Pre-provision earnings are a bank's first line of defence: strip out one-offs, then run them against the capital above the floor.
Pre-provision net revenue is net interest income plus non-interest income minus non-interest expense, before loan-loss provisions, taxes and one-off items. An illustrative $10 billion bank with $300 million of net interest income, $68 million of recurring fees and $235 million of recurring costs has core PPNR of $133 million: 1.33 per cent of assets, enough to absorb loan losses of 1.90 per cent of its loan book every year before it reports a pre-tax loss.
Worked in full in Bank Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
PPNR is the first line of defence in every bank stress test. Capital is the second. A bank with thin earnings must take losses straight into capital; one with strong PPNR earns through a recession before the capital ratio moves. Analysts quote it constantly, and the most common error is computing it from reported lines that include gains and costs that will not recur.
| Line | $m |
|---|---|
| Total assets | 10,000 |
| Loans | 7,000 |
| Net interest income | 300 |
| Non-interest income, as reported | 80 |
| of which gains on securities sold | 12 |
| Non-interest expense, as reported | 239 |
| of which merger and restructuring costs | 4 |
| Provision for credit losses | 35 |
| Risk-weighted assets | 8,000 |
| CET1 ratio / stress floor including buffers | 11% / 7% |
Reported PPNR = 300 + 80 − 239 = 141
Strip out what will not recur: the $12m securities gain from income and the $4m merger costs from expense.
Core PPNR = 300 + (80 − 12) − (239 − 4) = 300 + 68 − 235 = 133
Excel: =NII+(NonIntInc-SecGains)-(NonIntExp-OneOffs)
PPNR ROA = 133 ÷ 10,000 = 1.33%
Loss absorption = 133 ÷ 7,000 = 1.90% of loans, or 190 basis points a year
Coverage of the current provision = 133 ÷ 35 = 3.80x
Reported PPNR overstates the recurring figure by $8m, 6.0 per cent, because the $12m one-off gain outweighs the $4m one-off cost. The efficiency ratio on the same core figures is 235 ÷ 368 = 63.9 per cent; the method is in how to calculate a bank's efficiency ratio.
The loss-absorption figure becomes useful when it is run against capital. Assume a two-year downturn in which PPNR falls 30 per cent, to $93.1m a year, as margins compress and fees fall, and cumulative credit losses (charge-offs plus reserve build) reach 5 per cent of loans.
Stressed PPNR over two years = 133 × (1 − 30%) × 2 = 186.2
Credit losses = 5% × 7,000 = 350
Pre-tax result = 186.2 − 350 = −163.8; after tax at 21% = −129.4
CET1 = 880 − 129.4 = 750.6, a ratio of 750.6 ÷ 8,000 = 9.38%
The bank starts with $320m of CET1 above its 7 per cent floor ($880m against $560m). That is $405.1m of pre-tax losses once the tax effect is allowed for. Add the two years of stressed PPNR and the bank can absorb cumulative losses of $591m, or 8.45 per cent of loans, before it breaches the floor. Without PPNR the same capital absorbs only 5.79 per cent.
The tax line assumes losses produce a usable tax benefit. If the bank cannot recognise the deferred tax asset, use the pre-tax figure and the capacity falls.
| PPNR fall | Losses 3% | Losses 5% | Losses 7% | Losses 9% | Break-even loss rate |
|---|---|---|---|---|---|
| 0% | 11.55% | 10.17% | 8.79% | 7.41% | 9.59% |
| 30% | 10.76% | 9.38% | 8.00% | 6.62% | 8.45% |
| 50% | 10.24% | 8.86% | 7.47% | 6.09% | 7.69% |
At 3 per cent losses with PPNR unchanged, the bank ends the stress with a higher ratio than it started: earnings exceed losses. The PPNR assumption moves the break-even by almost two points of loans, which is why supervisors spend as much time on revenue projections as on loss rates. Margin compression is the usual driver: a bank whose deposit costs reprice faster than its loans can lose a third of its PPNR without a single default.
Compute PPNR on core lines, express it as a percentage of loans, and run it against the capital above the floor: here $133m of core PPNR lets the bank absorb 8.45 per cent cumulative losses over two stressed years, against 5.79 per cent on capital alone. The capital side is in how to calculate a bank's CET1 ratio, and the margin and liquidity workbooks for the book's bank are on the Bank Management companion page.
Close, but not quite. PPNR excludes the provision for credit losses and should also exclude non-recurring items such as securities gains and merger costs. In the illustrative bank reported PPNR is $141m but core PPNR is $133m, so a figure taken straight from the income statement overstates recurring earnings by 6.0 per cent.
Project PPNR under the stress scenario, subtract projected credit losses, tax the result and deduct it from capital. With $133m of PPNR cut 30 per cent for two years, $350m of losses and a 21 per cent tax rate, the bank's CET1 falls from $880m to $750.6m, a ratio of 9.38 per cent on $8,000m of risk-weighted assets.
It depends on the business model, but the useful test is what losses it covers. PPNR of 1.33 per cent of assets on a book where loans are 70 per cent of assets covers annual losses of 1.90 per cent of loans before a pre-tax loss, 3.80 times the current $35m provision. Compare it with the bank's own stressed loss history rather than a single benchmark.
This article is one calculation from Bank Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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