Description
profitability of banks and various ratios associated with it.
Profitability of Banks : A Juggling Act
Banks play an important role of mobilizing small savings and lending them to businesses that require the funds. This function of intermediation has four components: ? ? ? ? Mopping up customer deposits(liabilities) and converting them into loans (assets) Transformation of the size of deposits. Converting small savings collating them with larger deposits and lending them out as large loans. Transformation of the maturities. Accepting deposits of various maturities and provide customers with loans of different tenors. Reduce Risk for depositors through diversification of assets and also by conforming to the RBI / regulatory norms
The classical function of banks was intermediation and still continues to remain an integral part of a banks income pie. Tough competition, a need for sophisticated banking products and savvy customers demanding competitive pricing coupled with the pressure to maintain a healthy bottom line have led to banks looking for alternative avenues such as using sophisticated treasury products and variations thereof. To put it simply Profit can be defined as the surplus revenue after deducting all the expenses. Profit has various variants such as: ? Operating Profit: Derived after deducting business expenses such as utilities, salaries etc .Non-operating expenses and income are excluded while computing operating profit. Operating Profit measures the efficiency of operations after the expenses required to run the business have been deducted. Profit before tax: Shows the overall performance of the firm before the tax component is excluded. Tax is a statutory component and required to be paid by the firm whether they like it or not. Net Profit: It’s the residual amount left in a business after all the business expenses, other expenses and tax have been paid out. It’s what is available for distribution to the stakeholders or for saving by the firm in the form of reserves. Retained Profit: This is what is left over after paying out the dividends. In other words, it’s the net profit less dividends. Dividend payment is discretionary and translates into a charge on the capital. A study of the retained earnings help to know the profit ploughed back into the business
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Profitability of Banks : A Juggling Act
In case of banks, these components also can be applied but mostly for studying the financials of clients to whom the banks plan on lending funds. Since banking is a service, the main component of income and expense for a bank is interest income (revenue) and interest expense (expenditure). Banks are required to prepare a P/L (also called the Income Statement) as per the 3 rd Schedule of the Banking Regulation Act. The main items pertaining to a bank can be found in the following schedules. Item Schedule No
Income Interest Earned Other Income Expenses Interest Expended Operating Expenses 15 16 13 14
Banks P/L format can be illustrated as follows: Current Year Income Interest Earned Other Income Total Expenditure Interest Expended Commercial Banking: Raji Ajwani: October 2009 Page 2 Prev Year
Profitability of Banks : A Juggling Act
Operating Expenses Provisions & Contingencies Total Profit/Loss Net Profit/Loss for the year Profit/Loss brgt forwd Total Appropriations Transfer reserves to statutory
Transfer to other reserves Transfer Dividend to Proposed
Balance carrd/ovr to B/Sheet Total
Analysis of the components of a banks Income Statement. Income: ? ? Interest Income Other Income
Interest Income: Depends upon various components such as the size, quality (performing assets v/s non performing assets) of a bank’s lending portfolio, and the rate at which the business has been booked. It consists of:
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Profitability of Banks : A Juggling Act
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Income on the investments made by the bank( by way of interest and dividend) Interest on advances and discount on trade bills : On all types of loans( cash credit, overdrafts, term loans) and trade bills( domestic and foreign bills discounted and purchased and includes regular and overdue interest ) Interest on balances with other banks : RBI, inter-bank funds, call money, money market placements
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Other Income: Also called non interest income and comprises: ? Commission, fees, brokerage for services rendered such as : o o o o o o o ? ? ? ? ? ? ? Remittances and Funds transfer Collections Letters of Credit / Guarantees Merchant banking services Government business undertaken Rentals on lockers Service charges of various types of accounts and products
Profit on sale of investments Profit on revaluation of investments Profit on sale of land, other assets Profit on foreign exchange transactions. Income earned by way of dividends from subsidiaries, companies, joint ventures abroad and in India Lease income including lease rental, management fee, financial charge overdue charge Miscellaneous income such as income from any property that the bank may have leased out etc
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Profitability of Banks : A Juggling Act
Commission/brokerage and profits made in treasury and foreign exchange transactions are the major contributors to a banks bottom line. Other income plays an important role since it is income earned without any addition to a bank’s assets and contributes to a large extent in increasing a bank’s ROA (Return on Assets) Expenditure: Can be divided into 3 broad categories: 1. Interest Expended 2. Operating Expenses 3. Provisions and Contingencies
1. Interest Expended ( or paid out): This includes : ? ? ? ? Interest paid on customer deposits, borrowings from other banks Interest on borrowings from the RBI (repo) and other banks such as discount paid on refinance availed from banks/RBI Other borrowings from FI’s Interest paid out on Participation Certificates, any penal interest paid etc.
Interest expense depends on the size of the deposit portfolio, the term and the rate structure Banks with a high CASA ( Current and Savings Account Portfolio) are able to compete more aggressively as these low cost deposits can be lent out at competitive rates thus helping the bank to earn on the difference ( also called spread income)
2. Operating Expenses: Also called establishment cost. This is the cost incurred involved in keeping the business functional such as rents, salaries, other utilities etc. This can be broken down as under: ? ? ? Salaries: Basic salary ,allowances, and other benefits such as PF, Gratuity, LTA, medical reimbursements, HRA, etc Rent, taxes, lighting, maintenance expenses on premises, water, taxes(municipal taxes excluding income tax and interest tax) etc Printing and Stationery used ( non publicity expenditure)
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Profitability of Banks : A Juggling Act
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Advertising and Publicity expenses Depreciation expenses on the bank’s property property,cars,vehicles,furniture&fittings,vaults,lifts,leasehold and non banking assets) ( bank’s properties
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Directors Fees such as sitting fees, and other expenditure such as travel, hotel stay, conveyance and travel charges etc. Auditors Fees paid for rendering professional services and any reimbursements Legal charges Postage, telephone charges, internet connection charges Repairs of the bank’s property Insurance Paid on the banks property, DICGC etc Any other expenditure incurred such as donations made, subscriptions to various publications etc.
The largest contributors to the operating expenses portion are the salary costs and the rental costs. Incase of foreign banks and Private sector banks the manpower costs are typically higher than those of PSU Banks. However in case of PSU banks factors such as union agreements etc hamper the management from linking the compensation to the productivity.
