Methodological Recommendations on Conducting Bank Activity Analysis Based on Coefficients

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Creation date: 2024-10-31

Approved

by the Resolution of the Supervisory Committee of the NBKR No. 7/7 dated 12.02.2004

Methodological Recommendations

on conducting bank activity analysis

based on coefficients

(amendments and additions approved by the Resolution of the Supervisory Committee No. 53/2 dated 24.12.2012, No. 39/1 dated 10.09.2024)

I. INTRODUCTION.

1.1. This document was developed by the National Bank of the Kyrgyz Republic to assist commercial bank employees (hereinafter referred to as "banks") in analyzing financial conditions and evaluating the activities of commercial banks using assessment coefficients.

(In the edition of the Resolution of the Supervisory Committee No. 39/1 dated 10.09.2024)

1.2. The set of coefficients presented in these Methodological Recommendations is not exhaustive; therefore, other coefficients may be additionally used when conducting the analysis.

1.3. Analysis must be conducted not only for a specific point in time (date) but also over a certain period (month, quarter, half-year, and year), as balance sheet data and income statements characterize the bank's state at a specific point in time, i.e., statically. Evaluating the current state considering the bank's activities over previous periods allows for identifying trends and forecasting the bank's future. It should be kept in mind that no coefficient values or trends themselves are indisputable or final indicators of a specific state (especially when comparing banks with each other). Before drawing a conclusion, all factors and aspects related to the bank's activities must be taken into account. Indicators may suggest that a bank has problems, but they do not always explain the causes of their occurrence. Therefore, only a detailed discussion of the situation with the bank's management and a thorough study of the bank's financial condition will provide a complete and reliable picture.

1.4. It is desirable to produce the analysis of indicators and evaluation of the bank's activities in comparison with similar-sized (or other parameter) banks.

1.5. When analyzing various aspects of the bank's activities, the same coefficients may be used. Therefore, some coefficients in this document are intentionally repeated.

II. GENERAL CONCEPTS.

2.1. When calculating indicators, comparability of the numerator and denominator must be ensured (for example, annual profit should be related to average annual assets, as profit was generated and accumulated throughout the year, not just at the end of the period). The use of average values also allows for smoothing out sharp deviations between the indicators under consideration if they arose during the analyzed period.

2.2. Average indicators must be calculated based on daily balance sheet data, using the principle of calculating arithmetic means.

2.3. When calculating average values for a quarter, balance sheet data for the three months of the analyzed quarter, presented for the last days of the months (for example, when calculating average values for the 1st quarter, balance sheet data for January 31, February 28(29), and March 31 are used), are used.

2.4. If balance sheet data for the three months of the analyzed quarter and balance sheet data for the last month of the previous quarter (in this case, for December 31, see paragraph 2.3) are presented, the following methods may be used:

a) the presented data are summed and the result is divided by four (this method is the most preferable);

b) balance sheet data for the last month of the previous quarter (December 31), the last month of the current quarter (March 31) are summed, and the result is divided by two.

2.5. Using the above method, bank activity analysis can also be conducted based on the results of the year. For this, average values of indicators for each quarter of the current year are required. For example, when calculating average values for a year (ending December 31), four average quarterly values of the current year are summed, and the resulting figure is divided by four.

2.6. If, when calculating average values for a year, data from balance sheets presented for the last days of each quarter of the analyzed year (i.e., for March 31, June 30, September 30, December 31) and data for the last quarter of the previous year (December 31) are used, the following method should be used:

sum the four quarterly balance sheets of the analyzed year, the balance sheet of the last quarter of the previous year, and divide the result by five (this method is the most preferable).

2.7. The proposed calculation methods are not the only ones.

Any statistically valid method that mitigates distortions, increases reliability, and improves the accuracy of the analysis can be used.

2.8. For the analysis, all data from the income statement must be converted to annual measurement. This means that if quarterly reports are presented, the calculated data must be multiplied by the following conversion coefficients:

for March 31 - 4.0; for June 30 - 2.0; for September 30 - 1.33; for December 31 - 1.0.

III. ANALYSIS OF INDIVIDUAL BALANCE SHEET INDICATORS.

3.1. Data from the periodic regulatory bank report (PRBR) must be used for the analysis of individual balance sheet indicators.

3.2. Data must be reviewed for changes in the composition of assets, liabilities, and capital, as well as considering the analysis of trends in these changes.

