Can we Assess a Bank’s Financial Position from its Reported Financials

The current article in this series provides responses related to the following queries:

• Can we know the true financial position of a Bank by reading its reported financials?
• What should we look at while investing in Banks/Financial Institutions?
• Do we invest in PSU banks? 

Can we assess the true financial position of a Bank by reading its reported financials?

Hello Dr. Vijay Sir,

I had done some little analysis on Karnataka Bank.

Net interest margin (NIM) was in the range of 2.5% until 2016-17. Now we are seeing NIM being an improvement in the range of above 3%. GNPA and NNPA are decreasing from a 2016-17 yearly peak of 4.21% and 2.64%.

Recently they have collaborated with BCG firm for the transformation of the bank. MD and CEO Mahabaleshwara M S looks aggressive to me. Moreover, they are intending to create some wealth for shareholders and investors now. Branches and ATM networks are at a good stage ~800 and 1382. Other operational efficiency numbers are improving quarter after quarter. The capital adequacy ratio looks somewhat concerning at ~12.2% in 2017-18 TTM. However, I think Bank is maintaining their CAR at ~12.5%. They do not have any aim to improve on that front. The biggest improvement we see is in NIM margins and NPA improvement.

As we know, they have transformational targets of doubling their business and decreasing the NPA percentage significantly in 2020. In addition, as far as I have seen their targets are being fulfilled in time. Some of the concerns may rise for the banking sector while rising bond yield. However, I do not think KTK bank has much exposure to the bond side.

I agree ROA is lower than 1% at ~0.65% currently and ROE as well. However, if we see business improvement and NIM margins improvement steadily and loan growth at around 25%. They can go beyond 1% as well. In addition, the Bank, recently, had a rights issue, which is why we see a drop in ROE percentage significantly; otherwise, they were in line with another old private bank ~10%. I believe going forward they will also improve to the original level of 10% and furthermore.

As we talked about business. Now let me come to the valuation of the bank.

P/E is around ~7 TTM at 9-3-2018 price. P/B is ~0.66 for the same date.

At this valuation, looks cheapest from private sector banks. I would agree price might discount previous results hurdles. However, from the last 2 quarters, the numbers are good and are better than the banking sector numbers as well. I believe if they can go by their targets and double the business, improving numbers efficiency, then after 2 years or so, bank valuation may also demand some premium, which is not there at all. I would like to know is this an opportunity for a great investment having a great valuation, safety in this costly market valuation. Or is it some sort of trap? Any information/foresight that I do not know.

I request you to help me, with the little analysis that I have done. I would also like to hear what you believe about Karnataka Bank and about its business and valuation.

Hope to hear from you soon.

Thank you.

Author’s Response:

Hi,

Thanks for writing to us and sharing your views on Karnataka Bank.

Looking at the outcomes in the banking companies in the last couple of years, it comes out that almost all the banks were hiding many NPAs/bad assets in their beautifully prepared audited financials, which were certified by the best of the auditors in the world. NPAs of banks initially always seemed to be within 1-2%, whereas now most of the private sector banks are accepting that NPAs are above 5% and PSU banks are accepting that NPAs are mostly above 10%. In addition, no one knows about the true extent of bad assets the banks hold in their books.

An investor will appreciate that until very recent times, one of the private banks, Yes Bank Ltd, used to report low NPA numbers. However, it turns out that the bank had a higher number of bad loans, which reached unmanageable proportions. As a result, the Govt. of India and RBI had to bail out Yes Bank.

Similarly, an investor would remember the cases of PMC Bank and other financial institutions like IL&FS and DHFL where despite audits by various agencies, the underlying issues remained undetected over time until these organizations could not cover them up anymore.

In light of the above developments, in the hindsight, it seems that almost all the banks lied to the stakeholders in their audited financials. Therefore, we believe that it is difficult to have an opinion on the financial position of a bank by relying on the audited financials prepared by it.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

Almost all the analysts in different brokerage houses/research companies, who used to cover banks and used to read every line of the annual reports of the banks and used to have direct conversations with the management of the banks. Now the analysts also seem to have learned that it is difficult to opine about the health of the bank by relying on the information supplied by the bank.

Therefore, in light of these developments, we find ourselves unable to provide an opinion about Karnataka Bank and your analysis.

Advised Reading: Selecting Top Stocks to Buy – A Step-by-Step Process of Finding Multibagger Stocks

All the best for your investing journey!

Regards

Dr. Vijay Malik

Related Query:

Hello sir,

Please give me a reference (any website, forum, books etc.) for analysis of micro-finance, finance and housing finance companies. I have gone through the Peaceful Investing e-book. For the general case, it helped me a lot. However, I want to do an analysis of some housing finance companies. I am not able to get any reliable material for this specific sector.

What fundamental factors should we look at while studying the annual reports and balance sheets of finance/housing finance sector companies?

I am from a science background. Nevertheless, I have had a good interest in economics, especially in the last 3-4 years. I need your help, please.

Author’s Response:

Hi,

Thanks for writing to us!

