May 23, 2011

Evaluating banks - More factors

In the previous post, I covered several important variables in analyzing a bank. These factors are a good starting point in evaluating a financial institution, but they are not sufficient to arrive at a conclusion.

I am listing several additional criteria I consider personally, when analyzing these kinds of companies. Some of these factors are commonly used by other analysts, whereas some are of interest to me (even though others don’t care about them)

Growth – This is one of the top criteria used by a majority of the investors. A high growth trajectory (in deposit and advances) throws most analysts and investors into ecstasy. As some of you have realized, I like growth, but I am not a big fan. For most businesses, a moderate growth (between 12-15% per annum) is usually more sustainable, attracts lesser competition and provides good returns over the long term.

In the case of banks and other financial institutions, I am almost allergic to high growth. Financial institutions are highly leveraged institutions (read high debt) and as a result, a focus on growth can result in shaky loans which can haunt it in the future.

Take the example of ICICI bank – Don’t get me wrong on this one. I
invested a miniscule amount in the bank IPO way back in the 90s and exited in the mid 2000s.I liked the bank service then (in late 90s the service was actually good!) and liked the way it was conducting its business.

However by mid 2000, the loan growth started increasing and my personal experience (and that of a few friends) of their underwriting standards (criteria to give you a housing or other loan) left me worried. They were much more lax in their standards than other banks. The bank has since then, slowed down its asset growth and is trying to work through its bad loans.

The key point of this story is this – An above average growth is good (though it does not guarantee conservative lending), but a high growth in a bank is a risky proposition. It may all work out in the long run, but I will not bet big on it.

Cost ratios
There are two costs ratios i look at closely when analyzing a bank or financial institution. The first one is borrowing costs, which I covered in the previous post. The other one is the operating cost ratio for the bank.

The operating cost ratio covers all the overheads of the bank such as salary for the employee, branch opening expenses, pension costs etc. I would prefer a downward trend in this number, unless the bank is expanding its network and is incurring the associated costs.

The new private banks such as Axis bank, which are expanding rapidly have an operating cost ratio in the range of 22-24%, where as the older private or public sector banks have this number in the range of 16-18%. I would expect the number to stabilize in this range for most banks as they expand their retail network and the growth slows down.

Credit deposit ratio
This is another important ratio to track. This is the ratio of deposits gathered by the bank to the amount lent out as loans. The RBI guideline is that this number should not exceed 75%. So if you see the number inching to 75%, the bank may have to resort to bulk deposits which are more costly than retail deposits - which means lower spreads and thus lower margins

In case you have a sneaky feeling that your bank is able to take a deposit at 7% from you and lend at 12% and make a nice spread on it – you are right. Banks have a nice thing going with its customers (you and me) – where they get money on the cheap and also charge money for all the other services they provide to us.

Yield on assets
One of the last commonly used ratios is the yield on assets – the return the bank makes on all the loans and other investments. I would like to see a high number, but too high a number could mean risky loans which could hurt the bank profits in the future.

So what is a high or low number? There are no absolutes here. The best option is to compare it across banks and get sense of this number. Currently, the average seems to be around 9.5-10%.

Let’s now look at additional factors which are not commonly followed

Contingent liabilities
I have yet to find a single report which talks of this. So what are contingent liabilities?

Think of these as possible costs, under certain circumstances (such as a particular level of interest rate changes) and hence they are called contingent. If you look at the balance sheet of a bank, all the open derivative and other contracts are included under this number.

For example, this number is around 3.2 Lac crore (yes not a typo) for axis bank which around 2 times their asset base. In a similar fashion this number has ranged between 3-4 for Yes bank and is as low as 25% for public sector and old private banks.

So whats the significance of this number? Does it mean a Yes bank or Axis bank is liable for 2 their total asset value (or 20 times networth ?).

The key point to remember is that these contingent liabilities are a notional value (total contract value) and not the amount which the bank would make or lose on these contracts. The amount which the bank can lose or gain is also provided in the notes to account.

If your head is hurting on hearing some these terms such as notional amount, derivative etc – I will not blame you. I cannot do justice to these topics in the post – you can easily Google it and find out.

The key point to remember is that contingent liabilities are off balance sheet risks (remember Lehman brothers and other investment banks ?). In good times, these derivatives help the bank in making money and are a nice source of ‘other income’ (the stuff which analysts like). However, if the market crashes or something nasty happens, then these contingent liabilities can kill the bank.

Does it mean Axis bank and Yes bank are risky banks ? Frankly I don’t know and an outside investor cannot evaluate the derivative book of a bank. However if you just use common sense in this case, a 25% ratio of contingent liability to asset (as in case of KV Bank) is definitely less risky than a 400% ratio in the case of Yes bank.

If you look at this ratio, the performance of several of the new gen, aggressive banks will make you pause and think

Other contingent liabilities
If you think, I have something against private banks, that is not the case. Public and old private banks have their cockroaches in their kitchen. These banks have pension and gratuity liabilities which have not been provided for. The RBI guideline requires the banks to provide these liabilities in phases and hence we are seeing the impact of these provisions on the results of the banks ( for ex: SBI in Q4).