3. Provisions and Contingencies : The major provisions are : ? ? ? ? ? Provisions made against Non Performing Assets Provisions against depreciated investments. Provisions for taxes ( income-tax and other taxes) Provisions for accrued interest Provisions for salary revisions
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Profitability of Banks : A Juggling Act
4. Net Profit: Is the difference between the income and expenditure of a bank. A healthy Net Profit helps in bolstering public confidence and the share price and also acts as a buffer to set-off losses and build reserves. Sr No 1 2 3 ( 1-2) Items Gross Interest Income Gross Interest Expense NII or NIM ( also called spread) Prov for loan losses. PLL NII after PLL Non interest income Non interest expense Net non burden) interest income(
4 5(3-4) 6 7 8 ( 6-7)
9 ( 5+8) 10
Pre-tax operating income Gains/Losses Investments Profit before taxes Extraordinary Items Taxes Net Profit Dividends Retained Profits/Reserves from
11(9+10) 12 13 14(11-12-13) 15 16(14-15)
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Profitability of Banks : A Juggling Act
The quality of a banks loan portfolio has a great bearing on the bottom line of any bank. It can be seen from the above table that if the Gross Interest Income itself is low, then it will have a cascading effect on the banks spread and ultimately on the net profit and the reserves that can be ploughed back into the business. The need to compete on an international level and the Basel norms have also meant that banks have to set aside capital to buffer any risks ( capital adequacy) and hence NPA’s hit the banks in more ways than one On the whole NPA’s drag the banking system down as it means that the funds in the banking sector get tied down towards unproductive use and to that extent banks have to look for alternative avenues like treasury operations ( which have a inherent risk reward factor built in)plus charge their retail customers a higher rate to offset these unproductive assets. Hence NPA’s are bad for the economy as a whole. This can be explained with the help of an illustration: Balance Sheet of XYZ (Rs Crore s) Bank Resources (Liabilities) Share Capital 700.00 Reserves 1,400.00 Deposits 50,000.00 Inter Bank Deposits 500.00 Borrowings 300.00 Total 52,900.00 P/L of XYZ Bank Income Total Income 7,480.00 Interest Income 5,500.00 Other Income 1,980.00 Profit 2,430.00 Commercial Banking: Raji Ajwani: October 2009 Page 8 Other Expenses 1,550.00 Interest Expenses 3,500.00 52,900.00 Fixed Assets 500 Bills Loans & Advances 37,400.00 6000 Investments 8000 Uses ( Assets) Cash 1000
Expenses Total Expenses 5,050.00
Profitability of Banks : A Juggling Act
Tax 801.90 PAT 1,628.10 In the above illustration, the bank has made a profit of Rs 1628.10. If we assume that the portion of the non performing loans and assets increases to the extent of 20% i.e about Rs 7480 crores, the interest income of the bank will also go down. In addition the bank will have to make provisions and set aside other expenses. This will hit the bottom line of the bank and reduce the profit of the bank. The components of analyzing a bank’s profitability can be further broken down as explained in Annexure 1 appended at the end of the note. The break-up can be explained as follows: Abbrev ROE Explanation Ret on Equity Abbrev ROA Explanation Ret on Assets Abbrev EM Explanation Equity Multiplier Net Income Int Expenses
PM TI
Profit Margin Total Income
AU AA
Asset Utilizn Average Assets Tax Service Chgs
NI IE
OE II
Opert Exp Income Investm Cash Other Assets Salary Balance Sheet Income Held to Mat fr
T SC
IL OI
Int on Loans Other Income
C OA S BS
I D Prov OBS
Investm Deposits Provisions Off-Balance Sheet Income Avail for Sale
L B O HFT
Loans Borrowngs Others Held Trading for
HTM
AFS
SME
Small & Med Enterprises
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Profitability of Banks : A Juggling Act
C AGL IRR
Commercial Agricultural Int Rate Risk
I PER CR
Institutional Personal Credit Risk
LR
Liquidity Risk
Banks take risks to earn a risk premium or profits. Hence the overall bank performance is a factor of risks and returns. Risk is the variation of the actual return from the expected return, hence an entrepreneur or a business enterprise has to decide how much variation (from the anticipated) profits /losses will it be able to absorb. Hence individuals/entities take calculated risks. Typically there is an inverse relationship between risk and return. This means that higher the risk, higher the return. Sometimes too much risk taking even for very sophisticated players can have dire consequences. This is best illustrated with the example of Barings Bank where the actions of a single individual caused the bank to go belly-up. The captioned table can be explained as follows: 1. ROE: = NP /Equity NP= Income available to the shareholders Equity= Share Capital + Reserves. If the above formula is broken down further: (NP/Assets) * (Assets/Equity) Now (NP/Assets) = Return on Assets and And (Assets/Equity) = Equity Multiplier Hence ROE= ROA* EM
2. Return on Assets (ROA) = (Net Profit/Assets) This shows the banks ability to use its assets to generate income. Hence for a bank to have a higher denominator, it should have more assets that earn a good income for the bank (earning assets).for eg: good quality loans, investments and less of fixed assets (which don’t earn much Commercial Banking: Raji Ajwani: October 2009 Page 10
Profitability of Banks : A Juggling Act
although there is an opportunity cost associated with their usage).Poor quality loan assets or NPA’s eat away into the profits of the bank.. A low ROA indicates a poor return on assets or high operating expenses or poor grade loans. The ROA analysis is broken down further to analyze: ? ? Profit Margin Asset Utilization (both explained subsequently) to analyze causes for the high/low ROA.
