How to analyse   bank   performance without the clutter

Higher net profit or net interest margin does matter, while analysing thefinancial  performance of a bank. RBI may also consider mandating banks reporting total assets/  balance sheet size rather than the so-called 'total business' adding deposits, liabilities and loan assets to have a true and fair sense of banks' business growth

Come quarterly and annual  bank financial  results  and investors and readers of business and financial  newspapers are all agog over some analyst gushing 'Bank A’s net profit rises 35%, and some other analyst emoting ‘Bank  B’s NIM is highest at 5 or 6 %' ! And all these are taken by readers and investors as holy grail suggesting that banks concerned have been exceptionally efficient and profitable! This need, and may, not at all be so. But before seeing why, it would only be instructive and value-adding to consider  the business modelof a typical competit ive, efficient, safe, and sound  bank. A bank is typically characterised by relatively high  financial  leverage, which, in turn, is measured by what is known as Equity Multiplier (EM), which, in turn, is nothing but total assets of a  bank divided by its common equity/ shareholder funds. Multiplying this leverage (EM) by what is called Return on Assets (ROA) gives Return on Equity  (ROE) for a  bank. Typically, competit ive, efficient, safe and sound banks have had historically an average ROA of about 1% and a reasonably safe EM of about 15, implying an average market-competitive equilibrium ROE of about 15%. In the recent period, the Indian Banking System has had leverage of about 13 to 14 times. Significantly, and hearteningly, to the credit of Reserve  Bank of India (RBI) and the Indian banking sector, this corresponds to an average leverage ratio ( inverse of EM) of 7%+, which, at about 2.5 t imes, is way higher than 3% mandated by new Basel III capital rules to be complied with only in 2018 ! In other words, the Indian banking sector is already more than 2.5 t imes compliant on this cri tical Basel III parameter !! In this context, another key  financial  parameter is what is known as Net Interest Margin (NIM), which is the difference between interest earned and interest expended as apercentage  of a bank’s assets. Collectively for Indian Banks in the recent period, NIM has varied between 2.5% to 3%. If we deduct ROA from NIM, we get what can be called Non Interest cost of Intermediation. In fact, it is this cri tical parameter/ objective function viz (NIM-ROA) which, for a given

ROA derived, in turn, from a given ROE and EM, it must be the  dharma/ mantra of a role model  bank management to minimize for maximizing returns to depositors and/ or minimizing costs to borrowers . Thus, either way, constrained minimization of the objective function (NIM-ROA) delivers value to all stakeholders viz, shareholders, insured and uninsured depositors, borrowers, taxpayers, in particular, and the real economy, in general. To recapitulate, "the business model  of a competitive, efficient, safe and sound bank is one which, while by minimizing the objective function (NIM-ROA) subject to the constraint of a given ROA, derived, in turn, from a given market-competit ive equilibrium ROE, maximizes value for all stakeholders viz, depositors, borrowers, shareholders and public policy insti tutions, and allows it to grow sustainably by helping the real sector grow consistent with 'financial  sector-real sector balance ' where the  financial  sector is ever a means to the real sector end !! " Significance of NIM-ROAWe are now ready to unclutter the clutter in  bank financial  performance analysis and evaluation. As regards the myth of NIM being a key measure of profitabili ty, let it be said that NIM by, and in, itself conveys nothing more than what it apparently does viz, as we have seen before, it is just the difference between interest earned, and interest expended, as a  percentage of a bank’s assets. It is just a means to an end and not an end in i tself ! For it , therefore, to make any sense, it needs to be analysed further beyond what it is by considering (NIM-ROA). For if NIM be 6%, and ROA be zero, then automatically ROE will also be zero and it is no brainer to see that this nominally very high NIM only establishes that the bank is neither competitive, efficient, safe nor sound ! Even if ROA be, say 2%, then ( NIM-ROA) will be (6%-2%) i.e. 4%. And this bank will be far less efficient and competit ive than a bank whose NIM is, say 3%, and ROA , say 1% , and, therefore, (NIM-ROA) 2% ! This is because non-interest cost of intermediation of the higher- NIM bank is twice that of the lower- NIM bank and it is precisely this twice as large (NIM-ROA) and its reasons through its granular analysis and dissection that should engage the attention of bank analysts and investors!

For it is this (NIM-ROA) that subsumes all non- interest expenses such as taxes,  salaries/wages /compensation, operational expenses, loan loss provisions, marked-to-market provisions, write-offs etc. And this (NIM-ROA) becomes even more significant, if the reported gross NPAs (non performing assets) are unusually low! Therefore, in the above example, the  bank with lower (NIM-ROA) will be twice as efficient and competit ive as the one with higher (NIM-

ROA) because the former maximizes value for all stakeholders viz, depositors by way of higher deposit  interest rates, borrowers by way of lower borrowing costs, shareholders by way of given ROA and market - competitive equilibrium ROE ! Higher net profit may not show real growthFinally, coming to too much being made of, say 25% to 35% growth in net profits, this too needs to be regarded with circumspection for these numbers need to be adjusted for the growth in  balance sheet  / assets and not just considered in isolation and on a stand- alone basis. For if net profit grows at 35%, on a year-on-year ,or a CAGR, basis and assets/balance sheet  also grow by, say 35%, then there is really nothing to write home , or to feel gung-ho, about for the bank in question has been no more, and no less, efficient and profitable than before ! Another equally insightful way to see this is in terms of change in ROA. For example, if previous ROA be, say 1%, then there is no change in ROA as the ROA also remains unchanged at 1% for 35% growth both in net profits and assets/balance sheet! On the other hand, if for a 35% growth in net profit, assets/  balance sheet  grow by, say 25%, then the  bank has been more efficient and profitable only to the extent of (1.35/1.25-1)*100 i.e.+ 8%, and not 35%, as bank analysts would unwittingly have readers and investors believe ! In this case, ROA increases fom 1% to 1*1.08 i .e 1.08% only! Also, significantly, and equally, if assets/  balance sheet  grow by 40%, then the so-called nominal profit growth of 35% will translate into a less efficient and less profitable performance of (1.35/1.40-1)*100 i .e - 3.5% and not 35% as ROA will decline to 0.96% from 1% previously although absolute net profit increased by 35% ! This then is the conceptually robust and technically rigorous nuts-and-bolts way of how bank analysts and investors must dissect  bank financial  performance and judge true and fair value of banking stocks for value investing/ buying! Flaws in using deposits and loans as total businessWhile on the how-and-how-not of bank financial performance analysis and evaluation, a tail piece on banks' reporting of 'total business' will not be out of place and context. Typically, in India, it is routine for banks to report total business as the sum of deposits and loans to give analysts and investors a sense of growth in banks' business. But this is not only at variance with the international practice but also intellectually and conceptually flawed and vitiated for all 'business' is about generating revenues and returns for shareholders and it is ' total assets ' that precisely do that and it is tautological and axiomatic that there is no way revenue generating assets can exist and grow without corresponding expense contributing liabilities! That is also precisely why, as sources and uses of funds, liabili ties and assets appear opposite each

other on a balance sheet. Significantly, the so called total business of banks has typically exceeded total assets/ balance sheet size by about 50%! Therefore, while bank analysts and investors will do well to go that extra mile to have a true and fair sense of banks' business growth, with a view to aligning with the international practice, RBI may also consider mandating banks reporting total assets/ balance sheet size rather than the so called 'total business' adding deposit liabil ities and loan assets.