MANAGEMENT OF COMMERCIAL BANKING

PROF. JITENDRA MAHAKUD

DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 06 : Bank Performance Measures ‐I
 Profitability and efficiency measures of commercial banks
 DuPont Analysis
 Factors affecting bank profitability
 Measuring Performance of Commercial Banks

• Performance refers to how adequately the bank meets the needs

of its stockholders (owners), employees, depositors and other
creditors and borrowing customers
• Bank performance measures are evaluated with help of the
Income Statement and Balance Sheet
 Profitability Ratios

• ROA is an indicator of managerial efficiency

• It indicates how capable management has been in converting
assets into net earnings
 Profitability Ratios Cont..

• ROE is a measure of the rate of return flowing to shareholders

• It approximates the net benefit that the shareholders have
received from investing their capital in the financial firm
 Profitability Ratios Cont..

• These are efficiency as well as profitability measures

• They indicate how well the management and staff have been
able to keep the growth revenue ahead of rising costs
 Profitability Ratios Cont..

• The net interest margin measures how large a spread between

interest revenue and interest cost management has been able to
achieve close control over earning assets and pursuit of the
cheapest source of funding
• The net non‐interest margin measures the amount of non‐
interest revenue stemming from service fees the bank has been
able to collect relative to the amount of non‐interest cost
incurred
 Profitability Ratios Cont..

• Traditional measure of earnings efficiency

• It measures the effectiveness of a firm’s intermediation function
in borrowing and lending money
• It also shows the intensity of competition in the market
• Greater competition tends to squeeze the difference between
average asset yields and average liability costs
DuPont Analysis
Factors affecting the components of ROE
• Equity multiplier (Capital structure decisions)
• What sources of funding should be used?
• Decisions about dividend payments
• Net profit margin and Asset utilization ratio
• The mix of funds raised and invested
• Size of the bank
• Control of operating expenses
• Pricing of services
• Minimization of tax liability
Factors affecting profitability
• Bank size
• Capital ratio
• Risk
• Funding cost
• Revenue diversification
• Bank age
• Corporate governance
• Industry structure
• Business cycle
• ROA, ROE. Net Interest Margin, Net Operating Margin are
the major profitability measures of the commercial banks
• Capital structure, dividend policy, pricing of the services,
tax liability are the major factors affecting the
components of ROE
• Bank size, risk, capital ratio, funding cost, revenue
diversification, corporate governance, industry structure,
macroeconomic condition are the major determinants of
bank profitability
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007
MANAGEMENT OF COMMERCIAL BANKING
PROF. JITENDRA MAHAKUD
DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 07 : Bank Performance Measures ‐II
 Stability Measures
 Asset Quality Measures
 Liquidity Measures
 Capital Adequacy Ratio

• Ratio of the bank’s capital to its risk weighted assets

• Capital= Tier‐I Capital + Tier‐II Capital
• Tier‐I Capital :
i. Paid‐up Capital
ii. Statutory Reserves
iii. Reserves which are not kept aside for meeting any specific liability
iv. Surplus generated from sale of capital assets
• Tier‐II Capital :
i. Subordinate debt
ii. General provisions and Loss reserves
iii. Undisclosed Reserves
iv. Perpetual preference shares
 Asset Quality Ratio

• Credit worthiness of a particular bank’s loan portfolio

i. Gross Non‐Performing Assets (NPA) to Total Loans Ratio
ii. Net NPA to Nat Advances
Net NPA = Gross NPA – Net Provisions on NPA and Interest on
Suspense Account
𝑷𝒓𝒐𝒗𝒊𝒔𝒊𝒐𝒏𝒔 𝒇𝒐𝒓 𝒍𝒐𝒂𝒏 𝒍𝒐𝒔𝒔𝒆𝒔
iii. Provisions for Loan Loss Ratio
𝑻𝒐𝒕𝒂𝒍 𝒍𝒐𝒂𝒏𝒔
 Non‐Performing Assets

• NPA is a loan or advance where the interest and/or installment of

principal remains over due for a period more than 90 days in
respect of the loan
• For agricultural loans a loan granted for short duration crops will
be treated as NPA if the installment of principal or interest
remains overdone for two crop seasons and loan granted for long
duration crops will be treated as NPA if the installment of
principal and interest overdue for one crop season
 Loan Classifications

• Standard Assets: It does not disclose any problems (not NPA)

• Sub‐standard Assets: If the asset remained as NPA for a period
less than or equal to 12 months
• Doubtful Assets: If the asset remained as NPA for a period more
than 12 months
• Loss Assets: Loss has been identified by the bank, or internal or
external auditors, or central bank but the amount has not been
written off wholly or partly
 Liquidity

