Examples of Ratios in Banking: Analyze real-world cases where financial ratios

played a crucial role in lending decisions, internal ratings, and loan pricing within
the banking industry.

Module-2
Advance Management Program

Name: Subhash M
Roll No: 1334
Date of Submission: 23-11-2024
Introduction

In the banking sector, financial ratios are essential tools for assessing the
creditworthiness of potential borrowers, managing risks, and determining loan pricing.
These ratios, which measure various aspects of financial health, provide a clear picture
of the risk involved in lending money. Banks across the globe, including those in
India, use these ratios to guide their decision-making in areas such as lending, internal
ratings, and loan pricing.

Lending decisions in the banking industry are heavily reliant on financial ratios to
ensure that loans are only given to those borrowers who are most likely to repay their
debts. By examining ratios such as Debt-to-Income (DTI), Interest Coverage Ratio
(ICR), Loan-to-Value (LTV), and Debt-to-Equity (D/E), banks can evaluate the ability
of individuals and businesses to meet their financial obligations.

This project aims to analyse real-world cases where these financial ratios have played
a crucial role in lending decisions, internal credit ratings, and loan pricing within the
banking industry. Through various case studies, we will explore how banks use these
ratios to minimize risk, set interest rates, and ensure the stability of their financial
systems.

Role of Ratios in Lending Decisions

Lending decisions are vital for banks as they directly impact the financial stability of
these institutions. Financial ratios allow banks to assess the risk involved in lending to
a borrower, helping to determine the likelihood of loan repayment. Ratios are used as
tools to evaluate the borrower’s financial health, stability, and ability to repay debt.

Debt-to-Income (DTI) Ratio: The Debt-to-Income (DTI) ratio is one of the primary
metrics used in assessing a borrower’s capacity to take on additional debt. It compares
a borrower’s monthly debt obligations to their gross monthly income. A high DTI
ratio suggests that the borrower may already be overburdened with debt, making them
a higher-risk candidate for further borrowing.

 HDFC Bank (2021): HDFC Bank uses DTI to assess salaried individuals
applying for home loans. The bank typically sets a threshold of 40% for
salaried borrowers and 45% for self-employed individuals. If the DTI ratio
exceeds these thresholds, loan applications may be rejected or priced higher to
reflect the increased risk.

 State Bank of India (SBI): SBI’s internal lending guidelines state that
borrowers with a DTI above 50% are considered high-risk and are subjected to
higher interest rates or loan rejection, particularly for personal loans.
DTI Thresholds Across Indian Banks

The following table displays the DTI thresholds set by various Indian banks for
different types of borrowers.

Bank Salaried DTI Threshold (%) Self-Employed DTI Threshold (%)

HDFC Bank 40 45
SBI 40 50
ICICI Bank 35 50

Interest Coverage Ratio (ICR): The Interest Coverage Ratio (ICR) is used to
determine the ability of a company or individual to meet their interest payments with
their earnings. It is calculated as:

ICR= Interest Expense EBIT (Earnings Before Interest and Taxes) ÷ Interest Expense

A higher ICR suggests that a borrower has ample earnings to cover interest expenses,
reducing the risk to the lender.

 ICICI Bank (2022): In its evaluation of companies in sectors such as aviation

and hospitality, ICICI Bank requires a minimum ICR of 2.0 to consider them as
low-risk borrowers. If the ICR falls below this threshold, the bank may charge
a higher interest rate or even decline the loan.

 HDFC Bank (2020): HDFC uses an ICR of 2.5 as a benchmark for lending to
the manufacturing sector, ensuring that companies can meet their interest
obligations before borrowing additional funds.

The chart below table the average ICR in different sectors, helping to highlight
industry-specific risk profiles.

Bank Average ICR

Pharmaceuticals 4.0
Hospitality 1.8
Manufacturing 2.5

Ratios in Internal Credit Ratings

Banks also use financial ratios as part of their internal credit rating systems. These
ratings are crucial in determining the terms of a loan, including the interest rate,
repayment schedule, and loan amount. Ratios such as Debt-to-Equity (D/E) and
Return on Assets (ROA) are used to assess a company’s financial stability and its
ability to repay debts.
Debt-to-Equity (D/E) Ratio: The Debt-to-Equity (D/E) ratio is a measure of a
company’s leverage. A high D/E ratio indicates that a company is highly reliant on
debt to finance its operations, which can increase the risk for the lender.

 Axis Bank: In 2020, Axis Bank observed that companies in the infrastructure
sector often had D/E ratios as high as 3.0, signifying higher leverage and risk.
These companies were typically assigned a lower internal credit rating due to
their high reliance on debt financing.

 SBI: For FMCG companies, which tend to have lower D/E ratios (around 1.2),
SBI assigned higher credit ratings, leading to lower loan interest rates.

The table below illustrates how D/E ratios vary across different sectors in India.

Sector D/E Ratio

Infrastructure 3.5
FMCG 1.2
Technology 1.0

Loan-to-Value (LTV) Ratio: The Loan-to-Value (LTV) ratio is a financial term used
to express the ratio of a loan to the value of an asset purchased. In real estate, for
example, the LTV ratio helps the bank assess how much of the property’s value is
being financed through the loan.

