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How to evaluate banking stocks

Since a bank's business model is different from that of a manufacturing company, the method used to evaluate a bank stock is also different

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.

Economic moats in banking
One of the biggest deterrents that prevent more players from entering the banking industry is the tough regulatory requirements that all banks are supposed to comply with. In India, in any case, bank licenses are given out by RBI only from time to time and after much due diligence.

Banking is also a capital-intensive business; hence not too many players can enter it.

Economies of scale also give greater muscle to a bank. A State Bank of India (SBI) or a Citibank (internationally) enjoys scale-based advantages that are difficult for smaller players to match.

A large branch network, as mentioned earlier, is another key advantage. Punjab National Bank's (PNB) large branch network in north and central India gives it access to low-cost deposits that is hard for smaller players to match.

Going by the numbers
Capital base. In case of Indian banks, check their credit to deposit ratio (CDR). This ratio indicates the funds lent out of the total amount raised through deposits. A higher ratio indicates more optimal utilisation of funds. Check the bank's CDR vis-à-vis the industry range.

Next, look at a bank's capital adequacy ratio (CAR). The RBI has stipulated that the minimum capital adequacy ratio should be 10. This ratio ensures that banks do not expand their business without having an adequate buffer of capital.

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

Keep an eye on the reserve provisions made for bad loans relative to non-performing assets (NPAs). Net NPA ratio is a measure of the overall quality of the bank's loan book. A higher ratio reflects rising incidence of bad loans.

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

Profitability. Return on equity (RoE) and Return on Assets (RoA) are the standard metrics for checking a bank's profitability.

A red flag should go up in your mind if a bank's RoE or RoA shows excessive deviation from that of its peer set. It is easy for a bank to boost its earnings in the short term by under provisioning for bad loans or by leveraging the balance sheet. This increases the risk over the long term. The recent financial crisis in the US is an example of all that can go wrong when excess leverage is employed by financial institutions.

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

Efficiency ratio. Check the operating profit margin of the bank you are evaluating. If a bank is able to keep its expenses under check, that is a positive sign.

Operating profit for banks is calculated after deducting administrative expenses (which include salary cost and network expansion cost) from its net interest income.

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

Controlling overheads is critical. This can be done through branch rationalisation and technology upgradation. The cost to income ratio indicates how good a job a bank is doing at controlling costs:

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

Net interest margin. Net interest margin (NIM) is the net interest income as a percentage of average earning assets. It shows how profitable a bank's lending and deposit-taking activities are. Keep a tab on the long-term trend in a bank's NIM.

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

Price-to-book. This is the key measure of valuation for banking stocks. Compare the bank's current P/B with its historical P/B levels (say median for past three years). Also compare it with that of its peers. This will tell you how expensive its valuation is.