Types of Banks in India:There are more than 97,605 banks in India. But only 35 banks are listed on National Stock Exchange which are either private banks, public banks, or small finance banks. If you want to discover lucrative opportunities among them then you must first understand how the sector works. Public Sector Banks Government has more than 50% stake in these banks. Top public sector banks include State Bank of India (SBI), Bank of Baroda (BOB), Indian Bank, etc. You can check various Public Sector Banks here. Private Sector Banks These banks are owned by a private owner. For example, HDFC Bank, ICICI Bank, etc. However, they are regulated by the RBI to protect the public interest. You can check various Private Sector Banks here. Small Finance Banks These banks provide basic banking services of acceptance of deposits and lending. Their aim is to provide financial service to sections of the economy not being served by other banks. For example, marginal farmers, small business units, unorganised sector entities, etc. All these banks collectively keep the economy running. Banking operations are unlike any other sector which uses commodities to produce goods. Money is the only raw material for banks. Let’s have a quick look and understand how money works for banks.
Banking Model - How Does a Bank Work?The primary business of a bank is to accept deposits and give out loans. The loans given by the banks are their asset on which they earn interest. On the other hand, deposits that banks accept are their liabilities. They have to pay interest to depositors on their deposits. Thus, earned interest minus paid interest is their profit. This is their bread and butter. To check the bank’s interest income, we must check their income statement.
a. Interest IncomeBanks earn interest on the loans they have issued. This is their main source of income. In other words, this is their lifeline.
- Interest earned from issued loans
- Interest earned from investments
- Interest earned on balances with Reserve Bank of India (RBI) and other inter-bank funds
b. Other IncomeApart from interest income, banks earn revenue in the form of fees that they charge for various services. For example, banks also deal in foreign exchange operations and act as a broker and earn forex fees. They earn commission by selling mutual funds and insurance to their customers. It also includes income from various trading operations and other miscellaneous income. These other sources of income help them diversify their income stream rather than being dependent on interest income. So those are the major sources of income for a bank. Now let’s talk about the expenses.
c. Interest ExpenseBanks pay a fixed percentage of interest on the amount deposited by the customers. This is their main expense which drives their cost. Consider these deposits as their raw materials. There are four types of deposits - The rate of interest banks have to pay on current account and savings account (CASA) is relatively low than fixed deposits. Banks pay an interest of around 2% to 3% on saving accounts and 0% on current accounts. For fixed and recurring deposits, banks pay an interest of around 6% to 7%. CASA deposits let banks borrow funds at a lower rate. Hence, the higher the proportion of CASA, lower is the interest cost burden. For example, if a bank has a CASA Ratio of 30%, we can say that for every 100 rupees of deposits, 30 rupees have been through CASA. Pro Tip: If the CASA Ratio is high, it is a positive sign for investors. It means that banks are able to generate their raw material (money to loan) at a cheaper rate. A low CASA ratio means the bank heavily relies on costlier funding. Here are 5 Indian banks with the highest CASA Ratios as of September 2020 -
|Name of the Bank
|CASA Ratio (%)
|Kotak Mahindra Bank
|IDFC First Bank
d. Net Interest Income (NII)The difference between bank’s interest income and interest expense is their profit. Let’s say that a bank lends at 7% interest and pays interest on deposits at 3.4%. The difference of 3.6% is bank’s net interest income. For example, HDFC Bank’s NII increased by 16.72 % in 2019-20.
|2018-19 (in Rs.) ‘000
|2019-20 (in Rs.) ‘000
e. Net Interest Margin (NIM)This is calculated by dividing NII by the average income earned from interest-producing assets. It is a profitability metric. This gives us an idea about the bank’s profitability on its interest income and their interest expenses. It is readily available in the bank’s annual report. For example, here is HDFC bank’s NIM from its 2019-20 Annual Report. You can find it under the key performance highlight system. We can say that for HDFC bank, 4.3% is the net benefit of lending funds. Its capital is used efficiently. Monetary policies set by central banks majorly influence bank's net interest margins. They dictate whether consumers will borrow or save money. When interest rates are low, loans become cheaper. Thus, people are more likely to borrow money and less likely to save it. If borrowing increases, interest income for banks increases. This results in higher net interest margins. When interest rates are high, loans become costlier. Thus, people opt to save money rather than borrowing loans. If borrowing decreases, interest income for banks goes down. This decreases net interest margins. A positive NIM suggests that the bank is efficiently investing. Whereas a negative NIM suggests inefficient investing. Pro Tip: It is all connected. If the bank’s CASA ratio is high, NIM will be high. Analyse NII and NIM collectively to form a better opinion on a bank’s earnings performance. One element that can drastically affect NII and NIM is Non-Performing Assets.
