SSRN-id1015238

A STUDY ON FINANCIAL RATIOS OF MAJOR COMMERCIAL BANKS Dr. Y. Sree Rama Murthy Director Research & Senior Faculty Member College of Banking & Financial Studies Sultanate of Oman RESEARCH STUDIES 2003 _______________________________________________________

College of Banking & Financial Studies PO Box 3122, PC 112 Sultanate of Oman

CONTENTS

Chapter 1

INTRODUCTION

Chapter 2

PROFITABILITY MANAGEMENT RATIOS

Chapter 3

LIQUIDITY RISK MANAGEMENT

Chapter 4

INTEREST RATE RISK MANAGEMENT

Chapter 5

CAPITAL ACCOUNT MANAGEMENT

Chapter 6

CREDIT RISK MANAGEMENT

Chapter 7

COST MANAGEMENT

Chapter 8

INTERNATIONAL COMPARISONS

Chapter 9

CONCLUSIONS

REFERENCES

Summary

The objective of the study is to calculate the important financial ratios of major

commercial banks in Oman and compare their financial management practices as

indicated by the ratios. The study also compares ratios of commercial banks in

Oman with ratios of other banks in developed countries so that it throws up not

only intra country performance comparisons but also cross country comparisons

which makes study all the more useful.

For the purpose of the study data was drawn from the balance sheets and income

statements of commercial banks. The study uses data from December 1997 to

December 2004 for the profitability ratios part of the study. For studying liquidity,

interest rate risk, capital adequacy etc the study uses the data from December 2000

to 2004. For purposes of international comparisons data was drawn from various

internet based sources and from the “Banker” Journal.

The ratios used in the study are divided into five broad groups:

Liquidity Management Ratios

Interest Rate Risk Management Ratios

Credit Risk Management Ratios

Capital Account Management Ratios

Cost Management Ratios

Profitability Management Ratios

Each group of ratios throws light on the differences in financial management

practices of banks in the respective area. The study clearly shows that there are

wide differences in the ratios of different banks and that some banks have better

financial management practices than others. A reading of the study allows us to

identify best practice in each of the areas of liquidity management, interest rate risk

management, credit risk management, capital account management and cost

management.

Chapter 1

INTRODUCTION

INTRODUCTION

This study aims to compare different banks in the Sultanate of Oman using a variety

of ratios which are indicators of financial management. The study also compares the

financial performance of banks with those in other countries (although such

comparisons may not be strictly valid due to differences in money & capital market

conditions, regulatory environment and size differences).

Published financial statement (balance sheet and profit & loss account) data of six

major local commercial banks in Oman are used in the study. It was felt that non-

commercial and specialized banks cannot be assessed using the same ratios as the

ones used in this study and were therefore not included in the study.

The banks included in the study are:

Bank Muscat

National Bank of Oman

Oman International Bank

Oman Arab Bank

Bank Dhofar Al Omani Al Fransi

Majan International Bank

However the names of the banks are not mentioned while analyzing the data as the

purpose of the study is to provide information which would throw light on the

performance of the banks in general and is not to comment on any bank in particular.

Best ratios and best practice would also enable other banks to check whether they can

improve their performance in that area of management.

For the purpose of analysis the banks are mentioned as Bank A, Bank B, Bank C,

Bank D, Bank E and Bank F but are not in the same order as the list given above.

The second part of the study compares the performance of commercial banks in

Oman with commercial banks in other countries. However a smaller set of ratios is

used in this section on international comparisons, because of data constraints and

availability of data.

The ratios used in the study are :

Loan to Deposit Ratio(%) Liquid Asset Ratio(%) Asset Interest Yield(%) Break Even Yield(%) Net Interest Margin(%) Return on Assets (ROA)% Leverage Multiplier (Lf) Return on Equity (ROE)% (Profits on Average Capital) Capital Adeqacy Ratio (BIS) % Loan Loss Provision as % of Total Loans Risk Adjusted Margin (RAM) % Overhead Burden Ratio Productivity Ratio Cost/Income Ratio Asset Yield % Profit Margin% Cumulative Gap (0 -12months) (RSA - RSL) (in millions) Cum Gap/Assets( %) Capital Assets Ratio % NPL to Total Loans %

The above ratios are divided into the following five groups :

Liquidity risk management ratios

Interest rate risk management ratios

Capital account management ratios

Credit risk management ratios

Cost management ratios

The above five are the critical management variables in bank financial management

[Sinkey (1989)1 and Prefontaine & Thiebault (1993)]2. Any bank which successfully

manages these five critical variables will be able to achieve success in profitability

management which is what bank financial management is all about. While

comparing different banks on the above facets, it is important to also recognize that

there are trade offs between the variables. For example a bank may be successful in

liquidity management by maintaining a high level of liquidity but in the process will

be able to lend less and may in the process make less of profits. Comparing the

profitability management of banks can to some extent reveal how the trade offs were

managed.

After discussing profitability trends using the Dupont model, the performance of

different banks in the above five critical management areas is analysed.

1 Sinkey, J. F., Commercial Bank Financial Management, New York: Macmillan, 1989 2 Prefontaine, J & Thibeault A, Introduction to Bank Financial Management, Institute of Canadian Bankers, 1993

Chapter 2

PROFITABILITY MANAGEMENT

PROFITABILITY MANAGEMENT RATIOS

Profitability can be measured by a variety of ratios depending on the purpose of the

study. For purpose of profit comparisons a popular ratio is Return on Equity,

which is essentially Profit after Tax divided by Shareholders equity. From the

investors point of view Return on Equity on a Post – Tax basis is a better measure of

profitability. While ROE (post tax ) itself is not an indicator of investors return on

investment (investors return on investment would rather depend on dividend declared

plus capital appreciation if any ) we can argue that a higher ROE leads to better

return to the shareholders.

Return on Assets is another good measure of performance and profitability. However

ROA does not reflect the impact of capital structure decisions ( financial leverage

also called gearing ) on the firms earnings.

For the purpose of studying profitability the study uses the Dupont Model.

Return on Equity = Profit Margin × Asset Yield × Leverage

Return on Equity = Return on Assets × Financial Leverage

The Dupont model expresses profitability as a percentage of total assets and total

shareholders equity. This is last property is very useful to evaluate how a bank is

doing over time.

The Dupont model decomposes ROE into its two related components : ROA and Lf

where ROA measures operational profitability whereas Lf measures financial risk

which in turn is the result of capital structure decisions. ROA is further broken

down into its determinants : Profit Margin and Asset Yield. Asset Yield measures

asset productivity and Profit Margin measures cost productivity.

DUPONT MODEL

PROFITABILITY RATIOS

Return on Equity = Profit Margin × Asset Yield × Leverage

‘ where ROE is Return on Equity

PM is Profit Margin

AY is Asset Yield

Lf is Financial Leverage

‘which can be stated as

ROE = PM × AY × Lf

[ PAT / E ] = [ PAT / I ] × [ I / A ] × [ A / E ]

‘ where PAT – Profit after Tax

E - Shareholders Equity

I - Total Income

A - Total Assets

Return on Equity = Return on Assets × Financial Leverage

‘where Return on Assets can be further expressed as

ROA = Profit Margin × Asset Yield

Profit Margin is arrived at by dividing Profit after Tax by Total Income ( where

total income ( also called total operating income) is net interest income plus other

income. Profit Margin indicates the amount of profit (after tax) the bank is able to

generate for every Rial of income it earns. To arrive at Profit after tax from Total

Income the major items to be deducted are staff & administration expenses,

depreciation and loan loss provision. Profit Margin is influenced by a bank’s cost

management and credit risk management practices. A bank which is able to control

its non-interest cost and which is able to keep loan losses low will show high profit

margin.

