capital
  2. Liquidity


While in theory it should be possible to measure performance of a bank on both parameters, return on risk capital as well as on liquidity, in practice the approach adopted attempts to answer the following two distinct and very broad questions:


  1. How well is the bank deploying its capital? (optimisation)
  2. Is the bank operating within the limits of liquidity available to it? (constraint)


Most of the specific parameters that are used to evaluate banks (such as the NPA ratio, Net Interest Margin, Return on Assets, Return on Equity and various liquidity ratios and gap numbers) are intended to directly or indirectly, answer these two questions.  However, unless the nature of the business of banking and the role that risk capital and liquidity play is understood clearly there is a real danger that the parameters may convey an incorrect and incomplete picture of the true nature of the risk-return tradeoffs that a bank is making.  Therefore, before going into the details of the specific parameters that should be used (and qualitative questions that should be asked[3]) it would be useful to spend some time understanding, more carefully, the “business of banking”.


The Business of Banking


The most important aspect of a bank is that money is its raw material and its assets are primarily composed directly of this very same raw material.  And, unlike any other asset or raw material that any other company has, money has some very unique characteristics:


  1. Its “value” changes every instant (for example, money at 10:00 a.m. has a very different value from money at 5:00 p.m. and money at a rupee-dollar exchange rate of Rs.50 has a very different value from money at a rupee-dollar exchange rate of Rs.45).


  1. Money available for one month has a very different value from money available for ten years and even this value changes every instant.


  1. Markets for money have far less friction than do markets for real goods and services and “true” values are often very close to “realisable” values.  And, even if, for example, a loan given to a company is non-saleable it is possible to execute an off-setting financial transaction (credit or interest rate derivative) that effectively ends up “neutralising” the loan in the books of a bank.  A plant or a machine in a manufacturing facility would be far more difficult to sell or “neutralise”.


This has some very interesting consequences for a bank and for the evaluation of a bank:


  1. Traditional product differentiations become very hard in a bank because each “transaction” is a new product and is created only upon the instant of delivery because the raw material that went into it (money at a specific moment and for a specific set of maturities) was frozen only at that instant.  And, while on the face of it several different names are used to describe bank “products”, such as, home loans, cash-credit limits, credit cards and interest rate swaps, in reality they are all financial flows and are composed of the very same raw material “money”, put-together in infinitely different ways.  This poses some very difficult challenges for banks seeking to effectively manage their operations in a profitable manner.


  1. It is very hard to make the claim that the annual profits of a Bank is a fair judge of the annual performance of the management of the bank – if a Rs.100 crore ($20 million) loan is given for 5 years at a spread of 2% per annum, Rs.2 crore ($0.4 million) would appear in the first annual profits of the bank, Rs.100 crore ($20 million) would appear in the balance sheet of the bank, but the reality is that the act of giving the loan has already had a considerable impact on the future profits of the bank – the impact on the future cumulatively is four times the impact on the current profits.  Taking this argument further if one were now to evaluate the performance of the bank in the fourth or the fifth year of the loan, very marginal amounts of the profits of that year would be on account of decisions taken by the management in that year – in the fourth year for example, if every year the management just made identical Rs.100 crore ($20 million) loans at the same spread of 2%, the reported profit would be Rs.8 crore ($1.6 million) with only a quarter of that because of the decision made by the bank in the current year.  The reality is that most of the performance of a bank in any year is driven by the state of its historic balance sheet and simplistic interpretations of bank performance numbers based on the current year profits of a bank could therefore be very misleading.


  1. While the banking product is “created” upon the instant of delivery, the “sale” (from a bank’s point of view) is completed only when the money is returned (say five years later or in case of a mortgage as long as 30 years later) because only then can the true “sales margin” be computed – very much as in the case of a large construction contract, where, until the complete building is built and delivered it is hard to arrive at a true picture of the profits of the construction business.  This is a similar point to the one above and stresses the fact that in evaluating the current years performance a bank one needs to somehow take changes in the character of the balance sheet during this period and combine them traditionally defined profit number to arrive at the “true” profit of a bank.