• Liquidity is defined as the extent to which the bank has funds

available to meet cash demands for loans and deposit
withdrawals
• Banks require different amounts of liquidity depending on their
growth rate and variability in lending and deposit activities
 Liquidity Ratio

𝑪𝒂𝒔𝒉 𝒂𝒕 𝑩𝒂𝒏𝒌 𝑩𝒂𝒍𝒂𝒏𝒄𝒆 𝒘𝒊𝒕𝒉 𝑪𝒆𝒏𝒕𝒓𝒂𝒍 𝑩𝒂𝒏𝒌 𝑪𝒂𝒍𝒍 𝑴𝒐𝒏𝒆𝒚

i. 𝑪𝒂𝒔𝒉 𝒕𝒐 𝑫𝒆𝒎𝒂𝒏𝒅 𝑫𝒆𝒑𝒐𝒔𝒊𝒕 𝑹𝒂𝒕𝒊𝒐
𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒎𝒂𝒏𝒅 𝑫𝒆𝒑𝒐𝒔𝒊𝒕

𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕𝒔 𝒖𝒏𝒅𝒆𝒓 𝑺𝒕𝒂𝒕𝒖𝒕𝒐𝒓𝒚 𝑶𝒃𝒍𝒊𝒈𝒂𝒕𝒊𝒐𝒏𝒔

ii. 𝑺𝑳𝑹 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒕𝒐 𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐
𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕𝒔

𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒎𝒂𝒏𝒅 𝑫𝒆𝒑𝒐𝒔𝒊𝒕𝒔

iii. 𝑫𝒆𝒎𝒂𝒏𝒅 𝒕𝒐 𝑻𝒊𝒎𝒆 𝑫𝒆𝒑𝒐𝒔𝒊𝒕𝒔 𝑹𝒂𝒕𝒊𝒐
𝑻𝒐𝒕𝒂𝒍 𝑻𝒆𝒓𝒎 𝑫𝒆𝒑𝒐𝒔𝒊𝒕𝒔

𝑻𝒐𝒕𝒂𝒍 𝑳𝒐𝒂𝒏𝒔
iv. 𝑪𝒓𝒆𝒅𝒊𝒕 𝒕𝒐 𝑫𝒆𝒑𝒐𝒔𝒊𝒕 𝑹𝒂𝒕𝒊𝒐
𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒑𝒐𝒔𝒊𝒕𝒔

Higher CD Ratio implies that bank may not have enough liquidity to
cover any unforeseen fund requirements
 Liquidity Ratio Cont..

v. 𝑻𝒆𝒎𝒑𝒐𝒓𝒂𝒓𝒚 𝑰𝒏𝒗𝒆𝒔𝒏𝒕𝒎𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐

𝑪𝒆𝒏𝒕𝒓𝒂𝒍 𝑩𝒂𝒏𝒌 𝒇𝒖𝒏𝒅𝒔 𝒔𝒐𝒍𝒅 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑺𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔 𝒘𝒊𝒕𝒉 𝒎𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝒐𝒇 𝒐𝒏𝒆 𝒚𝒆𝒂𝒓 𝒐𝒓 𝒍𝒆𝒔𝒔 𝑫𝒖𝒆 𝒇𝒓𝒐𝒎 𝒃𝒂𝒏𝒌𝒔
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒕𝒆𝒔
𝑻𝒐𝒕𝒂𝒍 𝒗𝒐𝒍𝒂𝒕𝒊𝒍𝒆 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝑻𝒆𝒎𝒑𝒐𝒓𝒂𝒓𝒚 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕𝒔
vi. 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒆 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝑫𝒆𝒑𝒆𝒏𝒅𝒆𝒏𝒄𝒚 𝑹𝒂𝒕𝒊𝒐
𝑵𝒆𝒕 𝒍𝒐𝒂𝒏𝒔 𝒂𝒏𝒅 𝒍𝒆𝒂𝒔𝒆𝒔

Volatile liabilities are: brokered deposit, CDs, deposits in foreign offices, Central
Bank funds purchased
It considers the degree to which riskiest assets are being funded by unstable
or ‘hot’ money funds that can disappear from the bank overnight
The volatility dependency ratio varies inversely with liquidity
• Capital Adequacy Ratio, Total NPA to Total Loans Ratio,
Provision for Loan Loss Ratio are the major indicators of
bank stability and asset quality
• The definition of NPA varies across the types of loans
• Total loans of the bank can be categorized as standard,
sub‐standard, doubtful and loss assets
• Temporary Investment Ratio, Volatile Liability Dependency
Ratio, Cash to Demand Ratio & Credit Deposit Ratio
measure the liquidity of the banks
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007
MANAGEMENT OF COMMERCIAL BANKING
PROF. JITENDRA MAHAKUD
DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 08 : Bank Performance Measures ‐III
 Non‐Interest Income
 Non‐Interest Expense
 Productivity Ratio
 Non‐Interest Income