Asset Yield is arrived at by expressing Total Income as a percentage of Total

Assets. Total income in turn is net interest income (interest income minus interest

expense) plus other income. Asset Yield is influenced by the banks interest rate risk

management practices and liquidity management practices and asset mix. If a bank

is able to maintain the spread between interest income and interest expense during

period of changing interest rates, its asset yield would be high. However if a bank is

unable to manage the impact of changes in the interest rate environment it would

experience a lowering of asset yields. Similarly the bank’s asset mix and

percentage of assets in liquid low earning or non-earning assets would also influence

the asset yield. A bank with a higher level of liquid assets is normally expected to

earn less interest income and therefore a lower asset yield.

Financial Leverage (Lf) which is calculates as assets divided by equity indicates

capital account management practices of commercial banks. (Lf is reported not as a

% but as times). Financial Leverage is the result of a bank’s capital structure

decision. On the other hand some writers use Lf a measure of financial risk.

While two banks may have the same operating profitability as indicated by ROA,

they may have different returns on equity depending on the managements capital

account management practices and how much of assets it would like to build for a

given level of equity. The bank which decides to maintain a higher leverage would

be able to report a higher ROE and would be rewarding it shareholders more, while

at the same time financial risk is higher.

Table 2.1 DUPONT MODEL

PROFITABILITY RATIO ANALYSIS

Ratios 1997 1998 1999 2000 2001Bank A Return on Equity 27.7% 14.0% 9.6% 7.3% -7.8% Profit Margin 27.1% 24.4% 14.1% 10.3% -9.4% Asset Yield 8.4% 8.8% 9.0% 9.7% 8.4% Leverage 12.2 6.5 7.6 7.3 9.9 Return on Assets 2.3% 2.2% 1.3% 1.0% -0.8% Bank B Return on Equity 33.5% 24.3% 17.6% 17.7% 15.4% Profit Margin 34.7% 31.2% 26.4% 24.9% 20.2% Asset Yield 10.1% 10.0% 9.0% 9.9% 9.3% Leverage 9.5 7.8 7.4 7.2 8.2 Return on Assets 3.5% 3.1% 2.4% 2.5% 1.9% Bank C Return on Equity 24.4% 22.9% 19.2% 14.9% 6.1% Profit Margin 25.5% 20.4% 17.4% 13.0% 6.4% Asset Yield 8.0% 9.7% 9.2% 9.3% 9.0% Leverage 12.0 11.6 11.9 12.3 10.6 Return on Assets 2.0% 2.0% 1.6% 1.2% 0.6% Bank D Return on Equity 19.8% 12.7% 11.2% 10.5% 2.2% Profit Margin 31.8% 18.6% 14.6% 13.3% 3.1% Asset Yield 8.8% 9.3% 8.6% 10.1% 9.3% Leverage 7.0 7.3 8.9 7.9 7.6 Return on Assets 2.8% 1.7% 1.3% 1.3% 0.3% Bank E Return on Equity 8.6% 13.3% 13.8% 13.8% 14.3% Profit Margin 16.9% 22.4% 22.2% 20.8% 20.2% Asset Yield 7.9% 9.4% 9.3% 9.7% 9.0% Leverage 6.4 6.3 6.7 6.8 7.9 Return on Assets 1.3% 2.1% 2.1% 2.0% 1.8% Bank F Return on Equity 4.7% -24.6% Profit Margin 18.2% -62.1% Asset Yield 6.9% 7.9% Leverage 3.8 5.0 Return on Assets 1.3% -4.9%

Profit margins of Omani commercial banks have tended to vary from one bank to the

other. For example in year 1997 one bank reported a profit margin as high as 60.7%

while in the same year another bank reported a PM of only 30.4%.

An analysis of the profit margin ratios of various banks over the period 1997 to

2001 shows that Bank B and Bank E (except in year 1997) have both been successful

in managing profit margins which also indicates that these banks probably have been

able to control they non-interest costs and loan losses well.

Asset yields of Omani commercial banks during the period 1997 to 2001 have been

varying in the range of 3.7% to 5.8%.

Analysis of asset yields of various commercial banks over the period 1997 to 2001

shows that some banks have consistently been able to earn higher asset yields.

Specifically we find that Bank B and Bank D have higher asset yields of more than

5% in most of the five years for which the data was analysed. Good interest rate

risk management practices and asset mix decisions may be the reasons for these

banks ability to generate higher AY – asset yields.

Financial leverage in the six Omani commercial banks during the period 1997 to

2001 have been in the range of 12.3 times (Bank C in year 2000) to 5 times ( Bank

F in year 2001). Bank C in general has been following a practice of maintaining a

high leverage of around 12 ( assets are 12 times the equity) while Bank D and

Bank E have been following a policy of low leverage of around 7 to 8.

Obviously Bank C would therefore be able to generate a higher ROE compared to

the other banks for the same level of operational profitability – ROA. For example

in year 1998, Bank C which had an ROA of 2.0% reported a ROE of 22.9%

while Bank E which had an ROA of 2.1 % reported an ROE of only 13.3%. If

we agree that shareholders and investors are ultimately interested in return on

equity3 ( ROE ) then Bank C’s performance is better. Bank C has been able to

3 Modigliani and Miller the well capital structure theorists argue that in world of perfect capital markets without taxes financial leverage decisions are unimportant and it is return on assets which determines investor return.

achieve this result because it had leverage ratio of 11.6 in that year as compared to

Bank E’s leverage ratio of only 6.3.

Analysis of ROE trends in the six Omani commercial banks over the period 1997

to 2001 indicates that year 1997 was a good year for banks in general. Further the

ratios reported above also show that the good performance in 1997 was mainly due

to good profit margins generated by banks in that year. Similarly year 2000 and

year 2001 ratios show that poor profit margins had a significant impact on return on

equity in these years. Asset Yield and leverage variations from year to year have

been less important. The conclusion therefore is that Omani banks should focus on

factors influencing profit margins like cost management and credit risk

management practices.

Profitability Analysis : Trends in Years 2002 & 2003

Profitability ratios based on the Dupont Model for year 2002 and 2003 are shown

in the table 2.2 shown below.

Compared to previous two years, Omani commercial banks in general have done

better during the years 2002 and 2003. They reported a return on equity of about

15 to 19 percent during this period. Only one bank reported losses during these

years. Dupont analysis indicates that improved profit margins has definitely

contributed to the improved profitability. Leverage figures have not changed

significantly during this period. There is a slight reduction in Asset Yields which

is expected given the downward trend in interest rates during 2002 and 2003. It is

interesting to note that quite a few banks have managed to improve profit margins in

spite of a general reduction in interest rates during this period. If one were to

look at the figures of the one loss making bank (Bank A) one would notice

immediately this bank’s leverage and asset yield figures are similar to the other

banks. The loss appears to be due to negative profit margins. We again conclude

that Omani banks should focus on factors influencing profit margins like cost

management and credit risk management practices. However, the strategy of one

bank (Bank C) needs to be noted - the bank has been able to generate an ROE of

16.6% in 2002 although its profit margin was only 22.4% by good management of

leverage and asset yield.

