On Lending Business – 1

For a software engineer like me it has been a constant struggle to understand the financial statements of lending businesses like banks and NBFCs. Early this year, I came across this book which improved my knowledge on lending businesses leaps and bounds. Few days back my friend Vishal analyzed the annual report of a lending company. You can find his analysis here.

By reading these excellent resources one can attain 70% knowledge on lending businesses. Knowledge is cumulative and attaining the remaining 30% takes hard work and time. In the quest of attaining the remaining 30%, I will be writing several posts whenever I learn something new about lending. In this post I will be writing about (1) how to find out asset-liability mismatch (2) difference between net interest margin (NIM) and spread.

1. How to find out asset-liability mismatch

Lending companies borrow money (its liabilities), at one rate and lends it out (its assets) to borrowers at a higher interest rate. The interest and principal paid back by the borrowers is used to payback its lenders. What happens when it funds its long-term assets by using short-term liabilities? The outflows to its lenders will be much higher than the inflows from its borrowers. In such a scenario the only way for it to service its liabilities is to borrow more money. Most of the times the company can get away by doing that. But once in a while that doesn’t happen.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job. Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees. – Buffett

Many lending companies believe that they can fund the asset-liability mismatch (ALM) by borrowing more funds. This kind of thinking is akin to jumping out of a plane with a parachute that opens 99% of the time. The image shown below is borrowed from Prof. Bakshi’s presentations.

lending-business-parachute-jump

How do you find out if the lending company you are interested in has an ALM? In India all lending companies have to disclose the asset-liability maturity pattern in their annual report. With few additions and subtractions we can easily check if the company has an ALM. Take a look at the table given below for Shriram City Union Finance (SCUF). You can download their annual report from here. The rows with bold texts are mine and the rest are obtained from the annual report. Spend some time to go through the table and it’s self explanatory.

lending-business-ALM-Table

From the table we can see that SCUF has an ALM of 381.46 crores between 3-5 years. This is minuscule compared to the cumulative surplus it was running in the previous years. So if you’re an investor with SCUF you can sleep peacefully. SCUF lends money to micro-small-and-medium enterprises, two-wheelers, auto, gold, and personal loans. Majority of its loans are short term in nature. And it funds them using long term borrowings. This is the reason why they don’t have a lot of ALM.

2. Difference between NIM and spread

Sometime back I studied the business model of Repco Home Finance and I wrote about it here. In FY2015, Repco had a net interest margin (NIM) of 4.50% and a spread of around 3%. I couldn’t understand why should NIM and spread differ by over 1%. Upon further digging I came across an excellent explanation which is given below.

NIM and spread are the two key parameters that give an indication of a bank’s operational efficiency. As a concept, NIM and spread are similar, but there is a subtle difference between the two. While NIM is arrived at by dividing a bank’s net interest income by its average interest-earning assets, spread is the margin between the yield on assets and the cost of liabilities, or the difference between interest income and interest expense as a percentage of assets. NIM can be higher or lower than the net interest spread. – A Bank For The Buck

The table given below contains the details of Repco’s assets, liabilities, interest income and expense. Using this information let us calculate the NIM and spread for FY2015 and understand why they differ.

Lending-Business-Repco

NIM2015 = (Interest Income / Average Assets) - (Interest Expense / Average Assets)
NIM2015 = (Interest Income - Interest Expense) / Average Assets
NIM2015 = (Net Interest Income) / Average Assets
NIM2015 = 237.3 / 5273.33
NIM2015 = 4.5%

Spread2015 = (Interest Income / Average Assets) - (Interest Expense / Liabilities)
Spread2015 = (692.2 / 5273.33) - (454.9 / 4738.54)
Spread2015 = (13.12%) - (9.6%)
Spread2015 = 3.52% -- My calculations slightly differs from the reported spread of 3.0%

For calculating NIM we used assets in the denominator. But for calculating spread we used both assets and liabilities in the denominator. All else being equal if (interest-earning-assets > liabilities) then your interest expense as a percentage of interest-earning-assets will be lower resulting in higher NIM. And this is the reason why Repco had higher NIM than its spread. On the other hand if (interest-earning-assets < liabilities) then your interest expense as a percentage of interest-earning-assets will be higher resulting in lower NIM.

Advertisements

30 thoughts on “On Lending Business – 1

  1. A simple way to think about it could be that the difference between NII and spread depends on the capitalization level of the lender. Spread is difference in borrowing and lending RATES, and hence, not affected mechanically by Equity/Debt ratio of the lender. But,
    NII = (Interest Income – Interest Expense)/Asset
    = Lending Rate – (Borrowing Rate*Debt)/Asset
    = Lending Rate – Borrowing Rate*(1-Equity/Asset)
    = (Lending Rate – Borrowing Rate) + Borrowing Rate * (Equity/Asset)
    = Spread + Borrowing Rate * (Equity/Asset)

    Surprise for me! On writing the basic equations, it looks like the difference between Spread and NII does not only depend on capitalization levels, but also, Borrowing Rate. The higher the Borrowing Rate, higher is the NII (unless Net worth is negative, which would be rare for Lenders.)

    • Please excuse , for my brty naive question. Instead of NII it should be NIM.
      Also Interest income = lending rate*assets
      could be also explain how debt became 1-equity part

      • Hi Saurabh,
        Thanks for correcting me. It should be NIM and not NII. I look at spreads and capitalization levels separately, and do not look at NIM that much, may be that’s why I made the mistake of call it NII.
        I have used Interest Income = Lending Rate * Asset in the equation and also I have written `Debt = Asset – Equity` and not `Debt = 1- Equity`. The parenthesis “()” in the equations take care of these.

    • Hey pranav,

      I think you’re wrong on saying: “The higher the Borrowing Rate, higher is the NIM”.

