In this article I will take you through the basics of a bank’s balance sheet.
Why should an investor consider banks?
Good bank stocks can be great wealth creators. For example, HDFC Bank stock traded at Rs. 45.65 (after adjusting for corporate actions like splits) in Dec 2000. Today it trades at around Rs. 690. This works out to a compounded annual return of around 23%.
When you look at stocks it is good to see the demand in the sector first. Next you can look at the competitive positioning of different companies in that sector.
In an under-banked country like India, the banking sector has miles to go before we see saturation.
A bank is very different as compared to a manufacturing or services business. This is also why banks are studied separately along with typical parameters and ratios which you might not see in a company from outside the banking and non-banking financial company (NBFC) sector.
A bank is an intermediary which channels money from depositors and lends it to individual and corporate borrowers. It makes money on the spread between what it pays to depositors and what it earns when it makes a loan (also may be called as an advance). In the last decade we have seen the rise of “fee income” apart from the core income on loans. It now makes up a relatively large portion of a bank’s income as compared to a decade agao. Examples of fee income could be money earned because of late fees on credit cards and loan processing fees respectively.
I will take ICICI Bank’s balance sheet as an example for discussion.
ICICI Bank’s balance sheet
|Assets||Rs. In cr.||%||Liabilities||Rs. In cr.||%|
|Investments||1688||30.0%||– Equity capital||12||0.2%|
|– SLR||986||17.5%||– Reserves||719||12.8%|
|– Equity Investments in Subsidiaries||120||2.1%||Deposits||3090||54.8%|
|– RIDF and related||229||4.1%||– Savings||935||16.6%|
This data is taken from the September 2013 disclosures of ICICI Bank.
Assets in a bank’s balance sheet
Cash is self explanatory.
SLR stands for Statutory Liquidity Ratio. SLR is prescribed by the Reserve Bank of India. A bank is expected to hold a certain ratio (presently 23%) of their Net Demand and Time Liabilities (NDTL) in approved securities like government securities, cash or gold. I suggest reading this link by IDFC MF on Net Demand and Time Liabilities to understand NDTL better.
Investments – SLR covers investments made into approved securities towards the SLR requirement.
RIDF stands for Rural Infrastructure Development Fund which is set up by the Government of India. Banks are expected to deploy money towards the RIDF to the extent they lend less towards agriculture as compared to mandated lending requirements.
Advances – This is the most important heads on the asset side. This talks of the core business of a bank. This is also called the loan book. Banks report the breakup of their loan book by borrower type (retail, small and medium enterprises (SME) and large corporates). They also usually report the sector-wise breakup of their loan book.
Fixed assets broadly covers the money spent to develop the bank’s branch network and corporate offices.
Liabilities on a bank’s balance sheet
Net worth is the shareholders’ capital in the bank. This is also called as the book value of a bank. As is the case for any business in general, a shareholder would like to see a growing book value year on year. This is what is left if one subtracts all the other liabilities from the assets side.
Deposits is a key item in the liabilities. This is part of the core business of intermediation of capital – borrow from depositors and lend to borrowers. Deposits are broadly of three kinds.
- Savings accounts – Depositors receive 4% or higher. Recently the RBI has deregulated savings bank account interest rates and we have seen some banks offer rates of around 6% which is 50% more than the 4% that depositors would receive earlier. Money in savings accounts can be withdrawn at any time. It does not have an associated time period.
- Current accounts – Used by companies. A bank does not pay interest on current accounts.
- Others – Fixed deposits and the like where depositors receive higher interest than a savings bank account. They have a definite time period and usually there are penalties in place for premature withdrawal.
Borrowings are made up of bonds, debentures and certificates of deposit where the bank borrows money of varying tenor.
One should look at the deposits and borrowings from the perspective of respective interest rates and corresponding cash inflow and outflow for the bank. If you were the owner of a bank you would like to pay the least amount of money on your deposits and borrowings.
CASA – Current account, savings account
CASA is a commonly used parameter that is used to understand the amount of liabilities that the bank pays relatively less interest on. The higher the amount of CASA as a percentage of total liabilities, the lesser will be the interest paid by the bank.
Investors should look at the CASA numbers carefully, as CASA is a source of strength for the bank. For example, ICICI Bank is considered to have a comparatively healthy CASA percentage.
|Deposits||Rs. In cr.||%|
The CASA deposits add up to around 43% of their total deposits.
Non-performing assets – NPA
Basically, NPAs are advances made by the bank on which borrowers are not paying interest payments or principal repayments on time. The RBI has standards for NPA classification that dictate when a “standard” bank loan becomes an NPA.
