How does NPA affect NII and NIM? When good assets turn bad, the average interest-generating assets go down. This reduces interest income while the interest expenses remain the same. This directly affects their primary source of income. So, higher the NPA, less will be NII and NIM. NPA Adversity Learning and Examples: a. The Indian Economy enjoyed a boom phase from 2000-2008. Banks extensively issued loans to corporates with an expectation that the boom phases will benefit everyone. However, the 2008 financial crisis badly hit the economy and shook corporate profits pushing them to bankruptcy and other crisis. This further affected the NPA’s during the recession, especially for public sector banks. b. Yes bank suffered almost 90% downfall when the news of their high NPAs and poor financials broke out. Out of panic, customers rushed to withdraw their deposits. To control the situation, all the withdrawals were capped at Rs. 50,000. This further impacted many businesses’ cash flow. But, the devil is in the detail. If we analyse Yes bank’s advances break-up, we will find that about 67.9% of Yes Bank’s loans are offered to large corporates. Banks incur low costs if they lend funds to huge corporates. However, the risk factor cannot be ignored.
If a couple of such large borrowers default on their repayment, it could result in a very stressful situation for banks and the investors. Worst fears came true for Yes Bank They had financed couple of huge loans which ended up as NPA’s like IL&FS, Jet Airways, Anil Ambani Group, Essel Group, DHFL etc.
Covid-19 has induced uncertainty amongst many economic and global factors. This can deteriorate the asset quality of the banking system to a certain extent. In such unforeseen scenarios, the market sentiments are often low. In such times, it is important to closely monitor the bank’s NPA behavior. Check at which rate is the good loans turning bad. This is known as the slippage ratio. It helps us evaluate how much of a fresh NPA was added in a particular year or a quarter. Fresh slippage is the amount of how much of a bank’s advances turned bad in a year. Banks usually report this amount on a quarterly basis in their annual report or in a separate press release. A sharp increase in fresh slippage has a significant impact on the net profit of the bank. Low or no slippage shows a bank’s efficiency in handling its assets. Historically, Public Sector Banks have a very unstable slippage ratio. It increased in 2018 and followed a sharp fall in 2019.
Banks are the backbone of every economy. If they collapse, the entire country eventually collapses.
This makes the banking sector one of the most attractive sectors for investment. However, with great power comes great risks and responsibilities.
Small Finance Banks These banks provide basic banking services of acceptance of deposits and lending. Their aim is to provide financial service to sections of the economy not being served by other banks. For example, marginal farmers, small business units, unorganised sector entities, etc.
Banking Model – How Does a Bank Work? The primary business of a bank is to accept deposits and give out loans. The loans given by the banks are their asset on which they earn interest. On the other hand, deposits that banks accept are their liabilities. They have to pay interest to depositors on their deposits. Thus, earned interest minus paid interest is their profit. This is their bread and butter.
nterest Income Banks earn interest on the loans they have issued. This is their main source of income. In other words, this is their lifeline
But how do banks earn interest from RBI? Banks have to reserve a certain portion of the amount deposited by customers with RBI. This is to maintain a certain amount of liquidity in the system. What if there is a sudden rush of depositors to withdraw their money? If entire deposits have been issued as loans, there will be a liquidity problem. This can lead to a panic-like situation among stakeholders. Hence, banks should keep a minimum percentage reserve with RBI. This is called Cash Reserves Ratio (CRR). If the CRR percentage is reduced by the RBI, the amount available to loan out with the banks increases.
Banks also have to invest a proportion of the deposits in government bonds. In return, banks earn interest on their risk-free investment. This is known as the Statutory Liquidity Ratio (SLR). In return for these reserves, RBI pays a small percentage of interest to banks. It then constitutes as bank’s interest income. This is done to maintain a portion of deposits as emergency funds. If banks ever run into liquidity crises, RBI steps in and uses these reserves.
b. Other Income Apart from interest income, banks earn revenue in the form of fees that they charge for various services. For example, banks also deal in foreign exchange operations and act as a broker and earn forex fees. They earn commission by selling mutual funds and insurance to their customers. It also includes income from various trading operations and other miscellaneous income. These other sources of income help them diversify their income stream rather than being dependent on interest income. So those are the major sources of income for a bank. Now let’s talk about the expenses.