What are Non-Performing Assets (NPA)?Imagine you have lent Rs. 5,000 to your friend. He promises to repay you the amount after 15 days. But it has been 5 months and he still hasn’t repaid. You eventually lose hope of getting your money back. If you had those 5,000 in your pocket, you could have done many things to create future value. But you can no longer use them. Similarly, if a borrower defaults on interest or principal payment, the bank’s asset (loan issued) is no longer profitable. They thus become a non-performing asset (NPA). This is the most important data which needs to be compared amongst banks. NPAs of a bank can affect banking operations and revenue. If you are able to correctly analyse NPA’s, you will have a fair idea of which bank performs better than its peers. So, straighten up, and let’s understand this in detail! Interest earned on loans is the main source of income for banks. But what if the borrower fails to repay the principal amount of defaults with an interest payment? A loan is classified as a non-performing asset when the repayment is overdue for more than 90 days. Gross NPA is the total amount of NPAs without deducting the provisional amount. It consists of interest defaults as well as principal amount defaults. So, if a bank loans Rs. 50 lakhs to a start-up with a 10% interest rate, there is a risk that the bank might lose these Rs. 50 lakhs as well as the interest payments if the start-up fails to repay the amount. Banks classify Gross NPAs further into three categories - substandard, doubtful, and loss assets. a. Substandard assets Assets that are NPA for a period less than or equal to 12 months are substandard assets. b. Doubtful assets An asset that remains NPA for a period exceeding 12 months is a doubtful asset. They have a significantly higher risk level. c. Loss assets When a loss has been identified by an auditor and the amount has not yet been fully written off, it is classified as a loss asset. In other words, such an asset is considered uncollectible. Its record as an asset is not warranted although there may be some recovery value. In the financial year 2019-20, HDFC Bank reported a gross NPA of 1.26% which is one is the lowest in the banking industry. Pro Tip: It is very important to keep a track and analyse the bank's NPAs. Too many NPAs adversely affect a bank's liquidity and growth abilities. This is a big red flag. Have a look at the Public Sector bank’s (PSU) and Private Bank’s Gross NPA levels.
How does NPA affect NII and NIM?When good assets turn bad, the average interest-generating assets go down. This reduces interest income while the interest expenses remain the same. This directly affects their primary source of income. So, higher the NPA, less will be NII and NIM. NPA Adversity Learning and Examples: a. The Indian Economy enjoyed a boom phase from 2000-2008. Banks extensively issued loans to corporates with an expectation that the boom phases will benefit everyone. However, the 2008 financial crisis badly hit the economy and shook corporate profits pushing them to bankruptcy and other crisis. This further affected the NPA’s during the recession, especially for public sector banks. b. Yes bank suffered almost 90% downfall when the news of their high NPAs and poor financials broke out. Out of panic, customers rushed to withdraw their deposits. To control the situation, all the withdrawals were capped at Rs. 50,000. This further impacted many businesses’ cash flow. But, the devil is in the detail. If we analyse Yes bank’s advances break-up, we will find that about 67.9% of Yes Bank’s loans are offered to large corporates. Banks incur low costs if they lend funds to huge corporates. However, the risk factor cannot be ignored. If a couple of such large borrowers default on their repayment, it could result in a very stressful situation for banks and the investors. Worst fears came true for Yes Bank They had financed couple of huge loans which ended up as NPA’s like IL&FS, Jet Airways, Anil Ambani Group, Essel Group, DHFL etc. Watch our case study on the entire Yes Bank saga. https://www.youtube.com/watch?v=aOskhHSGM4w&t=8s Pro Tip: When you are reading a bank’s annual report, check their loan issuing pattern. This will give you an idea about the risk they are taking or might face in the future. Covid-19 has induced uncertainty amongst many economic and global factors. This can deteriorate the asset quality of the banking system to a certain extent. In such unforeseen scenarios, the market sentiments are often low. In such times, it is important to closely monitor the bank’s NPA behavior. Check at which rate is the good loans turning bad. This is known as the slippage ratio. It helps us evaluate how much of a fresh NPA was added in a particular year or a quarter. Fresh slippage is the amount of how much of a bank’s advances turned bad in a year. Banks usually report this amount on a quarterly basis in their annual report or in a separate press release. A sharp increase in fresh slippage has a significant impact on the net profit of the bank. Low or no slippage shows a bank’s efficiency in handling its assets. Historically, Public Sector Banks have a very unstable slippage ratio. It increased in 2018 and followed a sharp fall in 2019.
