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Banks: Pros and cons

May 27, 2003

The rally seen in banking stocks looks reminiscent of the rally seen in software stocks before the indices collapsed in 2000. So does it mean that investors should panic and start booking profits? Well not exactly. The rally seen in banking stocks has been to a certain extent limited to the public sector banking stocks. The rally seen in these stocks has been fueled by various factors. One of the major factors for this rally has been the proposal by many banks to return capital to the government, which essentially means that the government holding in these banks is going to reduce. The return of capital has a two-fold effect on a stock's valuations. Due to return of capital the government's stake reduces, indicating that the government interference in the management of the bank will lessen.

Bank Amount (Rs m) Status
BOI 1,504 Returned in FY02
Andhra Bank 500 Proposed
PNB 1,300 Proposed
OBC 500 Proposed

For many years nationalized banks have been plagued by government interference in the form of appointment of the heads of these banks. Due to this valuations have suffered, as there seemed to be no continuity in the policies initiated by different managements. Now if indeed the government's stake in these banks is reduced, it will automatically lead to better perception regarding PSU banks. The second positive effect of this activity is that when capital is returned, there is a reduction in the number of shares outstanding and therefore an automatic improvement in earnings per share. Thus valuations will automatically improve.

For banks the motive is clear. While they need enough capital to grow their assets, there are increasing concerns that excess capital is in itself a liability. For example, the RBI stipulation for Capital Adequacy Ratio (CAR) stands at 9%, but most of the public sector banks have CAR well in excess of the stipulated levels. Thus excess CAR also portrays a sign of inefficiency as it indicates that the bank is not able to grow its asset size efficiently and has idle funds that are not being efficiently utilized. Thus, the legitimacy for returning capital.

Clearly one gets the impression that the public sector banks are trying to enhance the value of their shareholders. The returning of capital seems to be in line with the government's long-term objective to reduce their stake in these banks. While the motive and the benefit of this exercise is clear as far as the banks are concerned, we would like to caution investors regarding the hidden dangers of this exercise. The biggest danger in this kind of an exercise is that until the government approves this scheme in relation to a particular bank, it is a risky reason for investing.

Looking at the way the government has handled the disinvestment process, one must not be surprised if it decides not to take back the capital in order to maintain adequate control over the bank. Thus any disappointment over this issue may lead to a downward correction in these stocks. Also due to the speculation on this front, banking stocks that have not announced such a scheme have also run up on the bourses in the last 2-3 months. For the long-term investor, we reiterate, while these activities (return of capital) may trigger the stock prices in the short term, one needs to look at the management vision and performance in the face of competition to make a viable long term investment decision.

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