Bank On Growth

[INSERT_1]

Crisis is a great equalizer. Till few months back, there was a lot of noise that only few large Indian banks will survive post April 1, 2009 following the banking liberalization era when foreign banks will have same freedom as domestic banks in respect of opening branches, acquisition of banks, and such others. The whole Indian banking landscape was supposed to change. But, with the sub prime crisis in US which led to the process of de-leveraging of assets, the entire banking scenario in the world has changed.

Nationalization seems to be the new buzz word, which otherwise was unheard of in developed economies, which are now ready to embrace it. A case in point is that of Freddie Mac and Fannie Mae which was taken over by US government, and more recently the talks of stress test for banks which will test banks’ qualification for nationalization. The financial sector, which remained in the centre of a whirlwind that engulfed the entire economy, has changed the perception of Indian banks. Public sector banks (PSBs), which were out of the limelight for the last couple of years, are back with a vengeance.

They have outperformed their private counterparts in almost every performance matrix for the quarter ended December 2008. Therefore, it is not surprising that in the recently-announced top 500 global financial brands by Brand Finance in association with UK’s The Banker magazine, there were 13 new entrants from India, all of them were public sector banks. Apart from this, there has been a remarkable shift in perception of India Inc about the banks. In the last quarter alone, leading Indian IT companies have shifted around Rs 1400 crore from private banks to public sector banks. Till now, Indian banks have not suffered any major casualty and have demonstrated good growth amid the upheaval faced by banks in US and Europe. We will try to figure out whether they will continue to perform and what are the areas which can act as Achilles heels for Indian banks.

Income
When banks around the world, especially in the developed world, are struggling to survive and many have already gone bankrupt or have been taken over by some other bank or government, Indian banks not only survived but showed spectacular performance both Y-o-Y basis as well as Q-o-Q basis. Starting from total income of the banks, which increased by 35 per cent in FY08, the momentum was maintained even in the third quarter of FY09 when banks continued to show their strong growth and increased by 33 per cent Y-o-Y basis. The best performance was demonstrated by Axis Bank which increased by 65.6 per cent. Coming to profits, at a time when banks in developed markets are posting highest ever losses in their existence, the Indian banks have matched the growth in their profit to income, and profits grew by 35 per cent last year and 33 per cent this quarter Y-o-Y basis. Lakshmi Vilas Bank was the best to perform, increasing its profit this quarter by a whopping 400 per cent.[PAGE BREAK]

[INSERT_2]

Apart from interest income, which is the primary source of income for banks, they derive income from non-interest sources like fees, treasury operations, and such others. Interest income earned by the banks, has increased by 28 per cent CAGR between FY06 to FY08, and was major contributor to the topline with more than 83 per cent contribution.

This spectacular increase in interest income can be explained by the expansion in advances by 26.67 per cent in the same time period. Even a hike in PLRs (prime lending rates) by the banks helped to boost their interest income.

Non-interest income, which mainly comprises commission, exchange and brokerage (CEB), fee income from business clients and government agencies, etc, have increased by 25 per cent CAGR between FY06-FY08. It contributed 16 per cent share in overall revenue of banks in FY08.

It was the private sector banks and PSBs having large branch network which increased their revenue from other sources. We believe, going ahead, other PSBs too will adopt the latest technologies and compete with private banks for the non-interest income pie. Many PSBs have already upgraded the technology and are ready to increase their non-fee income. But, large branch network and technology alone do not drive non-interest income. It is also the over all market condition which dictates these incomes.

For example, banks like ICICI Bank and Kotak Mahindra, which are major player in the capital market and M&A activities, may see decline in their fee income owing to slowing down of capital market activities. Cracks are evident in their current quarter’s result too, where fee income for ICICI Bank declined by 24.5 per cent in Q3FY09 Y-o-Y basis. For Kotak Mahindra, it was even worse where it fell by more than 50 per cent. Future performance of Indian banks will hinge upon the interest rate movement. We believe interest rates will continue its downward trend due to easing of inflation and monetary supply (M3), both of which are within comfortable zone for RBI. This might depress bank’s net interest margins which remain a concern, but it is even going to help banks in two ways. First, banks having large part of their investment in SLRs (Statutory Liquidity Ratio) instrument will have unrealized profits in their books due to falling interest rates. It is expected that it will be around 2-3 per cent of total loan book because banks have around 60 per cent of their SLR investment in HTM (Hold Till Maturity).

The second benefit of falling interest rate will accrue to those banks that are having lower CASA (Current Account and Saving Account) ratio.

Banks will benefit only for few quarters because they have large part of the loan books to be re-priced which can help them reduce their interest cost momentarily and increasing the NIMs. But, in the long term, banks having better CASA ratio, which provide low-cost funds and largely remain stable, are better placed to improve their net interest margins (NIM).[PAGE BREAK]

[INSERT_3]

This is palpable from the NIMs of two largest private sector banks. At the end of third quarter FY09, HDFC Bank with CASA ratio of 40 per cent was having NIM of 4.2 per cent whereas ICICI Bank, having CASA ratio of 27 per cent, had NIM of 2.7 per cent. In the last few years, there has been a major shift in share of CASA ratio. The PSBs have lost their market share to private sector banks. Overall, market share of CASA for PSBs have declined from 67 per cent in FY2000 to 54 per cent in FY08. This was primarily due to expansion in the branch network. Private sector banks expanded their branch network at 30 per cent CAGR compared to 2 per cent for PSBs in the last three years.