The growing shift from the banks moving away from traditional intermediation activities to fee based services has meant an increase in the off balance sheet activities. These activities are riskier and hence have a greater reward. A low ratio indicates that the bank is not adequately compensated for the additional risks assumed. 3. Equity Multiplier(Equity Multiplier) Measures the financial leverage and affects the banks profit because it has a multiplier impact on the ROA to determine a bank’s ROE. EM= Assets / Equity This ratio shows the relationship that the assets bear to equity. Assets are funded out of debt and equity. A high EM means that the bank has funded most of its assets out of debt and borrowings. It shows the degree of leverage of a bank. An analysis of the EM helps to evaluate whether the capital is adequate to support the risks assumed in the B/S. ROE= ROA*EM A high EM would enhance the ROE for a given level of ROA. Typically for banks, ROA is pretty low hence a bank with a high EM can get a good ROE. For eg: A bank that has an ROA of 1% can expect to have an ROE of 10% only if its EM is 10 (Assets = 10, Equity = 1 and Debt 9). Hence a bank with a high capital (denominator) will have a lower ROE. There needs to be a balance between the debt and equity mix for a bank to have a good ROE. Situation 1: An all equity bank or equity dominated bank. Hence the ratio of Assets/Equity or EM will be 1. Now ROE = ROA * EM and since EM=1 and the typical ROA for banks tends to be low, therefore the whole ROE will be low. Situation 2: Normal equity and high EM say 100/33 and normal ROA say 1% Commercial Banking: Raji Ajwani: October 2009 Page 11
Profitability of Banks : A Juggling Act
EM (Assets/Equity) =100/33 ROE = (ROA*EM) = (1/100)*(100/33) % = 3.03% Hence here it is seen that even if the ROA is just 1, shareholders can expect to earn approx 3% on their income due to high EM. 4. Profit Margin ROA = Net Profit/Assets (NP/Total Income………. Part A also called Profit Margin)* (Total Income/Assets…………. Part B also called Asset Utilization) Explanation of Part A of the equation A= Profit Margin. This shows how much the bank has been able to make after covering all its costs. To break this down further, this is: NP = (Total Income-Total Expenditure) Total Income = (Interest Income+ Non Interest Income + Other Income) Interest Income is the main bread and butter for a bank in a traditional environment. Non interest income is interest earned of the banks investments, fees and service charges. Other income is income generated from off balance sheet activities such as fee or commission charged for issuing a Letter of Credit or dividends earned from a subsidiary. Total Expenditure = (Interest expense+ Provisions + Operating Expenses+ Tax+ Misc) Interest Expense occurs on account of borrowing by the bank or when the bank pays its depositors. Operating expenses are items such as salaries and wages, rent &admin etc and the taxes are statutory expenses such municipal and income taxes. For understanding break-up of net income we can analyze it in two ways: ? Spread: Difference between the interest income and expense. A healthy bank would have a good spread as its quality of interest bearing assets (loans) would mean that the profit would be good. Burden: Diff between the non interest income and non interest expenditure. Non interest income is earnings from fees, service charges. Non interest expense like
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Profitability of Banks : A Juggling Act
staff and admin costs. A bank can increase its profits by increasing its non interest income although it’s difficult. Explanation of Part B of the equation: B= Asset Utilization. This shows the earning potential of a bank’s assets. It’s the yield or return per rupee of assets. AU= Total Income / Assets These assets are also called average assets because they are a mixture of earning and non earning assets. Within the earning category also some earn more than the others. These include: ? ? ? ? Cash & balances with the RBI Investments (taxable & tax free) Loans & Advances ( Eg: Retail loans, commercial loans, small industries loans, agricultural loans) Fixed Assets
Hence to conclude we can state that: ROE = NP/Equity Or (NP/Total Income)*(Total Income/Total Assets)*(Total Assets/Total equity) After cancellation of common factors we get ROE= PM*AU*EM Another major component that affects a banks performance is the risk component. Higher the risk, the reward is greater. However banks are affected by a variety of risk factors. Notably among the risks that a bank encounters are: a. Credit Risk: Is the risk of default in payments of the Principal/ Interest. The quality of the loan portfolio is very important in mitigating the credit risk. Poor quality of loans means a high percentage of defaults and this pushes up the credit risk. Lending to prime or very good customers poses a challenge of having to earn profits because everybody wants to book business through them.
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Profitability of Banks : A Juggling Act
b. Liquidity Risk: Is the risk that the bank may not have the necessary liquidity. A bank has to have a good ratio between the liquidity outflow( maturing deposits, repayment of bank borrowings) and the anticipated fresh liquidity inflow ( fresh deposits, maturing investments ) c. Interest Rate Risk: Changes arising out of interest rate changes and their impact on the income of the bank. Interest rate risk can be measured as the ratio of interest sensitive assets to interest sensitive liabilities. d. Operational Risk: Arises out of doing business. It is the risk of doing and remaining in the business of banking. It is associated with losses arising from fraud or litigation. There are other risks also such as market risk; reputation risk etc which can affect banks operations. These have been discussed in detail in another note. Given below is an illustration of a hypothetical bank. Three illustrations are shown to illustrate the impact of low and higher risk on the profitability of banks. Balance Sheet on 31st March ***** Liabilities Capital Reserves & Surplus Rs Crores 1000 6000 Assets Cash Balance Rs Crores 6900
Balances with Banks, 15000 Money at Call and Short Notice Investments Bills Purchased Cash Credit Term Loans Fixed Assets 15000 20000 20000 20000 3100
Current Account Savings Deposits Time Deposits Borrowings
30,000 30,000 30,000 3000
Total
100000
Total
100000
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P/L for the year ended 31st March ***** Income Interest Income Other Income Operating Income/Profit Tax Net Income/Profit Rs Crores 6950 0 1230 Expenses Interest Expenses Other Expenses Rs Crores 3720 2000
400 830
In the above table: ? ? ? ? Total Assets = Rs 100000 crores: Earning assets are Rs 90000 crores ( excluding premises and cash balances) Rate sensitive assets are Rs 55000 (all except term loans hence cash-credit, bills, Investments) Rate sensitive liabilities are: Rs 63000.
