Chapter Four: Profitability 4.1 Importance of Profitable Banks Profitability, in terms of retained earnings, is a key source of capital generation. A sound banking system is built on profitable and adequately capitalized banks. Profitability is a revealing indicator of a bank’s competitive position in banking markets and of the quality of its management. The income statement reveals the sources of earnings and their quantity and quality, plus quality of loan portfolio and focus of its expenditures.

The income statement structure indicates bank business orientation. Interest is traditionally the major source of bank income, but the move toward nontraditional business is reflected in the income statement. Changes and stability of profits sometimes attributed to capital and reserves requirements. Taxation influences bank profitability and policy choices.

4.2 Income Statement Composition (%) of gross income A. Interest income (from loans and inter-bank deposits)205 B. Interest expenses (on deposits and borrowings)170 Net Interest income (A-B)35 Other banking-related operating income20 Trading-related income (stable liquidity & trading portfolios) 41 Investment –related income (subsidiaries & associates)4 Gross income100

Specific loan loss provisions & write-offs6 Operating expenses (Salaries, administrative, auditing, rents, depreciation, and amortization) 55 Expenses related to trading and investment activities20 Other expenses and interest related to non-deposit borrowings 4 Net income / (loss) before tax14 Income tax7 (%) of net income Transfers to general provisions46 Dividends declared14 Retained earnings40

4.3 Profitability Indicators Profit is the ultimate performance result showing the net effects of bank policies and activities in a financial year. Its stability and growth trends are the best summary indicators of a bank’s performance in both the past and the future. Profitability is usually measured by all or part of a set of financial ratios.

Key indicators include: A. Return on Equity: measures the rate of return on shareholder investment. B. Return on Assets: measures the efficiency of use of the bank’s potential. C. Other ratios measure the profitability of a bank’s core business, contribution of various types of activities to profit, bank operating efficiency, and the stability of its profits. Analysis of changes in ratios reveals changes in bank policies and strategic and/or in its business environment. Other factors influence profitability: inflation, interest rates, exchange rates, and investment in infrastructure.