A Closer Look At Bank Profitability and Risk

The financial market is considered to be one of the most volatile platforms in the industry as it can be influence by a number of factors that can be either objective or subjective. Today in this article, let's take a closer look at what are the determinants of profitability and risk for banking institutions.

What is a bank risk?

Just like other businesses, banking institutions also has a lot of risks that they should properly manage as huge amount of their funds comes from their customers and because risks can also affect the profitability of a firm. Not having a reliable risk management, any bank can be perceived as a weak entity in the industry which will only make them lose their existing and potential depositors and other opportunities that could help them gain more profit. Although we can say that risks has become pretty inherent in our daily lives, banks are still considered to be one of those entities who cannot afford to take any risk all due to the regulated environment where they operate. Below is a short list of risks that banks should be aware of at all times.

1. Liquidity risk - these are risks that comes from the unpredictability coming from the services required by the depositors and the ability of a bank to deliver the services or outputs that is expected from them.
2. Credit risk - this occurs when the individual who took a loan from the bank doesn't have the ability to pay his dues.
3. Interest rate risk - this is a type of risk that arise where banks are forced to pay more for the liabilities of their interest that result to the decrease in their profits.
4. Trading risk - as there is a need for banks to abide to the law implemented by the government, banks would have to venture into other activities such as trading securities in order to gain more profit, which in return create a trading risk as banks would also have to depend or hire a trader to engage in such activities.
5. Operational risk - this occurs when a bank has an ineffective business process and procedures or when the asset or resources that they need to properly operate the institution has been destroyed.

What is bank profitability?

In order for a bank to meet their goals and continually provide the services need by their depositor, banks would also need to gain profit, in which most of it comes from the fees that they charge to their customer's transaction and interests from their assets.

Before, many specialists uses the net income to be the common metric system to measure a bank's profitability but they have realized that it doesn't cover some of the areas that can show how effectively a bank functions in relation to its size and asset efficiency. This concerns have pushed the specialists to shift to a profitability based measurement where it gauges the operational efficiency of bank as well as the diversification of its assets. Listed below are some of the profitability based performance measurement metrics that are being used today.

1. Return of Assets
2. Risk Adjusted Return on Asset
3. Return on Equity
4. Risk Adjusted Return on Equity
5. Risk Adjusted Return on Capital
6. Economic Value Added