Calculation of Interest Income & Interest Expense (Yield) Assets Amount (Rs Crs) Cash balance Bal with Money at call Investments Bills Purchased banks, 6900 15000 0 5% Yield% Income (Rs Crs) 0 750
15000 20000
8% 7%
1200 1400
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Cash Credit Term Loans Fixed Assets Total Int Income
20000 20000 3100
9% 9% 0%
1800 1800 0 6950
Liabilities
Amount (Rs Crs)
Cost%
Expenses (Rs Crs)
Demand Deposits Savings Time Deposits Borrowings Total Int Expense
30000 30000 30000 3000
3% 4% 5% 4%
900 1200 1500 120 3720
Note: Interest Rates paid/received are hypothetical. Measures of Returns: a) Interest Margin: (Interest Income-Interest Expenses)/Earning Assets = (6950-3720)/90000=3.59% b) Net Profit Margin = (Net Income/Total Returns) = (830/6950=11.94% c) Asset Utilization = Total Income/Assets = (6950/100000) =6.95% d) Return on Assets = Net Income/Assets = (830/100000) = 0.83% Commercial Banking: Raji Ajwani: October 2009 Page 16
Profitability of Banks : A Juggling Act
e) Equity Multiplier = Assets/Equity = (100000/7000) =14.29% f) Return on Equity=Net Income/Equity
= (830/7000) =11.85%
Measures of Risks a) Liquidity Risk = Short term securities / Deposits Short Term defined as balances with banks, money at call and short notice = (15000/90000) =16.67% b) Interest Rate Risk = Interest Sensitive Assets/Interest Sensitive Liabilities = (55000/63000) =0.87% c) Credit Risk = Medium quality loans / Assets = (20000/100000) =20% d) Capital Risk = Capital/Risk Assets = (7000/75000) =9.33% The above calculations are shown for the purpose of illustration in a simple manner. At this stage the bank can take two approaches: A) Low Risk and Low Profits Portfolio ( Scenario II) B) High Risk and High Profits Portfolio ( Scenario III)
A) Low Risk and Low Profits Portfolio ( Scenario II) Assumptions: The bank management wants to play it safe and increase liquidity and safety in the coming year. It targets a deposit growth of Rs 10000 crores and a capital Commercial Banking: Raji Ajwani: October 2009 Page 17
Profitability of Banks : A Juggling Act
augmentation of Rs 1000 crores It decides to place all the newly attracted funds after providing for additional cash reserves into money at call and short notice. The P/L and B/S would look as under:
Balance Sheet on 31st March ***** Liabilities Capital Reserves & Surplus Rs Crores 2000 6000 Assets Cash Balance Rs Crores 7300
Balances with Banks, 25600 Money at Call and Short Notice Investments Bills Purchased Cash Credit Term Loans Fixed Assets 15000 20000 20000 20000 3100
Current Account Savings Deposits Time Deposits Borrowings
30,000 35,000 35,000 3000
Total
111000
Total
1110000
P/L for the year ended 31st March ***** Income Interest Income Other Income Rs Crores 7480 0 Expenses Interest Expenses Other Expenses Rs Crores 4170 2000
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Profitability of Banks : A Juggling Act
Operating Income/Profit Tax Net Income/Profit
1310
440 870
A comparison between Scenario I and Scenario II
Measures of Returns Interest Margin NP Margin Asset Utilization ROA EM ROE
Scenario I 3.59% 11.94% 6.95% 0.83% 14.29% 11.85%
Scenario II 3.29% 11.63% 6.74% 0.78% 13.88% 10.88%
Measures of Risks Liquidity Risk Interest Rate Risk Credit Risk Capital Risk
Scenario I 16.67% 0.87% 20% 9.33%
Scenario II 25.60% 0.75% 18.02% 10.67%
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Profitability of Banks : A Juggling Act
Observations: ? The liquidity risk ratio (short term securities to deposits) indicates that the bank has more liquid investments. These securities earn less income but are more liquid. The low interest liquid investments affect both the interest margin and net profit margin. The interest rate risk ratio has decreased which means that the rate sensitive assets are less compared to the interest sensitive liabilities. The banks income can get affected in such a case if the interest rates rise. Credit Risk ratio has reduced marginally indicating a improvement in the quality of assets The bank has raised fresh capital of Rs 1000 crores. This has improved the capital risk ratio from 9.33% to 10.67%. However the ROE has come down from11.85% to 10.88%.The ROA has fallen from 0.83% to 0.78%.. The risk ratios have improved but profitability has been affected. ROA has fallen down from 0.83% to 0.78% and ROE from 11.85% to 10.88%. This approach would please the depositors and creditors happy but not the shareholders. The regulatory bodies,rating agencies would find the bank position less risky and therefore more acceptable.
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B) High Risk and High Profits Portfolio ( Scenario III) The bank decides to place fresh funds of Rs 11000 crores into high yielding assets. The scenario would appear as under. Balance Sheet on 31st March ***** Liabilities Capital Reserves & Surplus Rs Crores 2000 6000 Assets Cash Balance Rs Crores 7300
Balances with Banks, 15000 Money at Call and Short Notice Investments 15000
Current Account
30,000
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Profitability of Banks : A Juggling Act
Savings Deposits Time Deposits Borrowings
35,000 35,000 3000
Bills Purchased Cash Credit Term Loans Fixed Assets
25500 25100 20000 3100
Total
111000
Total
1110000
P/L for the year ended 31st March ***** Income Interest Income Other Income Operating Income/Profit Tax Net Income/Profit Rs Crores 7853 0 1683 Expenses Interest Expenses Other Expenses Rs Crores 4170 2000
573 1110
A comparison between Scenario I and Scenario III
Measures of Returns Interest Margin NP Margin
Scenario I 3.59% 11.94%
Scenario III 3.66% 14.14%
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Profitability of Banks : A Juggling Act
Asset Utilization ROA EM ROE
6.95% 0.83% 14.29% 11.85%
7.07% 1.00% 13.88% 13.88%
Measures of Risks Liquidity Risk Interest Rate Risk Credit Risk Capital Risk
Scenario I 16.67% 0.87% 20% 9.33%
Scenario III 15.00% 0.89% 22.97% 9.35%
Observations: ? ? ? ? Interest margin and Net profit margin has increased due to greater investment in high yielding loans. However the liquidity ratio (risk) and credit (risk) ratio have worsened. No major variation in the interest rate risk ratio. Both interest sensitive assets and interest sensitive liabilities have increased in almost the same proportion. ROA has increased from 0.83% to 1% , due to asset utilization.ROE has improved from 11.85% to 13.88% The above position would be seen as risky by the depositors and creditors but shareholders would appreciate it.
Comparative analysis of all the 3 scenarios:
Measures of Returns Interest Margin
Scenario I 3.59%
Scenario II 3.29%
Scenario III 3.66%
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NP Margin Asset Utilization ROA EM ROE
11.94% 6.95% 0.83% 14.29% 11.85%
11.63% 6.74% 0.78% 13.88% 10.88%
14.14% 7.07% 1.00% 13.88% 13.88%
Measures of Risks Liquidity Risk Interest Rate Risk Credit Risk Capital Risk
Scenario I 16.67% 0.87% 20% 9.33%
Scenario II 25.60% 0.75% 18.02% 10.67%
Scenario II 15.00% 0.89% 22.97% 9.35%
Hence it can be seen from the above that a simple decision of choosing an investment option (safe or relatively riskier) can have an impact on a lot of other variables. From a shareholders perspective the main motives are: ? ? The capital invested should remain safe and grow ( dividends) Realize benefit if the entity(bank) is sold
Hence a bank has to maximize profits from its business operations to meet these objectives. This very seemingly simple objective becomes very tough given various factors such as: ? ? ? ? ? Competition Government rules and regulations Adherence to the central governing body and its norms ( RBI) Globalization Growing alternatives for investors and business entities.
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Profitability of Banks : A Juggling Act
But with the increased emphasis on corporate governance, Basel norms and the recent debacle caused to the subprime mortgage crisis in the US, banks have realized that they need to grow in a manner that the objective of increased profits but not at the cost of taking risks that can backfire and endanger their existence.
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doc_301743832.pdf
profitability of banks and various ratios associated with it.
