Bank Profit Planning: How Commercial Banks Plan For Profit
An important part of profit planning is developing a formal profit plan, a written statement in both financial and non-financial terms of a firm’s profit objectives. Usually, a bank develops annual and three- or five-year profit plans.
Table Of Contents:
Bank Profit Planning
Bank profit planning is a managerial process designed to achieve a company’s objectives over a specified period.
Understanding profit planning is essential if you’re studying finance or considering a career in the banking industry. In the dynamic world of commercial banking, profit planning is a strategic tool that helps banks achieve sustainable growth and competitiveness.
Profit planning is a critical process that allows commercial banks to set financial and non-financial goals, align resources, and implement strategies to maximize profitability.
In the commercial banking sector, profit planning takes on a unique significance as it directly impacts the bank’s long-term success and ability to thrive in a competitive market.
Commercial banks can chart a course toward sustainable growth and profitability by setting clear objectives and developing a formal profit plan.
This blog post’ll explore the ten-step profit planning program tailored specifically for commercial banks. Whether you’re a first-year university student or an aspiring banker, this guide will provide you with a comprehensive understanding of profit planning in the commercial banking sector.
Profitability of Banks
Several factors influence the profitability of banks, including the following:
- Economic conditions
- Interest rates
- Competitive conditions
- Percent of resources employed
- Securities gains and losses
- Loan losses and recoveries
Management includes planning, organizing, staffing, directing, and controlling.
Banks that have expertise in these areas are more likely to experience profitability than those that do not. Unfortunately, some banks, because of limited resources, are at a disadvantage in securing the services of personnel experienced in these important areas.
Banks’ profitability depends greatly on the economic health of the community it serves.
The return on assets is a significant factor in determining bank profitability. Normally, as lending rates and the return on securities rise, so does the profitability since there is a slight lag in rates paid on deposits.
Banks’ competitive position influences profitability by reducing the resources available to banks and forcing up rates paid on these resources; consequently, a bank’s net interest margin is lessened.
The number of bank resources invested in earning assets increases income and profitability. The amount allocated to loans and investments is an important management decision and depends on many factors, including a bank’s liquidity needs.
Profitability and Bank Size
The profitability of banks has varied by bank size. Although the return on assets and equity declined in all banks during the 1981-86 period, the most noticeable decline in return on assets was 54 percent compared to a decline of only 16 percent for all banks.
The decline in return on equity was also 54 percent compared to a decline of 22 percent for all banks. The decline in return on assets and equity for money center banks was less than for most other classes on banks.
Banks classified as agricultural banks have shown the poorest profitability performance in recent years, and for the obvious reason, the nation’s agricultural sector has been depressed.
Banks that had a large proportion of their loan portfolio in energy loans also experienced profitability problems in the last few years due to the economic problems that have beset the nation’s energy sector.
Ten-Step Profit Planning Program for a Commercial Bank
Step 1: Economic and Financial Forecasts- Analyzing the Factors That Shape Commercial Banking
Commercial banks must first delve into economic and financial forecasts to begin the profit-planning journey. These forecasts help banks understand the national and local economic factors that influence commercial banking operations. Banks can gain valuable insights to guide their profit-planning decisions by analyzing economic indicators and financial trends.
Step 2: Setting Preliminary Goals- Charting the Course for Profitability in Commercial Banking
Commercial banks must establish preliminary goals for earnings per share and return on capital. These key performance indicators serve as benchmarks to measure profitability. By setting clear targets, banks can align their efforts toward achieving optimal profitability and ensuring long-term success in the commercial banking landscape.
Step 3: Estimating Credit Demand – Meeting the Financing Needs of Businesses and Individuals
Understanding the projected demand for credit products and banking services is crucial for commercial banks. By segmenting credit demand by type and assessing market trends, banks can estimate the potential revenue streams and align their offerings accordingly.
This step helps commercial banks optimize their lending capacity and capitalize on opportunities in the market.
Step 4: Estimating Deposits and Funds – Building a Strong Foundation for Profitability
Deposits and funds play a vital role in a commercial bank’s profitability.
Banks can assess their lending capacity and identify potential investment opportunities by estimating the volume and types of deposits and other funds. This step enables banks to allocate resources effectively and ensure a solid foundation for profitability.
Step 5: Branch and Department Profit Plans – Harnessing the Power of Individual Units
Profit planning is not a one-size-fits-all approach. Each branch and department within a commercial bank contributes uniquely to the overall profitability.
Banks can develop tailored profit plans by involving individual units in the profit planning process that align with specific goals and opportunities. This step fosters a sense of ownership and accountability among the bank’s employees.
