How to Analyze a Bank or Financial Service

Bank  or Financial Service posses an enviable position in the global economy . Because the service that a bank provide is so vital to long term economic growth, the banking industry is almost certain to grow inline with world total output , no matter which sector generates grater need for capital.

Business Model :- The banking business model is simple it receive money from depositors and capital market and lend to borrower, profiting from the difference. The revenue of a bank comes from mainly two operations interest income and non interest income.

•  Interest Income (NIM):- The difference between the money earn as interest from the borrower and money spend as interest to the depositor or capital market.
•  Non Interest Income :- Some basic fees that the bank charge to it's customer for providing different services.

This summaries the bank or financial service business model.

Relation with Federal Reserve (RBI)  :- Federal govt has all but given the keys to the liquidity kingdom to banks by essentially subsidizing banking industry. Bank can effectively borrow at below market rate from Federal Reserve if it face any short term liquidity crunch. That also make this industry low cost safest producer of liquidity of the world. Few parameters you need to know to understand this relationship.

• Repo Rate :- 

Definition: Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation.

Description: In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

The central bank takes the contrary position in the event of a fall in inflationary pressures. Repo and reverse repo rates form a part of the liquidity adjustment facility.

• Reverse Repo Rate :- 

Definition: Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest.

Description: An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.

• Cash reserve Ratio (CRR) :- 

Definition: Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. The RBI uses the CRR to drain out excessive money from the system.

Description: Scheduled banks are required to maintain with the RBI an average cash balance, the amount of which shall not be less than 4% of the total of the Net Demand and Time Liabilities (NDTL), on a fortnightly

• Statutory Liquidity Ratio(SLR) :-

Definition: SLR or statutory liquidity ratio is the minimum percentage of deposits that a bank has to maintain in form of gold, cash or other approved securities. It is the ratio of liquid assets (cash and approved securities) to the demand and term liabilities / deposits.

Description: RBI is empowered to increase this ratio up to 40%. An increase in SLR restricts the bank's leverage position to pump more money into the economy, thereby regulating credit growth.

Risk :- The heart and soul of banking is centered on one thing : risk management. Bank accept three type of risks.(1) Credit, (2) Liquidity & (3) Interest Rate & they get paid to take on this risk. But this ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan losses grow faster than expected.

• Managing Credit Risk :-To examine this risk we first have to had some idea of few parameter which is readily available in the balance sheet & they are :-
• NPA(Non Performing Loan) :- These are the loans on which borrowers are not paying.
• Charge Off Rate :- It measures the percentage of loans which the banks thought will never be repaid. 
• Delinquent Loan :- Loan made against an individual which can not be diversified. i.e. either you earn the entire interest rate or loose everything.
• Portfolio Diversity :- Bank can either originate a wide variety of loan to the large borrower or buy and sell loan portfolio to manage the credit risk.
• Conservative underwriting and account management :- It is the way of writing off any bad loan and aggressive collection mechanism is in place also a proper credit rating check and background check for the borrower.
• Analyzing the credit quality :- To understand the credit quality of a bank one must analyze the charge off rate and delinquency rate , which are seen as an future charge off . Look for the trend not just the absolute level. In an economic downturn the charge off rate may rise quickly but they must remain fairly low in terms of loan[less than 1%].
• Credit culture :- Types of loan bank used to give and it's collection process.
• Managing Liquidity :- To examine this we have below factors as discussed ..
• Low cost core deposit :- Check weather low cost core deposit like Savings and Current accounts are growing or not? If deposit is declining over the years it means management is not performing well.
• Entry to a new segment of loan portfolio :- Check if the bank has entered into a new riskier loan portfolio or not on which they have not had good experience. Like a traditional home loan or gold loan bank have turned into a much riskier auto loan portfolio or not?
• Factoring :- Selling of receivables to some financial services at a discount which also can worked as an Economic moat.
• Managing Interest Rate :-  
• Selling the Loan :- Check if the bank have the capability to access the capital market to pass the buck by letting investor purchase the loan(much like a bond) and assume the interest risk.
• Repositioning Balance Sheet :- Repositioning balance sheet from one sector to another depending on operating environment is also a good idea to balance the Interest Risk.
• 4 factors that control interest rate :- Banks are supported by 4 elements (1) Interest income, (2) Interest Expense, (3) Non Interest Income, (4) Provision for loans. Say if rate cut happen [in an under performing economy]then interest expense might go down but the provision fro loan loss will increase hence it virtually balance the interest rate. So we have to look at the balance sheet transformation of Liability sensitive from Asset sensitive one.
• Conservative accounting :- As discussed earlier we must look into the bank accounting policy and it should be liability sensitive than to asset sensitive i.e. interest rate on liability grow much faster than interest rate on asset.

