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The financial services sector has been giving a great impetus to the Indian economy, as it accounts for 60 per

cent of the gross


domestic product (GDP) wherein the financial services segment has been a major contributor. Financial services industry mainly
includes banking, financial services (like broking, mutual funds) and insurance and hence, is majorly referred as the BFSI industry.
The Indian Banking, Financial Services and Insurance (BFSI) industry has retained global investor confidence with due diligence even
in the toughest of international climate; thanks to its conventional approach and strong fundamentals. Regulators such as the Reserve
Bank of India (RBI), the Insurance Regulatory and Development Authority (IRDA), Association of Mutual Funds in India (AMFI) and the
Securities and Exchange Board of India (SEBI) formulate policies which are well in alignment with the Government regulations and
objectives.
Insurance Sector
The Indian insurance sector has 24 life insurers and 27 general insurers.
According to data released by IRDA, first year premium of the life insurance companies grew by 1.4 per cent during April-May 2012,
wherein the first year premium (combined of the public and private sector insurers) during April-May, 2012 stood at Rs 12,428.83 crore
(US$ 2.25 billion), up from Rs 12,253.44 crore (US$ 2.21 billion) during the same period a year ago. A total of 40, 46, 777 policies were
enrolled during April-May, 2012.
The gross premium of non-life insurance companies during April-May (2012-13) expanded by 18.27 per cent to Rs 11,387.32 crore
(US$ 2.1 billion) from Rs 9,627.91 crore (US$ 1.74 billion).
Banking Services
The Rs 64 trillion (US$ 1.16 trillion)-Indian Banking industry is governed by the Banking Regulation Act of India, 1949 and is closely
monitored by RBI.
According to the RBI's 'Quarterly Statistics on Deposits and Credit of Scheduled Commercial Banks', December 2011,
Nationalised Banks, as a group, accounted for 52.1 per cent of the aggregate deposits, while State Bank of India (SBI) and
its associates accounted for 21.9 per cent. The share of New Private Sector Banks, Old Private Sector Banks, Foreign
Banks, and Regional Rural Banks in aggregate deposits was 13.9 per cent, .8 per cent, 4.5 per cent and 2.9 per cent,
respectively.

Regarding gross bank credit also, Nationalised Banks held the highest share of 51.2 per cent in the total bank credit followed
by SBI and its associates at 22.5 per cent and New Private Sector Banks at 13.8 per cent. Foreign Banks, Old Private Sector
Banks and Regional Rural Banks had relatively lower shares in the total bank credit at 5.2 per cent, 4.8 per cent and 2.5 per
cent, respectively.
Another statement released by RBI revealed that banks' credit grew 1.2 per cent in April-June 2012, while deposits expanded
by 1.9 per cent. The RBI projects credit growth at 17 per cent and deposit growth at 16 per cent in 2012-13.
India's foreign currency assets (FCAs) grew by US$ 1.17 billion to US$ 256.95 billion for the week ended June 29, 2012
which incremented foreign exchange reserves by US$ 1.36 billion to US$ 289.992 billion. The value of gold reserves
increased by US$ 0.17 billion to US$ 25.76 billion during the same week.
Mutual Funds Industry in India
The Rs 6.70 trillion (US$ 121.25 billion) Indian mutual funds (MF) industry has 44 asset management companies (AMCs). Recent data
released by AMFI indicated that average assets under management (AUM) rose by 4 per cent during the first quarter of 2012-13
wherein the industry added over Rs 27,389 crore (US$ 4.96 billion) to mark the asset base at Rs 6,92,180 crore (US$ 125.28 billion).
HDFC Mutual Fund maintained its pole position as the country's biggest MF with an average AUM of Rs 92,625 crore (US$ 16.76
billion), followed by Reliance MF, ICICI Prudential, Birla Sunlife MF and UTI MF.
Private Equity (PE), Mergers & Acquisitions (M&A) in India
PE companies invested around US$ 1,848 million across 102 deals during April-June 2012 quarter, according to a study by Venture
Intelligence, a firm that keeps a record of PE investments and M&A activities in India. Among the sectors, IT & ITeS attracted highest
PE investments worth US$ 379 million.
Another report by Grant Thornton India has revealed that the total value of M&A transactions in the first half of 2012 stood at US$ 24.6
billion wherein internal mergers and restructuring accounted for deals worth US$ 15 billion. Key M&A deals during January-June 2012
include the HSBC-RBS deal, Piramal's Group acquisition of Decision Resources Group, US and Mitsui Sumitomo Insurance's
investment into Max New York Life Insurance.
Foreign Institutional Investors (FII) in India
According to data released by capital market regulator SEBI, total FII investment in 2012 (till July 13, 2012) stood at US$ 9.82 billion
wherein US$ 1.3 billion were infused during the first two weeks of July itself.
The foreign fund houses also infused US$ 309 million in the debt market in July 2012 taking the overall net investments by FIIs into debt
markets to US$ 4.32 billion in 2012 (till July).
As on July 13, 2012 the number of registered FIIs in the country stood at 1,754 while the total number of sub-accounts was 6,358.
Recent Developments
With an aim to enhance financial inclusion in the North-Eastern circle of India, SBI has decided to open 56 'ultra small
branches' (USB) across five districts in Assam in July 2012. The bank plans to complete 100 such USBs by July 31, 2012
and eventually convert all SBI customer service points into USBs in a phased manner.
SAP India has recently launched its Private Equity Advisory Council in the country through which it intends to use its global
experience and expertise for Indian PE firms and help them materialise their investment objectives through information
technology (IT) solutions.
Insurance sector regulator IRDA has given its nod to Mumbai-based company Liberty Videocon General Insurance to
commence its operations in India. The joint venture (JV) between the Videocon Group and the US-based Liberty Mutual
Insurance Group will start with an initial capital of Rs 300 crore (US$ 54.27 million).
Government Initiatives
In order to boost retail participation in sovereign debt, RBI had allowed direct access to bond holders in the Annual Monetary and Credit
Policy for 2012-13. To further enhance the participation, it has launched the web-based platform at www.ndsind.com which is being
supported and run by the Clearing Corporation of India Limited (CCIL). Retail participants can now manage their Government bond
holdings directly and can also initiate trade in the secondary market through the web portal.
Qualified foreign investors (QFIs) have been granted permission to invest in those mutual funds (MF) that hold at least 25 per cent of
their assets (either in debt or in equity or in both) in infrastructure sector pertaining to the current US$ 3 billion sub-limit for investment in
mutual funds related to infrastructure.
Apart from that, RBI has also enhanced the FII investment limit in Government securities (G-secs) by US$ 5 billion to US$ 20 billion with
a view to curb rupee depreciation and improve the market sentiment. The Government has further rationalised the terms and conditions
(pertaining to lock-in period and residual maturity) for the scheme for FII investment in infrastructure debt.
Road Ahead
FIIs are betting high stakes on Indian equity markets and are positive about the news that Dr Manmohan Singh, the Prime Minister of
India, has taken additional onus of the finance portfolio. Investors are hopeful that he would take steps to further boost the economy.
Considering such sentiments, experts project that investment by overseas investors would cross US$ 10 billion-mark in 2012.
The Indian BFSI sector is poised to grow tremendously owing to rising personal incomes, corporate restructuring, financial sector
liberalisation and the growth of a more consumer-oriented, credit-oriented culture. Being the second-fastest growing economy in the
world, India is leveraging on the monetary expansions made in the west.
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The major future trends to watch out for are:
1.Retail banking will be immensely benefited from the Indian demographic dividend. Mortgages to grow fast and will
cross Rs 40 trillion by 2020:
Mortgages typify the retail banking opportunity in an economy. The total mortgages in the books of the banks have
grown from 1.5 percent to 10 percent of the total bank advances, in a period of ten years. The ratio of total
outstanding mortgages, including the Housing Finance Companies (HFCs) to the GDP is currently 7.7 percent. If by
2020, this ratio were to reach 20 percent, a number similar to that of China, we could expect the mortgage industry
growing at an average rate of over 20 percent during the next decade. The outstanding mortgages are expected to
cross Rs 40 trillion which is higher than the entire loan book of the banking industry pegged at Rs 30 trillion.

