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hi so in this video we're going to try and understand the basic tenets of evaluating a bank how do you go and evaluate a bank what are the key parameters that you to keep in mind when you're looking at a particular bank it's not a very exhaustive video we are going to try and touch upon the core elements of the banking system and understand you know what makes one bank better as compared to another bank right so let's begin with a very basic understanding of how does a bank work i mean how does the banking system basically operate at its heart the banking system is a very straightforward system where the bank is going to accept deposits from depositors these are technically the sort of liabilities for the bank and the bank will then use that money to extend loans to people who would need that money so basically you know take hundred rupees from depositors and give it out to to people who need it in the context of those loans this is how basically the banking system mobilizes the capital in the country or the economy from people who have that money to people who need that money so that's a straightforward mechanism however there are a few issues with this model if it was this simple there are going to be challenges here there are two broad challenges the first challenge depositor is somebody who's given you the money so it's like a lender to the bank essentially so when i deposit my money in the bank the bank is supposed to safeguard it right in this environment if a bank is functioning technically speaking there is no skin in the game for the bank somebody else's money being loaned out to you know a third person if something goes wrong it goes wrong what does the bank really lose in that so that's problem number one that comes into the picture even if the bank has the interest of the depositor completely in their heart right even then it's possible that some loans don't come back so how do you ensure that things don't go bad there in addition if you take 100 rupees of deposits and you give out 100 rupees of loans what do you do of the liquidity issue so there are multiple issues that need to be addressed liquidity is one of them you know depositor can go tomorrow to the bank and say please give me my money right bank manager technically if you have your money in the bank the bank has to give it to you the second problem is skin in the game whereas banks own money into the game that is there and the third problem is risk management you know who's being given that loan has to be assessed clearly to address these problems the central banker of the country who controls the banking system in india's case rbi will come in and create certain regulations regulations so the first regulation and i'm using very basic ballpark simple numbers here to kind of get a sense of you know what these numbers are i'm not getting into too much nitty gritty here in terms of the exact way it works because it's simple video right in the context of trying to put in skin in the game what rbi stipulates is the bank has to have some of its own capital some of its own equity capital has to be put on on the pedestal so that that could be loaned out right so let's simplistically just assume that that number is 10. so bank takes 100 of deposits and 10 of its own equity and goes and gives it out as loans 110 that solves one of the problems which is this skin in the game problem now there is skin in the game and of course depositors are lenders for the bank these are people who have given debt to the bank so the order of precedence will be first for the depositor the depositor will get paid first right even if you recall most of the bank bailouts in india in any kind of a bank bailout the depositor is saved if there is a problem the equity holder goes out of out of the area in that context so that's the idea behind this thing this also sort of because you put in skin in the game solves what traditionally is commonly known as the principal agent problem the bank is the agent who acts on the behalf of the principal who's the depositor and tries to generate a return on the on the money that the depositor has given to the bank but of course the bank will try to maximize its profits in this entire scenario and that could cause a little bit of you know this manifestation of the principal agent problem where the interests of the agent which is the bank is not really aligned well with the interests of the principal who's the depositor right so there are safeguards for that as well as we go along equity kind of puts a little bit of skin in the game one point to be noted here is that unlike some of the other industries this industry starts with a debt to equity ratio of close to 10 sometimes even more right so it's a highly leveraged industry and consequently it has to be a regulated industry you wouldn't find 10 times debt to equity in a lot of the other industries and if you do find it you will see a lot of regulation coming into the picture right now how does the rbi solve the liquidity problem in this case so you take money from depositors you take money from equity holders you pull that money in that's 110 here right now what the central bank will stipulate is some part of this money has to be put aside as reserves there are two kinds of reserves we would have heard the names crr and slr once again just using ballpark numbers here to kind of make the point not using the exact numbers that are there so rbi will say whatever deposits you have four percent of that has to be put as cash crr is cash reserve ratio right this is to tackle any immediate demand of cash right slr would be approximately another 20 odd percent i mean the exact numbers are slightly different but just to simplify it let's say about 20 percent odd is the slr which is statutory liquidity ratio this is money that is deposited or put or invested in very liquid bonds what do you mean by very liquid bonds you can offload them whenever you want kabhibi bait sakth in bonsco so that you get money back immediately the idea of putting this approximate 25 rupees out of the 100 rupees of deposits that have come in as reserves is that it provides liquidity to the depositors see a bank also always works with a basic issue if you look at the way the deposits come and the loans go out deposits don't have a fixed term in mind there could be term deposits but usually are short term in nature i can go tomorrow morning to my bank and you know take out money from the bank that is there loans on the other hand are usually long term i mean people who need money would want it largely for longer term things they would take a take a house to a home loan or a car loan or infrastructure loan to a corporate take all of those into account and you'll find that these loans are typically going to be for a period of you know three years going all the way up to 20 years 25 years in certain cases and so on and so forth so there is an asset liability mismatch which means your assets which are your loans are all long term your liabilities may be short term the depositor could walk in tomorrow in the bank branch and say please give me my money the bank may not have money there is a liquidity issue to solve that you keep these reserves right now these results obviously because slr is invested in bonds it creates another income stream for the bank in the form of investment income that comes in correct so that's this and then you you know sort of loan out