Step 6: Consolidated Profit Plan – Uniting the Efforts for Maximum Impact
Creating a comprehensive profit plan consolidating the individual branch and department plans is critical.
The consolidated plan enables commercial banks to evaluate the organization’s financial performance. Calculating earnings per share, return on capital, and estimating provisions for income taxes provide a clear picture of the bank’s profitability and tax obligations.
Step 7: Reviewing and Evaluating – Ensuring Alignment and Identifying Opportunities
In this step, commercial banks compare actual and projected earnings per share and return on capital against preliminary goals. By conducting in-depth reviews of branch and department profit plans, banks can ensure alignment with the overall profit
objectives. This critical evaluation process helps identify areas for improvement and opportunities to enhance profitability.
Step 8: Exploring Strategies for Profit Enhancement – Driving Growth and Innovation in Commercial Banking
Commercial banks must continuously explore alternative strategies to increase profitability. This may include expanding service offerings, optimizing operational efficiency, exploring new market segments, and developing innovative financial solutions.
Commercial banks can stay ahead of the competition by adopting forward-thinking strategies and uncovering new avenues for profit growth.
Step 9: Finalizing the Profit Plan – Setting the Course for Profitability
In this step, the final profit plan is drafted, incorporating adjustments and strategies specific to commercial banking.
It ensures that profit objectives are aligned with the bank’s resources and market dynamics. The profit plan serves as a roadmap, guiding the bank toward maximizing profitability and achieving its long-term goals.
Step 10: Monitoring and Measuring Results – Staying on Track and Adapting to Change
The final step of the profit planning program involves continuous monitoring and measuring of financial performance.
Commercial banks must analyze variances, identify areas for improvement, and make necessary adjustments throughout the year. This ongoing evaluation process allows banks to stay on track, adapt to market changes, and ensure their profitability remains on target.
Bank Income and Expenditure
The Bank’s income will be higher if revenue is of high volume and the cost is lower than usual. The income will be less if revenue is low and when the cost is higher than usual.
Items of Bank income
- Interest income
- Discount income
- Dividend income
- Commissions, fees, exchange charges, and brokerage.
- Other incomes
- lockers’ fees
- remittance handling
- service charges
- delay fines
- investigation fees
- commitment charges
Heads of Bank’s expenditure
- Interest on Deposits
- Interest on Borrowings
- Operational Expenses.
- Employees’ salaries,
- Employees’ other allowances,
- Funds Compensations,
- prizes, etc.
- Other Expenditures:
- Directors’ fees
- Committee members fees
- Auditors’ fees,
- Law charges
- Postage & stamps
- Printing & stationeries
- Advertisements, etc.
Earning Structure of Bank
As in business organizations, commercial banks’ income or profit results from revenue and cost functions. The revenue function shows that the banks’ total income is derived from the services rendered by the banks, and the cost function shows the total expenses incurred m producing any service rendered.
Interest and Discount
Interest on loans made by a bank and discounts charged on bills of exchange constitute the principal source of income since loans account for a sizeable proportion of total bank funds.
The level of interest income in a bank depends on the volume of loans, the type of loans made, and interest rates.
Interest rates are notoriously variable depending on the characteristics of the individual loan and the general conditions of supply of and demand for credit in the money market.
Dividend income, another important source of banks’ earnings next only to the interest income level of dividend income, depends largely on the amount and composition of investments and the rates of return.
Commission, Exchange, and Brokerage
Another important source of bank earnings is commissions, fees, exchange charges, and brokerage, which the bank charges for a wide assortment of services it performs.
Other Sources of Earnings
This category includes earnings horn lockers, remittances, and service charges on loans which the bank charges from credit applicants for a credit investigation and late payments. Banks may also charge for a loan commitment anti for the execution of mortgages or agreements securing loans.
The problem of Allocation of Bank Income
One of the most important problems facing bank management is allocating the bank income between different heads in light of the current and forthcoming requirements. Bank’s profits may be used in the following three ways:
- establishing special reserve funds such as valuation reserves out of profits of the bank to protect against unusual losses;
- retaining a portion of profits for general capital accounts;
- distributing a portion of bank profits to the owners as dividends.
A part of the bank earnings must be distributed to the bank owners. This is necessary to maintain the confidence of existing stockholders and tempt potential investors to invest in the bank’s securities.
Some investors are wary about the future and strongly prefer immediate income, which reduces uncertainty about the level of earnings for the investors. Stockholders may give greater weight to expectations concerning present dividends than beliefs about price trends and dividends over the long run.
Furthermore, a dividend carries a price of information about the future earnings capacity of the firm. A high dividend exhibiting small but steady growth is looked at as indicative of the organization’s stability. This is why variations in dividend rates cause fluctuation in share prices.
