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Leverage is an investment strategy of using borrowed money specifically, the use of various financial
instruments or borrowed capital to increase the potential return of an investment. Leverage can also
refer to the amount of debt a firm uses to finance assets.
5. Why are there three types of leverages and what are their uses?
(ii) Financial leverage -Financial leverage is primarily concerned with the financial activities which
involve raising of funds from the sources for which a firm has to bear fixed charges such as interest
expenses, loan fees etc. These sources include long-term debt (i.e., debentures, bonds etc.) and
preference share capital.
(iii) Combined leverage -Operating leverage shows the operating risk and is measured by the
percentage change in EBIT due to percentage change in sales. The financial leverage shows the
financial risk and is measured by the percentage change in EPS due to percentage change in EBIT.
Net interest margin measures the difference between interest income generated and interest
expenses. Unlike most other companies, the bulk of a bank’s income and expenses is created by
interest. Since the bank funds a majority of their operations through customer deposits, they pay out
a large total amount in interest expense. The majority of a bank’s revenue is derived from collecting
interest on loans.
The formula for net interest margin is:
I .Return on assets (ROA): Returns on asset ratio is the net income (profits) generated by the bank on
its total assets (including fixed assets). The higher the proportion of average earnings assets, the
better would be the resulting returns on total assets. Similarly, ROE (returns on equity) indicates
returns earned by the bank on its total net worth.
ROA = Net profits / Avg. total assets
CASA Ratio: -
Different kinds of deposits like current account, saving account and term deposits forms the major
source of funds for banks. CASA deposit is generally a cheap source of fund for banks if its high.
Higher CASA Ratio helps the bank in improving net interest margin as these deposits come with an
Interest payment which is negligible for Banks.
The Current account does not attract any Interest Burden but term deposits come with a higher
interest burden compared to Savings Account Deposit.
I. Efficiency Ratio
The efficiency ratio assesses the efficiency of a bank’s operation by dividing non-interest expenses by
revenue.
The efficiency ratio does not include interest expenses, as the latter is naturally occurring when the
deposits within a bank grow. However, non-interest expenses, such as marketing or operational
expenses, can be controlled by the bank. A lower efficiency ratio shows that there is less non-
interest expense per dollar of revenue.
ii. Operating Leverage
Operating leverage is another measure of efficiency. It compares the growth of revenue with the
growth of non-interest expenses.
A positive ratio shows that revenue is growing faster than expenses. On the other hand, if the
operating leverage ratio is negative, then the bank is accumulating expenses faster than revenue.
That would suggest inefficiencies in operations.
Non-performing asset (NPA) ratio: The net NPA to loans (advances) ratio is used as a measure of the
overall quality of the bank's loan book. An NPA are those assets for which interest is overdue for
more than 90 days (or 3 months).
Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end
from gross NPAs. Higher ratio reflects rising bad quality of loans.
As the name suggests, the liquidity coverage ratio measures the liquidity of a bank. Specifically, it
measures the ability of a bank to meet short-term (within 30 days) obligations without having to
access any outside cash.
Liquidity Coverage Ratio = High-Quality Liquid Asset Amount / Total Net Cash Flow Amount
The 30-day period was chosen as it is the estimated amount of time it takes for the government to
step in and help a bank during a financial crisis. Thus, if a bank is capable of fund cash outflows for 30
days, it will not fall.
2. Leverage Ratio
The leverage ratio measures the ability of a bank to cover its exposures with tier 1 capital. As tier 1
capital is the core capital of a bank, it is also very liquid. Tier 1 capital can be readily converted to
cash to cover exposures easily and ensure the solvency of the bank.
The real interest rate gives lenders and investors an idea of the real rate they receive after factoring
in inflation. This also gives them a better idea of the rate at which their purchasing power increases
or decreases. They can estimate their real rate of return by comparing the difference between
a Treasury bond yield and a Treasury Inflation-Protected Securities (TIPS) yield of the same maturity,
which estimates inflation expectations in the economy.
It reflects the rate of time-preference for current goods over future goods. the real interest rate is a
reflection of the change in purchasing power derived from an investment or given up by the
borrower.
9. What is the application of Basel Norms?
Basel norms or Basel accords are the international banking regulations issued by the Basel
Committee on Banking Supervision.
The Basel norms is an effort to coordinate banking regulations across the globe, with
the goal of strengthening the international banking system.
They lend the deposits of the public as well as money raised from the market i.e., equity
and debt.
This exposes the bank to a variety of risks of default and as a result they fall at times.
Therefore, Banks have to keep aside a certain percentage of capital as security against the
risk of non – recovery.
The Basel committee has produced norms called Basel Norms for Banking to tackle this
risk.
Repo rate- When, banks borrow money from RBI during a cash crunch on which they are required
to pay interest to the Central Bank. This interest rate is called the repo rate. During high levels of
inflation, RBI makes strong attempts to bring down the flow of money in the economy. One way to
do this is by increasing the repo rate. This makes borrowing a costly affair for businesses and
industries, which in turn slows down investment and money supply in the market.
On the other hand, when the RBI needs to pump funds into the system, it lowers the repo rate.
Consequently, businesses and industries find it cheaper to borrow money for different investment
purposes. It also increases the overall supply of money in the economy. This ultimately boosts the
growth rate of the economy.
