Framework for the Assessment of Bank Earnings

FSI Papers
September 2002

Introduction

The framework for analysis of bank earnings presented in this paper was created to aid supervisors in answering three very important questions about a bank: What are its expected results considering the available information and a given set of business conditions? How does it generate its income? What is the sensitivity of its earnings to changes in interest rates, spreads, loan volumes, delinquency and other banking business factors?

Supervisors have repeatedly asked these questions, and efforts have been made to satisfy their need for this kind of information. The framework contained herein evolved through the accumulation of experience and the expansions and adaptations made to meet specific needs and deal with the unique circumstances of each case. It has already been applied, in different stages of development, over the past four years to eight Brazilian banks, including the most important ones. The information obtained in the analyses has served as input for some highly important banking supervision decisions.

The framework is essentially forward looking, using accounting and managerial information on past performance as an indicator of what may be expected in the future. The framework may be implemented to a greater or lesser extent, depending on the availability of data and the time and other resources to be employed. The concepts on which the framework is based and the techniques it employs are well known and established. This paper presents a method for applying these techniques and certain ways of treating the data, which have produced the best results in assessing the earnings position of Brazilian banks. The advantages of this method are in great measure due to the conditions of greater instability faced by banks in Brazil and in other emerging market economies.

Assessing the earnings power of a bank, or of any enterprise, is a notoriously difficult task. The conclusions of such an assessment can easily go astray, due to a lack of accurate information or analytical skill, and may also lose relevance quickly, because of significant changes in business conditions. No analytical framework produces accurate predictions of results for a certain period in the future and it is not the objective of the framework presented here to make such predictions.

The assessment of bank earnings is, nonetheless, an integral part of most models of supervision and supervisory rating systems. Moreover, the questions presented above are too essential to be ignored. Although it is not possible to make accurate predictions of bank results, it is possible, in many relevant situations, to arrive at a well-founded conclusion about the capacity of the bank to generate earnings, and also to produce valuable information for other areas of examination.