2.Rapid accumulation of wealth in rich households will drive wealth management to 10X size.
3.The Next Billion consumer segment will emerge as the largest in numbers and will accentuate the demand for
low cost banking solutions:
the income group right below the middle class in the annual house hold income range of Rs 90,000 to Rs 200,000
per annum will be the largest group of customers. These customers will be profitably served only with low cost
business models having low break even ticket size of business. The next decade would witness banks experimenting
with different low cost business models, smaller cost effective branches and new use of technology to serve this
segment profitably.
4.Branches and ATMs will need to grow 2X and 5X respectively to serve the huge addition to bankable
population.Low cost branch network with smaller sized branches will be adopted.
5. Mobile banking to see huge growth and will redefine transaction banking paradigm:
.
6.Banks will adopt CRM and data warehousing in a major way to reduce customer acquisition costs and improve risk
management:
The average number of banking products per customer in India is significantly lesser than the global benchmarks.
There is a significant potential for cross selling amongst all categories of banks in India. Given that cross selling is
highly costeffective as compared to all other means of customer acquisition, banks will adopt CRM strategies
aggressively in pursuit of costeffective business models

7.Margins will see downward pressure both on retail and corporate banking spurring banks to generate more fees and
improve operating efficiency.
8.Banks will discover the importance of the SME segment for profitability and growth and new models to serve SME
segment profitably will be found:
Due to higher risk and lower ticket size, the SME typically get less attention. Banks are yet to create innovative
models to serve SMEs with sufficient and timely credit at the right price. In general, the level of dissatisfaction is
higher on pricing and product range. A further analysis highlights that the dissatisfaction on pricing is higher for the
private sector banks while dissatisfaction on product range is higher for the public sector ones. As the yields in large
corporate banking falls with further deepening of wholesale debt markets, the banking industry in India will find
costeffective ways to serve the SME customers where yields are quite high.

9.Investment banking will grow 10X, driven by demand from corporate for transaction support and capital market
access:
Investment banking will be among the fastest growing segments in the banking industry rising from 4 percent to 7
percent of the entire corporate banking revenue pool. The larger corporate customers expect to demand higher
support for international expansion and mergers and acquisitions over next decade. Further, as the wholesale debt
markets deepen, the larger corporates would avail of advisory and capital market services from banks to access
capital markets. The revenue pool will shift from traditional corporate banking to investment banking and advisory


10.Infrastructure debt will surpass Rs 45 trillion half of which will be on banks books. It will touch the ALM
limits of banks and will require a significant upgrade of banks risk management systems.