Therefore, we can say that though income growth will moderate to some extent in coming quarters due to falling interest rates, they will not be substantial. Moreover, part of the fall will be compensated by profits in investments.

Assets
It is primarily the balance sheet which drives the income for banks, and in last four years banks have grown their total assets by 21 per cent CAGR.

It was primarily driven by the aggressiveness of private banks who managed to grow their assets faster than public sector banks. They grew by 30 per cent CAGR compared to 19 per cent achieved by PSBs. For example, Yes Bank, which had assets of little over Rs 1250 crores in FY05, has grown more than thirteen times in the last four years and stood at Rs 17000 crore in FY08. It was the advances for the bank which increased faster than deposits. Advances increased by 30 per cent CAGR compared to 20 per cent increase in deposits since 2004. This resulted in the lowering of investment by Scheduled Commercial Banks (SCBs) in SLR instruments. It continuously decreased in the last couple of years before starting to rise in October 2008. Currently, it is more than 27.1 per cent of NDTL (Net Demand and Time Liabilities) for SCBs, against the required limit of 24 per cent.

Therefore, bankers are accused of not lending more and are charged of “lazy banking”. But bankers enunciate they are using the excess reserves for taking short-term loans under repo window, as excess SLR investment allows them to take short-term loans. It is estimated that percentage point cut in SLR releases approximately Rs 40,000 crore into the system. This is even apparent from the latest third quarterly review of RBI  holding Rs 121792 crore, as on December 19, 2008 which, otherwise, would have been used for lending. The other reason for the bank not lending much is the fall in key policy rates.  As many banks, especially PSBs having large investments in government securities, tend to benefit once the rate get reduced. Along with that, the yield in the bonds takes a dipping which increases the value of bonds and disincentives the banks to lend as they are getting good risk-free return in their investments.[PAGE BREAK]

To discourage this, the government has to reduce yield in G-secs and allow other players to participate in this.

The  RBI has already started the process by reducing reverse repo rate (rate at which banks lend money to RBI) by 200 basis points (bps) since November 2008. In recent quarter, banks have maintained credit growth of 23.9 per cent due to drying up of other resources for Indian corporates such as ECBs, FCCBs , capital markets, and others. Despite this, there is a fall in the flow of financial resources to commercial sector by 3 per cent compared to the same quarter last year. Most of this incremental credit was absorbed by industry which accounted 48 per cent but there was sharp drop in the credit provided to housing sector - it was just one per cent of incremental growth in credit from last quarter.[INSERT_4]

But growth in credit was not matched by increase in deposit rate. Deposits increased by just 21.2 per cent Y-o-Y basis. This has resulted in higher incremental CD (Credit Deposit) ratio of 81.4 per cent. Going forward, for FY10, it is expected that credit will grow at 17-20 per cent depending upon how economy grows. If it is by government spending, then credit growth will be on lower limit, that is around 17 per cent. Otherwise, it can be around 20 per cent. One of the most important factors which will boost the credit growth in next couple of quarters is refinancing of foreign debts. According to RBI data, it is estimated that USD 89 billion worth of external debt is due by end of June 2009.

This is almost 37 per cent of total foreign exchange reserve as on January 31, 2009. Another boost for the credit growth will come from huge capex planned by the India Inc. According to data compiled by CMIE (Centre for Monitoring Indian Economy), Rs 300,000 crore worth of projects are likely to be completed in FY09. Therefore, we feel that in coming quarters, banks will continue to see credit growth.

Quality of Assets
The party seems to come to an end abruptly for banks after few years of high growth when quality of assets improved along with increase in topline and bottomline. Standard assets of the banks improved from 97.3 per cent in FY07 to 97.6 per cent in FY08. One of the reasons for improvement in asset quality is boom in economy leading to better cash flow for the corporate. Moreover there is positive co-relation between credit growth and asset quality. NPAs of PSBs decreased from 4.3 per cent to 1.1 per cent and for private sector banks it decreased from 3.6 per cent to 0.9 per cent between FY04 to FY08.  But, the total landscape has changed with slowdown in economy, scarcity of easy and cheaper money, demand destruction and flaccid personal incomes - all signaling the tough road ahead for banks.[PAGE BREAK]

[INSERT_5]

For the quarter ended December 2008, NPAs have started rearing their ugly head once again and have increased by average of 12.32 per cent this quarter for 43 listed banks. The sectors which are vulnerable to changing business cycles are going to give more pain to the bank’s assets.  Bank of Baroda CMD M D Mallaya, when asked about stressed assets, said, “It depends upon the over-all mix of portfolios. Personal segment, retail segment are stressed. SME can pose some pain and in corporate, there are some industry segments which are dependent upon the export market like gems and jewelry, textiles and auto ancillary which are stressed.” Banks which are exposed to these sectors will see their assets quality deteriorating. For example, ICICI and HDFC bank have their loan books skewed towards this stressed sector with 40 and 45 per cent exposure respectively affecting their NPAs. For Punjab National Bank and SBI, the exposure is limited to around 28 per cent. Therefore, we feel banks with more exposure to these sectors will trade discount to other banks having less exposure to stressed assets. But, again, documentation level and risk monitoring measures will determine the actual level of NPAs.

