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Industry Analysis: Banking – Part 1

First a warning – Banking is not within my circle of competence. This post is an attempt to put forward whatever little I have studied and know about this industry. It’s now upon you to build on the same and learn more about how this industry works.

About Banking
Wikipedia defines a bank as…

…a financial intermediary that accepts deposits and channels those deposits into lending activities, either directly by loaning or indirectly through capital markets. A bank links together customers that have capital deficits and customers with capital surpluses.

Banks have come a long way from the temples of the ancient world, but their basic business practices have not changed.

Banks issue credit to people who need it, but demand interest on top of the repayment of the loan. Although history has altered the fine points of the business model, a bank’s purpose is to make loans and protect depositors’ money. Even if the future takes banks completely off your street corner and onto the internet, or has you shopping for loans across the globe, the banks will still exist to perform this primary function.

Now, due to their importance in the financial system and influence on national economies, banks are highly regulated in most countries.

Most nations have institutionalized a system known as fractional reserve banking, under which banks hold liquid assets equal to only a portion of their current liabilities.

Prior to the Industrial revolution, the currencies were actually pegged against equal amount of gold, which was held by the issuing central bank; this was like; for every currency denomination present in the market, there was an equal amount of gold held by the issuing central bank (RBI is India’s central bank, or the ‘bank of banks’).

With the advent of Industrial revolution and resultant money multiplier effect, there was huge need for liquidity infusion in the market. Fractional currency reserve can be considered to be a response to this phenomenon.

Anyways, in addition to other regulations intended to ensure liquidity, banks are generally subject to minimum capital requirements based on an international set of capital standards, known as the Basel Accords.

About Indian Banking
The concept of borrowing money in India is as old as the Vedic period (beginning 1750 BC). Later during the Maurya dynasty (321 to 185 BC), an instrument called adesha was in use, which was an order on a banker desiring him to pay the money of the note to a third person, which corresponds to the definition of a bill of exchange as we understand it today.

In the modern sense, banking in India originated in the last decades of the 18th century. The first banks were Bank of Hindustan (1770-1829) and The General Bank of India, established 1786 and since defunct.

The State Bank of India (SBI) is the largest and the oldest bank still in existence. It originated in the Bank of Calcutta in June 1806, which almost immediately became the Bank of Bengal.

This was one of the three presidency banks, the other two being the Bank of Bombay and the Bank of Madras, all three of which were established under charters from the British East India Company. The three banks merged in 1921 to form the Imperial Bank of India, which, upon India’s independence, became the SBI in 1955.

For many years, the presidency banks acted as quasi-central banks, as did their successors, until the Reserve Bank of India (RBI) was established in 1935.

In 1969 the Indian government nationalised all the major banks that it did not already own and these have remained under government ownership. They are run under a structure know as ‘profit-making public sector undertaking’ (PSU) and are allowed to compete and operate as commercial banks. The

There are broadly two types of banks in India – Scheduled Commercial Banks (SCBs) and Scheduled Co-operative Banks.

Scheduled Commercial Banks are categorised into five different groups according to their ownership and/or nature of operation. These include:

  1. State Bank of India and its Associates
  2. Nationalised Banks
  3. Private Sector Banks
  4. Foreign Banks
  5. Regional Rural Banks

As per the census of 2011, just around 58% of Indian households avail banking services in the country. There are over 102,000 branches of SCBs in India, out of which 38,000 (37%) bank branches are in the rural areas and 27,000 (26%) in semi-urban areas, constituting 63% of the total numbers of branches in semi-urban and rural areas of the country. A significant proportion of the households, especially in rural areas, are still outside the formal fold of the banking system.

How a Bank Works
The primary function of banks is to put their account holders’ money to use by lending it out to others who can then use it to buy homes, businesses, send kids to college.

When you deposit your money in the bank, your money goes into a big pool of money along with everyone else’s, and your account is credited with the amount of your deposit. When you write cheques or make online withdrawals, that amount is deducted from your account balance. Interest you earn on your balance is also added to your account.

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the central bank – the Reserve Bank of India or RBI in India’s case.

Two key mechanisms the RBI uses to regulate the supply of money in the Indian economy are –

  1. CRR or cash reserve ratio is a certain percentage (4% currently) of the total bank deposits that has to be kept in the current account with RBI. This means banks do not have access to that much amount for any economic activity or commercial activity. Banks can’t lend this money to companies or individual borrowers, and they can’t use this money for investment purposes. Also, CRR remains in current account with the RBI and thus banks don’t earn anything on that.
  2. SLR or statutory liquidity ratio, which is at 22.5% currently, is the amount of money (as % of total deposits) that banks have to invest in certain specified securities predominantly central government and state government securities. Banks earn some interest on their SLR investments, unlike CRR where the earnings are zero.