We believe that it is very difficult to assess the true financial position of any financial institution by analysing its reported financial numbers. Almost the entire analyst community has realized this aspect by looking at the sharp rise in NPAs reported by almost all the banks/financial institutions (FIs).

We are until now, not able to differentiate below two cases from the annual reports of financial institutions (FI):

1) Cases where FIs give genuine loans to one borrower, collect interest and principal repayments and then give genuine loans to other different borrowers and

2) Cases where FIs first give the loan to one borrower, are not able to collect interest and principal repayments from the borrower as the borrower is under stress. Therefore, the FIs indulge in evergreening to give more loans to the same borrower/any of its related companies, so that the money goes to the first borrower and then he pays back to the bank. In this fashion, the bank saves the NPA recognition of a stressed loan.

Hope it clarifies our views on Banks/financial institutions including HFC, NBFCs etc.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Related query:

Then what should one look at while investing in banks/financial institution/non-banking finance company (NBFC) stocks?

Author’s Response:

From the above discussion, an investor would note that it is difficult to assess the real financial position of any financial institution by analysing the financial data provided by it in the public documents. Investors would remember many instances where the financial data reported by banks/NBFCs did not present their actual financial position like Yes Bank, DHFL.

Despite spending hours analysing the annual reports etc., investment analysts could not decipher that the position of the loans given by these financial institutions was worse than what was disclosed by them in their disclosures.

It is not only a limitation of the investment analysts who get access only to the public data. An investor would note that in certain cases, even the regulators (RBI) could not ascertain the real financial position of the financial institutions despite having access to all the insider data of the banks and financial institutions. e.g. PMC Bank.

RBI tells court how it was ‘cheated’ by scam-hit PMC Bank (Source: Economic Times)

Therefore, an investor would acknowledge that the disclosures of any bank/financial institution/NBFC leave a lot of room for the management of these companies to hide the actual poor performance. If an investor/analyst is not able to detect the misrepresentation by these institutions, then she should not take it on herself as it may not be her incompetence, but the nature of the business of banks/financial institutions that makes the analysis of their real business position difficult.

Therefore, investors should always keep this fact in front of them, that despite the best of their efforts, whatever conclusion they might have arrived about the business position of any financial institution, it might be proved completely wrong in future.

Therefore, in such cases, the only parameter that an investor can analyse and take comfort from, before investing, is the management of the financial institution.

If an investor can not rely on her analysis of the financial statements of the banks/financial institutions/NBFCs, then it becomes essential that she should do a very thorough analysis of the management of these institutions.

How to do Management Analysis before Buying Stocks

In case, after putting in the best of her efforts in the management analysis of a bank/financial institution, an investor is convinced that the management of the bank is honest, has integrity and is minority shareholder-friendly, then she may invest in the bank/financial institution/NBFC.

Even after making the investment decision, an investor should always be open to accepting that her analysis of the financial position of the company may be completely wrong. This is because of the nature of the business in which financial institutions operate. Investors have been wrong in their analysis of these institutions in the past and more often than not, will be wrong in the future as well.

Therefore, if an investor wishes to invest in any bank/financial institution, then she may invest only after doing a thorough management analysis of the financial institution.

An investor should acknowledge that an investment in a financial institution is blind faith in the management of the financial institution because whatever efforts an investor may put in her financial analysis; if the management of the financial institution is determined to misrepresent their numbers, then she would not be able to identify it in time.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Readers’ Queries about analysing Banks/NBFCs

Do we invest in PSU Banks?

Dear Sir,

Your site is good and informative.

I have invested in SBI and would like to know if I should continue for the long term.

Author’s Response:

Thanks for writing to us!

I do not prefer investing in PSU banks due to a number of reasons.

PSU banks do not have long term CEO/Chairmen tenors. Every person on the top comes with a fixed tenure of 3-4 years and in order to keep his/her record clean, he/she tries to show the result in the joining quarter (resultantly, also the joining financial years) as bad as possible. All the provisioning is usually done within one quarter in order to wipe the slate clean.

This by no means should be interpreted that provisioning should not be done or is to be avoided. However, the way PSU banks show a cyclical trend of bad to good results and then again bad with a frequency of 3-4 years. It indicates that something else other than shareholders’ interest is also at play.

Most of the time, the management of PSU banks seems to be motivated by short term vision. SBI shows the same trend with years of chairman changes 2011, 2014 etc. showing exceptionally bad results.

Due to certain reasons, PSU banks always seem to have higher non-performing assets (NPAs) than their private counterparts. Higher NPAs hurt shareholders’ interests. SBI also has higher NPAs than most private banks.

Currently, I am not invested in any PSU bank. In future, I may or may not. However, you should decide about holding or selling SBI, for your own reasons. I have presented you with mine.

Hope it helps!

Does the quality of borrowers reflect upon the quality of the lender?

Hi Dr Vijay,

It is always a good learning experience to read your analysis of management quality based on related party transactions.

