The Hindu Business Line : What is behind the valuations

Issues such as regulatory prescriptions, asset valuation (investment portfolio) norms, the stance of central bank monetary policy and the way it affects the dynamic management of bank balance-sheets, all have an impact on the performance of bank stocks. Here's a detailed look at each of these factors.

One of the prominent industry groups driving, and even exceeding, the overall market rise of the past year is the banking sector. The NSE's index of bank stocks was up 30 per cent over the last year compared to the 17-18 per cent gain by the broad index. Sectoral valuations have been supported solidly by the performance of index majors ICICI Bank and HDFC Bank. Both stocks have risen handsomely — around 45 per cent and 30 per cent respectively.

With the overall market at, or close to, all-time highs and the broad economy on a fairly strong footing but expected to slow moderately, it is worth studying the investment prospects in banking stocks at this juncture.

An overall assessment indicates that the way each bank handles sector-specific issues will, as always, continue to exert significant influence on valuations. The rising tide may surely lift all boats but the star performers could be those that better manage sector-specific issues. Equally, the impact of any broad market fall may well be limited for those companies that handle such smartly.

The sector-specific issues include regulatory prescriptions, such as those on capital adequacy, asset valuation (investment portfolio) norms, the stance of central bank monetary policy and how this impacts the dynamic management of bank balance-sheets.

All the above-mentioned factors will impact banks' earnings performance significantly. Also to be reckoned with is the opening up of the sector to increased competition from foreign banks from 2009, though this will have more of a medium-term impact.

Periodic Capital Dilution

Valuations may be impacted significantly on an on-going basis by the capital raising programmes of banks. The knee-jerk fall in ICICI Bank shares following the company's recent announcement of a Rs 20,000-crore capital issue plan is a case in point. Though only an immediate reaction to the size of the proposed offer, the fall nevertheless indicated the market's distaste for capital dilution.

Investors have to note here that banking is probably the only industry where there is an official mandate on the level of capital needed to support the balance-sheet. In other words, the degree of leveraging is officially prescribed (approximately 10:1), unlike in other sectors. Given that leveraging in banking is much higher than in other sectors, given the very nature of the business, a regulatory requirement on the level of capital should, in fact, be welcomed.

All banks in India will migrate to the latest international capital standards, Basel II, by March 2009, while those banks with operational presence outside India have to comply with the standards even from March 2008. Broadly, the Basel II standard calls for capital to be maintained for risks not covered under Basel I.

Periodic capital market forays may be necessary for companies with aggressive balance-sheet expansion plans. A growth rate of 30 per cent means that risk-weighted assets will double every two-and-a-half years. Capital has to increase correspondingly.

With high dividend payouts and a cap on the amount of hybrid capital that can be raised, periodical equity issues may become quite normal. Investors in this scenario have to look at how well the assets created by the capital infusions/subsequent leveraging are earning. In other words, look at the overall profitability of the assets and do not be unduly bothered by any proposed capital issue.

Asset Valuation Norms

One of the key factors that could impact the earnings performance of banks could be the method of valuation of their investment portfolios. As of now, banks have generally benefited from the stipulation that 25 per cent of their demand and time liabilities invested in government securities need not be marked to market to show any fall in value.

This is a subtle but significant variation over the earlier stipulation (up to September 2004) that mark-to-market valuation could be avoided for a maximum 25 per cent of the investments portfolio. Since most banks in the system are maintaining their overall securities portfolios at, or slightly above, the mandated 25 per cent minimum, provisioning requirements in the last financial year have not been significant.

The provisioning burden was also mitigated by the fact that the sovereign yield curve had not steepened too much (only by around 40 bps for 10 years) by the close of the financial year, despite the multiple rate hikes put through by the Reserve Bank of India during the course of the financial year. Overall, lower portfolio duration and a smaller interest rate shock than in earlier years have both contributed to lower provisioning.

The important question here, though, is if banks will continue to take shelter under the 25 per cent non-market valuation norm. A willingness to subject a greater part of the investments portfolio to market valuation (as is being done even now by some banks) could work both ways — that is, both valuation gains and losses are possible under that scenario. In other words, more earnings volatility on account of the methods adopted for investment assets valuation should be watched out for.

Monetary Policy Stance

FY07 provided tell-tale evidence of the impact the central bank's monetary policy moves have on the earnings performance of financial institutions. The interest rate policy of the central bank is a key factor influencing banking companies' performance. All the more so when interest rate moves are packed into a shorter time-frame than expected by the market. Some of the biggest banks have, in varying degrees, felt the impact of rising interest rates on their bottomlines in the past half year.

This is a system-wide issue calling for an assessment of interest rate volatility. More intensive central bank watching is needed for clues on where RBI policy is headed. This will enable quick-footed responses in balance-sheet management to avoid or mitigate the impact of market-wide adverse factors. As is obvious, this is a qualitative phenomenon with definite quantitative implications.

Banks with a good share of non-interest income in total income may be able to better weather the earnings pressure caused by sharp interest rate moves by the central bank. The market could also place higher valuations on those banks with higher margin businesses in the overall credit portfolio — some segments of the retail portfolio such as credit cards, personal loans, consumer loans being cases in point.

In effect, banks have to go beyond the core deposit-taking and lending activities and position themselves to offer a range of non-fund based products and services. This will encompass both non-fund-based banking products, such as letters of credit/guarantees, which will be an off-shoot of the main lending activity, but pure financial services as well — for instance, distribution of financial products such as mutual funds and insurance, syndication of capital market issues, and the like.

Overall Prospects

At around 50 per cent of the country's GDP, (18 lakh crore out of 35 lakh crore) the level of bank assets (credit) as a share of GDP is still much below the levels in other countries that have experienced rapid economic growth. In Korea, for instance, this ratio is well above 100 per cent. This ratio is bound to go up as an expanding economy draws in more bank finance. Even with growing markets, which can provide risk-capital (equity) and also easier access to overseas funding, the bank loan market will continue to be a critical financing vehicle in the economy.

Looked at this way, business growth prospects for banks are assured. The key factors to watch out will be quality and consistency of earnings, the expertise banks build in economic analysis and forecasting (including central bank watching), and risk-management skills, which are necessary to function profitably in today's complex financial markets. With technology bridging the gap in many ways on the manpower and distribution-reach fronts, the soft-skills listed above could play a crucial role in affecting the earnings performance of banks on an on-going basis.

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