What a Financial Institution Is and How Each Makes Money

A financial institution stands between people who have money and people who need it, and lives on the difference between the two claims. A bank takes deposits and lends. A finance company borrows in the market and lends. An insurer collects premiums against claims that may arrive later. An asset manager charges a fee on money it never holds. An exchange charges for matching.

Nine separate requirements appear below, and where a value would sit the row carries the address of whoever sets it instead. Because a minimum, a buffer or a weight moves, a typed value is wrong rather than merely old on the morning it changes. An address stays right for years. The value is read at the address in the row, on the day it is needed.

What is a financial institution, before any type is named?

The list of types is long and the shape is one sentence, so start with the shape. A financial institution takes in a claim on one side and gives out a claim on the other, and it lives on the difference between the two.

Everything else is detail about what the two claims are called. A deposit is a claim. A loan is a claim. A policy is a claim. A borrowing raised in the market is a claim. Once the two sides of any institution are seen as claims pointing in opposite directions, the whole set stops being six unrelated businesses that happen to share a shelf.

The first thing worth noticing is how little of what an institution works with belongs to it. Suvarna Commercial Bank Limited, an invented bank whose figures run through this whole reading, holds Rs 2,40,000 crore of assets against net worthWhat would be left for the shareholders if every rupee the business owes were paid off. Assets less liabilities, and nothing more mysterious than that. of Rs 24,000 crore. Divide the second into the first and 90.0 per cent of what the bank works with was handed to it by somebody else and has to go back.

Domestic scale is what makes borrowed money feel ordinary rather than alarming. Try it there for a moment. Somebody borrows Rs 9,00,000/- to hold Rs 10,00,000/- of stock in a shop. Nine rupees in every ten on those shelves is somebody else's money. Ask that person what they do and they will say they run a shop, not that they are a borrower. The shopkeeper is quite right, and so is a bank.

Look at where the money came from and the point sharpens. Deposits account for Rs 1,92,000 crore, or 80.0 per cent of assets, and net worth accounts for another 10.0 per cent. The remaining 10.0 per cent is neither of those two. Because the record never says what sits there, the gap is named and left empty. An honest empty space beats a plausible filling every time, because a reader cannot tell a good guess from a disclosure once it has been typed in.

Financial Market vs Financial Institution: where does the claim end up?

People swap these two words about freely, and they describe different kinds of object altogether. The separation is neither size nor formality. The separation is where the claim ends up sitting.

In a market, two parties end up holding claims on each other. Somebody with money and somebody who needs it are introduced, terms are agreed, and from then on the two of them are joined. If the borrowing side stops paying, nobody stands in between, and the trouble arrives at the lending side directly.

An institution ends up holding the claim itself. When a saver puts money into Suvarna Commercial Bank Limited, the saver receives a claim on Suvarna Commercial Bank Limited. The bank then makes a loan, and the claim on that borrower belongs to the bank. Two claims exist and neither one joins the saver to the borrower.

So the institution absorbs and the market transmits, and that single difference is what an institution is being paid for. A saver who wanted to carry a borrower's trouble directly could have lent directly. Standing in the middle is what the bank sells before it sells anything else.

What does each type take in, and what does it give out?

Six types cover almost everything a reader will meet, and each one answers the same two questions differently. Which claim comes in, and which claim goes out.

A bank takes deposits repayable on demand and gives out loans repayable later. A finance company takes no deposits at all and borrows in the market instead. Swapping deposits for market borrowing is the entire difference between Rukmini Finance Limited and Suvarna Commercial Bank Limited here. An insurer takes premiums now against claims that may arrive later. An asset manager never takes the money onto itself at all: it takes an instruction and gives back a managed holding and a report. An exchange with its clearing corporationThe body that steps between the two sides of a completed trade so that each of them faces it rather than each other, and that sees the trade through to settlement. takes two orders that want to meet and gives back a matched trade and a settlement. A payment system takes an instruction to move value and gives back value moved.