Table 2.2 DUPONT MODEL PROFITABILITY RATIO ANALYSIS 2002 – 2003 2002 2003 Ratios

Bank A Return on Equity -0.27% -53.6% Profit Margin -0.34% -83.9% Asset Yield 8.09% 7.1% Leverage 9.6 8.4 Return on Assets -0.028% -5.9%

Bank B Return on Equity 18.7% 19.4% Profit Margin 28.1% 31.8% Asset Yield 7.8% 7.23% Leverage 8.8 8.1 Return on Assets 2.2% 2.3%

Bank C Return on Equity 16.3% 16.6% Profit Margin 18.9% 22.4% Asset Yield 8.4% 7.81% Leverage 10.1 9 Return on Assets 1.6% 1.7%

Bank D Return on Equity 19.3% 12.8% Profit Margin 38% 30.8% Asset Yield 7.4% 6.6% Leverage 6.2 6.3 Return on Assets 2.8% 2%

Bank E Return on Equity 18.2% 18.4% Profit Margin 27.5% 31% Asset Yield 8.7% 8% Leverage 7.2 7.5 Return on Assets 2.4% 2.5%

Bank F - Merged -

Chapter 3

LIQUIDITY RISK MANAGEMENT

LIQUIDITY RISK MANAGEMENT RATIOS

Liquidity risk management refers to the ability of a bank to strike the right balance

between avoiding the problem of “excess cash” while at the same time ensuring that

the bank does not run into a problem of “deficit cash”. The word cash here means

“currency held with the banks” plus balances with CBO. Taking care of reserve

requirements and other regulations of the CBO is also a part of liquidity

management.

Whenever a bank is required to pay other banks because of a negative clearing

balance, such payments will typically be through debits to the bank’s own account

with the CBO. A bank’s treasury has to ensure that the funds available in the CBO

account are sufficient not only meet negative clearing balances but also are enough to

take care of the reserve requirements regulations of the CBO.

A bank maintaining a high level of cash, that is excess cash suffers from a

problem of profit sub-optimization. More specifically the bank will be losing on

profit which it could have otherwise made, had its cash management been better. The

reason being that excess cash earns a zero interest. If such cash is invested in the

form of commercial loans or securities then the bank would earn a return which

directly contributes to profit. Further we should also note that the cash is funded by

raising a deposits which have a cost in the form of interest paid to depositors.

To measure liquidity management policies of banks we use two ratios in this study:

LIQUIDITY MANAGEMENT RATIOS

Liquid Assets Ratio = Total Cash Resources / Assets * 100

where Total Cash Resources = Cash + Treasury Bills + Placements with Banks

Loans to Deposit Ratio = Loans / Deposits * 100

Liquid Assets Ratio indicates what percentage of assets a bank maintains in the

form of liquid assets which are available to meet any possible shortage of cash.

The ratio is based on the concept that a bank facing cash problems can easily convert

the T-Bills into cash or draw down on amounts lent to other banks in the inter-bank

market. A low liquid assets ratio indicates that a bank is managing its liquidity

more profitably, but at the same time if the liquidity is too low there is a risk of

cash deficit.

Loan to Deposit ratio is an indicator of the ability of the bank to convert deposits

into loans. This ratio has a variety of meanings. From a liquidity point of view a

high loan to deposit ratio indicates a bank’s ability to manage with a low level of

cash and marketable investments. An implicit assumption here is that loans are more

profitable than investments ( in government securities and other securities).

Table 3.1

LIQUIDITY MANAGEMENT RATIOS OF

MAJOR COMMERCIAL BANKS IN OMAN :

YEAR 2001

Liquid Asset Ratio (%) Loan to Deposit Ratio (%)

Bank A 12.00 137.62

Bank B 17.12 102.28

Bank C 16.08 120.39

Bank D 21.50 93.69

Bank E 14.19 98.15

Bank F 14.53 121.41

Year 2001 liquidity management ratios for the six local commercial banks in Oman

show that there is wide variation in liquidity management policies followed by

different banks. As shown in the table Bank D has liquid assets ( cash plus t-bills

plus placements with banks) which are 21.5% of total assets indicating a very high

level of liquidity, while Bank A which is operating in the same environment and

within the same regulations has liquid assets which are only 12 % of total assets.

The Loan to Deposit ratio leads us to the same conclusion, that Bank D is able to

deploy only 93.69% of its deposits as loans, while Bank A’s loans are 137.62%

in comparison to deposits. Clearly Bank A prefers to hold a low level of liquid

assets while deploying as much funds as possible in the form of loans (which are

higher earning assets) while Bank D not only has high level of liquidity but also

lends much less in percentage of deposit terms. Other things remaining the same

Bank D interest income would be lower, but in reality it is recognized that interest

income also depends on other factors such as interest rates, maturity mix and non-

performing loans.

Table 3.2



YEAR 2000


Bank A 12.94 147.44

Bank B 11.77 111.36

Bank C 18.86 119.92

Bank D 22.93 90.86

Bank E 15.43 100.76

Bank F 14.34 137.23

Year 2000 data give us a similar picture as the one in year 2001. Bank D has a

very high liquid asset ration and a low loan to deposit ratio again indicating that it is

the bank’s policy to be high on liquidity and low on loans. In year 2000 Bank B has

the lowest liquid assets ratio at 11.77 while Bank A also had a fairly low level of

liquid assets. While a low level of liquid assets ratio may be good from the point of

utilization of funds for lending there is always the risk that it may lead to situations

of cash shortage and the treasury of such banks has to be very adept at ensuring that

cash shortages are avoided.

It is interesting to further note that Bank B which had a low liquid asset ratio (of

11.77) has moved to a higher liquid asset ratio (of 17.12) in year 2001. At the same

time the bank’s loan to deposit ratio has come down from 111.36 in year 2000 to

102.28 in year 2001. The figures may indicate that the bank is deliberately

following a policy of lower level of lending and the higher liquid assets ratio

might be just a consequence of this policy. Reasons for this change in policy may

be many - one of which could be that the bank feels that it is safer to deploy funds in

securities and the interbank market rather than go for high risk lending. Such

practices are common other countries. For example Canadian banks follow a

cyclical policy of high levels of lending when the market conditions are optimistic

and low levels of lending when market conditions are pessimistic.

Trends in Years 2002 & 2003

Table 3.3 and 3.4 reported below show the trends in liquidity management ratios

during years 2002 and 2003. There has been a general increase in liquid assets

ratio during this period compared to the earlier period of 2000 and 2001. In year

2003 as many three out of the five banks had a liquid assets ratio of more than 20,

with Bank D having a liquid asset ratio of 27%. Bank E has consistently followed a

low liquidity policy of around 15% through out this period.

During this period Loan to Deposit ratios have also come down with all banks

except one showing a less than 100 loan deposit ratio. Both the liquidity

management ratios seem to indicate that banks in general are parking funds in T-

Bills and other liquid assets may be due to lack of demand for credit. One would

probably seen a change in these ratios once loan demand picks up.

