PROJECT REPORT ON
Financial Analysis of Banking Sector
(ICICI Bank VS HDFC Bank)
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Financial Statements Analysis of Banks:
Financial ratios in case of banking sector are very different from manufacturing or trading firms. For
example, interest income and interest expense for a manufacturing or trading firm are non-operating
items, whereas these are primary operating items for banks. A bank’s major source of revenue is
interest income and its biggest operating expense is interest expense on deposits and loans. Thus a
bank’s profitability is largely based on its capacity to earn interest on its assets (loans and advances)
at a rate higher than its cost of funds. The difference between gross yield (interest income as a
percentage of interest earning assets) and cost of funds (interest expense as a percentage of interest
bearing liabilities) is called the Net interest margin or spread. Every bank should endeavour to
maximise the spread.
The recent trend in banking shows that banks are also focussing their attention to the promising non-
interest income opportunities. It may be mentioned that interest income accrues from a bank’s
traditional lending business. A bank is primarily meant for lending money to business, farmers and
individuals. However, banks have started venturing into non-fund based activities (e.g. corporate
advisory, services, treasury activities, loan appraisal and processing, merchant banking, bank
guarantees etc.). Treasury activities may not strictly be called non-fund based activities because
these activities involve trading in securities. Every bank today, as part of its business strategy,
diversifies its income sources into interest income and non-interest income. The second stream of
income comes from the following activities in general:-
a) Fee income: Guarantee fees, bank commission, loan processing fees, income from credit
b) Treasury income: Trading profits on Govt. And corporate securities, profit from derivatives.
c) Lease income: Lease rental.
d) Others: Dividend or interest income on investment in subsidiaries and other entities.
The expenses of a bank can be broadly classified as below:-
a) Interest expenses
b) Operating expense (e.g., salary, rent, printing and stationery, depreciation etc.)
c) Direct Marketing Agent (DMA) expenses
d) Provision for credit losses (e.g., provision for Non-Performing assets)
Advances and Investments are the major income generating assets of a bank rather than fixed assets
like land, building and computer equipments. This feature of a bank’s assets clearly distinguishes it
from manufacturing and other trading businesses.
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Banks main business is to mobilise resources from the public and channelize the same as loans to
business entities and others. So by its very nature of its business, a bank’s external liability would be
quite high and hence traditional debt-equity ratio is not calculated in case of banks.
Leverage and Risk
Banking is a highly leveraged business requiring regulators to dictate minimal capital levels to help
ensure the solvency of each bank and the banking system. In India, a bank's primary regulator is the
Reserve Bank of India. These regulators focus on compliance with certain requirements, restrictions
and guidelines, aiming to uphold the soundness and integrity of the banking system.
As one of the most highly regulated banking industries in the world, investors have some level of
assurance in the soundness of the banking system. As a result, investors can focus most of their
efforts on how a bank will perform in different economic environments.
As financial intermediaries, banks assume two primary types of risk as they manage the flow of
money through their business. Interest rate risk is the management of the spread between interest
paid on deposits and received on loans over time. Credit risk is the likelihood that a borrower will
default on its loan or lease, causing the bank to lose any potential interest earned as well as the
principal that was loaned to the borrower. As investors, these are the primary elements that need to
be understood when analyzing a bank's financial statement.
Interest Rate Risk
The primary business of a bank is managing the spread between deposits (liabilities, loans and
assets). Basically, when the interest that a bank earns from loans is greater than the interest it must
pay on deposits, it generates a positive interest spread or net interest income. The size of this spread
is a major determinant of the profit generated by a bank.
As a result, net interest income will vary, due to differences in the timing of accrual changes and
changing rate. Changes in the general level of market interest rates also may cause changes in the
volume and mix of a bank's balance sheet products.
Banks, in the normal course of business, assume financial risk by making loans at interest rates that
differ from rates paid on deposits. Deposits often have shorter maturities than loans and adjust to
current market rates faster than loans. The result is a balance sheet mismatch between assets (loans)
and liabilities (deposits). This mismatch of maturities generates the net interest revenue banks enjoy.
