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Banks: Banking on 'deliverables'!

Dec 27, 2005

Introduction
In 1950, the old Imperial Bank of India was ten times bigger than the Hong Kong & Shanghai Bank (HSBC). Since then, the Imperial Bank has morphed into the State Bank of India (SBI), our domestic banking behemoth. It towers over its competition here. Yet, SBI is today a mere tenth of the modern HSBC's size. This nugget tells us a lot about how Indian banks - just like their peers in manufacturing - have lost out in the quest for global scale.

Despite having achieved a lot over the past few decades, from expanding their rural reach to cleaning the muck off their books, Indian banks continue to be pygmies in the land of giants. With the increasing levels of globalisation of the Indian banking industry, evolution of universal banks and bundling of financial services, competition in the industry is set to intensify further. The industry has the potential and the ability to rise to the occasion as demonstrated by the rapid pace of automation, which has already had a profound impact on raising the standard of banking services. The financial strength of individual banks, which are major participants in the financial system, needs to be the first line of defence against financial risks. In this article, we examine the sector's performance during 2005.

2005: The year that was...
The BSE-Sensex, in 2005, outdid targets foreseen by every analyst worth his salt! What is even more surprising is that even at 9,000-plus levels, despite being over 16 times FY07 forward earnings, one could still find select stocks offering a decent return on investment. Banking has been one sector that has retained investor confidence throughout the year, thereby delivering exactly the same returns, as one would have garnered by investing in the index. While the Sensex gained 44% till December 23, 2005, 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 adjacent graph, that compares Rs 100 invested in both the Sensex as well as the BSE Bankex during the year 2005, we observe, that while initially the Sensex trailed closely behind Bankex, the former caught up in the fag end of the year to generate Rs 144 at the year end, as in the case of the Bankex.

It would be interesting to note that as against last year, wherein the PSU banks delivered high returns, their private sector counterparts largely outdid them in 2005. Also, worth noting is the fact that behemoths like SBI and ICICI Bank showed considerable movement and proved to be the market movers during 2005. The reason for the same was the investors' confidence in the larger banking stocks that have the potential to capitalise on the credit boom. Banks like Kotak Bank also managed to register appreciable gains due to their diversified business interests. Amongst the laggards, while the 'GTB impact' and treasury losses weighed heavy on banks like OBC and ING Vysya, others that were not able to deliver akin to their peers were also shunned by the markets.

The Outperformers...
(Rs)22-Dec-0423-Dec-05% change
Kotak Bank104 237 127.9%
UTI Bank173 300 73.4%
Syndicate Bank50 83 66.0%
ICICI Bank361 583 61.5%
SBI594 891 50.0%
The Laggards...
(Rs)22-Dec-0423-Dec-05% change
OBC327 257 -21.4%
ING Vysya Bank199 160 -19.6%
Bank of Rajasthan57 47 -17.5%
IDBI108 100 -7.4%
Vijaya Bank65 60 -7.7%

Our 2005 assumptions Vs reality
Profits to be driven by core income: Analogous to our expectations, banks witnessed a steady growth in incremental credit disbursements in 2005. As per the RBI's Trends and Progress in Banking (FY05), the incremental credit offtake grew at 28% YoY during FY05, as against 17% in FY04. Thus, with banks' funds focused on 'lending', investments grew by mere 5% YoY against 16% YoY in FY04. Even though lending rates have declined for some time now due to the intense competition among banks to advance loans, deposit rates were also falling at the same time. Resultantly, banks had not felt the pinch in margins until FY05. In 2005, however, while the deposit rates hardened, the lending rates continued to remain flat. This led to the banks scurry for high yielding retail portfolios and inclusion of the 'SME segment' in its books.

Corporate offtake to replace retail boom: Credit disbursals to the corporate sector did not take off the way it was expected. Nevertheless, advances to the corporate sector accounted for over 40% of the total advances made by banks. Corporate loan yields, however, shrinked with companies tapping overseas markets for raising funds. Over the last few years, given the steep fall in overseas interest rates and the appreciation of the rupee, companies have begun to tap the global market in increasing numbers. As a result, the share of bank credit in total funds raised by industry (from internal and external sources) stood at just 31% in FY05. This was despite the fact that banks continued to resort to sub-PLR lending thereby compromising on their net interest margins.

Consolidation to drive synergies: The M&A activity that was tipped to be the 'mantra' for the sector in 2005 saw very few takers, thanks to the social and political hurdles. While the example of Centurion Bank of Punjab could be reckoned amongst the select few consolidation stories, merger amongst PSU banks continued to remain in the backburner due to protests from the labour unions and the Left party.

What to expect in 2006?
Scouting for resources: Despite the credit growth being at all time high levels, the penetration of the same remains very low in India as compared to other developing nations of the world. Besides, the loan to GDP ratio in the country being fairly low at 37%, retail loans (consumer credit) as a percentage of GDP in India at 7% is abysmally lower as compared to an average of 45% for other Asian countries (Source: RBI and World Bank). India is still an economy where the corporate sector relies heavily on bank lending. Plus, interest rates in the global markets are rising. This, together with the fact that the rupee is now beginning to depreciate, means that most firms will find it increasingly unviable to raise money from overseas markets. Given this, banks will feel the need to scout for additional resources besides their net owned funds. This in turn suggests that banks will be seen vying for a higher share of low cost deposits.

Infrastructure investments: Besides corporates, the government's thrust on infrastructure investment is expected to be another trigger for credit demand. The current rate of infrastructure investment in India at 3.5% of GDP is well below the target rate of 8.0% proposed by the Expert Group on Commercialisation of Infrastructure Projects (Source: ADB). Also, the share of private players is expected to rise from 20% to 40% in the next 5 years, thus propelling the incremental credit demand.

'Priority' weighing heavy: The pressure from the finance ministry on banks to hike their exposure to the 'priority sectors' may weigh heavy on the sector's margins. PSU banks especially have been asked to concentrate a sizeable portion of their credit portfolio on this segment. Although banks have tied up with credit rating agencies for the risk appraisal of this segment, an overexposure to the same may not augur well for the entities.

Gearing up for FY09: In 2005, the Reserve Bank of India (RBI), in its twin-phased roadmap, set out guidelines for the penetration of foreign banks and the acquisition of stake by the foreign entities in Indian private banks by FY09. While on one hand, the same was a step towards facilitating the entry of foreign banks into India and fulfilling the key objectives of competition, consolidation and convergence in the sector, it also provided the domestic entities the buffer time for gearing up to global competition. In 2006, we therefore see the domestic banking entities taking initiatives to acquire size and scale (through organic and inorganic routes), thus safeguarding their position.

To conclude...
The banking 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. At the same time, the behemoths will have to exhibit resilience to margin pressures and ability to retain asset quality. In all, 2006 will see investors weighing the 'delivered' against the 'deliverables' for the banking sector.

To read our thoughts on year 2005 and our view for 2006, click here - Reflections 2005.

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