Data Source: RBI

This combination of CRR and SLR is the amount of money which remains blocked for statutory reasons and is not available for investment in various other high earning avenues like loans. While this restricts the resources a bank has in hand to carry on its business, this money also remains safe and with that mechanism the RBI offers safety to the depositors who have entrusted money in banks.

To see how this affects the economy, think about it like this. When a bank gets a deposit of Rs 100, assuming the total CRR and SLR requirement of 26.5%, the bank can then lend out Rs 73.5. That Rs 73.5 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out Rs 54 of that Rs 73.5 deposit (after keeping aside 26.5% of Rs 73.5 as CRR and SLR), and that Rs 54 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.

In this way, money grows and flows throughout the economy in a much greater amount than physically exists. That Rs 100 of original deposit makes a much larger ripple in the economy than you may realize!

How Banks Make Money?
Banks are just like other businesses. Their product just happens to be money. Other businesses sell products or services; banks sell money – in the form of loans, certificates of deposit (CDs) and other financial products.

They make money on the interest they charge on loans because that interest is higher than the interest they pay on depositors’ accounts.

The interest rate a bank charges its borrowers depends on both the number of people who want to borrow and the amount of money the bank has available to lend. As I mentioned above, the amount available to lend also depends upon the reserve requirement the RBI has set.

At the same time, it may also be affected by the funds rate, which is the interest rate that banks charge each other for short-term loans to meet their reserve requirements.

Loaning money is also inherently risky. A bank never really knows if it’ll get that money back. Therefore, the riskier the loan, the higher the interest rate the bank charges.

While paying interest may not seem to be a great financial move in some respects, it really is a small price to pay for using someone else’s money. Imagine having to save all of the money you needed in order to buy a house. We wouldn’t be able to buy houses until we retired!

Banks also charge fees for services like ATM access, overdraft, convenience fees for non-bank ATMs, annual fees on credit cards and other fees and penalties charged to customers. Loans have their own set of fees that go along with them. Another source of income for banks is investments and securities.

To see how a typical bank’s Income Statement looks like, look at the under-mentioned snapshot from HDFC Bank’s latest annual report. You would see that the major income sources for the bank include the interest it earned from several sources like loans, investments, and deposits with RBI, plus commissions and brokerage it earned for certain services. This is also the case with most banks.

Sources of Income for a Bank

Source: HDFC Bank’s FY14 Annual Report

Now, unlike manufacturing or services companies that spend a lot of money on raw materials and employees respectively, the biggest expense for a bank is the interest it pays on its own borrowings (which is its raw material).

As you can see the snapshot below from HDFC Bank’s annual report, almost 65% of its total expenses are in the form of “Interest Expended” on deposits from individual depositors like you and me, borrowings from the RBI and other banks, and other interest.

Key Expenditure Items of a Bank

Source: HDFC Bank’s FY14 Annual Report

Now, if you were to look at the entire Income Statement of HDFC Bank, it looks as small and simple as…

Income Statement of a Bank

Source: HDFC Bank’s FY14 Annual Report

Thus, Net Profit = Interest and Other Income – Interest and Other Expenses – Provisions and Contingencies

Here, “Provisions and Contingencies” include provision for bad loans or expense set aside as an allowance for bad loans (customer defaults, or terms of a loan have to be renegotiated, etc) plus provision for tax.

Two key metrics to look at in a bank’s Income Statement are –

  1. NII or Net Interest Income – This is the difference between the interest income earned by a bank (from borrowers and on investments) and the amount of interest it pays out (to depositors, RBI, and other banks).
  2. NIM or Net Interest Margin – This is calculated as NII divided by the amount of a bank’s interest-earning assets.

NIM is similar to the gross margin of non-financial companies.

For example, a bank’s average loan to customers was Rs 100 in a year while it earned interest income of Rs 6 and paid interest of Rs 4. The NII in this case with be Rs 2 (Rs 6 – 4), and NIM will be 2%, calculated as (Rs 6 – 4) / Rs 100.

Let us understand NII and NIM using HDFC Bank’s Income Statement and Balance Sheet.

As you can calculate from the bank’s Income Statement above…

NII = Interest Earned – Interest Expended = Rs 41,136 crore – Rs 22,653 crore = Rs 18,483 crore

Now, consider the Assets side of the bank’s Balance Sheet and calculate the average interest-earning assets…


Source: HDFC Bank’s FY14 Annual Report

As per the above numbers, the average interest-earning assets for HDFC Bank equal Rs 421,075 crore.