Table 3.3



YEAR 2002


Bank A 14.57 123.13

Bank B 24.40 90.72

Bank C 14.37 119.26

Bank D 23.12 90.73

Bank E 15.08 96.02

Bank F - merged -

Table 3.4



YEAR 2003


Bank A 20.08 99.80

Bank B 26.23 87.17

Bank C 15.13 115.49

Bank D 27.32 85.0

Bank E 14.81 99.62

Bank F - merged -

Chapter 4

INTEREST RATE RISK MANAGEMENT

INTEREST RATE RISK MANAGEMENT RATIOS

Interest rate risk management refers to a managing risk posed by changing

interest rates which have a direct impact on the interest earned on loans and

investments and the interest paid on deposits. Interest rate risk management is all

about managing the net interest margin ( interest income minus interest expense) and

controlling the risk posed by changing interest rates while trying to take advantage of

changing interest rates.

Even when interest rates change a bank can control interest rate risk by matching

the repricing maturities of assets and liabilities. If the both an asset and a liability

are repriced at the same time a bank will be able to maintain net interest margin as

interest cost and interest earnings either go up or down simultaneously.

However the realities of the market may be such that a bank may not be able to

match maturities of assets and liabilities. In Oman a typical banks faces a maturity

mismatch problem because deposits are short term in nature while loans are long term

in this market. This would result in a situation where deposits are repriced much

faster than loans (unless loans allow for faster repricing although their maturities are

long). In a situation where interest rates are falling this would be an advantage to the

banks. However if interest rates rise this would go against a bank which is financing

long term loans with short term deposits.

For banks operating in an environment of changing interest rates, which is the

situation in Oman over the last few years, interest rate risk management becomes a

key issue.

INTEREST RATE RISK MANAGEMENT RATIOS

Asset Interest Yield = Interest Revenue as % of Assets*

Break Even Yield = Interest Expense as % Assets*

Net Interest Margin = Net Interest Income as % of Assets*

Where net interest income is interest income minus interest expense

Cumulative Gap = Rates Sensitive Assets minus Rate Sensitive Liabilities

( 0 – 12 Months)

Cum gap / Assets = Cumulative gap as % of Assets*

* Average Assets ( = average of previous year and current year figures )

The above five ratios are used in this study to analyse the interest rate risk

management practices of commercial banks in Oman. The first three ratios are

discussed first followed by a discussion on the second set related to gap management.

Asset Interest Yield gives us information about the average interest earned per Rial of

assets deployed by the bank while the Break Even Yield gives information about the

average interest expense the bank has to pay for generating funds for one Rial of

assets deployed. Net Interest Margin shows net interest income per Rial of assets

and is arrived at by deducting Break Even Yield from Asset Interest Yield. A

bank’s ability at managing interest rates is revealed by looking at the Net Interest

Margin. As interest rates go up Asset Interest Yield as well s Break Even Yield

would also go up but not necessarily together as this depends on the maturity and

repricing profile of the assets and liabilities. If a bank is successful in interest rate

risk management we would find the Net Interest Margin would be steady whether

the interest rates are going up or down. If Net Interest Margin is shrinking this could

be an indication of poor interest rate risk management.

Cumulative Gap is a standard method of measuring the interest rate risk sensitivity

of a bank’s balance sheet. The higher the gap the more sensitive is the bank’s Net

Interest Margin to fluctuations in interest rates. Gap is calculated by first estimating

the Rate Sensitive Assets and Rate Sensitive Liabilities and netting one from the

other. Gap can be calculated for different planning horizons - one month, three

month, six months, one year etc. In this study we analyse the one year (0 –12

months) gap which shows the interest rate risk sensitivity to changes in interest rates

occurring over a period of one year. A positive gap indicates that a bank has more

rate sensitive assets than rate sensitive liabilities. A negative gap on the other hand

indicates that rate sensitive assets are less than rate sensitive liabilities.

The implications of gap to a bank’s profitability are as follows:

Change in Net Interest Income = Gap × Expected change in Interest Rate

For example if bank has a negative gap of say RO 100 million and the change in

interest rates over the coming 12 months is say an increase of 2%, then the impact

is a decrease in net interest income by RO 2 million.

Change in Net Interest Income = -100 million × +2% = -2 million

A decrease in net interest income by 2 million rials, other things remaining the same

would imply a decrease in profit for the year by 2 million.

Cum Gap as a % of Assets indicates the size of the gap in relation to the size of

the bank. It is accepted by banking experts that if this percentage is more than

10%, the gap could have a substantial impact on profitability if interest rates change

in an unexpected direction. To quote “ under most circumstances, the dollar interest

rate sensitivity Gap should not exceed 10% of the bank’s total assets over a one year

planning horizon”4

Negative gap or positive gap in itself does not indicate that the bank is in a risky

position. The gap in conjunction with the expected change in interest rates is what

matters. A negative gap during a period of decreasing interest rates, and a positive

gap during a period of increasing interest rates are beneficial to the bank. However

a bank having a negative gap during a period of rising interest rates would stand to

make losses and is taking a risk.

Table 4.1

INTEREST RATE RISK MANAGEMENT RATIOS - I


YEAR 2000

Asset Interest Yield (%)

( interest revenue)

Break Even Yield (%)

( interest expense)

Net Interest Margin (%)

(spread) Bank A 8.24 4.87 3.38

Bank B 8.27 4.34 3.93

Bank C 8.84 5.17 3.67

Bank D 8.06 4.52 3.54

Bank E 8.78 4.70 4.07

Bank F 7.90 4.15 3.75

The above table shows three interest rate risk management ratios for the year 2000.

Asset interest yield of the six banks are very similar with Bank C having the highest

yield at 8.84 and Bank F having the lowest at 7.90. However Bank C also has the

highest interest expense as shown by the Break Even Yield indicating that it could

not take advantage of its high interest earning yield. Bank F which has the lowest

interest yield also has the lowest break even yield at 4.15. In terms interest rate

management Bank E shows the best performance since it has the best Net Interest

4 Prefontaine, J & Thibeault A, Introduction to Bank Financial Management, Institute of Canadian Bankers, 1993, page 126

Margin, in other words its spread management is the best of the six banks in year

2000.

Table 4.2

INTEREST RATE RISK MANAGEMENT RATIOS - I


YEAR 2001


( interest revenue)


( interest expense)


(spread) Bank A 7.77 4.02 3.75

Bank B 8.08 3.66 4.43

Bank C 8.11 4.41 3.70

Bank D 7.78 3.87 3.91

Bank E 8.79 3.75 5.04

Bank F 7.18 3.88 3.30

Three interest rate risk management ratios for year 2001 are shown in the table given

above. Interest yield variation is quite high in year 2000 compared to year 2000.

While in year 2000 inter bank variation was less than one percent in the year 2001

the interest variation is nearly 2 % ( lowest 7.18 and highest 8.79 ). Bank E in

particular managed to maintain the interest yield at 8.79% while many of the other

banks reported a decrease in interest yield. On the break even yield side (that is

interest expense) all the banks reported a lower level of break even yield. In

particular Bank E managed to lower its interest cost to 3.75 almost one percent lower

than the previous year. Bank E shows the best performance in terms of spread

management with a Net Interest Margin (NIM) of 5.04, followed by Bank B which

reported a NIM of 4.43. All other banks have a NIM less than 4 %.

Interest rate risk management of Bank E and Bank B are the best in both the years

inspite of the rapid fluctuations in interest rates in Oman during these two years.

(It is worth remembering here that asset interest yield ratio is based on interest

revenue which shows interest earnings net of reserved interest. Therefore interest

yield also depends on the credit risk management abilities of the bank and not just on

portfolio mix and maturity management.)

