Banks: Lost the 'Midas' touch! - Views on News from Equitymaster

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Banks: Lost the 'Midas' touch!

Oct 7, 2005

As the indices continued to defy the laws of gravity until a couple of days back, certain select sectors made hay. Banking stocks were amongst those that stole significant limelight, as they remained the least affected by rising crude prices. Benign inflation, surplus liquidity and relatively softer interest rates also kept sentiments buoyant towards the sector. Not to mention, the government and the RBI's renewed focus on reforms for the financial (read banking) sector, also aided the momentum. Resultantly, the sector that was under performing the Sensex over the past few quarters, caught up to the investor fancy. Will banks deliver?
Although markets have already factored in most of the potential upsides into the prices of most banking stocks, what remains to be seen is whether these entities can deliver what the markets expect of them. While we do not deny that the fortunes of the sector have certainly improved, we find it pertinent to highlight some deterrents that may defer some of the deliverables (be it in terms of growth or countering competition).

Market share: Separating the men from the boys
27 PSU banks, 25 private banks, 30 foreign banks and a host of cooperative and regional rural banks cater to the banking populace in the country. The fact that top 7 banks account for 57% of the market share suggests that several smaller players occupy the remaining 43%. Thus, it goes without saying that it's the bigger players that enjoy the economies of scale and access to top tier customers.

On the other hand, the smaller banks get handicapped due to sheer lack of size (including capital) and scale. This deficiency compels them to compromise on margins as well as asset quality. Nevertheless, the apex bank (Reserve Bank of India (RBI)) has now given an ultimatum to the weaker entities to acquire the requisite size prior to FY09. The success of the consolidation drive in the banking sector (which the government and the RBI alike are struggling to trigger), will thus determine the survival of the smaller entities. Not to mention, the larger entities also need to consolidate their positions to safeguard their shares from foreign encroachment. They must therefore look for 'suitable matches' to complement their strengths.

Pricing pressure: Squeezing margins
As banking gets commoditised by the day, with more and more players trying to lure customers at attractive prices (lower cost of advances), banks have also been compromising on their yields. Although the same are not comparable to those existent during the high interest rate regime (late 90's), banks have also been victimized by the 'AAA' corporates arm-twisting them for sub-PLR rates. Several banks (including those in the top league) have witnessed severe erosion of net interest margins over the last couple of years due to re-pricing of assets. The same if not countered with marginalisation in cost of funds will pose a serious threat to these entities.

Yield on advances (%)
Banks FY04 FY05 Increase/(Decrease)
HDFC Bank 7.5 7.7 0.2
Corporation Bank 7.6 7.7 0.1
Canara Bank 3.5 3.6 0.1
Bank of Baroda 3.6 3.5 (0.1)
Allahabad Bank 4 3.7 (0.3)
SBI 7.6 7.2 (0.4)
OBC 9 8 (1.0)
UTI Bank 9.3 7.8 (1.5)
ICICI Bank 9.7 7.4 (2.3)

Treasury: Not a cakewalk anymore!
When the soft interest rates prevailed, banks had to do little over investing their funds in G-Secs and bonds. This was all that was required of them to post attractive treasury profits and register strong bottomline growths. In such a scenario, they neither had to bother about credit growth nor about efficiency levels. However, with the tables now having turned, banks need to concentrate on their 'core banking' operation for which they need to also upgrade their risk mitigation skills and enhance non-fund based (fee income generating) activities. Also, to keep their treasury operations well hedged, banks need to transfer a substantial proportion of investments to the HTM (held to maturity) category (thus taking mark to market losses) as well as keep the duration of assets low.

What to expect?
Given this scenario, the rationale behind according unprecedented valuations to the sector seems unreasonable. This is because, most of the potential upsides being already factored into prices, investors can expect little upside. While we do not deny that some of the larger players in the sector will continue to outperform market expectations, investors also need to take a look at the valuations. Or should we say that banks that looked very attractive at a certain point in the past have now lost their 'Midas touch'?

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