Thus, NIM = Rs 18,483 crore / Rs 421,075 crore = 4.4%


Data Source – RBI;
Old Private Sector Banks include – City Union, ING Vysya, J&K, Karur Vysya, South India, etc.;
New Private Sector Banks include – Axis, HDFC Bank, ICICI, IndusInd, Kotak, and Yes


Source: RBI

Here are the NIMs of leading Indian banks for the year ended March 2013, as I have calculated using the reported Income Statements and Balance Sheets sourced from the RBI’s website.

Source: RBI

NIM is not a measure of a bank’s total profitability, since most banks also earn fees and other non-interest income from providing services, like brokerage and deposit account services, and it doesn’t take operating expenses, like employees and oither operating costs into account.

NIM can be used to track the profitability of a bank’s investing and lending activities over a time period. Like conventional profit margins, wider the NIM, better it is.

Also, comparisons between the NIMs of different banks are not always meaningful since the margin reflects the bank’s unique profile, that is, the nature of its activities, the composition of its customer base, and its funding strategies. No two banks are exactly the same.

On one end of the range, the widest NIMs probably would be found at banks with traditional lending and deposit businesses, that is, those for which loans make up the bulk of their interest-earning assets (loans, especially to consumers, typically have higher interest rates than investment securities and other short-term investments) and banks that fund their interest-earning assets mostly with deposits rather than higher-cost borrowed funds.

In India, such banks include HDFC Bank, which had a NIM of 4.4% (FY14). Loans accounted for nearly 63% of the bank’s average interest-earning assets, and deposits made up the lion’s share of its sources of funds. Against this, ICICI Bank, with an NIM of less than 3% had loans that were just about 57% of its interest-earning assets.

Overall, the trend in the NIM of a bank would give you a quick look at the profitability of its lending and investing activities.

Porter’s Five Forces Analysis
Porter’s Five Forces Analysis provides a “competitive forces” framework that allows us to better understand the different dimensions that govern competition within an industry. Porter’s five forces are –

  1. Competitive rivalry;
  2. Threat of substitutes;
  3. Bargaining power of buyers;
  4. Bargaining power of suppliers; and
  5. Barriers to entry and exit.

Let us use Porter’s framework to analyse the Indian banking industry…

The above figure depicts the five competitive forces that shape the Indian banking industry. As you can see…

  • Competitive rivalry in the industry is high;
  • Effect of substitutes is rising;
  • Buyer power is moderate;
  • Supplier power is high; and
  • Entry/exit barriers are high.

To be continued…



Key Documents
1. Income Statements of Indian Banks (Source: RBI)
2. Balance Sheets of Indian Banks (Source: RBI)
3. HDFC Bank’s FY14 Annual Report
4. About Banking Industry (Wikipedia)



Let me know your feedback on my above analysis of the Banking industry, which is the first of the two part analysis I will do on this industry.

Also, if you know of something important important about the Banking industry, which I missed in my analysis above and should cover in the second part, please suggest in the Comments section below.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. thank you so much vishal. great analysis and very very useful. the explanation is simple and effective. looking forward to 2nd part. some of the things that I am interested to see in 2nd part : why PB is considered over PE for valuation. how equity dilution is good or bad for the business. how to assess the quality of earnings and book. what would be a good strategy for provision coverage. what are the statuatory provisions for various categories. will you cover NBFCs also or is it a separate topic.

  2. Harsh Punjabi says:

    A couple of points on How Banks make money…There are 3 sources of Banks income..Interest on Loans which the Banks receive, Fee Based Income & Treasury income (income from Investments that the Bank makes with RBI & other investment avenues open to them which are either regulated by RBI or by their own internal Investment policies).

    Also a couple of more metrics to look at:
    1. NPAs (Non performing Assets): Loans which are not recoverable primarily. This also relates to the Asset quality (the kind of loans Banks have in their portfolio)
    2. Capital Adequacy ratio: Some banks keep higher than the required Capital adequacy requirements to have a Margin of safety which also means that they earning with lesser resources on hand.
    3. Ratio of Operating vs Treasury income, i.e. Sum of Interest income & Fee based income/Treasury income. The Higher a commercial bank relies on Treasury income the more stagnant portfolio it has.

  3. A great article Vishal, it covers good topics for someone to understand the overall structure of banking and its economics. It would be very helpful if you can shed some light on banks “off-balance sheet” activities. They usually consists of forward and swap contracts, bank guarantees, endowments etc. The whole lot that falls in this category goes under contingent liability shown as cumulative notional sum. This is where it becomes very hard to evaluate the risk associated with these derivative contracts. On one hand the notional number is so big (usually 10 times bigger than the actual advances made by the banks) that cannot be ignored for potential black swan incidents and on other hand we need to be realistic while evaluating them

    So how do we incorporate “off-balance sheet activity” while valuing a banking stock since basic valuation tools like P/B or P/E may not give a realistic picture due to the amount of leverage a bank carries

  4. My compliments on simple yet power packed article on Banking Industry in general. My question relates to Investment Banking side and the income thereof. Where do this income figure in Banks P&L. My understanding is Investment Banking, Prop Trading and such arm of Banks are most profitable per employee wise.