Table 4.3

INTEREST RATE RISK MANAGEMENT RATIOS – II


YEAR 2000

Cumulative Gap (0 – 12 months) RSA – RSL (in millions)

Cum Gap / Assets (%)

Bank A -129 -15.7

Bank B -67 -24.8

Bank C -363 -28

Bank D -92 -11.7

Bank E -60 -22.5

Bank F -16 -16.3

The above table shows the One Year Interest Rate Sensitivity Gap for different

commercial banks in Oman and the size of the gap in relation to assets. All the

banks have a negative gap. However there are wide variations in the size of the gap.

Bank D is maintaining the lowest Gap/Assets % at -11.7% while Bank C has the

highest Gap/Assets % at -28%. As discussed earlier if interest rates increase by 2%

Bank C would stand to lose approx 7 million Rials ( -363 × +2%) while if interest

rates decrease by 2 % the bank stands to gain 7 million in net interest income.

Compared to the norm that gap should not exceed 10% of assets all the banks in

Oman have a high gap. Such a gap is necessarily risky.

Table 4.4



YEAR 2001



Bank A -67.27 -7.6

Bank B n.a. n.a.

Bank C -439 -32.7

Bank D n.a. n.a.

Bank E -53 -17.4

Bank F -32.4 -25.1

For the year 2001 Gap information was not reported by two banks. Gap figures

reported by two of the remaining four banks show that the Gap/Assets % has

increased further as compared to year 2000. On the other hand Bank A has reduced

the gap significantly to –7.6 which is below the 10% norm. Bank C and Bank F gap

percentages are quite high at 32.7% and 25.1%. One of the difficulties with

maintaining such a high negative gap is that the bank may not be able to reverse the

gap very quickly in case it expects an increase in interest rates during the coming

year.

In our earlier discussion on interest rate risk management using NIM ratio (net

interest margin) we concluded that Bank E and Bank B are the best as they have

managed to improve NIM during a period of fluctuating interest rates. However in

terms of interest rate risk management as measured by Gap/ Assets % both the

banks are open to risk. Using the gap measure one would say that Bank A is in a

low risk position while Bank E has reduced its gap risk by bringing down the gap %

from –22.5% in year 2000 to –17.4% in year 2001.


Trends in interest rate risk management during 2002 and 2003 can be seen in

the tables 4.5 to 4.8. Comparing the interest rate management ratios with the

earlier period one notices a decline in both Asset Interest Yield as well as a

decline in Break Even Yield. Asset Interest Yield has declined from around 8%

to 6% while Break Even Yield has fallen from around 4.5% to 2%. Since the

decline in Break Even Yield has been in general more than the decline in Asset

Interest Yield the net impact is an improvement in Net Interest Margins from

below 4% to above 4%. The change in Asset Yield, Break Even Yield and Net

Interest Margin has to be viewed in the light of a general decline in interest rates in

the Oman economy. These ratios indicate that banks have been able to manage

and overcome the interest rate risk created by declining interest rates.

The years 2002 and 2003 also show a clear change in the interest risk gap

management strategies of Omani banks. For one, there has been a reduction in

the size of cumulative one year gap as shown the decline in Gap to Asset Ratio.

Further some banks have changed their negative gap position into a positive gap

Example Bank D had a negative gap of - 92 million in year 2000 and this has

changed to a positive gap of +77 in year 2002 and +104 in year 2003. A positive

gap implies that this bank will benefit from an increase in interest rates. The

overall reduction in the size of the gap to below 10% for four out of the five

banks indicates a safe interest rate gap strategy.

Table 4.5

INTEREST RATE RISK MANAGEMENT RATIOS – I


YEAR 2002


( interest revenue)


( interest expense)


(spread) Bank A 6.76 2.48 4.28

Bank B 5.92 1.76 4.16

Bank C 7.23 2.89 4.33

Bank D 6.14 2.13 4.01

Bank E 7.55 1.88 5.67

Bank F - merged -

Table 4.6

INTEREST RATE RISK MANAGEMENT RATIOS – I


YEAR 2003


( interest revenue)


( interest expense)


(spread) Bank A 5.84 2.5 3.34

Bank B 5.37 1.18 4.19

Bank C 6.53 2.13 4.41

Bank D 5.41 1.51 3.90

Bank E 6.77 1.54 5.22

Bank F - merged -

Table 4.7



YEAR 2002



Bank A -214 -22.9

Bank B n.a. n.a.

Bank C -290 -20.1

Bank D 77 11.8

Bank E 75 22

Bank F - merged-

Table 4.8



YEAR 2003



Bank A -72 -8.3

Bank B n.a. n.a.

Bank C -98 -6.3

Bank D 104 16.1

Bank E 21 5.1

Bank F - merged -

Chapter 5

CAPITAL ACCOUNT MANAGEMENT

CAPITAL ACCOUNT MANAGEMENT RATIOS

Capital account management refers to the ability of the bank to ensure that there is

enough capital both to satisfy the regulations as well as to provide an adequate

base for asset growth. Regulations require that every bank should have enough

capital to maintain the minimum capital adequacy requirement as defined by the

BIS (Bank of International Settlements) Capital Adequacy Ratio. Further we also

recognize that capital is required for asset growth. If a bank does not have enough

capital which is above the minimum required by the regulators, then further asset

growth will have to constrained or stopped by the bank’s management, as further

asset growth will worsen the Capital Adequacy Ratio.

To measure capital management policies of banks we use two ratios in this study:


Leverage Multiplier (Lf) = Assets as a % of Capital

‘ where capital is same as Shareholders funds or equity also called Asset to Equity Ratio

BIS Capital Adequacy Ratio = Total Capital Base as a % of Risk weighted

assets

Capital Assets Ratio = Capital as a % of Assets

Leverage multiplier is arrived at by dividing assets by capital or assets by equity.

It is a number which shows how much of assets the bank has created for

every one rial of equity. A high leverage indicates a higher level of risk

compared to a low leverage figure. Capital helps a bank to withstand the impact of

bad times when a bank faces losses. To the extent a bank is heavily capitalized its

ability to withstand the pressure of bad years is much more than a bank which is

thinly capitalized. Financial leverage multiplier (Lf) indicates the extent to which

Why Leverage helps a bank to improve its profitability

Consider two banks with the following simplified balance sheets

My Bank Our Bank

Assets Liabilities Assets Liabilities

Assets = 3000

Deposits = 2000

Equity = 1000

Assets = 6000

Deposits = 5000

Equity = 1000

My Bank’s Lf is 3 and Our Bank’s Lf is 6.

Assuming that for both the banks earnings rate on assets is 10% and cost of

deposits is 5%, other income takes care of non – interest expenses and tax rate is

50%, the Profit after Tax would be

My Bank Our Bank

Income = 300

Deposit cost = 100

PBT = 200

Tax = 100

PAT = 100

Income = 600

Deposit cost = 250

PBT = 350

Tax = 175

PAT = 175

The figures worked out using simplifying assumptions indicate that higher the

leverage the higher is the profitability.

a bank is willing to take risk. A low leverage figure indicates that the bank prefers

to follow a safe path as it grows, while a high leverage indicates that the bank is

following a risky policy. However a higher leverage helps a bank to improve its

profitability as shown the box above. At the same time, finance experts, say that

cost of equity is high compared to cost of deposits and therefore a bank’s

management may prefer to finance its asset growth with more of deposits and less

of capital (equity) which naturally results in a high leverage ratio.

