Banking Handbook — Part I
What is a Bank?
It’s a financial entity that takes your deposits and gives out loans. The difference between the rate it pays you for your deposits and the rate it charges on the loans it makes becomes its profit.
How many types of banks are there?
There are three categories of banks in India:
1. Co-operative banks: These have development goals, targeting small industries, agricultural sector, and are run on a no-profit no-loss basis and NOT supervised by RBI
Ex: Jain Cooperative bank
2. Rural Banks: These aren’t supervised by the RBI either and serve rural areas with a single focus on the agricultural sector, providing them basic banking services. These were set-up by the RBI in 1975 to stop the exploitation by money lending sharks who charged them exorbitant interest rates (as high as 10% per month)
Ex: Garmin Bank
3. Commercial bank: They are primary for-profit banks, highly supervised/regulated by the RBI
a. Domestic Banks: Indian promoters
There are two categories of domestic banks:
i. Scheduled: All scheduled banks are guaranteed by RBI that customer will not lose their deposits
These are further two kinds of these based on the type of shareholders:
1. Public: nationalized banks: Gov. is a shareholder in the bank
2. Private: Gov. is not a shareholder in the bank
ii. Non-Scheduled: RBI does not guarantee them; no such bank in India now
b. Foreign Banks: Foreign origin bank with an Indian branch. The home governments of these foreign banks assure the Indian government that deposits with their branches will be safe
Ex: Citibank is a US origin bank with Citibank India as its subsidiary here, the US government guarantees the safeguard of capital deposits made with Citi India
How are a Bank’s financial statements different from Non-Bank Companies’?
We have a Companies Act in the Constitution of India that governs how all companies in the country are supposed to operate, from their organizational structure to how they have to report their financials to the government — you know, for income tax purposes. This Act was constituted in 1956 at first and later revised heavily in 2013.
The Companies Act 2013, today, has 7 Schedules in total. These Schedules are a detailed set of instructions on whatever it is that they endorse.
Financial statements of non-bank companies — companies that are not banks, like Tata Motors, Tech Mahindra — are prepared in accordance with Schedule III of Companies Act 2013. But Banking companies, on the other hand, are governed by the Banking Regulation Act of 1949. The format of the balance sheet and P&L statement of banks is specified in Form A & Form B respectively.
Financial Statements covered in the post:
- Profit & Loss: a statement that shows the net profit/ (loss) in a period
Ex: during the financial year of 2019–20
- Balance Sheet: a statement that shows the financial position at a point in time
Ex: as on the day when it was prepared, say 31st March
- Schedules: It’s a note that describes the constituents of the line item
What’s the format of a Bank’s financial statements?
The format of a bank’s financial statements, therefore, is very specific and unique. Firstly, a bank needs to report the same P&L and B/S statements as every other business, except they have line items that are specific to a bank because of the nature of its business. A bank, you see, does not hold any inventory in terms of raw material because it does not really manufacture anything. Nor does it sell a product or a service such as a soap-like HUL or a coding service like Infosys. What a bank does is, it takes in deposits from people like you and me who open up Savings and Current Accounts with them to store our money, and the bank then uses those deposits as “raw material”, to give out loans. Now we are not the only people a Bank goes to take money from, it also goes to the RBI to borrow money. And like how banks pay us a small interest rate on our deposit in our savings and fixed deposit accounts, they also pay the RBI an interest rate called the Repo Rate.
Format of the Balance Sheet
Equity: the money that owners invest in the business. It is divided into two parts. The initial money that a founder puts in the company goes under capital and the profits that the company generates and puts back in the business go under Reserve & Surplus.
- Capital (Schedule 1)
- Reserves & Surplus (Schedule 2)
Liabilities: everything the business owes to its lenders is recorded under liability. For non-bank companies, this part records all the debt the company raises to grow its business. For a bank though, liabilities record all the money its depositors, i.e. you & I put in the bank. So essentially, my money is as an asset for me but when I put it in a bank, it becomes a bank’s liability because it needs to keep it safe and return it back to me too. While deposits are the biggest portion of a bank’s liabilities, banks are also required to borrow money from other sources like insurance companies, other banks, & investors. This is extremely important because, as we know a bank lends out our money to borrowers. What if those borrowers default? How will a bank still pay us back our money if its borrowers don’t pay back the bank? This is exactly why the banking authority — RBI — makes it compulsory for banks to raise some money from other people too. This money, however, is not lent out but is kept in the bank to protect the borrower’s money because if on any given day, its borrowers fail to pay back there is money to still pay back depositors from the extra money it raised from other investors. Other liabilities below will just include any other operational obligation a bank has. This is explained in detail later under Schedule 5.