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Contribution of Banking&Insurance to GDP=14%
the usual thumb rule is that banking sector growth is 2.5 x GDP growth. So if the economy is growing at 7%, the banking space
should grow by around 17-18%





The public sector banks hold over 75% of total assets of the banking industry, with the private and foreign banks holding 18%
and 7% respectively.
Since 2002, Bankex (Index tracking the performance of leading banking sector stocks) has grown at a compounded
annual rate of about 31%
Indias gross domestic product (GDP) growth will make the Indian banking industry the third largest in the world by
2025. According to the report, the domestic banking industry is set for an exponential growth in coming years with its
assets size poised to touch USD 28,500 billion by the turn of the 2025 from the current asset size of USD 1,350 billion
(2010).
If we look at 5 years historical performance of different types of players in the banking industry, public sector bank has
grown its deposits, advances and business per employee by the highest rate 21.7%, 23% and 21.1% respectively. As
far as net interest income is concerned, private banks are ahead in the race by reporting 24.2% growth, followed by
pubic banks (21.4%) and then by foreign banks (14.8%)
n the last 5 years, foreign and private sector banks have earned significantly higher return on total assets as compared
to their pubic peers. If we look at its trend, foreign banks show an overall decreasing trend, private banks an increasing
trend and Public banks have been more or less stagnant. The net NPA of public sector bank was also significantly
higher than that of private and foreign banks at the end of FY11, which indicates the asset quality of public banks is
comparatively poor. The Capital Adequacy ratio was also very high for private and foreign bank as compared to public
bank.
overall the top private banks have grown faster than that of public banks. Axis Bank, one of the new private sector bank,
has shown the highest growth in all parameters i.e. net interest income, deposits, advances, total assets and book
value. Among public sector banks, Bank of Baroda has been the outperformer in the last five years. Kotak Mahindra
Bank has reported the highest 5-year average net interest margin and currently, it also has the highest CAR
whereas HDFC Bank has the highest CASA, the lowest net NPA to net advances ratio and the highest five-year-
average ROA. On the other hand, Indias largest bank, SBI reported the lowest five-year-average ROA. Currently, it has
the highest net NPA to net advances ratio and the lowest CAR.


Important ratios
FY11 and FY12
(% outstanding as
on)
Mar 25, 2011 Mar 23, 2012
Cash-deposit 6.7 6.1
Investment-
deposit
28 29
Credit-deposit 75 78



four segments of banking activity, namely,
credit disbursement,
deposits mobilisation,
investments

Credit
Credit
Disbursement
(Rs crore)
FY11 FY12
Bank credit
Growth in bank
credit (%)
21.5 17.0
Growth in credit
like instr. (%)
commercial
paper,shares/bo
nds/debentures
8.4 15.7

Disbursement of bank credit registered a clear slowdown from 21.5% growth in FY11 to 17.0%
growth in FY12. While the FY11 growth rate for bank credit crossed the then target of 18% on
account of higher borrowings to meet telecom-spectrum auction payments, this years credit
disbursement has crossed the revised target of 16%
Credit-disbursement this year has been low on account of
Higher costs of borrowings continuing with its monetary tightening stance, the RBI raised repo
rate by 175 bps during FY12
o Banks in a bid to safeguard their bottom-line transmitted this interest burden onto customers.
Evidence of monetary transmission lies in the movement of base rates. Bank base rates at the
beginning of FY12 ranged between 8.25%-9.50% (April 1, 2011), which moved up to range between
10.00%-10.75% as of March 23, 2012.
o Manufacturers as well preferred to remain on the sidelines, keeping financing of working capital
at the minimum necessary level
Shelving of investment decisions weaker global and domestic economic conditions naturally
prompted a postponement of investment and expansion plans thereby lowering demand for credit.
This is visible in the slowdown in the rate of capital formation from 32.5% of GDP in FY11 to an
estimated 31.9% of GDP in FY12.



Deposits
Incremental
Deposits
Mobilisation
FY11 and FY12
(Rs crore)
FY11 FY12
Growth in
deposits (%)
15.9 13.4

Growth in deposits moderated this year from 15.9% in FY11 to 13.4% in FY12, primarily driven by a
decline in both demand deposits and time deposits.

Inflation - time deposits declined, partly on account of high inflation; which has prompted
households to hold greater amounts of cash in hand to meet higher expenses. Hence, there was an
increase in liquidity preference .Additionally, while borrowing rates have increased considerably
during the year , deposits rates have been rather stagnant during the year. This has diminished
incentives in terms of monetary payoffs from savings
Moving towards mutual funds it also appears as though individual investors moved away from
conventional bank deposits and invested in mutual funds. Overall the net investment position of
mutual funds has grown by 39.6% in FY12 over FY11


Investments
Investments by SCBs in Government Securities grew at a rate of 15.7% in FY12 when compared with
8.4% in FY11, on the back of increased supply of government debt through auctions of GSecs, along
with the motive of meeting regular reserve requirements.



Credit cycle + Pension + BASEL III a drag on
ROE

Banks ROE to remain depressed in the coming years due to structural problems
Banks ROE contracted 90bps to 15.1% . ROE is likely to remain under pressure driven by (1)
continued deterioration of asset quality in the near-term; (3) cash infusion to pension fund
required to manage the highly underfunded status of pension plan; and (4) increase in
equity base to meet higher capital requirement under BASEL III.