What is Capital Adequacy Ratio (CAR)? Why is it important?It particularly measures the financial risk of banks. CAR examines the available funds with banks in relation to extended credit weighted by exposure to various risks. In other words, it ensures credit discipline in a bank and protects the depositors. It analyses if the bank can absorb a reasonable amount of loss. Thus, this ratio becomes very important while analysing a bank's stock. It further promotes stability and efficiency in the financial system. Capital Adequacy Ratio = (Tier I Capital funds + Tier 2 Capital funds / Risk-weighted assets) Tier-1 capital absorbs losses without a bank being required to terminate trading. It is easily available to cushion losses sustained by a bank. It consists of equity capital, ordinary share capital, intangible assets, and audited revenue reserves. Tier-2 capital absorbs losses in the event of bank liquidation. If the bank loses all its tier 1 capital, tier-2 capital is used to absorb losses. It provides a lesser degree of security to depositors. Thus, tier-2 is observed as less secure than tier-1. It comprises unaudited retained earnings, unaudited reserves, and general loss reserves. For Indian private sector banks, RBI has mandated the minimum requirement of Tier-I capital ratio at 8.875%. Risk-weighted assets are calculated by studying bank loans and assessing risks. Weights are then assigned depending on each factor. It takes into account credit risk, market risk, and operational risk. The ratio is difficult to calculate as enough information is not easily available. However, these figures are easily available in the company’s annual report. Pro Tip: If a bank has a good CAR, it means that it has enough capital in the buffer to absorb potential losses. The bank has less risk of becoming insolvent and losing depositors’ money. It is financially strong. This is a positive sign for investors. The RBI has set the minimum capital adequacy ratio at 9% for banks. A CAR below 9% means that the bank does not have sufficient cushion. The chances of banks running into insolvency during stressed periods are high.
Provision Coverage Ratio vs Capital Adequacy Ratio (PCR vs CAR)Both these ratios provide a cushion to banks in case of financial crises. Provisioning Coverage Ratio (PCR) is the percentage of funds that a bank sets aside to cover bad-debt related losses. Capital Adequacy Ratio manages the bank's capital to its credit exposure. It indicates the position of capital adequacy of a bank. In simple words, one takes care of the NPAs while the other looks after credit efficiency. However, a high CAR reduces a bank’s ability to lend funds. The capital set aside cannot be used further as advances. The capital could have been used as advances to earn future interest income. By reserving funds, it slows down bank’s growth in the long run. Thus, banks usually set aside a greater portion during the years when they earn higher profits. This helps them create a buffer to face financial shocks. It saves them from insolvency or bankruptcy. This is how banks prepare themselves to face any kind of risk. However, one thing to understand is that they can prepare sufficient reserves only if they earn better profits. So, it is important for banks to churn out the best from their assets. To decode bank’s asset qualities, we will have to look at their balance sheet. Deposits by the customers are the largest liability for the bank. Although they fall under liabilities, they are significant for banks to lend capital as loans. If a bank doesn't have enough deposits, lending will slow down. This further slows down growth if enough capital is not available in the system. Banks might have to borrow money (take loans) from RBI to meet the general public's loan demand. This is a costly way to generate funds and can affect the NII. Pro Tip: In their annual report's notes to accounts, look at deposits’ breakdown. We earlier saw how banks can generate funds at a cheaper rate with a higher CASA ratio. Observe which type of deposit is growing. Is it the current and savings account? Or is it fixed or recurring deposits? Here is HDFC bank's deposit breakdown from their annual report 2019-20. In 2018-19, HDFC bank’s total deposits grew by 17.03%. In 2019-20, the growth rate was 24.30%. In 2018-19, CASA deposits grew by 14.02%. In 2019-20, the growth rate was 23.88%. Whereas, in 2018-19, time deposits grew by 19.36%. In 2019-20, the growth rate was 24.61%. We can observe that the total deposits’ and CASA deposits’ growth rate has improved by a healthy amount. This is a positive sign for investors. Another element to evaluate in the balance sheet is the total advances or the loans issued by the bank. Advances is the largest assets of