  5. See here.

  6. Thanks for all your articles. Apart from points written by Bala. I would like to understand effect of leverage, CASA, CD ratio on NIM and ROE. Also want to understand more about restructured loans, CAR, NPA etc.

  7. Vishal,

    There are certain misconceptions regarding the way banks conduct their operations and if you permit me, I would like to provide more clarity on the same. There are a couple of myths that I’d like to dispel:

    1. Myth 1: A bank collects deposits and channels those deposits into lending activities.
    Fact: Banks do not lend out deposits but instead create credit. The loan is created first and the money is then deposited into the borrower’s account. Therefore the truth is that loans create deposits and not vice-versa. The extension of credit is responsible for the increase in our total money supply and the repayment of these loans leads to a contraction. If deposits create loans, there would be no increase in the total money supply.

    2. Myth 2: The money multiplier measures the maximum amount of commercial bank money that can be created for given unit of central bank money. The theory states that if the required reserve ratio is 10%, then for every Rs. 100 (monetary base) created by the RBI which then enters the commercial banking system, banks will initially lend 90 {100*(1-10*)}, then 81 {90*(1-10%)} and so on till the total money supply becomes 1000. The formula provided is: {monetary base i.e. 100 in our case} / {Required reserve ratio i.e. 10%}.
    Fact:Commercial banks are not at all constrained by the reserve requirement and the money multiplier does not exist in practice. As mentioned before, whenever a bank lends money, it first creates a loan and then a corresponding deposit. Central banks don’t constrain the amount of bank reserves they supply. Rather they supply whatever amount of reserves that the banking system demands given the reserve requirements and the amount of deposits that have been created. The true constraint on commercial bank lending is the ability of banks to find profitable borrowers. This is not determined by the central bank by fixing the quantity of reserves but by setting interest rates on those reserves which then serves as a benchmark for all investment / lending decisions.

    3. Regarding CRR, I believe it is used to meet the demands of customers who may want to withdraw some cash from their bank accounts.

    • Karl,

      I do not understand what are you trying to say in Myth1/Fact1.
      Suppose bank gives loan of Rs 100 and then try to create deposit of Rs 100. And is ultimately not able to create deposit of RS 100. From where bank is going to pay Rs 100 to the person who has taken loan of Rs 100?

      • Jigyasu,

        The bank that a borrower has taken a loan from has created money “out of thin air” to lend to the borrower. The bank is not lending any spare funds that it has. When the customer signs a loan agreement, the bank then creates money and deposits it in the borrowers account. They call this process credit creation. This created money is deposited into the borrower’s account. I suggest you read the document in the link below to gain a better understanding of the money creation process.

        • Slight correction to my point above. For the sake of clarity replace “customer signs a loan agreement” with “borrower signs a loan agreement”.

  8. paran saikia says:

    Hi Vishal, I don’t have much knowledge or experience to add anything substantial to your writings (master-pieces these are, already) but in the present scenario of banking, what i feel the most important statement an investor should look for is the DCB (Demand-Collection-Balance) statement that depicts the real picture of the cash inflow against the demands created. Now the real problem is, the whole amount of demands created during a financial year is shown as income for the bank in the PL statement and that is exactly why common people like us never gets to know what the exact situation of the cash inflow. I think DCB is a quarterly or monthly statement but not publicly available. As for NPA management, there are two things important to notice, one is NPA recovery and other is NPA reduction. A bank can deceive the investors with NPA reduction figures which can be misleading as this includes the assets upgraded from non-performing to performing. I mean to say, when the bank say that NPA reduction is of one crore, they mean that they have recovered that amount out of one crore, recovery of which has enabled them to remove the whole sum of one crore from NPA and this amount recovered may be one lac or 20 lac. Therefore, I personally favour hearing “NPA recovered” than “NPA reduced” from the Bank’s end. Please rectify my points if anywhere I have gone wrong. I am just a learner in this vast world of investing. Regards.

  9. vivek gupta says:

    Hi Vishal,
    This is a really nice post on banking industry. It is the one of the kind I have been looking for.

    BUT WHERE IS THE 2nd PART.

    Am I missing it on the site or it is not yet out.

    Regards,

  10. Dear Vishal,

    Thanks for the great article. I am eagerly awaiting the 2nd part.

    Thanks/ Best regards
    Mhaisale

  11. Hello Vishal,

    The article is really wonderful. Learn so many things about Banking industry. Thanks a lot. Can you please share the part 2 with us.

    Thanks & Regards,
    Niradhip Chakraborty

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