Investors Map to Banking Stock.

Banks possess an enviable spot in any economy. They are the funnel in the capital formation process and the engine that keeps vehicle speeding. Without banks businesses would find it impossible to keep growing and consumers keep saving and spending. Since service that banks provide are so very vital for economic activity across all its elements that banking sector is bound to grow with growth in economy. It hardly matters whether demand for money comes from cement companies or semiconductor companies or a consumer, what is certain is banks would keep humming.

The banking business model is simple and understandable. Banks receive money from depositors and the financial markets and lend it to borrowers or invest in financial securities. Difference or spread in this two leg is profits. If banks borrow at about 8% from depositors and are able to lend it to some business for their working capital needs or to someone looking to buy a new car at say 11% than the spread 3% (11%-8%) is what is popularly called Net Interest Income. Beside lending and borrowing, banks also advice corporate on their forex exposure or a higher net worth individuals on their investment. Money made by banks by providing other services is referred to as non-interest income or other income. In developed economies, banks derive nearly 50% of revenues from this stream. This stream of revenues contributes a relatively lower 15% in the Indian context. Net Revenues of a bank is total of net interest income and non-interest income.

In order to earn these net revenues banks employ thousand of people in hundreds of branches. Employee cost (One need to watch out Union activity) and other Operating expenses (may move with brand expansion and inflation) are key expenses in banks profit loss account.

At times borrowers fail to pay up. This means assets are not earnings and are called Non-Performing Assets (NPAs). Banks provide for this potential loss as Provisions for NPAs. In its investment activity depending on ups and downs of interest rates, market value of the investment portfolio keeps making unusual profits and losses. Provision in mark to market loss on investment portfolio is provided as expense.
In case of a bank, capital (read money) is a raw material as well as the final product. a bank is mandated to maintain a certain percentage of deposits with the Reserve Bank of India (RBI) as CRR (cash reserve ratio), on which it earns lower interest. Whenever there is a reduction in CRR announced in the monetary policy, the amount available with a bank, to advance as loans, increases. The second part of regulatory requirement is to invest in G-Secs that is a part of its statutory liquidity ratio (SLR). The bank’s revenues are basically derived from the interest it earns from the loans it gives out as well as from the fixed income investments it makes. If credit demand is lower, the bank increases the quantum of investments in G-Sec.

Sources of Competitive Advantage:

- Banks are borrowing from many depositors and lends to various borrowers. Result is they end up having diversified portfolio of assets and liabilities. This result in lowering of risk as compared what it would be if depositors had lend directly to borrowers. This unique advantage of pooling forms one of the base of lasting economic moat for the banking industry.
- Other key moat comes from better management of risk. A top-notch credit culture along with the subsequent borrower/lender relationships that banks establish can create a competitive advantage for firms in the industry.
- Other source of moat is management of liquidity. In world without banks depositor needing cash before borrower is ready to return can create chaos. But in world fill with banks, deposits can pre-withdraw and lenders can pre-pay their respective assets and liabilities.
- Several other factors have also led to deeper and wider economic moats. Some key deterrents to competition include: Huge balance sheet, large economies of scale, a regional oligopoly type industry structure and customer switching costs.

Investors should seek to buy banks:

- With strong capital base
- Earning Consistently high ROEs and ROAs
- With ability to grow revenues at steady rate
- Valued attractively based on P/BV
- Strong Management team