The insurer is the case where somebody else's money is somebody else's in the strongest sense of all six. Chandrika Life Insurance Limited, invented, carries policyholder fundsMoney an insurer holds that is set against what it will owe the people it has insured. The money sits on the insurer’s books and is not the insurer’s to spend. of Rs 72,000 crore, and its net worth beside them is Rs 7,200 crore. Ten rupees of the first for every rupee of the second. Treating that larger number as the insurer's own misses the entire liability standing behind it.

How does each type actually earn its money?

Each type has one earning line, and the whole economics of that type turns on it. Get the earning line right and the questions to ask write themselves.

How to Analyse a Bank’s Core Economics: what does it pay, and what does it charge?

A bank earns a difference between two rates, so the two questions are what it pays for money and what it charges for it. At Suvarna Commercial Bank Limited, Rs 18,600 crore came in as interest for the year and Rs 11,160 crore went out again, so Rs 7,440 crore stayed. Divide that by earning assetsOnly the assets that throw off interest, which here means the advances and the investments. A building or the cash in a till is an asset that pays nothing, so it stays outside this base. of Rs 2,04,000 crore and the margin is 3.65 per cent for the year. Divide it by total assets of Rs 2,40,000 crore and the same income reads 3.10 per cent. Same numerator, two bases, and that is why a margin without its base is not a figure at all.

The record gives no price for either side on its own, so both are written as ceilings rather than as rates. Set the whole Rs 11,160 crore interest bill against Rs 1,92,000 crore of deposits and the arithmetic gives 5.8125 per cent for the year. The interest bill covers every liability the bank pays interest on, and no split by source is stated anywhere, so treat 5.81 per cent for the year as a ceiling on what deposits cost rather than as their price. The same trick works on the other side. Rs 18,600 crore over advances of Rs 1,44,000 crore is 12.92 per cent a year, and advances would yield that much only if investments earned nothing at all. Across advances and investments together the ceiling is 9.12 per cent a year.

How to Analyse an NBFC or Digital Lender: what changes when there are no deposits?

The earning line is the same shape and the funding side is not. Rukmini Finance Limited runs assets under managementThe total a lender or a manager has working. The base differs at each. For a lender the base is the book it funds. For a manager the base is money belonging to other people. of Rs 18,000 crore at 14.50 per cent a year, which is Rs 2,610 crore, against borrowings of Rs 14,400 crore priced at 8.50 per cent for the year, an interest bill of Rs 1,224 crore. Rs 1,386 crore stays behind, or 7.70 per cent of assets under management.

Notice the trap sitting in the stated spread. The gap between 14.50 and 8.50 per cent a year is 6.00 percentage points, and the return on assets is 7.70 per cent rather than 6.00. Both are right. Borrowings fund only 80.0 per cent of the assets and the other 20.0 per cent carries no funding cost at all. The 6.00 is a gap between two rates and the 7.70 is a return on a base.

How to Analyse a Lending Product: what does one loan earn, and what can go wrong with it?

Drop one level below the institution and a single loan has the same two sides. A loan charges a rate, the money behind the loan cost something, and repayment can stop. Credit costsThe amount a lender charges against its own profit for loans that have gone wrong or look likely to. The credit cost line sits below the operating lines and above profit before tax. are the line where the last of those three shows up: Rs 396 crore at the finance company and Rs 1,800 crore of provisions at the bank. A product that prices well and breaks often is not a good product, and one line cannot tell which of the two it is.

How to Analyse an Insurance Company: how much of the premium goes back out?

An insurer earns the gap between premiums taken in and claims paid out, plus whatever the held funds earn while they are held. So the question is what proportion of premium leaves again. Chandrika Life Insurance Limited took Rs 15,600 crore of total premium and paid Rs 6,720 crore of claims. Take the second over the first and 43.1 per cent of total premium went back out.

How to Analyse an Asset Manager or Investment Platform: is the question revenue or margin?

