Tuesday, 16 April 2013

Some More Banking Concepts for Investors

We have already dealt with some of the concepts needed to know about banking sector in our post on Fundamental Parameters of Banking. We continue to give some more concepts here to understand banking better so that we are in a good position to evaluate before in any good banking sector stocks.

The income and profit of banks depend on two things.
  • Advances that are lent to various borrowers in different economic sectors eg. corporate loans. 
  • Gross NPA that it carries on its books. 
These two signify the quality of assets which generate interest income for banks and is the core business of any bank. As the economy grows, the advances also increase to cater to the needs of a growing economy.

The ideal situation for any bank is to have source of funds that carries low liability cost which, in turn will be beneficial to the Net Interest Margin. However, in a rough economic situation with tight liquidity in the system, banks will be subjected to high interest costs which will reflect in high lending rates of banks. No bank can be isolated from these effects of high interest rate regime which is generally the reflection of the broader state of the economy. In these times, those banks which control their NPA along with growth in their advances reflect their tight oversight, cautious approach and good business tactics.

Now for the parameters which help us estimate the business strategy of various banks based on the above points.

Net Interest Spread :

It is the difference between the average lending rate for interest earning asset and average cost of total deposits (liabilities).
(total interest income / income generating advances) - (interest expense / total deposit)
given on percentage basis.

CASA Ratio :

Current and Savings Account (CASA) is the cheapest source of funds for banks.  It forms a substantial percentage of total deposits in any bank. CASA ratio is the ratio of deposits in CASA funds to the total deposits in a bank.

Stable to high CASA Ratio leads to stable net interest margin.

Operational Income :

It is the total of net interest income and income from other sources.

Interest income comes from the advances lent by the bank to various borrowers and from investments.

Other income comes from fees and other processing charges that the banks levy on its various services.

Growth of a bank is invariably linked to growth in advances in a growing economy.

Cost Income Ratio :

It is the ratio of operating expense to the operating income of the bank.

Fee Income Ratio :

It is the ratio of income from fees to the operating income.

Return on Asset :

The definition of RoA is slightly different for the banking sector. It is the ratio of profit after tax to the total interest generating assets. This is a reflection of the quality of assets that the banks have and also reflects the control on the NPA.

There are many other parameters, ratios and figures which are used while comparing banks, but the above concepts coupled with those mentioned in the Fundamental Parameters of Banking are sufficient to give a good insight to an investor to compare different banks and invest in some good stocks in this sector.