Banks

A bank is a middleman for money

Some people have spare cash they want kept safe. Others need money right now, for a house, a shop, a car. A bank simply stands between the two. It takes the spare cash from the first group and hands it to the second. Here is the part that surprises people the first time they hear it: the bank is barely using its own money at all. It is lending yours.

Interest is just rent on money

Lend a friend your bike for a week and you might expect a little something for it when you get it back. Money works the same way. When you borrow it, you pay for the time you had it, and that payment is called interest. An interest rate is nothing more than that rent written as a yearly percentage. Once you see interest as rent, the whole business stops being mysterious.

The bank pays rent too

Most people think of interest as something they pay. But the bank pays it as well, to you. The moment your money lands in your account, the bank is really borrowing it from you, and it pays you a little for the privilege. That is your deposit rate. So the whole game is simple to state and hard to do well: pay as little as possible to the people it borrows from, charge as much as it sensibly can to the people it lends to, and live off the difference.

Cheap money beats expensive money

Not every rupee a bank takes in costs it the same. The money sitting in ordinary current and savings accounts is almost free, because the bank pays you next to nothing to keep it there. Bankers have a name for it: CASA, short for current and savings accounts. Money locked in a fixed deposit is the opposite. You only agreed to lock it away because the bank promised you a higher rate, so it is expensive money. A bank swimming in cheap savings deposits has a huge head start over one that has to bid up for fixed deposits. This, more than almost anything, is why some banks are simply better than others.

The gap is the profit, and it has a name

That gap, between what a bank earns on everything it lends and what it pays on everything it borrows, is the single most important number in banking. It is called the Net Interest Margin, or NIM. When you hear that a bank's NIM is widening, its profit engine is running well. When you hear it is shrinking, something is eating into the core business, and you should want to know what.

And a little on the side: fees

Not all of a bank's money comes from lending. It also charges fees: on cards, on transactions, on lockers, and as commission for selling you insurance and mutual funds. Bankers call this non-interest income, and it is prized, because unlike a loan, a fee cannot turn bad on you. A bank with plenty of it has a steadier, higher-quality profit that does not depend entirely on the lending cycle.

Private banks

These are owned by ordinary shareholders and run to make a profit. As a group they grow faster, run tighter, and tend to lend more carefully. It is no accident that most of the market's beloved long-term compounders are private banks, because good management sitting on cheap deposits shows up, year after year, as high and steady returns.

Public sector banks (the government ones)

These are majority-owned by the government. They are enormous, they reach villages no private bank bothers with, and they sit on mountains of cheap deposits. But historically they have been slower, less efficient and more accident-prone on bad loans, partly because their lending was not always driven purely by what made commercial sense. They can have their moment when the cycle turns and old bad loans get cleaned up, but they are a rougher, more up-and-down ride.

Small finance banks, and why NBFCs are not banks

Small finance banks lend to smaller, riskier borrowers the big banks skip, usually at higher rates. And then there are NBFCs, which get their own section on this site. They look like banks and lend like banks, but they are missing the one thing that makes a bank powerful: they cannot take your everyday deposits. So they have to borrow from markets and other banks instead, which is costlier and far more fragile when money gets tight. The humble deposit account is the whole secret.

The interest rate cycle

The RBI, India's central bank, sets the base rate for the whole economy, and it moves that rate up and down over time. When it does, a bank's loan rates and deposit rates both shift, but rarely at the same speed. Sometimes a bank gets to charge more on its loans before it has to pay more on its deposits, and its margin fattens. Sometimes it works the other way and the margin gets pinched. So the rate cycle is forever nudging bank profits up and down, no matter how well the bank itself is run.

The health of the economy

A bank is really a geared-up bet on the country. When the economy is humming, people and businesses borrow more and pay it back without trouble. When it stumbles, borrowing dries up and defaults creep in. Because a bank is lending out ten times its own money, both the good and the bad get amplified, which is why bank stocks tend to swing harder than the market they sit in.

