There is no smoke without fire. Several signs can alert you when a bank is in trouble. The recent collapse of Yes Bank in March 2020 has shattered the myth of many investors that a bank cannot fail. Yes Bank was quickly bailed out by the joint efforts of the RBI, Central Government and the State Bank of India. Yes Bank is not the first bank to fail and it will definitely not be the last bank to fail. Every generation of investors has their own share of learning experiences and Yes Bank has set an example for the decade gone by.
Failed Banks in the past
Since the 1970s, there have been 37 instances of private bank failures in India (including Yes Bank). In recent past, Global Trust Bank faced a similar crisis in 2004 and was promptly taken over by the Oriental Bank of Commerce. Similarly, United Western Bank merged with IDBI Bank in 2006 and ICICI Bank took over Bank of Rajasthan in 2010. In all cases, depositors got their money back.
How does a Bank fail?
A bank fails when it is unable to meet its obligations towards its depositors (account holders) and creditors. This may occur due to the bank losing out a lot of money on bad loan accounts and is unable to raise capital in time to continue its lending business. In such a scenario, the assets of a failing bank may decline in value and become illiquid and their net worth may drop below market value. A bank failure may be attributed to bad decisions taken by its management in terms of taking excessive risks in giving out loans to sub-prime accounts with an intention of earning more profits. Several other macroeconomic factors may also affect the operations of a bank but these factors are usually not responsible for a banking collapse.
What happens when a bank fails?
A banking failure is considered as a major event in a country’s economic environment. This is due to the fact that banks serve as the backbone of a country’s business ecosystem and a failed bank may have drastic effects across many other industries. Banks are heavily regulated by the Central Bank and Government policies but still every once in a while, a bank failure occurs.
India’s central bank, The Reserve Bank of India (RBI) is the apex body in India that regulates the banking industry. One of RBI’s primary role is to safeguard the interests and the money of the bank depositors. Every single time a bank has failed in the past, RBI has managed to come up with a solution of either a forced merger or bailout and save the depositors’ money. But that does not mean the depositors should be care free and under the impression that RBI has got their back. When it comes to investors, they do not enjoy such a luxury of protection from the RBI. They are on their own and should do their due diligence before investing in a banking stock and also keep monitoring the KPI’s of the bank they’re already invested in.
Top 8 Banking Metrics
For a common depositor, it may not be possible to go through and understand complex financial statements of banks. Nevertheless, they can always consult their financial advisors or a friend / family member having finance background. But for investors, understanding financial statements is something that is expected as a basic skill to possess. Below are the key performance indicators that investors should track in banking stocks.
1. Gross Non-Performing Assets (GNPA)
When you take a loan from the bank, you’re required to pay it back in the form of EMIs. These EMIs include the principal amount as well as the interest. NPAs indicate how much of a bank’s loans are in the danger of not getting repaid. If interest in the form of EMIs is not received for a period of 90 days (3 months) then that loan account turns into an NPA.
Significance: A very high gross NPA ratio means that the bank’s asset quality is in very poor shape. A high GNPA value is a negative sign.
2. Net Non-Performing Assets (NNPA)
Banks consider the fact that some portion of the loans will go bad and that is part of the business. To safeguard their loans, banks usually take some kind of guarantee like a mortgage, insurance, etc. before issuing the loan. Net NPAs are those bad loan accounts that are not backed by any such collaterals and have very low chances of a recovery.
Significance: As compared to Gross NPA, a very high net NPA ratio is a more defined indicator of the fact that the bank has a lot of bad loans. A high NNPA is a negative sign.
3. Provision Coverage Ratio (PCR)
When banks recognize that certain loans are expected to go bad in the future, they provision some part of their profits towards covering the losses that may be incurred due to such bad loans. It’s like the bank’s own safety funds set aside to protect against any NPAs.
Significance: A high PCR (above 70%) means that the bank has already taken care of most of it’s NPAs and it is not vulnerable to any surprises in loan defaults. A high PCR is a positive sign.
4. Capital Adequacy Ratio (CAR)
CAR is the measure of a bank’s insolvency (failure) risk. It indicates how much capital does the bank have with respect to it’s liabilities and risk weighted assets. RBI defines the minimum CAR for all banks in India. Currently, for private banks the CAR is 9% and for public banks it’s 12%. In simple terms, it’s a ratio of how much you have with respect to how much you owe.
Significance: CAR indicates the bank’s ability to meet its obligations. A higher CAR w.r.t to the minimum requirement as per RBI means that the bank has sufficient capital reserves to absorb any losses in the future. A high CAR is a positive sign.
5. Current and Savings Accounts Ratio (CASA)
CASA is a ratio of the current and savings accounts to the total deposits a bank is holding. Total deposits include all forms of deposits like fixed deposits, recurring deposits, etc. Current and savings accounts bear a very low interest rate while term deposits like FDs bear higher interest rates. So it’s beneficial for the bank to have higher current and savings accounts as they have to pay less interest on those accounts.
Significance: A high CASA indicates that the bank has a healthy number of current and savings bank accounts. A high CASA is a positive sign.
6. Credit Deposit Ratio (CDR)
CDR measures how much portion of the total deposits (money of account holders) does the bank lend out to its customers as loans. Along with the depositors’ money, banks also use their core capital to lend out loans. CDR for private banks in India is around 85% while that for public banks is around 75%. This means that private banks lend out ₹75 out of every ₹100 that they have in the form of customer deposits.
Significance: A higher CDR indicates that the bank is taking excessive risks by lending more while a low CDR indicates that the bank is not using its money to full capacity. A very high CDR (above industry average) is a negative sign while a stable CDR is a positive sign.
7. Net Interest Income (NII)
A bank’s main business is lending money. It’s primary source of income is the interest it receives on the lent money. A bank also has to pay interest to its account holders. NII is the difference between interest earned from loans (assets) and interest paid on deposits (liabilities).
NII = interest earned – interest paid.
For example, if a bank earns ₹100 in interest from its loan accounts and pays out ₹80 as interest to its account holders, then NII is ₹20.
Significance: A higher NII indicates that the bank is doing good business and that it is able to generate higher profits. A higher NII is a positive sign.
8. Net Interest Margin (NIM)
NIM is the measure of a bank’s profitability w.r.t to interest income and assets (loans). NIM is affected by factors like the quality of loans the bank is issuing, central bank interest rates, etc. A risky loan account may bear higher interest rates while a stable loan account may bear lower interest rates.
NIM = Net Interest Income (NII) / Assets (loans)
For example, if a bank has given out total loans of ₹1000 and earns an interest (NII) of ₹50 then its NIM stands at 5%.
Significance: A higher NIM may indicate that the bank is taking undue risks while a low NIM may indicate that the bank is not operating at its peak performance. A very high NIM (above industry average) is a negative sign while a stable NIM is a positive sign.
Where do you get all these metrics?
All these ratios are mentioned in the bank’s financial statements i.e. profit & loss, balance sheet and cashflow statements. Banks are required to submit these statements every quarter. You can download these statements from bank’s website and have a look at all these KPIs to understand your bank’s health.
So now that you understand the basics of evaluating a bank’s health using the above KPIs, go ahead and compare the metrics of your main bank with various other top banks to get an idea of where it stands.