Indian banking industry entered into a new wave of credit cycle on weakening economy
Indian banking industry entered into a new wave of credit cycle in FY12 due to weak
economic & fiscal scenario (which will prevent govt to come out with another expansionary
policy and increases the risk of crowding out of private invts) and persistent trend of high
imported inflation (which has made RBIs stance on tight monetary policy ineffective as it is
increasingly hurting growth prospects without necessarily containing imported inflation).
As a result, gross NPA rose from 2.3% in FY11 to 2.8% in FY12 & restructured assets up from
2.7% in FY11 to 4.9% in FY12. Given our expectation that asset quality will remain under
stress in FY13, we forecast banks credit cost to remain at elevated levels in FY13.

ROE of PSU banks to decline due to highly underfunded status of pension fund
Highly underfunded status of pension fund will negatively influence the ROE of PSU banks
in the near-term. According to our estimates, PSU banks have a shortfall of Rs. 65,000 cr in
pension fund in FY12, which translates to 20% of networth. Considering large number of
employees retiring over the next 4 years, pension outgo is expected to surge in the coming
years. Consequently, banks would be required to provide cash into pension fund to meet the
liabilities, which in turn would negatively impact banks ROE.

ROE of banks with low core equity to fall by 100-200bps on higher equity requirement
domestic banks will be required to raise equity in the range of 5 trillion over the next six
years to meet BASEL III guidelines. Banks ROE is projected to fall by 80-100bps for every 1%
increase in core equity ratio, if other things remain constant. Given that most PSU banks core
equity ratio is in the range of 6-9%, we believe their ROE is expected to remain under
pressure in the range of 100-200bps on account of higher capital requirement. However,
banks could increase/decrease their lending/ deposit rate by 15-25 bps, increase fee income
or bring in cost efficiency to protect their ROE to fall from the current levels
Prospects

In order to step up agricultural credit the target for bank credit has been increased by Rs 1 trillion to
Rs 4.8 trillion for FY12. Banks have been asked to increase focus on credit lending to small and
marginal farmers. Plus, under the financial inclusion target, banking facilities will be provided to all
73,000 habitations having a population of over 2,000 during FY12. (expansion in villages )

New banking licenses are expected to be issued by the RBI to private sector players. However,
these licenses will only be awarded to certain players meeting strict requirements on the capital,
exposures, and corporate governance front. Lots of players including NBFCs, industrial houses,
microfinance companies etc are all vying for this coveted license.
Technology is also said to be the way forward with India seeing a mobile and internet revolution and more
traditional banks need to accept the same
pillars of focus for banks:
1. Basel III: The Basel III requirements will be a new challenge for Indian banks to meet. As per these international
regulations, banks need to maintain a minimum total capital (including a capital conservation buffer) of 11.5% of risk
weighted assets by FY18. As per RBI estimates, Indian banks would require additional capital of Rs 5 trillion to meet
Basel-III norms by 2018. These projections are based on the conservative assumption that banks will show a
uniform growth of 20% per year. Public sector banks will need an infusion from the government, their majority
shareholder.the Center would need to infuse Rs 900 bn in PSU banks in order to maintain its current shareholding
after the new norms come into force. If it is willing to reduce its stake in these banks to 51%, the burden may come
down to Rs 700 bn. But, this is still a tough task for a government facing twin deficits. Indian banks are currently
adequately capitalized (FY12 CRAR - 14.3%). However as they grow in size more capital would be required.
2. Asset quality deteriorating: The economic slowdown, elevated interest rates and mass restructurings of state
electricity boards (SEBs) and airlines all caused asset quality to sharply deteriorate for the banking sector. State run
banks were the worst affected in this regard. The gross Non Performing Assets (NPAs) of the public sector banks
(PSBs) increased sharply to 3.2% of gross advances at the end of FY12 from 2.3% at the end of FY11. containing
gross NPAs below 2% will also be a huge challenge

3. Falling Net Interest Margins (NIMs): NIMs are a measure of operating profitability of a bank. On account of higher
cost of funds, NIMs reported a decline in FY12. Banking NIMs thus decreased from 3.14% in FY11 to 3.07% in FY12.
This was on account of slower CASA accretion and term deposits (FDs). Accordingly Return on Equity of banks
posted a slight decline from 13.7% to 13.6% during the same period and the Return on Assets stayed constant at
1.1%.
4. Financial Inclusion: It is indeed unfortunate to note that in India 40-45% of the rural populace does not have access
to banking channels. Thus they are forced to borrow from moneylenders at usurious rates. Microfinance Institutions
(MFIs) were established to help plug the gap; however they were also impacted by adverse regulations in Andhra
Pradesh in 2011 and still haven't fully recovered. But yet, the need for the penetration of formal banking into smaller
townships cannot be underscored. India also fares poorly in respect of credit cards, outstanding mortgage, health
insurance, adult origination of new loans, mobile banking, etc. The new challenge for banks would be to cover
villages with a population below 2,000 as well as to expand the scope of the business correspondent model.

