The primary business of a bank is to accept deposits and give out loans. So in case of a bank, capital (read money) is a raw material as well as the final product. Bank accepts deposits and pays the depositor an interest on those deposits. The bank then uses these deposits to give out loans for which it charges interest from the borrower.
Of the cash reserve, a bank is mandated to maintain a certain percentage of deposits with the Reserve Bank of India (RBI) as CRR (cash reserve ratio), on which it earns lower interest. Whenever there is a reduction in CRR announced in the monetary policy, the amount available with a bank, to advance as loans, increases. When the RBI increases this percentage, the amount actually available with the commercial banks comes down. The RBI may increase the CRR to draw out excessive money from the banking system and thus checks increase in prices. The second part of regulatory requirement is the amount which a bank has to maintain in the form of cash, gold or approved securities - Statutory liquidity ratio (SLR).
The bank’s revenues are basically derived from the interest it earns from the loans it gives out as well as from the fixed income investments it makes.
Apart from this, a bank also derives revenues in the form of fees that it charges for the various services it provides (like processing fees for loans and forex transactions) . In developed economies, banks derive nearly 50% of revenues from this stream. This stream of revenues contributes a relatively lower in the Indian context.
Before we proceed further, let us define some key ratios/terminologie s used in day to day:
Prime lending rate (PLR) is a benchmark against which the lender sets his rate of interest. The Reserve Bank of India (RBI) announces key changes and increase in rates to contain inflationary forces and to stabilise the economy. The RBI contains inflation and liquidity by toggling parameters like cash reserve ratio (CRR), repo rate and reverse repo rates. The CRR is a tool used by the RBI to control the money supply and interest rates. A hike in the CRR will draw out excess money supply from the banking system and check the rise in prices. Here are some major parameters that directly affect the PLR which impacts your home loan rate.
Repo rate (Repurchase Agreement)
If banks face any shortfalls of funds, they may borrow from the central bank. The repo rate is the rate at which banks borrow money from the RBI. If the RBI reduces the repo rate, it will be cheaper for banks to borrow money. On the other hand, if the repo rate goes up, borrowing becomes expensive.
Reverse Repo rate
The RBI can borrow money from the banks and offer them a lucrative rate of interest. This is called the reverse repo rate and banks will be very glad to have their money with the RBI for a good interest rate as the money is safer here. When the reverse repo rate is increased banks find it more attractive to have their money with the RBI, and hence money is drawn out of the system.
If a borrower has opted for a pure fixed rate loan, then his EMI repayments remain constant. Most fixed rate loans come with certain clauses that empower the lender to increase their lending rates. Monthly EMI repayments fluctuate in case of floating rate loans. If the interest rates go up, the EMI increases. In case interest rates go down, the EMI decreases. The benchmark, PLR against which the banks fix their rates varies from lender to lender. It is not the RBI but the bank itself that sets this benchmark that decides the rate of interest. Borrowers must look into what their rate is measured or benchmarked against.
Having looked at the basic terms, let us consider some key factors that influence a bank’s operations. One of the key parameters used to analyse a bank is the Net Interest Income (NII). NII is essentially the difference between the bank’s interest revenues and its interest expenses. This parameter indicates how effectively the bank conducts its lending and borrowing operations (in short, how to generate more from advances and spend less on deposits).
Interest revenues = Interest earned on loans + Interest earned on investments + Interest on deposits with RBI.
Interest on loans:
Since banking operations basically deal with ‘interest’, interest rates (read bank rate) prevailing in the economy have a big role to play. So, in a high interest rate scenario, while banks earn more on loans, it must be noted that it has to pay higher on deposits also. But if interest rates are high, both corporates and retail classes will hesitate to borrow. But when interest rates are low, banks find it difficult to generate revenues from advances. While deposit rates also fall, it has been observed that there is a squeeze on a bank when bank rate is soft. A bank cannot reduce interest rates on deposits significantly, so as to maintain its customer base, because there are other avenues of investments available to them (like mutual funds, equities, public savings scheme).