Factors Influencing the Pattern of Allocation of Bank Income
Internal Factors Influencing the Pattern of Allocation of Bank Income
1. Asset structure and its risk Complexion
The amount of special and general reserve funds in a bank is closely related to the risks that the bank has assumed. Loans and security investments, excluding Govt bonds, are considered risky assets.
2. Credit and Investment Losses
The losses which the bank is likely to sustain in the future, both in respect of creditor’s default to repay and the sale of securities, should be reckoned separately to decide how much current income the bank should devote to the amassing of a reserve for losses on loans and reserve for less on security investment.
3. Repayment of Loan
A bank with debt may extinguish it by employing new obligations to replace the old debt or retained earnings. If the management adopts the second alternative, a larger portion of the bank’s earnings will be retained.
4. Growth rate of the Bank
A bank is growing more rapidly than the banking system as a whole has more than an ordinary reason for building up its capital account. A rapidly growing bank will have constant funds to seize favorable opportunities for which a sufficiently large amount of funds is needed.
5. Access to Capital Market
A bank has ready access to capital market sources at a reasonable rate because of its high and stable earning record in the past and the resourcefulness of the board of directors. The management need not be too conservative in retaining a larger share of the earnings.
6. Ownership of Bank
In a closely held bank with a few but affluent stockholders, as is generally with small banks, management will always retain a larger share of the profits to reduce the tax liability of stockholders.
Control is also an important factor that influences the pattern of income distribution. The issue of additional common stocks for procuring funds dilutes control to the detriment of existing stockholders who dominate the firm’s voice.
8. Bank’s Lending and Investment Opportunities
An appropriate dividend policy takes due care of the lending and investment opportunities of the bank.
A firm has haste of profitable lending and investment opportunities in hand; management has no alternative but to retain entirely or a sizeable portion of its earnings to seize upon the opportunities provided stockholders are willing to sacrifice the present dividend income for a future higher return.
External Factors Influencing the Pattern of Allocation of Bank Income
General State of the Economy
The level of business activity of the bank and its earnings are subject to the general economic conditions of the country. Uncertainty about future economic and business conditions may lead to the retention of all or a larger part of the profits in the bank to build up funds to protect itself against any loss in the future.
Similarly, in the event of depression, when the level of business activity is very likely to say demand for bank credit lends to below. Banks do not get enough deposits because of the drop in per capita- income of the people.
Condition of the money
Market In the event of tight money market conditions, banks should retain more and more funds to protect themselves against any contingency and meet society’s pressing credit needs at a higher interest rate.
Considering the significance of a strong capital position in a banking concern, the supervisory and regulatory authorities have consistently prodded bank management to retain the sizeable
amount of earned profits.
In India, the banking authorities have also emphasized the role retained earnings could play in strengthening a bank’s capital position.
The government’s tax policy also influences dividend decisions in a bank. Sometimes, to quicken capital formation, the government provides tax incentives to companies to retain a larger share of their earnings.
Structure of Bank Expenditure
Banking is a highly personalized service industry. The expenses of commercial banks are, to a large measure, fixed, particularly in the short run. Unlike other industries, bank management cannot curtail expenditure by suspending operations or reducing the labor force.
Generally, bank expenditure can be divided into three broad group
- Interest on deposit,
- Salaries, allowances, provident funds, and bonuses.
- Other expenses include stationery, depreciation, repairs, and other overheads.
Interest on deposits and borrowings
A commercial bank’s most important expense is the interest paid on time, savings, and other deposits and borrowings. Interest cost on deposits would largely depend on bank deposits’ volume, composition, and interest rate structure.
Salaries, allowance, Provident Funds, etc
Commercial banks’ next largest expense item is salaries and allowances of policies and employees. This category of expenditure arc included salaries, allowances, and other benefits such as provident funds, bonuses, etc.
This category of expenditure arc included Directors and Local Committee member’s lees, auditors’ law charges, rent, taxes, insurance, depreciation, replies, postage, telegrams and stamps and stationery, printing, and advertisements.
Like any other business, maximizing profit is the main goal of banks. In the process of earning, justified costs are to be incurred. But, if effectively managed, such costs can be reduced, resulting in a higher profit volume.
On the other hand, it can be effectively managed; items of income will yield larger profits.
Structural management of income and expenditure in both planned and logical order will surely help the bank to be cost-effective, raising income and ultimately resulting in a higher profit volume.
Similarly, allocating bank income to effective must consider some essential internal and external factors. Banks’ earnings may be raised further if proper steps are taken through appropriate profit planning.
Shareholders are interested in profit for dividends. Hence, there should be a well-devised dividend policy without jeopardizing the bank’s funds and retained earnings growth.