LDM | Risk Management

Background

After the restoration of democracy, Nepal has adopted more liberal and open economic policies. The process of economic liberalization and reforms in the financial sector introduced in the early 1980s has led to significant changes in the banking industry. The open and liberal policy of the government in the financial sector has helped in establishing many banks and financial institutions in the country. These banks have contributed towards the introducing new technology, new banking systems and efficient service delivery in the country. These banks have been contributing inline with the thrust of economic liberalization and financial sector reform, i.e., making the financial system more competitive, efficient and profitable.

Consolidation in Banking Industry

Banking industry was booming until a decade back. But, economic slowdown during that period started affecting their performance of commercial banks. So, this led to consolidation of banking industry resulting into merger between banks and merger of development banks and finance companies with commercial banks and development banks.

Competitive Banking

Banking sector in Nepal is highly fragmented, especially in comparison with other key economies. Competition in the banking industry is increasing with great intensity. The principle of ‘survival of the fittest’ will hold good under such a scenario. Therefore, a bank has to increase its efficiency to win the competition.

Efficiency in Banking

Banks measure efficiency using different parameters. We can apply the concept of productivity and profitability to evaluate banking efficiency. The term productivity refers to the relationship between the quantity of inputs employed and the quantity of outputs produced. The input in the banking industry can be referred to the costs involved in producing the products and services, e.g., interest expenses, staff costs, operating costs. As there is difficulty in measuring the quantity of output produced by banks, the amount of income can be used to measure output of banking products.

Which Banks are More Efficient?

An increase in productivity means that more output can be produced from same inputs or same outputs can be produced from fewer inputs. Banking efficiency is mainly measured by following ratios:

• ROA (Return on Assets) – net profit for the year divided by average assets deployed to earn the profit, and
• ROE (Return on Equity_ – net profit for the year divided by average equity capital deployed during the year

To measure operational efficiency in detail, banks use use following parameters:

• other income to interest income (OI/II)
• interest expenses to interest income (IE/II);
• staff cost to net interest income and other income [SC/(NII+OI)];
• operating expenses to net interest income and other income[OE/(NII+OI)]; and
• operating profit to total income (OP/TI). 

Following table compares efficient banking by 18 banks of Nepal, on the basis of age of operation:

Return on Assets (ROA)

In terms of ROA, SCB is the best bank followed by NABIL and ADBL. This ratio is mainly guided by interest rate spread followed by earnings of non-interest income and cost efficiency. Interest rate spread of SCB (5.06%) is lower than that of ADBL (5.46%). However, it has been able to achieve the best ROA due to earnings of non-interest income. Similarly, NABIL has performed better than ADBL, RBB, NBL and NSBI despite having lower spread. This is because earnings of non-interest income of NABIL is higher. NIC is at the bottom of the 18 banks.

Return on Equity (ROE)

Computation of ROE is important on two grounds. First, an increase in earnings available to shareholders leads to increase in shareholders’ value. Second, in well-functioning competitive markets, the maximisation of shareholders’ value will lead to efficient allocation of capital. In this front, RBB is the leader followed by NABIL and EBL. NBB and LBL are at the bottom of the 18 banks.

Other Income to Interest Income (OI/II)

SCB is the best bank in therms of other Income to interest income ratio whilst NBB secured second position. On the other hand, NIC and MBL are at the bottom of the 18 banks. NBB has been able to secure second position mainly due to bank guarantee business in significant volume. Banks with higher ratio can be considered efficient, but also vulnerable in the sense that a reduction in other income will hit the profitability.

Interest Expenses to Interest Income (IE/II)

Interest expenses to interest income ratio shows the efficiency of banks in mobilising resources at lower costs and investing in high yielding assets. In other words, it reflects the efficiency in the use of funds. Two of the public sector banks – RBB and NBL are most efficient banks under this parameter while NCC is the most inefficient bank.

Staff Cost to Net Interest Income and Other Income [SC/(NII+OI)]

NCC has the highest ratio signifying worst performance. This could be probably due to recent mergers yet to achieve synergy perceived by the management. Staff efficiency of NIBL is the where NABIL stands second.

Operating Expenses to Net Interest Income and Other Income [OE/(NII+OI)]

NCC has the highest ratio signifying worst performance. This could be probably due to recent mergers yet to achieve synergy perceived by the management. NABIL and NBL are efficient banks are they have the lowest ratio in the industry.

Operating Profit to Total Income (OP/TI)

The operating profit to total income ratio helps in assessing whether banks are doing the right things internally. In this front, SCB is the best bank and NBL and NABIL rank next two positions. NCC is the worst bank. This may be due to negative synergy of merger. This bank, however, has managed better ROA and ROE due to recovery of non-performing loan.

Conclusion

The analysis of operational efficiency of banks will help one in understanding extent of the vulnerability of banks under the changed scenario and in deciding whom to bank upon. This may also help the inefficient banks upgrade their efficiency and be winner in the situations developing due to slowdown in the economy. The regulators should also be concerned on the fact that the banks with unfavourable ratios may bring catastrophe in the banking industry.