  1. Unlike manufacturing companies, banks meet most of their obligations through flows from the balance sheet (for example principal repayment on loans taken by a bank in the form of deposits are primarily met out of repayments of loans given by the bank to its borrowers).  And, since the precise set of sources from which a specific rupee used to finance a loan given to a borrower are hard to discern, it is entirely possible that a bank may consciously decide to fund a 20 year fixed rate loan out of money borrowed for three months from a depositor in the hope that at the end of three months: (a) interest rates will not rise (interest rate risk) and (b) it will able to find other depositors that will be willing to lend it money at the same rates as they did three months ago (liquidity risk).  The profit that a bank reports in the very first year, leave alone over the next twenty years is therefore a function of how the credit risk of the borrower behaves as well as how interest rates behave and how the liquidity environment that a bank faces, behaves.


Given all these complexities, and the inter-relationships between each of these variables, evaluating a bank properly is a difficult exercise.  In particular, frameworks such as the CAMELS framework and the various traditionally defined ratios such as the NPA ratio (which has a lagged, mechanically defined, numerator but a contemporaneous denominator), Net Interest Margin (NIM) (a complex function of historic and current credit risk, rate risk and liquidity risk) and return on networth provide incomplete and worse, misleading, indicators of a bank’s performance.  However, over the years (particularly in the last two decades) among others, bankers, regulators, analysts, rating agencies and academics have evolved a broadly consistent framework within which the “true” performance of a bank may be evaluated.  A starting point of the framework is in fact the framing of the two questions that were posed in the previous section. In order therefore to get to the precise parameters that would be useful in evaluating a bank and its management it is important to understand the role that capital and liquidity play in the life of a bank.


Role of Liquidity


One of the key roles that a bank plays is that of liquidity transformation.  For example millions of savings account holders while individually providing liquidity which can vanish in an instant, collectively allow the bank to treat a large part of this liquidity as permanent (or “core”).  As has been mentioned earlier, the principal assets of a bank are financial and it can therefore always raise more money (“from money”) by “selling” these assets or by making them available as collateral. Since the assets are financial in nature, at least in theory it should be possible to value them precisely and therefore find a buyer for them.  Since, money in the future is really a “promise to pay”, large amounts of liquidity can be raised by a bank merely on the assurance that it will pay.  Even when a bank’s word is not good enough the Central Bank of a country (the Reserve Bank of India within India) can extend a line of credit (as a lender of last resort) to the bank.


While all this is true, in practice the supply of this liquidity is very seriously limited and has to be very carefully managed.  Most banks set very strict limits on how much credit they will extend to each other and there is always a possibility that the collective group of depositors may decide to act in concert instead of independently and seek to withdraw all of their savings all at once (as in the case of “run on the bank”) producing a disastrous consequence for a bank.


All banks run liquidity mismatches of one sort or another but several parameters seek to limit the cumulative impact of these mismatches.  Typically banks tend to monitor:


  1. Daily gap in relation to the amounts a bank can raise in the market.


  1. Cumulative weekly, fortnightly, monthly, quarterly and semi-annual liquidity gaps once again in relation to the amounts a bank can raise in the market.  As a rule of thumb, if the bank needs to raise more than 10% of the total size of the market over any particular period it would be a cause of concern.


  1. Ratios such as savings deposits to total deposits, demand deposits to total deposits and wholesale funds to total funds to reflect the stability characteristics of their funding base.  These third set of ratios tend to be highly correlated with each other and often tend to confuse the issue.  The first two sets of ratios in any case capture all the behavioural assumptions around stability of these deposits and are far more effective measures of the liquidity risks of a bank.


Where multiple currencies are involved and there are limits to fungibility between currencies, these liquidity gaps need to be monitored on a currency by currency basis.  Many behavioural and other assumptions are made while determining the liquidity character of each asset and liability. It becomes important to examine the nature of these assumptions (the qualitative part of the evaluation), the process a bank has for constantly validating them and the liquidity exposure of a bank (or its emergency plan) in case these assumptions suddenly break down (as in the case of a “run”).