Minimum capital ratios (as a % of Risk Weighted Assets) 31-Mar-18
Minimum Common Equity Tier 1 (CET1) 5.5
Capital conservation buffer (CCB) 2.5
Minimum CET1 + CCB 8.0
Minimum Tier 1 capital 7.0
Minimum Total Capital* 9.0
Minimum Total Capital + CCB 11.5
5. Maintaining Credit Growth: managing 18-20% credit growth in light of slowing GDP growth. large industries
such as mining, textile, iron and steel, power, airlines etc are all seeing stress. However on the retail front auto and
home loans are seeing robust growth. Infrastructure financing also remains a challenge as the country needs to build
new roads, ports, airports, etc and repair its aging ones. This requires investments that need to come from the
banking space.


Threat
from new
entrants(L
):
Licensing requirement, investment in technology and branch network, capital
requirements is high.
Bargainig
power of
suppliers(
H)
High during periods of tight liquidity.. Depositors may invest elsewhere if interest rates
fall.RBI is supplier and commands the interest rates.
Bargainig
power of
customer(
H)

For good creditworthy borrowers bargaining power is high due to the availability of large
number of banks.If bank not customer centric ppl can move for services to other
bank..switching cost is low 4 customer.
Rivalry
(H)among
competito
r:
High- There are public sector banks, private sector and foreign banks along with non
banking finance companies competing in similar business segments. Plus the RBI is
planning to issue a few new banking licenses.


Threat of Substitution(M): Customers can always put money somewhere to make a little interests, there
are all kind of bonds, mutual funds, stocks etc. However, the power of check clearing of the banks are
undeniable. All the paychecks, payments goes through some banks to clear. Imagine if there is no banks to
clear checks, then the whole economy will goes in halt


Challenges in Indian Banking:

1)Need for further improving the efficiency
parameters of the I ndian Banks










Financial Ratios:

Capital adequacy ratio (basel1)
Tier 1
Tier 2

Capital adequacy ratio (basel 2)
Tier 1
Tier 2

Credit-deposit ratio

Cost of deposits

Dividend payout ratio

Yield on advances

Net interest margin

Interest income/average working funds(awf)

Interest expenses/average working funds(awf)

Interest spread /average working funds(awf)

Non interest income/awf

Operating expenses/awf

Cost income ratio

Net profit/awf

Returns on assets

Returns on net worth

Returns on average assets


KEY PARAMETERS FOR ANALYSING BANKING STOCKS
Unlike any other manufacturing or service company, a banks accounts are presented in a different manner (as
per banking regulations). The analysis of a bank account differs significantly from any other company. The key
operating and financial ratios, which one would normally evaluate before investing in company, may not hold
true for a bank (like say operating margins). Cash is the raw material for a bank. The ability to grow in the long-
term therefore, depends upon the capital with a bank (i.e. capital adequacy ratio).

Capital comes primarily from net worth. This is the reason why price to book value is important. As a result,
price to book value is important while analyzing a banking stock rather than P/E. But deduct the net non-
performing asset from net worth to get a true feel of the available capital for growth.

Lets look at some of the key ratios that determine a banks performance.

Net interest margin (NIM):
For banks, interest expenses are their main costs (similar to manufacturing cost for companies) and interest
income is their main revenue source. The difference between interest income and expense is known as net
interest income. It is the income, which the bank earns from its core business of lending. Net interest margin is
the net interest income earned by the bank on its average earning assets. These assets comprises of advances,
investments, balance with the central bank and money at call.

NIM = (Interest income - Interest expenses) / Average earning assets

Operating profit margins (OPM):
Banks operating profit is calculated after deducting administrative expenses, which mainly include salary cost
and network expansion cost. Operating margins are profits earned by the bank on its total interest income. For
some private sector banks the ratio is negative on account of their large IT and network expansion spending.

OPM = (Net interest income - Operating expenses) / Total interest income

Cost to income ratio:
Controlling overheads are critical for enhancing the banks return on equity. Branch rationalization and
technology upgrade account for a major part of operating expenses for new generation banks. Even though,
these expenses result in higher cost to income ratio, in long term they help the bank in improving its return on
equity. The ratio is calculated as a proportion of operating profit including non-interest income (fee based
income).

Cost to income ratio = Operating expenses / (Net interest income + non interest income)

Other income to total income:
Fee based income account for a major portion of the banks other income. The bank generates higher fee income
through innovative products and adapting the technology for sustained service levels. This stream of revenues is
not depended on the banks capital adequacy and consequently, potential to generate the income is immense.
The higher ratio indicates increasing proportion of fee-based income. The ratio is also influenced by gains on
government securities, which fluctuates depending on interest rate movement in the economy.

Credit to deposit ratio (CD ratio):
The ratio is indicative of the percentage of funds lent by the bank out of the total amount raised through
deposits. Higher ratio reflects ability of the bank to make optimal use of the available resources. The point to
note here is that loans given by bank would also include its investments in debentures, bonds and commercial
papers of the companies (these are generally included as a part of investments in the balance sheet).

Capital adequacy ratio (CAR):
A banks capital ratio is the ratio of qualifying capital to risk adjusted (or weighted) assets. For example, the
central bank has set the minimum capital adequacy ratio at 10% for all banks. A ratio below the minimum
defined by central bank indicates that the bank is not adequately capitalized to expand its operations. The ratio
ensures that the bank do not expand their business without having adequate capital.