• Fiduciary activities
• Deposit service charges
• Trading revenue, venture capital revenue and securitization income
• Investment banking, advisory, brokerage and underwriting fees and
commissions
• Insurance commission fees and income
• Servicing fees for credit card, real estate, mortgage etc
Non‐Interest Income Cont…

• Net gain or loss of real estate owned or held by others

• Disposal of fixed assets
• Others: income from safe deposit loans, sale of bank deposits, cheques,
execution of acceptances and letters of credit, credit card
• Fees, foreign currency fees, penalties for early withdrawals, etc
 Non‐Interest Expenses

• Personal Expenses: wages, salaries and benefits

• Rent and depreciation on building and equipment
• Goodwill impairment
• Amortization expense and impairment losses for other intangible
assets
• Other operating expenses
(The sum of these five component expenses is called overhead
expenses)
 Ratios

𝑵𝒆𝒕 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆 𝑵𝑰𝑬 𝑵𝒆𝒕 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 𝑵𝑰𝑰

• 𝑩𝒖𝒓𝒅𝒆𝒏 𝒐𝒓 𝑵𝒆𝒕 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅 𝑬𝒙𝒑𝒆𝒏𝒔𝒆 𝑹𝒂𝒕𝒊𝒐
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
where: NIE‐NII = Burden
𝑵𝒐𝒏𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆
• 𝑬𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒄𝒚 𝑹𝒂𝒕𝒊𝒐
𝑵𝒆𝒕 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 𝑵𝒐𝒏𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑰𝒏𝒄𝒐𝒎𝒆

The Efficiency Ratio measures the amount of non‐interest expense a bank pays to earn one
dollar of net operating revenue
The Efficiency Ratio shows the tradeoff among NIE,NIM and NII
Lower Efficiency Ratios are derived from a combination of cost control, improvement in
NII and growing NIM
𝑵𝒐𝒏𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆 𝑭𝒆𝒆 𝑰𝒏𝒄𝒐𝒎𝒆
• 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑹𝒊𝒔𝒌 𝑹𝒂𝒕𝒊𝒐
𝑵𝒆𝒕𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 𝑵𝑰𝑴
It has an inverse relationship with the operating performance of the bank
 Productivity Ratios

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒔𝒔𝒆𝒕𝒔
• 𝑨𝒔𝒔𝒆𝒕𝒔 𝒑𝒆𝒓 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒆
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒇𝒖𝒍𝒍 𝒕𝒊𝒎𝒆 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒆𝒔
Higher Assets per Employee indicates that fewer employees handle business
associated with larger volume of assets
𝑷𝒆𝒓𝒔𝒐𝒏𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔
• 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒆𝒓𝒔𝒐𝒏𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒔𝒆
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒇𝒖𝒍𝒍𝒕𝒊𝒎𝒆 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒆𝒔
The Average Personal Expenses measures the average cost of an employee when
salaries and benefits are recognized
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑳𝒐𝒂𝒏𝒔
• 𝑳𝒐𝒂𝒏 𝒑𝒆𝒓 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒆
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒇𝒖𝒍𝒍𝒕𝒊𝒎𝒆 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒆𝒔
It measures the loan productivity
𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
• 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 𝒑𝒆𝒓 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒆
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒇𝒖𝒍𝒍𝒕𝒊𝒎𝒆 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒆𝒔
It measures the profitability of a bank’s workforce
 Major Issues Related to Bank Performance

• Bank Capital and Profitability

• Bank Risk and Profitability
• Regulations and Profitability
• Monetary Policy and Profitability
• Economic Uncertainty and Profitability
• Major Non‐Interest Income includes commission, fees,
trading revenue, disposal of fixed asset penalties etc.
• The overhead expenses are the major non‐interest
expenses of commercial banks
• Burden Ratio, Efficiency Ratio are the major performance
indicators of non interest activities of the bank
• Asset, net income, personal expenses and loans per
employee measures the productivity of the full time
employees of the commercial bank
• Other factor that affects bank profitability include bank
capital, regulations, monetary policy, economic
uncertainty, etc.
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007
MANAGEMENT OF COMMERCIAL BANKING
PROF. JITENDRA MAHAKUD
DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 09 : Bank Performance Measures‐IV
 Internal Performance Evaluation
 Consumer Profitability Analysis
 Internal Performance Evaluation