Economic Moats :-

• Asset growth :- Balance Sheet must have quality number of asset by value compare to it's peers and it's growth rate should be high.
• Economic Scale :- Big banks and financial service with much higher asset is able to generate better revenue [based on ROA comparable]. It has been observed that larger player will able to generate better revenue per employee than the smaller player. They are also better in squeezing their customer asset for more revenue (primarily through fees).
• Market Oligopolies :- Larger market capitalization with diversified presence in all geography makes a strong economic moat for the banks.
• Customer Switching :-   Nominal customer attrition rate is mandatory for a Bank and more often than not it has seen that people are not keen to switch their bank account much due to lots of process and troubled involved with the service they are getting from the bank and quite acquainted with it just because of some higher interest rate.

 Hallmarks of Success for Banks :- The entire business it's strength,opportunity is built on risk it's a good idea to focus on conservatively managed institution that consistently deliver solid but not knockout profits.

• Strong Capital Base :- One must look at the higher equity to asset ratio and also look for a high level loan loss reserve relative to NPA.
• ROE & ROA :- High level ROA (upper than 1.2) coupled with high ROE is a good parameter to judge the bank but witl low ROA even if ROE is high you must reject it.
• Efficiency Ratio :- It measures non interest expenses or operating cost as a percentage of net revenue. Lower is better(generally lower than 50% is good).
• Net Interest Margin :- The difference between the money earn as interest from the borrower and money spend as interest to the depositor or capital market. Generally a high NIM is good but it also depend on type of loan the bank used to provide i.e Credit card interest is higher than general mortgage but it is very riskier as well.
• Strong Revenue :-  As NIM varies widely on the economic factor hence it is important to see fee income as a percentage of revenue and fee income growth. Higher is always better.
• Price to Book Value :- Considering all other factor any bank trading at less than 2 times of it's book value is a good buy. The reason behind considering the P/B ratio is to judge the asset quality of the bank compare to it's current value and this ratio coupled with ROA & ROE is very important.

Key Ratios :-

• yield on advance
• cost income ratio
• fee income/asset
• NPA
• Leverage
• ROA
• ROE

SWOT Analysis Framework :-

• Strength :-

1. Easy & Fast appraisal &  disbursement ?
2. Product innovation & superior delivery ?
3. Strong market penetration & increased in operating efficiency ?
4. Collection efficiency ?

• Weakness :-

1. Too much diversification from the core business ?
2. Increased regulatory coverage ?
3. No access to SATFAESI or DRT for recovering from bad loan and no asset to refinance ?
4. Volatile business environment ?

• Opportunity :-

1. Large unprotected market both rural, urban & also geographically ?
2. Tie up with global financial giants ?
3. New opportunity in credit card, personal finance, home equity etc. ? 

• Threat :-

1. High cost of funds ?
2. Restriction on deposit taking NBFCs ?
3. Growing retail thrust within the banks and competition from unrecognized money lender ?
4. Significant slowdown in economy affecting various segments of NBFC ?
5. Deterioration of asset quality & rising levels of NPA ?

Few more things :-

• What is loan disbursement ? 

Loan disbursement is the process of giving money to the lender. The growth in this parameter means loan growth and provision of income growth.

• What is cost of fund ?

The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one of the most important input costs for a financial institution, since a lower cost will generate better returns when the funds are deployed in the form of short-term and long-term loans to borrowers. The spread between the cost of funds and the interest rate charged to borrowers represents one of the main sources of profit for most financial institutions.


Now all these things might looks very confusing but checking some banking stocks might be very easy and you can get conviction on it. e.g. When Rakesh Jhunjunwala buy DHFL it had Rs 230 book value, 6 percent dividend yield, 4 times earnings, growing at 20 percent for the last ten years, available at Rs 105.
Consider this example the price of the stock was 105 and it's book value is at 230 with 20% growth rate for last 10 years so it is a no brainer stock. More over it was having 6% div yield which is just exceptional and was available at 4 PE. If you still can not make you conviction right simply look at the economic moat like financial leverage and all and calculate the DCB & risk value. That will do enough for you.

Along with it if you are willing to compare with other housing finance stock then check three parameter apart from PEG 1. (Sales Turnover/Market Cap) * 100 and 2. (Net Profit/Marke t Cap)*100 3. (Total Asset/Market Cap)*100