Analysing banks and lenders

In simple terms

A bank is different from an ordinary company. Its raw material is money. It borrows, mostly in the form of deposits, and lends at higher rates. Its main income is the difference between the interest it earns and the interest it pays. Because borrowing is the core of its business, the usual debt and EV-based ratios do not apply.

Analysing a bank means answering four questions:

1. How profitably does it lend? Margins and costs.
2. How good are its loans? Asset quality.
3. How much loss can it absorb? Capital.
4. How stable is its funding? Deposits.

Non-bank lenders work similarly, though they rely more on borrowing from markets and banks than on deposits.

Profitability: net interest margin

Net interest income is interest earned on loans and investments minus interest paid on deposits and borrowings.

A bank's cost of funds depends heavily on its deposits. Current and savings account deposits, often called CASA, usually pay little or no interest, so a bank with a high share of them can lend profitably at lower rates. A strong deposit base, built over years from many customers, is one of the clearest competitive advantages in banking.

Other income, such as fees, adds to profit. Operating costs are often measured as a cost-to-income ratio: operating expenses divided by net interest income plus other income.

Asset quality: the biggest risk

A bank lends around ten times its own capital or more, so a small share of loans going bad can wipe out a large part of its equity. Asset quality is therefore the most important part of bank analysis.

• Non-performing assets (NPAs) are loans on which the borrower has stopped paying for longer than a period set by the regulator. Gross NPAs are the total; net NPAs subtract provisions already made.
• Provisions are amounts set aside to cover expected losses. The provision coverage ratio, provisions divided by gross NPAs, shows how much of the bad loans are already covered.
• Credit cost, provisions charged in a year divided by average loans, shows how much bad loans cost each year. Judge it over a full credit cycle, not just in good years.
• Restructured loans and loans already overdue but not yet classified as NPAs can hide future problems.

Bad loans usually appear years after they are made. Rapid loan growth, especially in risky segments or at low rates, is a warning that the next downturn may be painful.

Capital adequacy

A bank's capital absorbs losses before depositors are hurt. Regulators require banks to hold capital above minimum levels relative to their risk-weighted assets, with riskier loans needing more capital. This is the capital adequacy ratio. The rules and minimums are set by the Reserve Bank of India and change over time.

For an investor, two points matter: a bank close to the minimum has little room for losses, and a bank growing fast will need more capital, which may mean issuing new shares and diluting existing shareholders.

Valuing banks

Because debt is a bank's raw material, enterprise value and EV/EBITDA are meaningless. Banks are valued on:

• ROA, the cleanest measure of how profitable the lending is, as the ROA lesson explains.
• ROE, which is ROA multiplied by leverage.
• P/B, because a bank's book value is mostly financial assets recorded near their value, provided bad loans are fully recognised. As the P/B lesson shows, banks earning high ROE sustainably trade at higher P/B.

Adjust book value for any under-provided bad loans before using P/B: a bank whose NPAs are not adequately covered has a smaller real book value than reported.

Why it matters

Banks are a large part of the stock market, and their failures can be sudden and severe. Standard company analysis misses their main risks. Understanding margins, asset quality, capital and funding lets you tell a well-run lender from one growing too fast on weak loans, and avoid valuing a bank with tools that do not fit.

Limitations

Outsiders cannot see the quality of individual loans; asset quality data depends on how strictly the bank recognises problems. Banking rules change, and figures across banks, non-bank lenders and countries are not always comparable. A bank that looks sound can deteriorate quickly in a downturn.

Common mistakes

• Treating fast loan growth as good news without checking quality.
• Using P/E alone, ignoring asset quality and capital.
• Using book value without adjusting for under-provided bad loans.
• Judging credit costs only in good years.

Try it yourself

Choose a listed bank and its latest annual report or results presentation.

1. Find its net interest margin, CASA share, cost-to-income ratio and ROA.
2. Find gross and net NPAs, the provision coverage ratio and credit cost, for several years.
3. Find its capital adequacy ratio.
4. Find its P/B and ROE, and write a sentence on whether the valuation looks consistent with its returns and asset quality.