Assess your bank's quality

BANKING PRIMER

The recent failure of the Global Trust Bank (GTB) begs the question: how can the average account holder assess the quality "" and therefore the safety "" of a bank?

Keeping an eye on some basic pointers "" based on the financials of a bank that are accessible on the internet "" can ensure peace of mind.

The foremost concern should be the level of non-performing assets (NPAs) "" or loans that are not being repaid or serviced through interest payments on time "" in a bank.

For a bank, a loan that it gives out is an 'asset' since it earns revenue, while a deposit is a 'liability' because it has to be repaid at some point in time.

According to the Reserve Bank of India, an asset or loan becomes 'non-performing' or bad when it has not been serviced "" meaning, the interest and/ or installment of principal has remained 'past due' or unpaid "" for more than 90 days.

These could include term loans, overdraft, cash credit and bills purchased/ discounted. On the other hand, an agricultural loan becomes an NPA if interest and/ or installment of principal remains overdue for two harvest seasons but for a period not exceeding two half-years.

Now, there are two types of NPAs "" net NPAs (NPAs minus provisions) and gross NPAs.

GROSS NPA LEVELS
What you should check is whether the bank's gross NPAs are increasing "" quarter on quarter or year on year. If it is, "" indicating that the bank is adding a fresh stock of bad loans "" it would mean the bank is either not exercising enough caution when offering loans or is too lax in terms of following up with borrowers on timely repayments.

The short point here is that such a bank is not taking enough care of your money, and is therefore not worthy of your trust.

But then, you would say that a bank's business is making loans and world over, some percentage of the loans always turn bad.

True, but a prudent bank goes out of its way to make sure that it is conservative in its estimates of what percentage of loans will go bad.

Banks usually set aside a part of their net profit "" or 'provision' "" every year to provide for such contingencies. That is why it makes sense to look at the provisioning numbers, i.e., how much of the NPAs have already been covered by provisions.

For instance, the provision cover of IDBI Bank, which is being merged with parent IDBI, currently stands at 92 per cent. This means the bank is well covered for any possible degeneration of 92 percent of the outstanding loans into bad debt or irrecoverable assets.

And low NPAs are good because it means less provisioning, which, in turn, leads to higher net profit.

Also, see whether a bank has 'restructured loans'. Loans are often restructured to afford the client the benefit of a better or lower interest rate. Some times, to mitigate the problems an industry is facing, banks reduce or waive off some interest burden.

For example, steel prices are soaring currently. Now, IDBI has substantial exposure to the sector. But in future, when steel prices come down "" commodity prices always move in rise & fall cycles that spans a year or more "" some of IDBI's current loans could become NPAs as steel industries would find it difficult to service them. Therefore, the loans may have to be restructured to help the industries.

THE INTEREST RATE RISK
A key risk these days pertains to the interest rate "" how badly will the bank be affected by rising rates? The way to find this out is by checking the growth in a bank's loans or 'advances' portfolio and in its net interest income.

How much did treasury income (or income generated from non-banking investments such as government securities) contribute to the bank's net profit last year? Was that substantial?

The moot point is, will the bank be able to grow its lending enough to offset the inevitable loss in treasury income?

In the case of public sector banks, there is a buffer "" they have large unrealised gains from treasury. Unrealised because instead of selling, they are holding on to old securities that they had invested in a long time back, and whose values have vastly appreciated. This will help them take a 100 to 200 basis points (100 basis points is one percentage point) rise in interest rates comfortably.

Then check how much fee income has grown "" this is the core business revenue for a bank and it de-risks profitability from over-reliance on treasury income.

And since we are on interest rate, look at:

Net interest margin: The higher it is (net interest margin is interest earned minus interest paid divided by total earning assets) the better it is for the bank.

Cost to income ratio: This is simple "" the lower the cost, the better the bank.

THE CAPITAL ADEQUACY RATIO
Another critical barometer is the bank's capital adequacy ratio. Capital adequacy ratio measures the amount of a bank's capital expressed as a percentage of its credit exposure.

Globally, the capital adequacy ratio has been developed to ensure banks can absorb a reasonable level of losses before becoming insolvent.

Indian banks are expected to maintain a minimum capital adequacy ratio of 9 per cent (Rs 9 as capital for every Rs 100 in loans or asset). Remember, the Global Trust Bank was running on nil capital adequacy ratio "" and had NPAs of over Rs 1,500 crore. No wonder it was teetering on the brink.

Applying minimum capital adequacy ratios serves to protect depositors and promote the stability and efficiency of the financial system by reducing the likelihood of banks becoming insolvent.

In the event of a wind-up of a bank, depositors' money gets precedence over capital. This means, depositors would only lose money if the bank makes a loss that exceeds the amount of capital it has.

Ergo, the higher the capital adequacy ratio, the higher the level of protection available to depositors. But there's a catch here "" a higher capital adequacy could also mean a bank is sitting on money rather than making productive use of it "" interest is not being earned.

THE BODY LANGUAGE
Also, be alert to the "body language" of the bank. For instance, a bank may be coming out aggressively with products and prices to grow its business. Should you read this as a positive sign at all times? Well, mostly.

But beware, there may be times when a bank may be playing a "double or quits" game: where it wants to grow its business aggressively only to hide the stock of bad loans in its books. Before you know it, such a bank may just throw in the towel one day.

Above all, keep in touch "" never forget to read what's being written about your bank. Are credit rating agencies downgrading or upgrading your bank or its instruments such as fixed deposits?

If there is a downgrade, what was the reason for it? Is your bank's accounts full of auditor's qualifications? Remember, those long notes at the end of the financials say a lot about the quality of the bank.

Whoever said putting your money is a bank is a simple proposition?

Key indicators

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• NON-PERFORMING ASSETS: An asset or loan becomes 'non-performing' or bad when it has not been serviced""meaning, the interest and/ or instalment of principal has remained 'past due' or unpaid""for more than 90 days. These could include term loans, overdraft, cash credit and bills purchased/ discounted. On the other hand, an agricultural loan becomes an NPA if interest and/ or installment of principal remains overdue for two harvest seasons but for a period not exceeding two half-years.
  
  
• NET INTEREST MARGIN: Net interest margin is the difference between interest income and interest expenses, divided by average earning assets. Earning assets are those which bring income for a bank. They are interest bearing accounts, bonds, and securities available for sale. Mainly expressed as a percentage, the ratio is a guide to the profitability of a bank's investments. Or more simply, it indicates the average interest margin that the bank is receiving by borrowing and lending funds.
  
  
• CAPITAL ADEQUACY RATIO: A bank's capital, or equity, is the margin by which creditors are covered if the bank had to liquidate assets. In banking, there are two types of capital. Tier I capital (comprising money from ordinary shares that help a bank absorb losses without being required to stop trading), and Tier II capital (comprising subordinated debt). Capital adequacy ratio, or the ratio of total capital (Tier I plus Tier II) to total risk weighted assets must not be less than 9 per cent.