We have been analysing the banking space for the last 5+ years now and today wanted to talk about something which is perhaps not given its due attention. It is the ‘Other Income’.
Other income, also known as non-interest income, which includes loan processing fees, distribution (MF, insurance etc) fees, brokerage, income from dealing in forex, treasury gains, loans write backs, forex profits, dividends, and few other smaller heads. CEB, (commission, exchange, brokerage) income is looked at separately as it represents the ability of a management to generate extra sources of income using the already existing infrastructure and sales personnel (may be some are specially hired for generating CEB but not much). Thus, CEB flows directly to PBT, contributing massively to profitability. We can call CEB as core other income (OI).
Now let’s understand why is it important?
OI is generated using the already laid out infrastructure and is a measure of how effectively management is able to sweat its resources. Since there isn’t much aditional cost for generating OI, it directly adds to ROA/PAT (adjusting for taxes).
Lets take a look at the ROE tree below comparing New Private Banks with Old Private Banks:
Highlighted row at the end of the table above shows contribution of total OI to PBT for the last 5 years for the private banks under study. For few banks, almost all of PBT is coming from other income which essentially means core lending is not profitable enough to keep the bank afloat.
If we just remove CEB income, ROEs fall below 10% for most of the banks including Yes, IndusInd and Kotak
However, one can argue that some components of OI such as loan processing fees is an integral part of lending operations and most of other non-interest income is generated using the various resources such as branch infra, personnel, customer deposits which are into place only because of core lending operations. Lot of other income is generated because of cross selling. We also agree that existence of OI relies on core lending operations of a bank, however, an efficient and focused management can use the resources in a way that brings all the difference into the profitability of the bank. From the first table, it is pretty evident that new private banks are much more focused on generating other income than their old counterparts. In my view, this is making all the difference to their return ratios.
Role of management in generating OI becomes quite evident when we look at CEB (core OI) metric for 5 largest PSU banks. As expected, none of the banks including country’s largest lender, SBI, comes closer to any of New Private Sector lenders.
Its amazing to see how private banks specially new private banks have been able to generate high core OI (CEB). Table below shows this stark comparison of new private banks vis-a-vis old private and PSBs (public sector banks). A major outperformance in PBT is being generated by outperformance in core OI thereby reiterating the significance of OTHER INCOME.
Other takeaways from the comparison table –
- Improving other income metric could be a good leading indicator of a bank’s strategy
- CUB is the best bank amongst all private banks on ‘return on risk weighted assets’ (RORWA) metric; it generates more risk adjusted returns than even HDFC bank though the out-performance is in few bps 🙂
- RBL stacks up in bottom quartile on ROE but still gets P/B multiple which is comparable to IndusInd and Yes
- Yes is highest ROE generator amongst all private banks while at the same time it is one of the most levered as well
- Leverage – Old banks are more levered than their new counterparts, despite that they generate lower ROEs. PSBs’ leverage is shooting through the roof.
- Credit costs (provisioning for bad assets in P&L) – Both, old and new, banks are at par on this metric, but provision coverage is lower for old banks (69%) vs new banks (72%) indicating that new banks are more progressive in providing for bad loans
- Tax rate – some of the old banks such as CUB, KVB and Karnataka almost always pay less taxes (~20%) than other banks (~33%) mainly because of tax deduction claimed under section 36 (1) (VIII) for creating special reserves