Evaluating Underwriting Quality, Spreads & Solvency
Traditional financial metrics fail when evaluating banks and lending institutions. Learn how to analyze Net Interest Margins, Asset Quality (NPA), Provision Coverage, and Capital Adequacy.
For a manufacturing company, debt is an operational risk. For a bank or Non-Banking Financial Company (NBFC), debt (in the form of customer deposits and borrowings) is raw material.
Because money is both the input and output of a financial institution, standard ratios like EBITDA margin, ROCE, and Debt-to-Equity are meaningless. You cannot evaluate HDFC Bank or Bajaj Finance using the same metrics as Reliance or Infosys.
To value lending institutions accurately, you must look through the specialized lens of banking metrics.
A bank's primary business model is borrowing money at a low interest rate (from savings accounts and fixed deposits) and lending it out at a higher interest rate (home loans, vehicle loans, commercial credit).
$$\text{Net Interest Income (NII)} = \text{Interest Earned on Loans} - \text{Interest Expended to Depositors}$$
NIM is the net yield on the bank's interest-earning assets: $$\text{NIM} = \frac{\text{NII}}{\text{Total Earning Assets}} \times 100$$
When borrowers stop paying their Equated Monthly Installments (EMIs) for more than 90 days, the loan becomes a Non-Performing Asset (NPA).
The total value of loans classified as non-performing as a percentage of total gross loan advances.
Gross NPAs minus the provisions (reserves) set aside by the bank from its profits: $$\text{Net NPA} = \text{Gross NPA} - \text{Provisions}$$
PCR measures the cushion a bank has built against bad debts: $$\text{PCR} = \frac{\text{Total Provisions Held}}{\text{Gross NPAs}} \times 100$$
Current and Savings Accounts (CASA) represent the cheapest funding source for any Indian bank:
$$\text{CASA Ratio} = \frac{\text{CASA Deposits}}{\text{Total Deposits}} \times 100$$
A bank with a CASA ratio above 40% to 45% enjoys an insurmountable structural advantage over competitors. It can lend at aggressive rates while still preserving wide net interest margins.
Under Reserve Bank of India (RBI) Basel III guidelines, banks must hold a minimum regulatory capital cushion to absorb unexpected credit losses:
$$\text{Capital Adequacy Ratio (CAR)} = \frac{\text{Tier 1 Capital} + \text{Tier 2 Capital}}{\text{Risk-Weighted Assets}} \times 100$$
While the RBI mandates a minimum threshold around 11.5%, conservative Indian banks maintain CAR above 16% to 19%, providing ample headroom to grow their loan books without frequent equity dilution.
Never value a bank primarily on its P/E ratio. In bad credit cycles, net profits can drop to zero due to sudden provisioning, making P/E skyrocket artificially.
Instead, value banks on Price-to-Book Value (P/B) relative to their Return on Assets (ROA):