• Evaluation is made for the different business units of banks. For example:
Consumer banking, wholesale Banking and securities components
• Banks evaluate line‐of‐business profitability and risk via Risk Adjusted
Returns on Capital (RAROC) and Return on Risk Adjusted Capital (RORAC)
𝑹𝒊𝒔𝒌 𝑨𝒅𝒋𝒖𝒔𝒕𝒆𝒅 𝑰𝒏𝒄𝒐𝒎𝒆
• 𝑹𝑨𝑹𝑶𝑪
𝑪𝒂𝒑𝒊𝒕𝒂𝒍

The objective is to identify the measure of return generated by a line of

business and compare that return to the allocated capital. The income or
return may be adjusted for risk, which means that expected losses are
subtracted from revenues along with other expenses
 Internal Performance Evaluation Cont…

• RAROC is used to evaluate loans and product lines and customers

• Applied to pricing loans RAROC allocates equity capital depending on
risk of loss, calculated a required rate of return on equity and then uses
this information in pricing loans to ensure that they are profitable for
the bank
𝑰𝒏𝒄𝒐𝒎𝒆
• 𝑹𝑶𝑹𝑨𝑪
𝑨𝒅𝒋𝒖𝒔𝒕𝒆𝒅 𝑹𝑰𝒔𝒌 𝑪𝒂𝒑𝒊𝒕𝒂𝒍

The capital is adjusted for risk which means that it represents a

maximum potential loss based on the profitability of future returns or
an amount necessary to cover loss associated with the volatility of
earnings
 Internal Performance Evaluation :Example (Loan Pricing)

Let: Cost of funds = 6%

Provision for loan loss = 2%
Direct Expenses= 0.5%
Indirect Expenses = 0.25%
Overhead expenses = 0.25%
Total cost before Capital charge = 9%

The capital charge is determined by multiplying the equity capital

allocated to the loan times the opportunity cost of equity and then
converting to a pre‐tax level
 Internal Performance Evaluation :Example Cont..

Assume: Equity to Loan Ratio = 12%

Opportunity Cost of Equity = 18%
Then after tax Capital Charge = 1.5%
𝟏.𝟓 𝟏.𝟓
• If the tax rate is 0.3, the pre‐tax capital change is 𝟐. 𝟏𝟒
𝟏.𝟎 𝟎.𝟑 𝟎.𝟕

• Loan Rate = 9% + 2.14% = 11.14%

• This implies that if the loan rate is 11.14%, the bank will earn the
target ROE of 18%
 Drawbacks of Application of RAROC

• It may not be possible to separate the economic costs and

revenues of the different products
• The production of outputs may share inputs such as land, labor
and capital, which makes it impossible to individually analyze the
product lines
 Economic Value Added

• It is another performance metric similar to RAROC

• EVA = Adjusted earnings – Opportunity Cost of Capital
Adjusted earnings: Net income after taxes
Opportunity Cost of Capital: Cost of Equity times Equity Capital
• Managers can apply EVA to loans, projects, product lines in order
to evaluate whether the investment will be justifiable in terms of
rewarding shareholders
 Economic Value Added Cont..

• New investments should be undertaken until the marginal

contribution of the last investment is zero (i.e. EVA=0)
• A higher EVA can be achieved by boosting adjusted earnings (via
lowering costs, increasing sales etc.) and lowering cost of equity
• RAROC compares business unit profits with the unit’s capital‐at
risk whereas the EVA compares business unit profit with the cost
of capital
 Customer Profitability Analysis

• It is used to evaluate whether net revenue from an account

meets a bank’s profit objective
• General customer profitability rule is that 20% if a firm’s
customers contribute about 80% of overall profits
• Banks use customer profitability analysis to differentiate between
the firm’s high value customers and those customers who are
marginally profitable in order to move these latter customers to a
more profitable position for the bank
 Customer Profitability Analysis Cont..

• Customer Profitability analysis is more often performed using

monthly or quarterly historical data so that pricing can be
modified where appropriate
• This process involves comparing revenues from all services
provided with associated costs and bank’s target profit
 Customer Profitability Analysis Cont..

