The global financial crisis of 2007-09 shattered the popular notion that banks are the safest place on earth to park your funds. While authorities might bail out banks that are considered too big to fail, it would help if you can assess a bank’s financial health yourself. If you are wondering how to check the financial health of a bank, you should know the key indicators of a bank’s financial health, such as non-performing assets (NPAs), provision coverage ratio (PCR), and capital adequacy ratio (CAR). In this blog post, we will discuss these key indicators and their importance in analyzing a bank’s financial health.
Key indicators of a bank’s financial health
Several key indicators can help you analyze a bank’s financial health, including the CAR, NPA, and PCR in banking. We will learn about these key indicators in detail.
Capital Adequacy Ratio (CAR)
A key indicator of a bank’s financial health is the Capital Adequacy Ratio. Checking a bank’s CAR is the safest way to assess its ability to absorb potential losses. In simple words, CAR measures how much capital a bank has in comparison with its credit or lending exposure. CAR is usually enforced by the bank regulatory authority to refrain banks from excessing leverage and turning insolvent.
Typically, a higher CAR indicates that a bank has enough capital to absorb its losses, while a lower capital adequacy ratio indicates a higher risk of bank failures. Usually, RBI considers to 8-12% CAR as the average for banks.
Non-Performing Assets (NPAs)
A bank’s financial health can also be gauged by its non-performing assets (NPAs). For banks, their assets or performing assets are loans, credits, and other financial services that help them generate income. But when any credit or loan repayment stops for up to 9 months, it automatically turns into non-performing assets or NPAs. NPAs have significant negative effects on banks’ financial health as the NPAs with a long pause in repayment with no chance of recovery turn into their loss.
Therefore, the higher amount of NPA in the bank’s financial statement indicates poor lending capacity and chances of bank failure. On the other hand, lower NPA in comparison to its performing asset and total capitalization indicates financial stability.
Liquidity Ratios
Liquidity ratio also indicates a bank’s financial health. Learning about the liquidity ratio of a bank usually refers to the adequacy of its liquid assets that can be used to meet short-term obligations and responsibilities. Usually, the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are used to indicate a bank’s liquidity. Assessing the liquidity ratio of a bank is very important as the higher liquidity ratio helps to safeguard the bank and the funds stored in it from economic breakdowns and liquidity crises.
Net Interest Margin (NIM)
Net Interest Margin is another key indicator to assess a bank’s financial health. NIM serves as the measurement of a bank’s lending activities. In simple terms, the calculation of the NIM of a bank includes the difference between the bank’s interest earned and interest paid divided by the interest-earning asset. Normally, a higher net interest margin suggests a bank’s capability to run efficient lending operations, while a lower NIM ratio suggests a bank’s inefficiency in running successful lending operations.
Provision Coverage Ratio (PCR)
One of the key metrics to assess the financial health of a bank is PCR. It is the percentage of bank funds set aside to deal with NPAs or bad assets. The Provision Coverage Ratio of a bank indicates its ability to deal with bad assets or capital. It also indicates the overall financial health of a bank.
Understanding PCR
PCR is a crucial metric in assessing a bank’s financial health. A good PCR ratio shows a bank’s risk management ability and preparedness to address financial losses caused by bad loans. PCR can be calculated by dividing the percentage of funds allocated for bad loans by the gross value of non-performing assets.
Significance of a high PCR
To understand what is PCR in banking, one must understand the significance of high PCR. A high Provision Coverage Ratio means that a bank has put aside a substantial percentage of its funds to deal with financial losses arising from bad loans. It also shows that a proactive risk management and financial management system is in place.
Implications of a low PCR
Unlike high PCR, a low PCR indicates a bank’s inability to deal with crises arising from bad loans. It also means that a bank is not prepared to cover potential financial losses caused by NPAs. A low PCR can lead to financial instability and impact the confidence and trust of depositors.
How to check PCR
After learning the significance of PCR in banking, let us understand how to check the financial health of a bank by assessing its Provision Coverage Ratio.
Reviewing Annual Reports
The best way to check a bank’s PCR is by reviewing the annual financial reports of a bank as a reliable and primary source of information. It is mandatory for banks to publish detailed financial reports, including the price-to-book ratio and provision coverage ratio annually.
Regulatory websites
In India, the Reserve Bank of India (RBI) publishes financial reports of banks on its official website, making it accessible to the public. This report also includes the PCR of banks and offers valuable insights into the financial health of a bank.
Financial news and analysis
Financial analysis firms and news platforms also offer detailed assessments of the financial health of various government and non-government banks. The analysis also includes PCR of a bank.
Interpreting PCR in context
It is important to interpret PCR in context for a better understanding of how it works.
Comparative analysis
One of the best ways to interpret PCR in context is by either comparing a bank’s PCR with its competitors or with the industry average. If a bank’s PCR is well below its competitors or the industry average, you should conduct further research and analysis.
Historical trends
Using historical trends to assess the provision coverage ratio of a bank can offer valuable context. If there is a consistent decline in a bank’s PCR, it may indicate the rise of potential risks in the loan portfolio of a bank.
Limitations of PCR
As a financial metric, PCR plays a significant role in assessing the financial health of a bank. However, it also has some limitations that one should keep in mind while using the metric.
Potential for manipulation
PCR offers valuable insights into a bank’s financial health. But this metric can also be manipulated. For example, a bank may not have a good PCR and use incentives to present a more favorable percentage by manipulating its actual provisions. It is advisable to use PCR analysis in conjunction with other financial metrics.
Macroeconomic factors
Macroeconomic factors such as policy changes and economic downturns can also present limitations for PCR analysis. These factors can create a significant impact on a bank’s PCR. That is why one should take these macroeconomic aspects into consideration when checking a bank’s PCR.
The calculation for the Provision Coverage Ratio (PCR) is as follows:
Provision for NPAs / gross NPA= PCR
PCR in banking is calculated by comparing a bank’s provision for NPAs with the total gross NPAs in its financial books. Divide the Provision with the gross NPA to find the PCR of a bank. The ratio is a bank’s ability to proactively manage financial losses caused by bad loans. It also gives insights into a bank’s overall financial health.
If a bank’s PCR is at 70% or above, it has the financial strength to deal with non-performing assets and other risks associated with it. However, a PCR below 70% is considered low and shows that a bank is not properly equipped to deal with bad assets.
Is provision coverage ratio a misleading metric for investors?
If you are learning about PCR in banking, you know that it is a quite useful metric in assessing NPAs and financial health, but it can be misleading. This is primarily because the definition of a non-performing asset is subjective and there are no clear regulations for the provision write-back process. Hence, it typically relies on the authorities’ optimistic projections of NPA recovery, and provisions are therefore adjusted accordingly. Furthermore, banks often fail to allocate sufficient fresh provisions for the new NPAs.
Conclusion
The financial health of a bank is important for all its stakeholders, be it individual depositors or institutional investors. Understanding what is PCR in banking and other key indicators will help one assess the financial health of a bank.
