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Banks: Retard after the rally

Dec 28, 2006

Introduction
One fact that can be underscored for the banking sector in the year 2006 is that - it was a year of sheer excesses! While financial inclusion and evolution of advanced monetary infrastructure is the hallmark of any developing economy, in India, the same has been conspicuously evident over the last two years. To put things in perspective, while the credit to GDP ratio grew by 23% point to point between FY04 and FY06, the per capital credit in the economy (Rs 13,614 in FY06) also grew by 7% in that period, one of the highest in the past 3 decades. The incremental year on year money supply, deposit and advance growth clearly manifested the inherent strength in the economy. This was backed by a degree of steadiness in the level of inflation and interest rates.

Coming on close counters to the Basel II implementation deadline, the RBI's emphasis on KYC (know your customer) norms, higher risk weightage on certain asset classes and the necessity to align with global peers, however, were some of the hurdles. The latter half of 2006 has shown early signals of a staggered slowdown, as is the case before an economic cooling off. While this certainly does not signal any threat to the sector, what needs to be construed is the fact that the best may already be behind us.

2006: The year that was…
As the rising interest rates and mark to market losses on investment portfolio of banks rubbed off on investors, the sentiment towards banking stocks got relatively muted as compared to other sectors in 2006. An overhang of liquidity concerns post the IMD (India Millennium Deposits) redemption in the fag end of 2005 also led to banking companies bearing the brunt.

If one looks at the adjacent graph, that compares Rs 100 invested in both the <BSE-Sensex as well as the BSE Bankex at the start of 2006, it can be observed that while initially the Bankex trailed closely behind the Sensex, the latter outperformed by a reasonable margin for the rest of the year to generate Rs 144 at the year end, as compared to Rs 135 in the case of the Bankex.

While credit growth of 29% YoY in 1HFY07 was relatively lower than the 32% YoY growth clocked in FY06, the same can be attributed to a high base effect and a lag in deposit growth with the gradual upmove in interest rates.

Earlier in 2005, even though lending rates saw marginal hardening due to the intense competition among banks to advance loans, the deposit rates were also not very admonishing. Resultantly, banks had not felt the pinch on margins until 2005. In 2006, however, while the deposit rates hardened at a faster clip, the lending rates remained flat (due to the temporary lag). This led to the banks scurrying for high yielding retail portfolios and inclusion of the 'SME segment' in their books. 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.

The outperformers and the laggards…

The Outperformers…
(Rs) 22-Dec-05 22-Dec-06 % change
Yes Bank 68 132 94.8%
Kotak Bank 237 376 59.0%
UTI Bank 297 461 55.1%
ICICI Bank 573 857 49.4%
Bank of India 127 190 49.2%

During testing times, when banks had to survive with a non-remunerative treasury portfolio and shrinking margins in their core business, it were the private sector banks that emerged winners by promptly passing on the rate hikes to their customers (thereby retaining margins) and being proactive in treasury provisioning. It is thus not surprising to see banks like Yes Bank, UTI Bank and ICICI Bank having merited investor confidence due to their relative fundamental strength and averseness to risks posed to the sector by the macro-economic developments. Bank of India was the top PSU Bank to garner investor interest due to its proactive provisioning and the possibility of write-back of some of it (thus aiding its bottomline).

The Laggards…
(Rs) 22-Dec-05 22-Dec-06 % change
Indusind Bank 61 42 -31.1%
IDBI 101 74 -26.4%
Bank of Rajasthan 48 39 -19.3%
UCO Bank 25 21 -18.1%
Vijaya Bank 56 46 -17.1%

Smaller banks that suffered from absence of scale and geographical presence, bargaining power in terms of margins as well as lack of hedge in terms of fee income, grossly under performed their peers. Thus the stocks understandably bore the brunt of investor disinterest in them.

What to expect in 2007?
Financial inclusion: Although the depth of banking services has increased (with the rise in per capita income of urban households), the breadth has not widened - substantiated by the increasing population per rural branch. According to the RBI deputy governor Dr. Rakesh Mohan, accelerated growth of the banking sector could be achieved only by 'financial inclusion' of first time savers, non-banked population and funding new entrepreneurs.

Basel II implementation: The central bank has, time and again, reiterated its gradualist stance in implementing Basel II in India, deferring it beyond the March 2007 deadline. The implementation of internal rating based approach (for credit risk) and advanced measurement approach (for operational risk) will meaningfully impact the capital adequacies of the strong and weaker players in the sector.

Higher risk weights: The Reserve Bank of India (RBI), in the past, has been proactive in assigning higher risk weights to residential mortgage, real estate loans and personal loans as compared to those required by Basel II - taking into account the risks perceived due to an unprecedented credit growth. It remains to be seen whether this measure proves to be a cushion for asset delinquencies when the credit cycle turns. While the recent CRR hike-induced liquidity tightening was a step towards curbing the incremental credit growth, the RBI may not refrain from according higher weightage to the risky assets in the event of palpable delinquency risks.

External ratings: Currently only 10% of the banks' corporate borrowers are rated by external rating agencies. As the un-rated borrowers attract a risk weight of 100%, it leads to incorrect pricing of risks and higher cost of credit to banks. A shift to external rating system may not only influence banks to make their operations more transparent, but also align the sector with its global peers.

Consolidation - Fence-sitting to continue: At the outset, it is widely acknowledged that the weak and fragmented nature of the Indian banking sector leads to duplication of banking network, capital inefficiency and reduced ability to withstand the onslaught of foreign banks post 2009. However, very little has been done when it comes to consolidation, sparing a few attempts at infrastructure and manpower sharing. Unless the public sector banks themselves discard their rigidity towards mergers and adopt a more realistic approach for their survival, the regulators' roadmap for consolidation will continue to remain on paper.

Conclusion
Despite the fact that we have witnessed an unprecedented rally in credit offtake in the country, India's low credit to GDP (around 50%) and mortgage to GDP ratios (6%) lead us to believe that we have barely scratched the surface. This is when we benchmark the broader statistics of the sector to the global standards. While the banking sector will continue to act as the harbinger of India's economic evolution, it will be the extent to which the domestic banking sector aligns itself with its global peers that will justify the acceleration in credit appetite.

To read our thoughts on year 2006 and our view for 2007, click here - Reflections 2006.

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