• If Revenue > Expenses + Target Profit, the account generates a

return in excess of the minimum return required by the bank
• If Revenue = Expenses + Target Profit, the account just meets the
required return objective
• If Revenue < Expenses, the account is clearly unprofitable
• If Revenue < Expenses + Target Profit, the account is profitable,
but does not generate the minimum acceptable return to the
bank
 Steps for Evaluating Customer Profitability

• Identify the full list of services used by a customer such as

transactions account activity, extension of credit, security
safekeeping, letter of credit, safe deposit boxes etc.
• Assess the cost of providing each service
• No systematic method for allocation of fixed cost so estimation of
unit cost is the best way
• Banks evaluate line‐of‐business profitability through Risk
Adjusted Returns on Capital (RAROC) and Return on Risk
Adjusted Capital (RORAC) ratios
• Banks use EVA to loans, projects, product lines in order to
evaluate whether the investment will be justifiable in
terms of rewarding shareholders
• New investments should be undertaken until the EVA is
zero
• Bank profitability analysis is used to evaluate whether net
revenue from an account meets a bank’s profit objective
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007
MANAGEMENT OF COMMERCIAL BANKING
PROF. JITENDRA MAHAKUD
DEPARTMENT OF HUMANITIES AND SOCIAL SCIENCES, IIT KHARAGPUR

Module 01: Functions, Regulation, Financial Statements and Performance

Lecture 10 : Bank Performance Measures ‐V
 Cost management strategies
 Transfer Pricing
 Cost Management Strategies

• Expense reduction
• Operating efficiencies
• Revenue enhancement
• Contribution growth
 Expense Reduction

• Reduction of non‐profit generating branch and medical benefits

of employees
• Outsourcing the data processing services
• Use of temporary or contractual workers
• Elimination of redundant tasks
• Digitalization of the system
 Operating Efficiencies

• Reduction of costs but maintaining the existing level of products

and services
• Increasing the level of output but maintaining the level of current
expenses
• Improvement of workflow
 Mechanism of Attaining Operating Efficiency
• Reducing workforce
• Increasing work requirements
• Economies of Scale: It is said to exist when a bank’s average cost
decreases as output increases
• Economies of Scope: How the joint cost of providing several
products change as new products are added and existing output
is enhanced. The argument is that joint costs will grow by much
less than the costs allocated with producing products or providing
services independently
 Revenue Enhancement

• Changing the price of specific products and services with high

volume of business
• Identification of products and services that exhibit price inelastic
demand
• Increase in price reduces the demand of the product
• Proportionate decrease in demand is less than the proportionate
increase in price
• Expansion of volume keeping price constant
• Enlarging the base of the consumers by increasing product quality
 Contributing Growth

• Allocation of resources to improve the overall long‐term

profitability
• Increase in expenditure should be associated with increase in
associated revenues
Example: Investment in new technology, digitalization of the
system etc.
 Transfer Price

• It is an internal rate of interest used to calculate transfer income

or cost due to an internal flow of funds in a bank
• There is a transfer cost for each loan and transfer income for each
deposit
• The difference between interest rate and transfer price is called
interest margin which allows to calculate the internal interest
profit on a transaction
 Methodologies of Transfer Price

• Single Pool Method: Same one and only transfer price rate is
assigned to all loans and deposits. There is no difference in
pricing products with various repricing and maturity
characteristics.
In this method the transfer price is the weighted average rate of
interest of all assets and liabilities of the bank
• Double Pool Method (Split Pools): Average loan rate is used as
transfer price for loans and mean deposit rate is used as transfer
price for deposits
 Methodologies of Transfer Price Cont..

• Multiple Pool Method: Products are divided into different pools on

the basis of maturity. The bank establishes a set of transfer price for
each product pool, i.e. one price for each pool. It is calculated as the
average interest rate on assets and deposits in each pool
At any point of time, the rates prevailing in the market is accepted as
the cost of funds suitable for the bank
The transfer price assigned to each pool is based on its maturity and
market rates prevailing for its term.
 Methodologies of Transfer Price Cont..
• For assets, which carry the interest income the TP is negative in
order to calculate the cost of the fund For liabilities bearing
interest costs, the TP is positive, which shows the internal income
attributed to funds raised
• Depending on market interest rates, transfer prices change from
one period to another and the length of the period needs to be
determined.
• Matched Rate Method: In this method prices are assigned to each
transactions separately instead of pooled transactions
• The cost management strategies of commercial banks
include methods of expense reduction, increasing
operating efficiencies, enhancement of revenue and
proper allocation of resources
• Transfer price is the internal rate of interest used to
calculate the transfer income or cost due to an internal
flow of funds
• Methodologies for calculation of transfer price are single
pool method, double pool method, multiple pool method
and matched rate method.
• Bank management & financial services by Rose, P. S., & Hudgins, S. C., McGraw‐Hill
Education, 2008.
• Commercial banking: The management of risk by Gup, Benton E., and Kolari, James W.,
John Wiley & Sons Incorporated, 2005.
• Management of Banking, 6e. by MacDonald, Scott. S., & Koch, Timonthy. W, Thomson,
2007