May 11, 2011

Evaluating banks - Key factors

I recently started analyzing financial institutions such as brokerages, banks and HFC (housing finance companies). I wrote about brokerage firms here and here.

In this post, I will be looking at some key factors in analyzing banks. I have written about banks earlier – see here, here and here. I have covered several factors important in analyzing a bank, in these earlier posts and will be analyzing some additional factors now with some current examples to emphasize my point.

Key factors
Return on equity – This is a critical factor in analyzing a bank. A high ROE is good and low is bad – right? It’s not completely black and white. Other factors being equal (which are listed below), a high ROE is good. However this number has to be looked at in context of CAR (capital adequacy ratio) and quality of assets (NPA number). Most of the top banks such as HDFC, Axis etc have an ROE in excess of 20% or higher.

An additional number to look at in conjunction with ROE is ROA (return on asset). A number in excess of 1.3% is generally good.

CAR – This is the ratio of equity to risk weighted assets. The RBI has a guideline on the minimum CAR ratio for a bank and if the CAR ratio falls below this number, then the bank has to either raise equity or reduce the assets (read loans) to get the number in line with the guidelines. You can think of this number as fuel for growth – higher the number, higher the amount of loans which the bank can make. In addition a high number also enables the bank to absorb loan losses.

The CAR number for most of the banks has improved in the last few years and banks like HDFC, Axis , Karur vyasa bank (KVB) etc have CAR ratios of around 15% (v/s statutory number of around 9%)

Net or Gross NPA – This number points to the amount of bad loans (interest over due by 90 days) on the bank’s books. A low number is always good. An NPA number (net NPA) of more than 4% is alarming and points to a considerable amount of bad assets. In addition, one can expect the bank to take provisions (keep aside some of the profits) to reduce the NPA

This number has dropped considerably in the last few years for most banks and is as low as 0.2% for banks such as Axis, HDFC bank and Yes bank.

Provision / GPA – This is another key factor to look at from an asset quality standpoint. One can look at this number in conjunction with Net NPA. Provision/Gross NPA tells us how much of the bad loans have been accounted for (profits set aside to write off the loans). A 100% number would mean that the bank has set aside the entire bad loan amount from the profits.

The current guideline from RBI is that all banks need to have a minimum 70% coverage ratio.

Borrowing cost – This is the equivalent of raw material cost for a manufacturing company. A low number is always good. A bank is able borrow money via the savings/current accounts of its customer and through bulk deposits. The savings/ current account generally payout a low interest rate and is the best source of low cost funds for the bank.

An associated number to track for the bank is the CASA ratio (current and saving account/ total deposit). A high and growing CASA ratio, means that the bank has a low cost of funds and is growing this source further.

Banks such as Axis bank or State bank of India which have a high CASA ratio, have cost of funds which is as low as 5%. On the other hand the newer banks such as Yes bank which are still putting their retail network in place have a low CASA ratio of around 10% and a much higher cost of funds. One can expect these banks to keep expanding their network and drive down their cost of funds .

NIM (net interest margins) – This is the difference between the borrowing costs and the lending rate. A higher number is good, but upto a point. A number much higher than industry average can be risky as the bank may be lending to risky borrowers (real estate developers, brokers etc) and may face bad debts at a later date.

This number has seen an improvement in the last few years to around 3% levels for most banks due to a combination of reducing loan losses (NPA) and improvement in cost ratios (operating costs)

NII (non interest income) – This is the non lending type income – think of it as the icing on the cake (in some cases a lot of icing). This includes income from investments (in bonds and government securities), brokerage/ service income from distribution of financial products, income from derivative and forex contracts etc.

There is almost an unsaid assumption, that NII is good and higher the NII, better the quality of the earnings. I don’t agree with this assumption. I prefer to look at the composition of NII. If the non interest income is through trading or through gains in the value of investments, then the quality and sustainability of the earnings is not high.

Next post : More ratios and some non financial factors and how to look at them to develop a composite picture of the bank.


VIKAS KUKS said...

Nice compilation of all the factors and their effects. A substancial article.

Manjunatha said...

Hi Rohit

Very good article.I think most of the Indian Banks are very sound in all these key factors compared to the Banks in West.

Thanks & Regards

Vic said...

Thanks Rohit.

Wow!! Quiet a few parameters for evaluating a bank..:-)

Good to see such level of detail.



JK said...

Hi- One more value investing based blog-

Do visit & share your feedback. Thanks.

Rohit Chauhan said...

Hi vic
there is another post lined up with even more factors :) ..but all these factors are to be looked at together to form a composite picture of the bank/ financial instution


Rohit Chauhan said...

i guessed that your blog has been influenced by prof bakshi. hopefully you will be able to keep posting on it regularly

btw, agree with your triveni analysis - have invested in the arb deal ..though remains to be seen if it will work out


Anonymous said...

rural electirifcation corporation, a financial institution ,trading at low pe ratio
your thoughts about this stock ?

ashu said...

Thanks Rohit for an Informative post as usual,

Looking at SBI numbers yesterday, would you agree that factors one needs to look at while evaluating PSBs are way too different and more complex than private banks. I mean they have provided hefty sums for things like gratuity and pension etc. we dont really expect an ICICI or HDFC to do it or do we??

Also chairman Pratip Chadhury said that Net NPAs in SBI were "Structurally" different than PRivate or other players and cant be wished away. Did he mean to say SBI's risk appetite is lot more different than others??

Kindly clear the confusion.

Thanks again

anurag said...

Dear Rohit,

Despite severe correction across all sectors,you have not posted any investment idea?.


JK said...

Hi Rohit.. Thanks for comment about the blog.

Also what's your view on SBI with more than 10% correction after those 4Q numbers?

Rohit Chauhan said...

hi ashu
i have not looked at SBI's numbers closely, but i think the under-provisioning of pension and other costs have been known now for a few years.
I think the banks are now being forced to acknoledge those costs. at the same time i am not worried about these costs ..they are a one time write off all the older banks have to do now.
I have a bigger concern on the asset quality - for all banks. the asset quality seems to be good for everyone as the economy has been good ..but if we have 1-2 yr slow down, the NPA will rise

due to this factor, it is important to select a conservative bank in the long run


Rohit Chauhan said...

hi anon
never looked at the stock. any key reasons beyond low PE on why you like it ?


Rohit Chauhan said...

Hi anurag
why do call it a severe correction...i see at best a 10% correction since the begining of the year with midcaps at best 15-20% correction from the peaks. there are some attractive ideas, but it is definitely not bargain season yet


Rohit Chauhan said...

need to look at SBI's numbers, plan to do so soon to see why the drop happened ?


Anonymous said...

hi sir,
other reasons for looking at the rural electrification stock is
-high cagr
-high net profit margins
-seems underrvalued

the only problem is their major customers are state electricity boards,which are in bad financial positions...ultimately which can cause loan defaults

Anonymous said...

i am eagerly waiting for the second post on banks to come :)