With the economy looking up and interest rates likely to rise again, safety-seeking investors may like to shop around for bank FDs offering attractive rates. But as we had explained in an earlier article, given the way deposit insurance works in India, it simply isn’t worth taking risks with your bank deposits for slightly higher rates.
But identifying a sound bank has become infinitely tougher post-Covid. Borrowers are just coming out of a loan moratorium and banks are prevented from reporting their true bad loan picture due to a Supreme Court standstill. If bad loan provisions get out of hand, some currently profitable banks can turn loss-making or face capital shortfalls.
If you’ve come upon a bank advertising high rates, do run this Master Health Checkup on it before investing in it. This article explains the key measures to test a bank’s financial health.
#1 Loan exposure
The biggest threat to a bank’s financial position comes from its borrowers going rogue or defaulting due to a cash crunch. Here are some general rules on this:
- banks with exposure to unsecured loans (such as personal loans or microfinance loans) are likely to take a bigger hit from defaults than those whose loans are backed by hard assets (home, gold, vehicle loans).
- Banks lending to debt-heavy sectors are riskier than those lending to cash-rich ones.
- Post-Covid, retail borrowers are believed to be facing more income stress than corporate borrowers.
Therefore, knowing a bank’s largest loan exposure is a good first step to vetting it.
The sectoral breakdown of a bank’s loans is available in the mandatory “Regulatory Disclosures” section under the “Basel 3 Pillar III” reports, uploaded every quarter on the bank’s website.
The latest disclosure from Ujjivan Small Finance Bank tells us that Rs 10,527 crore out of its Rs 13,889 crore loans outstanding were microfinance (small-ticket) loans. This makes it a much riskier entity than Kotak Mahindra Bank, whose largest exposure (Rs 31,693 crore out of Rs 3.24 lakh crore outstanding) was to home loans.
When a bank is in trouble, large investors and often get wind of this before ordinary retail folk. Therefore, trends in a bank’s deposit flows can often be a good lead indicator of building stress.
#2 Deposit base
When it comes to financial firms, there’s safety in size. The larger a bank’s existing deposit base, the more likely it is that it’s a trusted name with depositors. The government and regulators are also loath to let a bank with a large deposit base run into hot waters lest it trigger a run on the rest of the financial system. To gauge this, look at the Total Deposits (CASA plus term deposits) number from a bank’s quarterly results announcement to the stock exchanges or its investor presentation.
With Rs 77,289 crore in total deposits in December 2020, IDFC First Bank had just 6% of HDFC Bank’s deposit base of Rs 12.7 lakh crore.
#3 Deposit growth
When a bank is in trouble, large investors and often get wind of this before ordinary retail folk. Therefore, trends in a bank’s deposit flows can often be a good lead indicator of building stress. Most banks provide year-on-year deposit growth numbers in their quarterly financial result updates. Check for positive trends here to know if a bank is facing a deposit flight.
Faced with stress, Yes Bank was placed under RBI directions with withdrawal restrictions in March 2020. In the quarter from September to December 2019 preceding the RBI action, Yes Bank’s deposits fell from Rs 2.09 lakh crore to Rs 1.65 lakh crore.
#4 Capital to Risk-Weighted Assets Ratio (CRAR) and Tier 1 CRAR
One key reason why banks so easily turn turtle is that they lend out sums that are many times their long-term capital. This is why regulators the world over like to dictate bank capital adequacy ratios. Capital adequacy is measured as the proportion of the bank’s own capital (leaving out deposits and other borrowed money) to the loans it gives out (which are assets on its balance sheet).
The CRAR or Capital to Risk-Weighted Assets ratio is the official ratio used to measure a bank’s capital adequacy. It is the ratio of the bank’s own and supplementary capital to its risk-weighted loans. What are these risk weights? To discourage banks from giving out too many loans risky borrowers, regulators specify ‘risk weights’ for each category of loans.
Globally, Basel III norms decide the ideal CRAR for commercial banks. In India, RBI further tweaks these norms to set minimum regulatory requirements on bank CRAR. As per RBI rules, all Indian banks are required to maintain a minimum CRAR Ratio of 10.875% (including a capital buffer), while ‘systemically’ important ones are required to maintain 11.075%.
The higher a bank’s CRAR is above the minimum regulatory limits, the more cushion it has to keep lending and to absorb losses from bad loans and provisions. By December 2020 end, HDFC Bank had a comfortable total CRAR of 18.91% against the RBI requirement of 11.075%. When a bank’s CRAR ratio threatens to breach the regulatory minimum, RBI may place the bank under PCA (more on it below) or impose withdrawal limits.
A sub-set of the CRAR, a bank’s Tier 1 capital ratio, is the amount of own capital held by the bank in relation to its loans. It measures the permanent capital on a bank’s books by way of equity, reserves and surpluses and perpetual bonds. RBI requires scheduled commercial banks to maintain a Tier 1 CRAR of 8.875% (including capital conservation buffer) while systemically important banks are required to maintain 9.075%. The higher a bank’s Tier 1 ratio is above this, the higher the cushion against losses.
