Even banks with long track records of good management and growing net worth can very quickly reverse direction, and spin out into a value-destroying mode of operation...especially during times of economic stress.
Too often, much damage is done before management recognizes that it has a problem, is able to diagnose its causes, and take corrective action.
The ability to respond quickly to changing conditions can make all the difference. That’s why it’s crucial for management and directors to have an accurate and timely means of taking the financial temperature of their institution on a regular basis. To this end,
IDC Financial Publishing (IDCFP) uses the Operating Profit Margin, which we believe to be the best measure of productivity in delivery of banking services.
What is the Operating Profit Margin?
The Operating Profit Margin (OPM) is a deceptively simple calculation; the ratio between operating profits (before the loan loss provision and excluding gains/losses from asset sales and amortization expense of intangibles), divided by net operating revenues (interest income less interest expense plus non-interest income). It measures the percent of net operating revenues consumed by operating expenses, providing the remaining operating profit.
Clearly, the higher this margin, the more efficient is the bank. Recent federal legislation referred to complex banks. The standard deviation or volatility in the operating profit margin best illustrates the risk in the operating profit margin. The lower the risk, the less complex and more stable the profit structure.
The higher the OPM margin the more favorable and, the more efficient the bank. And you can increase this margin in either (or both) of two ways: 1) By reducing operating expenses, and/or 2) by raising the denominator (increasing yields on earning assets, raising non-interest income, or controlling the cost of funds).
The median OPM for all commercial banks is 36.1%. Better-managed institutions maintain a margin above 46.8%. Any margin below the median is an early warning; and if your margin is less than 24.3%, you could be headed for serious profit problems. An operating profit margin below 10% or negative, coupled with high financial leverage above 10-times creates high risk in a bank. While IDC’s CAMEL rating system for banks considers a series of other financial ratios as well, we’ve found a remarkably strong correlation between changes in the OPM, the overall CAMEL rating, and return on equity capital.
John E Rickmeier, CFA