This is the fourth and last article on the banking sector series. First, we saw what makes HDFC Bank the respected and most tracked/invested bank it is today, second we saw an in-depth analysis of Kotak Mahindra Bank and how it has avoided every crisis, third we saw what strategies the Top 5 Banks use for banking and last but the most important, in this article we will look at what a Bank actually does, what do all the fancy-sounding terms mean in the Banking Sector and factors to look at while picking a good bank.
Banking as a sector will always be in vogue given that it forms the backbone of our economy and our stock market indices.
Ray Dalio, hedge fund manager at Bridgewater Associates (one of the world’s largest hedge fund) always breaks complex mechanisms or processes into sum of the parts (Fun Fact – He used this very approach when McDonald’s wanted to launch McNuggets).
We will do the same to find what a Bank takes in (input) and what it gives out (output). This will help us understand how a bank functions in a very simple manner!
In simple words, a bank takes money from people (depositors) and lends it to the ones who need money (borrowers). It is safe to say that a bank majorly works on borrowed capital. (The banking sector uses leverage massively.)
Types of banks
Scheduled Banks (Public and Private), Public Sector Commercial Banks, Private Sector Commercial Banks, Regional Rural Banks (RRBs), Foreign Banks, Payments Banks, Small Finance Banks, Post-Office Savings Banks (POSB), Wholesale and Long-Term Finance Banks (WLTFB), Non-banking Financial Companies (NBFCs)
How does a bank earn money?
It pays x% to the depositor and takes y% as interest from the borrower. The bank’s earning is y%-x% in simple terms. (For simplicity sake, we are not factoring in fixed expenditures such as employee costs, etc)
But then this is risky as the bank can lend all of Rs 100, hence the regulator RBI says have owners’ equity as well. (If 100 rs are the deposits, then the company may put up 20 rs as equity. This is just an example, banks have to put up capital adequacy ratio which is a certain level of equity, which will be touched upon in the latter part of this article)
NPA, NPA, NPA! Kya hain yeh NPA?
A loan (an amount of money extended by the bank) is said to be an NPA when it is in default or in arrears on scheduled payments of principal or interest. Simply put, debt is classified as nonperforming when loan payments have not been made for a period of 90 days.
Gross NPA (GNPA)
It is the total figure of loans on which no payments have been paid for 90 days or more. GNPA % is usually shown in each Bank’s quarterly results. The percentage is basically the GNPA amount as a % of the total advances. Banks are supposed to provide provisions for this every quarter as per RBI stipulations.
Gross NPA is defined as “Principal dues of NPAs plus Funded Interest Term Loan (FITL) where the corresponding contra credit is parked in Sundries Account (Interest Capitalization – Restructured Accounts), in respect of NPA Accounts.”
Net NPA (NNPA)
The total figure left after deducting provisions made for bad loans from GNPA. (GNPA – Provisions = NNPA)
Net NPA definition is Gross NPA – (Balance in Interest Suspense account + DICGC/ECGC claims received and held pending adjustment + Part-payment received and kept in suspense account + Total provisions held).
Example of GNPA and NNPA illustration
A Bank has a 100 Rs loan book, 8 rs of NPAs and 4 rs of provisions. This means the bank has 8 rs of GNPA, 4 rs of NNPA and in percentage terms 8% GNPA and 4% NNPA.
A sub-standard asset would be one, which has remained NPA for a period of less than or equal to 12 months.
An asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months or more.
Why are NPAs so widely tracked?
Because if a sizeable percentage of the loan book of a Bank becomes NPA, the equity portion gets hit of the Bank (because remember deposits have to be returned and some money is in CRR/SLR, so the direct hit is to equity). Due to NPA, equity value gets hit, and if equity value gets hit, the stock price can get hit badly and also limits the growth of the bank. If 10% becomes NPA, out of 80 rs, so 8 rs NPA. If the banks’ equity value gets hit then 8 out 20 rs gets evaporated translating into a 40% equity hit!
Special Mention Account (SMA) – SMA 1 and SMA 2
SMA-1 is a category in which stress with respect to the principal and interest has remained overdue for a period of 30 to 60 days.
SMA-2 is the category devised in order to mitigate the bad loan problem with the amount being overdue for tenure between 61 days but less than 90 days.
Net Interest Income (NII)
This is the spread the bank makes on its lending. It is calculated as Interest Income – Interest Expended
Net Interest Margin (NIM)
This is the spread the bank makes on its lending. It is the earning which is left after deducting the cost paid to depositors from its yields on Loans. This is denoted in % terms.
