Question

1.Discuss why investors are willing to buy shares in banks when:

(i) the ROA of banks is typically quite low, and

(ii) banks are subject to many restrictions and are closely monitored by the regulators.

2.What is the capital adequacy ratio for a bank? Discuss why it is a good way to assess the risk of a bank

Answer 1

1. ROA

i. ROA for banking industry in general tends to be lower than other industries. This is because banks are highly leveraged institutions with huge amount of debt/borrowings on their balance sheets.

ROA= net income/ Assets

Assets= Liabilities + Equity

The asset base tends to be large owing to huge liabilities (deposits, bonds issued and other borrowings). The ROA tends to be low for banks. But even a 1% ROA translates into huge profits due to the large denominator. This is why investors favor banks in spite of relatively low ROAs. The ROE or return on Equity for banks, on the contrary, tends to be higher for the same reason.

ii. Banks primarily make profits by raising money from sources (like customer deposits) at a lower rate and lending this money (retail/corporate loans) at higher rates. The difference between these rates is pocketed by the bank in the form of net interest income. This structure is peculiar to banks as they have easy access to funds and understanding of credit markets to invest/lend these funds. In spite of tightening of regulations, in terms of higher capital requirements and lending restrictions, the underlying model with money as both raw material and output remains profitable.

2. Capital Adequacy Ratio

The Capital Ratio or CRAR (Capital to Risk Weighted Assets) ratio is a regulatory mandated ratio maintained to safeguard the bank's depositors against insolvency.

CRAR = Eligible capital/ Risk Weighted Assets.

Eligible capital is maintained as a cushion to absorb losses to a reasonable extent before the depositors funds are affected and the bank turns insolvent. There are different classifications of eligible capital (Tier I, Tier II etc), depending on their safety and availability to absorb losses.

Risk weighted assets shows all the assets of the bank scaled up/down by the individual risk weights. For example, a bank has given loans of $100 each to parties A and B. Depending on their credit worthiness and prospects of repaying, A and B are assigned risk factors of 20% and 100% respectively (A is safer than B).

The total RWA for the bank (assuming only 2 loans) is computed as: $100*20% + $100 *100% = $120

Suppose the minimum regulatory CRAR requirement is 10%, the amount of eligible capital the bank has to maintain is:

Capital = CRAR * RWA =10%* $120 = $12.

The CRAR ratio thus shows the capital cushion available to absorb losses before the depositor's money is at risk.

A higher CRAR therefore is an indicator of higher safety and lower risk of the bank. However a very large CRAR relative to the regulatory prescribed levels indicate that the shareholder funds may not be effectively utilized.