Assessing a financial institution’s management of credit risk reveals information about sustainability of operations. The analysis involves examining financial ratios related to loan quality. Future loss from loans that are not repaid is never certain. However, sound institutions have sufficient reserves of capital for potential losses (see References 1, page 29). Banks provide quarterly reports to the Federal Financial Institutions Examination Council disclosing loans that are delinquent and those that are non-accrual—meaning no longer accruing interest income on the bank’s financial statements. These reports also disclose reserves for future losses.
Things You'll Need
- Most recent Call Report—the Consolidated Reports of Condition and Income filed with the Federal Financial Institutions Examination Council (FFIEC).
Divide the bank’s reserve for loan loss by total loans. An adequate reserve for potential losses is generally a minimum of one percent.
Calculate the bank’s coverage ratio by dividing the reserve for loan loss by non-performing loans. Non-performing loans consist of non-accrual loans plus loans that are 90 days or more overdue but still accruing interest. A result that exceeds 1.5 is considered sound.
Divide the bank’s loans that are over 30 days past due by total loans. This ratio indicates adequacy of credit underwriting standards and collection procedures. The past due loans should be a low percentage of total loans. A rising percentage of past due loans over several quarters is indicative of a bank’s deteriorating loan quality.
Add the bank’s total equity and reserve for loan losses. Divide the result into non-performing loans. A ratio of more than 1 indicates that the bank has insufficiently managed risk by having inadequate capital for potential losses (see References 2).