Banking basics

If you ever apply the valuation criteria that you use for the non-financial businesses, to the banks, you would definitely get surprising results. For example, the debt to equity ratio in the range of 6 to 10, will spook you. When you look at the stock prices of banks, you will be surprised to see some banks perennially selling below the book value. In most cases, you will not see the banks losing money in their long history, partly because the ones which do lose money, either lose their solvency or their independence. They are bailed out by the government and merged with others. You would see that the banks which are doing well keep growing at steady pace. At the same time, you would note that the markets are not giving them the kind of P/E you would expect for a steadily growing services company.

What sets banking business apart from non financial businesses? How should we take into account these differences while valuing a bank? In this article we will delve into these questions.

A bank is more like a services company but the service it provides – intermediation between the savings and investment – has characteristics that make it a category in itself. The bank uses the deposits to lend money. The size of the bank's business is constrained by the deposits it can attract. The deposits aren't limited by its physical infrastructure of branches. A bank is able to use the deposits as a form of debt to generate returns. However there are many regulatory constraints on how this debt can be utilized by the bank. These regulations ensure that the bank is able to provide adequate safety to the depositors. Within these constraints the bank is free to lend its money to generate adequate returns at reasonable risk. Here is the list of factors which allow a bank to achieve this objective.

• Trust

Banking is all about trust. The day a bank loses trust of its depositors, it loses deposits. That literally takes the wind out of its sails. A bank run, as it is called, can have characteristics of a self fulfilling prophecy. If people believe that a bank is going bankrupt, it WILL even though it was completely fine just before people got that mistaken belief. Bank runs were never a rare event and have become even more common with the recent financial crisis. In India, ICICI Bank almost had a bank run when rumors about its weak financial health caused a rush of depositors queuing up to get their money back. The stock lost two thirds of its value.

The history of the bank, the financial strength of its promoters and strong branding, help in building trust. Scale also helps here. People feel safer with a bank which most of their relatives and colleagues bank with. So a higher deposit base begets more depositors.

Indicative Factors: The level of trust is a qualitative factor. But a sure shot indicator of the level of trust is the interest rate a bank pays for its long term fixed deposits. The banks which are considered less trustworthy have to shell out extra money to get deposits. The failed Global Trust bank, even in its heydays, used to pay 1% extra for fixed deposits. This data is readily present and can be used as a proxy.

• Asset Liability Management

The banks have two types of deposits. Demand deposits and Term deposits. The money in demand deposits (savings/checking accounts) can be pulled out at short notice. The term deposits have a fixed term. The money in term deposits can still be pulled out but there are penalties associated with premature withdrawal. The lending, on the other hand, has an average maturity of a much higher period. This opens up a possibility of asset-liability mismatch. If your depositors want money back after 3 years but you have lent money for 10 years, you will have to scour for funds. If the interest rates have gone up in the meantime, your net returns on the advances may turn out to be negative.

The profitability of a bank in the long term depends on how well the bank manages its assets and liabilities.

Indicative Factors: The banks provide data about the maturity profiles of their assets and liability in the annual reports. This data should be read in conjunction with the guidelines on Asset Liability Management from regulators.

• Risk Management

A bank makes a very low return (1-3%) on advances after paying interest to depositors. However the advances are subject to the risk of default. When there is a default the bank may lose 100% of its loan. Suppose a bank has a net interest margin of 2.5%. After paying interest to the depositors, it makes Rs 2.5 on every Rs 100 lent. It the cost to income ratio is 40%, the bank has an operating cost of Rs 1 on every 100 Rs lent. If more than 1.5% of the bank's loan becomes bad loans, the bank will lose money.

The risk management of the bank is important not only to protect its income but also for the survival of the bank. The Non Performing Assets (NPA) of SBI were 7.18% of its advances in March 1999. But for the government support, the bank would not have survived.

