Understanding the Banking Business Part – II

In last blog, we got to know about the basics of Banking Business like how banks generate revenue, what are the sources of Funds, the importance of Asset Quality. In this blog we will discuss regulatory ratios a bank has to maintain, return ratios, and lastly How to value a bank.

Banking is a leveraged business and leverage is a double-edged sword. It is important to keep in check and oversee banks operation to make sure that they don’t get involved in risky activities, endangering their solvency status. In India, RBI is the regulatory body that oversees Banks and NBFC.

What are the Regulatory Ratio that a bank has to abide by?

1. Capital Adequacy Ratio (CAR)

It is a measure of how much capital a bank has available as a percentage of its Risk-weighted asset. It acts as a cushion to absorb losses and helps in maintaining stability in the financial system.

Higher the CAR, the better capitalized the bank is. The bank has less risk of becoming insolvent and losing depositor’s money. In India, as per the RBI norms, Indian-scheduled commercial banks are required to maintain a CAR of 9 per cent, while Indian public-sector banks are required to maintain a CAR of 12 per cent.

2. Liquidity Coverage Ratio (LCR)

It is required that banks must hold an amount of high-quality liquid assets (HQLA) that’s enough to fund cash outflows for 30 days over the stress period. HQLA are those assets that can be easily converted to cash like G-Sec. It is a preventive measure that helps the bank to stay afloat during periods of stress.

Generally, LCR > 100% is considered good.

Apart from the ratios discussed above, there are other regulatory requirements that a bank has to abide by. However, these two are considered to be most important ones. Now we will understand how to look at return ratios in a bank.

What are the Return ratios to look for in a bank?

1. Return on Assets (ROA)

Return on assets implies how profitable a bank is relative to its total assets. In other words, how effectively banks are employing their assets to generate earnings. Higher the ROA, the better.

ROA is impacted by many underlying factors making it vulnerable to manipulation. We can understand factors affecting Return on assets through ROA TREE given below:

One should understand how each factor is impacting banks ROA to get a better picture. For example, Banks can earn Higher NII by taking excessive risk, however it can translate into higher credit cost leading to reduced overall profitability.

It is necessary for banks to balance NII, Operating expenses and credit cost in a way to generate maximum profitability.

2. Return on Equity (ROE)

It is a measure used by shareholders to measure their return on investment. ROE can be calculated by dividing Net profit by its Net Worth. Another way to calculate ROE is by multiplying ROA*Leverage (Assets/Equity).

Banking being a leveraged business, Higher leverage can lead to better return for shareholders but one should keep in mind that leverage is a double-edged sword.

After covering so many aspects to understand and analyze in a bank, it becomes important to know how to value a bank from investing point of view.

How to value a bank?

To value a banking business, Price-to-book (P/B) is the most acceptable tool, as Bank’s assets and liabilities are marked to market representing a true picture.

Book value = Assets – Liabilities

P/B = price of share/Book Value of share

To get an overall perspective, look at P/B along with ROE. As ROE captures return on asset and leverage elements which P/B misses out. If a bank has high ROE and a low P/B relatively, we can say the bank is undervalued.

Now, we have come the to end of the understanding banking system series. For our precious readers, lets run through the important factors again.

  1. What are the sources of funds for banks and how do they generate Revenue
  2. What is the Profitability and Return ratios
  3. Importance of asset quality
  4. Important Regulatory ratios banks have to abide by
  5. How to value a bank relative to its peers

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