The perception that commercial banks will never be allowed to fail has led many depositors to invest their money in banks with the highest interest rates, paying little attention to their business or financials. But the Yes Bank and Lakshmi Vilas Bank episodes remind us that even if the Reserve Bank of India (RBI) steps in to bail out a distressed commercial bank, the process is not pain-free for depositors.
In the case of Lakshmi Vilas Bank (LVB), RBI has capped deposit withdrawals at ₹ 25000 for a 30-day period, while a merger is in the works. If you’re keen to avoid such episodes with your bank deposits in future, how do you spot the trouble signs in a bank?
Financial checks
Growth and profits in the banking business are fuelled mainly by leverage. For every ₹ 100 of assets in a bank’s balance sheet, it may have just ₹ 4 of its own capital, with deposits and borrowings making up the rest. This is what makes banks particularly fragile entities that can be tripped up by defaults, delays in loan repayments or funding constraints.
Four financial ratios can alert you early to brewing trouble. The first is the capital adequacy or capital to risk weighted assets (CRAR) ratio, which measures the amount of its own and supplementary capital held by a bank for every rupee of loans advanced by it.
A sub-set of this is the Tier I CRAR, which represents the bank’s permanent capital consisting of equity, reserves and other capital against which losses can be set off. Indian banks are required to maintain a minimum CRAR of 10.875 per cent and Tier I CRAR of 8.875 per cent. LVB had a CRAR of just 0.17 per cent as of June 2020, with a negative Tier I CRAR. SBI, in contrast, had a CRAR of 14.87 per cent and Tier 1 CRAR of 12.10 per cent as of September 30, 2020.
Then, there’s the quantum of doubtful loans in the bank’s books, as measured by its NPA (Non-performing asset) ratio. The gross NPA ratio measures the proportion of loans given out that are overdue for over 90 days.
The net NPA ratio measures bad loans after the bank has made provisions. Broadly, gross and net NPA ratios that are below 5 per cent signal reasonable health, but trends in this ratio are more important to watch. A more than 0.5 percentage point quarterly jump in the NPA ratio suggests problems escalating.
Leverage ratio captures the extent of a bank’s Tier I capital to its total loans. The RBI allows banks to run with a ratio of 3.5-4 per cent, but a ratio above 5 is a comfortable number. HDFC Bank boasted a leverage ratio of 10.71 per cent in September 2020 quarter.
To gauge if a bank has enough cash to meet its near-term dues, the Liquidity Coverage Ratio, or LCR, is your guide. Measured as the high-quality liquid assets held by the bank against its dues over the next 30 days, the higher this ratio is above 100 per cent the better placed it is on liquidity. LVB was comfortable on this score with an LCR of 294 per cent in June 2020.
These ratios are readily available for every scheduled commercial bank on a quarterly basis, in the document ‘Basel III-Pillar 3’ disclosures on the bank’s website.
RBI actions
If RBI believes that a bank is walking a tightrope on indicators such as NPAs, CRAR or return on assets, it can immediately subject it to Prompt Corrective Action (PCA). During PCA, RBI can impose a variety of business restrictions on a bank, induct new management, replace Board members or even merge it with another. Most PCA measures impact a bank’s financials and growth plans, until afresh capital infusion helps them pull out of PCA.
Indian Overseas Bank, Central Bank of India, UCO Bank and United Bank of India are under the RBI’s PCA framework. LVB was put under RBI’s PCA framework in September 2019. Depositors need to worry more about private sector banks being under PCA than public sector banks, as the latter can be quickly bailed out by the Government infusing new capital, while private banks will need to find bona fide investors.
Management churn
If a bank you’re invested with sees a string of top management exits before their term is done, it could be an indication of governance issues. The RBI actions to replace or remove the bank’s CEO or Board members or to supersede the Board are a red rag and provide early warning of suspected governance issues. Skirmishes between key shareholder factions or churn on top appointees are trouble signs, too.
LVB saw shareholders voting out the re-appointment of its MD and CEO along with a clutch of directors in its recent AGM. Yes Bank saw RBI refuse another term to its founder and a string of independent director exits before the moratorium.
Stock prices
When a bank share suffers a precipitous drop or trades at a fraction of reported book value, your antennae should be up for likely problems. A bank share trading at a fraction of its book value could mean that the stock market is under-valuing a good business. But more often, it could mean that it is sceptical about the reported value of the bank’s book. Stock markets, after all, were ahead of rating agencies in spotting problems at stressed NBFCs; they may not be far off the mark with banks.
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