Attempt to Study Banking Stocks

 Attempt to Study Banking Stocks

Key feature of how bank’s work:

·         Give loans, earn interest (revenue).

·         Accept deposits, pay interest (cost).

·         Earned interest minus paid interest is profit.

Interest earned on loans should be more than interest paid on deposits. This income is called “Interest Income”

Banks also make money from the other sources like:

·         Distribution of mutual funds.

·         Distribution if insurance schemes.

·         Offering wealth management services.

·         Treasury operations (buying/selling debt securities).

By providing these services, banks charge a nominal fees. Income earned from other source is called “Other Income”

Banks pay “lower” interest rate on deposits and charge “higher” interest on loans. This difference in interest rates between loans and deposits is called as “Interest Spread”.

What is CRR?

Minimum reserves that a bank must keep with RBI. On CRR, RBI pays nothing to bank (no interest). The purpose of CRR is to ensure some liquidity. At present, RBI has keep the minimum CRR limit of 4%.

What is SLR?

Minimum amount that a bank must invest in government bonds. On SLR, banks also earn a return in form of interest. This way, the banks are forced to invest their funds. These funds remain safe always.

The interest earned (@7.7% approx.) on these investments is an added benefit. At present, RBI has keep the minimum SLR limit of 19.5%.

What happens if bank’s runs out of cash?

RBI comes into play. RBI acts as banker to banks. RBI gives loan to banks and charge an interest. This interest is called Repo Rate. Banks must maintain CRR+SLR, and on top of this, if banks need money, take loan.

Depositors perspective, CRR and SLR are beneficial, because 23.5% [CRR (4%) + SLR (19.5%) ] of their deposits are always safe.

Investors point of view, CRR and SLR are not as useful, because 23.5% of bank’s funds yields very low returns. CRR yields 0% returns. SLR yields only 7.7%.

Final Words:

When CRR/SLR goes down, means bank’s margin will improve.

When CRR/SLR goes up, means bank’s margin will fall.

FINANCIAL RATIOS FOR BANKS:

·         Net Profit

·         Advance-Deposit Ratio (ADR) & Their Growth Rates - A bank which maintains a low ADR (Advance To Deposit Ratio) is considered safe.

·         Equity Multiplier (EM) – (EM = Total Capital / Net Worth = 15 (max)). EM is a ratio between total capital and net worth. It is a sum of bank’s Net Worth plus External Debt; i.e. deposits accepted from public.

·         Return on Asset (ROA) – (ROA = Net Profit / Total Assets). For Banks, ROA of 1% or more is considered good.

WHY?

Unlike other business sector, banking business typically show lower ROA, because banking business is based on taking deposits from public. Deposits for banks are what “debt” is for other companies. Other business can survive without debt. But banks needs debt to survive.

·         Return on Equity (ROE) – (ROE = Net Profit / Net Worth). ROE >15% for banks is considered acceptable.

·         Net Interest Margin (NIM) – (NIM = (Interest Earned – Interest Expended) / Total Assets). The higher is the NIM the better, because higher NIM means, more “interest profit (IP)” per unit asset. NIM (max) – 4%.

·         CASA Ratio - Ratio of deposits in current and savings account/total deposits. A higher CASA ratio is desired because banks give low rate of interest in savings account (3-4%) deposits and no interest in current account deposits. High CASA ratio indicates lower cost of funds.

·         Gross NPAs - Higher NPAs is adverse for the banks. This should be checked to determine the asset quality of the banks.

·         Provision Coverage Ratio (PCR) - Total provision balances of the bank to gross NPAs. PCR ratio indicates the extent to which the bank has provided for the weaker part of its loan portfolio.

·         Capital Adequacy Ratio (CAR) – (CAR = (Tier-I capital + Tier-II capital)/ Risk-weighted Assets). It is the ratio of bank’s capital to aggregated risk-weighted assets.