Since a bank lends to both retail as well as corporate clients, interest revenues on advances also depend upon factors that influence demand for money. Firstly, the business is heavily dependent on the economy. Obviously, government policies (say reforms) cannot be ignored when it comes to economic growth. In times of economic slowdown, corporates tighten their purse strings and curtail spending (especially for new capacities). This means that they will borrow lesser. Companies also become more efficient and so they tend to borrow lesser even for their day-to-day operations (working capital needs). In periods of good economic growth, credit off take picks up as corporates invest in anticipation of higher demand going forward.
Similarly, growth drivers for the retail segment are more or less similar to the corporate borrowers. However, the elasticity to a fall in interest rate is higher in the retail market as compared to corporates. Income levels and cost of financing also play a vital role. Availability of credit and increased awareness are other key growth stimulants, as demand will not be met if the distribution channel is inadequate.
Interest on Investments and deposits with the RBI:
The bank’s interest income from investments depends upon some key factors like government policies (CRR and SLR limits) and credit demand. If a bank had invested in G-Secs in a high interest rate scenario, the book value of the investment would have appreciated significantly when interest rates fall from those high levels or vice versa.
A bank’s main expense is in the form of interest outgo on deposits and borrowings. This in turn is dependent on the factors that drive cost of deposits. If a bank has high savings and current deposits, cost of deposits will be lower. The propensity of the public to save also plays a crucial role in this process. If the spending power for the populace increases, the need to save reduces and this in turn reduces the quantum of savings.
Current Account Savings Account (CASA): These deposits pays no or very low interest. They tend to be cheaper than the bank issuing time deposits / certificates of deposit (CDs) and are considered more dependable as well. From a bank's perspective, it is a source of cheap fund and is always encouraged.
Unlike, any other manufacturing or service company, a bank’s accounts are presented in a different manner (as per the banking regulation). The analysis of a bank’s accounts differs significantly from any other company due to their structure and operating systems. Those key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank. We have attempted to throw light on some of the key ratios, which are unique for banks and determine the financial stability of a bank.
Before jumping to the ratio analysis, lets get some basic knowledge about the sector. The Banking Regulation Act of India, 1949, governs the Indian banking industry. The banking system in India can broadly be classified into public sector, private sector (old and new) and foreign banks.
• The government holds a majority stake in public sector banks. This segment comprises of SBI and its subsidiaries, other nationalized banks and Regional Rural Banks (RRB). The public sector banks comprise more than 70% of the total branches.
• Old private sector banks have a largely regional focus and they are relatively smaller in size. These banks existed prior to the promulgation of Banking Nationalization Act but were not nationalized due to their smaller size and regional focus.
• Private banks entered into the sector when the Banking Regulation Act was amended in 1993 permitting the entry of new private sector banks. Most of these banks are promoted by institutions and their operating environment is comparable to foreign banks.
• Foreign banks have confined their operations to mostly metropolitan cities, as the RBI (earlier) restricted their operations. However, off late, the RBI has granted approvals for expansions as well as entry of new foreign banks in order to liberalize the system.
Now lets look at some of the key rations that determine a bank’s performance.
1. Ratios for evaluating operating performance
1. Net Interest Margin (NIM)
2. Operating Profit Margin (OPM)
3. Cost to Income Ratio
4. Other income to total income
2. Other key financial ratios
1. Credit to deposit ratio (CD ratio)
2. Capital adequacy ratio (CAR)
3. NPA ratio
4. Provision coverage ratio
3. Efficiency ratios
1. Interest income per employee
2. Profits per employee
3. Business per employee
A. Ratios for evaluating operating performance
1. Net Interest Margin (NIM): For banks, interest expenses are their main costs (similar to manufacturing cost for companies) and interest income is their main revenue source. The difference between interest income and expense is known as net interest income. It is the income, which the bank earns from its core business of lending. Net interest margin is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the RBI and money at call.