One question. I was analysing Pincon Spirits; I found that banks are giving huge short-term working capital loans to Pincon despite stressed CFO and negative FCF. Most of the banks were regional banks. One among them was _____ bank (sic).

So is it right to form an opinion on the quality of a bank based on its disbursements made to such a financially stressed company?

The reason I came up with this question is that I had formed an investment rationale for _____ bank sometime back and I avoided it after analyzing Pincon.

Thank you. 

Author’s Response:

Hi,

Thanks for writing to us. We are happy that you found the article useful. We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

Different banks follow different lending approving mechanisms. In some cases, individuals may approve the loans. In such cases, some poor lending decisions may be a result of the decision of a few individuals. Therefore, might not be representative of the entire organization.

On the other hand, in other banks, the lending decisions may be centralized in certain authorities indicating general practices in lending. Therefore, it is difficult to have an opinion.

Moreover, it is very difficult to assess the lending quality of any bank by relying on the numbers reported by them. This has been evident from the results reported by banks in last a few quarters when suddenly a lot of NPAs have come up whereas earlier the asset quality was reported to be good.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr Vijay Malik

Debt Securitization: What benefits does it bring to the seller of the loans?

Hi Vijay,

Your articles and the “Peaceful Investing” workshop are enjoyable as always.

Can you also elaborate if “Debt Securitization” is another common practice for financial institutions (FI) to convert their long term debts into cash? What kind of incentives/commissions does a bank & the special purpose vehicle (SPV) get to keep in the process of Debt Securitization?

My understanding of debt securitization is that it allows banks to convert debt into a security instrument, which is then sold to investors in the debt market. The bank gets the cash immediately, which it can deploy for the next set of loans. The investors get the interest income from the debt bought by them.

In some cases, nonbanking financial companies (NBFCs) also end up selling their loans (along with the risks and benefits) to banks to generate quick cash.

If an NBFC sells loans of ₹100 of interest rate 14% to another bank/investor via securitization, is it a good thing to do?

NBFCs get the cash, but they also lose on the future interest from an acquired loan customer. Do they get to keep some commission, like say 1-2%, in the process for all future interest?

Author’s Response:

Hi,

Thanks for sharing your views about debt securitization. Your presentation of the learning in a concise manner is very helpful for all the readers.

An investor would appreciate that for any financial institution (FI) that originates a loan and then hands it over to another FI i.e. securitizes the loan, there has to be some incentive to go through all this process. This incentive usually comes in some of the following forms:

1. The originating NBFC may keep part of the interest payment with itself. E.g. if the interest rate on the loan is 14%, then it may pass on a lesser interest rate to the FI, which buys the loan say 12%. Therefore, upon securitization, the loan originating FI gets the upfront cash as well as 2% interest (14% – 12%) income on the amount of loan sold/securitized.
2. Many times, the loan originating NBFC charge a hefty loan-processing fee in addition to the interest rate to their borrowers. This is especially true for corporate loans. It might be a case that on the loan bearing interest rate of 14%, the loan originating NBFC may have charged a loan-processing fee of 2% of total loan amount. In such cases, the NBFC may pass on entire 14% interest rate (but not the hefty loan-processing fee) to the FI buying the loan as it has already earned a good amount of processing fee.

Therefore, in one form or another, the loan originating NBFC will ensure that it keeps a sufficient amount of earnings/incentive with itself so that the entire process of loan origination and then its securitization makes economic sense for it.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr Vijay Malik

Net Interest Margin and Spread

Hello Vijay,

Thank you for your valuable time and support beginners like me.

I need your clarification about net interest margin (NIM) and interest spread. I try to understand from the internet but I couldn’t. Please confirm my below understanding

• NIM = (Interest Income – Interest Expense) / Interest earning assets

Spread, on the other hand, is the difference between yield and cost of borrowing, where yield is the interest income earned on interest-earning assets and cost of borrowing is interest expense charged on interest-bearing liabilities.

• Spread = (Interest Income/ Interest earning assets) – (Interest Expense/ Interest bearing Liabilities)

E.g.

• If Interest income = Rs. 150 crore
• Interest expense = Rs. 80 crore
• Interest earning assets = Rs. 2,250 crore
• Interest bearing liabilities = Rs. 3,000 crore
• NIM = (150 – 80) / 2250= 3.11%
• Spread = (150 / 2,250) – (80 / 3,000)= 4%

Some websites explain spread = (interest earned – interest expenses)

E.g.: interest expenses= 8%, interest earned = 12% Spread= 4%

Thank you again for your support

Author’s Response:

Hi,

Thanks for writing to me!

I am happy that you are trying to understand different key concepts relevant to understanding stocks of different industries and referring to different resources for them.

Different resources would always define different ratios differently as per their preference. From your calculations, I find that you have correctly understood the basics behind NIM/Spread.

Therefore, the first thing that you need to take care of while using NIM &/or spread is that before taking the NIM/spread value mentioned on any website/source for granted, you should calculate it on your own from the annual report data and secondly, you should compare any two stocks for NIM/Spread by calculating their values by a similar method.

Regards,

Vijay

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.