The formula is Yield on Loans – Cost of funds/deposits/interest-bearing assets.
Example – Ignoring all the other factors, a bank earning 4.3% NIM is much more efficient and profitable when compared to a bank earning 3.9% NIM.
Capital Adequacy Ratio (CAR)
Capital adequacy ratio is basically equity / debt ratio which means how much equity is needed to give a certain amount of loan by a bank. Capital adequacy ratio is the percentage of total capital(total of tier 1 and tier 2 capitals) to the total risk-weighted assets.
Under Basel III, a bank’s tier 1 and tier 2 capital must be a minimum of 8% of its risk-weighted holdings. The minimum capital adequacy ratio, also including the capital conservation buffer, is 10.5%.
Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk-weighted assets
Parts or components of Capital Adequacy Ratio
Post-crisis, with a view to improving the quality and quantity of regulatory capital, it has been decided that the predominant form of Tier 1 capital must be Common Equity; since it is critical that banks’ risk exposures are backed by a high-quality capital base. Non-equity Tier 1 and Tier 2 capital would continue to form part of regulatory capital subject to eligibility criteria as laid down in Basel III. Accordingly, under revised guidelines (Basel III), total regulatory capital will consist of the sum of the following categories: (i) Tier 1 Capital (going-concern capital2) (a) Common Equity Tier 1 (b) Additional Tier 1 (ii) Tier 2 Capital (gone-concern capital)
Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
Tier I Capital –
Tier I capital or Core Capital consists of elements that are more permanent in nature and as a result, have a high capacity to absorb losses. This comprises of equity capital and disclosed reserves. Equity Capital includes fully paid ordinary equity/common shares and non-cumulative perpetual preference capital, while disclosed/published reserves include post-tax retained earnings. However, given the quality and permanent nature of Tier I capital, the accord requires Tier I capital to constitute at least 50 percent of the total capital base of the banking institution.
Tier II Capital –
Tier II capital is more ambiguously defined, as it may also arise from difference in accounting treatment in different countries. In principle, it includes revaluation reserves, general provisions and provisions against non-performing assets, hybrid debt capital instruments, and subordinated term debt.
Note – Tier I and Tier II definition has been taken from an Alpha Invesco article. I tried summarising the definitions on my own, but Alpha Invesco has done the best work in synthesizing these 2 complex definitions.
Capital Conservation buffer (CCoB) –
The capital conservation buffer (CCoB) is a capital buffer of 2.5% (was expected to be applicable from 31/03/2020) of a bank’s total exposures that need to be met with an additional amount of Common Equity Tier 1 capital. The buffer sits on top of the 4.5% minimum requirement for Common Equity Tier 1 capital. Its objective is to conserve a bank’s capital.
Why is Capital Adequacy Ratio (CAR) important?
It is a measure of banks capital, Helps to prevent bank failure, One of the shock-absorbers to the banks besides CRR & SLR.
What are CRR and SLR?
Banking is a business of probability wherein even banks factor in a certain amount of bad loans. All loans are not safe, so to safeguard depositors and equity holders, CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio )are created out of total capital of 120 (deposits + owner equity)
SLR (Statutory Liquidity Ratio) is the money a commercial bank needs to preserve in the form of cash, or gold or government authorized securities (Bonds) before providing credit to their own customers. This limitation is added by RBI on banks to make funds available to customers on-demand at your earliest convenience. 18.25% is the current SLR Rate.
CRR – CRR means Cash Reserve Ratio. Banks in India are required to hold a certain proportion of their deposits in the form of cash. However, actually Banks don’t hold these as cash with themselves, but deposit such amounts with Reserve Bank of India (RBI) / currency chests, which is considered equivalent to holding cash with RBI. 3% is the current CRR Rate.
Why is CRR and SLR imposed on Banks?
There can be a sudden surge of depositors or there can be loan problems, and hence the bank won’t have enough liquidity with them to serve them. CRR and SLR work on an assumption that a certain % of people will not come on a single day to liquidate their deposits.
You may ask there may not be a run on the bank. But the best example for this is ICICI Bank, Yes ICICI Bank! There was a run on the ICICI bank and the bank had to move truckloads of cash to meet the withdrawal demand.
