Some of India’s largest banks have announced their results recently. Amid a global economic slowdown, investors have eagerly awaited these results to obtain a picture of these banks’ health. In evaluating this health, investors have been treating capital adequacy ratio (CAR) as the most critical indicator, at least for the past few decades. Unfortunately, CAR is far from adequate in painting a true picture.
CAR is defined as a bank’s capital divided by the risk (assets) it takes on. The higher the CAR, the better the “cushion” available to absorb losses without affecting depositors. At present, the Reserve Bank of India (RBI) mandates that tier I CAR—primarily equity capital, though, in some cases, also long-term bonds—be greater than 6% and total CAR be greater than 9%. But CAR rarely tells the entire story. For that, we need to look at more variables.
India’s largest private bank, ICICI Bank, reported its tier I CAR at 11.8% and total CAR at 15.5%. The numbers are healthy and, at face value, it would appear that the bank is well positioned to increase its balance sheet and win market share from its competitors. So, why is ICICI Bank talking about reducing the size of its balance sheet?
A careful examination of ICICI’s results shows that net non-performing assets (NPA) of ICICI stands at Rs4,554 crore, while profit after tax (PAT) for the last fiscal year is Rs3,758 crore. Recently, RBI has exempted banks from considering restructured loans as part of NPA. ICICI has reported that it has restructured loans of Rs1,115 crore. But all of this is precarious: Even a minor deterioration in asset quality will see ICICI reporting red next year. Presumably, this is why ICICI is trying to lighten its balance sheet.
Canara Bank, a top public sector bank, reported a total CAR of 14.11%. Its net NPA is Rs1,507 crore, while PAT is Rs2,072 crore; however, Canara Bank restructured advances of Rs2,066 crore. In both these cases, CAR paints a far rosier picture of the asset quality than what is reality.
CAR is expected to tell us if a bank is over-leveraged (an over-leveraged bank will supposedly have a lower CAR). But it doesn’t. In the last fiscal, the credit to deposit (C-D) ratio of ICICI was almost 100%, meaning the value of advances was double that of deposits. C-D ratio was only about 74% for Canara Bank. It is paradoxical that ICICI, with a higher CAR, appears vulnerable to deposit flight, while Canara Bank, with a lower CAR, still has sufficient “cushion”—thanks to a better C-D ratio—in case some depositors withdraw funds.
CAR also does not provide a picture of “maturity mismatch”, where liabilities may exceed assets in the short term. Let us consider the example of the growth of current account and savings account (CASA) deposits. CASA carries lower costs than term deposits; hence the increase in their number in recent years. At ICICI, CASA deposits make up 28.7% of total deposits, while Canara Bank has reported the same figure as 30.7%. The ratio of CASA to cash is an important measure of a bank’s vulnerability to “hot money”, money that is quickly deposited in banks but may also be quickly withdrawn. But ICICI only carries a little less than half the amount of CASA deposits as cash at hand.
It’s about time other measures such as ratio of net NPA to profit, C-D ratio and ratio of CASA to cash are considered to provide a better picture of the health of banks to investors.
Puranika Narayana Bhatta is chief financial officer at a software company in Bangalore. Comments are welcome at firstname.lastname@example.org