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Banks: Look before you leap!

Mar 16, 2002

The Indian banking sector is currently in a transition phase. While public sector banks are in the process of restructuring, private sector banks are busy consolidating through mergers and acquisitions (the sector has been recently opened up for foreign investments). With the Finance Minster’s announcement of introducing a Bill on Banking Reforms, law on foreclosure and plans to set up an asset reconstruction company (ARC), the sector is likely to witness a significant structural change the coming years. The sector, which was considered dry in the last several years, has caught the investor fancy in expectations of changing regulations and improving business conditions due to opening up of the economy. Entry of private and foreign banks in the segment has provided healthy competition and is likely to bring more operational efficiency into the sector. However, before investing in a banking stock an investor should look at certain key performance ratios.

Unlike, any other manufacturing or service company, a bank’s accounts are presented in a different manner (as per the banking regulation). The analysis of a bank’s accounts differs significantly from any other company due to their structure and operating systems. Those key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank. We have attempted to throw light on some of the key ratios, which are unique for banks and determine the financial stability of a bank.

Before jumping to the ratio analysis, lets get some basic knowledge about the sector. The Banking Regulation Act of India, 1949, governs the Indian banking industry. The banking system in India can broadly be classified into public sector, private sector (old and new) and foreign banks.

  • The government holds a majority stake in public sector banks. This segment comprises of SBI and its subsidiaries, other nationalized banks and Regional Rural Banks (RRB). The public sector banks comprise more than 70% of the total branches.

  • Old private sector banks have a largely regional focus and they are relatively smaller in size. These banks existed prior to the promulgation of Banking Nationalization Act but were not nationalized due to their smaller size and regional focus.

  • Private banks entered into the sector when the Banking Regulation Act was amended in 1993 permitting the entry of new private sector banks. Most of these banks are promoted by institutions and their operating environment is comparable to foreign banks.

  • Foreign banks have confined their operations to mostly metropolitan cities, as the RBI restricted their operations. However, off late, the RBI has granted approvals for expansions as well as entry of new foreign banks in order to liberalize the system.

Now lets look at some of the key rations that determine a bank’s performance.

Ratios for evaluating operating performance

  1. Net interest margin (NIM): For banks, interest expenses are their main costs (similar to manufacturing cost for companies) and interest income is their main revenue source. The difference between interest income and expense is known as net interest income. It is the income, which the bank earns from its core business of lending. Net interest margin is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the RBI and money at call.

    NIM = Interest income – Interest expenses ------------------------------------ Average earning assets

  2. Operating profit margins (OPM): Banks operating profit is calculated after deducting administrative expenses, which mainly include salary cost and network expansion cost. Operating margins are profits earned by the bank on its total interest income. For some private sector banks the ratio is negative on account of their large IT and network expansion spending.

    OPM = Net interest income (NII) – operating expenses ----------------------------------------------- Total interest income

  3. Cost to income ratio: Controlling overheads are critical for enhancing the bank’s return on equity. Branch rationalization and technology upgradation account for a major part of operating expenses for new generation banks. Even though, these expenses result in higher cost to income ratio, in long term they help the bank in improving its return on equity. The ratio is calculated as a proportion of operating profit including non-interest income (fee based income).

    Cost to income ratio = Operating expenses -------------------------- NII + non interest income

  4. Other income to total income: Fee based income account for a major portion of the bank’s other income. The bank generates higher fee income through innovative products and adapting the technology for sustained service levels. This stream of revenues is not depended on the bank’s capital adequacy and consequently, potential to generate the income is immense. The higher ratio indicates increasing proportion of fee-based income. The ratio is also influenced by gains on government securities, which fluctuates depending on interest rate movement in the economy.

From the sample selected here, HDFC Bank tops the list with the best performance ratios. The bank’s higher interest margins are on account of it’s lending to retail sector, which is considered to be high margins business owing to low cost funds from retail deposits. SBI’s high cost to income ratio is on account of its large employee base while ICICI Bank’s high cost to income is due to its aggressive spending on expansion.

Comparative operating performance
FY01NIMOPMCost to incomeOther income
to total income
HDFC Bank4.0%15.6%44.8%12.8%
ICICI Bank2.7%5.6%53.5%15.0%
UTI Bank1.2%-3.4%49.3%15.5%
Corporation Bank3.4%13.3%39.1%13.9%
Oriental Commerce Bank3.2%11.4%45.0%9.7%

Other key financial ratios

  1. Credit to deposit ratio (CD ratio): The ratio is indicative of the percentage of funds lent by the bank out of the total amount raised through deposits. Higher ratio reflects ability of the bank to make optimal use of the available resources. The point to note here is that loans given by bank would also include its investments in debentures, bonds and commercial papers of the companies (these are generally included as part of investments in the balance sheet).