2. NIM = Net Interest Income (NII) = Interest income – Interest expenses
3. ------------ --------- ---- ------------ --------- --------- ------
Average earning assets Average earning assets
4. Operating profit margins (OPM): Banks operating profit is calculated after deducting administrative expenses, which mainly include salary cost and network expansion cost. Operating margins are profits earned by the bank on its total interest income. For some private sector banks the ratio is negative on account of their large IT and network expansion spending.
5. OPM = Net Interest Income (NII) – Operating expenses
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7. Total Interest Income
8. Cost to Income ratio: Controlling overheads are critical for enhancing the bank’s return on equity. Branch rationalization and technology upgradation account for a major part of operating expenses for new generation banks. Even though, these expenses result in higher cost to income ratio, in long term they help the bank in improving its return on equity. The ratio is calculated as a proportion of operating profit including Non-Interest Income (fee based income).
9. Cost to Income ratio = Operating expenses
10. ------------ --------- -----
11. NII + Non Interest Income
12. Other income to Total income: Fee based income account for a major portion of the bank’s other income. The bank generates higher fee income through innovative products and adapting the technology for sustained service levels. This stream of revenues is not depended on the bank’s capital adequacy and consequently, potential to generate the income is immense. The higher ratio indicates increasing proportion of fee-based income. The ratio is also influenced by gains on government securities, which fluctuates depending on interest rate movement in the economy.
B. Other key financial ratios
1. Credit to Deposit ratio (CD ratio): The ratio is indicative of the percentage of funds lent by the bank out of the total amount raised through deposits. Higher ratio reflects ability of the bank to make optimal use of the available resources. The point to note here is that loans given by bank would also include its investments in debentures, bonds and commercial papers of the companies (these are generally included as part of investments in the balance sheet).
2. Capital Adequacy Ratio (CAR): A bank's capital adequacy ratio is the ratio of qualifying capital to risk adjusted (or weighted) assets. The RBI has sets the minimum capital adequacy ratio for all banks. A ratio below the minimum indicates that the bank is not adequately capitalized to expand its operations. The ratio ensures that the bank do not expand their business without having adequate capital.
Note: Tier I capital is core capital, this includes equity capital and disclosed reserves (generally these instruments that can't be redeemed at the option of the holder). Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt, and more. Tier III capital or Tertiary capital is held by banks to meet part of their market risks (commodities risk and foreign currency risk), that includes a greater variety of debt than tier 1 and tier 2 capitals.
CAR is used to protect depositors and promote the stability and efficiency of financial systems around the world.
CAR = Tier I capital + Tier II capital
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Risk weighted assets
3. NPA ratio: The net non-performing assets to loans (advances) ratio is used as a measure of the overall quality of the bank’s loan book. Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end from gross NPAs. Higher ratio reflects rising bad quality of loans.
4. NPA ratio = Net non-performing assets
5. ------------ --------- ------
6. Loans given
7. Provision coverage ratio: The key relationship in analyzing asset quality of the bank is between the cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high ratio suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross non-performing assets do not rise at a faster clip).
8. Provision coverage ratio = Cumulative provisions
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10. Gross NPAs
11. Return on Assets (ROA) is the net income (profits) generated by the bank on its total assets (including fixed assets). The higher the proportion of average earnings assets, the better would be the resulting returns on total assets. Similarly, ROE (returns on equity) indicates returns earned by the bank on its total net worth.
ROA = Net profits
Avg. total assets
C. Efficiency ratios
1. Interest income per employee
2. Profits per employee
3. Business per employee
4. Business per branch
5. Employees per branch
The first three ratios indicate the productivity level of the bank’s employees. Since state run banks are operating with large employee base, the productivity ratio for these banks lags behind when compared with new generation private sector banks. Banks can improve these ratios by increasing the technology infrastructure, frequent offering of innovative products and also employee rationalization.