No Indian institution was affected as badly as ICICI Bank by the global financial crisis. So deep were the concerns over ICICI Bank at that time that Infosys, whose founder NR Narayana Murthy was once on ICICI Bank board, withdrew Rs 1,000 crore of its fixed deposits with the bank and moved them to State Bank of India. The main trigger for this panic was that ICICI Bank’s global ambitions had resulted in the private lender being the only institution to be directly hit by the Lehman collapse because of its UK arm’s $80-million exposure to the failed investment bank. It was in the midst of this crisis that Chanda Kochhar took charge as the new CEO and announced a change in strategy. Compared to the earlier strategy of chasing bulk deposits in order to grow fast, the bank started focusing on retail and transnational banking.
Repo (Repurchase) rate
The rate at which the RBI lends short-term money to the banks against securities. Current Rate is 4.4%.
Reverse Repo rate
The rate at which banks park their short-term excess liquidity with the RBI. The current rate is 4%.
The difference between repo and reverse repo is one of the main ways (along with bonds and t bills investments) through which RBI earns money.
Current Account Saving Account (CASA)
There is no interest paid on the Current Account and a small interest rate is paid on a savings account. The combination of both is called CASA which shows the number of liabilities that the bank pays relatively less interest on. This is why CASA % is widely tracked and a higher CASA % is always favored because if the cost of liabilities is less, then the spread can be higher for the bank.
Marginal Cost of fund-based Lending Rate (MCLR)
A methodology by the Reserve Bank of India (RBI) for setting the lending rates on loans by commercial banks. For example – According to a recent SBI press release, the one-year MCLR comes down to 7.4% per annum from 7.75%, with effect from April 10, 2020, for them.
RWA- Risk-Weighted Asset
Risk-weighted asset (also referred to as RWA) is a bank’s assets or off-balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution.
Provisioning Coverage Ratio (PCR)
This is the ratio of provisioning to gross non-performing assets and indicates the extent of funds a bank has kept aside to cover loan losses. For Instance, a company has GNPAs of 100 Rs and they have set aside 50 Rs, then the PCR is 50%.
When banks refer to credit costs they are talking about the amount they expect to lose because of standard credit risks. It is basically the cost of doing business for a bank. NPA/advance is the credit cost. It is usually denoted and guided for in % terms.
Slippages denote the fresh amount of loans that have turned bad. The slippage ratio of a bank is calculated as Fresh accretion of NPAs during the year /Total standard assets at the beginning of the year multiplied by 100.
Restructured assets or loans are that assets whose terms have changed so as to help the borrower repay the loan. The changes may include an extended repayment period, reduced interest rate, converting a part of the loan into equity, providing additional financing, or some combination of these measures. Hence, under restructuring, a bad loan is modified as a new loan. Hence, a lot of people add restructured assets % + NPA% to derive the total bad assets % as restructured assets are bad assets only, it’s just that in most of the cases the NPA recognition gets delayed due to labeling it as restructured assets.
A legal authorization to debtors to postpone payment.
With the country being in lockdown to contain the spread of COVID-19, the Reserve Bank of India had announced a slew of measures, to tide over the economic fallouts. Among other measures, one measure that has brought a lot of cheer is the RBI allowing banks to grant a three months moratorium to their borrowers for term loans outstanding as on March 1, 2020.
It is a technical term for a repayment holiday, which is basically a length of time during which a borrower gets time off from his or her loan repayments.
Fee income is the revenue that a financial institution earns on services rather than interest payments. Fee income includes revenue earned on retail and corporate banking fees, processing fees on loans, brokerage or commission earned on forex transactions, distribution of third party products like mutual funds, insurance, and financial advisory services.
Asset Liability Mismatch (ALM)
Funding long-term assets by short-term liabilities. If the short term financial instruments market sees credit events, the costs may shoot up badly. (The best example of this is the IL&FS crisis where a lot of banks and NBFCs saw their costs shooting up due to ALM mismatch and the liquidity drying up in the money markets.)
Loan Book just states a breakup of where the bank has lent money and how much. For instance, in the above figure, we can see that Kotak Mahindra bank has lent 83423 Cr in the corporate and business banking segment which formed 39% of the total loan book in the Dec 2019 quarter. There are various segments of loan books such as Commercial Vehicle+ Construction Equipment (CV+CE), Home loans and Loan against portfolio, agriculture and so on.
This is just used to denote the GNPAs and NNPAs of a bank. If the bad loans are less in percentage terms, then the asset quality of the bank is said to be good and if the loans are more in percentage terms, then it is said to be bad. And if bad loans increase, the asset quality is said to be deteriorating.
