JAIIB RBWM Paper-4 Module-A Unit 4: Branch Profitability

11/02/2023

JAIIB Paper 4 (RBWM) Module A Unit 4: Branch Profitability (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 4 (Retail Banking and Wealth Management) includes an important topic called “Branch Profitability”. Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 4 (RBWM) Module 1 Retail banking Unit 4: Branch Profitability Aspirants must go through this article to better understand the topic, Branch Profitability and practice using our Online Mock Test Series to strengthen their knowledge of Banker Customer Relationship. Unit 4: Branch Profitability

Banking System: An Introduction

What Is Banking?

Banking is classically defined in the Banking Regulations Act, 1949 (BR Act). As per Section 5(1) (b) of the BR Act, banking is ‘the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise.’
Section 5(l)(c), further defines a banking company as any company which transacts the business of banking in India. Section 6 of the BR Act defines, in detail, the types of activities that banks are authorised to carry out, although under modern day banking, banks have embraced many other types of activities, too. The traditional types of businesses that banks
Another important aspect on banking in India is that, in terms of Section 7 (1) of the BR Act, ‘No company other than a banking company shall use as part of its name any of the words “bank”, “banker” or “banking” and no company shall carry on the business of banking in India, unless it uses as part of its name at least one of such words.’
Further, Section 7(2) states ‘No firm, individual or group of individuals shall, for the purpose of carrying on any business, use as part of its or his name any of the words “bank”, “banking” or “banking company”.’

History Of Banking In India

The banking sector development can be divided into three phases:

Phase I: The Early Phase which lasted from 1770 to 1969
Phase II: The Nationalisation Phase which lasted from 1969 to 1991
Phase III: The Liberalisation or the Banking Sector Reforms Phase which began in 1991 and continues to flourish till date

Pre Independence Period (1786-1947)

The first bank of India was the “Bank of Hindustan”, established in 1770 and located in the then Indian capital, Calcutta. However, this bank failed to work and ceased operations in 1832.

During the Pre Independence period over 600 banks had been registered in the country, but only a few managed to survive.

Following the path of Bank of Hindustan, various other banks were established in India. They were:

The General Bank of India (1786-1791)
Oudh Commercial Bank (1881-1958)
Bank of Bengal (1809)
Bank of Bombay (1840)
Bank of Madras (1843)

During the British rule in India, The East India Company had established three banks: Bank of Bengal, Bank of Bombay and Bank of Madras and called them the Presidential Banks. These three banks were later merged into one single bank in 1921, which was called the “Imperial Bank of India.”

The Imperial Bank of India was later nationalised in 1955 and was named The State Bank of India, which is currently the largest Public sector Bank.

Pre-Indepence Banks in India
Bank Name	Year of Establishment
Allahabad Bank	1865
Punjab National Bank	1894
Bank of India	1906
Central Bank of India	1911
Canara Bank	1906
Bank of Baroda	1908

Post Independence Period (1947-1991)

At the time when India got independence, all the major banks of the country were led privately which was a cause of concern as the people belonging to rural areas were still dependent on money lenders for financial assistance.
With an aim to solve this problem, the then Government decided to nationalise the Banks. These banks were nationalised under the Banking Regulation Act, 1949. Whereas, the Reserve Bank of India was nationalised in 1949.

Candidates can check the list of Banking sector reforms and Acts at the linked article.

Following it was the formation of State Bank of India in 1955 and the other 14 banks were nationalised between the time duration of 1969 to 1991. These were the banks whose national deposits were more than 50 crores.

Given below is the list of these 14 Banks nationalised in 1969:

1.Allahabad Bank

2.Bank of India

3.Bank of Baroda

4.Bank of Maharashtra

5.Central Bank of India

6.Canara Bank

7.Dena Bank

8.Indian Overseas Bank

9.Indian Bank

10.Punjab National Bank

11.Syndicate Bank

12.Union Bank of India

13.United Bank

14.UCO Bank

In the year 1980, another 6 banks were nationalised, taking the number to 20 banks. These banks included:

Andhra Bank
Corporation Bank
New Bank of India
Oriental Bank of Comm.
Punjab & Sind Bank
Vijaya Bank

Apart from the above mentioned 20 banks, there were seven subsidiaries of SBI which were nationalised in 1959:

State Bank of Patiala
State Bank of Hyderabad
State Bank of Bikaner & Jaipur
State Bank of Mysore
State Bank of Travancore
State Bank of Saurashtra
State Bank of Indore

All these banks were later merged with the State Bank of India in 2017, except for the State Bank of Saurashtra, which merged in 2008 and State Bank of Indore, which merged in 2010.