I am however less worried about these kind of liabilities as they are not open ended and will be provisioned by the banks in the next 2-3 years.

No. of branches and ATM etc
I also like to track the growth in the number of branches, ATM and employees. The raw numbers alone are not enough. One also needs to look at the quality of the expansion – Is the bank expanding in clusters or is it making a thrust into the rural areas (which is good in the long term , though could hurt profits in the short term)

Technology adoption
There are no numbers for this factor. You have to read the annual report for the bank for the last few years and get a sense of how the bank is investing in the technology aspect of the business. Is the bank at the forefront of technology adoption or is it a few years behind the curve ?

Another easy way is to go to a local branch and see if you can get the various services such net banking, anywhere access etc from the bank.

Asset liability profile
Another data point which can be found in the notes to account. This table gives an indication, on whether the bank is exceedingly funded by short term deposits alone. It’s difficult for me to cover this topic in this post, but as a quick pointer – Higher the longer duration deposits, better the risk profile ( remember the term asset liability mismatch ? – if not, please look it up if you plan to invest in a bank)

We now come to a very important and the most difficult factor to evaluate. These are no numbers or tables to evaluate the bank’s management, but if you read the annual report and follow the management, you will get some sense of it.

For ex: Axis bank, ICICI and Yes bank have aggressive management which is looking at growing the bank on both the retail and lending side. HDFC has an aggressive management, but it is also very risk conscious. There are several old private sector banks, which have conservative managements which are growing the banks at a nice pace and with low risk.

Finally we have the public sector banks, where the management is essentially government deputed officers and so it’s difficult to get any picture as such banks (though in some cases there have been individuals who have done well, but then they are posted to some other institution)

Are you exhausted :) ?

We have looked at all the factors which can be used to evaluate a bank. There is unfortunately no mathematical rule to combine all these factors. One has to put all these parameters together and come up with a composite picture of a bank. I will take an example or two in the subsequent posts to evaluate some banks.


VIKAS KUKS said...

deeply digged writeup...thanks for the insights :)

Anonymous said...

HI Rohit

Just to correct you on the point on contingent liability. Pls note that not all contingent liability is on account of derivative exposure .a lot of it has to do with what is called as transaction banking (LC etc). This is actually a very high quality revenue and is a flow based fee business which is actually a indicator of high performance.

The post is really excellent !

Amit Mehta

Anonymous said...

This was exhaustive analysis .. As a banker I can not tell you that most important in any bank's b/s is quality of accounting as any Bank/FI/NBFC in lending business, profit is more of accountant's imagination. Even minor changes in NPA provisioning can make profit into loss.. look at SBI current chairman's action seems to be admission that previous loss provisions were fudged and if that is for govt banker you can't even imagine what goes on in private listed banks despite all the charade of internal, external, rbi audits
And all indian private bank's B/S are hopelessly fudged. I can only tell you that having worked in this industry for more than a decade I am absolute certain that I will never buy a bank stock.
For all those who want- best of luck

ms420 said...


Kudos for a great write up on various factors you have listed. Unfortunately most broker reports don't even cover 5% of the factors you have discussed. I wonder how knowledgable or dalaal street traders or institutional investors regarding these check parameters. More power to you!

sagar said...


I follow your blog and always wait for the next one :)

Have you looked at Rural electrification. It has negligible NPA and is available at low valuation. Risk is , its loans are concentrated on state electricity boards and they are making losses.I'm not sure how to measure this much do you think there is a chance of default from SEB's ? In worst condition do you think government can come for rescue ?

vinayak said...

Dear Rohit
Could you please throw some light on ALM(Asset Liability Management ) in banks ? I mean how do they accept deposit up to 10 yrs max & lend up to 30 yrs ?
Also I have herd banks can convert Rs 100 deposit into Rs 1000 loan ? How does it happen ?

7 regards


Anonymous said...

"...banks can convert Rs 100 deposit into Rs 1000 loan ? How does it happen ?"

Rohit Chauhan said...

hi vikas
thanks for the comment

hi amit
thanks for the input. i was not aware of the transaction banking ..though i knew that banks issue LC, but the balance sheet typically does not give a breakout of it


Rohit Chauhan said...

Hi anon
i agree there is a bit of cooking of the books ..but thats true for almost all businesses. on the contrary we atleast have RBI doing some monitoring. The NPA's are definitely higher than what we see, but that does not mean i will write off all the banks as an investment - that would mean throwing the baby out with the bath water


Rohit Chauhan said...

hi ms
thanks for the comment. brokers are in the business of making you churn the portfolio ..they dont have to provide good research ..just need u to buy/sell


Rohit Chauhan said...

Hi sagar
i have not looked at rural electrification. I dont think SEBs will default ..but i am pessimistic. its like the oil industry ..companies will not make money till the goverment fixes the sector and as a result the investor will suffer


Rohit Chauhan said...

hi vinayak
converting 100 Rs to 1000 as loan is called fractional banking as anon has pointed out.

banks generally borrow short and lend for longer duration. they do that as most customer keep renewing deposits on an ongoing basis - when they dont do that - we have a bank panic which can cause the bank to collapse