Liquidity in many ways is the short-term counter part of the bank’s capital base.  While the capital base provides longer term and “true” protection (Solvency), liquidity provides the shorter term protection to a bank.  And, while banks (and often companies) can deliver higher shorter term profits by taking strong liquidity mismatch positions, since it is a relatively simple metric to compute and monitor regulators generally do an adequate job of reigning in banks which seek to do this overly aggressively.


Role of Capital


As has been mentioned earlier, for a variety of reasons, capital has become the scarce resource on the basis of which banks tend to be evaluated most often and holds the key to the modern approaches towards evaluation and supervision of a bank.  Most generally speaking capital acts as an explicit reserve (it may be useful to think of it as actual money that is placed in risk-free securities or in a deposit with a risk-free entity) which seeks to protect the lenders to a bank from the uncertainties of the asset side of the bank which may impair the ability of the bank to meet its own obligations towards its lenders.  In fact one of the first questions that a bank needs to ask itself is how safe would it like to be and then decide how much of a capital reserve it would like to hold against the assets that it seeks to hold on its balance sheet?  The Basle I Accord made a judgement that 4% of “pure” capital was the minimum a bank should have in relation to its assets.  Given the “cash-in-reserve” role of capital one of the most important tasks for a bank management is to decide how to allocate this scarce reserve between its various asset classes so as to remain consistent with its own internal safety goals (from its lender’s perspective) as well as to maximise the returns from the businesses that use this reserve.  In order to do this effectively managements have to have in place several building blocks (and it is one more set of qualitative evaluation parameters to focus on) which include the following:


  1. Matched Fund Transfer Pricing (MFTP):  this effectively translates the “yield curve” dimension of the price of money and the “real-time-variability” dimension of the price of money into a formal process.  This is an absolute pre-requisite for any bank and if a bank does not have a formal view on this, it would be possible to go so far as to argue that it does not really have the base capability to function as a bank.  Effectively the MFTP process, by assigning exactly matched maturity funds to each asset, “moves” the interest rate and liquidity risk to a central pool, to be managed on an aggregated and bank-wide basis and allows the business unit originating the asset to focus on the “pure” credit risk.


  1. Risk Quantification Methodologies (RQMs): Just as the MFTP provides clarity on the cost dimension of money (including the price of liquidity), RQMs provide clarity on the capital dimension of the bank.  Here is where a bank demonstrates the capability of being able to formally convert all of its judgement and analytical skills on credit evaluation, for example, into an assessment of the amount of “cash-in-reserve” (also called capital adequacy or economic capital) required to support a particular asset.  In a similar manner the whole process of identifying an impaired asset and the level of provisioning required is a very important RQM that all banks need to have.  RQMs are required for all the risks that a bank faces, including liquidity risk, market risk and credit risk.  RQMs generally accomplish two purposes: (a) they determine the extent of losses (credit losses for example), given the rating and maturity of each asset, that can be expected to occur with near certainty (Expected Loss) and (b) the amount of capital (or cash-in-reserve) that needs to be held by a bank against a particular asset (or liability) should its value decrease (or increase in the case of a liability) in an uncertain manner (Capital At Risk or Economic Capital).  Expected Losses go to reduce the returns from the asset and should in the normal course be deducted from the profits of a bank (as a standard provision) while the Economic Capital needs to be carved out from the networth of the bank to support each asset (or liability).


  1. Activity Based Costing (ABC): While this is not as critical a capability as the first two, it is still quite important because a bank is nothing if not extremely transaction and “activity” intensive.  As a consequence a large part of the total cost base of bank is overhead – it is not unusual for banks to have a 50% cost-to-income ratio.  In order to drive proper decision making about risk-return tradeoffs it would be very important for the bank to be able to link its “activities” (drivers of costs) to the actual costs themselves.


