How Healthy Are Big U.S. Banks?

With the help of SNL Financial, BusinessWeek's scorecard ranks 10 big banks using several key financial metrics

With so many questions swirling about the health of big U.S. banks, BusinessWeek decided to take a look at just where some of the top institutions stand. Specifically, we asked bank analysis firm SNL Financial to screen the 10 largest U.S. banks in terms of market capitalization based on important financial ratios that provide important clues to how well a bank performs financially—and how solid its balance sheet is.

The banks in the following table were screened for how they performed through the second quarter of 2008 in several key categories. Here they are, with definitions provided by Standard & Poor's Equity Research and InvestorWords.com:

• Return on average assets (ROAA): This is a comprehensive measure of bank profitability—a bank's net income divided by its average total assets during a given period. A trend of rising ROAA is generally positive, provided it is not the result of excessive risk-taking. Because banks are highly leveraged, they tend to have low ROAAs relative to other industries. Historically, most banks have had ROAAs within a range of 0.60% to 1.50%.

Profitability measures like ROAA "build upon a bank's existing equity in the form of retained earnings (earnings after dividends), and losses will negatively impact equity," notes Sebastian Hindman, an analyst with SNL. "So continued losses will slowly, or rapidly, depending on the size of the losses, diminish the equity of an institution."

• Return on average equity (ROAE): Another measure of profitability, usually considered in conjunction with ROAA, is return on equity. A bank's ROE is calculated by dividing net income by average shareholders' equity. Because shareholders' equity normally backs only a small fraction (usually 5% to 10%) of a bank's assets, ROE is much larger than ROAA—typically, ranging from 10% to 25%. In 2007, the industry's average ROE was 8.17%, compared with 12.34% a year earlier.

• Net interest margin (NIM): The NIM is calculated by dividing the tax-equivalent net interest income by average earning assets. (Tax-equivalent net interest income is calculated by subtracting interest expense from tax-equivalent interest income.)

A NIM of less than 3% is generally considered low, notes S&P; more than 5% is very high. This range is only a rough guideline, however, because the NIM can vary with the particular business mix of individual banks. The NIM tends to be higher at small retail banks, credit-card banks, and consumer lenders than at large wholesale banks, international banks, and mortgage lenders.

A widening NIM is a sign of successful management of assets and liabilities, while a narrowing NIM indicates a profit squeeze. According to the Federal Deposit Insurance Corp. (FDIC), the industry's average NIM was 3.29% in 2007, down slightly from 3.31% in 2006, but down more sharply from 3.49% in 2005.

• Nonperforming assets (NPA)/assets: A loan or lease that is not meeting its stated principal and interest payments is a categorized as a nonperforming asset. Banks usually classify as nonperforming assets any commercial loans which are more than 90 days overdue and any consumer loans which are more than 180 days overdue. This metric shows what percentage of a bank's total assets are nonperforming.

"[A]s nonperforming asset levels increase, banks are forced to increase reserves," notes Hindman. Any increase in reserves is taken out of income in the form of a provision for loan losses, which diminished net income, and thus affects the equity of an institution.

• Reserves/NPA: To protect banks from possible default by loan customers at some point in the future, they are required to maintain a reserve for loan losses. This metric shows just how well a bank has set aside reserves for nonperforming assets. A reserves/NPA equaling 100.0% means that for every $1 of nonperforming assets, $1 is reserved for that loss, says Hindman.