How to assess the financial health of your bank

The financial health of your bank

¹ is as important as the money you put into it. So what does financial health look like in the context of a bank, and how do you determine if a bank is healthy?

All U.S. banks are regulated and required to submit their financials and industry-standardized health metrics to the FDIC, even if they’re not publicly traded. Banks are also regularly audited by regulators to ensure accuracy. This information is publicly available through the FDIC and Federal Reserve Websites. Many banks post their financials on their websites (look for the Investor Relations page). For example, Mercury customers can dive into our partner banks’ financials by looking at Evolve’s latest quarterly report and Choice’s most recent Federal Financial Institutions Examination Council (FFIEC) report. That said, interpreting the information in any bank’s report necessitates a baseline familiarity with how banks work, knowledge of a few key industry terms, plus an awareness of what questions should be informing your assessment.

In the sections that follow, we explore how banks work and outline some questions you should ask when assessing a bank’s financial health — helping you make informed decisions when it comes to where you hold your money.

How do banks work?

Before diving into a bank’s financials, it’s helpful to understand how banks operate — including how they make money.

Banks typically make money by taking in deposits from customers and lending cash from those deposits to individuals or businesses in the form of loans. You can think of this as financial matchmaking between those who have money and those who need it. Loans can take many forms, including residential mortgages, auto loans, credit cards, commercial loans, construction loans, equipment financing, and SBA loans. There are also cases in which a bank may invest in municipal and government securities, though this is subject to SEC oversight. Loans and investments are considered assets for a bank (inverse from a company or borrower’s perspective, where a loan is a liability), because banks profit from loans by charging interest. Depending on the bank and its business lines, other revenue streams may include advisory fees, interchange fees, transaction fees, or other services.

Loans and investments can carry risk, including repayment/default risk and price volatility risk, respectively. A bank’s core responsibility is to underwrite risk appropriately — and to ensure it has a strong enough balance sheet to weather potential losses. That said, a manageable level of risk-taking and related loan losses is actually healthy for the bank and the economy. By extending credit to a broader base of borrowers (thereby helping businesses grow or enabling home and auto ownership), banks can be a critical force in funding economic expansion.

Now that we have a basic understanding of how banks work, let’s outline some of the key questions you should ask in determining whether or not a bank is in good health.

Question 1: Does your bank have healthy capital ratios?

Capital ratios are the single most important metric in assessing a bank’s financial health. They measure whether a bank has enough of its own capital (i.e., cash) to take losses in their asset book, and are calculated as capital to risk-adjusted assets. The numerator of this ratio (i.e., capital) consists of money the bank has raised through equity, debt raises, and profits from operations. The denominator (i.e., risk-adjusted assets) factors in the relative safety of varying assets and weighs them accordingly. U.S. treasuries, for example, have a risk weight of 0%, while residential mortgages are weighted higher depending on the value of the property. Riskier assets can even be weighted over 100% to account for outsized risk.

The capital ratio you should pay the most attention to is a bank’s tier 1 leverage ratio. This refers to the ratio of core capital to risk-adjusted assets and is the most telling indicator of a bank’s health. Since the Great Recession of 2007–2009, banks have been required to maintain a tier 1 leverage ratio of more than 4%, but a healthy metric for most banks is around 6%. Most larger household-name banks operate in the 6–8% range. Typically speaking, the higher the percentage, the healthier the bank. This is because a higher percentage indicates that a bank has more capital to absorb losses. Nevertheless, too high of a percentage could indicate that a bank is stagnant or limited in revenue potential.

In addition to the tier 1 leverage ratio, two other capital ratios are worth monitoring: the tier 1 risk-based capital ratio and the total risk-based capital ratio. These ratios are similar to the tier 1 leverage ratio, but expand the definition of “capital” by including additional quality tiers of capital, which is determined by the source of capital. For example, capital raised from equity investors and capital raised from debt issuances would be considered two different quality tiers of capital — and while both are good, the former is considered better “quality” than the latter.

Question 2: What is the quality of your bank’s assets?

A bank’s assets consist mostly of loans made to the bank’s customers and investments in securities. The nature of loans can vary significantly depending on a bank’s preferred business lines. Again, lending activity can include anything from residential mortgages to SBA loans — and different types of loans come with different levels of risk. Investment securities can include U.S. treasury bonds, government agency bonds, other debt securities, and — in limited quantities — mutual funds or stocks.

In selecting a bank — or, in determining whether or not you should continue banking with your current bank — it’s important to investigate the nature of the bank’s assets, especially if you’re wary of alternative assets such as crypto. In general, the rule is simple: the riskier your bank’s assets, the riskier they are to bank with, especially when those high-risk assets make up a large percentage of the bank’s asset book. You can find much of this information through the FDIC’s mandated financial filings, which break down a bank’s loans and assets. It’s wise to keep an eye on this balance sheet in order to spot any major changes in loans or investments that could increase the bank’s potential for loss.

