Management Capabilities and Earnings Quality

Management Capabilities

The quality of a bank’s management influences the success with which the bank is able to exploit profitable opportunities while also controlling the level of risks taken. Risk management and control is critical for banks. This includes identification and control of different types of risk (e.g., credit, market, operating, legal, and other).

A bank’s internal control and governance systems (including an independent board) ensure that managers do not take undue risks or engage in self serving behavior. The board also sets appropriate levels of maximum allowable risk for the managers. Internal control systems should continuously measure and monitor the myriad risks that the bank may be exposed to.

Earnings

Earnings are considered high quality if they are adequate (providing a rate of return above the cost of capital) as well as sustainable. Ideally, the trend in earnings should be positive and the underlying accounting estimates (used to arrive at reported earnings) should be unbiased. Finally, earnings should ideally be derived from recurring sources.

A major source of earnings of a bank is from investment in securities. Estimates used in the valuation of these securities may lead to biased earnings. Both IFRS and U.S. GAAP use the concept of a fair value hierarchy based on types of inputs used in determining the fair value of financial assets.

Level 1 inputs are quoted market prices of identical assets. Level 2 inputs are observable but not quoted prices of identical assets. Examples of Level 2 inputs include quoted prices of similar assets, quoted prices of identical assets in nonactive markets, observable interest rates, spreads, and implied volatility.

Level 3 inputs are nonobservable and hence subjective. For example, fair value may be derived from models or based on estimated future cash flows discounted at an estimated discount rate.

In practice, banks often use the fair value hierarchy to label their assets (e.g., Level 2 securities are those whose value was determined using Level 2 inputs) or to label their valuation methodology (e.g., Level 2 methodology is defined as one that uses Level 2 inputs).

Similar to other companies, other subjective estimates (e.g., goodwill impairment, recognition of deferred tax assets, and recognition of contingent liabilities) affects the quality of a bank’s earnings.

For a typical bank, major sources of earnings are (1) net interest income, (2) service income, and (3) trading income. Of these, trading income is the most volatile year to year. Hence, on a relative basis, banks with proportionally higher net interest income and service income would have more sustainable earnings.