Saturday, October 31, 2009

A primer on Analysis of Banks – Part 1

Recently I had a chat with one of my fellow junior..He asked me what is the significance of ratios like “D/E , Accounts payable , Accounts receivable ratio” for a bank…I had to elaborate what we learnt in Commercial bank management course in about half an hour…Here is the summary of our discussion

Function of a bank: Every organization has some reason for its existence. They benefit the owner, his relatives and to a certain extent a society at large..But the existence of banks is driven by the societal motive (Not that every owner wants to do it so, but the very design of a banking system makes it so!!)

If I want to put in simple terms the role of a bank is to borrow money from who have surplus and lend it to somebody who has deficit. This very definition of the bank makes its financial analysis different from companies in all other sector..

D/E ratio does not have any significance: How often have we heard analysts cribbing about the fact that the D/E of the company is almost reaching 1 which is a danger sign..But have we ever thought about the D/E of a bank..It’ll be approximately 10-12..Thats a very big number..It means the owner has put around 8 rs from his pocket and has borrowed 92 rs from outside..

As I have already said this is the business of a bank..They borrow it at a cheaper rate (through the deposits – fixed, floating …inter bank borrowings, borrowing from other agencies, borrowing from RBI) and lend it at a little higher rate..Hence they make a profit margin out of this transaction.

So can a banks always borrow and lend (with no money of its own) : Luckily there are stringent regulations (??!!) concerning the amount the owner of the bank needs to infuse in order to be complaint . We call it the capital adequacy ratio. Capital adequacy ratio, in simplified terms , is the amount of equity that a bank needs to hold given its balance sheet size..Now the Basel II regulation for banking assigns risk weights according to asset subclasses and according to the risk weighted assets you have to maintain a capital..and this ratio has to be atleast 8%...Let me clarify risk weight with an example..If the bank lends out to a AAA borrower like Infy it entails a risk weight of 50% meaning if he gives out loan of 100 rs to Infosys then the bank need to have 4 Rs(8/2) as equity capital..In the same way if it lends a housing loan , which entails 150% risk weight then it has to maintain 12 Rs(8*1.5) for every 100 Rs of loan it lends out..With every default that happens it is the equity capital which absorbs the losses..Hence if the equity capital goes below zero then the bank is said to be bankrupt(even if the bank might have 90% of its good loans still in the market)..

P/E ratio will also be closer to one: Turn into any newspaper and the first ratio that an analyst speaks about is the Price earnings ratio of a company..I was surprised yesterday to see a company with a P/E of 800..A company quotes at a P/E at such high levels because of the expectations of its future earnings..It means that the assets in the balance sheet of the company are worth much more than what is quoted..But if we observe for a bank it’ll be closer to 1..This is because of the fact that the bank has just interest income and interest expense..Hence there is nothing which is being quoted at a wrong value..All the assets and liabilities are quoted at proper values in the balance sheet(I don’t want to confuse you with the HTM , AFS , HFT concepts)..

Hope the part 1 has brought in some clarity..I will discuss some of the major risks faced by a bank and concepts like VAR in the part 2….

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