How to evaluate banking stocks

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

This article was originally published on October 27, 2010.