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Identifying an FI stock: Do's and Don'ts - Views on News from Equitymaster
 
 
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  • Sep 13, 2003

    Identifying an FI stock: Do's and Don'ts

    Financial institutions (FI) are specialized organisations that undertake long-term project finance, both for the public and private sectors in the country. However, their role in the economy is slowly losing relevance as banks have over the years entered this domain, i.e. term lending. FIs on their part have expanded their focus to encompass working capital requirements of corporates and thus the distinction between FIs and banks is slowly getting blurred.

    Recognizing this aspect, the government has taken a decision to restructure ailing FIs like IDBI and Industrial Finance Corporation of India (IFCI) by converting them into banks. We take a look at how FIs go about their business and the changes that are taking place in the way they work.

    A bank accepts deposits and gives out loans. So, in case of a bank, capital (read money) is a raw material as well as the final product. A bank accepts deposits and pays the depositor an interest on those deposits. The bank then uses these deposits to give out loans for which it charges interest from the borrower. An FI on the other hand, largely performs the same function, however with some minor differences. For an FI, borrowings are a bigger source of capital, unlike a bank where deposits are the major source of income. Also, FIs do not lend to the retail segment, as their role is to promote industries by providing term as well as working capital lending.

    FIs are distinct from banks in another major area, as they are not mandated to make CRR and SLR provisions like banks. FIs are, however, permitted to raise capital by issuing fixed deposits like any other company. This also supplements the capital requirements of the institutions. FIs revenues are basically derived from the interest they earn from the loans they give out as well as from the investments they make. As FIs are not bound to maintain a CRR and SLR provision (unlike banks), their investment income (especially interest earned on investments) as a proportion of total income is low. Therefore, the main focus in this article will be on interest income of the FIs from the lending operations that they carry out.

    Having looked at the profile of the sector in brief, let us consider some key factors that influence an FI's operations. One of the key parameters used to analyse an FI is the Net Interest Income (NII). NII is essentially the difference between the FI's interest revenues and its interest expenses. This parameter indicates how effectively the FI conducts its lending and borrowing operations (in short, how to generate more from advances and spend less on borrowings).

    NII = Interest on loans - Interest expenses

    Interest on loans

    Since FI operations basically deal with 'interest', interest rates prevailing in the economy have a big role to play. So, in a high interest rate scenario, while FIs earn more on loans, it must be noted that it has to pay higher on borrowings also. But if interest rates are high, corporates will hesitate to borrow. But when interest rates are low, FIs find it difficult to generate revenues from advances. While borrowing rates also fall, it has been observed that there is a squeeze on a FI when market interest rate is soft. An FI does not have the flexibility of a bank, which can lower deposit rates at will. It has to rely on the market determined interest rates.

    Since an FI lends to corporate clients, interest revenues on advances also depend upon factors that influence demand for money. Firstly, the business is heavily dependent on the economy. Obviously, government policies cannot be ignored when it comes to economic growth. In times of economic slowdown, corporates tighten their purse strings and curtail spending (especially for new capacities). This means that they will borrow lesser. Companies also become more efficient and so they tend to borrow lesser even for their day-to-day operations (working capital needs). In periods of good economic growth, credit offtake picks up as corporates invest in anticipation of higher demand going forward.

    Interest expenses

    FIs have bonds and debentures as their main source of funding apart from borrowings from banks and other term lending institutions. And hence an FI's main interest expense is in the form of interest outgo on total borrowings. This in turn is dependent on the factors that drive cost of borrowings. FIs, unlike banks, do not have the flexibility to manipulate the borrowing rates (except for their fixed deposits). Hence, their interest expenses cannot be lowered as fast as banks in a falling interest rate scenario. Institutions like IDBI and ICICI raise capital by way of bonds that are sold directly to the public. In this regard they still have the flexibility to lower (or increase) fixed deposit rates in tandem with the movement of interest rates in the economy. However FIs, are still not allowed to access low cost savings and current deposits and hence there is a limit to which they can improve their margins. Also another hindrance in the flexibility of cost of capital for FIs (especially deposit capital) is the fact that deposit rates for bonds issued by a FI (like IDBI) has to be more attractive than that offered by a bank so as to attract the retail investor.

    Key parameters to keep in mind while analysing an FI:

    Similar to a bank, one key aspect in analyzing an FI stock is the price to book value (more important than P/E). As we had mentioned earlier, cash is the raw material for an FI. The ability to grow in the long-term therefore depends upon the capital with an FI (i.e. capital adequacy ratio). Capital comes primarily from net worth. This is the reason why price to book value is important. But deduct the net non-performing asset from net worth to get a true feel of the available capital for growth. Most of the other parameters used to analyse an FI is common to that of banks.

    FIs, like banks, play a very vital role in the working of the economy. However, with the blurring of functions between banks and FIs, the business model of a bank is being increasingly accepted even for FIs also. Thus the move to restructure ailing FIs like IDBI and IFCI. One also needs to understand the fact that a majority of these FIs are controlled by the government and in the past politics has played a major role in their functioning. Any investment decision in FIs must be made taking into consideration government policies apart from pure fundamental considerations. As long as FIs are government controlled, their ability to keep up with the market dynamics will always be in question.

    Click here to identify stocks from other sectors.

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