  2. Capital adequacy ratio (CAR): A bank's capital ratio is the ratio of qualifying capital to risk adjusted (or weighted) assets. The RBI has set the minimum capital adequacy ratio at 10% as on March 2002 for all banks. A ratio below the minimum indicates that the bank is not adequately capitalized to expand its operations. The ratio ensures that the bank do not expand their business without having adequate capital.

    CAR = Tier I capital + Tier II capital --------------------------------- Risk weighted assets

  3. NPA ratio: The net non-performing assets to loans (advances) ratio is used as a measure of the overall quality of the bank’s loan book. Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end from gross NPAs. Higher ratio reflects rising bad quality of loans.

    NPA ratio = Net non-performing assets --------------------------- Loans given

  4. Provision coverage ratio: The key relationship in analyzing asset quality of the bank is between the cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high ratio suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross non-performing assets do not rise at a faster clip).

    Provision coverage ratio = Cumulative provisions ----------------------- Gross NPAs

  5. ROA: Returns on asset ratio is the net income (profits) generated by the bank on its total assets (including fixed assets). The higher the proportion of average earnings assets, the better would be the resulting returns on total assets. Similarly, ROE (returns on equity) indicates returns earned by the bank on its total net worth.

    ROA = Net profits --------------- Avg. total assets

Comparative financial performance
FY01CD ratioCARNPA ratioProvision
HDFC Bank39.8%11.1%0.5%85.9%1.5%
ICICI Bank42.9%11.6%1.4%63.4%0.8%
UTI Bank53.0%9.0%3.4%19.7%1.0%
Corporation Bank52.3%13.3%2.0%64.7%1.4%
Oriental Commerce Bank44.9%11.8%3.6%36.2%0.8%

Efficiency ratios

  1. Interest income per employee
  2. Profits per employee
  3. Business per employee

These ratios indicate the productivity level of the bank’s employees. Since state run banks are operating with large employee base, the productivity ratio for these banks lags behind when compared with new generation private sector banks. Banks can improve these ratios by increasing the technology infrastructure, frequent offering of innovative products and also employee rationalization.

  1. Business per branch
  2. Employees per branch

A bank’s performance cannot be judged only from its large network. It has to be in relation with the bank’s ability to capitalize on its network. Large number of branches are sometimes unviable if they are situated at places where the business opportunity is low. Private sector banks are likely to have better ratios vis a vis their PSU peers on account of their concentration on top 100 business centers. Unlike PSU banks, private banks in general lack presence in rural areas. Since state run banks are present in every corner of the country, it impacts their average productivity ratios (as business opportunity differs).

Productivity comparisons
FY01Interest incomeProfitsBusinessBusiness Employees *
(Rs m)Per employeePer branch
HDFC Bank 4.6 0.8 59.2 1,243.9 21.0
ICICI Bank 2.8 0.4 52.1 619.3 11.9
UTI Bank 7.5 0.7 117.4 1,617.8 13.8
SBI 1.2 0.1 16.6 392.6 23.7
Corporation Bank 1.7 0.2 23.3 386.9 17.0
Oriental Commerce Bank 2.0 0.2 26.3 383.7 14.6
BOI 1.2 0.1 19.0 329.5 17.4
* absolute number

Valuations parameters

  1. Price to book value: Unlike other manufacturing/services company, a bank’s market valuations cannot be only measured from its price to earnings ratio (P/E ratio). This is due to the reason that a bank’s net earnings are influenced by the amount of non-performing assets provision, which again depends on the bank’s internal policy. Consequently, the bank could make low provisions to show a better picture. Therefore it’s prudent to remove non-performing assets for which no provisions are made from the net worth of the bank to arrive at the adjusted book value.

  2. Market cap to total income: This ratio helps in judging the market valuations of the bank’s total income. It is similar to the market cap to sales ratio for a manufacturing company. It indicates valuations accorded by the market to the total income of the bank.

Comparative valuations
FY01PBVP/EMarket cap/total income
HDFC Bank6.427.44.0
ICICI Bank2.517.72.0
UTI Bank4.46.20.5
Corporation Bank1.46.30.8
Oriental Commerce Bank0.63.80.3
Valuations based on market price as on March 15, 2002

Banking stocks have witnessed a sharp run up in prices in the last few days. Over the last nine months the fundamentals of the sector have been negatively impacted on account of a slowdown in the credit growth resulting in pressure on margins. Private sector banks have however managed to outperform on account of their aggressive retail lending which fueled their total income. Even though valuations of some of the old private banks look attractive, it’s worth to look at their financials and some of the ratios given here to determine where they deserve higher valuations. Look before you leap!

Read more on the sector:

  • ALM: Tightrope walking
  • NPA: Hole in the pocket

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