Happy festivities to you and family!
On this auspicious occasion do get started with something that has always been on your wish list, something that is important to you but not urgent. Because that’s the category we tend to ignore until something gives.
The data points emerging from the domestic economy have been very encouraging. Credit growth, deposit growth, GST collections, private capex order announcements, order book of economy facing businesses all look good. The macro environment continues to have challenges but our sense is that things may start getting more tolerable by the end of this CY. Narratives may become more conducive for good quality growth assets, if not speculative ones.
Capacity utilization continues to trend higher, credit growth is finally hitting the 15% YoY range while corporate India finally has hygienic leverage and NPA levels. Behemoths like HDFC Bank growing advances at 23%+ YoY augurs well for the overall scheme of things, even if the FY22 base was a tad lower. Credit to Deposit ratio for scheduled commercial banks is at 72% from 76% in 2020, gross NPA ratio is at its lowest since 2015 while net NPA ratio is at lowest since 2012. One should expect credit growth to pick up over the next few quarters. Would encourage you to glance through the data on the RBI database every once in a while, this is a treasure trove of data on banking and the economy.
On that note, a few thoughts on how we view banks in India. A longer read this time around compared to previous newsletters
Banking is primarily a balance sheet business. You start with a net worth, get deposits or borrow from a variety of sources and lend that money out at leverage into a combination of loans at a healthy spread. All the while ensuring RBI guidelines on liquidity & assured safety of minimal amount of capital. In a nutshell this is the business of lending. Over a period of time you also figure out how to sweat existing the customer base through non fund based activities like transaction banking, fee generating products like cards, payments, mutual funds, insurance and others. These lines do not have a cost of capital attached, instead they need upfront and recurring opex in the form of technology spends and people.
The key pieces of the puzzle in banking thus are the ability to borrow funds at a hygienic cost (branch network, brand name, safety, access to capital markets), well managed lending practices (diversified risk, pricing risk well, walking away from risky deals) and running cross selling (people & systems) efficiently. The third part is often given the least importance by many analysts since this cannot be quantified in an excel model. Cross selling is brutal business, walk into the 9 AM huddle at any large branch in a top 5 private sector bank and see the fireworks for yourself.
The questions we ask ourselves on this aspect are –
What is the primary customer segment of the bank? A Bandhan Bank has a very different base from an IndusInd Bank. An SFB works with a different profile of customers compared to a private scheduled commercial bank
How well does the credit engine work in tandem with this? Ideally a bank should onboard a customer through the liabilities route than the credit route, unless the lending is for less risky assets
Is the bank able to facilitate an inclusive, professional & cosmopolitan culture where an employee of any background can work hard and grow?
The last point above is a key one. Imagine being a north Indian branch manager in a bank where most internal meetings are conducted in a south Indian language. Now go back to all the banks that were touted as the “next big thing” in 2010, not many could make the transition from being an efficient regional bank to a pan India bank. These banks have minimal presence in areas like wealth management where one deals with cosmopolitan, urban customers who are demanding.
This is just one example, it takes many more cultural aspects to become a pan India bank and to put in place systems for the bank to growth deposits and assets at 15% p.a. over 10 years. All the while maintaining a contemporary, vibrant culture that can attract urban customers. For all the talk about multi year growth in India, money is clustered primarily in the urban centers; Mumbai alone accounts for > 40% of the MF AUM. If you don’t get the brand image and culture right, it is almost impossible to become a pan India bank. Unless you can become a pan India bank, the market is unlikely to value you at a healthy market cap. Some south India based lenders have excellent credit culture but they struggle to grow outside their home markets.
Efficiency without a respectable amount of scale is rarely valued well.
Well managed credit and healthy growth aren’t easy to pull off at the same time, during the journey some mistakes will be made. Even top 5 banks like ICICI bank, Axis Bank have made mistakes in previous cycles. If the bank manages to generate a ROE of 15%, it usually means it can growth advances at a healthy rate without needing to dilute equity to fund growth. Any accretion to the net worth can be levered up many times and lent out at a healthy spread. Any depletion in net worth compromises the bank’s ability to grow over the near term and may also lead to equity dilution, a double whammy for investors. Which is why the market values banks on price to estimated book rather than any other methodology, what remains as book value after adjusting for credit quality is what can be levered and lent out as assets at a healthy spread over the cost of capital.
Fairly basic stuff but the intricate unit economics workings don’t get their due as many investors focus on superficial ratios rather than estimating how the ratios can change materially 12-18 months from now. Alpha is generated in catching a transition right, buying and holding a proven business will net you a steady 12-15% return p.a. so long as you don’t screw up on the entry valuation. One also needs to be aware of what levers can tweak RoA and RoE going forward, any one with internet access can tell you what the historical numbers are. Think of culture, customer segments, cross selling, operating leverage in addition to risk management and credit quality.
For this reason, investor return from the banking sector has been cyclical. Every 8-10 years we have a macro event impacting the asset quality, and then you have business specific mistakes and events. Very important to play the cycle right in banking in our opinion, easier said than done but worth a try after doing the work.