 Kotak Mahindra Bank (2021): Kotak Mahindra Bank set an LTV ratio of 70%
for home loans, offering loans up to 70% of the property’s value. Borrowers
with an LTV above this threshold are considered higher risk and face higher
interest rates.

 SBI (2022): SBI adjusted its LTV ratios for personal loans, offering an LTV
ratio of 75% for salaried borrowers and 80% for self-employed borrowers.
However, borrowers with an LTV above 80% are typically subject to higher
interest rates.

LTV vs. Interest Rate

The table below demonstrates the relationship between the LTV ratio and the interest
rate offered by banks.

LTV Ratio (%) Interest Rate (%)

< 70 6.5
70-80 7.0
> 80 7.5
Ratios in Loan Pricing

One of the primary uses of financial ratios in banking is in loan pricing. Banks adjust
the interest rates they offer based on the perceived risk associated with the borrower.
A borrower with higher financial ratios indicating strong repayment capacity (e.g.,
low DTI, high ICR) will be offered loans at lower interest rates, while higher-risk
borrowers will face higher rates.

Impact of Ratios on Loan Pricing: Banks assess the borrower’s overall risk by
examining various financial ratios. If the borrower’s ratios indicate higher financial
health and lower risk, they are more likely to receive a loan at competitive interest
rates. On the other hand, borrowers with poor ratios, such as high D/E or low ICR, are
seen as risky, leading to higher loan pricing.

Case Study: Real Estate Loans

HDFC Bank (2021): When HDFC Bank offered home loans, they took into account
the borrower’s LTV ratio, credit score, and DTI. If the borrower had an LTV ratio
above 80%, the interest rate offered was 8.0%, compared to 6.5% for those with an
LTV ratio below 70%. The use of these ratios ensured that the bank could offer
competitive rates while mitigating risk.

Interest Rate Adjustments Based on Financial Ratios: The table below illustrates
how interest rates vary based on LTV and DTI ratios.

LTV Ratio (%) DTI Ratio (%) Interest Rate (%)

<70 < 40 6.5
70-80 40-50 7.0
>80 > 50 8.0

Integrated Use of Ratios in Credit Monitoring

Banks continuously monitor the financial health of borrowers, especially for long-
term loans, to ensure that the borrower’s situation has not deteriorated. Regular checks
of key ratios allow banks to take corrective actions, such as modifying the loan terms,
restructuring the loan, or initiating default recovery procedures.

Case Study: Pandemic Response

ICICI Bank (2020): During the COVID-19 pandemic, ICICI Bank increased its
scrutiny of the Interest Coverage Ratio for borrowers in the hospitality and aviation
sectors. Borrowers with an ICR below 1.5 faced higher loan provisions and were
offered temporary loan restructuring.
Regulatory Context

 RBI Guidelines: Emphasis on Capital Adequacy Ratios (CAR): Indian banks

are required to maintain a minimum CAR of 9%, ensuring they have adequate
capital to absorb losses. Mandated LTV Caps: RBI caps the LTV ratio at 75%-
80% for home loans, reducing risk exposure in the housing sector.
 Basel III Standards: Indian banks must comply with Basel III, which requires
stringent evaluation of leverage, liquidity coverage, and risk-weighted asset
ratios.

Industry Applications

Case Study 1: NBFC Crisis in India (2018)

 Many non-banking financial companies (NBFCs) like IL&FS faced liquidity
crises due to over-leveraging (D/E ratios exceeding 5.0) and low ICRs (<1.0).
 Impact: Reduced trust in NBFCs, leading to stricter credit risk evaluations by
banks.

Case Study 2: Indian Real Estate Sector Post-RERA

 Post-RERA implementation, banks scrutinized real estate developers'
financials, prioritizing low LTV ratios and high ICRs.
 Example: Developers with LTV >80% faced higher interest rates (8%-10%)
compared to those with LTV <70% (6.5%-7%).

Conclusion

Financial ratios are indispensable tools for banks in making informed lending
decisions, assessing borrower risk, and pricing loans appropriately. Ratios such as
Debt-to-Income (DTI), Interest Coverage Ratio (ICR), Debt-to-Equity (D/E), and
Loan-to-Value (LTV) provide critical insights into the financial stability of borrowers,
allowing banks to minimize risks and ensure that loans are offered to creditworthy
individuals and businesses.

Real-world applications in India, such as those seen in HDFC Bank, SBI, and Kotak
Mahindra Bank, demonstrate the importance of these ratios in shaping lending
policies, internal ratings, and loan pricing strategies. Moving forward, the integration
of advanced technologies like artificial intelligence (AI) and machine learning (ML) is
likely to enhance the precision and efficiency of ratio-based decision-making, further
improving the lending process.

References

1. SBI [Link]
2. ICICI - Annual Report 2021-22
[Link]
[Link]
3. chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://
[Link]/content/dam/Kotak/investor-relation/Financial-Result/Annual-
Reports/FY-2022/kotak-mahindra-bank-21/[Link]

4. Reserve Bank of India (2021). Guidelines on Loan Pricing and Risk

Management.

5. [Link]
378794287_Unlocking_Insights_Financial_Ratio_Analysis_of_Indian_Private
_Banks_2018-2022