The above discussion brings out the dilemma faced by bank management in

managing their capital account. Higher leverage improves profitability and cost of

equity is high compared to cost of deposits and therefore a bank’s management

would prefer to be high on deposits and low on equity. However, a low equity

implies a high leverage ratio which is risky. A bank with a high leverage ratio (

that is low capital to assets ratio ) faces the problem of solvency risk ( bankruptcy

risk) during periods of recession.

Table 5.1



YEAR 2000

Leverage Multiplier (Lf)

(times)

BIS Capital Adequacy Ratio

(%)

Capital Asset Ratio (%)

Bank A 6.94 17.62 14.42

Bank B 6.58 18.00 15.20

Bank C 10.22 16.39 9.78

Bank D 8.37 16.03 11.95

Bank E 6.76 15.70 14.79

Bank F 3.21 26.44 31.14

The above table shows that all major commercial banks in Oman are well

capitalized by any standards, as shown by the BIS Capital Adequacy ratio. All the

banks are well above the 12% norm. In terms of financial leverage policy the

figures show that while Bank C prefers a high leverage multiplier at 10.22,

BankF manages with a leverage ratio of 3.21. Other banks have leverage ratio

ranging between 6.5 to 8.37. The data clearly shows that Bank C is deploying

10.22 Rials of assets for every rial of capital. While Bank C’s risk profile is

higher, it is also likely to be more profitable, other things remaining the same.

Table 5.2



YEAR 2001


(times)


(%)


Bank A 8.22 12.71 12.17

Bank B 7.32 17.00 13.67

Bank C 11.38 15.80 8.78

Bank D 7.75 16.93 12.90

Bank E 7.39 13.80 13.53

Bank F 4.28 19.62 23.35

Year 2001 shows that Bank C has continued its policy of higher leverage, while at

the same time maintaining a good BIS Capital Adequacy ratio. One may get a doubt,

whether it is really possible for a bank to have a good capital adequacy ratio while at

the same time having a high leverage, but one can see that it is possible as shown by

Bank C. Probably Bank C has been able manage its asset mix in such a way that it

deploys more of its assets in low risk weight assets.

In general for most of the banks leverage multipliers in Year 2001 are slightly

higher than year 2000.

Most of the banks continue to have a high Capital Adequacy ratio well above

the 12% norm. These ratios imply that major Omani commercial banks have room

for rapid asset growth without facing a capital constraint problem. However Bank A

might face a capital constraint problem very soon and may have to restrict asset

growth unless it is able to increase capital either through external financing or

retention of profits.


Table 5.3 and 5.4 show the capital account management ratios of Omani

commercial banks during the period 2002 and 2003. There is no significant

change in the leverage ratios and capital to assets ratios of banks during this

period as compared to the earlier period. Bank C and Bank D experienced a slight

lowering of financial leverage ratio indicating their are not able to deploy as

much assets for every rial of capital as in the earlier periods. BIS ratios

continue to be excellent for most of the banks. However as will be commented

later capital to assets ratios of Omani commercial banks (at around 12 rials of

capital for every 100 rials of assets) are extremely high compared to

international average which is below five (which would imply an leverage ratio (Lf)

of more than 20). Omani banks are not able to use financial leverage to their

advantage as compared to banks in other countries. Better leveraging would help the

banks to improve profitability and reduce spreads.

Table 5.3



YEAR 2002


(times)


(%)


Bank A 9.59 13.31 10.42

Bank B 8.79 19.70 11.38

Bank C 10.08 16.05 9.92

Bank D 6.22 24.06 16.07

Bank E 7.26 14.30 13.78

Bank F - merged -

Table 5.4



YEAR 2003


(times)


(%)


Bank A 8.4 18.26 11.91

Bank B 8.14 20.04 12.29

Bank C 8.98 16.39 11.13

Bank D 6.29 24.96 15.90

Bank E 7.51 15.06 13.32

Bank F - merged -

Chapter 6

CREDIT RISK MANAGEMENT

CREDIT RISK MANAGEMENT RATIOS

Credit risk is a an important part of bank management. Credit risk is the risk

that a financial contract will not be honoured according to the original set of terms or

expectations. Credit risk occurs whenever a bank lends money or invests in

securities. Whenever a bank lends and for some reason finds that repayments and

interest payments are not taking place, there is double impact on the bank’s

finances. One, bank will have to stop accruing interest on the doubtful loans and

therefore there is an immediate income loss to the bank. Second, the bank will have

to make provisions for the non performing loans and this has to be made from the

net interest income which the bank is currently earning, which implies that profit

will be reduced.

In this study three measures of credit risk are used :


Total Loan Loss Provisions as % of Loans ‘ where total loan loss provision indicates balance in the loan loss provision account which includes not only current year provisions but also previous provisions adjusted for write offs and recoveries

Risk Adjusted Margin (RAM)% =

{ Net Interest Income + other Income – Provision for Credit Losses } / Average Assets

where net interest income = interest income minus interest expenses and provisions for

credit losses indicates provisions made during the year

Non Performing Loans to Loans %

The first ratio shows total loan loss provisions as a percentage of loans and reflects

the credit risk of the bank. Non performing loans to loans is a similar measure of

credit risk.

Risk Adjusted Margin (RAM) is a measure which shows the impact of credit risk on

the profitability of the bank. Specifically it is calculated as net interest income plus

other income minus provisions made during the year for loan losses divided by

assets. When compared with the Net Interest Margin (NIM) figure it shows the

impact of loan losses on the bank. RAM rather than NIM is a true reflection of the

risk management abilities of the bank, because it shows the spread ( or margin)

net of loan loss provisions. Further it shows the risk faced by the bank in the

process of managing its credit portfolio. If one were to measure a bank’s

management abilities only using NIM it would show only the interest income

generation net of interest expense but it would not show the attendant risks. A bank

can increase its NIM by giving high interest loans, but if the high interest loans

carry a higher risk this would not get reflected in NIM. On the other hand RAM

reflects this risk to the extent higher risk results in higher provisions.

Table 6.1



YEAR 2000

Total Loan Loss Provisions as % of

Total Loans

Risk Adjusted Margin (%)

NPL to Total Loans (%)

Bank A 6.79 3.5 9.25

Bank B 2.37 5.66 5.73

Bank C 3.13 3.54 7.91

Bank D 5.94 3.99 14.66

Bank E 5.21 4.84 1.71

Bank F 0.37 4.53 1.04

The above table shows the credit risk management ratios for year 2000. The

figures show that credit risk experience of different banks varies from each other.

While some banks reported 6.69% total loans loss provisions as percentage of total

loans there are other banks which reported a figure of just 2.37% and one bank

whose figure was only .37%.

The performance of the banks in terms of Risk Adjusted Margin (RAM) has in

general been good with the RAM figures ranging from 3.5 to 5.66. The figures

show that in general banks have done a good job of managing their credit

portfolio since as we said earlier RAM reflects net interest margin plus other income

net of loss provisions. RAM also shows what is available to meet the non-interest

expenses ( like staff and administration expenses) and profit expectations of the

shareholders. Just for the purposes of comparison, one could compare the above

figures with say Canadian Banks. Canadian banks reported RAM figures in the

range of 2.26 to 3.82.