      Just look on your second equation –
      ” Lending Rate – (Borrowing Rate*Debt)/Asset ”

      It’s quite obvious that the outcome of this equation will be higher (higher NIM) as borrowing rate is lower.

      It’s just that you forgot to take into account the borrowing rate hidden in your ‘spread’ figure in your last equation.

      By the way, Jana, WFC treats NIM as you treats ‘spread’. So I guess it’s always better to check these things…

      Kind regards,

      Michael

      • Hi Michael,

        Thanks for looking carefully at the comment that I wrote. I wrote only half of sentence in “The higher the Borrowing Rate, higher is the NIM” and then after posting I could not edit it. What I meant was “The higher the Borrowing Rate, higher is the NIM” when the spread and Equity/Asset are same for two Lenders. And this is correct. To explain, let me reproduce what I replied to Saurabh who asked the same question.

        NIM = Spread + Borrowing Rate * (Equity/Asset)
        Here, “The higher the Borrowing Rate, higher is the NIM” when the spread and Equity/Asset remain constant.

        For example, consider two lenders A and B with same Equity/Assets, Compared to B, A lends to somewhat riskier borrowers. As a result, A has both lending and borrowing rates higher by 1%. To summarize, A and B have the same spread and same capitalization levels but A is in riskier business . In this example, B will have higher NIM, because it has higher borrowing rate. I would rather prefer to invest in A, while NIM will point to B.

        ~regards,
        Pranav

      • correction: In this example, A (riskier lender) will have higher NIM, because it has higher borrowing rate. I would rather prefer to invest in B (less risky lender operating at the same spread), while NIM will point to A.

      • Hey pranav,

        That’s true, because an additional 1% yield for the lending rate (1%*assets) is bigger than an additional 1% cost for the borrowing rate (1%*debt), as assets>debt.

  2. Pranav… “The higher the Borrowing Rate, higher is the NII “….. NIM actually should be the net interest margin that the company gets . If the borrowing rate is higher the NIM should gt squeezed , in my opinion

    PS :- , i do not think that a pure lending business would get a margin of more than 2-3 %.

  3. Saurabh,

    NIM = Spread + Borrowing Rate * (Equity/Asset)
    Here, “The higher the Borrowing Rate, higher is the NIM” when the spread and Equity/Asset remain constant.

    For example, consider two lenders A and B with same Equity/Assets, Compare to B, A lends to somewhat riskier borrowers. So, A has both lending and borrowing rates higher by 1%. That is, A and B have the same spread and same capitalization levels. In this example, B will have higher NIM, because it has higher borrowing rate. I would rather prefer to invest in A, while NIM will point to B.

    • coorection: In this example, A (riskier lender) will have higher NIM, because it has higher borrowing rate. I would rather prefer to invest in B(less risky lender operating at the same spread), while NIM will point to A.

  4. Hi Jana,

    Do you know any good book for Financial Statement Analysis, reading balance sheets, accounting etc., especially for engineers??

    Thanks.

  5. Jana,

    Isn’t true that the average assets is always greater than liabilities for lending institutions as the shareholders equity is included in the assets side and the expense side the cost of funds doesn’t include the interest expense for the share holders equity

    Srinivas

    • Srinivas,

      In general it’s true. But depending on the capital adequacy ratio and the asset quality this mightn’t be true always. A good exercise would be find out lending companies with spread > NIM and understand why.

      Regards,
      Jana

  6. In US, we do not see spread very much. NIM is calculated using net interest income over average earning assets. It is broken down alternatively as interest income as a percentage of average earning assets less interest expense from average funding sources. In this manner, “spread” and NIM would come out the same, We do not use the gross asset or gross liability base. Only use those liabilities that are relevant to funding sources. NIM itself is not a GAAP figure so different banks will use different terms. It is interesting to learn about these alternative views. Thank you for the post.

  7. Hi Jana
    Is the information in ALM table is a projection of future cash flow or are these numbers historical?
    If this info is a projection then on what basis you or the company have made these projections about advances and other inflows and if these are the historical numbers then why are they important as things in future may not be same as that in past

    • Sahil,

      This is how the company is expecting the future to unfold and this should be based on past experience. You’re right there is no guarantee that the future is going to be similar.

      Regards,
      Jana

  8. Hi Jana, just read your article. Trying to understand the lending business. Could you tell me what is leverage for a lending business. Is it the loaned assets/ equity capital of lender or is it borrowings/equity capital. According to my understanding, it would the loan assets to equity capital for a lending business and debt or borrowings/equity for a non lending business, say manufacturing. Can you explain this concept. Would be highly appreciated. Thanks

  9. Hi Nishant,
    If I may take an opportunity to answer your question.
    So, you can use Assets / Equity as a leverage both in case of Financials as well as non-financials companies. As we see ROE as an important parameter in case of financials companies (which could be calculated as ROA * Leverage) and leverage in this case would be Assets / Equity.

    Now, in case of financials Loans / Equity is also used as leverage in some cases (or you can say as a proxy to leverage) – primary reason is that if you look at the Banks balance sheet – Large part c.60-70% of assets are in the form of loan assets and there is some chunk in the form of investments. These investments are largely in Government Securities which is to comply with RBI’s CRR / SLR guidelines (which are compulsory).

    So, from Banks point of view from capital allocation perspective they have flexibility to deploy capital largely in the form of loans. Whereas for other companies – capital could be allocated in the form of fixed assets or current assets. Also, when you compare two banks – Bank A which has higher amount of deposits and the other Bank B with lower Deposits. so, as per RBI – Bank A will have higher investment into government securities compared to Bank B. Therefore for comparison across banks – Loans / Equity forms a good measure to see leverage.

    Hope this helps.

Comments are closed.