Indicative Factors: Gross NPA, the ratio of gross non performing assets to the total advances is a good indicator of the quality of risk management. This ratio is also dependent on the state of the economy, hence a relative comparison among banks will give you more credible information.
The level of Net NPA, which is Gross NPAs minus provisions made for future losses, gives an indication of the extent to which the bank has covered for the losses. However, I feel that Gross NPA is a better indicator. A bank, which keeps losing money to bad loans and then keeps taking out a chunk from the income to provide for these losses, is not a good bank even if its net NPAs are low.

The annual reports also contain information about the risk management policies adopted by the banks to counter various types of risks like credit risk, market risk, liquidity risk, operational risk etc which can be used to judge risk management in a bank.

• Quality of credit portfolio

NPAs are a record of the bank's past lending. By the time a bank reports huge NPAs, it's already too late for investors to exit. The investors must pay close attention to the quality of credit exposure. The factors to watch include the concentration of credit to certain industries, percentage of retail vs corporate loans, exposure to currencies, stock markets etc.

Indicative factors: Most banks report distribution of credit risk exposure by industry sector in their annual reports. You can watch out for excessive exposure here.

• Capital Adequacy

When loans go bad, the depositors don't pay for bad loans, the bank has to pay from its own pockets. Even if a bank is able to mobilize huge amount of deposits, it cannot use all of it to pay back the lenders. The regulators ensure that the bank should have adequate capital to pay for the losses on bad loans. The banks must maintain a minimum capital adequacy ratio, which is a ratio of the bank's capital to the risk weighted credit exposures. The RBI guidelines require this ratio to be above 9%.

The capital adequacy ratio (also called Capital to Risk Weighted Assets Ratio (CRAR)), sets an upper limit on growth. A bank which is seeing good growth in business, yet lacks adequate capital, is forced to augment its capital. For investors, this is an aspect that must be kept in mind while making assumptions on growth.

Indicative Factors: Capital adequacy ratio is mentioned in the results and annual reports. For the year 2007-08, the average CRAR of the nationalized banks stood at 12.10 per cent while that of foreign banks was at 13.10 per cent and of private banks at 14.30 per cent.

• Cost of deposits

The deposits are raw material for the banks. The cost of deposits directly affects the profitability of the bank. The interest rates on term deposits are always higher than the rates on demand deposits. For that reason, it is important for a bank to have a high percentage of deposits in the form of demand deposits. The cost of funds affects not only the profitability but also the risks. The high cost of deposits for weaker banks forces them to lend to riskier industries to be able to earn a higher interest on loans. This increases the risk to the bank.

Indicative Factors: The higher is the ratio of CASA deposits (Current Account/Savings account) to total deposits, the better for the bank. This ratio is provided in the annual reports. Another metric is the cost of deposits which gives an indication not only of lower interest costs but also the level of trust the bank enjoys.

• Interest magins

The profitability of the bank arises from the spread between the interest cost and returns on loans. A bank has to be able to maintain a healthy spread to remain profitable. Higher profitability also translates into capacity to bear risks and higher growth in the bank's capital which opens up doors for expanding the business.

Indicative Factors: Net Interest Margin gives an indication of the profitability. However, it should be used in conjunction with other factors. A bank with cost of funds at 5% and returns on loans at 8% is much better than a bank with cost of funds at 8% and returns at 11%, even though the Net Interest Margin is same. The first one has lower risk.

• Operating efficiency

To be able to mobilize deposits and provide loans, a bank has to maintain a vast infrastructure of branches and ATMs along with the other channels like internet banking, mobile banking. This costs money and this cost gets paid from the spread between the interest deposits and loans. A bank which is able to keep a tab on this cost will be more profitable.

Indicative Factors: The annul reports of the banks include yearly data about the business per branch, business per employee, profit per employee etc. which give an fair indication of the operating efficacy of the bank and changes in operating efficiency. The cost to income ratio is another handy tool to learn what percentage of interest income goes to support operations.

