Liquidity measures an institution's ability to meet its anticipated short- and long-term obligations to customers and creditors. It is important to measure liquidity because a lack of it may bring about the failure of the bank when financial problems become apparent.
Kroll Bond Rating Agency (KBRA) primarily considers temporary investments minus volatile liabilities-to-average assets and loans-to-average assets.
A high degree of liquidity enables an institution to meet unexpected needs for cash without the untimely sale of investments or fixed assets, which may result in substantial realized losses due to temporary market conditions or tax consequences.
Liquidity for financial institutions is difficult to measure since their liquidity position changes daily and the data reflected in the financial statements may not reflect their current position.
A bank's asset quality is measured by its amount of nonperforming assets. Nonperforming assets are assets which revenue recognition has been discontinued or is restricted. This includes both nonperforming loans and securities and other real estate owned or acquired in connection with the collection effort on loans.
Financial institutions generally fail due to a large percentage of nonperforming assets in comparison with its total capital and loan loss reserves.
Asset quality also affects earnings through provisions to the loan loss reserve. An inadequate reserve will require additional provisions, which reduces earnings. Poor asset quality can also affect earnings through reduced interest income. Loans, which are past due and are not paying interest as scheduled, have a negative impact on interest income.
A bank's capital position is of paramount importance to its overall financial condition. Earnings are the primary means for banks to increase capital internally, which is accomplished through retained earnings (net income less dividends paid).
For many small community banks, retained earnings are even more important, because they are often the only practical source of raising capital. If a bank is not profitable, losses will decrease its capital strength, which may ultimately affect the institution's overall safety, soundness and viability.
KBRA measures capital strength mainly through the institution's amount of regulatory capital as compared to its risk-weighted assets and asset equivalent off-balance sheet exposures.
Analyzing a bank's capital level in this way increases the emphasis on common equity and restricts the amount of loan loss reserves that can be counted as capital. It also recognizes the relative degree of credit risk associated with various assets by setting different capital requirements for some assets that clearly have less credit risk than others.
Earnings are the primary means for banks to increase capital internally, specifically through retained earnings. KBRA uses return on assets (ROA) as its primary earnings indicator. The ROA is compared with past earnings to identify trends. Vital for an institution, earnings:
The institution's dividend policy is of importance since excessive dividends can weaken a bank's capital position. Banks located in rapidly growing markets must be attentive to their rate of earnings' retention so they may properly plan for new capital funds as needed.
For most banks, the loan portfolio comprises the majority of earning assets although interest income can be derived from other earning assets.
Noninterest income is typically the second largest source of revenue for a bank.
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