Note: The Regional Rural Banks in India were established in the year 1975 for the development of rural areas in India.

Liberalisation Period (1991-Till Date)

Once the banks were established in the country, regular monitoring and regulations need to be followed to continue the profits provided by the banking sector. The last phase or the ongoing phase of the banking sector development plays a hugely significant role.

To provide stability and profitability to the Nationalised Public sector Banks, the Government decided to set up a committee under the leadership of Shri. M Narasimham to manage the various reforms in the Indian banking industry.

The biggest development was the introduction of Private sector banks in India. RBI gave license to 10 Private sector banks to establish themselves in the country. These banks included:

Global Trust Bank
ICICI Bank
HDFC Bank
Axis Bank
Bank of Punjab
IndusInd Bank
Centurion Bank
IDBI Bank
Times Bank
Development Credit Bank

What Is Profitability

Before moving to Branch Profitability, let us first have a broad view of profit and profitability. Profitability is a measure of an organization’s profit relative to its expenses.
Organizations that are more efficient will realize more profit as a percentage of its expenses than a less-efficient organization, which must spend more to generate the same profit. In other words, Profitability is a measurement of efficiency – and ultimately its success or failure.

What Is Profit?

Profit is the money a business pullsing after accounting for all expenses. Whether it’s a lemonade stand or a publicly-traded multinational company, the primary goal of any business is to earn money, therefore a business performance is based on profitability, in its various forms.
Some analysts are interested in top-line profitability (Gross Sales), whereas others are interested in profitability before taxes and other expenses. Still others are only concerned with profitability after all expenses have been paid (bottom-line profitability).

Three major types of profit

Gross profit
Operating profit, and
Net profit

Gross Profit

The first level of profitability is gross profit, which is sales minus the cost of goods sold. Sales are the first line item on the income statement, and the cost of goods sold (COGS) is generally listed just below it. For example, if Company A has ₹1,00,00,000/- in sales and a COGS of ₹60,00,000/- it means the gross profit is ₹40,00,000/-, (i.e. ₹1,00,00,000 minus ₹60,00,000/-). Divide gross profit by sales for the gross profit margin, which is 40% (i.e. ₹40,00,000/- divided by ₹1,00,00,000/- multiplied by 100).

Gross Profit = Total Sales − Cost of Goods Sold

Operating Profit

The second level of profitability is Operating Profit, which is calculated by deducting operating expenses from gross profit. Gross profit looks at profitability after direct expenses, and operating profit looks at profitability after operating expenses. These are things like selling, general, and administrative costs (SG&A). Company A (stated above) has ₹20,00,000/- in operating expenses, and hence, the Operating Profit is ₹40,00,000/- minus ₹20,00,000/-, which is equal to ₹20,00,000/-. Divide operating profit by sales for the operating profit margin, which is 20%.

Operating Profit = Gross Profit − Operating Expenses
Operating Profit Margin = Operating Profit/ Total Sales

Net Profit

The third level of profitably is net profit, which is the income left over after all expenses, including taxes and interest, have been paid. If interest is ₹5,00,000/- and taxes are another ₹5,00,000/-, net profit is calculated by deducting both of these from operating profit. In the example of above Company, the answer is ₹20,00,000/- minus ₹10,00,000/-, which equals ₹10,00,000/-. Divide net profit by sales for the net profit margin, which is 10%.

Net Profit = Operating Profit − Taxes & Interest

Profit And Profitability In The Context Of Banking

Like other businesses, banks profit by earning more money than what they pay in expenses. The major portion of a bank’s profit comes from the interest that it earns on its assets mainly and fees it charges for its services. Its major expense is the interest paid on its liabilities.
The major assets of a bank are its loans and advances to individuals, businesses, and other organizations and the securities that it holds, while its major liabilities are its deposits and the money that it borrows, either from its customers or other banks or by selling commercial paper in the money market.
Banks increase profits by using leverage or gearing, which is the extent to which the banks fund its assets with borrowings rather than equity. Profits can be measured as a return on assets and as a return on equity. Because of leverage, banks earn a much larger return on equity than they do on assets.