CRR-Cash Reserve Ratio (CRR) is the share of a bank’s total deposit that is mandated by the
Reserve Bank of India (RBI) to be maintained with the latter in the form of liquid cash.
During high levels of inflation, attempts are made to reduce the flow of money in the economy. For
this, RBI increases the CRR, lowering the loanable funds available with the banks. This, in turn,
slows down investment and reduces the supply of money in the economy. As a result, the growth
of the economy is negatively impacted. However, this also helps bring down inflation.
On the other hand, when the RBI needs to pump funds into the system, it lowers CRR. which
increases the loanable funds with the banks. The banks thus extend a large number of loans to
businesses and industry for different investment purposes. It also increases the overall supply of
money in the economy.
Repo rate is a powerful arm of the Indian monetary policy that can regulate the country’s money
supply, inflation levels, and liquidity. Additionally, the levels of repo have a direct impact on the
cost of borrowing for banks. Higher the repo rate, higher will be the cost of borrowing for banks
and vice-versa.
Reverse Repo Rate-Reverse Repo Rate is when the RBI borrows money from banks when there is
excess liquidity in the market. The banks benefit out of it by receiving interest for their holdings with
the central bank.
During high levels of inflation in the economy, the RBI increases the reverse repo. It encourages the
banks to park more funds with the RBI to earn higher returns on excess funds. Banks are left with
lesser funds to extend loans and borrowings to consumers.
Monetary policy refers to central bank activities that are directed toward influencing the quantity
of money and credit in an economy.
A non performing asset (NPA) is a loan or advance for which the principal or interest payment
remained overdue for a period of 90 days.
Description: Banks are required to classify NPAs further into Substandard, Doubtful and Loss
assets.
1. Substandard assets: Assets which has remained NPA for a period less than or equal to 12
months.
2. Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard
category for a period of 12 months.
3. Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value that its
continuance as a bankable asset is not warranted, although there may be some salvage or recovery
value.”
Nonperforming assets are listed on the balance sheet of a bank. After a prolonged period of non-
payment, the lender will force the borrower to liquidate any assets that were pledged as part of
the debt agreement. If no assets were pledged, the lender might write-off the asset as a bad
debt and then sell it at a discount to a collection agency.
The non-payment of interest or principal reduces the lender's cash flow, which can
disrupt budgets and decrease earnings.
Loan loss provisions, which are set aside to cover potential losses, reduce the capital available to
provide subsequent loans to other borrowers.
Once the actual losses from defaulted loans are determined, they are written off against earnings.
Carrying a significant amount of NPAs on the balance sheet over a period of time is an indicator to
regulators that the financial health of the bank is at risk.
When companies struggle to service their debt, lenders may take proactive steps
to restructure loans to maintain cash flow and avoid classifying the loan as nonperforming
altogether. When loans in default are collateralized by the borrower's assets, lenders can take
possession of the collateral and sell it to cover losses.
Lenders can also convert bad loans into equity, which may appreciate to the point of full recovery
of principal lost in the defaulted loan. When bonds are converted to new equity shares, the value
of the original shares is usually eliminated.
Payment and settlement cycle-NBFC do not take part in payment and settlement cycle as they do
not take money from public.
Self-Drawn check- NBFC cannot issue cheques drawn on itself whereas banks can.
Demand Deposits-NBFC’s do not accept demand deposits from public, nor do they accept short
term securities. One can withdraw money from NBFC without prior notice. Banks, however can
take demand deposits and allow their withdrawal.
Credit card and cheque books-NBFC’s cannot issue credit cards or cheque books. Banks on the
other hand can issue credit card ad cheque books as they hold a banking license.
CRR and SLR-Banks are required to maintain reserves such as CRR and SLR since they deal with
public money. NBFC’s are not required to maintain any such reserves.
Deposit insurance facility-Deposit insurance is readily available to bank customers. The facility is
given by Deposited Insurance and credit Guarantee corporation (DICGC). There is no such
insurance available from NBFC’S.
16. Why do we need to calculate time value of money?
The time value of money is a basic financial concept that holds that money in the present is worth
more than the same sum of money to be received in the future. This is true because money that
we have right now can be invested and earn a return, thus creating a larger amount of money in
the future. (Also, with future money, there is the additional risk that the money may never actually
be received, for one reason or another.) The time value of money is sometimes referred to as
the net present value (NPV) of money.
he time value of money is also related to the concepts of inflation and purchasing power. Both
factors need to be taken into consideration along with whatever rate of return may be realized by
investing the money.
Why is this important? Because inflation constantly erodes the value, and therefore the purchasing
power, of money. It is best exemplified by the prices of commodities such as gas or food.
Where:
20. How to make decision when IRR and NPV differ in project rankings?
Since NPV is an absolute measure, it will rank a project adding more dollar value higher regardless
of the initial investment required. IRR is a relative measure, and it will rank projects offering best
investment return higher regardless of the total value added.
Whenever an NPV and IRR conflict arises, always accept the project with higher NPV. It is because
IRR inherently assumes that any cash flows can be reinvested at the internal rate of return. This
assumption is problematic because there is no guarantee that equally profitable opportunities will
be available as soon as cash flows occur. The risk of receiving cash flows and not having good
enough opportunities for reinvestment is called reinvestment risk. NPV, on the other hand, does
not suffer from such a problematic assumption because it assumes that reinvestment occurs at
the cost of capital, which is conservative and realistic.