Every story has a history and story of banking is no different. We need to understand where we came from to understand where we are going. As someone who manages @BankHistory twitter handle, this is my favorite part anyhow.
Banking is older than money. Necessity is the mother of all inventions. So if you ask me, loans were a necessity and banking was an invention. Don't hate me if you are from liabilities side of banking, but contrary to popular belief, first came loans & then came deposits. The concept of banking began in ancient Babylonia, China & India with merchants offering loans of grain as collateral within a barter system. Later the lenders in ancient Greece and during the Roman Empire added two important innovations a) deposit taking & b) money exchange
If you've ever been to Louvre in Paris, you wouldn't have missed Monalisa. But it's the most over hyped painting in history. Louvre has another jewel which in all probability you would have missed.
In a quite corner not so far away from the busy Renaissance paintings in Louvre, lies a carved stoned called as "Code of Hammurabi". It is one of the oldest deciphered writings of significant length in the world.
Among many other things, the Code of Hammurabi from 1754 BC recorded interest-bearing loans. But it didn't talk about deposits. Why? Reason is, in all probability early loans were made out of capital and hence there was no need to take deposits.
Initially wealth (to make loans) and power (to recover loans) were concentrated in few hands. Slowly but surely wealth started to move to masses (in form of surplus). But power of course still remained concentrated. That's when deposits were invented.
Ultimate motive of all businesses is to maximize profits. You can do this by buying input materials at as low prices as possible, add your business value as economically as possible and then selling the finished goods at the highest possible price to consumers. One can extend this corollary to modern day banking model as well. So you take deposits at lowest possible interest rates, add business value in terms of branch distribution & credit risk evaluation skills and eventually loan out these deposits at highest possible interest rates.
It's not exactly this straight forward always (I'll come to it soon). But for the time being let's stay with this model. If banks were just to collect money in form of deposits and distribute all of these deposits in form of loans, there would be no skin in the game for banks. So how do we get bank's skin in the game? Simple. Stipulate a minimum capital requirement. Meaning, for every Rs. 100 of loan, banks need to put in Rs. 9 of their own. This explains what Capital Adequacy Ratio (CAR) is. So higher the CAR higher the skin in the game! CAR technically also limits the leverage that a bank can employ. Higher the CAR lower the leverage, lower the CAR higher the leverage. And like with all leverages - this leverage is also a double edged sword. Historically excessive leverage is number one reason for bank failures.
Since some loans are riskier than others - like say a Home Loan vis-a-vis a Credit Card loan - the capital requirement stipulated for HL is way lower than CC loan. This in banking is called risk weighted assets (RWA). So HL which is secured lending is @ 70% RWA while CC is @ 125%. Banks need higher capital for doing a higher RWA lending product like a Personal Loan, Capital Market Loan or a Credit Card outstanding. So in a way higher skin in the game is mandated by regulators as perceived risk of lending product increases.
Once all capital of banks are lent out, banks will need deposits to disburse additional loans. There are three broad deposit types - (a) current account deposits (b) savings account deposits (c) fixed deposits. Together these three are called Net Demand & Time Deposits (NDTL)
Govt. is our biggest borrower. How does government ensure enough demand for it's bonds? Simple. Stipulate a Statutory Liquidity Ratio or SLR. Current SLR mandated by @RBI is 18.25%. So 18.25% of all deposits of the banks have to be mandatorily parked in GOI bonds.
Cash Reserve Ratio (CRR) is nothing but that part of bank deposits which is parked idle with
@RBI. Current CRR mandated is 4%. Banks don't earn return on money parked as CRR. Both CRR & SLR is used by RBI to control liquidity in the system. Higher SLR/CRR means lower liquidity.
After global financial crisis, Basel III norms stipulate one another liquidity measure for banks and it's called Liquidity Coverage Ratio (LCR). One of the biggest risk for banks is to keep sufficient liquidity for the clients who have deposited money with the bank. LCR prescribes to keep sufficient liquidity in High Quality Liquid Assets (which mostly is Govt. bonds) to meet net cash outflow for next 30 calendar days. Minimum LCR required for banks from 1st Jan 2019 is 100%. With LCR not all deposits are equal (I will explain)
As per Basel III guidelines all deposits are tagged with a run-off percentage. So deposits held by individuals and small business customers come with run-off percentage of only 10%. While those of corporate and govt. departments are bucketed in 40% run-off. All others is @ 100%. So clearly of every Rs. 100 in deposits from individuals, Rs. 90 goes to loans and only Rs. 10 in low yielding GOI bonds (HQLA). Had this Rs. 100 deposit come from say a Trust/HUF/University/NGO entire Rs. 100 need to be deployed in HQLA with nothing available to lend further.