Cost Of Funds
This is the cost paid by financial institutions for the funds that they deploy in their business. For example – A Bank has deposits of 100 Rs (on which it pays 6%) and bonds of Rs 100 paying 7% and thus the weighted average cost of funds for them comes to be 6.5%. In a nutshell, it is the cost of money.
A Bank is like a tree that needs strong roots. When the roots (cost of funds) are not strong, then other things may not grow well.
Basel III Norms
Basel III is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector.
One of the underlying features of the crisis was the build-up of excessive on- and off-balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while still showing strong risk-based capital ratios. Subsequently, the banking sector was forced to reduce its leverage in a manner that not only amplified downward pressure on asset prices but also exacerbated the positive feedback loop between losses, declines in bank capital and contraction in credit availability. Therefore, under Basel III all rules came.
Types of Risk bank has –
Liquidity Risk – Funding of long-term assets by short-term liabilities, also called as ALM mismatch.
Interest Rate Risk – Adverse movements of interest rates.
Market Risk – The risk of adverse deviations of the mark-to-market value of the trading portfolio.
Credit Risk – bank borrower or counterparty failing to meet its obligations in accordance with the agreed terms.
Operational Risk – Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events’. Thus, the operational loss has mainly three exposure classes namely people, processes and systems.
Now that we know the various complex terms of banks, this must make you think about what to look at in a bank? Banking is a very risky business where the inherent nature of the business is such that leverage is used to the extent of 5-10 times. So it goes without saying that banks are expected to lend conservatively, do excellent underwriting and not miss the forest for the trees (meaning not missing balance sheet strength for just P&L. We all know of a bank who did things simply for P&L and ended up capital-starved).
Some points to remember while investing in a Bank –
#1 – Lending is all about betting on the leader.
When someone bets on a banking stock, one bets not on the horse but completely on the jockey. Everyone has branches (some have more and some less) and everyone has the same raw material (deposits), and hence it is imperative that the person steering the horse is a person you can bet your house on!
Example – When the driver of a bank is excellent like Aditya Puri he will create rules in a way that the bank and minority don’t get hurt. If you think I am just going on and on about only good things of HDFC Bank let me give you the best example which tells the ground of ethics and carefulness on which HDFC bank is built on.
Everyone knows that Aditya Puri, who sits at the helm of HDFC Bank, has built HDFC Bank into India’s most valuable bank by the bank’s efficient risk management framework which has only benefited shareholders all along. He was recently asked why he refused loans to his “friends” Vijay Mallya and Nirav Modi, both now fugitive offenders that owe large sums of money to banks. He said, “Somebody in Mallya’s office will tell you, every time the call came from me, Mallya gaali deta tha (he used to abuse). His blood pressure would go up”. He was referring to how HDFC bank declined Mallya’s requests. “Friendship and banking are not co-related. If you are a bad risk, you are a bad risk. You can be my good friend, I can give you coffee and send you away.” He added that both Mallya and Modi had come to him for a loan, “I gave them coffee and told them that I will consider the loan.”
Coming to the Altico liquidity crisis, we saw that the HDFC bank enchased its security while other banks kept waiting for restructuring and other terms. This was very much at the dismay of SBI and when interviewed Aditya Puri said: “He is only there for the protection of interests of his deposit holders, offer competitive rates and if anyone does not behave in a proper way, he is there to kick them.” While we know him as the master strategist at HDFC bank, this episode also sheds light on the ruthless side of his which is essential since Lending is a difficult business and difficult times can call for difficult strategies.
#2 – Learn to differentiate between an aggressive bank and a calculated growth achiever bank.
The investing and analyst community loves growth. But extraordinary growth is not normal always, and hence it should be questioned! Compare growth with peers and see if the growth is legitimate! Many banks clocked high fee income growth in the past 2-3 years, but the cost is clearly visible now for these banks!
Below I have compared one of the best banking franchises (HDFC Bank) to another bank. Fun Fact – HDFC Bank began with five clients—the Tatas, Birlas, Reliance Industries Ltd, Hero Honda Motors Ltd, and Siemens Ltd. Today, there is hardly any firm in India that doesn’t bank with them.
#3 – Learn to judge Banks by not their performance in good times but in bad times.
Example 1 – IL&FS Crisis – How HDFC Bank fared when compared to its smaller peers?