Profitability of Banks : A Juggling Act
Banks play an important role of mobilizing small savings and lending them to businesses that require the funds. This function of intermediation has four components: ? ? ? ? Mopping up customer deposits(liabilities) and converting them into loans (assets) Transformation of the size of deposits. Converting small savings collating them with larger deposits and lending them out as large loans. Transformation of the maturities. Accepting deposits of various maturities and provide customers with loans of different tenors. Reduce Risk for depositors through diversification of assets and also by conforming to the RBI / regulatory norms
The classical function of banks was intermediation and still continues to remain an integral part of a banks income pie. Tough competition, a need for sophisticated banking products and savvy customers demanding competitive pricing coupled with the pressure to maintain a healthy bottom line have led to banks looking for alternative avenues such as using sophisticated treasury products and variations thereof. To put it simply Profit can be defined as the surplus revenue after deducting all the expenses. Profit has various variants such as: ? Operating Profit: Derived after deducting business expenses such as utilities, salaries etc .Non-operating expenses and income are excluded while computing operating profit. Operating Profit measures the efficiency of operations after the expenses required to run the business have been deducted. Profit before tax: Shows the overall performance of the firm before the tax component is excluded. Tax is a statutory component and required to be paid by the firm whether they like it or not. Net Profit: It’s the residual amount left in a business after all the business expenses, other expenses and tax have been paid out. It’s what is available for distribution to the stakeholders or for saving by the firm in the form of reserves. Retained Profit: This is what is left over after paying out the dividends. In other words, it’s the net profit less dividends. Dividend payment is discretionary and translates into a charge on the capital. A study of the retained earnings help to know the profit ploughed back into the business
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Profitability of Banks : A Juggling Act
In case of banks, these components also can be applied but mostly for studying the financials of clients to whom the banks plan on lending funds. Since banking is a service, the main component of income and expense for a bank is interest income (revenue) and interest expense (expenditure). Banks are required to prepare a P/L (also called the Income Statement) as per the 3 rd Schedule of the Banking Regulation Act. The main items pertaining to a bank can be found in the following schedules. Item Schedule No
Income Interest Earned Other Income Expenses Interest Expended Operating Expenses 15 16 13 14
Banks P/L format can be illustrated as follows: Current Year Income Interest Earned Other Income Total Expenditure Interest Expended Commercial Banking: Raji Ajwani: October 2009 Page 2 Prev Year
Profitability of Banks : A Juggling Act
Operating Expenses Provisions & Contingencies Total Profit/Loss Net Profit/Loss for the year Profit/Loss brgt forwd Total Appropriations Transfer reserves to statutory
Transfer to other reserves Transfer Dividend to Proposed
Balance carrd/ovr to B/Sheet Total
Analysis of the components of a banks Income Statement. Income: ? ? Interest Income Other Income
Interest Income: Depends upon various components such as the size, quality (performing assets v/s non performing assets) of a bank’s lending portfolio, and the rate at which the business has been booked. It consists of:
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Profitability of Banks : A Juggling Act
? ?
Income on the investments made by the bank( by way of interest and dividend) Interest on advances and discount on trade bills : On all types of loans( cash credit, overdrafts, term loans) and trade bills( domestic and foreign bills discounted and purchased and includes regular and overdue interest ) Interest on balances with other banks : RBI, inter-bank funds, call money, money market placements
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Other Income: Also called non interest income and comprises: ? Commission, fees, brokerage for services rendered such as : o o o o o o o ? ? ? ? ? ? ? Remittances and Funds transfer Collections Letters of Credit / Guarantees Merchant banking services Government business undertaken Rentals on lockers Service charges of various types of accounts and products
Profit on sale of investments Profit on revaluation of investments Profit on sale of land, other assets Profit on foreign exchange transactions. Income earned by way of dividends from subsidiaries, companies, joint ventures abroad and in India Lease income including lease rental, management fee, financial charge overdue charge Miscellaneous income such as income from any property that the bank may have leased out etc
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Profitability of Banks : A Juggling Act
Commission/brokerage and profits made in treasury and foreign exchange transactions are the major contributors to a banks bottom line. Other income plays an important role since it is income earned without any addition to a bank’s assets and contributes to a large extent in increasing a bank’s ROA (Return on Assets) Expenditure: Can be divided into 3 broad categories: 1. Interest Expended 2. Operating Expenses 3. Provisions and Contingencies
1. Interest Expended ( or paid out): This includes : ? ? ? ? Interest paid on customer deposits, borrowings from other banks Interest on borrowings from the RBI (repo) and other banks such as discount paid on refinance availed from banks/RBI Other borrowings from FI’s Interest paid out on Participation Certificates, any penal interest paid etc.
Interest expense depends on the size of the deposit portfolio, the term and the rate structure Banks with a high CASA ( Current and Savings Account Portfolio) are able to compete more aggressively as these low cost deposits can be lent out at competitive rates thus helping the bank to earn on the difference ( also called spread income)
2. Operating Expenses: Also called establishment cost. This is the cost incurred involved in keeping the business functional such as rents, salaries, other utilities etc. This can be broken down as under: ? ? ? Salaries: Basic salary ,allowances, and other benefits such as PF, Gratuity, LTA, medical reimbursements, HRA, etc Rent, taxes, lighting, maintenance expenses on premises, water, taxes(municipal taxes excluding income tax and interest tax) etc Printing and Stationery used ( non publicity expenditure)
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Profitability of Banks : A Juggling Act
? ?
Advertising and Publicity expenses Depreciation expenses on the bank’s property property,cars,vehicles,furniture&fittings,vaults,lifts,leasehold and non banking assets) ( bank’s properties
? ? ? ? ? ? ?
Directors Fees such as sitting fees, and other expenditure such as travel, hotel stay, conveyance and travel charges etc. Auditors Fees paid for rendering professional services and any reimbursements Legal charges Postage, telephone charges, internet connection charges Repairs of the bank’s property Insurance Paid on the banks property, DICGC etc Any other expenditure incurred such as donations made, subscriptions to various publications etc.
The largest contributors to the operating expenses portion are the salary costs and the rental costs. Incase of foreign banks and Private sector banks the manpower costs are typically higher than those of PSU Banks. However in case of PSU banks factors such as union agreements etc hamper the management from linking the compensation to the productivity.