So fixed deposits from Trusts (typically temples, universities) is actually loss making for banks. Banks pay 5.5% interest on these deposits and directly deploy all such trust deposits in GOI bonds (HQLA) which yields around the same depending on their maturities.
On the other side for individual deposits only 10% gets deployed in HQLA and remaining 90% can be lent out as client loans at interest rates ranging anywhere between 7% - 18%. That is why Mr. Market give higher valuation to retail banks compared to corporate banks.
Now about loans or assets side of bank's balance sheet. Loans are banks version of finished goods. You sell your loans at highest possible interest rate. Banking is a great business if you recover all you've lent. But losses in form of defaults is inevitable.
So like banks set aside a part of deposits as SLR and CRR, banks also set aside a part of loan book in form of provisions. Banks are mandated to set aside 0.4% of their loan book as a safeguard against all kinds of future unknown defaults. This is call standard provisions
As long as bank's borrowers keep on repaying the money borrowed, there is no better business than banking. The problem comes when customers don’t pay interest and/or principal. A loan gets flagged as Non Performing Asset if interest and/or principal remains unpaid for 90 days or more.
The downward spiral starts as soon a loan turns NPA. First the banks have to reverse the interest income earned over last 90 days. Second higher provisions (much more than 0.4% in standard provisioning) have to be taken against the principal outstanding.
Gross NPA is the total amount of unpaid principal for 90 - 180 days. Once the loan remains unpaid for more than 180 days it is technically a write-off meaning 100% provision. Provisioning means, amount equivalent of principal outstanding is deducted from banks income and has direct impact on bank's P&L. Net NPA is calculated as Gross NPA less (balance in interest in suspense account + total provisions held by the bank).
Gross & Net NPA divided by total loan assets gives you GNPA & Net NPA in percentage terms. If a borrower makes a repayment on a NPA account & loan becomes current, then provision against that loan gets reversed & interest in suspense moves to the P&L of the bank. Deposits which are not lent out as loans are invested in government and corporate bonds (for sake of simplicity, I will leave derivative book). This becomes the investment book of the bank. As interest rates fall, these bonds gain in price and as interest rates rise, these bonds lose value.
This is pretty much everything about banking. Every bank's Endeavour is to earn from it's customers in form loan interest income which is much higher than what it pays to it's depositors. The difference between what banks earn and what banks pay is called Net Interest Margin.
Since both assets and liabilities (loans and deposits) use up capital of the bank by way of CAR and LCR respectively, return on equity is one of the important parameter to judge performance of a bank. Everything else being equal, if bank A generates a profit of Rs. 100 on a capital of Rs. 5 and bank B generates a profit of Rs. 100 on a capital of Rs. 4, investors will value bank B much higher than bank A. Fees are a big way to boost ROE since all fees income earned directly goes to the bottom line and unlike loans and deposits fees consume zero capital. Now you know why all bankers want to sell you that low yielding Life Insurance policy? Not for higher fees but for higher ROE
Anything else (apart from loans & deposits) that bank does is either to make fees or to reduce costs. So banks offer high tech Internet Banking & Mobile App not because they care for customers, but that reduces their costs of servicing a customer. Works symbiotically honestly.
You might argue why does banks offer payment solutions like Credit Cards. Why do banks give those juicy reward points on Credit Cards. Quoting someone - "Credit Card is the business of transferring money from poor to rich". Question is does Credit Card give fees to the bank? Or does CC give loan book to the bank? Or does CC help save costs to the bank? The answer is it's all three.
CC is a beautiful product. CC issuer sells the CC for the rewards and ease of payments. However, ends up making enough interest and fee income from each CC (more than what they do from personal loans and at fraction of the cost). 50% of Credit Card income from the loan book. There are three types of CC users. Defaulters, Revolvers and Transactors. It is Revolvers who are the most profitable. Revolvers are the ones who do not pay their CC bill in full but instead pay interest rates upward of 36%.
In spite of CC being so profitable business, most banks sell CC only to their existing customers who mostly are salaried. That's the fear of default. Here's a thread on Indian Credit Card industry based on DRHP of SBI Cards IPO.
Lastly. If deposits are input raw material and loans are the end good for banks. Banks are blessed (or cursed!) to be the only industry that simply by selling more finished goods (loans) create their own raw material (deposits). Here's where Prof @ananthng explains how money is created in Indian Banking System.
Hopefully these banking explanations were basic enough for layman to understand. Do send me your feedback on niravsss@gmail.com about what could have been simpler. Thanks!
Cheers,
Nirav