CAR = Tier I capital + Tier II capital / Risk weighted assets

NPA ratio:
The net non-performing assets to loans (advances) ratio is used as a measure of the overall quality of the banks
loan book. Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end
from gross NPAs. Higher ratio reflects rising bad quality of loans.

NPA ratio = Net non performing assets / Loans given

Provisioncoverageratio:
The key relationship in analyzing asset quality of the bank is between the cumulative provision balances of the
bank as on a particular date to gross NPAs. It is a measure that indicates the extent to which the bank has
provided against the troubled part of its loan portfolio. A high ratio suggests that additional provisions to be
made by the bank in the coming years would be relatively low (if gross non-performing assets do not rise at a
faster clip).

Provision coverage ratio = (Cumulative provisions) / Gross NPAs


Key factors that influence a banks operations.

One of the key parameters used to analyze a bank is the Net Interest Income (NII). NII is essentially the
difference between the banks interest revenues and its interest expenses. This parameter indicates how
effectively the bank conducts its lending and borrowing operations (in short, how to generate more from
advances and spend less on deposits).

Interest revenues:
Interest revenues = Interest earned on loans + Interest earned on investments + Interest on deposits with RBI.

Interest on loans:
Since banking operations basically deal with interest, interest rates prevailing in the economy have a big role to
play. So, in a high interest rate scenario, while banks earn more on loans, it must be noted that it has to pay
higher on deposits also. But if interest rates are high, both corporates and retail classes will hesitate to borrow.
But when interest rates are low, banks find it difficult to generate revenues from advances.

While deposit rates also fall, it has been observed that there is a squeeze on a bank when bank rate is soft. A bank
cannot reduce interest rates on deposits significantly, so as to maintain its customer base, because there are
other avenues of investments available to them (like mutual funds, equities, public savings scheme).

Since a bank lends to both retail as well as corporate clients, interest revenues on advances also depend upon
factors that influence demand for money. Firstly, the business is heavily dependent on the economy. Obviously,
government policies (say reforms) cannot be ignored when it comes to economic growth. In times of economic
slowdown, corporates tighten their purse strings and curtail spending (especially for new capacities).

This means that they will borrow lesser. Companies also become more efficient and so they tend to borrow lesser
even for their day-to-day operations (working capital needs). In periods of good economic growth, credit off-take
picks up as corporates invest in anticipation of higher demand going forward. Similarly, growth drivers for the
retail segment are more or less similar to the corporate borrowers.

However, the elasticity to a fall in interest rate is higher in the retail market as compared to corporates. Income
levels and cost of financing also play a vital role. Availability of credit and increased awareness are other key
growth stimulants, as demand will not be met if the distribution channel is inadequate.

Interest on Investments and deposits with the RBI:
The banks interest income from investments depends upon some key factors like government policies (CRR and
SLR limits) and credit demand. If a bank had invested in Government Securities in a high interest rate scenario,
the book value of the investment would have appreciated significantly when interest rates fall from those high
levels or vice versa.

Interest expenses:
A banks main expense is in the form of interest outgo on deposits and borrowings. This in turn is dependent on
the factors that drive cost of deposits. If a bank has high savings and current deposits, cost of deposits will be
lower. The propensity of the public to save also plays a crucial role in this process. If the spending power for the
populace increases, the need to save reduces and this in turn reduces the quantum of savings.

The banking sector plays a very vital role in the working of the economy and it is very important that banks fulfill
their roles with utmost integrity. Since banks deal with cash, there have been cases of mismanagement and greed
in the global markets. And hence, investors need to check up on the quality of management.


Key regulatory developments
impacting Indian banks:

Savings rate deregulation for banks
in I ndia: The RBI has deregulated the
savings rate regime for improving the
transmission of the monetary policy, as
has been observed in peer economies like
Hong Kong. It has also ensured that banks
offer uniform rates across the country
for different slabs they create. As savings
deposit is the source of low cost funds,
competition amongst banks will see an
upward trend in deposit rates and will
adversely impact the net interest margin
for banks with high savings deposit as its
core funding base. While a few private
banks have offered lucrative savings
deposit rates, the public-sector banks as
well as leading private sector banks have
not yet followed suit.
The deregulation of non-resident
(external) rupee (NRE) deposits and
ordinary non-resident (NRO) accounts,
however, has led to severe competition
between banks. As a result, savings rates
have increased by 70-80%, hovering just
below the fixed deposit rates offered.
These accounts have significant and stable
balances, thus ensuring a constant source
of funding.
Savings deposit interest rates do not
necessarily indicate the bank chosen by
customers. However, the prevailing high
inflation and possibility of savings bank
portability may lure the customers to shift
banks for higher rates, as has happened in
the case of the telecom sector

I mplementation of base rate for
lending: This has led to enhanced
transparency in the banking segment, as
banks cannot lend below the base rate to
new borrowers.

Provision coverage ratio (PCR) of
70% mandatory for banks: The RBI
has mandated a PCR of 70% for banks;
this will raise the provisioning
requirements for some banks. However,
the impact is partly nullified by the fact
that technical write-offs can now be
included in the PCR calculation.

