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Thursday, December 8, 2011

Understanding how do banks work-some FAQs for investors

The inspriration for this post came from the fact that banks are difficult to understand, and even more difficulty to invest in. For this, I referred publicly available documents like RBI master circulars, NCFM banking sector module(http://www.nseindia.com/content/ncfm/ncfm_bsme.pdf) amongst others.
  1. What does a bank do? The basic functions are intermediation and payment services. Any other services like advisory etc are icing on the cake.
  2. What do investment banks invest in? They do not themselves invest(atleast thats not an essential attribute) but act as an intermediary between issuers and investors, for which they can often get fees/commission from both
  3. Why do banks eventually become conglomerates offering A-Z financial services? Though banks claim that this allows them to service the customer better/have all services under one roof, the real reason in my view is the benefit of cross selling, economies of scale and the wider scope for knowledge management. For example, a commercial bank may have an excellent knowledge base on some industries, which can be leveraged into good research reports for the investment banking/broking arm. Or the same online banking platform can be used as single sign on login to give the customer access to other services, without incremental customer acquisition cost. And more the products per customer, the higher should be the customer retention rate. 
  4. Explain the CAMELs model to evaluate a bank's performance: This model is implicitly used without acknowledging in many banking analyst research reports, but I notice that they often miss out on the liquidity and asset quality aspects, which came back to haunt the sector in the later part of 2011, with power sector NPAs, defaults in farm loans/student loans, more CDRs etc, all culminating in the downgrading of some banks by the credit rating agencies. Anyways, CAMEL is
    1. Capital Adequacy;-This is a measure of financial strength, in particular its ability to cushion operational and abnormal losses. It is calculated based on the asset structure of the bank, and the risk weights that have been assigned by the regulater for each asset class. Post the subprime crisis, I think we should give bonus for "Too Big to Fail"
    2. Asset Quality:-This depends on factors such as concentration of loans in the portfolio, related party exposure and provisions made for loan loss
    3. Management:-Management of the bank obviously influences the other parameters. Operating cost per unit of money lent and earnings per employee are parameters used. In Indian context, I think implicit government guarantee for PSU banks, is a +ve here.
    4. Earnings:-This can be measured through ratios like ROA, ROE, NIM
    5. Liquidity:- In order to meet obligations as they come, the bank needs an effective asset-liability management system that balances gaps in the maturity profile of assets and liabilities. However, if the bank provides too much liquidity, then it will suffer in terms of
      profitability. This can be measured by the Loans to Deposit ratio, separately for short term, medium term and long term.
  5. What does financial inclusion imply for bank business models? It means that if the banks want to open more branches in metros/cities, they better focus on the unbanked. This is over and above their 30% lending requirement to priority sector
  6. Basel III/Volcker rules:-A classic example of bolting the stable after the horse has escaped. It makes banks hold more capital, measure risk more conservatively, cap their pay and a whole host of measures to ensure banks bear some of the costs they impose on others. This debate is clouded with acronyms and technicalities, but that is the essence of it. To avoid regulatory arbitrage, major financial centres should implement these measures consistently, and that is what holds up the implementation of these rules.
  7. What differentiates NBFCs from banks? They do not have access to cheap bank deposits from the public (in the form of savings account, current account etc.although they can accept fixed deposits. Their cost of funds being higher than banks, their lending is costlier.
  8. Why do people borrow from NBFCs at costlier interest rates? Because they are unable to mobilise funds from banks, or to fund their requirements beyond what banks would give. NBFCs are particularly active in consumer finance and personal finance, as they are flexible, have laxer credit standards, and often give higher loan to value ratio on secured asset financing(cars etc).
  9. What are scheduled banks? Banks which meet specific criteria are included in the second schedule of the RBI Act, 1934. These are called  scheduled banks. They may be commercial banks or co-operative banks. Scheduled banks are considered to be safer, and are entitled to special facilities like re-finance from RBI. Inclusion in the schedule also comes with its responsibilities of reporting to RBI and maintaining a percentage of its demand and time liabilities as Cash Reserve Ratio (CRR) with RBI.