Having put these three principal building blocks in place the bank is ready to establish a performance evaluation framework.  The three key generic risks that a bank needs to provide capital for are, (a) credit risk; (b) market risk and (c) operations risk.  While well-established RQMs exist for credit risk and market risk, for operations risk this is still an evolving field and heuristics are at this stage the best set of tools that exist.  Methodologies like MFTP and ABC seek to separate and aggregate each of these risks in different pools so that they may be managed as portfolios rather than discretely, product-by-product.  Banks run business by customer segment or by product type or as a hybrid of the two.  Typically therefore a business unit will comprise of a combination of product types and customer segments.  Banks have processes that seek to combine the capital allocated for each of the generic risks that are present in a business unit to produce an economic capital allocation by business unit.  A key evaluation parameter for any business unit then becomes the provisioning adjusted (provisioning for both realised and anticipated levels of losses) return on economic capital.  When expressed in Rupees as an absolute quantum this is often referred to as Shareholder Value Added (SVA) with the hurdle rate being an estimation of the rate of return expected by the shareholder.  If expressed as a pure percentage rate of return over the economic capital deployed it is known RAROC (Risk Adjusted Return on Capital).


Implications for Evaluation and Supervision of a Bank


Given all this discussion what then are the implications for the evaluation and supervision of a bank.


  1. In order to ensure that the bank is soundly managed the regulator needs to ensure that the three building blocks mentioned earlier, MFTP, RQMs for all the critical risks and ABC are in place and that the top management and all levels of operating management understand them and actually use them in their day-to-day decision making process.  This is essentially a qualitative exercise involving a great deal of detailed investigation and interviewing by the regulator on an on-going basis.


  1. It also needs to compare the actual levels of capital possessed by a bank with the level of capital implied by the risk levels assumed by the bank (based on an as-on-date evaluation of the operations of a bank not historic) and satisfy itself that the bank is adequately capitalised.  If for example, it determines that the interest rate risk exposure of a bank is higher than it considers acceptable, it could require higher levels of capital adequacy to be maintained by a bank (very different from the current IFR requirement applicable to banks but very similar in spirit to the guidelines applicable to the primary dealers).  It should allow banks to hold higher level of capital than the amount that is required but banks with lower levels should be asked to reduce the level of operations or bring-in additional capital. All such issues should be fully disclosed in the annual report of the bank.


  1. Since credit risk assessment involves a great deal of judgement internal to a bank, the bank should be required, by the regulator, to assign risk grades (or credit ratings) to each asset class and publish the Expected Loss and Capital At Risk numbers that it estimates against each asset class.  Each year then, it will be required to re-grade all its existing assets and then compute standard provisioning and economic capital required.


  1. For complete transparency it must require a bank to report in detail expected loss and applicable cost adjusted revenues and the capital at risk for each product segment and each and every customer segment of the bank.  This will allow the shareholder and the depositor to more completely understand the risk and return drivers of a bank and reach their own conclusions on the aggregate level of risk and profitability of a bank.


Several other parameters are often used to evaluate a bank. Several of these parameters are incomplete and flawed.  These include:


  1. Cost to Income Ratio and the Cost to Asset Ratios.   The Best banks are targeting anywhere between 30 to 40% for the first ratio and under 1.5% for the second ratio.  This however, is a strategic issue.  Some banks may wish to service customer segments that are very low risk but expensive to serve. Typically a bank with very high transaction intensity would have high cost-to-income ratios but if it is doing well on a return on economic capital basis then a high cost-to-income ratio need not be a cause for concern.  The high cost-to-income ratio may be balanced by the low risk nature of the current and future revenue streams thus require lower levels capital.  Banks very heavily reliant on non-capital consuming fees would have these characteristics (State Street?).


  1. Net Interest Margin.  Taken alone, this is a seriously flawed ratio because it includes the spreads due to each and every risk taken by the bank.  Seen along with MFTP, in a disaggregated manner, it can give some insight into the drivers of profitability of a bank.


  1. Fees to Total Income.  Fees are generally viewed as having infinite returns on equity because there is a perception that they generally are compensations for services rendered and do not require “cash-in-reserve” to be held.  Therefore this is often a number that is looked at very favourably while evaluating a bank.  However, even if we ignore the almost certain requirement of capital for operational risk even in pure transaction intensive business, there is often a substantial amount of credit risk and market risk embedded in these transactions.  There is also a belief that since these fees often do not involve the commitment of funds, they make it unnecessary to use a scare bank resource: liquidity.  In reality there are several fee earning products (such as trade finance and guarantees) that impose a substantial liquidity cost on the bank on a contingent basis often akin to a zero coupon bond defaulting on the date of maturity – producing a sizeable shock.