An advance can become an NPA and come back on track too.
On recognition of an NPA the bank has to make “provisions” which are deducted from the income. This is to account for the probability that the money lent out might not come back. I will discuss more on this in the next in the bank analysis series when I cover profit and loss statements for banks,
In the last 1-2 years, we have heard of the NPAs in the banking system and the fact that they are rising to dangerous levels. In this regard, you might want to read an address by Dr. K. C. Chakrabarty, Deputy Governor, Reserve Bank of India at BANCON 2013.
Why should an investor look carefully at NPAs?
Let us look at the leverage in a bank. What is the indebtedness?
Think of debt to equity ratios in a manufacturing company for example. If D/E ratio goes above 1, investors get cautious. Figures above 1.5 indicate cause for worry.
Now, consider the debt to equity ratio in a bank.
Look at ICICI Bank’s leverage.
I add the Deposits and Borrowings together and get a figure of Rs. 4544 cr.
Divide this by the Net Worth of Rs. 731 cr and we get a D/E ratio of 6.2.
If you have not seen a bank balance sheet before this will seem shocking. This would never be seen in typical manufacturing companies. Not even in normal infrastructure or project finance cases which can see high debt equity ratios of 3:1.
This is the reason why banks are regulated by the central bank, the RBI. They operate with very high leverage as compared to companies in other industry sectors.
Any company operating with high leverage usually has less room for error. Leverage is a double edged sword. It can give you high returns or high losses. All banks live by this rule.
So, we come back to the NPA issue.
Consider the balance sheet shown above. Suppose that 2% of the advances on this balance sheet go bad and end up as NPAs because the borrowers cannot make payments to the bank.
2% of Advances works out to around Rs. 64 crore. This seems like a small amount. Let us compare this Rs. 64 crore to the shareholders capital in the bank, also the book value. Book value stands at Rs. 731 crore.
2% NPAs work out to 8.7% of ICICI Bank’s book value or net worth.
You will now appreciate that the NPA numbers in the headlines seem low. When you re-frame the context as damage to book value you get the true picture.
Presently, the banking sector is facing stress as a slowing economy puts pressure on borrowers, with some defaulting. Private and public sector banks are seeing rising NPA levels. PSU banks are comparatively harder hit as they are widely believed to have deficient lending standards as compared to their private sector counterparts.
This recent article in the Hindu Businessline talks of the problem of rising bad loans.
If there is a hole in the balance sheet, it has to be filled. One way it can be filled up is with the profits left after paying dividends. In bad times profit growth reduces so it does not help the situation to a great extent.
The other usual way is to raise equity capital.
This dilution is a big risk to a bank investor. The earnings now get distributed over a larger number of shares and thus earnings per share (EPS) is affected negatively.
A bank that has bad loans and attendant capital problems cannot grow its loan book as well as healthy counterparts. This is because they face regulatory pressure.
This brings us to the next topic.
Capital Adequacy Ratio
The Basel reforms stipulate that a bank should maintain adequate capital against its assets. This is because banks are systemically important institutions. If one bank sees trouble, contagion spreads in the financial system because of the financial inter-linkages. We have seen this happening in the 2008 credit crisis in the global economy.
The regulator places different types of assets in different buckets depending on how risky they are. Different buckets have different risk weights to quantify the risk.
For example if the bank has parked money in Government Securities they are given zero risk weight. Check the risk weights set by the RBI for housing loans.
In ICICI Bank’s case, as of the quarter ending of September 2013, their risk weighted assets (on balance sheet and off balance sheet) are Rs. 4971 crore.
The total capital (calculations based on RBI stipulated rules) as of September 2013 stands at Rs. 820 cr.
Capital adequacy ratio (CAR) is total capital divided by total risk weighted assets. This works out to 16.50% as of September 2013.
Take CAR to be a sign of relative safety. The RBI stipulates that the CAR should be at least 9%.
Bad loans bring down the CAR of a bank reducing room to grow advances. As an investor you will want the bank to have a high capital adequacy ratio.
ICICI presentation on September 2013 results
You can download the presentation released by ICICI Bank after they released their September 2013 results.
You can also visit the ICICI Bank Investor Relations page. In the Quarterly Financial Results page, read an analyst call transcript and read the management’s talk about the company’s results. Get familiar with banking terms and issues.
Read the next article and understand a bank’s income statement (or profit and loss statement) in in the series on understanding bank stocks. After that I will write an article in which I will describe how to look at the complete financials of a bank and how to value banks.
Hope you had a good time reading this article on bank balance sheets. Let me know your views.