A Timely Warning About Financial Stocks in Your Portfolio

The value of your fixed deposit in ABC Bank crashed by 95% at today's closing prices.

Has your bank ever sent you such messages?

Do you find the idea ridiculous?

Well, not if you expect your bank to be completely honest with you. And believe that it should worry about its own bankruptcy.

Today, more than half the public sector banks do not have the capital to pay back depositors.

Thankfully this is not about 2024. I wrote this to Equitymaster readers back in 2018.

Yes, the NPA position of several public sector banks back then was indeed scary.

Left on their own, the banks would have to mark down the value of deposits by 90% to 100%. Simply because they never managed to recover the loans fully.

The gross NPAs of public sector banks had shot up to almost 14.6% in 2018, when their private sector and MNC peers had the ratio at 4.6% and 3.8% respectively.

But public sector banks are not alien to the concepts of loan write-offs and government bailouts. Time and again the entities have resorted to these.

Rather, whenever the credit cycle tightens and non-performing loans (NPAs) spike, the government gets generous about bailing out the big banks. So, the vicious cycle makes a comeback every few years.

There are also other reasons why the public sector banks typically get away with the NPA stress every few years. Its because the investors have very little memory of such stress.

For instance, is your banker obliged to tell you about a possible crash in the value of your fixed deposits based on the estimated NPAs?

Never.

But on the other hand, a sharp fall in earnings estimates could be an ominous warning about the possible crash in stocks.

Reminds you of the crash in smallcaps, doesn't it?

The problem is that we think about stocks and fixed deposits very differently.

We take it for granted that stocks are perpetually at high risk, for their returns are not guaranteed.

And the guaranteed return from fixed deposits makes us complacent about their risk, especially if the deposit is in a public sector bank!

Now, over the last six years the performance of PSU banks in India has improved dramatically. The focus on bringing down bad loans has brought the NPA levels to a multiyear low of 2.8% in 2024.

The low NPAs have had a benign impact on the capital adequacy ratio (CAR at 16.8%) and return on equity (RoE at 13.8%).

So, the Reserve Bank of India, in its 29th Financial Stability Report released in 2024, declared Indian banks absolutely stable.

The problem is that the Financial Stability Report is backward and not forward looking.

If it were, then the central bank should have warned about NBFCs complaining about over leveraged borrowers. The September 2024 quarter results gave away the stress building up in the banking system.

Entities like Bajaj Finance and Piramal Enterprises pointed to the rise in non-performing assets, for their tighter underwriting norms.

Concerns are especially mounting after seasoned banks like Kotak Mahindra Bank and IndusInd Bank reported elevated stress in unsecured loans.

The pain is more acute in NBFCs and small finance banks like Ujjivan Small Finance that focus on smaller-ticket loans.

The sharp rise in growth of unsecured loans, like personal loans, over last three years, was already a reason to get cautious about the possibility of NPAs. Especially once interest rates moved up. Yet the regulator did not seem to be too worried about it.

Back in 2018, 11 out of the 21 public sector banks in India had NPAs higher than or almost equal to their networth.

In an ideal case, their depositors would be warned and the entities would be wound up. Offering deposits in the garb of safe assets, in near bankrupt entities, is mis-selling.

If this was the case with private sector banks, depositors would have at least tried to redeem them as soon as possible. But the PSU banks, with blessing of the government, manage to keep depositors in the dark.

So, this time around, when the government is coaxing PSU banks to lend more to smaller enterprises, investors must get cautious. It is only a matter of time before callous lending and the burden of steep interest rates, take a toll on credit quality.

The memories of 2018 NPAs may be behind us. But it may not take too long for bank and NBFC stocks to get rerated to 2018 valuations, if the NPAs begin dampening shareholder returns once again.

Warm regards,


Tanushree Banerjee
Editor, StockSelect
Equitymaster Research Private Limited (formerly Equitymaster Agora Research Private Limited) (Research Analyst)