How to analyse bank performance without the clutter

Higher net profit or net interest margin does matter, while analysing
thefinancial performance of a bank. RBI may also consider mandating banks
reporting total assets/ balance sheet size rather than the so-called 'total
bsiness' adding deposits, liabilities and loan assets to ha!e a tre and fair
sense of banks' bsiness growth
Come quarterl y and annual bank financial results and investors and readers
of business and financial newspapers are all agog over some anal yst gushing
' Bank As net profit rises 3!" and some other anal yst emoting #Bank Bs $%&
is highest at or ' !' ( And all these are taken by readers and investors as hol y
grail suggesting that banks concerned have been e)ceptionall y efficient and
profitable( *his need" and may" not at all be so+ But before seeing why" it would
onl y be instructive and value,adding to consider the business modelof a t ypical
competi tive" efficient" safe" and sound bank+

A bank is t ypical l y characterised by relativel y high financial leverage" which" in
turn" is measured by what is known as -quit y &ultiplier .-&/" which" in turn" is
nothing but total assets of a bank divided by its common equit y0 shareholder
funds+ &ultipl yi ng this leverage .-&/ by what is called 1eturn on Assets .12A/
gives 1eturn on -quit y .12-/ for a bank+ *ypicall y" compet itive" efficient" safe
and sound banks have had historicall y an average 12A of about 3! and a
reasonabl y safe -& of about 3" impl yi ng an average market,compet itive
equilibrium 12- of about 3!+

%n the recent period" the %ndian Banking 4ystem has had leverage of about 33 to
35 ti mes+ 4ignificant l y" and hearteningl y" to the credit of 1eserve Bank of %ndia
.1B%/ and the %ndian banking sector" this corresponds to an average leverage
ratio . inverse of -&/ of 6!7" which" at about 8+ times" is way higher than 3!
mandated by new Basel %%% capital rules to be compli ed with only in 893: ( %n
other words" the %ndian banking sector is already more than 8+ times compli ant
on this critical Basel %%% parameter ((

%n this conte)t" another key financial parameter is what is known as $et %nterest
&argin .$%&/" which is the difference between interest earned and interest
e)pended as apercentage of a banks assets+ Collectivel y for %ndian Banks in the
recent period" $%& has varied between 8+ ! to 3!+ %f we deduct 12A from
$%&" we get what can be called $on %nterest cost of %ntermedi ation+ %n fact" it is
this critical parameter0 ob; ective function vi< .$%&,12A/ which" for a given
12A derived" in turn" from a given 12- and -&" it must be the dharma/
mantra of a role model bank management to mini mi <e for ma)i mi <ing returns to
depositors and0 or minimi<ing costs to borrowers + *hus" either way" constrained
minimi<at ion of the ob; ective function .$%&,12A/ delivers value to all
stakeholders vi<" shareholders" insured and uninsured depositors" borrowers"
ta)payers" in particul ar" and the real economy" in general+

*o recapitulat e" =the business model of a compet itive" efficient" safe and
sound bank is one which" while by minimi<ing the ob; ective function .$%&,
12A/ sub; ect to the constraint of a given 12A" derived" in turn" from a given
market,competi tive equilibrium 12-" ma)i mi <es value for all stakeholders vi<"
depositors" borrowers" shareholders and public policy institutions" and allows it
to grow sustainabl y by helping the real sector grow consistent with
' financial sector,real sector balance ' where the financial sector is ever a means
to the real sector end (( =