Using the FDIC’s publicly available records, it’s also helpful to track a bank’s allowance for loan losses relative to their loan book in order to ensure that potential losses are in a reasonable range. This allowance is a forecast of future losses and is regularly updated based on deterioration of borrower quality, repayment trends, and macroeconomic conditions. Of course, some amount of loss is expected when lending. The key here is to ensure that your bank is diligent in their underwriting and servicing processes. This allows them to manage losses within an economically viable range while still facilitating borrowing activity for customers.

Question 3: Does your bank have a healthy loan-to-deposit ratio?

A bank’s loan-to-deposit ratio measures what percentage of a bank’s deposits are lent out at any given point in time. If the ratio is too high, a bank may not have enough liquidity to cover unforeseen withdrawals because its deposits are not liquid until loans are repaid. However, this doesn’t mean that a lower loan-to-deposit ratio is always better, because interest-bearing deposits can increase operating costs — impacting a bank’s profitability. A “good” loan-to-deposit ratio really depends on the bank and the type of lending it engages in, as well as its business model and strategy. A bank that focuses more on advisory services vs. lending could have a much lower loan-to-deposit ratio. Ratios as high as ~90% aren’t necessarily bad, though once that number gets closer to 100% or above, it could be cause for concern.

Keep in mind that industry averages for this specific ratio are also greatly impacted by consumer behavior and macroeconomic conditions. In 2020 and 2021, for example, COVID stimulus programs and decreased consumer spending pushed deposits to extreme highs, resulting in lower loan-to-deposit ratios across the board. Additionally, some banks’ loan-to-deposit ratios may be affected by their participation in sweep networks. Deposits held in sweep networks don’t appear on the bank’s balance sheet. Instead, they’re presented as off-balance-sheet items, meaning the bank may have access to greater deposits than shown.

Remember, any losses the bank takes on their assets (e.g., on a loan that defaults) do not directly impact your deposits. Banks are required to have healthy capital ratios so that they’re directly responsible for losses on asset decisions. Customer deposits are also insured by the FDIC — typically up to $250K per account, but with potential for greater coverage depending on how your deposits are managed (as in the case of a bank participating in a sweep network, for example).

Question 4: Does your bank have a track record of profitability?

It may seem like common sense to ask this question, but do you actually know if your bank is profitable? For many of us, bank operations are so foreign that the question of profitability is rarely on our minds. A solid track record of profitability is a strong indicator that your bank will be around for the long run — and that your money is in good hands. What’s more, profitability also helps boost a bank’s capital, increasing the buffer on their capital ratio.

There are a few ways to measure profitability. Having a bank with a larger net income number is good, but smaller banks with smaller profit dollars can still be safe options if their net income is healthy relative to their size. In assessing bank profitability, there are three commonly reported metrics worth considering: net interest margin, net income margin, and return on assets.

• Net interest margin (NIM) is the bank version of gross margin and measures the spread the bank earns between the interest rate made on loans versus the interest paid to depositors. The greater the margin, the stronger the profit potential. A healthy NIM will depend on the current interest rate environment and the bank’s business model; historically, banks on average have a NIM of 3-4%. In most cases, a margin lower than 3% isn’t a good sign — unless the bank in question has a large source of non-interest income.
• Return on assets is a measurement of how much net income was generated from the average value of the bank’s assets during the reporting period. A higher return on asset measurement means the bank was more profitable relative to the bank’s size. Keep in mind that when you evaluate a return on assets, it’s important to look at the numbers in the context of a bank’s broader financials. A higher return is good, but if this return was driven by riskier assets, it could be bad in the long term. On the other hand, if a bank’s high return on assets is the result of smarter risk management and efficient operations — both of which reduce losses and lower operating costs — the bank is likely in good shape.
• Net income margin — not to be confused with net interest margin — measures how much of a bank’s revenue translates into net income profitability. This is a good measure for how efficiently the bank operates, capturing not just the amounts earned on banking activity, but also the costs of operating a bank.

As helpful as financials are in assessing a bank’s health, they can’t give us the full picture. Truly understanding a bank’s health also means understanding the story of the bank, the bank’s management decisions, and the macroenvironment influencing the bank’s financials — both past and present. In other words, assessing a bank’s health is also a question of nuance. With this in mind, a bank’s financials — and the questions you ask as you read them — can tell you a lot of what you need to know as you decide where to you store your money.

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At Mercury, we put a lot of thought into selecting our bank partners to ensure the safety and scalability of our services. Our goal is always to provide a trusted banking experience that exceeds customer expectations — and to share our knowledge with you.

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