Traditional Measures Of Profitability

The traditional measures of the profitability of a business are primarily its Return on Assets (ROA) and Return on Equity (ROE). Assets are used by businesses to generate income. Loans and securities are bank’s assets and are used to provide most of a bank’s income.
However, to make loans and to buy securities, a bank must have money, which comes primarily from the bank’s owners in the form of bank capital, from depositors, and from money that it borrows from other banks or by selling debt securities — a bank buys assets primarily with funds obtained from its liabilities as can be seen from the following classic accounting equation:

Assets = Liabilities + Bank Capital (Owners’ Equity)

Return on Asset (ROA)

Return on Asset is determined by the amount of income that it earns on its Net Interest income and fees on its services.

Net interest income depends partly on the Interest Rate Spread, which isthe Average Interest Rate earned on it assets minus the Average Interest Rate paid on its liabilities.

Net Interest Margin shows how well the bank is earning income on its assets. High net interest income and margin indicates a well- managed bank and also indicates future profitability.

Net Interest Margin = Net Interest Income / Average Total Assets

Return on Asset for Banks:

(Note: Herein we will refer to Average Total Assets as simply Bank Assets.)

Return On Equity (ROE) For Banks

The return on equity is what the bank’s owners are primarily interested in because that is the return that they earn on their investment, and depends not only on the return of assets, but also on the total value of the assets that earn income. However, to purchase more assets, a bank needs to pay for it either with more liabilities or with bank capital. Therefore, if the owners want to earn a greater return, they would rather use liabilities rather than their own capital because this greatly increases their return.

When a bank increases its liabilities to pay for assets, it is using leverage, otherwise a bank’s profit would be limited by the fees that it can charge and its interest rate spread. But the interest rate spread is limited by what a bank must pay on its liabilities and what it can charge on its assets. Since banks compete with each other for depositors and deposits compete with other investments, banks must pay competitive market rate to attract depositors. Likewise, banks can only charge so much for loans since there is competition from other banks and businesses can get loans by selling debt securities, either commercial paper or bonds, in the financial markets. Hence, interest rate spreads are not wide, so a bank can only earn more net interest income by increasing the number of loans that it makes compared with the amount of its bank capital, which it does by using leverage:

The leverage that banks use is similar to a business using debt to increase its earnings. After all, deposits are just money that the bank owes to its depositors. Hence, the leverage ratio is the same as the debt ratio used to determine the leverage of other business types. The return on equity can be increased by increasing leverage, but banks can only increase leverage by so much, because with increased leverage comes increased risk. For instance, let us consider the following hypothetical bank:

Bank Assets = ₹ 100
Bank Liabilities = ₹ 95
Bank Capital = ₹ 5

This is a leverage ratio of 20 to 1 (₹100/₹5). If the value of its assets drops just 5%, then the bank’s capital will be wiped out. To protect the safety of the banking system, the regulator (i.e. RBI in India) restricts the amount of leverage that banks can have. In USA to protect the safety of the banking system, the Federal Reserve restricts the amount of leverage that banks that are depository institutions can use. Typically, the leverage ratio is about 10 to 12. In other words, a bank’s assets may have at least 10 times the value of its capital, but not much more.

Branch Operating Efficiency

With the challenges banks are facing these days, it’s becoming clear that banks must get the best “bang for the buck” from all resource expenditures. Continued inefficiency at a bank might be robbing important efforts of the resources banks need to be fully successful. But a focus on cutting costs alone is not a formula for long-term success. A balanced approach – one that enables a bank not only to improve operating efficiency but also to upgrade its capabilities to respond to market needs and prepare for the future – is imperative to the success of a bank’s operations and profitability.