3. Provisions and Contingencies : The major provisions are : ? ? ? ? ? Provisions made against Non Performing Assets Provisions against depreciated investments. Provisions for taxes ( income-tax and other taxes) Provisions for accrued interest Provisions for salary revisions
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Profitability of Banks : A Juggling Act
4. Net Profit: Is the difference between the income and expenditure of a bank. A healthy Net Profit helps in bolstering public confidence and the share price and also acts as a buffer to set-off losses and build reserves. Sr No 1 2 3 ( 1-2) Items Gross Interest Income Gross Interest Expense NII or NIM ( also called spread) Prov for loan losses. PLL NII after PLL Non interest income Non interest expense Net non burden) interest income(
4 5(3-4) 6 7 8 ( 6-7)
9 ( 5+8) 10
Pre-tax operating income Gains/Losses Investments Profit before taxes Extraordinary Items Taxes Net Profit Dividends Retained Profits/Reserves from
11(9+10) 12 13 14(11-12-13) 15 16(14-15)
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Profitability of Banks : A Juggling Act
The quality of a banks loan portfolio has a great bearing on the bottom line of any bank. It can be seen from the above table that if the Gross Interest Income itself is low, then it will have a cascading effect on the banks spread and ultimately on the net profit and the reserves that can be ploughed back into the business. The need to compete on an international level and the Basel norms have also meant that banks have to set aside capital to buffer any risks ( capital adequacy) and hence NPA’s hit the banks in more ways than one On the whole NPA’s drag the banking system down as it means that the funds in the banking sector get tied down towards unproductive use and to that extent banks have to look for alternative avenues like treasury operations ( which have a inherent risk reward factor built in)plus charge their retail customers a higher rate to offset these unproductive assets. Hence NPA’s are bad for the economy as a whole. This can be explained with the help of an illustration: Balance Sheet of XYZ (Rs Crore s) Bank Resources (Liabilities) Share Capital 700.00 Reserves 1,400.00 Deposits 50,000.00 Inter Bank Deposits 500.00 Borrowings 300.00 Total 52,900.00 P/L of XYZ Bank Income Total Income 7,480.00 Interest Income 5,500.00 Other Income 1,980.00 Profit 2,430.00 Commercial Banking: Raji Ajwani: October 2009 Page 8 Other Expenses 1,550.00 Interest Expenses 3,500.00 52,900.00 Fixed Assets 500 Bills Loans & Advances 37,400.00 6000 Investments 8000 Uses ( Assets) Cash 1000
Expenses Total Expenses 5,050.00
Profitability of Banks : A Juggling Act
Tax 801.90 PAT 1,628.10 In the above illustration, the bank has made a profit of Rs 1628.10. If we assume that the portion of the non performing loans and assets increases to the extent of 20% i.e about Rs 7480 crores, the interest income of the bank will also go down. In addition the bank will have to make provisions and set aside other expenses. This will hit the bottom line of the bank and reduce the profit of the bank. The components of analyzing a bank’s profitability can be further broken down as explained in Annexure 1 appended at the end of the note. The break-up can be explained as follows: Abbrev ROE Explanation Ret on Equity Abbrev ROA Explanation Ret on Assets Abbrev EM Explanation Equity Multiplier Net Income Int Expenses
PM TI
Profit Margin Total Income
AU AA
Asset Utilizn Average Assets Tax Service Chgs
NI IE
OE II
Opert Exp Income Investm Cash Other Assets Salary Balance Sheet Income Held to Mat fr
T SC
IL OI
Int on Loans Other Income
C OA S BS
I D Prov OBS
Investm Deposits Provisions Off-Balance Sheet Income Avail for Sale
L B O HFT
Loans Borrowngs Others Held Trading for
HTM
AFS
SME
Small & Med Enterprises
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C AGL IRR
Commercial Agricultural Int Rate Risk
I PER CR
Institutional Personal Credit Risk
LR
Liquidity Risk
Banks take risks to earn a risk premium or profits. Hence the overall bank performance is a factor of risks and returns. Risk is the variation of the actual return from the expected return, hence an entrepreneur or a business enterprise has to decide how much variation (from the anticipated) profits /losses will it be able to absorb. Hence individuals/entities take calculated risks. Typically there is an inverse relationship between risk and return. This means that higher the risk, higher the return. Sometimes too much risk taking even for very sophisticated players can have dire consequences. This is best illustrated with the example of Barings Bank where the actions of a single individual caused the bank to go belly-up. The captioned table can be explained as follows: 1. ROE: = NP /Equity NP= Income available to the shareholders Equity= Share Capital + Reserves. If the above formula is broken down further: (NP/Assets) * (Assets/Equity) Now (NP/Assets) = Return on Assets and And (Assets/Equity) = Equity Multiplier Hence ROE= ROA* EM
2. Return on Assets (ROA) = (Net Profit/Assets) This shows the banks ability to use its assets to generate income. Hence for a bank to have a higher denominator, it should have more assets that earn a good income for the bank (earning assets).for eg: good quality loans, investments and less of fixed assets (which don’t earn much Commercial Banking: Raji Ajwani: October 2009 Page 10
Profitability of Banks : A Juggling Act
although there is an opportunity cost associated with their usage).Poor quality loan assets or NPA’s eat away into the profits of the bank.. A low ROA indicates a poor return on assets or high operating expenses or poor grade loans. The ROA analysis is broken down further to analyze: ? ? Profit Margin Asset Utilization (both explained subsequently) to analyze causes for the high/low ROA.
