Unlike any other manufacturing or service company, a bank’s accounts are presented in a different manner (as per banking regulations). The analysis of a bank account differs significantly from any other company. The key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank (like say operating margins).
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 which acts as a positive for Banks in healthy credit off-take scenario. The second part of regulatory requirement is to invest in Government Securities that is a part of its 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. If credit demand is lower, the bank increases the quantum of investments in Government Securities.
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 15% in the Indian context.
Having looked at the profile of the sector in brief, 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 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 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 Government Securities 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.
Interest expenses
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.
Key parameters to keep in mind while analysing a banking stock
As we had mentioned 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. This is the reason why price to book value is important. As a result, price to book value is important while analysing a banking stock rather than P/E. But deduct the net non-performing asset from net worth to get a true feel of the available capital for growth.
Before jumping to the ratio analysis, let’s 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 bank branch network in the country.
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. Foreign banks have confined their operations to mostly metropolitan cities, as the regulations 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 let’s look at some of the key ratios that determine a bank’s performance.