As economies grow and diversify, their agricultural and manufacturing sectors expand, and their services sector matures. To support this, the banking sector needs to keep up. Growing economic complexity is, of course, an inevitable consequence of growth. It means that the benefits of efficient credit allocation rise, i.e., those projects or sectors are financed where the payoff is perceived to be highest. But it also means that the challenges for those assessing alternative loan applicants mount. They must develop means of allocating credit among competing needs. They must enhance their skills to assess business plans and identify and manage risk. Such is the challenge posed by the Indian banking entities in the coming era.

The year that was…

6,500 and counting! Speculations about whether the Sensex will touch the historical 7,000 levels are still ruling. While the Sensex gained 14% till December 27, 2004, the BSE Bankex moved in tandem. The sector sustained its attraction to investors on the back of optimism regarding economic growth.

If one looks at the graph below, that compares Rs 100 invested in both the Sensex as well as the BSE Bankex during the year 2004, we observe, that while initially the Sensex trailed closely behind Bankex, the latter outperformed against the Sensex and became Rs 134 by December 27 while Sensex stood at Rs 114.

Here the interesting point to note is that, the annual top gainers of the sector were largely PSUs that seemed to have regained confidence amongst investors, thanks to the steady decline in their NPA levels. Also, as the private entities were already trading at a significant premium to their book values compared to their PSU counterparts, the spurt in price levels was less ‘visible’ in their case. Centurion Bank, although a laggard as on the given date, has recovered and come back to its early 2004 levels.

Vs 2003!

Loss on the treasury side: An environment of uncertainty over the pace of reversal of the interest rate cycle and the impact of the spurt in oil prices on inflation and growth prospects temporarily muted the optimistic sentiment, as the banks booked huge treasury losses. Interest rates witnessed a correction from the record lows seen in FY04 in consonance with the international trends and increase in inflation. The other income fillip that was witnessed in FY04 was invalidated in 1QFY05 with the interest rates falling and most banks booking massive treasury losses. This was coupled with the one-time shift of their investments from the “available for sale” to the “held to maturity“ category, which the banks made to prevent further losses in the treasury side.

CD ratio at an all time high: The surge in G Sec rates compelled banks to revise their deposit and lending rates. Although this created a pressure on the banks’ margins, it lead to a healthy growth in deposits and advances. While advances grew at CAGR of 12% the deposits augmented at the rate of 7%. This coupled with the conversion of IDBI into a bank resulted in the credit deposit ratio witnessing a record high of 63%. The sharp rise in risk assets indicates that, the coming year will witness a rush of equity issues to meet the capital adequacy requirements as per the Basel II accord.

Revival in credit offtake: Food credit offtake revived on the back of expectations of a good harvest season. Corporates also have increasingly begun returning to bank credit. Most of the corporates who have in the past resorted to ECBs have now begun substituting the foreign currency loans with domestic borrowings anticipating a further hardening in interest rates. This was dominated by two sectors, viz., infrastructure and petroleum, which accounted for as much as 86% of the incremental off-take. In response, banks reduced their G-Sec exposure to meet the burgeoning credit demand.

What to expect in 2005?

Profits driven by core income: The hardening of the interest rates and escalating credit demand may prompt banks to dedicate focused efforts on their ‘core’ business. The wilting other income is likely to be an insignificant contributor to the sector’s bottomline in the coming year and is likely to be replaced by incremental revenues from the advances portfolio.

Corporate offtake may replace retail boom: Data on sectoral deployment show that in 2004, priority sector continued to be the largest recipient of bank credit largely driven by the demand for housing loans below Rs 10 lakh (Source: RBI report on Currency and Finance). Going forward, the retail market is expected to grow at a CAGR of 8% till 2007. However, the coming year may witness a trend reversal, with corporate lending set to increase on the back of planned fresh capacities. Besides, the pressure on retail margins may entail banks to concentrate on their corporate clients, which may provide support to yields.

Lift of cap on FDI limit and voting rights: Liberalisation of FDI limit in the banking sector is expected to unwrap new avenues for the sector’s growth. The FDI hike is being contemplated as most domestic private banks are otherwise lacking the muscle to survive on their own. The roadmap for acquisition of private banks to the extent of 74% is likely to be in place once the government clarifies its stand on lifting the voting rights cap.

Consolidation is the word: Although consolidation of banking PSUs is a relatively uncharted territory, this is being envisaged to lend better synergies to the banking entities. In tandem with the Narsimhan report, which recommended the emergence of a few banking behemoths (including SBI), the ‘consolidation mantra’ is expected to initiate better reforms aligned with the needs of the emerging economy.

Future belongs to technology: Cheaper delivery points like Internet and tele banking are expected to improve their shares to the sector’s growth. ATM banking costs 80% while Internet and tele-banking costs only 15% compared to normal banking transactions. Undoubtedly the banking entities will leverage on their technical muscle to augment their bottomlines.

Valuation snapshot with FY05 expected P/BV

Private sector entities are likely to continue to trade at a significant premium to their book values. Liberalized FDI norms and successful equity issues may bring the smaller players in the limelight next year. Although the PSUs seem undervalued, how far the ‘consolidation story’ holds good, will determine their true fortunes.

The sector certainly holds credible prospects for investors in the coming year. But it pertinent to note that, the optimism will hold ground provided the anticipated reforms do not remain on paper. The smaller banks that have significantly run up on the ‘reform expectations’, will have to deliver with performance. In all, 2005 carries the weight of significant investor expectations. All eyes on North Block!