3.3. Analysis of changes in individual report items over time (from one period to another) provides a general picture of the bank's activities and allows for diagnosing possible problems, for example:

a) an increase in the volume of loans or a reduction in loans issued to the agricultural sector over a certain period may indicate changes in the bank's credit policy;

b) if an increase in the volume of credit operations over a certain period was financed through interbank short-term borrowings, the bank, to increase the difference between income from these operations and the cost of attracted funds (margin), uses the advantage of cheap financing, sacrificing liquidity in the process;

c) an increase in the volume of material assets (real estate, equipment, etc.) not used in banking may indicate problems in the bank's credit portfolio;

d) if, during the period under review, the share of term deposits in the total volume of the bank's liabilities increased, this positively affects the stability of the resource base and facilitates the management of funding sources on one hand, but on the other hand, increases its cost, as the interest rate on term deposits is usually higher than on demand deposits.

IV. ANALYSIS OF BANK PROFITABILITY.

4.1. This analysis allows for assessing the nature of operations conducted by the bank, the level and quality of management, and the bank's strategic goals.

4.2. For conducting the analysis, it is recommended to use indicators for the calculation of which data from the income statement is mainly used, which can be simplified as follows:

Interest Income

• Interest Expenses

= Net Interest Income

---

• Other Income

• Administrative Expenses

• Provisions for Potential Credit Losses

= Income from Operations

---

+- Profit (Loss) from Sale of Assets

+- Extraordinary Income (Losses)

---

= Net Operating Income

• Taxes

= Net Income (Profit)

4.3. BANK PROFITABILITY AND RETURN ON ASSETS.

4.3.1. The level of bank profitability is determined by the absolute value of the net income (profit) received.

4.3.2. Return on assets is determined by the ratio of net income (profit) to average assets and is the most important indicator of bank activity. It reflects the bank's ability to generate income based on existing assets. The higher the value of this indicator, the more effectively the bank uses its assets, provided their quality is satisfactory.

Calculation procedure:

Net Income (Profit)

------------------------------------------------------------- * 100 %

Average Amount of Assets

4.4. RETURN ON EQUITY.

4.4.1. The ratio of profit (and the ratio of factors affecting income) to assets does not show how the bank operates from the perspective of its founders' interests. For these purposes, it is recommended to use the return on equity indicator, defined as the ratio of after-tax profit to the bank's equity capital.

Calculation procedure:

Net Income (Profit)

------------------------------------------------------- * 100 %

Average Level of Equity Capital

4.4.2. This indicator is used by founders and shareholders when determining the bank's results, evaluating the profitability of investments, and for comparison with other investment opportunities.

4.5. When conducting an analysis of bank profitability, the inflation rate must be taken into account. Thus, despite a nominal increase in the bank's income, the real net income may actually decrease. The cause may be high inflation rates exceeding the bank's income level.

In this context, the nominal level of profitability refers to the bank's income without taking inflation into account, i.e., the actually received income. The real level of profitability takes into account inflationary effects, i.e., after appropriate adjustment. Thus, the nominal level of profitability is higher than the real assessment by an amount equal to the inflation rate.

The level of return on assets that a bank must have at the existing level of inflation and the actual value of the total capital return indicator can be calculated using the formula:

A = {(1+R)*(1+I)-1}*K,

where A - required nominal level of return on assets; R - actual value of total capital return; I - inflation rate; K - capital adequacy indicator (total capital / assets).

At zero inflation, the nominal and real values of the return on assets indicator coincide.

Example. With an actual level of total capital return of 12% and a capital adequacy indicator of 0.05, the nominal return on assets should be 0.6% if there is no inflation. With an inflation rate of 35%, the required nominal level of assets to maintain the previous level of total capital return must increase to 2.56%.

The use of this formula will allow the bank to timely adjust its activities to the existing level of inflation and achieve the required level of capital return.

4.6. The analysis of net income (profit) should be conducted considering the bank's activities over previous periods, in comparison with similar banks, as well as considering its components, i.e., net interest income, non-interest income, non-interest expenses, provisions for potential credit losses, etc.

4.7. NET INTEREST INCOME.

4.7.1. The main source of income for almost all banks is net interest income, defined as the difference between the sum of the bank's interest and similar income and the sum of expenses for paying interest and other similar costs. The level of net interest income, supplemented by other income, must be sufficient to cover administrative expenses and necessary provisions for possible credit and lease losses.

4.7.2. Based on the net interest income indicator, one can judge the profitability of the bank's credit operations. The main amount of income banks receive as a result of conducting credit operations.

Therefore, if a bank has significant interest income, it can be said that the bank is conducting its activities quite successfully.

Calculation procedure:

Net Interest Income

------------------------------------------------* 100 %

Average Amount of Assets

4.7.3. Since not all assets generate income, to determine the real level of asset return, it is advisable to use a coefficient known as the net interest margin:

Calculation procedure:

Net Interest Income

--------------------------------------------------------- * 100 %

Average Amount of Interest-Bearing Assets

4.7.4. The analysis of the bank's net interest income should be conducted considering its two components: interest income and expenses for paying interest.