Another aspect also worth noting is that the bank with the highest RAM (Bank B at

5.66 ) does not have the highest Asset Interest Yield (Bank B’s asset interest yield

is only 8.27 - figures reported in interest ratios table above) implying that the bank

followed a policy of lower return loans with a lower risk, but still managed to

achieve a high risk adjusted margin.

Table 6.2



YEAR 2001


Total Loans



Bank A 10.68 1.5 18.78

Bank B 3.62 5.43 5.86

Bank C 5.66 2.67 10.36

Bank D 8.40 2.82 21.33

Bank E 6.92 4.89 1.69

Bank F 9.47 -3.02 15.52

In year 2001 most of the banks reported a higher level of loan loss provisions as

compared to year 2000 reflecting the impact of external environment on all banks

in general. As expected the Risk Adjusted Margins were also lower reflecting the

credit risk pressure under which most banks were operating. However it is

interesting to note that even though the external environment in general affected all

the banks, some banks like Bank B managed to maintain a high RAM at 5.43.

The year 2001 experience brings out the importance of prudent capital account

management. Year 2001 was year of credit risk problems, however all the banks

sailed through the year with BIS Capital Adequacy Ratios of 12 % + indicating

that their excellent capital strength helped them to ride through the bad patch.


Trends in credit risk management ratios during the period 2002 and 2003 are

shown in tables 6.3 and 6.4 . Of the five banks three banks show a general

reduction in Loan Loss Provisions to total assets ratio and a general decline in Non

Performing Loans indicating a definite improvement in credit quality. Bank A

shows an increasing trend in these two ratios to alarming levels. Bank D has been

able to contain the credit risk problem and is coming out of the woods. Risk

Adjusted Margins improved considerably for four banks in 2003 again a indication

of general improvement in asset quality. If one were to make international

comparisons, one can conclude that NPLs to total loans are high in our

commercial banks compared to banks in other countries. Improving asset quality is

definitely an important task in front of the countries commercial banks.

Table 6.3



YEAR 2002


Total Loans



Bank A 11.02 1.83 30.84

Bank B 2.57 5.33 8.93

Bank C 4.65 4.07 9.98

Bank D 5.42 4.39 23.27

Bank E 5.35 5.34 5.64

Bank F - merged -

Table 6.4



YEAR 2003


Total Loans



Bank A 20.16 -3.54 51.78

Bank B 3.13 5.37 8.40

Bank C 5.32 4.28 9.11

Bank D 5.66 4.15 20.44

Bank E 5.84 5.48 9.62

Bank F - merged -

Chapter 7

COST MANAGEMENT

COST MANAGEMENT RATIOS

Cost management refers to issues related to management of non – interest

expenses like staff expenses and administration expenses. Good cost management

helps a bank in improving its long run profitability. Good cost management helps

a bank in improving its productivity and reducing its Overhead Burden. If a bank

manages to control its costs, it can become a low cost producer of financial

services and therefore has the ability to follow aggressive pricing strategies. Further

lower costs reduce the overhead risk and improves the bank’s ability to withstand

periods of low business turnover and periods of heavy competition.

In this two measures of cost management are used:


Overhead Burden Ratio (%) = {Non-Interest Expenses – Other Income} / Net Interest Income ‘reported as percentage

Productivity Ratio (%)=

{Non-Interest Expenses} / {Net Interest Income + Other Income)

‘also called the Cost to Income Ratio

‘reported as a percentage

Overhead burden ratio shows the expense burden (net of other income) on the

bank’s net interest income. In an ideal situation if all the non-interest expenses are

taken care of by other income a bank would have zero overhead burden ratio and

the bank would be in a position to adopt aggressive pricing strategies in order to

attract business and in dealing with competition.

Productivity or cost / income ratio is the most popular ratio to analyse cost

management in banking. The ratio is simple to interpret : it shows the cost

involved in producing one Rial of income. If a bank’s staff , admin and other costs

are high then the cost involved in producing one Rial of income would be high,

and therefore cost productivity would be seen to be low. It is important to note the

interest cost has already been netted out in arriving at the net interest income and

therefore interest cost does not get reflected in this ratio. The ratio focuses on non-

interest costs. The ratio is also called productivity ratio - the lower the ratio the

higher is the productivity.

Table 7.1



YEAR 2000

Overhead Burden Ratio* (%)

Productivity Ratio* (%) [ also called Cost / Income Ratio ]

Bank A 17 41

Bank B 29 52

Bank C 39 50

Bank D 30 49

Bank E 28 44

Bank F 41 54

* the smaller this ratio is, the better the performance

The above table shows the cost ratios of major Omani commercial banks in the year

2000. Overhead burden ratio’s have varied quite a lot between different banks as

shown by the data in the table. Bank A has the lowest Overhead Burden Ratio at

17% while Bank F has the highest at 41%. Bank A’s 17% reflects that non-interest

expenses net of other income accounted only for 17% of net interest income for the

bank, indicating that most of the non-interest expenses were taken care by other

income which would enable the bank to compete effectively and also to follow

aggressive pricing strategies.

Productivity ( or cost / income ) ratio has varied between 41% and 54% during

year 2000. Bank A achieved the best productivity ratio at 41%, that is, its cost to

income was the lowest. This figure indicates that to produce one rial of income the

bank spent 410 baisa. The extent of variation in cost/income ratio between

different banks is not very high, and the ratio’s themselves are not very high

indicating good cost management practices.

Table 7.2



YEAR 2001

Overhead Burden Ratio (%)

Productivity Ratio (%) [ also called Cost / Income Ratio ]

Bank A 20 40

Bank B 20 44

Bank C 31 44

Bank D 41 54

Bank E 31 44

Bank F 53 63


Year 2001 Overhead burden ratios of different banks varied between 20 to 41 if one

were to ignore Bank F which had a high figure. In terms of productivity or

cost/income the figures have varied between 40 to 54 if one were to again ignore

Bank F which seems to be an outlier. In general, productivity levels are very

uniform with most banks having a ratio around 40 to 44. The figure indicates that a

typical Omani bank spends 400 baisa to produce one rial of income.

By international standards Omani banks have low cost / income ratio ( or to say

Omani banks have good productivity ratios). Data reported by Banker Magazine

for year 2001 shows that most Asian, American and European banks have cost /

income ratios in excess of 52% ( generally between 60 to 70% )

The conclusion is that in terms of cost management the performance of Omani

commercial banks is excellent, and that these banks have high levels of

productivity.


Cost management ratios of commercial banks in Oman in the years 2002 and 2003

are shown in tables 7.3 and 7.4. The cost to income ratio or the productivity

ratio of banks continues in the ratio of 40 to 50 except in case of one bank.

Bank E continues to have a low cost to income ratio indicating excellent cost

management practices which probably contributed to its excellent Return on Equity.

By international standards banks in Oman continue to have low cost to income

ratios indicating good cost management and high productivity.

Table 7.3



YEAR 2002



Bank A 18 38

Bank B 27 50

Bank C 33 47

Bank D 38 53

Bank E 25 38

Bank F - merged -


Table 7.4



YEAR 2003



Bank A 31 50

Bank B 27 49

Bank C 29 45

Bank D 44 57

Bank E 28 42

Bank F - merged -


Chapter 8



For the purpose of comparison of financial ratios achieved by major Omani

commercial banks with those of banks located in developed countries we use data

on ratios reported by “The Banker”5 journal in its report on top world banks.