The growing shift from the banks moving away from traditional intermediation activities to fee based services has meant an increase in the off balance sheet activities. These activities are riskier and hence have a greater reward. A low ratio indicates that the bank is not adequately compensated for the additional risks assumed. 3. Equity Multiplier(Equity Multiplier) Measures the financial leverage and affects the banks profit because it has a multiplier impact on the ROA to determine a bank’s ROE. EM= Assets / Equity This ratio shows the relationship that the assets bear to equity. Assets are funded out of debt and equity. A high EM means that the bank has funded most of its assets out of debt and borrowings. It shows the degree of leverage of a bank. An analysis of the EM helps to evaluate whether the capital is adequate to support the risks assumed in the B/S. ROE= ROA*EM A high EM would enhance the ROE for a given level of ROA. Typically for banks, ROA is pretty low hence a bank with a high EM can get a good ROE. For eg: A bank that has an ROA of 1% can expect to have an ROE of 10% only if its EM is 10 (Assets = 10, Equity = 1 and Debt 9). Hence a bank with a high capital (denominator) will have a lower ROE. There needs to be a balance between the debt and equity mix for a bank to have a good ROE. Situation 1: An all equity bank or equity dominated bank. Hence the ratio of Assets/Equity or EM will be 1. Now ROE = ROA * EM and since EM=1 and the typical ROA for banks tends to be low, therefore the whole ROE will be low. Situation 2: Normal equity and high EM say 100/33 and normal ROA say 1% Commercial Banking: Raji Ajwani: October 2009 Page 11
Profitability of Banks : A Juggling Act
EM (Assets/Equity) =100/33 ROE = (ROA*EM) = (1/100)*(100/33) % = 3.03% Hence here it is seen that even if the ROA is just 1, shareholders can expect to earn approx 3% on their income due to high EM. 4. Profit Margin ROA = Net Profit/Assets (NP/Total Income………. Part A also called Profit Margin)* (Total Income/Assets…………. Part B also called Asset Utilization) Explanation of Part A of the equation A= Profit Margin. This shows how much the bank has been able to make after covering all its costs. To break this down further, this is: NP = (Total Income-Total Expenditure) Total Income = (Interest Income+ Non Interest Income + Other Income) Interest Income is the main bread and butter for a bank in a traditional environment. Non interest income is interest earned of the banks investments, fees and service charges. Other income is income generated from off balance sheet activities such as fee or commission charged for issuing a Letter of Credit or dividends earned from a subsidiary. Total Expenditure = (Interest expense+ Provisions + Operating Expenses+ Tax+ Misc) Interest Expense occurs on account of borrowing by the bank or when the bank pays its depositors. Operating expenses are items such as salaries and wages, rent &admin etc and the taxes are statutory expenses such municipal and income taxes. For understanding break-up of net income we can analyze it in two ways: ? Spread: Difference between the interest income and expense. A healthy bank would have a good spread as its quality of interest bearing assets (loans) would mean that the profit would be good. Burden: Diff between the non interest income and non interest expenditure. Non interest income is earnings from fees, service charges. Non interest expense like
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Profitability of Banks : A Juggling Act
staff and admin costs. A bank can increase its profits by increasing its non interest income although it’s difficult. Explanation of Part B of the equation: B= Asset Utilization. This shows the earning potential of a bank’s assets. It’s the yield or return per rupee of assets. AU= Total Income / Assets These assets are also called average assets because they are a mixture of earning and non earning assets. Within the earning category also some earn more than the others. These include: ? ? ? ? Cash & balances with the RBI Investments (taxable & tax free) Loans & Advances ( Eg: Retail loans, commercial loans, small industries loans, agricultural loans) Fixed Assets
Hence to conclude we can state that: ROE = NP/Equity Or (NP/Total Income)*(Total Income/Total Assets)*(Total Assets/Total equity) After cancellation of common factors we get ROE= PM*AU*EM Another major component that affects a banks performance is the risk component. Higher the risk, the reward is greater. However banks are affected by a variety of risk factors. Notably among the risks that a bank encounters are: a. Credit Risk: Is the risk of default in payments of the Principal/ Interest. The quality of the loan portfolio is very important in mitigating the credit risk. Poor quality of loans means a high percentage of defaults and this pushes up the credit risk. Lending to prime or very good customers poses a challenge of having to earn profits because everybody wants to book business through them.
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Profitability of Banks : A Juggling Act
b. Liquidity Risk: Is the risk that the bank may not have the necessary liquidity. A bank has to have a good ratio between the liquidity outflow( maturing deposits, repayment of bank borrowings) and the anticipated fresh liquidity inflow ( fresh deposits, maturing investments ) c. Interest Rate Risk: Changes arising out of interest rate changes and their impact on the income of the bank. Interest rate risk can be measured as the ratio of interest sensitive assets to interest sensitive liabilities. d. Operational Risk: Arises out of doing business. It is the risk of doing and remaining in the business of banking. It is associated with losses arising from fraud or litigation. There are other risks also such as market risk; reputation risk etc which can affect banks operations. These have been discussed in detail in another note. Given below is an illustration of a hypothetical bank. Three illustrations are shown to illustrate the impact of low and higher risk on the profitability of banks. Balance Sheet on 31st March ***** Liabilities Capital Reserves & Surplus Rs Crores 1000 6000 Assets Cash Balance Rs Crores 6900
Balances with Banks, 15000 Money at Call and Short Notice Investments Bills Purchased Cash Credit Term Loans Fixed Assets 15000 20000 20000 20000 3100
Current Account Savings Deposits Time Deposits Borrowings
30,000 30,000 30,000 3000
Total
100000
Total
100000
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Profitability of Banks : A Juggling Act
P/L for the year ended 31st March ***** Income Interest Income Other Income Operating Income/Profit Tax Net Income/Profit Rs Crores 6950 0 1230 Expenses Interest Expenses Other Expenses Rs Crores 3720 2000
400 830
In the above table: ? ? ? ? Total Assets = Rs 100000 crores: Earning assets are Rs 90000 crores ( excluding premises and cash balances) Rate sensitive assets are Rs 55000 (all except term loans hence cash-credit, bills, Investments) Rate sensitive liabilities are: Rs 63000.