the bank. They are their bread and butter on which they earn interest which ultimately makes the entire monetary cycle work. Here is HDFC bank’s advances from their 2019-20 annual report – Total advances constitute of 66% of total bank assets. Thus, it becomes critically crucial to evaluate this figure. Pro Tip: Analyse who is the bank issuing loans to. This is an important detail an investor needs to analyse. If the bank management makes poor decisions repeatedly then chances of these loans turning into an NPA are high. Hence observe the advances section under the asset side of the balance sheet. It includes loans issued within India as well as outside India. This can be in the form of cash credits, overdrafts, term loans, loans to other banks, loans to retailers as well as government. When you analyse the notes to advances, you will find the further breakdown to secured and unsecured loans. Evaluate how sensitive is the bank to market risk. Sensitivity to Market Risk records the changes in interest rates, foreign exchange rates, commodity prices, or equity prices. For most banks, market risk essentially indicates exposure to changing interest rates and the credit risk to sensitive sectors. Credit Risk to Sensitive Sector Credit risk occurs when borrowers fail to repay their loans. It is the biggest risk for banks. Banks always need to be prepared for credit risk challenges. If we want to invest our money in the banking sector, we need to analyse which bank is less sensitive to risks. Banks’ exposure to the capital market and real estate is considered very sensitive to risk. This is because of the constant fluctuation in prices. Pro Tip: To decrease market risk, diversification of investments is important. Review the bank's investment breakdown and its revenue sources. Are they dependent on a particular source? Or does the bank have a well-diversified portfolio? For example, here is HDFC Bank’s Revenue Mix. ICICI Bank’s Chanda Kochhar also had to quit in October 2018 over accusations regarding fraudulent loans to the Videocon Group. Pro Tip: read bank’s annual reports and press releases where they present their fraud records. Though these records are often sugar-coated in the annual reports, it gives us an idea to compare and evaluate a banking stock further. Here is HDFC Bank’s frauds and scams report –
SWOT AnalysisStrengths of a bank: Read about the recent achievements of a particular bank in their latest annual report. A bank’s strength may include – a. Excellent top-level executives We discussed how important it is for a bank to have the best management system. This helps the bank to improve and grow in the future. For example, HDFC Bank has one of the steadiest top management teams who has been associated with the bank for more than a decade. In 2018, Yes bank's management was constantly in news for its poor management. We all know how the bank plunged within days. b. Diversified business model Diversification makes banks less sensitive to sector-specific and concentration risks. For example, Kotak Mahindra Bank has a well-diversified business portfolio model. They operate across various domains like lending, insurance, asset management, capital market. This helps the bank to maintain steady earnings growth. c. Financial products Banks with a wide array of products like accounts, deposits, cards, loans, insurance, forex, and investment are stronger than others Their strengths also include high client retention, low staff turnover, and overhead, better credit ratings, etc. Weaknesses a. High Levels of NPAs NPAs are the bane of the banking sector. Developing countries such as India face instances of high NPAs. This amount eventually affects the entire credit system of the banks. They have a crippling effect. Over the years, the NPA levels are rising due to various frauds and scams. It is management's responsibility to have a strong system to control their NPAs to maintain efficiency. b. Covid-19 and other uncertainties Being a highly sensitive sector, banks must always be ready to face economic crises. For example, Covid-19 induced uncertainty amongst global factors. Such uncertainty can deteriorate the asset as well as earning quality of the banking system. In such scenarios, the market sentiments are often low. Banks prepare high provisions to face future losses. These provisions cannot be used for other operations and hence cannot generate further profits. c. Retaining Talents Banks thrive on the strength of their human resources. One of the most essential factors that can make or break a company is the performance of their employee. However, banks face the problem of employee retention, especially Public Sector Banks. Various factors lead to employees quitting the organisation. For