Unlike the financial ratio analysis reported above which looked into a variety of

issues such as profitability, liquidity, interest rate risk, capital account, credit risk,

cost management etc and is based on a large number of ratios ( 19 ratios), the Banker

data is limited to about 6 ratios which look into only some of these aspects.

The 19 ratios discussed in the earlier sections include the six ratios reported by the

Banker.

In order to compare therefore we report the data of our six Omani commercial

banks along with the banks into other countries only on those aspects reported by The

Banker. While we do believe that 19 the ratios discussed earlier in the study throw

more light and allow for a more detailed analysis of banks, in this section the

analysis is constrained by the availability of data.

One problem which we would like straight away point out in doing international

comparisons is the fact that the banks in various countries are not comparable in size

to banks in Oman and therefore while making comparisons this fact should be kept

in mind. Further comparisons are done only for the year December 2001.

5 The Banker published by Financial Times Business Ltd, London - July 2002

Table 8.1: International Comparisons Bank Capital

Assets

Ratio

%

Pre-Tax

Profit on

Avg

Capital

%

Return

on

Assets

(Pre-

Tax) %

Cost /

Income

Ratio %

BIS

Capital

Ratio

%

NPL

to

Total

Loans %

Oman

Bank A 12.1 -5.9 -0.64 40.5 12.71 16.5

Bank B 13.6 17.6 2.3 44 17 5.4

Bank C 8.7 8.0 0.68 44.2 15.8 9.4

Bank D 12.9 2.8 0.38 53.9 16.9 18.6

Bank E 13.5 16.3 2.2 44 13.8 1.6

Bank F 23.3 -24.2 -5.6 53 19.6 13.5

United Kingdom

HSBC Holding 5.0 23.5 1.16 56.42 12.99 3.0

Royal Bank of Scotland 4.2 31.5 1.19 63.88 11.52 Na

HBOS 4.5 Na .95 51.99 10.55 2.06

Barclays Bank 3.5 31.4 1.04 57.87 12.5 2.44

Germany

Deutsche Bank 2.70 7.8 0.20 90.45 12.10 4.8

HypoVereinsbank 2.98 7.2 0.21 78.70 10.80 Na

Commerzbank 2.43 0.3 0.01 84.71 10.30 0.28

Canada

Scotiabank 5.56 22.2 1.16 55.13 13 2.40

Royal Bank of Canada 4.25 27.2 1.10 66.22 11.79 1.10

Bankof Montreal 4.21 15.8 0.66 73.7 12.01 1.13

Australia

National Australia Bank 5.94 22.7 1.23 65.66 10.16 0.87

ANZ Banking Group 6.24 27.8 1.67 48.58 10.31 1.31

Commonwealth Bank Grp 4.82 36.5 1.82 58.59 9.16 0.74

Singapore

United Overseas Bank 11.24 12.3 1.06 39.3 18.5 9.3

DBS Bank 6.92 13.2 0.90 52.83 17.4 4.0

Overseas Chinese Bkg Corp 7.59 13.3 1.15 39.02 18.8 9.81

A close look at the above data throws up a number of trends.

Cost to Income Ratio which is an indicator of productivity (it shows the

cost involved in producing one Rial of income – the lower the ratio the higher

is productivity). All Omani commercial banks have a lower cost to income

ratio as compared to banks in developed countries (except Singapore). This

indicates that banks in Oman have a higher productivity as compared to banks

in other countries.

BIS Capital Adequacy ratio of commercial banks in Oman is high compared

to banks in other countries indicating good levels of capitalization.

Non – Performing Loans to Total Loans is high is case of four banks while

two Omani banks reported a low level of non performing loans as compared

to banks in other countries. However we agree that year 2001 was a difficult

year for banks in Oman.

The impact of non-performing loans on profitability (Pre tax profit to average

capital) can be readily seen.

Capital Assets Ratio (which reverse of Leverage ratio) of commercial banks

in Oman is generally high (expect in the case of Bank C) as compared to

banks in developed countries. While capital assets ratio in Oman is generally

in the range of 12 to 14, in case of developed countries this ratio is

averaging around 5 to 6. As pointed out in the profitability ratios part of the

study which analysed the data from 1997 to 2001 and in the capital account

management part of the study capital asset ratio have tended to remain

steady over the years, that is around the level of 12 to 14.

We can therefore definitely conclude that banks in Oman can in general

examine the possibility of increasing their capital asset ratios in line with

international banks. This would enable them to improve return on equity /

profitability further.

Chapter 9

CONCLUSIONS

CONCLUSIONS

Dupont Analysis: ROE of the six Omani commercial banks has been varying a lot

over the period 1997 to 2003 ( from 28% to -53%). The Dupont model tries to

explain the variations in ROE (profitability) through Profit Margin, Asset Yield and

Leverage ratios.

Analysis of ROE trends in the six Omani commercial banks over the period 1997

to 2003 indicates that year 1997 was a good year for banks in general. Further the

ratios reported above also show that the good performance in 1997, 2002 and 2003

was mainly due to good profit margins generated by banks in those years. On the

other hand year 2000 and year 2001 ratios show that poor profit margins had a

significant impact on return on equity in these years. Asset Yield and leverage

variations from year to year have been less important. The conclusion therefore is

that Omani banks should focus on factors influencing profit margins like cost

management and credit risk management practices.

Liquidity Management: While some banks have been consistently following a policy

of low liquidity (liquid asset ratio of 12% to 15%) there are other banks which are

operating in the same environment and within the same regulations which maintain

liquidity levels as high as 26%. Liquid asset ratios of banks have in general

increased over the period.

Interest Rate Risk Management: Net Interest Margins (spreads) have varied in the

range of 3.3% to 5.67%. Most banks reported NIM in the range of 3.5% to 4.5%.

Although year 2001 was not a good year in terms of profitability all banks reported

good net interest margins indicating interest rate management was not the reason for

poor profitability.

One year Cumulative Gap / Assets ratio is high for Omani banks compared to

international standards. In 2001 all banks reported negative gaps with some banks

having negative gaps ratios as high as 24, 25 & 32%. Such gaps are necessarily risky

especially if interest rates are likely to rise. Year 2003 saw a significant change in

banks gap strategy ( Gap/ Asset ratio started declining).

Capital Account Management Ratios: All banks have good BIS capital adequacy

ratios well above the 12% norm. A few banks are not only able to maintain a high

capital adequacy ratio but also leveraging well with leverage ratios of 11+ (or a

capital asset ratio of around 9 ). Compared to international banks, most Omani

banks have low leverage multipliers ( that is high level of capital to asset in the range

of 12% to 23% compared to banks in developed countries which have capital asset

ratio of around 5%).

Credit Risk Management: Total Loan Loss Provisions to Total Loans were high in

years 2001 & 2002 in the range of 5 to 10%, and as expected Risk Adjusted Margins

were lower. The year 2001 experience brings out the importance of prudent capital

account management. Year 2001 was a year of credit risk problems, however all

banks sailed through because of their excellent capital strength. By year 2003 there is

general improvement in asset quality (except in case of one bank )

Cost Management : Banks in Oman report cost / income ratios in the range of 38%

to 54%. By international standards Omani banks have low cost / income ratios

indicating good productivity.

REFERENCES

REFERENCES

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