One of the ways in which banks can reduce their delinquency level is re-pricing of the books but this may require understatement of the assets. Last year, there was an increase of 80 per cent in restructuring of loans by PSBs and private sector banks Y-o-Y basis. We feel in Q4FY09, bulk of rescheduling and restructuring of loans will take place and real NPA issue will appear in second half of the year or Q2FY10 if government fiscal stimulus fails to take off. But this can give relief to only corporate part of total port-folio; retail segment like credit card dues, two-wheeler loans, etc, remain vulnerable due to weak employment scenario and some of recovery issues that conforms to RBI norms. But, we feel, failing interest rate helps in better recovery and may not pose big problem. Other area of con-cern for the banking sector is the increase in off-balance sheet exposure of banks to derivative contracts, LOC, and guarantees which are not directly funded by banks and do not appear on their balance sheet. It has increased by 45 per cent CAGR between FY04-08 and is 80 per cent of total assets at the end of FY08. For private sector banks, it is 139 per cent of total assets. Most of these relate to forward exchange contract. Till now no bank, private or public, has faced any major problem due to this but same cannot be held true for future and remains one of the concern for the banks. One important development in last quarter is regarding stressed asset classification norms which have been relaxed. RBI has recently relaxed the classification of delayed infrastructure project execution as standard asset. Though this will reduce the NPAs for banks, it may throw challenges for banks going forward because it may misrepresent the standard assets of banks.

Overall, we think that asset quality will remain the prime concern for the banks in coming quarters but will not pose major problem especially for banks following stringent documentation and better risk monitoring. Moreover, different legal channels like SARFAESI, CDR (corporate debt restructuring), which has evolved in last few years, will help banks contain this risk. [PAGE BREAK]

Capital Adequacy Ratio
Capital adequacy Ratio (CAR) is a prime indicator of the health of a bank. It shows the bank’s capital against risk weighted assets of the bank, in terms of percentage. In this financial turmoil, faced by the entire banking space in world, it is better for banks to be adequately capitalized because using capital market to raise capital is quite unattractive at this time. All the banks having operational presence outside India, migrated to the new capital adequacy framework evolved by the Basel Committee from March 31, 2008. Indian banks were well capitalized even before implementation of Basel II norm, because most of the Indian banks that migrated to Basel II in FY08 reported a marginal reduction in CAR.

This was mainly due to better operational risk followed by banks. Moreover, many banks including SBI, ICICI and Axis, have raised capital last financial year at hefty premiums compared to current market conditions giving them comfort at this difficult time. ICICI Bank alone raised over Rs 20000 crore on a follow on issue in June 2007. Similarly, HDFC Bank raised Rs 3,784 crore through an ADR-cum-preference issue and Kotak Mahindra raised Rs 1,615 crore through preference issue. Axis Bank raised Rs 4,534 crore through a combination of GDR, preference and QIP.Federal Bank remained one of the healthiest banks with CAR of 19.85 per cent at the end of Q3FY09 improving by 673 basis points Y-o-Y. In PSB space, SBI and Canara bank were better capitalized than others. For SBI, at the end of Q3FY09, CAR under Basel II norm was 13.72 per cent (improved by 144 bps Y-o-Y) whereas for Canara Bank, it was 13.4 per cent (reduced by 25 bps Y-o-Y). As a whole, we feel Indian banks are adequately capitalized to tackle any eventuality.

Conclusion
We believe the banking sector remains the back bone for any economy and to support a vibrant and growing economy, it should be properly regulated, better practices should be introduced and technology should be leveraged to increase the productivity of the banks. Long term growth for banks will come from higher credit penetration. Credit penetration in India was just 69 per cent of GDP at the end of the FY08 compared to 136 per cent for China in FY07.

These will be prime areas from where banks could draw long term growth. But for this, banks have to contain their intermediation cost which still remains high. New private sector banks and some public sector banks were good at keeping intermediation cost low due to proper utilization of technology and good branch network respectively.

Other important factor which needs to be addressed with changing financial landscape is the supervision and regulation of the banks. We feel that Indian regulators are pro-active to ward off any financial calamity and recent tumult in banking sector in developed world with minimal effect in Indian banking sector, stands testimony to it.

We believe better regulation and supervision is important to strength-en the banking sector and meet the challenges arising out of new financial innovations and globalization. Therefore, we feel that going forward, those banks which are adequately capitalized, that is having good CAR, less exposure of loan book to stressed assets class such as retail and export oriented industry, having good CASA ratio and good non-interest  income will help the investors to bank on growth.