Return-On-Asset Ratio, Effects on the Loan Portfolio and the Investment Portfolio, and the FDIC
Low Return-on-Asset Ratio
It is always important for management to monitor all of the company’s finance, including income as well as expenses on a regular and frequent basis to make decisions on where to invest the company’s funds.
A low return on assets ratio indicates that unsuccessful or insufficient management of interest rate margin, noninterest income and expenses, and loan loss reserves is present. Banks have been focusing to receive a high portion of net income from noninterest income by providing other services, such as insurance or brokerage. Fees are another source of noninterest income for banks. When noninterest expenses (such as overhead or advertising expenses) exceed noninterest income however, then the return on assets declines.
A low return on asset can also be caused by high loan losses. This usually happens when banks offer loans to people who default on their payments, especially in times when economic conditions are less favorable. The net interest margin of a bank is impacted by many different factors including, but not limited to: interest income, non-interest income and expenses, loan loss reserves. Poor management regarding any or all of these factors result in a low net interest margin and low (if any) net income.
The relationship between the ROA and ROE
Return on assets and return on equity are both measures of a bank’s performance. As mentioned above, the return of assets for a bank is impacted by factors of interest income, non-interest income and expenses, loan loss reserves. Poor management regarding any or all of these factors result in a low net interest margin and low (if any) net income. The difference between the ROA and ROE of a bank is that return on equity depends on the return on assets and in addition depends on the financial leverage of a bank (which is multiplied by the bank’s return on assets to equal the return on equity). There is not a direct relationship between the ROA and ROE. While the ROA high, the ROE may be a lot lower and still decreasing.
Effect on the credit decision in the loan portfolio and the investment portfolio
Credit decisions in the investment portfolio from the stand point of an investor should be based on a bank’s return on assets to measure its performance, and also on its return on equity, which is closely related to the bank’s financial leverage. The lower a bank’s financial leverage, the higher the amount of money the bank simply holds in reserves and does not loan out to people or invest. As an investor, it is important to know that a bank holds enough money in reserves to pay out interest to its investors. The lower a bank’s return on assets the more risky it is to invest in any securities issued by that bank.
Credit decisions in the loan portfolio from the stand point of the bank should not be too conservative, meaning that the bank will only give out loans to people with a low risk of defaulting on loan payments, which would result in a low interest income and lower bank’s ROA. However, loans should not be given out to everyone either, because the risk would be higher to incur loan losses, which would lower a bank’s ROA as well. Thus, in times of less favorable economic conditions, banks should be more conservative of providing loans to people and vice versa to minimize the risk of incurring loan losses due to payment defaults by borrowers.
From the stand point of the FDIC:
Why is the capital position important?
The capital position of a bank is important from the stand point of the FDIC, because capital is an indicator of a bank’s strength and the higher a bank’s capital (leaving all other factors equal), the lower the risk of that bank causing the consumer losses. The Federal Deposit Insurance Corporation insures consumers up to a certain amount of their funds in case a bank goes out of business or files bankruptcy. Thus, a bank’s capital position is important to the FDIC, how likely it is for that bank to go out of business (for example) and make the FDIC pay the banks consumers’ funds back, which the FDIC obviously wants to avoid.