• Asset Composition

If you look at the deployment of the assets of a bank into various asset categories, you will be surprised to know that less than half of the assets of the bank earn interest rates higher than the cost of deposits. The banks have to meet various reserves requirement. Banks have to keep some portion of their deposits with the RBI which earns them no interest. This requirement is defined in term of a minimum limit on Cash Reserves Ratio which is 5% at present. The banks also need to maintain a certain minimum percentage of funds in liquid assets such as cash, govt securities, precious metals like gold and silver and other short term securities. This ratio is called Statutory Liquidity Ratio and it is 24% currently. The govt securities, having less risk than bank term deposits, yield less interest. Hence the investment in these may not cover the cost of deposits and operating cost.

Over and above the minimum requirements specified by the RBI, the banks may keep more money in govt securities and other liquid securities. Although the major portion of the earnings come from advances, the volatility in interest rates can change the carrying value of the govt. securities resulting in the treasury gains/losses. The current market regulations allow banks to define what portion of their govt. securities portfolio is held till maturity and what portion is available for sale (AFS). The mark-to-market requirements, which call for valuing the bonds at the market prices, apply only to the AFS portion.

The public sector banks may give loans to priority sectors like farmers, and small scale industries at subsidized rates of interest. Again, this portion of the assets is not profitable. Banks are also allowed to invest up to 5% of their assets in equities. These investments may become a source of returns or troubles depending on how well the bank manages its investments.

Indicative Factors: The Credit/Deposit ratio gives an indication of the percentage of the deposits that have been disbursed as loans. The ratio should not be too low because that would mean the bank hasn't been able to deploy the deposit money profitably. Low Credit/Deposit ratio also means that a major portion of bank's assets is in form of govt securities which makes the bank susceptible to changes in interest rates.

• Quality of earning

The banks have various income streams and each of them has varying degree of consistency. These income streams are interest on advances, interest on investments, interest on balances with RBI/other banks and other income. The investors should pay close attention to the contribution to the income from each of these sources.

If the other income is a significant portion of total income, you should see the composition of the other income. The income from treasury gains, profits from sale of investments and derivatives, should not be considered recurring income. On the other hand, dividends from subsidiaries, fee based income in form of commissions and brokerages may be relatively stable.

Indicative Factors: Interest income as a percentage of total income.Fee based income as a percentage of total income.

• Quality of service

Banking is a service business. The quality of service can be an important factor in the capability of the bank to mobilize deposits. The banks have a great opportunity to serve as a one-stop-shop for various financial products. Those with better service are able to cross sell the products to the customers. The quality of service provided at the bank branch is just one aspect of the service. If a bank provides enough ATMs, supplemented with a good internet and phone banking channel, a customer may not even need to visit the branch. The reach of a bank is another factor. Few years back, I ran short of money while trekking in a remote corner of Ladakh and an SBI branch came to my rescue. That changed my opinion about the customer service at SBI.

Indicative Factors: This is a qualitative factor and little hard to judge. The investors should not go by stray incidents to term the service good or bad. However, the factors like availability of branches, ATM and other banking channels should be weighed in while evaluating a bank.
Even this lengthy description of factors does not adequately cover the key determinants in the success of a banking business. There are other factors that assume critical importance on a case-to-case basis. For some banks the exposure to currency risks and derivatives can be significant. Similarly, independence on decision making can be a big factor in case of public sector banks which are, at times, forced by the government to lend to certain sectors at lower rates which do not compensate for the associated risks. The waiver of loans and the moral hazard associated with it is another key concern for these banks.

Some banks have large subsidiaries dealing in stocks, brokerages, insurance and other financial sectors. If the subsidiaries are large, you cannot use standalone accounts to correctly judge the strength of the bank.

The banks are a good proxy for participating in the growth of the economy. They should be present in every investor's menu but yes, their accounts are hard to digest. If you want to invest in banks, never be shy of number crunching.

Further Readings
Low-cost deposits key to banks' survival
http://www.livemint.com/2008/08/18004847/Lowcost-deposits-key-to-banks.html

Asset - Liability Management System in banks - Guidelineshttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/3204.pdf

Prudential Norms on Capital Adequacyhttp://rbidocs.rbi.org.in/rdocs/notification/PDFs/85410.pdf

Banks witness fall in low-cost deposits' share in Dec quarter
http://www.thehindubusinessline.com/2009/02/04/stories/2009020451650600.htm