Banks are often called the engines of economic growth, and their shares tend to reflect the nation’s financial health in remarkable detail. Many participants follow the Nifty Bank to gauge how lenders are performing as a group. Others examine the fii dii data to see whether large institutions are accumulating or trimming financial stocks. Whatever your starting point, a clear checklist helps you analyse lenders more rigorously than headlines allow.
Loan Growth and Its Quality
Credit growth reflects a bank’s eagerness to lend, but is not always positive. Rapid expansion into risky areas could hurt in later years. Study the breakdown of this growth – home loans/loans against property are safer, whereas unsecured personal credit, micro-finance or certain small business loans could turn sour quickly in a down turn.
Check if the growth has been across several sectors and borrowers, or is concentrated in certain areas which could sour. If the bank has consistently grown its loans much faster than deposits, it could lead to an increased need to raise expensive funds.
Indicators of Asset Quality
Gross non-performing assets is the amount of bad loans at a point of time. Net non-performing assets arrive after provisioning for the amount the bank expects to be unable to recover. While the ratio of bad loans to total loans is a good indicator, a closer look needs to be taken at the slippage ratio or additions to bad loans during the year, which reflects early signs of trouble. The provision coverage ratio shows how much protection the bank has against bad loans.
Look at the number of restructured loans and special mention accounts in the bank’s portfolio. These loans are classified in the next lower category or are past due, but not yet bad loans. A bank that has low levels of bad loans, but with high restructured loans or special mention accounts, may soon see these move into bad loans in the near future. Credit costs or provisioning costs to loans is a proxy to look at the costs incurred by the bank on bad loans. Banks with consistently low and stable provisioning costs are generally positive.
Capital Adequacy and Funding Profile
The level of capital in a bank determines how much it can be pushed in the event of an adverse scenario. Higher capital means higher cushion and headroom for expansion. When capital gets eroded, the lenders need to raise fresh capital through rights issues, thereby diluting existing shareholders, or reduce lending, thereby affecting growth.
The funding profile of a bank is also important. Cheap deposits like savings and current account balances allow the bank to maintain spreads. If the bank is overly reliant on wholesale deposits or term deposits, the spread it enjoys will get compressed in rising interest rate scenarios. Liquidity coverage ratios and current account balances of retail customers (which tend to be sticky) are other indicators to look at funding.
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Profitability and Efficiency
Profitability ratios such as return on assets and return on equity indicate how well a bank is able to convert its assets into profits. Consistently high returns suggest an edge the bank enjoys over its peers. However, look out for one-time gains or losses which may distort the figures. Look at the cost-income ratio to see if the bank is incurring too many costs without reaping benefits. Heavy investment in technology upfront could affect the ratio in the short-term, but would benefit the bank in the long-term.
Focus on the net interest margin. However, look at the other income, particularly in treasury gains, as well as recovery of written-off loans. A bank which is overly reliant on volatile gains in the treasury, or recouping bad loans from the past would benefit from more stable sources of income, such as fee income.
Each of the above ratios should also be compared to the peer group average, as well as the trends of the bank itself. Focus on the direction in which these figures are moving to get a better picture of the bank.
Valuation and Portfolio Fit
Compare the price-to-book value of the bank to the peer group average. Since banks hold financial assets primarily, the price-to-book value multiple is often a good measure of value for money. Banks with high returns and stable growth prospects will have higher P/B multiples, while concerns about governance or low returns can push the ratio below par. Do not get taken in by low valuations.
Finally, think about how banks fit into your portfolio. Having too many financial sector stocks in a diversified portfolio is generally not advisable. Take a close look at existing exposure to the sector and balance it out with your new investment. Take small steps and revise your decisions based on evolving circumstances. A SEBI-registered adviser can help you determine your options based on your specific needs. This article is meant for informational purposes only and cannot be used as a recommendation to buy or sell any securities.