Basel I I I guidelines: The RBI has
announced Basel III guidelines for
scheduled commercial banks. Preliminary
estimates show that banks will require
significant additional capital for
implementing Basel III guidelines. Higher
capital and liquidity requirement will
increase the cost of capital, thus putting
the banks at a disadvantage
Relaxation of mobile payment
guidelines: The RBI has removed the
transaction limit of 50,000 INR per
customer per day on mobile banking
and has allowed the banks to decide
transaction limits based on their own risk
perception. This will help the banks to use
mobile banking as an effective alternate
channel for large fund transfers; however,
they have to put strong anti-money
laundering (AML) systems in place.
Issue of final guidelines for new
bank licenses: With the new banking
licences on the anvil, competition in
the banking sector will increase with
new participants and encourage
financial inclusion.
Subsidiary route for foreign banks:
RBI is likely to make it mandatory for large
foreign banks in the country to operate as
wholly-owned subsidiaries, in line with the
international practice, so that the central
bank can have better control over their
working and ring-fence operations in India
based on global developments.
KEY GROWTH DRIVERS:
growth with aggregate deposits and bank credit
regulatory compliance is currently the foremost driver of IT adoption across banking firms
support for growth strategies as internet and mobile banking gain focus. New channel Mobile banking is expected to become
the second largest channel for banking after ATMs
enhanced customer experience for competitive differentiation
creation of new business opportunities by extending reach to the unbanked population.(financial inclusion program)
Rising per capita income(rising disposable income)
High growth of Indian Economy

The seven most important parameters that one needs to look at are Net Interest Income Growth Rate, Total Income
Growth Rate, EPS Growth Rate, Book Value per Share (BVPS) Growth Rate, Return on Assets (ROA), Net NPA to Net
Advances Ratio and Capital Adequacy Ratio


NBFCs analysis:
Concerns:

Regulatory Changes: The Reserve Bank of India (RBI) has introduced guidelines under which bank loans to
NBFCs are not considered priority-sector loans which reduces incentives for banks to lend directly to NBFCs and
will increase the latter's funding costs. These proposed and potential changes could weaken the NBFCs'
profitability and affect access to fresh capital and funding
Further, proposed regulatory changes include revising the NPL definition to 90 days overdue, setting a minimum
Tier 1 ratio of 12% and introducing a liquidity ratio requirement..
Funding Access Could Worsen: The large dependence on institutional/wholesale funding is an industry-wide
issue. While the proportion of short-term borrowings in FY11 was lower at most companies (compared with
FY08), the regulatory changes could adversely affect funding from banks, which represents the NBFCs' largest
source of funding. Although some of the larger NBFCs have attracted investments from domestic and
international institutional investors, gaining access to alternate long-term debt funding is a broad industry-wide
challenge.

Profitability Under Pressure: Despite the likely downward shift in interest rates in 2012, funding costs for
NBFCs may increase in the year, which, together with higher credit costs, will reduce profitability. Fitch expects
the weighted average return on assets (ROA) of the nine NBFCs to range from 1.5% to 2% in 2012 (H1FY12:
2.6%; FY11: 2.9%), from shrinking net interest margins (NIMs), low loan growth and high credit costs.

Asset Quality Deterioration Expected: a moderating economy is affecting the NBFCs' asset quality, and loan
growth will slow down in 2012. Fitch expects "reported" non-performing loan (NPL 180 days overdue) ratios at
the nine NBFCs of 2.5%- 3.0% in 2012 (2.1% for the financial year to end-March 2011 (FY11)). Delinquencies
are increasing in key business lines, but unless this is accompanied by a sharp erosion of collateral values, the
high risk-adjusted margins should be able to absorb the jump in credit costs
Report of the Working Group on the Issues and Concerns in the NBFC Sector

The recommendations of the "Report of the Working Group on the Issues and Concerns in the NBFC Sector"
(also called the Usha Thorat Committee, as the working group was chaired by Ms Usha Thorat, a former RBI
deputy governor), made public by the RBI in August 2011 and open for public comments until 30 September
2011.

The report's main recommendations are listed below:
1. The Tier 1 ratio of registered NBFCs should be increased to 12%, and three years should be given to achieve
the required ratio (currently the minimum Tier 1 ratio is 7.5%).
2. Asset classification and provisioning norms similar to those for banks are to be introduced in a phased manner
(this includes the 90 days overdue norm for classifying NPLs, from the current 180 days past due norm for
NBFCs).
3. Liquidity ratios may be introduced for all registered NBFCs, such that cash, bank balances and government
securities fully cover the gaps, if any, between cumulative outflows and cumulative inflows for the first 30 days
(currently only deposit-taking NBFCs are required to hold 15% of their public deposits in RBI-defined liquid
assets).
4. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002
(SARFAESI) may be extended to NBFCs (currently NBFCs cannot enforce their claims on defaulters under
SARFAESI).
5. Higher disclosures have been suggested by the RBI. These cover provision coverage ratios, liquidity ratios,
asset liability profiles, the extent of financing of a parent company's products and the movement of non-
performing assets.
6. Capital market and real estate exposures. Risk weights will be increased to 125% for capital market exposures
and 150% for commercial real estate exposures (from the current 100% for both these categories).