the remaining amount which is 85 that goes out so that's how the system works for a minute let's assume that we are in a zero interest rate environment right no interest rates to keep it simple right so at the end of the year the bank should get back 25 the bank should get back 85 the bank should repay 100 and the remaining 10 should go to the equity holder no profit no loss assuming 0 interest on both sides of the equation if there is an interest rate the way the bank charges is the bank makes higher interest on loans right and the bank wants to pay lower interest on deposits correct so that's the that's the picture that is going to emerge out of you know how do you really look and evaluate banks as you go along but that will something we'll uh we'll we'll come back to that in a moment right now let's introduce this concept of non-performing loans or non-performing assets what if you give a loan and it doesn't come back right so the bank has given 80 rupees of loans let's say five don't come back 85 rupees of loans have been given 80 come back five don't come back right assume the simple zero interest rate environment you get 25 from here you get 80 from here how much is that 105 out of the one zero five you pay hundred to the depositors what are you left with five on the equity you started with ten your equity is now down to five that is one of the reasons how much is the npa eight upon uh you know five upon uh 85 basically what percentage of loans have become non-performing assets npa is non-performing asset or non-performing loans and bls 5 upon 85 is going to be close to about what six percent approximately that not even that right so uh at six percent npa level the bank loses half of its equity value right and that's a problem and that's exactly why because in a highly leveraged environment this is going to be a possibility a the banks are regulated b if you do see an npa problem there would be a sudden dip in terms of in terms of the bank's equity value the stock prices will tumble so tomorrow morning suddenly if a bank comes and announces that okay i have extra two percent npa then what was announced earlier the stock price is going to tumble pretty much uh significantly more than that two percent npa number because of the leverage factor that comes into picture correct so that's the that's the construct of you know what what is there plus this doesn't stop there because you know you need this equity to go and lend more money because that's what the regulation says the first time the regulation of equity came in the idea was that you have to have a certain amount of capital to be able to extend a given amount of loans if your capital gets wiped out you can't give the loans even if you have the deposits right now let's think about what is necessary to evaluate a bank basically the picture emerges in this scenario you want to look at what is the cost of deposits right a bank that is able to raise deposits at a lower cost is going to have an advantage so somebody who has a large network somebody who has access to let's say the smaller cost deposits some of the current accounts or you know savings accounts which don't necessarily have to pay too much interest so any bank with a huge branch network that is spread in areas where you would get a lot of clientele would typically have access to low cost of deposits or lower cost deposits in in the books and that adds an advantage to the bank right any bank that is able to raise equity at any given point of time right some of the larger banks in india or well respected banks in india likes of hdfc bank can practically go and raise equity from markets at any point of time there are institutional there's always institutional demand there are domestic and foreign institutions who would want to invest into this particular bank so equity raising ability you know is also a very very big big component of the entire scenario who are you giving your loans to so are you getting what is the return on these assets or loans that you have created right are you getting a higher return on them are you getting a lower return on them remember risk and return go hand in hand so you also want to look at what is the risk here when you're evaluating a bank you want to see where has it given the loans and what is the process of identifying the risk correct suddenly a particular sector let's say argument's sake if real estate sector or steel sector is in trouble and you give a lot of money to the sector that is going to be a challenge return expected is going to be a critical component of your evaluation of the bank right so that that forms the component in terms of your returns on the bank and in terms of reserves you want to see what kind of uh what kind of investment portfolio the bank holds right so is the bank uh sort of giving uh you know you know is making money when interest rates are sort of stable or you know how much money does it lose when interest rates go up all that component forms a part of the investment portfolio there are obviously new answers to that in terms of you know uh are the bonds held for trading or they are available for sale or they are held for investment held till maturity depending on them the allocation and the investment income works but the moot point or the simple point is how good is your investment portfolio what kind of you know bonds you have bought in that is going to define the return on this and that's in a nutshell pretty much pretty much the game you need to see a bank if the bank has access to low cost deposits you need to see if the bank has you know sort of continuous demand of its equity in the markets you want to see where has the bank lend money and what is the risk taken there you want to see what kind of return the bank can generate with adequate risk management measures for example it is considered that retail loans given with proper underwriting are going to default less you know usually retail loans don't become systemic loans and systemic issues unless there is a very big problem that is that is going in the economy right but corporate loans could be a problem if that sector goes into stress right as we said let's say arguments taken in the you know period of 2015 to 2018 steel sector was in st was in trouble in india between 2018 and 2020 some of these infrastructure finance companies were in trouble in india right so you would you would have to see who that loan has been given to and usually banks that have given loans to general retail customers at large have ten you know to do better in india in the recent past or in the last couple of decades or so that we have seen and then of course the investment portfolio that comes into the picture the risk element is going to play out in terms of your non-performing assets evaluation so you want to see what are the challenges there how the bank is controlling that portion and on an ongoing basis these are the parameters that you evaluate for a bank low cost of deposits high return on assets with managed risk continuous access to equity and what are you doing on your bond portfolio on an ongoing basis you know and plus you know sometimes banks have other income also coming in so you want to see if there are other areas where a bank makes a lot of income like fee income investment banking and you know so on and so forth but those in a nutshell are the core points that you would want to evaluate when you are evaluating a bank that's it in this particular video thank you