Risk & Return Analysis of Banking Sector

Presented by:Prince Kumar (49)

Risk & Return

Risk and return are most important concepts in finance. Risk and return concepts are basic to the understanding of the valuation of assets or securities. The term "risk and return" refers to the potential financial loss or gain experienced through investments in securities.

Risk & Return Analysis

Return on security(single asset) consists of two parts:

Return = dividend + capital gain rate R = D1 + (P1 P0) P0

WHERE R = RATE OF RETURN IN YEAR 1 D1 = DIVIDEND PER SHARE IN YEAR 1 P0 = PRICE OF SHARE IN THE BEGINNING OF THE YEAR P1 = PRICE OF SHARE IN THE END OF THE YEAR

Average rate of return

R = 1 [ R1+R2++Rn] n
R = 1 Rt
n

t=1

Where R = average rate of return. Rt = realized rates of return in periods 1,2, ..t n = total no. of periods

Expected rate of return

It is the weighted average of all possible returns multiplied by their respective probabilities.

E(R) = R1P1 + R2P2 + + RnPn

E(R) = Ri Pi
i=1

Where Ri is the outcome i, Pi is the probability of occurrence of i.

Variance is the sum of squares of the deviations of actual returns from expectedn returns weighted by the associated probabilities. Variance =

(R i
i=1

E(R) )2* Pi

SD

= (variance2)

DIVERSIFICATION OF RISK
We have seen that total risk of an individual security is measured by the standard deviation ( ), which can be divided into two parts i.e., systematic risk and unsystematic risk Total Risk () = Systematic Risk + Unsystematic risk

What is a bank?
A bank is essentially a financial institution that acts as an intermediary between those who need money and those who have an excess of it. Banks accept deposits from companies and the general public and make loans to companies and individuals who need money. Banks offer interest on the deposits made with it and charge interest on the loans lent

RBI (Reserve Bank of India)

The Reserve Bank of India (RBI) is a government body that oversees the banking system in India and is in charge of regulating the affairs of the banks.

The banking sector in India

Banking is probably the most important sector in any country. A country cannot grow without a healthy and robust banking sector. Loans (credit) are the lifeblood of any economy. Companies need loans to take up new projects, to bridge short term liquidity gaps and for working capital.

Types of banks
Public sector banks (e.g. SBI, Andhra Bank) are owned at least partially by the Government of India. They tend to be conservative and have higher needs for documentation and collateral for making loans. Private banks are purely privately owned. They tend to be more aggressive and give out loans a little more easily than public sector banks. Some people feel that private sector banks are more focused on sales than public sector banks and tend to close deals faster.

Factors that affect bank shares

Interest Rates In general, the lower the interest rates, the better for the banks share price The bank rate is the rate at which RBI lends funds to commercial banks.

Net Interest Margin

The higher the Net Interest Margin of a bank, the better for its share price. Net interest margin is the percentage difference between income generated from loans made by the bank and the interest paid on loans taken by the bank. It is expressed as a percentage of what the financial institution earns on loans and other assets in a time period minus the interest paid on borrowed funds divided by the average amount of the assets on which it earned income in that time period .

Provisions and Non-Performing Assets (NPA)

The lower NPAs for a bank, the better for its share price When a bank does not expect a customer to repay the loan, it sets aside a certain sum of money for the expected loss. This is known as a provision. When a customer defaults on a loan (interest is outstanding or more than 90 days), the bank writes it off from its books and the loan is termed as a NonPerforming Asset (NPA).

Forms of NPAs:Gross NPA: The amount outstanding against the borrowers account (with the outstanding interest) Net NPA: Gross NPA - Provisions made on the loan Recoveries made on the loan other adjustments

Capital Adequacy Ratio (CAR)

The higher the CAR of a bank, the better for the its share price Capital adequacy ratios are a measure of the amount of a bank's capital expressed as a percentage of its risky loans. It is a measure of how well capitalized a bank is, i.e. how easily it can withstand losses. Applying minimum capital adequacy ratios serves to protect depositors and improve the stability and efficiency of the financial system. The RBI specifies the minimum capital adequacy ratios that all banks have to maintain.

Types of CAR:
Tier-I Capital Ratio: The level at which a bank can absorb losses without being required to cease trading. Tier-II Capital Ratio: The level at which a bank can absorb losses in the event of a winding-up. It provides a lesser degree of protection to depositors, e.g. subordinated debt.

CASA Ratio

The higher the CASA ratio of a bank, the better for its share price This is the ratio of current account and savings account deposits to the total deposit base of the bank Number of branches The more branches a bank has, the bigger and better it is. The greater the number of branches, the better connected the bank is to its customers.

Yearly Returns of Banking Stocks DATE PUBLIC SECTOR BANKS

DATE 31-Mar-09 SBI -34.26% ANDHRA BANK PNB -39.49% -17.48%

31-Mar-10

94.75%

139.38%

146.14%

31-Mar-11

33.06%

39.23%

19.74%

31-Mar-12

-24.19%

-21.91%

-23.72%

500.00% 400.00% 300.00% 200.00% 100.00% 0.00% -100.00% -200.00% PNB. ANDHARA BANK SBI

Evaluating Bank Performance (ROE Analysis)

Benchmark measure of a banks profitability is the return on equity which is profits per unit of dollars invested by the banks owners.

Example: Consider equity value of Some bank of India , at ends of 2004 and 2005 compared with income earned over 2005.
NI[2005] Equity NI/Equity 1,016,372 Dec. 31, 2004 11,372,560 8.9% Jun. 30, 2004 12,142,210 8.4%
Most appropriate to average balance sheet variables over the year.
NI Return on Equity ROE Average Equity

Profits vs. Risk

Earning high profits in good or even normal times will be easier if the bank is willing to take on some risk. But this risk may be more problematic in bad times. Important to measure the risk of the banking system as well as the profits

Market Measures of Bank Performance

Financial markets may be a measure of bank performance. Equity Markets: Common stock Book-toMarket ratio measures markets perception of growth potential and risk of assets. Preferred stock and subordinated debt holders are exposed to downside risk but not upside gains from risky activities. Price of these assets may help measure riskiness of activities.

THANK YOU