An asset manager charges a fee on money that never sits on its books, so the revenue figure is easy and almost uninformative. Vaidehi Asset Managers Limited charges a blended 0.55 per cent a year on Rs 1,80,000 crore, and the fee comes to Rs 990 crore. Costs are Rs 594 crore, so Rs 396 crore is left, an operating margin of 40.0 per cent of its own revenue. The revenue moves with a market the manager does not control. The margin moves with decisions it does, and the margin is therefore the figure that says something about the business.

How to Analyse a Brokerage or Exchange: how small can a rate be and still be a business?

An exchange earns a very small rate on a very large number. Kaveri Stock Exchange Limited charges 0.00325 per cent on turnover of Rs 48,00,000 crore, and the fee comes to Rs 156 crore. Put that at human scale: Rs 3.25 on every Rs 1,00,000/- that changes hands. A payment system works the same way and its average transaction decides everything. Setu Payments Limited moved Rs 3,60,000 crore across 1,200 crore payments, an average of Rs 300.00/-, and a system whose average payment is three hundred rupees is running a different business from one whose average is three lakh.

Which measures work across every one of them?

Two measures point at any institution, whatever it takes in. Return on assets asks what each rupee of assets earned. Return on equity asks what each rupee of the shareholders' money earned. Leverage is the bridge between the two, and it is arithmetic rather than judgement. Set profit over assets beside assets over net worth and multiply: the assets on the top of the second term cancel the assets on the bottom of the first, and what survives is profit over net worth.

The second measure is the first measure multiplied by how much borrowed money was used, so quoting it on its own hides exactly one of the two things a reader needs. Insisting on both limbs is not a stylistic preference. A reader given only the product cannot tell whether the money came from the assets or from the borrowing behind them.

How to Analyse Financial-Institution Performance: why must both limbs be printed together?

Here is the demonstration. Both Suvarna Commercial Bank Limited and Rukmini Finance Limited land on 9.38 per cent for the year. The bank reaches it on 0.9375 per cent of assets while carrying 10.0 rupees of assets for every rupee of net worth. The finance company reaches it on 1.875 per cent of assets while carrying 5.0. Double the earning on each rupee of assets at one, double the borrowed money at the other, and the two products land on one figure.

The equality was arranged on purpose, and saying so outright matters. A repeated figure nobody accounts for looks like a slip of the keyboard, and a reader who writes it off as one takes nothing away at all. The lesson is simple and uncomfortable. A ranking built on the equity return alone puts these two lenders on a single line, and no part of what they do is alike.

Now the part that trips people, and it is worth saying out loud rather than leaving in a footnote. Multiply the reported figures and the answer does not tie. 0.94 multiplied by 10.0 is 9.40. 1.88 multiplied by 5.0 is 9.40. Neither of those is 9.38.

Nothing is broken: the rounding happens after the multiplication rather than before it. Unrounded, the two returns on assets are 0.9375 and 1.875 per cent. Take the first up ten times or the second up five times and each route arrives at 9.375 per cent. Rounding 9.375 prints 9.38. Rounding a limb first and then multiplying it by ten magnifies the rounding by ten as well. The exact limb therefore stands beside the reported one wherever this decomposition appears.

One more test settles whether the equality is structural or a coincidence of two roundings. Put both sets of books in one pile. Nobody would ever actually do that with two unrelated lenders. Combined profit after tax is Rs 2,587.50 crore, combined net worth is Rs 27,600 crore, and the pile earns exactly 9.375 per cent on equity. A weighted average of two identical numbers is that number whatever the weights are, so the equality survives every possible blending.

The blend carries the rounding trap a third time. Full precision is what makes the trap visible. Combined profit over combined assets of Rs 2,58,000 crore is 1.0029 per cent, printed as 1.00. Combined assets over combined net worth is 9.3478 times, printed as 9.35. The printed pair multiplied gives 9.35, not 9.38. Even the four place pair multiplied gives 9.3749, not 9.3750. Only the exact fractions tie. A two place figure cannot be trusted far once anything is multiplied by it.

Capital Adequacy: capital measured against what, and who sets the number?