NBFCs have been pioneering at retail asset backed lending, lending against securities,
microfinance etc and have been extending credit to retail customers in under-served areas
and to unbanked customers.
an NBFC may be defined as a company registered under the Companies
Act, 1956 and also registered under the provisions of Section 45-IA of the Reserve Bank
of India Act, 1934 and which provides banking services without meeting the legal
definition of bank such as holding a banking license. NBFCs are basically engaged in the
business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities
issued by government or local authority or other securities of like marketable nature,
leasing, hire-purchase, insurance business, chit business but does not include any
institution whose principle business is that of agricultural activity or any industrial
activity or sale, purchase or construction of immovable property.
NBFCs are typically into funding of:
Construction equipment
Commercial vehicles and cars
Gold loans
Microfinance
Consumer durables and two wheelers
Loan against shares, etc.

List of major products offered by NBFCs in India:
Funding of commercial vehicles
Funding of infrastructure assets
Retail financing
Loan against shares
Funding of plant and machin
Small and Medium Enterprises Financing
Financing of specialized equipment
Operating leases of cars, etc

Types of instrument generally executed:
Loans
Hire purchase
Financial lease
Operating lease
Funding by NBFCs:
NBFCs account for 11.2% of the assets of the total financial system2. NBFCs have
emerged as an important financial intermediary especially in the small scale and retail
sector. There are a total of 12,630 NBFCs (end of June 2010) registered with RBI
consisting of NBFCs-D and NBFCs-ND. Of the 11.2%, asset finance companies held the
largest share of assets of nearly 74.5%
Funding sources of NBFCs:
Funding sources of NBFCs include debentures, borrowings from banks and FIs,deposits(only
deposit taking nbfcs),Commercial Paper and inter-corporate loans.
Banks are also a major source of funding for NBFCs either directly or indirectly. So in a
way NBFCs have a dependence on banks making them vulnerable to systemic risks in the
financial system.
NBFCs vs. Conventional Banks:
An NBFC cannot accept demand deposits, and therefore, cannot write a checking
facility.
It is not a part of payment and settlement system which is precisely the reason why it
cannot issue cheques to its customers.
Deposit insurance facility of DICGC is not available for NBFC depositors unlike in
case of banks.
SARFAESI Act provisions have not currently been extended to NBFCs. Besides the
above, NBFCs pretty much do everything that banks do
Classification of NBFCs-ND based on systemicimportance:
NBFCs-ND may also be classified into (i) Systematic Investment and (ii) Non-
Systematic Investment NBFCs based on the size of its asset.
Systemically Important NBFCs-ND
An NBFCND with an asset size of Rs.100 crore and more as per the last audited balance
sheet
is considered as systemically important NBFCsND (NBFC-ND-SI). However NBFCs
ND SI are required to maintain a minimum CRAR of 10 per cent. No NBFCNDSI is
allowed to:
a) lend to any single borrower/group of borrowers exceeding 15 per cent / 25 per
cent of its owned fund;
b) invest in the shares of another company/ single group of companies exceeding 15
per cent /25 per cent of its owned fund; and (iii) lend and invest
(loans/investments taken together) exceeding 25 per cent of its owned fund to a
single party and 40 per cent of its owned fund to a single group of parties.
Non-Systematically Important NBFCs-ND
A NBFCND whose asset size does not exceed Rs.100 crore as per the last audited
balance sheet may be considered as Non-systemically important NBFCsND (NBFCND-
SI).
Classification of NBFCs based on the Nature of its
business:
Loan Company (LC)
Loan company means any company which is a financial institution carrying on as its
principal business the providing of finance whether by making loans or advances or
otherwise for any activity other than its own but does not include an Asset Finance
Company.
Investment Company(IC)
Investment Company is a company which is a financial institution carrying on as its
principal business the acquisition of securities
Investment Companies are further divided into following subcategories:
Core Investment Companies:
Core Investment Companies in terms of RBIs Notification means:
a non-banking financial company carrying on the business of acquisition of shares and
securities and which satisfies the following conditions as on the date of the last audited
balance sheet:-
(i) it holds not less than 90% of its net assets in the form of investment in equity shares,
preference shares, bonds, debentures, debt or loans in group companies;
(ii) its investments in the equity shares (including instruments compulsorily convertible
into equity shares within a period not exceeding 10 years from the date of issue) in group
companies constitutes not less than 60% of its net assets

Net assets, for the purpose of this proviso, would mean total assets excluding
cash and bank balances;
investment in money market instruments and money market mutual funds
advance payments of taxes; and
deferred tax payment.
(iii)it does not trade in its investments in shares, bonds, debentures, debt or loans in group
companies except through block sale for the purpose of dilution or disinvestment;
(iv) it does not carry on any other financial activity referred to in Section 45 I (c) and 45 I
(f) of the Reserve Bank of India Act, 1934 except:
a) investment in
i. bank deposits,
ii. money market instruments, including money market mutual funds,
iii. government securities, and
iv. bonds or debentures issued by group companies;
b) granting of loans to group companies; and
c) issuing guarantees on behalf of group companies.
Other Companies

Asset Finance Company (AFC)
AFC would be defined as any company which is a financial institution carrying on as its
principal business the financing of physical assets supporting productive / economic
activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and
material handling equipments, moving on own power and general purpose industrial
machines. Financing of physical assets may be by way of loans, lease or hire purchase
transactions.
Principal business for this purpose is defined as aggregate of financing real/physical
assets supporting economic activity and income arising therefrom is not less than 60% of
its total assets and total income respectively
NBFCs may be further classified into(on basis of liabilities taken):
o NBFCs accepting public deposit (NBFCs-D) and
o NBFCs not accepting/holding public deposit (NBFCs-ND).

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