- Deposits (Schedule 3)
- Borrowings (Schedule 4)
- Other liabilities (Schedule 5)
Assets: For a non-bank, assets are typically plant, machinery, equipment & anything else that it uses to manufacture the products it sells and generates revenue. For a bank though, loans are its assets because that’s how a bank makes money. Loans are their primary products. Loans you’ll see are called Advances on a bank’s balance sheet. Besides loans, it will also put money in investment securities like stocks, bonds, etc. on which it makes money by trading them or just holding them and getting paid the interest. These securities will be included in the investment line item. The same line item will also have those investments that RBI wants the bank to invest and hold. The idea here is that if a rainy day arrives a bank can just sell off these easy-to-sell investments and payback its depositors their money. Fixed assets include all buildings, computers, furniture that a bank owns.
- Cash balance and balance with RBI (Schedule 6)
- Balance with other bank and money at call and short notice (Schedule 7)
- Investments (Schedule 8)
- Advances (Schedule 9)
- Fixed assets (Schedule 10)
- Other assets (Schedule 11)
The other two items are neither assets nor liability on the date of reporting. To understand contingent liabilities, it is important to understand that besides giving loans a bank also makes commission income. Say someone is given a contract to construct a road and if the contract is not delivered the person is liable for damages. In these cases, the parties awarding the contract want the contractor to get bank guarantees certifying that if the contract is not delivered the bank will pay all the damages. This is how a bank generates commission income on guarantees. In essence, it’s like insurance, just that there are no recurring payments, just a one-time fee to take the risk. Hence, the name contingent. There is no liability until say the contractor fails to deliver. Other very similar examples include acceptances and endorsements explained later under schedule 12.
Bills for collection is only one of the two-line items without a further detailed schedule. We all get cheques and deposit them in our branch to receive the payment intended, say a salary cheque. All the cheques that a bank gets and is yet to complete the process of crediting money to your account are recorded under the entry. Important to note it is neither recorded as an asset nor a liability.
- Contingent liabilities (Schedule 12)
- Bills for collection
Format of the P&L statement
Just by looking at the line items, it’s evident that a bank’s P&L statement is structured differently than a non-bank company say, a manufacturing firm, like Marico. There is no concept of looking at earnings before interest & taxes aka EBIT for instance. It makes sense because what’s the point of calculating income for a bank without taking into account its biggest cost i.e. interest expense — the interest it needs to pay you for deposits and other investors it borrows money from. Besides this, banks also need to record something call provisions for bad loans — this is just the amount of money a bank expects to not get paid back from the loans it has given. This is more of a prudence measure because you see the bank is recording the expense much before it actually faces the loss. These two are the biggest expenses for the bank. Operating expenses are very similar to what any other generic firm will have as it includes all expenses like rent, utility, depreciation, advertising expenses, etc. As you can guess, in order to improve profitability a bank has to manage its operating expenses — opex — well. Metrics like the cost to income & cost to assets are just widely tracked standardized measures for comparing two banks.
Below the profit line time to understand the transfer entries, it is first important to understand the connection between the P&L statement & the balance sheet. So every year any company makes a profit, it chooses to give part of the money back to its investors and retains the remaining. If I start a business by putting in my making and taking the risk of losing it all, any profit the company makes is also mine. I can choose to take out all the profit and pay myself back this year only or I can keep the money with the company so that it has more funds to grow, in this case, maybe given out more loans, start new branches, invest in technology, etc. thereby also increasing the capital invested.
To understand reserves, you need to understand how profit is transferred to the balance sheet. Every time profit is retained and put back into the company there are some portions that are taken out of profits and kept for specific purposes. The portions taken out are called reserves and the remaining balance is called a surplus. In the case of banks every year they have to put aside 25% of net profit and invest in easy-to-sell investments to prepare for a rainy day. This is also known as statutory reserve, which is what you see below. The remaining profit is transferred and put under Surplus under the broader bucker of Equity.
Breaking down line items — understanding schedules
The total number of Schedules in the bank’s financial statements is 18. Schedules 17& 18 does not give any breakup of any specific asset/ liability but give more details and disclosures about the business.
