The Hindu Business Line : Banking stocks: The consolidation call

Consolidation in the banking space is likely to gather momentum in the coming years. Despite stiff resistance from certain segments, consolidation holds the key to future growth.

Banking sector stocks have been the laggards, hardly participating in the extended bull-market over the last year. This is reflected in the BSE Bankex under-performing the benchmark Sensex by about 40 per cent. Stocks of public sector banks (PSBs), in particular, have remained weak, while their private sector counterparts have outperformed the former by a marginal 5-8 per cent.

The sector, which saw heightened interest at the start of the bull run in the second half of 2002-03 and kept the momentum high the following 12-15 months, has over the last year or so, seen little investor fancy, as is reflected in the lower multiples at which current earnings are capitalised. What are the reasons for this underperformance?

Waning investor fancy

Such an underperformance may be attributed to several factors, including the lack of pricing power and the re-investment of retirement proceeds of high-yielding bonds into securities offering lower yields then prevailing.

Intensifying competition among banks, too, has had its impact on net interest margins (the gap between the interest earned on loans and that paid on deposits), which have remained under pressure over the last few quarters.

The declining market share of the largest bank, State Bank of India (standalone), from over 19 per cent a few years ago to 17 per cent now is a clear indication of shrinking pricing power.

This had resulted in banks lending at rates that are at a discount of about 300-400 basis points to benchmark prime lending rates.

This scenario is, however, changing now as rising cost pressures have forced bankers to trim discounts on corporate loans. This, coupled with the hardening of interest rates, had led to banks booking losses on treasury operations.

As many as 50 per cent of the banking stocks are today quoting at a discount to their book values. While this does not necessarily mean they are all undervalued, it does show that the impact of interest rate hike — a key risk in the near term — has been factored into many of their stock prices.

The bond portfolios of a large number of banks are still not completely insulated, with nearly 40 per cent of the portfolio being designated as `available for sale'.

What this means is that any increase in the interest rate could result in the erosion of the portfolio value and tell on the financial performance of the banking sector.

Stable outlook

The last two years saw the loan books of Indian banks grow at a CAGR (compounded annual growth rate) of 31 per cent, making it the longest credit cycle in the last 35 years. What is more important is that over 75 per cent of this growth has come from riskier asset classes such as retail and SMEs (small and medium enterprises).

Even more worrisome is the fact that for most banks over 60 per cent of their outstanding loans have been created over the last two years. Thus, banks have not had an extended history of satisfactory credit performance of their borrowers in respect of a chunk of their loan portfolio.

This is more so in private sector outfits such as ICICI Bank, Yes Bank and HDFC Bank whose loan books have grown at a scorching pace. These banks are likely to be exposed to greater risk if credit quality deteriorates. In such a scenario, the pace of recoveries would hold the key in ensuring stability in the banks' income. HDFC Bank, which has a larger proportion of secured mortgages compared to the other two, is likely to fare better in such a scenario.

Volume growth is likely to remain strong, ensuring stability in revenues. A change is also expected in the asset composition of banks, with a higher share of farm credit followed by infrastructure lending.

Banks with insurance operations are likely to derive much of their value from this business. The contribution of the insurance business to total revenues for banks such as Kotak Mahindra, SBI and ICICI is expected to grow at a faster rate on the back of rich prospects in the sector. This is likely to improve stock valuations and unlock value for investors.

Proposed amendments to the SBI (Subsidiaries Banks) Act is likely to be a positive for both SBI and its subsidiaries. This move can help SBI reduce its stake in subsidiaries and generate funds that can be used as capital. For subsidiaries, the stock-split would make the counters more liquid and improve their valuations.

The consolidation mantra

Consolidation in the banking space, which has been on the counter over the last year or so, is likely to gather momentum in the coming years. Post April 2009, when the restrictions on operations of foreign banks will go, the banking landscape is expected to change dramatically. Foreign banks, which currently account for five per cent of total deposits and eight per cent of total advances, are devising new business models to capture the Indian market. Their full-fledged entry is expected to transform the business of banking in many ways, which would be reflected in terms of greater breadth of products, depth in delivery channels and efficiency in operations.

Thus Indian banks have less than three years to consolidate their position. Despite the stiff resistance from certain segments, consolidation holds the key to future growth.

This view is underpinned by the following: One, owing to greater scale and size, consolidation can help save costs and improve operational efficiency.

Two, banks will also have to explore different avenues for raising capital to meet norms under Basel-II, which will come into force from March 31, 2007. With the estimated capital infusion for banks pegged at Rs 42,000 crore by March 2010, consolidation is likely to be the superior alternative for banks to shore up their capital base.

Three, owing to the diversified operations and credit profiles of merging banks, consolidation is likely to serve as a risk-mitigation exercise as much as a growth engine.

Though there is no confirmation yet, speculative signals arising from the market point to the prospect of consolidation involving banks such as Union Bank of India, Bank of India, Bank of Baroda, Dena Bank, State Bank of Patiala, and Punjab and Sind Bank. Further, the case for merger between stronger banks has also gained ground — a clear deviation from the past when only weak banks were thrust on stronger banks. There is a case being made for mergers between banks with a distinct geographical presence coming together to leverage their respective strengths.

Regulatory changes

The RBI's approval for banks to raise funds abroad through innovative capital instruments holds great significance. Such fund-raising, which includes preference shares, will, however, not just substitute equity; it could have unintended consequences on the strategies of banks and their profitability.While the cost of raising monies through such instruments is likely to be higher (close to 10 per cent), the consequent higher leverage on equity funds is likely to result in expansion of return on net worth. This is because the same amount of capital supports a higher volume of business, generating higher profits. And 10 per cent is a significantly high rate.

Banks are likely to be able to raise long-term preference shares at coupon rates between six per cent and eight per cent. The positive impact on bank profitability could thus be significant.

Another consequence is on the consolidation front. Preference capital can be used as the currency for acquisition. The advantage for public sector banks is that they no longer need to bother about government stake falling below 51 per cent. Banks such as Dena Bank, Oriental Bank of Commerce and Andhra Bank are most likely to benefit from this move.

Public banks can now think of acquiring old private sector banks. At the same time, smaller or weaker banks may also find it easier to access capital through the preference capital route. They will no longer need to consider M&A as the only option for survival. Thus, the costs of acquisition could go up too for larger banks.

Preferred picks

Select stocks hold the potential to deliver attractive returns over the next one or two years. Allahabad Bank, Indian Overseas Bank, Centurion Bank of Punjab and UTI Bank were recently recommended in these columns.

Our other preferred picks are Union Bank, ICICI Bank and HDFC Bank. We, however, recommend that investors take exposure in small lots and expect moderate returns on the back of near-term volatility in the market.