  10. Why this whole debate on government stake in PSU banks falling below 51%? Other sector PSUs do see this. Even in other sectors, the privatization debate is kicking and alive as the respective sector ministry sees the PSUs as their turfs to implement populist policies, promote loyalists and generally display their power. In banking, while the finance ministry(the owner) itself favours divestment, others do not because that would reduce the power of government and politicans to direct PSUs on lending, CSR etc. For example, no private sector bank would have given Kingfisher Airlines such a long rope as SBI had given, some attribute this to the political influence of the owners. Even industrialists prefer PSU banks for their riskier loans! Of course, the arguments against this are couched in terms of valuation, affecting financial inclusion etc.
  11. Why SBI has not merged with its subsidiary banks? There are labour issues because the main SBI staff have better terms of service than those of the subsidiary banks, and hence integrating the workforces is an issue. This issue had cropped up in AI-IA merger also.
  12. How big are Indian banks versus global banks? Not very big in terms of assets. But then, they are more profitable and 'safe'.
  13. Where do I get reliable data on the Indian banking sector? The RBI releases reports and statistics on the sector, which can be downloaded from its website. For example, the FY11 reports are available at this link. Generally, Mint and other financial newspapers analyze those reports on the day of/soon after their release.
  14. Why are voting rights per shareholder capped at 10%, what would this imply for the valuation? Well, the RBI and other financial sector regulators do not want economically important entities like stock exchanges, banks, insurers etc to see concentration of ownership. Hence, the 10% rule leads to broadbased ownership. While there is no study on what is the valuation impact, one could argue that the voting stake beyond 10%, should be modeled as a Differentiation Voting rights share with economic benefits w/o voting rights! That model would invariably lead to a discount. 
  15. What is this whole financial inclusion furore? Thanks to challenges of geography, income inequality, logistics, technology etc, it is not practicable to profitably operate one branch in each of India's 600000 villages. Instead, it is proposed to use para banking(MFIs, banking correspondents, NBFCs) and  existing retail outlets( post offices, village knowledge kiosks) as outlets, use multi-language technology platforms via mobile phones etc. An unsaid fear is that while moneylenders can counter populist politician calls to voters of not to repay loans, banks constrained by the code of conduct and slow legal process, are helpless in the event of such political interference, which brought the MFI industry in Andhra Pradesh on its knees. 
  16. What are priority sector lending norms? Why does that encourage specialized institutions like MFIs and gold loan companies? The RBI currently mandates domestic commercial banks operating in India to maintain an aggregate 40.0% (32.0% for foreign banks) of their adjusted net bank credit or credit equivalent amount of off-agriculture, small enterprises, exports and similar sectors where the Government seeks to encourage flow of credit for developmental reasons. Banks in India that have traditionally been constrained or unable to meet these requirements organically, have relied on specialised institutions, better positioned to or focus on originating such assets through on-lending or purchase of assets or securitised pools to comply with these targets.
  17. What are the larger implications of the sector? Money talks bigtime. One of the obstacles cited for slow growth of organized retail/farm credit etc, is that farmers are indebted to the traders/landlords/rich farmers for their personal loans/crop loans, and are thus compelled to sell their produce to them for lower rates, and buy inferior inputs at higher rates. It is hoped that micro loans and rural credit will break the financial dependence of small farmers. Once this is done, one can explore reforms like rural warehouses for grains, retail reforms etc.
  18. How do many big banks manage to release their audited accounts before even a month elapses from year end? Thanks to the multiplicity of audits(concurrent, internal, inspection, RBI inspection, systems), the bank internal control systems are generally current. And the existence of core banking and sophisticated internal control systems ensures that the records are reasonably uptodate. That is why balance sheet audit of just test checking major accounts balances/revenue streams is in vogue.
  19. Non fee income:-More is better as it insulates a bank from the competition induced squeeze on NIM. But if these profits come from derivatives trading, then the quality of earnings may actually be lower and thus the bank riskier! Unfortunately, few banks disclose the true extent of their non fee income dependence on such activities. 
Phew! that ended a longish post. Depending on the response and my time constraints, I'll follow this up. 


Michelle said...

Why do we feel better about having our money in a bank than we do having it on our wallet? Will bank lending criteria be easier if you have big savings?

Anandh Sundar said...

@Michelle-not very sure what you meant by that comment. Besides the interest explanation(and perhaps that keeping money with banks saves you from theft/robbery), can't think of anything else. and about lending criteria easier for those with savings, maybe as that reflects one's credit worthiness

Apoorva Kumar said...

It had been very difficult time for to understand how bank works. My father taught me about it and then I could able to open my first account in HCBL bank. Thank you for writing this awesome post.

Best Regards,
HCBL Bank - Yeh Bank Zara Kuchh Khaas Hai