Business of bank is one of the most complex on account of high regulations. The primary business of the bank is to lend money to retail customers for their purchase requirements and to small, medium, & large companies for their business purpose. Since lending is the primary business, Bank needs to raise money in the form of loan, deposits, equity so that it can lend it further. To raise the money, bank pays interests on it and on lending it earns interests on it. Thus, the interest spread less operational expenses is the net profit for them. Let’s divulge in a brief manner on the business of a bank from a banker’s perpective:
– A banks balance sheet is opposite of usual corporate balance sheet. When a corporate places a deposit with bank, It is asset for them but it is liability for the bank. Similarly it is vice versa for loan.
– One of the most tricky thing in Banking is Asset-Liability management. Bank borrows short term (customer deposit) and lends long term (loans) which exposes their balance sheet to huge asset liability mismatch.
– This means if all bank customers withdraw their money at the same time, every bank in the world will default. They will go bust. This happened with Yes Bank earlier and recently with Silicon Valley Bank (SVB).
– But it does not happen that way. Not all customer withdraw their money at the same time (except in crisis situation). Hence bank step aside 20-25% of their money and invest in liquid asset which can be sold immediately to meet any customer withdrawals and lends only the balance.
– This 20-25% keeps changing and is based on regulatory requirements. It is called Cash reserve Ratio and Statutory Liquidity Ratio i.e. CRR and SLR. Currently SLR is 18% and CRR is 4.5%
– Banks has 3 primary sources of Revenue. Interest income, Fees income and Treasury Income. Interest income is from loan & investments, Fees income is in the form of commission, Processing charges etc., and Treasury income is from treasury services.
– In general, across banking, Interest income constitute 65-75% of the revenue, Fee income 25-30% and balance 5-10% from Treasury income.
– How Interest income is calculated:
(Rate at which loans are given to customer (-) Rate at which bank borrows or accepts deposit) * Total size of loan book
– There are 3 ways in which bank accept deposit. Current account (CA), Savings account (SA), and Fixed deposit (FD). CA being cheapest sources of funds, followed by SA and FD. Hence every bank track a key metric very closely i.e. CASA Ratio which is higher the better.
– For a bank the most important thing is to maintain a lower deposit interest rate and still be able to mobilise (attract) customer deposit. Understand the banks dichotomy : If they give lower rate to customer, customer will shift deposit to another bank. If they give higher rate to customer, Their net interest income will reduce. Hence ability to maintain that balance is very important
– Banks are into lending business and in this segment, business growing significantly comes with a cost. When any lender tries to grow fast they need to increase their loan book size and Loan spread. This inadvertently pulls bad borrower i.e. customer with low credit profile. Balance between growth and book quality is very tricky and another most important thing in banking.
Hope this helps in understanding some of the banking nuances.