The rule-maker: the RBI

Few businesses are watched as closely as banks, and for good reason: they are holding the public's savings. The RBI decides how much cushion they must keep, how much and to whom they can lend, and even what officially counts as a bad loan. One rule change can lift or wound the entire sector overnight, however well or badly any single bank is being run.

The loans that never come back

Handing out a loan is the easy part. Getting it back is where banking is actually hard. Some borrowers simply cannot repay: a business folds, a job is lost. A loan that has stopped being paid is a bad loan, or in the jargon a Non-Performing Asset. This is the thing that quietly kills banks. One can look gloriously profitable for years and then admit that a big slab of its loans is never coming back, and years of profit vanish in a single quarter.

Good times hide bad lending

This is the trap that catches even experienced investors. In the good years everyone repays, bad loans look tiny, and banks feel invincible, so they lend more and more, and to shakier and shakier borrowers. Then the economy turns, and all that weak lending goes bad together. The cruel part is the timing: the worst loans are made at the very top, when everything feels safe, and only reveal themselves on the way down. So a bank boasting almost no bad loans in a boom has not proven it is safe. It may just be standing early in the cycle.

The slow squeeze on margins

A bank does not need a single bad loan to disappoint you. If its margin, that NIM again, gets squeezed, profit falls anyway. Maybe deposits got expensive faster than its loans could reprice. Maybe rivals undercut it and forced loan rates down. Either way the gap narrows and earnings stall. That is why the margin deserves as much of your attention as the bad-loan number.

Why PE is the wrong tool here

For most companies, the PE ratio, price compared to earnings, is a fair quick check. For a bank it quietly lies to you, and there is one reason why: a bank is built to run on borrowed money. For every ₹1 of its own it is handling ₹10 or more of other people's. That enormous borrowed base makes the profit look big and, worse, distracts you from where the real danger lives, which is the loans, not the earnings. Remember, a bank almost never dies because profit dipped. It dies because its loans went bad.

Look at these instead

So skip the single PE number and read a bank through four windows, each answering a different question about how well it is run and how safely.

• Return on AssetsOf every rupee the bank puts to work, how much comes back as profit? It is the cleanest read on how well the thing is actually run. Above roughly 1.5% is genuinely excellent.
• Return on EquityThe return earned on the bank's own money, the bit shareholders put in. Mid-teens or higher is healthy, and this is the number that actually compounds in your pocket over the years.
• Bad-loan levelsWhat share of the loans have stopped being repaid? The lower and the steadier, the safer the bank. This is the window that shows you trouble the profit line is hiding.
• Price-to-BookWhat you are paying against the bank's own net worth. Because a bank is essentially a stack of financial assets, its book value actually means something, unlike at most companies. This is the price gauge that replaces PE.

And these four talk to each other. A bank earning a high return on its own money has earned the right to trade at a richer price against its book. One with bad loans creeping up has not, no matter how tempting its PE looks.

Your return runs on two engines

What you make on a stock comes from two things multiplied together. The first is how fast the company's earnings grow. The second is whether people decide to pay more or less for each rupee of those earnings, which is the multiple. Both can move, and here is the sting: a roaring first engine can be completely cancelled by a fading second one. A superb, growing bank can still hand you nothing at all if you bought it when the multiple was already too high.

HDFC Bank, where the multiple ate the engine

HDFC Bank is the textbook case, and a painful one for a lot of holders. Across roughly eight years its earnings per share tripled, from about ₹17 to ₹49. That is a magnificent engine by any measure. And yet the stock went almost nowhere. Why? Because over those same years the multiple, what investors were willing to pay per rupee of earnings, slid from around 30x down to about 15x. The shrinking multiple swallowed everything the growing earnings had cooked up. The business kept winning while its shareholders sat and waited.

Why it happened, and what to take from it

The multiple did not shrink out of spite. After HDFC Bank merged with its parent, its return on equity slipped from around 18% to 14% and its margin came under real pressure, so investors, quite reasonably, paid a bit less for each rupee of a slightly lower-quality engine. And that is the whole lesson in one line: buy a good bank, absolutely, but buy it at a sensible price. A fine business bought well compounds for you. The very same business bought too dear can sit dead for years while the multiple slowly lets the air out.