Part 5: Process or How the heck do I Invest in Equity Successfully?

5.6 How to identify a Quality Bank/NBFC Stock and avoid the rest

Banking, Financial Services and Insurance, BFSI is the largest sector by market capitalisation in India. It accounts for about 37% of Nifty 50. Your portfolio will almost certainly have some stocks from this sector. So, its important to understand how to select quality stocks from this sector. 
BFSI has many different industries and its not possible to cover all of them in one chapter. But the most important ones; Banks and NBFCs-Non-banking Financial Companies are covered here.  Bank and NBFCs are clubbed together because they are very similar to each other. However, they are very different than other companies simply because their raw material and final product is money. But all money is not the same though it appears so. The difference is its ability to earn interest or returns.
Banks/NBFCs add value by enhancing the ability of money to earn higher interest. Higher interest comes with higher risks and their ability to manage risk is what separates the men from the boys.
Simply put they borrow money eg from us as deposits in our saving accounts or FDs and also borrow from others, on which they pay interest at a certain rate and lend it to borrowers, their clients at a higher rate. The difference is what the Bank or NBFC earns and is called Net Interest Income, NII. They also earn revenue by providing services to clients, all clubbed as Other Income. NII and Other Income together is called the Total Income.
How does it get the money that it loans out and why is it important? Like any other company the first source of funds is the Bank/NBFCs’ equity which is the money invested in it by shareholders and the profits ploughed back into the business. The rest of the money is raised through borrowing.  
Banks are permitted to open Current and Savings accounts, CASA from customers like you and me. This is an important low-cost source of funds. NBFCs are not permitted to do so. Banks and NBFCs borrow the rest the money that they require to provide loans to their customers. Unlike most other companies, Bank/NBFCs borrow much more than their equity. This is called leverage. The amount and the cost of borrowing depends on several factors like the promoter credit standing, nature of loan products offered (secured vs unsecured), customer segment it caters to. 
For example, leverage for housing NBFC can be as high as 8-9x and available at lower cost (since housing loans are relatively safer) while the same for Micro Finance NBFC (MFIs give unsecured loans) would be as less as 3-4x and a higher cost. This limits how much money is available with...........Read More

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