- S1: Capital
Here, you’ll get details about money raised through different types of equity shares — common & preference equity shares. There’ll be technical details like the maximum capital the bank can raise through equity shares, the money it has raised till now and has been paid up by investors. Includes:
Authorized Capital
- Maximum capital that a bank has the approval to raise through shares
Issued, Subscribed & Paid-up Capital
- Money that has been raised through equity shares so far
- S2: Reserves and Surplus
Reserves are appropriations from profits created for specific purposes
Different types of reserves include:
General Reserve
Capital Reserve
Revaluation Reserve
Profit & Loss
Statutory Reserve
All banks are required to transfer 25% of the current year's profits to this reserve. In case of loss, the creation of a statutory reserve is not required. This is created to safeguard banks from unexpected losses
- S3: Deposits: Generally, ~80% of the total liabilities of a bank
This is the bank’s raw material. Higher CASA is better because the interest rates given on such deposits are lower than say term deposits & other borrowings. Types include:
Demand deposits (Current account)
Savings deposits (Savings deposits)
Term deposit (Fixed Deposit & Recurring Deposit)
- S4: Borrowings: More expensive than CASA
Banks can raise money from RBI for the short term at Repo rate and long term funds from other sources such as insurance companies. Sources include:
Borrowings in India
- RBI (at Repo rate — Currently 4.00% as of 9th Oct 2020)
- Other banks
- Other institutions and agencies such as LIC
Borrowings outside India
- from the World Bank, IMF
- S5: Other liabilities
The operational liabilities of the bank are recorded here. Types include:
Bills Payable
- If I have to pay someone through a demand draft, I will ask my bank to create a DD in favor of the beneficiary. Until the DD gets encashed by the beneficiary, it is recorded as a bills payable by the bank
Accrued Interest
- Interest that bank is yet to pay on SB, FD, RD
Interoffice adjustments
- Bank Financials are prepared at individual branch level — the one down the road, yes that. As the word suggests, this entry shows the borrowing from their own branches. Ex: one branch of SBI borrowing from another branch of SBI in a different area, city, or State, hence this line item appears in branch level reports only. Borrowings are netted off at head office level. If two other banks (Axis & HDFC) are involved, then borrowings & MCNS are recorded for the borrower & the lender respectively.
Provision for doubtful debt
- Doubtful debts are those that may or may not come in
Provision for tax, and
Provision for rebate on bill discounted
- S6: Cash and balances with RBI
This entry refers to any cash-like assets, ones that can be easily converted to cash such as government treasuries that the bank holds. Entries include:
Cash in hand
Cash with RBI
- Banks need to maintain cash in the current account of RBI to meet reserve requirements
- Extra funds can also be parked with RBI in the non-current account at reverse repo rate — 4.90% as of Feb 2020
- S7: Balance with other banks and money at call and short notice
Balance with other banks
- Any cash balance that a bank holds with other banks.
Money at call and short notice
- These are short-term unsecured funds lent to other banks. Banks often lend and borrow among themselves to meet short term money requirements.
- S8: Investments
Banks invest deposit money to make investment income. These investments include:
Government securities (long-dated)
Shares, bonds, debentures
Other approved securities
Subsidiaries, JV
Gold
- S9: Advances
This is the entry that records the loans banks make to their customers. Advances can be segmented on three parameters — term, type of collateral & customer as shown below
(i) Classification based on term
- Bills purchased these are very short term ~ less than six months
- Cash credit/ bank overdraft medium-term up to 12 months
- Term loan Long-term more than 12 months
(ii) Classification based on collateral
- Secured by fixed assets
- Secured by guarantees not backed by anything tangible
- Unsecured
(iii) Classification based on customer
- Priority sector agriculture, MSME primarily
- Public sector loans given to public companies
- Banks
- Other
- S10: Fixed assets
Land building
Plant
Furniture
- S11: Other assets
Interest accrued on advances
Interoffice adjustments
Stationary
TDS
Other
- S12: Contingent Liability
These include acceptances, guarantees, and endorsements and refer to liabilities that don’t exist at the moment but may arise in the future contingent on some event happening. Banks take on these liabilities in exchange for an upfront fee.
- S13: Interest earned
Income from investments & loans is recorded here. This is the core income of any bank that is primarily into lending.
Interest earnings on cash credit/term loan
Discount income
Interest earned from RBI
Interest earned on investments
- S14: Other income
This is to record all fees and commission charges on peripheral activities like brokerage, issuing demand draft, NEFT transactions. Examples include:
Commission, Exchange, and brokerage
- Commission charged on generating demand draft
- Brokerage fees for trading services
Profit/ (Loss) on sale of investments
Profit/ (Loss) on revaluation of investments
Profit/ (Loss) on fixed assets
Dividend income from subsidiaries, JV
Other income
- S15: Interest expended
Interest paid on deposit
Interest paid to RBI/ interbank borrowings
Others
- S16: Operating expenses
All operating expenses except provisions are recorded here
- S17: Accounting Policies
Depreciation policies, consolidation methods, valuation choices, and other accounting estimates are recorded here
- S18: Notes to accounts
Further details are included here
- Segment reporting
- List of subsidiaries/ JVs
- Customer complaints
Understanding adjustments to Profit & Loss and Balance Sheet items
These are bank-specific adjustments to income, expenses, and calculation of specific regulatory ratios as required by RBI and include the below:
1. Income recognition
RBI requires banks to classify their loans as Performing & Nonperforming basis payment of interest & principal due. Income on any performing loan is recorded when interest becomes due while interest on non-performing loans is recorded only when cash is received. RBI has given details on cutoff days to classify loans as — performing & nonperforming
2. Provision for doubtful debts
When a bank gives any loan, it needs to foresee any principal losses and reduce today’s income by that amount — known as a provision. The amount to be calculated as provision is specified by RBI and differs by the type of loan.
