The Indian banking sector has been an investor favourite for a while, and why not. The secular Indian growth story has its believers and one couldn’t have faith in this story without loving banks. A credit hungry Indian corporate sector, an under-leveraged and aspirational consumer class, millions of hitherto un-banked individuals being compelled to open bank accounts in order to receive cash subsidy payouts…..good times, it seems, were always around the corner.
Case in point on the investor love for banking stocks was the recent frenzied buying of the HDFC Bank stock by FPIs when the RBI opened up the trading window for them, albeit literally just a crack.
The party pooper is as much of a reality though. And there’s 7 of them!
1. NIM pressures
Investors for long were bullish on widening Net Interest Margins (NIMs). Part of the expectation was driven by the trajectory of lower benchmark interest rates – banks immediately lowered deposit rates while longer term corporate loans took longer to reprice, thus widening NIMs. The recent demonetisation move added to the enthusiasm – banks were flooded with cash deposits and they opportunistically reduced deposit rates since the move couldn’t dampen deposit growth.
The consensus is that benchmark rates aren’t headed much lower any more. Thus, with limited room for cutting deposit rates further and continued pressure to reduce lending rates, besides the fact that repricing and fresh loans will reduce average lending rates, the NIMs will continue to be strained; whether benchmark rates are benign or lower.
2. Continued NPA stress
ARCs, the new bankruptcy code, stringent action against willful defaulters….put together, these initiatives were expected to finally usher the new dawn for stressed bank balance sheets.
Even as the wave of bad loan buyouts by ARCs turned out to be case of ‘Waiting for Godot’, regulations have only made the nascent sector struggle. In August 2014, the RBI tweaked the rules and increased the upfront payment to be made by ARCs from 5% to 15% of takeover value, which messed up the economics of the business just when it had begun attracting some heavy names and even heavier capital. The buzz is that RBI is inclined towards an even larger up-front payment requirement, which may make the already difficult task of attracting the massive capital the ARC players need, even more difficult.
This could prove particularly worrisome for the stand-out PSBs like Indian Overseas Bank (GNPA of 22.4%!), UCO Bank (GNPA of 17.2%!), UBI (GNPA of 16%!), IDBI Bank (of Kingfisher fame; GNPA of 15.2%!), and Bank of Maharashtra (GNPA of 15.1%!). Private banks have stressed asset ratios that are much lower but are at levels that cannot be deemed healthy by any yardstick. Even a quality large bank like HDFC Bank has seen GNPAs escalate steadily from ~0.9% levels in mid-2015 to 1.05% currently. A bank far lower down the quality ladder, though equally important to the sector due to its size, Axis Bank has seen bad loans rise to as much as 4% in Q2!
While total stressed assets are staying where they were (est. at ~12% of total loans currently) due to continued financial stress with large borrowers, SME borrowers and Real Estate firms may start deepening the strain post demonetisation.
3. Anemic credit growth
The primary reason to love Indian banks was the strong credit growth rates that India was witnessing – in the pre-financial crisis years, this was as high as 35% and even since 2008 has averaged a healthy 15%.
Credit growth at 3% is now at par with or lower than most EMs AND developed economies. Retail was the only sector that was consuming bank credit in a big way and this has come crashing down after November’s policy move. Presently, corporate and SME credit growth rates, both of which haven’t been anywhere near healthy in a while, stand at 0% and 0.4%! Post-demonetisation, Real Estate, the informal sector, and consumer finance are likely to take a worse hit and we cannot expect credit growth to nudge past 10% in the medium term (next 2-3 years). If banks can’t deploy funds profitably then what can they do?…
4. Record G-Sec buying
…they can buy G-Secs in the absence of lending opportunities!
G-sec buying is at a 7.5 year record high and continuing. With lending proving either unattractive or suffering due to lack of credit growth, or both, the surge in deposits post demonetisation is finding its way into purchase of G-secs. This table would make one wonder what the business of banking in India is all about currently:
~ YoY growth as of 01/2017
|Investment in G-secs||
Unsurprisingly (though interestingly), the G-sec buying boom, the deposit boom, and the credit slide have all happened after 11/2016.
Since everyone agrees there is limited room for further rate cuts, how much will this yield banks in treasury gains? ¯\_(ツ)_/¯
5. Consolidation helping but at what cost
The ‘on again, off again’ SBI mega merger is iffy enough and aimed at absorbing relatively poor balance sheets into a larger, relatively cleaner one. Taking that one at face value, now there is talk about a bank like Axis (with its not-so-pretty balance sheet) and Kotak (with its own pre-ING acquisition gold standard balance sheet) merging. At its most benign, such a merger would a zero sum game, i.e. one where Axis gains and Kotak loses. In reality though, such a move would end up reducing the already few ‘Good’ banks that are out there!
6. No room for massive recapitalisation
The focus of the government in the coming months and in the run up to the 2019 elections will be on reviving and sustaining capex. This will not leave them with much ability (or cash) to recapitalise PSBs. Indradhanush and BBB didn’t achieve much and now there is talk of Indradhanush 2! Unless that Dhanush comes laden with hard currency for capital, it may prove to be yet another arrow shot in the dark (with full-on pun intended).
Moreover, there is strong speculation of NDA doing a (yet another) UPA in coming up with a farm loan waiver before 2019. Hence, not only does the government not have any capital for the banks, it may well just use the banks for cultivating its vote bank!
7. Competition turning unconventional
We have been through anemic credit growth, lowered risk appetite, lack of capital, new found love for investment in G-secs, bad balance sheets, and the like. Let’s say for a minute that many of these realities are dispensed with and we get into Michael Porter mode (he of the 5 Forces framework).
In areas like Retail Finance, which was the last bastion of growth for banks, competition is coming from hungry and lean firms like Bajaj Finance, niche NBFCs, and newly revived firms like GE Capital, apart from well funded fintech startups. The Edelweisses and Anand Rathis of the world have enthusiastically stepped in into the SME lending void that banks have created in the somewhat mistaken belief that small borrowers carry higher risks. These competitors have lower cost bases (fewer physical branches, no messy unions, more use of tech for processes, outsourcing, etc.), cleaner balance sheets, and are subject to fewer regulations….how can banks compete?
The factors listed above aren’t going to make Indian banks unattractive investment opportunities overnight. They will play out, though over the medium term. One does need to worry though considering that the average concentration towards the Banking sector in large-cap Mutual Funds is ~1/3rd of fund size. Pick up any scheme and at least 4-5 of the top 10 holdings will be banks! How are these funds going to unwind this Gargantuan holding if the stocks fall out of favour or if any or all of these factors suddenly play out more expeditiously? Who will step in to buy? Who can these banks bank on?