HDFC Bank before and After IL&FS Crisis –
Observations – We see that HDFC Bank’s GNPA and NNPA percentages were largely unchanged which shows how well the company was cushioned against the IL&FS crisis in terms of both liquidity and asset quality.
The bank’s stellar performance and stable asset quality during the time of crisis are commendable.
Here is another bank’s NPA before and after IL&FS Crisis –
Observations – We see that this Bank’s GNPA and NNPA percentages were continuously increasing and notice the number of NPA (in Cr) which shows hints of lenient lending. GNPA and NNPA more than double!
Only when the tide goes out (in our markets tide going out meant the liquidity tightening from the money markets) do you discover who’s been swimming naked. – Warren Buffet.
Example 2 – Demonetization – How top banks fared?
During demonetization, Kotak Mahindra Bank was the only bank from the above peer set to have reduced its GNPAs and NNPAs. At the same time, while the net profit of other banks got reduced due to heavy provisioning, Kotak Mahindra Bank and Axis Bank were the only ones to have increased their net profits.
The steady NIMs, when seen in conjunction with stable asset quality and increased profits, denotes how KMB not only got out unhurt from the demonetization crisis, it, in fact, grew its profits and advances during this time!
#4 – Excellent Underwriting Standards
After reading all the above factors you must be thinking that these are all qualitative factors. So what about Price to book, Cost to income ratio, fee income growth, and the other 1000 numbers people track? When investing in a bank, Price to book shouldn’t be used for filtering, nor GNPA, NNPA, PCR, CAR, SMA 2, etc. The only filter to be applied is the underwriting standard and quality of management, and then automatically all the above metrics will be excellent.
Underwriting explained here by Mr. Uday Kotak –
Now again after reading this, you would be asking how to gauge excellent underwriting. Well, the next point tells us exactly that.
#5 – They do not keep growing always. They sometimes slowdown their loan book to safeguard the loans and the interests of the bank and its stakeholders!
The return of capital is more important than return on capital!
A Bank avoids a crisis one time? Must be Pure Luck right? But avoid each and every crisis in the past 10 years and then it is not pure luck but a combination of excellent forecasting and quick action-taking. KMB’s history of avoiding risks and surviving is not limited to just the past 5 instances. During the Asian Crisis 1997, only 20 out of 4000 NBFCs survived and KMB was one of the companies to have survived. Mind you, the survival rate was just 0.5%.
The above examples show that Kotak Bank has always taken a cautious approach towards its lending and has not shied away from slowing down a particular segment just to insulate themselves from imminent risks. And it has played out amazingly well for them every time! So this example was shown to tell everyone that growth in good times and protection in slowdowns is what a good bank does! This is a trait of excellent underwriting standards! Growth at any cost is not the correct strategy!
#5- High savings rate need not necessarily mean the bank is better or efficient!
SBI pays 2.75% on Savings account! IDFC First pays upto 7% on a savings account! Some people view this as a moat for IDFC Bank! But building a deposit franchise is no joke!
A Bank is like a tree that needs strong roots. When the roots (cost of funds) are not strong, then other things may not grow well. Higher yields have to be chased so that NIMs come in good, shareholders are kept happy. But higher yields may mean lending to ones who are a high risk! But then one would say if underwriting is good? Well, that’s possible as well. But then a paradox may arise why would a loan taker pay a higher interest rate at IDFC First when he can go to HDFC and pay much lower.
The current interest rate offered on funds in a Savings Account is 4% per annum for HDFC Bank while for other banks it ranges from 5-7%! Here is the deposit number of HDFC bank as of December 2019 –
While here is the deposit number for one of the banks offering higher interest rates –
Confused? One bank offers a lower interest rate and still has deposits growing, while one has a higher interest rate but deposits still shrinking? The answer lies in Trust and brand name! HDFC Bank has never cheated its depositors or gotten cheated( by way of default through NPAs ) from its borrowers.
All of the above factors are quite visible in its share price! (Split, dividend not even included)
So to sum it up, a lot of qualitative factors have to be gauged while investing in a bank and the person leading the bank also has a big impact on how the bank delivers wealth to its shareholders (Good example is of Aditya Puri and the contrasting example is of Rana Kapoor)
Related Reads on this article-
This was part 4 of the banking series. With this my banking sector series ends and the next sector, I will analyze completely is the NBFC Sector.
Previous parts –
Disclosure – Please do not construe this article as a piece of investment advice. It is written simply for educational purposes.