The Story Underlying the Numbers by S. Veena Iyer

Author:S. Veena Iyer
Language: eng
Format: epub
Publisher: Business Expert Press
Published: 2018-11-22T16:00:00+00:00

The difference between interest earned and interest expended is termed net interest income and it forms (should form) the largest component of a commercial bank’s income. Other income comprises fees and commissions on services such as transaction support, loan proposal processing, card business, risk management services, etc. as well as capital gains/losses on sale of investments. Another important component of other income is the profit or loss from revaluation of investments. While this item may not be large in quantum for most periods in time, it is an inherent dynamic of a bank’s investment portfolio. Investments that are not held to maturity need to be marked to market (MtM), which means they need to be expressed at their market values (as against book values for HTM investments, as HTM investments are expected to be redeemed at maturity values and fluctuations in their value do not affect the bank’s financial position) in the balance sheet. As per Indian accounting rules, any notional loss on such revaluation has to be recognized in the P&L statement immediately, while any notional gain is accounted for in “Other comprehensive income” directly going into the reserves in the balance sheet. Rules in some other countries require both losses and gains to be recognized in the P&L statement similarly. What is important to understand is that despite these differences, the common understanding that investments are a core ingredient of banking and potential gains and losses on them need to be accounted for and get reflected in financial statements for prospective investors and decision makers to take calls based on these numbers. These numbers become significant during times of large interest rate swings and during economic instability.

Banks in India had been piling up longer-tenure debt securities as part of their investments portfolio in anticipation of interest rate cuts by the Reserve Bank of India (RBI) in the months to come. However, the yield on the government securities saw an unexpected upward movement during the last quarter of the calendar year 2017, and into the New Year. Banks therefore, had to take on huge MtM losses on their books on account of these investments that were unhedged.3 These losses will show up in their third quarter results for FY2018 and possibly in their FY2018 annual results.

Other income also includes gain or loss on foreign exchange transactions and on sale of fixed assets. The P&L statement has only two line items for expenses before taxes—operating expenses and provisions and contingencies—the latter having overtaken the former as the larger component in the last 2 years. Clearly, operating expenses are of a cash nature, while provisions are of a noncash nature. Banking being (still) a human resources intensive business, employee-related expenses dominate operating expenses.

Having understood a bank’s balance sheet at first brush, how does one analyze it? Can the DuPont framework work for a bank? The 4-way DuPont framework that was applied to all firms analyzed thus far is,

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