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When analyzing a bank you should also consider how interest rate risk may act jointly with other risks
facing the bank. For example, in a rising rate environment, loan customers may not be able to meet
interest payments because of the increase in the size of the payment or a reduction in earnings. The
result will be a higher level of problem loans. An increase in interest rates exposes a bank with a
significant concentration in adjustable rate loans to credit risk. For a bank that is predominately
funded with short-term liabilities, a rise in rates may decrease net interest income at the same time
credit quality problems are on the increase.
Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet
its obligations in accordance with agreed terms. When this happens, the bank will experience a loss
of some or all of the credit it provided to its customer. To absorb these losses, banks maintain an
allowance for loan and lease losses.
Provisioning for Non-performing assets
RBI defines a non-performing asset (NPA) as ‘a credit facility in respect of which the interest and /or
instalment of principal has remained overdue for a specified period of time’. Term loans in respect of
which interest and /or principal remain overdue for a period of more than 90 days are considered as
NPAs. Once an asset is classified as NPA, interest on such asset should not be recognized as
income in the Profit and Loss Account on accrual basis. Such income is booked only when it is
actually received. Hence, when a bank has higher proportion of NPAs in its asset portfolio, its income
recognition gets adversely affected.
Lending By Banks
The various sources of lending by banks are:
Borrowings – RBI
Borrowings - Other Banks
Borrowings - Government of India
Borrowings - Other agencies
Borrowings Outside India
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Most of the requirements of the banks are first met through call market borrowings and then through
the repo window of RBI. Thereafter in cases of extreme crisis or need for funds, the route for demand
loans are sought, which is usually at a higher rate compared to the repo rate of 9 per cent.
Call rate is the interest rate for lending and borrowing of funds by the banks for daily fund
requirements. The behaviour among banks in the call money market is not uniform. There are some
banks, mainly foreign banks and new private sector banks, which are active borrowers and some
public sector banks that are major lenders. The RBI has been a major player in the call/notice money
market and has been moderating liquidity and volatility in the market through repos and refinance
operations and changes in the procedures for maintenance of cash reserve ratio. Under the repo,
banks borrow funds from RBI by pledging government securities.
The borrowing from RBI as demand loans is done under section 17 of the RBI act.
FINANCIAL RATIOS FOR BANKS
Capital Adequacy Ratio (CAR):-
As banks depend more on external borrowings to carry on their operations, any default in realisation
of assets may jeopardise the fortune of hapless investors. The bank’s ability to meet its commitment
towards depositors and lenders is measured by a ratio called capital adequacy ratio or CAR. Solvency
risk in banks is the risk of not having enough (internal) capital to absorb losses generated primarily by
default of borrowers. A basic measure of solvency risk is capital adequacy ratio. It is the ratio of
capital to risk weighted assets.
Capital, for CAR purposes is of two types-core capital (known as Tier I capital) and supplementary
capital (known as Tier II capital). Tier I capital consists of paid up capital, statutory reserves, disclosed
free reserves and realised capital reserve. Tier II capital includes cumulative perpetual preference
share capital, revaluation reserve, general provisions and loss reserves, hybrid debt instruments and
subordinate debts. Hybrid debt instruments are those instruments which combine characteristics of
both equity and debt (e.g. convertible debentures). A subordinate debt is a debt that is either
unsecured or has low priority than that of another debt claim on the same asset or property. There are
certain restrictions on composition of Tier I and Tier II capital for e.g. the level of Tier II capital is not
allowed to exceed the level of Tier I capital.
Assets of a bank can be classified into two categories- balance sheet items and off-balance sheet
items. Cash balances with RBI, loans guaranteed by central/state governments, advances against
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term deposits, life insurance policies etc., are risk free assets. All other assets whether fully secured
or not, are assigned risk weights ranging from 2.5% to 102.5%. The implication is that for zero-risk
assets banks need not maintain Tier I and Tier II capital.
Once Tier I and Tier II capital and risk