3. Provision for doubtful debts on advances covered by ECGC/ DICGC/ CTGSI
An exporter or a borrower in a small scale industry can seek insurance from specific government bodies that are set up to promote these industries. If a loan is guaranteed by any of the below government departments, the provision on such loans is lower. Hence, the amount by which banks need to reduce their income while initiating such loans is also lower due to the extra cover. RBI has again specified norms as to how to create provisions.
- ECGC = Export Credit Guarantee Corporation
- DICGC = Deposit Insurance and Credit Guarantee Corporation
- CGTSI = Credit Guarantee Trust for small industries
4. Rebate on bills discounted
This entry is similar to unearned revenue and hence is recorded as a liability.
5. Bills for collection
These are cheques that are due for collection by the bank. This is neither reported under assets nor liabilities and is presented for informational purposes only
6. Capital Adequacy Ratio
The Capital Adequacy Ratio (CAR) helps make sure banks have enough capital to protect depositors’ money.
Deposits need to be covered for potential losses from default. Hence the bank needs to keep aside a fraction of its total capital as a buffer which is also known as Tier 1,2 capital. The amount of capital that needs to be kept aside depends on the types of loans the bank has. For eg., an unsecured loan is riskier than a secured loan, and hence as a lender, the bank needs to be more prudent for its unsecured loan book. The RBI specifies the amount of capital by providing a risk weight to different types of loans. The risk weight needs to be multiplied with the outstanding loan to get risk-weighted assets. RBI requires banks to keep at least 9% of their RWA as tier1&2 capital.
Capital adequacy ratio = Capital/Risk-adjusted assets * 100
Capital = Tier I Capital + Tier II Capital
Tier 1 capital consists of money paid up by owners and internally generated funds. It does not come with any mandatory fixed repayments and is also last in order of claims in case of winding up of the bank. Hence, Tier I capital is considered to be most important to protect in case of losses. It is also a higher fraction of the total capital ratio. Tier II capital is money raised from investors. These securities are second in order of claim in case of liquidation and may need to be paid back.
a. Capital Tier I includes Equity share capital, Profit & Loss, General Reserve, Statutory reserve, Security premium, Capital reserve realized in cash, Other free reserves
b. Capital Tier II includes Preference share capital, Convertible preference & share capital, Non Cash reverse (Capital reserve & Revaluation reserve) * 45%
Capital tier 2 cannot exceed capital tier 1.
7. Investments
Investments have to be recorded at purchase cost or market value which is lower. RBI defines rules for bank stating which type to use.
i. 25% of investments are assumed as a long term investment and hence valued at purchase cost
ii. Remaining 75% of investments are valued at cost or market value whichever is lower. The is to reflect profit/(loss) on the investments as the bank does not plan to hold them for long. This profit/(loss) is included in Schedule 14 under other income
8. Cash Reserve Ratio & Statutory Liquidity Ratio
These ratios are required to be maintained by the RBI.
- Cash Reserve Ratio: (Currently 3.0% as of 1st May 2020)
Every commercial bank is required to keep x% of its credit deposits in the form of cash. The money is kept at bank branches in the current account of RBI. Banks do not earn interest on these cash reserves. The purpose is to keep some liquid funds that can be used by the RBI if needed.
CRR is also used by RBI to limit the money supply in the economy to control inflation. If the CRR requirement by banks is increased by RBI, they need to keep more money as cash with them, thereby limiting their lending ability. The reverse happens if CRR is decreased.
2. Statutory Liquidity Ratio: (Currently 18.5% as of 1st May 2020)
Every commercial bank is required to keep x% of credit deposits in the following liquid assets.
SLR also limits a bank’s lending ability but they earn interest on investments under SLR. Liquid assets are prescribed by RBI as per below:
i. Cash in hand Cash in hand is taken after maintaining CRR
ii. Balance with RBI in the non-current account at the reverse repo rate
iii. Balance with other banks and Money at call and short notice
iv. Unencumbered securities can be easily sold off
v. Gold, silver
These are reported to the RBI every alternate Friday.