Calculation of Interest Income & Interest Expense (Yield) Assets Amount (Rs Crs) Cash balance Bal with Money at call Investments Bills Purchased banks, 6900 15000 0 5% Yield% Income (Rs Crs) 0 750
15000 20000
8% 7%
1200 1400
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Profitability of Banks : A Juggling Act
Cash Credit Term Loans Fixed Assets Total Int Income
20000 20000 3100
9% 9% 0%
1800 1800 0 6950
Liabilities
Amount (Rs Crs)
Cost%
Expenses (Rs Crs)
Demand Deposits Savings Time Deposits Borrowings Total Int Expense
30000 30000 30000 3000
3% 4% 5% 4%
900 1200 1500 120 3720
Note: Interest Rates paid/received are hypothetical. Measures of Returns: a) Interest Margin: (Interest Income-Interest Expenses)/Earning Assets = (6950-3720)/90000=3.59% b) Net Profit Margin = (Net Income/Total Returns) = (830/6950=11.94% c) Asset Utilization = Total Income/Assets = (6950/100000) =6.95% d) Return on Assets = Net Income/Assets = (830/100000) = 0.83% Commercial Banking: Raji Ajwani: October 2009 Page 16
Profitability of Banks : A Juggling Act
e) Equity Multiplier = Assets/Equity = (100000/7000) =14.29% f) Return on Equity=Net Income/Equity
= (830/7000) =11.85%
Measures of Risks a) Liquidity Risk = Short term securities / Deposits Short Term defined as balances with banks, money at call and short notice = (15000/90000) =16.67% b) Interest Rate Risk = Interest Sensitive Assets/Interest Sensitive Liabilities = (55000/63000) =0.87% c) Credit Risk = Medium quality loans / Assets = (20000/100000) =20% d) Capital Risk = Capital/Risk Assets = (7000/75000) =9.33% The above calculations are shown for the purpose of illustration in a simple manner. At this stage the bank can take two approaches: A) Low Risk and Low Profits Portfolio ( Scenario II) B) High Risk and High Profits Portfolio ( Scenario III)
A) Low Risk and Low Profits Portfolio ( Scenario II) Assumptions: The bank management wants to play it safe and increase liquidity and safety in the coming year. It targets a deposit growth of Rs 10000 crores and a capital Commercial Banking: Raji Ajwani: October 2009 Page 17
Profitability of Banks : A Juggling Act
augmentation of Rs 1000 crores It decides to place all the newly attracted funds after providing for additional cash reserves into money at call and short notice. The P/L and B/S would look as under:
Balance Sheet on 31st March ***** Liabilities Capital Reserves & Surplus Rs Crores 2000 6000 Assets Cash Balance Rs Crores 7300
Balances with Banks, 25600 Money at Call and Short Notice Investments Bills Purchased Cash Credit Term Loans Fixed Assets 15000 20000 20000 20000 3100
Current Account Savings Deposits Time Deposits Borrowings
30,000 35,000 35,000 3000
Total
111000
Total
1110000
P/L for the year ended 31st March ***** Income Interest Income Other Income Rs Crores 7480 0 Expenses Interest Expenses Other Expenses Rs Crores 4170 2000
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Profitability of Banks : A Juggling Act
Operating Income/Profit Tax Net Income/Profit
1310
440 870
A comparison between Scenario I and Scenario II
Measures of Returns Interest Margin NP Margin Asset Utilization ROA EM ROE
Scenario I 3.59% 11.94% 6.95% 0.83% 14.29% 11.85%
Scenario II 3.29% 11.63% 6.74% 0.78% 13.88% 10.88%
Measures of Risks Liquidity Risk Interest Rate Risk Credit Risk Capital Risk
Scenario I 16.67% 0.87% 20% 9.33%
Scenario II 25.60% 0.75% 18.02% 10.67%
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Profitability of Banks : A Juggling Act
Observations: ? The liquidity risk ratio (short term securities to deposits) indicates that the bank has more liquid investments. These securities earn less income but are more liquid. The low interest liquid investments affect both the interest margin and net profit margin. The interest rate risk ratio has decreased which means that the rate sensitive assets are less compared to the interest sensitive liabilities. The banks income can get affected in such a case if the interest rates rise. Credit Risk ratio has reduced marginally indicating a improvement in the quality of assets The bank has raised fresh capital of Rs 1000 crores. This has improved the capital risk ratio from 9.33% to 10.67%. However the ROE has come down from11.85% to 10.88%.The ROA has fallen from 0.83% to 0.78%.. The risk ratios have improved but profitability has been affected. ROA has fallen down from 0.83% to 0.78% and ROE from 11.85% to 10.88%. This approach would please the depositors and creditors happy but not the shareholders. The regulatory bodies,rating agencies would find the bank position less risky and therefore more acceptable.
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? ?
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B) High Risk and High Profits Portfolio ( Scenario III) The bank decides to place fresh funds of Rs 11000 crores into high yielding assets. The scenario would appear as under. Balance Sheet on 31st March ***** Liabilities Capital Reserves & Surplus Rs Crores 2000 6000 Assets Cash Balance Rs Crores 7300
Balances with Banks, 15000 Money at Call and Short Notice Investments 15000
Current Account
30,000
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Profitability of Banks : A Juggling Act
Savings Deposits Time Deposits Borrowings
35,000 35,000 3000
Bills Purchased Cash Credit Term Loans Fixed Assets
25500 25100 20000 3100
Total
111000
Total
1110000
P/L for the year ended 31st March ***** Income Interest Income Other Income Operating Income/Profit Tax Net Income/Profit Rs Crores 7853 0 1683 Expenses Interest Expenses Other Expenses Rs Crores 4170 2000
573 1110
A comparison between Scenario I and Scenario III
Measures of Returns Interest Margin NP Margin
Scenario I 3.59% 11.94%
Scenario III 3.66% 14.14%
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Profitability of Banks : A Juggling Act
Asset Utilization ROA EM ROE
6.95% 0.83% 14.29% 11.85%
7.07% 1.00% 13.88% 13.88%
Measures of Risks Liquidity Risk Interest Rate Risk Credit Risk Capital Risk
Scenario I 16.67% 0.87% 20% 9.33%
Scenario III 15.00% 0.89% 22.97% 9.35%
Observations: ? ? ? ? Interest margin and Net profit margin has increased due to greater investment in high yielding loans. However the liquidity ratio (risk) and credit (risk) ratio have worsened. No major variation in the interest rate risk ratio. Both interest sensitive assets and interest sensitive liabilities have increased in almost the same proportion. ROA has increased from 0.83% to 1% , due to asset utilization.ROE has improved from 11.85% to 13.88% The above position would be seen as risky by the depositors and creditors but shareholders would appreciate it.
Comparative analysis of all the 3 scenarios:
Measures of Returns Interest Margin
Scenario I 3.59%
Scenario II 3.29%
Scenario III 3.66%
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Profitability of Banks : A Juggling Act
NP Margin Asset Utilization ROA EM ROE
11.94% 6.95% 0.83% 14.29% 11.85%
11.63% 6.74% 0.78% 13.88% 10.88%
14.14% 7.07% 1.00% 13.88% 13.88%
Measures of Risks Liquidity Risk Interest Rate Risk Credit Risk Capital Risk
Scenario I 16.67% 0.87% 20% 9.33%
Scenario II 25.60% 0.75% 18.02% 10.67%
Scenario II 15.00% 0.89% 22.97% 9.35%
Hence it can be seen from the above that a simple decision of choosing an investment option (safe or relatively riskier) can have an impact on a lot of other variables. From a shareholders perspective the main motives are: ? ? The capital invested should remain safe and grow ( dividends) Realize benefit if the entity(bank) is sold
Hence a bank has to maximize profits from its business operations to meet these objectives. This very seemingly simple objective becomes very tough given various factors such as: ? ? ? ? ? Competition Government rules and regulations Adherence to the central governing body and its norms ( RBI) Globalization Growing alternatives for investors and business entities.
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Profitability of Banks : A Juggling Act
But with the increased emphasis on corporate governance, Basel norms and the recent debacle caused to the subprime mortgage crisis in the US, banks have realized that they need to grow in a manner that the objective of increased profits but not at the cost of taking risks that can backfire and endanger their existence.
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