Capital adequacy asks whether an institution holds enough of its own money to absorb losses without the people who funded it losing anything. Capital adequacy is a ratio, and the whole difficulty is in the denominator.

The denominator is not total assets but risk weighted assets, a restatement of each asset by how likely its class is to go wrong. A book of one kind and a book of another can carry the same total and produce very different risk weighted assets, which is exactly why the weighting exists. The weight schedule, the minimum ratio, every buffer above it and what counts as capital in the first place are all set by the Reserve Bank of India at rbi.org.in, and they move.

One figure is available here, and one label does not belong on it. The bank's Rs 24,000 crore of net worth divided into its Rs 2,40,000 crore of assets gives 10.00 per cent; the same at the finance company, Rs 3,600 crore against Rs 18,000 crore, gives 20.00 per cent. Neither of those is a capital adequacy ratio. No risk weighted asset figure is stated for either institution. Because risk weighted assets can sit below or above total assets depending on a schedule the regulator sets, the true ratio is neither a ceiling on these numbers nor a floor under them, and it cannot be worked out from a total asset figure at all.

How to Analyse Bank Liquidity: can it pay when it is asked?

Liquidity asks a different question from solvency, and the two get confused constantly. Solvency asks whether the assets exceed what is owed. Liquidity asks whether the institution can hand over money at the moment somebody asks for it. An institution can be entirely solvent and unable to pay on a Tuesday.

A bank owes deposits repayable on demand and holds loans repayable later. The mismatch is the design rather than a mistake in it. Suvarna Commercial Bank Limited holds advances of Rs 1,44,000 crore against deposits of Rs 1,92,000 crore, which divides out to 75.0 per cent, and Rs 60,000 crore of investments sits beside them. The investments are a large part of what the answer to the Tuesday question turns on.

The Reserve Bank of India at rbi.org.in sets what a bank must hold in liquid assets, against what, over what period, and what balances it must keep with the central bank. Every one of those requirements moves. The row on the card above carries the address at which the value is read.

Institution Research vs Security Research: which question is actually being asked?

Institution Research asks how the business works and whether it holds together. Security Research asks what a share of the business is worth and what its price implies. The two use overlapping figures to answer questions that do not overlap at all, and mixing them is how a reader ends up with a number that answers neither.

The same institution crosses the line here. Rs 2,250 crore of profit and Rs 24,000 crore of net worth describe how the bank works. The profit divided by 300.00 crore shares is Rs 7.50/- a share; with the net worth divided by the same count, book value a shareNet worth divided by the number of shares. Book value a share says what one share carries of the shareholders' claim, and says nothing about what anybody would pay for it. is Rs 80.00/-. At a price of Rs 105.00/- those become 14.00 times earnings and 1.31 times book.

The last two figures are about a price, and what any price should be is a different question from how the business works. How a security is valued and how a view is reached are set out under security research.

Institution Metric vs Non-Financial Metric: what can be divided, and what can only be counted?

An Institution Metric is denominated in money. Return on assets, the margin, the cost of running the place: each one is money over money. Money over money can be divided, compared and set against another institution that does nothing the same way.

A Non-Financial Metric is a count. Branches, customers, transactions, applications approved, complaints received. A branch divided by a complaint gives nothing, and a count from one institution is rarely the same object as a count from another.

The money measures say what happened, and the counted measures often say what is about to. Setu Payments Limited's 1,200 crore payments is a count. The Rs 300.00/- average that falls out of dividing value by count is a money measure. The count says how many people are in the habit; the average says what kind of habit it is, and the two answer different questions about the same year.

A Disclosed Fact, a Derived Metric and a conclusion: how far is each from what was published?

Three things get treated as though they were one, and they sit at increasing distances from anything anybody actually published.

A Disclosed Fact is a figure the institution published. Rs 2,250 crore of profit after tax at Suvarna Commercial Bank Limited is one of those. Nobody worked it out; it was stated. A Derived Metric is a figure a reader produced by dividing one disclosed figure by another and choosing the denominator. 0.9375 per cent of assets is one of those, and the choice of denominator is the reader's own. A conclusion is neither. Whether 0.9375 per cent is good is a judgement, and dividing one disclosed figure by another never produces a judgement.

