Authored by: Sumit Pradhanang (Chartered Accountant, Founder and Partner at KPIS)
(This blog is a guide to analysis of a bank for beginners. It is written in two parts. The first part covers the business model of the bank and top 5 qualitative factors to look at while analyzing banks. The second part covers top 5 quantitative factors to consider while analyzing banks.)
Analyzing a company requires an understanding a variety of key concepts and the ability to connect all the significant dots (data points) to get a wholesome understanding of the company so as to make a sound decision. This write-up is my attempt to explain a few of those ‘significant dots’ so that it may allow you, the reader, to analyze the bank like we do at KPIS.
Understanding the Business Model:
The first step while analyzing any business is to understand its business model. However, the business model of banks differ from that of most of the other businesses because (a) banks are highly regulated and monitored businesses, (b) banks have very high debt (rule of thumb is for every Rs.10 that the owners put into the bank, they raise debt, through Deposits, of Rs.90), and (c) Debt (deposit) is raw material for banks and is a source of operating capital rather than financing capital.
One of the core activities of the banks is to raise money from the market in the form of deposits and to mobilize this money to borrowers in the form of loans. When the bank collects deposits from individuals and institutions, it pays them interest, which is recorded in the books of banks as interest expense. Similarly, when the bank lends money, it collects interest in the form of interest income. Banks enjoy the difference between the interest income and interest expense and this difference is also known as the interest spread. This is the major source of revenue for a bank.
Banks also earn money in the form of fees and commission through provision of ancillary services. Such fees include credit card fees, trade finance, remittance et cetera. In order to provide the above mentioned services, the banks incur operating expenses, which include fees and charges paid to other companies/banks, rent, and salary paid to the employees.
Another major expense for banks, which is very unique to lending institutions like banks, is Provision for Loan Loss. Not all the money lent by banks is paid back by the borrowers. Some of them default or show signs that they will not pay back the money in future period. Therefore, banks estimate how much of the total loans will not be paid back and this amount is expensed (written off) in the Income Statement as Provision for Loan Loss. Higher the quality of loans, lower will be the Loan Loss Provisioning, and higher will be the profits for the banks.
- Background of the Promoter(s) and the Board of Directors
We start by evaluating the Promoters of the bank – their credibility and background, their knowledge and experience, their skin in the game, their ambition and vision for the bank, their efficient leadership, and cordial working of the board of directors. Most importantly, we try to evaluate the promoters on the above mentioned parameters from various sources. Another key consideration not mentioned above but crucial is, how much value the promoters place on Honesty and Ethics. This can be deduced, to an extent, from their interviews published/broadcast in the newspaper and media.
Any company’s strategy is only as good as its execution. The power to execute the banks’ strategies lies with their CEO and management team. It may be useful to evaluate their background and past experience. One may gauge their past performance by comparing their past claims versus performance in that period. We may look at their source and magnitude of motivation by looking at the incentive structures and by checking if the management owns shares in the bank. If the management has significant portion of their entire wealth in the bank, then it is generally a positive sign.
Evaluating the background of the board of directors and management is very difficult. One must try to meet the management if one can. If one can’t, one must collect necessary data points from press interviews, involvement, and performance in other entities, and their commentary in annual reports.
- Sustainable Competitive Advantage
The “sustainable competitive advantage” or “moat”, which we have often mentioned in the earlier blogs, is the most important factor to identify. Moat provides a bank an edge over the competitors for a sustainable period of time. Moats may arise from a wide range of factors such as technological base, access to international/government network and affiliation, widespread network, the image and positioning of the bank et cetera. In case of banks, presence of moats lead to lower cost of funds, higher spreads, and better quality of loans vis-à-vis peers.
- Quality of Loans
This might be the most difficult factor to evaluate. Not all loans given by banks are paid back by the borrowers. If the management lend recklessly, the quality of business suffers owing to the high risk borrowers and the bank becomes susceptible to the probability of loans being unpaid during downturn of economic cycle. This will increase the Loan Loss Provision and reduce profitability of the banks.
So, one must not only monitor how aggressively a bank is lending but should also try to evaluate the quality of loans being given out through periodic channel checks, if possible.
- Adoption of Information Technology
IT systems form the backbone of any operations at the present context and the banking industry is no exception. HDFC Bank in India is an exemplary case of how adoption of IT can bring down costs, drive efficiency, and enable quicker processes, which helps bring new business to the bank. Today, we are at the tipping point of next information system revolution in banking and this time, it is data- driven banking that will make a cut. We must watch out for banks whose management is tech-savvy, rendering the banks well positioned to enter new age of digital banking. Eg, HDFC Bank has Digital 2.0 strategy.
(PART II will be out next week. Till then, stay tuned and have a wonderful weekend!)