  1. Average Cost of deposits / borrowings:  When measured as an absolute quantity it conveys very little information even if it has risen or fallen relative to the previous year because it is entirely possible that the returns from deploying these borrowings may have risen or fallen faster.  However, what would be very interesting to track would be the spread of these deposits (matched timing) over the risk-free benchmark (say the Government of India Security) by maturity and to compare then with bond and commercial paper yields over the same benchmark.  This would give a sense of how the market viewed the “safety” level of the bank.  It would then be useful to examine if this was consistent with the desired safety level discussed earlier.


  1. Gross / Net Non Performing Assets Ratio:  While this is a popular ratio, as long as the ratio is not spiralling out of control (indicating a stable and consistent strategy) and as long as the management is provisioning and allocating capital using appropriate RQMs (and not mechanically as is done here in India – US GAAP provides a much better approximation of what the true provisioning numbers should be), and is adequately capitalised, this ratio is essentially irrelevant as a performance evaluation measure. It is useful to evaluate consistency of management strategy.  For example, an avowed low-risk-low-return-high-leverage strategy is inconsistent with a high level of NPAs for example because not surprisingly it will result in low RAROCs.  The recent stress on using NPAs as an additional evaluation measure merely serves to dissuade banks from taking any risks at all and gradually will result in the erosion of competencies within Banks to evaluate and manage risks inherent in any proposal within an emerging economy like India.


  1. Duration of Assets, Duration of Liabilities and Duration of Equity (Duration of Assets less the Duration of Liabilities):  This is one of the tools by which the capital for the MFTP unit or the Rate Risk Management Unit is calculated.  If a Bank has a formal capital allocation strategy is place then the amount of capital committed to Rate Risk can be directly set.  However, when banks don’t have this methodology properly worked out they often tend to use Duration of Equity limits.


  1. Average Portfolio Credit Rating and Portfolio Diversity Score:  As in the case of Duration of Equity, these are tools that are used to calculate the capital allocated to the credit portfolio but these serve as independent checks on the RQM used to do this.  Other than that these statistics reveal more about the strategy of the specific bank in question than serve to evaluate its performance.


  1. Capital Adequacy Ratio:  Each regulator specifies a minimum that must be maintained.  But each bank needs to set its own benchmark depending on the desired safety levels.  Generally the bank is adequately capitalised if the amount of actual shareholder capital available with exceeds the economic capital required to support existing assets at the desired level of safety for the bank.




As can be seen from the paper, it is not very difficult to clearly establish a simple set of metrics by which a bank’s performance needs to be measured.  With the help of modern quantification techniques, it is now possible to attempt to develop a consistent and parsimonious set of metrics: cumulative liquidity gap and RAROC / SVA that give a deep insight into the functioning of the bank.  However, the computation of these two metrics requires a number of pre-requisites such as MFTP, RQMs and ABC to be in place.  Once a regulator acquires the competence to evaluate banks using the CAR methodology then it become easier for it to dispense with several restrictions such as equity limit, unsecured / unrated asset limit, allow a bank to use approved RQMs to assign EL and CAR to each asset class then simply look at the aggregate adequacy of capital and the provision and cost adjusted return on that capital.  If these numbers look acceptable then its concern about the solvency of the bank is addressed without the imposition of any specific limits.


Also, as one looks across markets to non-banks, securities firms, insurance companies, etc. CAR, RAROC based methodology is amenable to be applied across the complete spectrum of these companies and can be aggregated in the case of conglomerates so as to reflect the true solvency of the holding company (which may often be a bank) without the necessity of having to bring in a single regulator.

[1] Nachiket Mor in an Executive Director at ICICI Bank (nachiket.mor@icicibank.com) and Basant Maheshwari (basant.maheshwari@icicibank.com) is a Manager in the Performance, Information and Value Management Group at ICICI Bank. The views expressed in this article are those of the authors and do not necessarily reflect those of the Bank.

[2] “What in the world happened to economics?” by Justin Fox.

[3] This aspect is often ignored in bank evaluations – often the processes a bank follows give you a deeper insight into how well a bank is managed and its performance than do the pure numbers.