The Hindu Business Line : ‘Interest’ingly insensitive

Among banking stocks globally, an Indian company’s balance-sheet probably ranks alongside those that have little sensitivity to interest rates. But the key question is whether the present valuation concepts will stand the test of time and be optimal for shareholders in the long run, asks T. B. KAPALI

Being cautious and incremental in financial sector reforms has stood India in good stead over the past many years. If in 1997, the Indian financial sector and the economy escaped the Asian financial markets crisis, ten years on, the same gradualist approach to financial markets is shielding Indian finance from the worst of the global securities/credit market crisis currently.

Stocks of Indian banks, for instance, are among the least affected asset classes, in a structural sense, as the mortgage market crisis in the US rolls on and takes a toll on finance stocks globally. Indian banking stocks too were sold off in the past few weeks but this has been part of a broader market correction occasioned principally by global investors shifting, temporarily, out of emerging markets.

Different valuation orbit

The fall in Indian bank stocks is qualitatively different in that the de-rating has not been on account of such companies’ exposure to certain classes of securities which suddenly become worthless pieces of paper. The fairly sharp fall (15-20 per cent) in key global finance stocks such as Goldman Sachs, Bear Stearns, Citigroup, JP Morgan or even European banks with exposures to the US credit markets, in the past few months, on the other hand, is the direct fall out of such companies’ exposure to securities and interest rate instruments which have lost nearly all market value in a crisis.

That Indian banking stocks are operating in a structurally different orbit as far as their market valuations go has been underscored by the latest developments. While welcome in the macro sense of the system and economy not getting affected by a global crisis, these developments nevertheless point to some chinks in the armour of these stocks (banks) and their valuations, so to say. These weak spots normally do not get identified/analysed and, therefore, are not inputs in the standard research literature on banking stocks. They (the weak spots), though, arguably have the potential to undermine long-term performance and returns from these stocks.

Low interest rate sensitivity

Among banking stocks globally, an Indian banking company’s balance-sheet probably ranks alongside those that have very little sensitivity to interest rates. That could even be a heretical statement (and not merely ironical) given that financial intermediaries’ balance-sheet will and ought to be dominated by interest rate-sensitive assets and liabilities. This low level of interest rate sensitivity has been brought about by a certain combination of circumstances — primarily the gradualism in financial sector reforms mentioned earlier (which results in some regulatory forbearance) and banking companies’ availing of the resultant concessions.

It is all good for the short-term. But the key question is whether the present valuation concepts will stand the test of time and be optimal for shareholders in the long run. Regulatory forbearance may well continue for some more time but the real proof of the integrity of a bank’s earnings potential and the value of its equity will come only when the entire balance-sheet is subject to interest rate risk.

The impact of interest rate movements on the performance of banking stocks does get analysed but this is more from a short-term earnings perspective. A statement such as “the net interest margin of the bank will be under pressure because the rise in interest rates will impact the funding side of the bank more than its lending side” is an example of such a short-term perspective. And it is clear that such a perspective basically flows from the manner in which a banking company’s balance-sheet is presently structured to avoid recognising the impact of changing interest rates (which as mentioned above is the result of banks fully availing of the regulatory concessions).

A more deeper impact analysis, on the other hand, will take account of how the interest rate shock — either up or down — directly impacts the market value of the net worth or the equity of the firm. In this framework, the entire balance-sheet of the bank comprises interest rate-sensitive assets/liabilities and the whole balance-sheet is subject to mark-to-market valuation on a continuous basis. The fall in stock market values of a Citigroup or a JP Morgan Chase, for instance, is more an understanding/appreciation of the interest rate sensitivity of such institutions’ whole balance-sheet and is not merely a reflection of the immediate impact on earnings of changed (changing) interest rate levels.

A more rigorous analysis is required in that scenario to calculate the interest rate sensitivity of individual items of assets and liabilities on the balance-sheet (and also of off-balance-sheet exposures). And such an analysis, in turn, will show the way on how to structure the balance-sheet (to immunise, preserve or even enhance the net worth of the firm) in response to interest rate shocks over which an individual bank can have no control.

To be sure, computing the interest rate sensitivity of each item of asset and liability on the balance-sheet will not be an easy, quick exercise. More so, since a typical Indian bank’s asset (credit) portfolio would be all “portfolio lending” — where the asset is held to maturity. (It is pertinent to note here that banks have been given the regulatory space to treat their investments portfolio also as “held to maturity”).

Again, on the liabilities side, the presence of demand deposits for close to 30 per cent of overall liabilities (for the average bank) makes the computation of interest rate sensitivity a more involved exercise — since it is not easy to define precisely either the maturity of a demand deposit or the relevant cash flows — the two parameters necessary to calculate the interest rate sensitivity of a financial asset/liability. Statistical techniques have to be applied here to estimate the degree and nature of sympathetic movements between the demand deposit base and interest rates.

Present state

Indian bank balance-sheets currently, though, are far removed from such a rigorous valuation environment. Even the biggest banking companies — with high IT, MIS capabilities and the expertise required to implement a more comprehensive risk management strategy — fight shy of subjecting their balance-sheets to more complete interest rate risk.

They either prefer to take refuge under the umbrella of regulatory forbearance or structure their lending portfolios in such a way that the bank’s balance-sheet does not carry interest rate risk.

Floating rate loans, for instance, completely transfer the interest rate risk on to the borrower and thereby protect the economic value of banks’ assets in a rising interest rate environment. The strategy (of lending portfolio structuring) apparently is perfectly valid but may ultimately turn out less than optimal from an earnings/risk point of view in the medium term.

The balance-sheet which is presented for public consumption, therefore, quite well incorporates the extant (friendly) regulatory provisions on valuation of assets/liabilities. (The present regulatory provision, broadly, is that fair value/market value need not be adopted as the basis for valuing a major part of the balance-sheet). But it is quite likely that some banks internally carry out more comprehensive (simulated) exercises which dynamically measure the worth of their equity.

The real, long-term key for investments in banking stocks will be identifying those companies which have initiated such comprehensive valuation programmes to measure the economic worth of their assets/liabilities. As on date, disclosure in public documents of the existence of such internal programmes is not mandatory.

More informed analysis and assessment of equity valuations in the banking sector will, therefore, have to wait for some more time.

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