The rate of interest banks have to pay on current account and savings account (CASA) is relatively low than fixed deposits. Banks pay an interest of around 2% to 3% on saving accounts and 0% on current accounts. For fixed and recurring deposits, banks pay an interest of around 6% to 7%. CASA deposits let banks borrow funds at a lower rate. Hence, the higher the proportion of CASA, lower is the interest cost burden. For example, if a bank has a CASA Ratio of 30%, we can say that for every 100 rupees of deposits, 30 rupees have been through CASA. Pro Tip: If the CASA Ratio is high, it is a positive sign for investors. It means that banks are able to generate their raw material (money to loan) at a cheaper rate. A low CASA ratio means the bank heavily relies on costlier funding.
Interest Expense Banks pay a fixed percentage of interest on the amount deposited by the customers. This is their main expense which drives their cost. Consider these deposits as their raw materials. There are four types of deposits –
ere are 5 Indian banks with the highest CASA Ratios as of September 2020 – Sr. No. Name of the Bank CASA Ratio (%) 1 Kotak Mahindra Bank 57.1 2 J&K Bank 53.3 3 IDBI Bank 48.3 4 HDFC Bank 41.6 5 IDFC First Bank 40.4 Kotak Mahindra Bank has the highest CASA Ratio. In other words, 57.1% of its total deposits are being generated at a very low to minimal cost. You can find this data easily from the bank’s annual reports under their financial highlights’ section. So, how does the bank profit from this? To answer this question, we will have to understand a very important parameter that needs to be evaluated while analysing a bank.
Net Interest Income (NII) The difference between bank’s interest income and interest expense is their profit. Let’s say that a bank lends at 7% interest and pays interest on deposits at 3.4%. The difference of 3.6% is bank’s net interest income. For example, HDFC Bank’s NII increased by 16.72 % in 2019-20. HDFC Bank 2018-19 (in Rs.) ‘000 2019-20 (in Rs.) ‘000 Interest Income 1,05,16,07,400 1,22,18,92,915 Interest Expense 53,71,26,876 62,13,74,216 NII 51,44,80,524 60,05,18,699 Pro Tip: A large portion of the bank’s revenues is derived from Net Interest Income. Hence, always check at what rate is the bank’s NII growing. Higher the better.
Compare the growth rate with its peers. Conduct a five-year trend analysis to have a better picture of the growth consistency. NII indicates how effectively is the bank conducting primary operations. So far, we understood how does a bank work and makes profits. This is on an absolute basis. But you cannot compare two different-sized banks on the basis of NII. For that, you must compare them on the basis of Net Interest Margin.
Net Interest Margin (NIM) This is calculated by dividing NII by the average income earned from interest-producing assets. It is a profitability metric. This gives us an idea about the bank’s profitability on its interest income and their interest expenses. It is readily available in the bank’s annual report. For example, here is HDFC bank’s NIM from its 2019-20 Annual Report. You can find it under the key performance highlight system
Monetary policies set by central banks majorly influence bank’s net interest margins. They dictate whether consumers will borrow or save money. When interest rates are low, loans become cheaper. Thus, people are more likely to borrow money and less likely to save it. If borrowing increases, interest income for banks increases. This results in higher net interest margins. When interest rates are high, loans become costlier. Thus, people opt to save money rather than borrowing loans. If borrowing decreases, interest income for banks goes down. This decreases net interest margins.
A positive NIM suggests that the bank is efficiently investing. Whereas a negative NIM suggests inefficient investing. Pro Tip: It is all connected. If the bank’s CASA ratio is high, NIM will be high. Analyse NII and NIM collectively to form a better opinion on a bank’s earnings performance.
Imagine you have lent Rs. 5,000 to your friend. He promises to repay you the amount after 15 days. But it has been 5 months and he still hasn’t repaid. You eventually lose hope of getting your money back. If you had those 5,000 in your pocket, you could have done many things to create future value. But you can no longer use them. Similarly, if a borrower defaults on interest or principal payment, the bank’s asset (loan issued) is no longer profitable. They thus become a non-performing asset (NPA). This is the most important data which needs to be compared amongst banks. NPAs of a bank can affect banking operations and revenue. If you are able to correctly analyse NPA’s, you will have a fair idea of which bank performs better than its peers. So, straighten up, and let’s understand this in detail! Interest earned on loans is the main source of income for banks. But what if the borrower fails to repay the principal amount of defaults with an interest payment? A loan is classified as a non-performing asset when the repayment is overdue for more than 90 days.
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