4.8. INTEREST INCOME AND SIMILAR INCOME.

4.8.1. Interest income is understood as the aggregate of interest received by the bank as a result of providing loans and advances, interest on bonds and other securities, interest on lease operations, etc.

4.8.2. The interest income indicator is determined by the ratio of interest and similar income to average assets.

Calculation procedure:

Interest Income and Similar Income

-----------------------------------------------------* 100 %

Average Amount of Assets

4.8.3. The level of the bank's interest income may change due to:

• changes in average balances of issued loans;

• changes in the average level of interest rates charged for loans;

• asset quality;

• changes in asset structure.

4.8.4. After the influence of each factor individually and all factors together is determined, the factors themselves must be analyzed.

4.8.5. Thus, changes in average balances of issued loans may be due to the following factors:

• growth (reduction) of loans and assets equivalent to them in the analyzed period compared to the previous period;

• changes in the weight of loans and assets equivalent to them, generating income, in the total amount of assets.

4.8.6. The quality of "working" (income-generating) assets is one of the main factors affecting the level of interest income.

Thus, an increase in the volume of non-performing and poor-quality assets means that income-generating assets decrease, and ultimately interest receipts decrease. Therefore, the analysis of interest income must be closely linked to the assessment of asset quality (see section "Analysis of Asset Quality").

4.8.7. An increase in the average level of interest rates charged for loans may be caused by:

• an increase in the general level of interest rates in the credit market (an external factor independent of the bank);

• the structure of the credit portfolio, i.e., an increase in the weight of loans provided at higher interest rates;

4.8.8. The next stage of interest income analysis may be the study of income structure. Such a study will allow determining which credit operations achieved the growth in interest income. For this, it is recommended to calculate the following coefficients:

Interest received on individual groups of loans

a) -------------------------------------------------------------------------;

Average balances of the studied group of loans

Interest received on short-term (long-term) loans

b) ---------------------------------------------------------------------------------------;

Average balances of short-term (long-term) loans

Interest on lease operations

c) -------------------------------------------------

Average balances of leases

4.9. EXPENSES FOR PAYING INTEREST AND OTHER SIMILAR COSTS.

4.9.1. Interest expense should be understood as the sum of the bank's interest payments, namely interest on attracted deposits, indebtedness to banks (including the National Bank) and other credit institutions, interest on bonds, etc.

4.9.2. The interest expense indicator is calculated as the ratio of expenses for paying interest to average assets.

Calculation procedure:

Expenses for Paying Interest

--------------------------------------------------- * 100 %

Average Amount of Assets

4.9.3. Conducting this analysis is similar to the analysis of interest income (see paragraph 4.8).

4.9.4. The level of the bank's interest expenses depends on the average balances of paid deposits and other interest-bearing liabilities, the average interest rate on deposits, and the structure of liabilities.

4.9.5. After it has been determined which of these factors has had the greatest impact on the change in interest expenses, the factors themselves must be analyzed.

4.9.6. Average balances of paid deposits depend on:

• growth of paid deposits, for which rhythmicity and dynamism in attracting resources are positively evaluated;

• growth of the weight of paid deposits in total liabilities; the growth of paid deposits in liabilities cannot be evaluated unambiguously because, on one hand, paid deposits are usually term deposits providing stability to the bank's resource base, and on the other hand, term deposits are relatively expensive resources, and therefore their growth affects the increase in interest expenses.

4.9.7. The average interest rate on deposits is influenced by the following factors:

• the market level of interest rates on deposits, depending on market conditions (an external factor);

• the structure of liabilities; for example, the larger the share of deposits and other attracted resources with a low interest rate, the less the bank's expenses for paying interest on them.

4.9.8. Next, expenses for each deposit instrument and their weight in total interest expenses must be considered. To determine the average cost of each instrument, it is recommended to calculate the following coefficients:

Interest paid on demand deposits, including all checking, deposit, and other accounts with interest payment

a) -----------------------------------------------------------------------------------------------------------;

Average balances of checking and other accounts

Interest paid on term deposits

b) ----------------------------------------------------------------------------;

Average balances of term deposits

Interest paid on interbank loans

c) ----------------------------------------------------------------------------

Average balances of interbank loans

4.9.9. For more thorough analysis, it is recommended to calculate the following indicators:

Interest paid on individual deposits

a) ---------------------------------------------------------------------------;

Average balances of individual deposits

Interest paid on corporate deposits

b) ---------------------------------------------------------------------------

Average balances of corporate deposits

4.10. When calculating the net interest income indicator (paragraph 4.7.2), an average value of assets is used in the denominator. In an alternative calculation method, only those balance sheet asset and liability items associated with the bank's interest receipts and payments can be used in the denominator. The application of this indicator, known as "net spread," allows excluding the influence on net interest income, and consequently on bank profit, of deposits, capital, and reserve requirements not associated with interest payments, as well as non-income-generating assets.

