It is said that the banking sector reflects the economy's health. The sector acts as a funnel providing the funds that corporates need to expand their business. When the economy is expanding, as is happening in India currently, banks lend more and hence profit more. Since a bank's business model is different from that of a manufacturing company, the way you go about analysing banking stocks is also different.
A bank's basic business is to accept deposits and give out loans. It makes money by charging a higher rate of interest on its loans than the rate it pays its depositors. This difference in interest rates is called 'spread'. The money that a bank earns from its deposit-taking and lending activities is referred to as 'net interest income'.
In addition, banks also earn money by offering a variety of services (say, distributing mutual fund and insurance products, offering wealth management services, and many more) for which they charge a fee. They also make money by buying and selling debt securities (referred to as their treasury operations). The money they earn by these means is reflected in their profit and loss statement under 'other income'.
The Reserve Bank of India (RBI), the regulator for the banking sector, imposes certain prudential norms on banks. For instance, it requires banks to maintain a certain percentage of their deposits with RBI as cash reserve ratio (CRR). Whenever there is too much liquidity within the system and inflation threatens to go out of control, the central bank announces a CRR hike. This reduces the amount of funds available with banks for lending. This is referred to as sucking liquidity out of the system. But since banks earn no interest on their CRR deposits, a hike in the CRR rate affects their profitability adversely.
RBI's prudential norms also require Indian banks to invest a part of their funds in government securities (G-Secs). These holdings are referred to as statutory liquidity ratio or SLR holdings.
And finally, given their importance to the system, banks can not be allowed to run short of liquidity. So the central bank runs an overnight liquidity window for them. Whenever banks need money for the short term, they borrow from the central bank at what is known as the repo rate. And when they have excess money, they deposit it with the central bank at a rate known as the reverse repo rate. These act as benchmark rates for short-term interest rates in the system.
Managing risk
Banks manage three types of risk: credit risk, liquidity risk, and interest-rate risk.
Credit risk. This is the core risk that banks run. To get an idea of how a bank is faring on this count, look at the trend of gross and net non-performing assets (NPAs) over a long period of time. Also keep track of a bank's capital adequacy ratio (CAR, which is capital that banks maintain to be able to absorb losses on their activities). When a bank's NPAs increase and its CAR falls below the stipulated level, it signifies a looming crisis.
To mitigate credit risk, banks try to diversify their loan portfolios. They do so either by making varied types of loans (so that a high proportion of their loans don't go bad at the same time) or by buying and selling loan portfolios from other players.
Another method by which banks safeguard themselves against credit risk is by employing sophisticated credit approval systems and processes to reduce default. A conservative approach to lending may lower earnings but usually works in a bank's favour over the long haul.
Liquidity. Banks are also expected to provide liquidity management services. For instance, there could be a company that is due to receive a large payment from a client in a few days but is in urgent need of money now. It can go to a bank, sell its receivables to it at a discount, and get immediate cash in return.
Many businesses also pay a regular fee to a bank to avail of overdraft facility.
All this makes it necessary for banks to have sufficient liquidity to be able to meet the demands made on them. Hence the prudential norms (such as CAR) that are imposed on them and the overnight lending window provided by RBI.
Interest-rate risk. The third major risk that banks face is interest-rate risk. Most people think that higher rates are good for banks and lower rates are bad. This is an oversimplification. The effect of interest-rate movements depends on whether at a given point of time a bank is asset sensitive or liability sensitive. Asset sensitivity means that the bank can change the interest rate on assets like loans more quickly than the interest rate on liabilities. In such a case, rising interest rates translate into greater profitability for the bank.
When a bank can change its deposit rates more quickly than its loan rates, it is said to be liability sensitive. In such a scenario, rising interest rates will hurt its margins. Interest-rate swaps are used nowadays by banks to mitigate the impact of interest-rate fluctuation.
In a rising rate scenario, as interest rates reach high levels, it becomes difficult for banks to raise their loan rates further and hence their net interest margin (NIM) begins to get compressed. In such a scenario, banks with a high CASA ratio (proportion of total deposits accounted for by low-cost current and savings accounts) tend to do well because of their access to low-cost deposits. When analysing a banking stock, pay heed to its CASA ratio. Banks with a large branch network have a higher CASA ratio.