Moreover, a bank’s performance cannot be judged only from its large network. It has to be in relation with the bank’s ability to capitalize on its network. Large number of branches are sometimes unviable if they are situated at places where the business opportunity is low. Private sector banks are likely to have better ratios vis a vis their PSU peers on account of their concentration on top 100 business centers. Unlike PSU banks, private banks in general lack presence in rural areas. Since state run banks are present in every corner of the country, it impacts their average productivity ratios (as business opportunity differs)
Banks' Valuations parameters
1. Price to Book Value: Unlike other manufacturing/ services company, a bank’s market valuations cannot be only measured from its price to earnings ratio (P/E ratio). This is due to following reasons. As discussed earlier, cash is the raw material for a bank. The ability to grow in the long-term therefore, depends upon the capital with a bank (i.e. capital adequacy ratio). Capital comes primarily from net worth. Also, a bank’s net earnings are influenced by the amount of non-performing assets provision, which again depends on the bank’s internal policy. Consequently, the bank could make low provisions to show a better picture. Therefore it’s prudent to remove non-performing assets for which no provisions are made from the net worth of the bank to arrive at the adjusted book value.
2. Market Cap to Total income: This ratio helps in judging the market valuations of the bank’s total income. It is similar to the market cap to sales ratio for a manufacturing company. It indicates valuations accorded by the market to the total income of the bank.
The banking sector plays a very vital role in the working of the economy and it is very important that banks fulfill their roles with utmost integrity. Since banks deal with cash, there have been cases of mismanagement and greed in the global markets. And hence, in the final analysis, investors need to check up on the quality of management. This is the last factor but not the least to be brushed aside.
Non Performing Assets (NPAs):
Advances are classified as standard assets and non-performing assets
• Standard assets: Standard Asset is a performing asset with interest and principal being serviced properly. Banks need to maintain a general provision on standard assets of 0.25% on agricultural advances and 0.40% on all other advances. Consumer loans and mortgage loans (more than Rs. 3mn) carry higher provision of 2% and 1% respectively
• Non-performing assets (NPAs): A standard asset becomes non-performing when it ceases to generate income for the bank i.e., interest and/or installment of principal remain overdue for a period of more than 90 days. NPAs are classified as sub-standard, doubtful and loss assets on various criteria
o Sub-standard: An asset would be classified as sub-standard if it remained NPA for a period less than 12 months. A general provision of 10% to be made for such assets
o Doubtful: An asset is required to be classified as doubtful, if it has remained NPA for more than 12 months. 100% provision required for the unsecured component. For secured portion, a total provision of 20% up to one year, 30% for one to three years and 100% for more than three years
o Loss: A loss asset is one where loss has been identified by the bank as noncollectable but the amount has not been written off
Income from NPAs are recognized on cash basis, not accrual basis. Investment portfolios of banks are classified under three categories:
• Held to maturity (HTM): Securities acquired by the banks with the intention to hold them up to maturity will be classified under HTM. Such securities do not get marked-to-market on a quarterly basis and are instead, valued at acquisition cost. Premium paid is amortized over the tenor of the security. Banks were allowed to include investments included under HTM category only up to 25% of their total investments till Sept 2004. Since then, fearing MTM losses, banks are allowed to exceed the limit provided the excess comprises of SLR securities and are not more than 25% of their demand and time liabilities.
• Held for Trading (HFT): The securities acquired by the banks with the intention to trade by taking advantage of the short-term price/interest rate movements will be classified under HFT.
• Available for Sale (AFS): The securities which do not fall within the above two categories will be classified under AFS.
AFS and HFT securities are marked-to-market on a quarterly basis, net depreciation is provided for and net appreciation is ignored. MTM losses provided for in an earlier period can be reversed in future periods if such provision is rendered redundant. Banks may shift investments to/from HTM with the approval of the Board of Directors once a year after providing for any MTM losses.