Why Efficiency matters for Bank Operations

As with any business, banks must be vigilant about spending wisely. Today, however, the banking industry faces a new combination of circumstances that are giving special impetus to the need for efficiency. Changes in customer preferences and expectations, new competition, and new technologies are transforming the nature of banking.
The business of banking is morphing toward a digital- and technology-based model while retaining important aspects of the traditional person-to-person business model. To remain competitive, banks need to invest in technology, marketing, automation, and self-service capabilities, and also must optimize their legacy investments in branches and traditional systems.

Setting operating targets for improvement

Banks today are focusing how, and by how much, efficiency and costs can be improved. Every institution is unique, of course, so the size of the improvement opportunity will vary greatly from one bank to another and also from one branch to another. Industry experience suggests that a concentrated and carefully executed efficiency initiative should be able to achieve significant savings.
The outcomes are not always realized through direct cost reductions. Ideally, improved efficiency means processes that are scalable and that support a faster pace of growth for the bank’s revenue stream and asset base than for its overhead costs.

Strategies For Improving Efficiencies Of Banking Operations

Business realignment
Channel optimization
Process costs
Staff productivity
Technology and automation
Vendor Management
Product Bundling and Relationship Pricing
Cross-lob data sharing and building a 360-degree Customer View
Sophisticated customer segmentation
Real time cross –selling/up –selling
Innovative Reward Design
Automating Customer Care
Digital Revolution
Big Data
Multi-Channel Seamless Experience
Innovative Bank Branch Design
Instilling a culture that values efficiency

Factors Affecting Profitability of Banks In India

The results indicate that profitability of banks in India is affected by both internal and external factors. Strength of equity capital, operational efficiency, ratio of banking sector deposits to the gross domestic product (GDP, cost of funds, non-performing assets(NPA) are few of the external factors which affect bank profitability whereas inflation, government policies, competition, etc. are few external factors affecting the profitability. Broadly the profitability of banks is affected by three major factors as follows:

Macro-economic factors-The profitability of banks respond positively to GDP growth and negatively, to inflation growth rate. Inflation has a strong effect on profitability of banks and banks’ profits are not significantly affected by the real GDP fluctuations. Low interest rates along with stiff competition among banks put pressure on interest margins of banks and hence negatively affect bank profitability.
Industry Specific Factors-NPAs have the most adverse impact on the profitability of banks. They reduce the profitability due to increase in operating costs and decline in their interest margins.
Other Bank Specific Factors-There exists a positive relationship between deposits and profitability as more deposits a bank collects, higher will be the availability of funds for generating loans and for other profitable uses such as investments. Non-interest income of the bank consisting of commission income, service charges, and fees, guarantee fees, net profit from sale of investment securities, and foreign exchange profit is another factor in determining the bank’s profitability.

Steps To Improve Branch Profitability

Focus on balancing profit, growth and risk
Assess the strategic fit and unique role for each branch in the network
Analyse the current customer base for each branch
Identify your best new prospect (potential customers) opportunities
Analyse the competition
Set specific goals by branch for business and consumer markets
Execute effective marketing campaigns to drive customer origination, retention and expansion
Redefine the bank model of the future

Besides the strategic steps stated above, the branches should also ensure to focus on the following steps too to improve profitability.

Relentless focus on NPA reduction
More quality loans
Focus on non-interest income
Low cost deposit
Holding Minimum Cash Balance
Cost Management
Good Customer Relationship
Courteous behaviour by Branch Head

Essential Factors To Make Continuous Improvement In Profitability

Locating areas in your business that could be improved or made more efficient, e.g. general business processes or administration
Using key performance indicators (KPIs) to analyse your strengths and weaknesses, e.g. rising costs or falling sales
Assessing your general business costs, e.g. overheads, how discounted deals with loyal customers affect your profits, how productive your staff are
Reviewing your areas of business waste and reduce them, e.g. power supply costs
Regularly reviewing the pricing of your products
Testing the prices of any products you review before making the changes permanent
Improving your profitability through your best customers – use up-selling, cross selling and diversifying techniques to improve your profit margins
Identifying areas of expenditure and limit these by bargaining with your suppliers
Long-term deals with suppliers to negotiate a better price on products
Researching new opportunities in your business sector and identifying where you could expand the market
Put monitoring systems and processes in place, e.g. benchmarking.