Calculation procedure:

Interest Income (--------------------------------*100 % - ------------------------------------------*100 %

Assets Generating Interest Income Liabilities on Which Interest is Paid

4.11. OTHER (NON-INTEREST) INCOME.

4.11.1. In addition to net interest income, banks receive significant income as a result of providing services such as maintaining current accounts and deposits, issuing various types of letters of credit, providing consultations, and conducting operations with securities and foreign currency, etc. The absolute value of non-interest income is determined as the sum of income from these types of activities.

4.11.2. The level of non-interest income can vary significantly among different banks. In some banks, especially those actively engaged in concluding contracts and deals, such income may constitute a significant part of operating income.

4.11.3. Large fluctuations in the structure of non-interest income must be carefully investigated. The causes of such fluctuations may include hiding losses on certain operations, as well as involvement (withdrawal) in new types of activities or changes in the general state of the banking sector. For more thorough analysis, it is recommended to break down the total amount of non-interest income into constituent components and determine the influence of each on the level of operating income.

4.11.4. The non-interest income indicator is determined by the ratio of the absolute value of non-interest income to average assets.

This ratio shows the dependence of the bank's financial position on non-interest income.

Calculation procedure:

Other (Non-Interest) Income (

------------------------------------------------- * 100 %

Average Amount of Assets

4.12. ADMINISTRATIVE-MANAGEMENT EXPENSES.

4.12.1. Administrative-management expenses are the second largest bank expenses (after interest expenses). The level of these expenses is determined by the sum of expenses for:

• maintenance of fixed assets (rental payments, depreciation, repair and other expenses related to fixed assets);

• personnel maintenance (salaries, bonuses, benefits, etc.);

• payment for communication, postal, telegraph services, electricity, heating, etc.

4.12.2. When considering the structure of administrative-management expenses, the bank's specialization and the nature of operations conducted by the bank should be taken into account. For example, if the bank's main activity is conducting interbank and currency operations or lending to large companies, it will require less personnel than a bank that mainly serves small clients.

4.12.3. The administrative-management expense indicator is determined by the ratio of the absolute value of these expenses to average assets.

Calculation procedure:

Administrative-Management Expenses

---------------------------------------------------------- * 100 %

Average Amount of Assets

4.12.4. Under equal conditions, banks with the lowest values of the administrative expense indicator can be considered to be operating more efficiently. However, a trend of increasing indicator values does not mean that administrative expenses are out of the bank's management control. For example, a bank may have recently acquired or rented premises, hired additional personnel, or purchased expensive but more efficient equipment. Since the operation of new premises or equipment becomes more profitable, the values of the administrative expense indicator will decrease over time. Any significant changes in the structure of administrative-management expenses and the causes of these changes must be carefully investigated.

4.13. RATIO OF PROVISIONS FOR POSSIBLE CREDIT LOSSES TO AVERAGE ASSETS. A trend of increasing this indicator indicates a deterioration in the quality of the bank's credit portfolio, requiring additional provisions. The level of profitability and income of the bank directly depends on the size of provisions (i.e., the quality of the credit portfolio). Therefore, the analysis of bank profitability must be closely linked to the assessment of asset quality (see section "Analysis of Asset Quality").

Calculation procedure:

Provisions for Reserves

------------------------------------------------------- * 100%

Average Amount of Assets

4.14. RATIO OF TOTAL BANK EXPENSES TO TOTAL INCOME. Naturally, the lower the value of this indicator, the more effective the bank's activities. At the same time, an acceptable value for this coefficient can be considered a value not exceeding 50%.

Calculation procedure:

Total Expenses

----------------------------------------- * 100 %

Total Income

4.15. INCOME (LOSSES) FROM SALE OF ASSETS AND EXTRAORDINARY INCOME (LOSSES)

4.15.1. Income (losses) from the sale of assets may not be the result of the bank's ordinary activities, but they can significantly affect its current state. For example, the sale of the most profitable part of material assets may cover significant losses from the bank's main activities. However, frequent (recurring) sale of assets may indicate more serious problems.

4.15.2. Extraordinary income (losses) represent accounting adjustments in accounting related to previous periods of activity, i.e., they are not related to current