example, lack of work-life balance, lagged succession planning, poor pays, no defined working hours for bank employees, etc. Opportunities a. Technology Implications The banking sector has evolved in many folds over the past few years. Banks have a huge opportunity to further adapt these technology innovations to increase their efficiency. b. Rural Expansion Opportunities Banks have a huge opportunity to penetrate the rural area's which are still untapped. Banks can grow their customer base by expanding into villages. Other banking opportunities include better reforms, growing economic, global political stability, etc. Threats a. Increasing competition in the finance market Various new services and products are being introduced and sold in unique ways. It is very important for financial industries to keep up with the competition and offer new services to their customers. b. The slowdown in the economy The economic slowdown is one of the biggest threats to every business. Banks ultimately face huge financial crises as a result of the slowdown. Their threats also include changes in banking norms, high unemployment, frequent changes in interest rates, etc. c. Data leaks and hacking
When to invest in banking stocks?The best time to invest in a bank is when it is undervalued. It means that the fundamentals of the bank are strong. But due to recent news or event, the stock is not trading at its intrinsic value. The potential of the stock to grow is high if it undervalued. Pro Tip: Warren Buffett said that if the fundamentals are strong, you must learn how to ignore the outside noise. This is one of the main points of his investment strategy. There are many valuation parameters that determine whether a stock is cheap or expensive. They are especially relevant when the market is growing or is at a peak. One of them is the Price to Book ratio (PB Ratio). To value a banking stock, PB ratio is the best tool. Bank’s assets and liabilities are normally marked to market. They are either very liquid instruments or their value is easily determined. For example, advances and deposits. Hence, PB Ratio is the most important parameter to check and compare before drawing conclusions.
Price to Book Value Ratio (PB Ratio)Book value refers to the value of a company’s assets minus the liabilities. Price to book value is the price of a company divided by its book value. It compares the bank’s market capitalization to its book value. This ratio has less volatility which makes the valuation more stable and reliable. PB Ratio = Market Price of the Share / Book Value per Share It is a perfect valuation metric for banks because it captures how efficiently the funds or the assets are being utilized. A high PB ratio generally means that the stock is trading at a much higher valuation than its book value and vice versa. For example, Kotak Mahindra Bank’s PB Ratio is 5.32 as of May 2021. This means investors are paying 5.32 times more for a company’s assets to buy a share. Ideal way to analyse a bank’s PB Ratio is by comparing it with its own historical ratio or the industry average. Let’s understand this with the industry average. The average PB ratio of private banks and public banks is 1.83 and 0.48 respectively. Here are three banks with the highest PB Ratio. These banks are well above the industry average and are over-valued.
|AU Small Finance
|Kotak Mah. Bank
|Bank of India
- ROE Formula = Net Income / Average Shareholder’s Equity
- PB Ratio = Market Price of the Share / Book Value Per Share
|Kotak Mahindra Bank
|Public Sector Banks
|Indian Overseas Bank
|Bank of India
|Union Bank of India
Returns on asset (ROA)ROA is the profit a bank is able to generate on its total assets. It is calculated by dividing net income by its total assets. It helps us understand if the management is using its assets efficiently to generate more income. When the quality of asset improves, benefits like liquidity and its risk capacity also improves. The higher the ROA, the more productive and efficient a management is in utilizing economic resources. A lower ROA means that the bank is not able to utilise assets efficiently. Negative ROA implies the bank’s assets are bearing negative returns (losses). This is a red flag for investors. A good banking system can absorb adverse conditions whereas a poor system can lead to financial crisis. Therefore, banks need to improve continuously and be ready to face any difficult situation.
Where can we find all the data to analyse a bank?Primary Sources
- Annual reports of banks
- Investor presentation reports
- Conference call transcripts
- Quarterly and half-year reports
- RBI website
- Company's website
- National Stock Exchange (NSE) website
- Bombay Stock Exchange (BSE) website
- Samco’s Stock Page