The distance matters because confidence usually runs the wrong way along it. The further a statement sits from what was published, the more assumptions are standing behind it, and the more firmly people tend to say it. The full three level treatment is covered separately; what matters here is telling them apart on sight.

How to Research a Financial Institution: in what order is it worked?

There is an order, and it matters more than any single measure in it. A reader who starts at return on equity has started at a product of two things and will spend the rest of the reading working backwards to find out what they were.

The shape comes first: what arrives on one side, and what leaves on the other. Then what it earns on each rupee of assets, then how many rupees of assets it runs per rupee of its own money, then what it costs to run on a base that has been named out loud, then what has gone wrong in its assets both gross and net, then what it must hold against loss and against being asked for money back. Only after all of that comes a check on whether the figures agree with each other.

How to Write a Financial-Institution Case Study: what goes into it, and in what order?

A write up follows the same order as the reading, for the same reason. Open with the shape, so the reader knows what kind of object this is before any number arrives. Then the earning line, worked in the open with every division shown. Then the two limbs together, never one alone. Then the cost of running it, on a named base. Then what has gone wrong, gross and net, with the denominator named at each step because it moves between them.

Then name every gap in the record out loud, rather than working around it quietly. Here that means three things said out loud: the composition of 10.0 per cent of the bank's funding, the split of interest expended by source, and any risk weighted asset figure at all. Each of those becomes a bound rather than a blank. The cost of deposits is a ceiling of 5.81 per cent a year. The yield on advances is a ceiling of 12.92 per cent a year. The capital adequacy ratio is unknowable. A write up that names its bounds is more useful than one that fills them in.

What happens when that order is run on two lenders at once?

The same answer arrives twice, and that is the entire point. Take the whole reading order down both institutions.

Read the ladder as a sentence. Of the Rs 18,600 crore that came in as interest, Rs 11,160 crore went straight back out as interest. Net interest income is the Rs 7,440 crore left. Other income of Rs 2,400 crore lifts total income to Rs 9,840 crore. Running the place cost Rs 5,040 crore, leaving operating profit of Rs 4,800 crore. Provisions took Rs 1,800 crore, leaving Rs 3,000 crore before tax. Tax for the year at 25.0 per cent came to Rs 750 crore, and Rs 2,250 crore is what was left. Set Rs 2,250 crore against assets of Rs 2,40,000 crore and the answer is 0.9375 per cent, reported as 0.94. Assets against net worth come to 10.0 times. Both limbs, in the same place, as they will be everywhere.

Same sentence, shorter. Rs 2,610 crore earned less Rs 1,224 crore paid leaves Rs 1,386 crore. Running the place took Rs 540 crore and credit costs took Rs 396 crore, so Rs 450 crore stood before tax. Tax for the year at 25.0 per cent was Rs 112.50 crore, and Rs 337.50 crore is what was left. Over assets under management of Rs 18,000 crore that is 1.875 per cent, reported as 1.88, and assets over net worth is 5.0 times. Both limbs again, and the product is 9.375 per cent for the second time.

The everyday mirror is exact rather than loose. Two people each turn Rs 1,00,000/- of their own money into Rs 9,375/- in a year. The first runs Rs 10,00,000/- of shop stock of which Rs 9,00,000/- is borrowed, and earns 0.9375 per cent on the stock. The second runs Rs 5,00,000/- of which Rs 4,00,000/- is borrowed, and earns 1.875 per cent on it. Same answer, and nobody would call those the same shop.

Which of the two ways of doing business is better does not follow from any of this. Running more borrowed money is not the same thing as being careless with it, and charging a wider gap between two rates is not the same thing as being good at the job. Each set of books shows one year, and this record holds no downturn, no second year and no failure anywhere in it. Neither institution, therefore, is evidence for or against the way it runs itself. The arithmetic is stated, and the questions the arithmetic cannot reach are named.

How does anyone actually use this?