"ignificance of #I$-R%&
>e are now ready to unclutter the clutter in bank financial performance analysi s
and evaluation+ As regards the myt h of $%& being a key measure of
profitabil it y" let it be said that $%& by" and in" itself conveys nothing more than
what it apparentl y does vi<" as we have seen before" it is ;ust the difference
between interest earned" and interest e)pended" as a percentage of a banks
assets+ %t is ; ust a means to an end and not an end in itself ( ?or it" therefore" to
make any sense" it needs to be analysed further beyond what it is by considering
.$%&,12A/+ ?or if $%& be '!" and 12A be <ero" then automaticall y 12- will
also be <ero and it is no brainer to see that this nominall y very high $%& onl y
establishes that the bank is neither competit ive" efficient" safe nor sound ( -ven
if 12A be" say 8!" then . $%&,12A/ will be .'!,8!/ i+ e+ 5!+ And this bank
will be far less efficient and competi tive than a bank whose $%& is" say 3!" and
12A " say 3! " and" therefore" .$%&,12A/ 8! ( *his is because non,interest
cost of intermediat ion of the higher, $%& bank is twice that of the lower, $%&
bank and it is precisel y this twice as large .$%&,12A/ and its reasons through
its granular anal ysis and dissection that should engage the attent ion of bank
anal ysts and investors(
?or it is this .$%&,12A/ that subsumes all non, interest e)penses such as
ta)es" salaries0wages 0compensation" operational e)penses" loan loss provisions"
marked,to,market provisions" write,offs etc+ And this .$%&,12A/ becomes even
more significant" if the reported gross $@As .non performing assets/ are
unusuall y low( *herefore" in the above e)ample" the bank with lower .$%&,
12A/ will be twice as efficient and competi tive as the one with higher .$%&,
12A/ because the former ma)imi<es value for all stakeholders vi<" depositors
by way of higher deposit interest rates" borrowers by way of lower borrowing
costs" shareholders by way of given 12A and market , competit ive equilibrium
12- (

Higher net profit may not show real growth
?inall y" coming to too much being made of" say 8! to 3! growth in net
profits" this too needs to be regarded with circumspect ion for these numbers
need to be ad; usted for the growth in balance sheet 0 assets and not ; ust
considered in isolation and on a stand, alone basis+ ?or if net profit grows at
3!" on a year,on,year " or a CAA1" basis and assets0balance sheet also grow
by" say 3!" then there is reall y nothing to write home " or to feel gung,ho"
about for the bank in question has been no more" and no less" efficient and
profitable than before ( Another equall y insightful way to see this is in terms of
change in 12A+ ?or e)ample" if previous 12A be" say 3!" then there is no
change in 12A as the 12A also remains unchanged at 3! for 3! growth both
in net profits and assets0balance sheet( 2n the other hand" if for a 3! growth in
net profit" assets0 balance sheet grow by" say 8!" then the bank has been more
efficient and profitable only to the e)tent of .3+ 303+ 8,3/B399 i+ e+ 7 :!" and not
3!" as bank anal ysts would unwittingl y have readers and investors believe ( %n
this case" 12A increases fom 3! to 3B3+ 9: i+ e 3+ 9:! onl y( Also" significant l y"
and equall y" if assets0 balance sheet grow by 59!" then the so,called nominal
profit growth of 3! will translate into a less efficient and less profitable
performance of .3+ 303+ 59,3/B399 i+ e , 3+ ! and not 3! as 12A will decline to
9+ C'! from 3! previously although absolute net profit increased by 3! ( *his
then is the conceptuall y robust and technical l y rigorous nuts,and,bolts way of
how bank anal ysts and investors must dissect bank financial performance and
; udge true and fair value of banking stocks for value investing0 buying(

'laws in sing deposits and loans as total bsiness
>hile on the how,and,how,not of bank financial performance anal ysis and
evaluat ion" a tail piece on banks' reporting of ' total business' will not be out of
place and conte)t+ *ypi call y" in %ndia" it is routine for banks to report total
business as the sum of deposits and loans to give anal ysts and investors a sense
of growth in banks' business+ But this is not only at variance with the
internat ional practice but also intellectual l y and conceptuall y flawed and
vitiat ed for all ' business' is about generating revenues and returns for
shareholders and it is ' total assets' that precisel y do that and it is tautological
and a)iomatic that there is no way revenue generating assets can e)ist and grow
without corresponding e)pense contributing liabi lit ies( *hat is also precisel y
why" as sources and uses of funds" liabil iti es and assets appear opposite each
other on a balance sheet+ 4ignificantl y" the so called total business of banks has
t ypical l y e)ceeded total assets0 balance sheet si<e by about 9!(

*herefore" while bank anal ysts and investors will do well to go that e)tra mile to
have a true and fair sense of banks' business growth" with a view to aligning
with the internat ional practice" 1B% may also consider mandat ing banks
reporting total assets0 balance sheet si<e rather than the so called ' total business'
adding deposit liabi lit ies and loan assets+