#5 GNPA and NNPA Ratio
Given that they make their profits mainly by lending out other people’s money, one thing that can quickly trip up a bank’s cash flows is delays or defaults in loan repayments by borrowers. This is captured in the Gross Non-performing Asset (GNPA) ratio.
Banks are required to treat any loans on which interest or principal repayments are overdue for over 90 days as non-performing assets or NPAs. When a loan turns NPA, RBI requires the bank to make specific loan-loss provisions against the NPA.
A bank’s Gross NPA ratio is the proportion of its total NPAs to its total loans/advances. The net NPA ratio is the proportion of loans, not covered by loss provisions, as a proportion of its total advances. Trends in this ratio can tell you if more and more of its borrowers are delaying their repayments. While GNPA comparisons are best done against the backdrop of economic conditions and peers, as a thumb rule, GNPA ratios of 5% or more are deemed high. An addition of more than 0.5% in GNPAs to a bank’s loans during a quarter can be treated as a worrying signal.
The net NPA tells you how much of the bank’s bad loans have already been accounted for in its past profits. The wider the gap between the net NPA ratio and the gross NPA, the better it is for the bank’s future profitability, as it indicates that the bank has already provided for a bulk of its existing bad loans. Both the Gross and Net NPA ratios can be found in the Basel 3 Pillar III disclosures.
For the quarter ended December 2020, SBI disclosed that its reported Gross NPAs were 4.72% whereas its net NPAs were at 1.21%. This suggests that SBI had already provided for losses amounting to three-fourths of its stock of doubtful loans.
#6 Proforma Gross NPA and Net NPA ratios
In a new addition to bank ratios necessitated by Covid, many banks are now disclosing their proforma Gross and Net NPA numbers in the notes to their financial results. As you may know, the Supreme Court of India has been hearing a case on extension of loan moratoriums to bank borrowers for many months now. In an earlier hearing, the Court decreed that pending its judgement, banks must not recognize the loans that fell due after August 31 2020, as NPAs even if the borrower had delayed repayments beyond 90 days.
This ‘time freeze’ on NPA recognition has effectively made the official NPA numbers reported by banks in their reported financial results and Basel 3 disclosures, a misleading indicator of their true bad loan picture for the last two quarters. To help out investors, some banks are disclosing their real NPA situation in their notes to accounts under the moniker “Proforma NPAs”. If your bank has disclosed proforma NPAs, do check this instead of the reported NPA to get a real-life picture of its latest asset quality.
The gap between a bank’s official NPAs and proforma NPAs can tell you if nasty surprises await you, when the Court lifts this standstill. Ujjivan Small Finance Bank for instance, reported official GNPA and NNPA ratios of 0.96% and 0.05% in its financial results. But its notes to accounts disclose much higher proforma numbers. Its GNPA ratio would have stood at 4.83% and NNPA at 2.05% had the Court standstill not been applied to bad loan recognition.
#7 Whether under PCA
If RBI believes that a bank is at risk of breaching its capital adequacy requirements or is heading to an unsustainable bad loan situation, it can place it under its “Prompt Corrective Action” framework. Once a bank is under PCA, it can be restricted from lending to select or all sectors, accepting deposits and pursuing its business in other ways to conserve capital. RBI can also step in to replace the bank’s Board or management and merge it with another bank. Being placed under PCA is seldom good for bank’s depositors as it can limit growth until fresh capital is infused.
The troubled Lakshmi Vilas Bank was placed under PCA in September 2019. While PSBs being under PCA is less of a worry than private banks being swept under it, it is best for depositors not to concentrate their deposits in PCA banks.
#8 Ownership
In India, public sector banks, which feature Government of India equity stakes of 51% or more are generally perceived to be safer than private sector banks. While there is no explicit sovereign guarantee backing PSBs, successive governments have been quick to infuse capital into PSBs or merge them into larger and stronger PSBs when they are on the brink of trouble. Given that the Government has large coffers at its disposal, PSBs that are short on capital adequacy can usually hope to get recapitalized by their promoter without too much trouble.
Within private sector banks, banks that are classified as ‘old’ private sector banks are usually seen a more chequered history than ‘new’ private sector banks which feature a large institutional shareholding. Recent banking troubles and governance skirmishes in India have also revolved around ‘old’ private sector banks such as Lakshmi Vilas Bank and Dhanlaxmi Bank.
Small Finance Banks, a new category of banks licensed by RBI in recent years, are permitted to have loans books concentrated on small ticket borrowers and usually quite closely held. They are therefore riskier than scheduled commercial banks with more diversified loan books.
#9 Systemically important
In the interests of shoring up public confidence in the banking system, the RBI designates giant domestic banks as ‘systemically important’ and keeps an extra-careful watch over them, by specifying higher capital adequacy and other norms. A bank’s Basel 3 Pillar III disclosures will usually tell you if it is systemically important. If you are looking for an ultra-safe parking ground for a windfall or a large lump-sum, stick to systemically important banks as these are the least likely to be allowed to get into financial trouble.
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