Note: This is follow-on report on Banking Sector Outlook of 12th September 2020 with buy & hold recommendation – it has been good gains on market cap of index stocks with better Price to Book value, since then.
Woes from NBFC crisis and its worst impact on the banking sector in 2019-2020 is seen to be behind from gaining speed on consolidation
It’s obvious that optimism on the economy is built on strong foundation of the banking sector. This got reflected in the economy from falling FY20 GDP growth momentum below 5% and overshoot in fiscal deficit beyond FRBM tolerance point of 3.5% of GDP when into banking sector crisis in 2019. Most banks got into struggle for capital & operating profit – hit by rising credit costs, pushing lending operations to back seat. Most banks didn’t have bandwidth to lend to economic & systemic important sectors that got majorly hit by NBFC crisis – infrastructure, real estate sectors etc., and those few with muscles to absorb risk didn’t have the desired credit appetite – playing conservative & safe game. The ball was pushed to Mint Street and North Block with SOS cries!
First, Government recognised the need for recapitalisation of PSU banks, but opted for going for consolidation to reduce headcount, which is down from 27 to 12 during 2017-2020. The agenda was to infuse capital only to those banks that have high probability of success. It’s also obvious that participation from PSU banks need to be very significant to strengthen the banking sector for credit support to the economy for output expansion and employment generation. I will leave this point here with belief that work-in-progress is at good speed on recapitalisation and upgrade of compliance & governance standards in PSU banks to ensure that 3 pillars of productivity, profitability and efficiency are restored to emerge at par standards with peer private banks.
The headcount of private sector banks in universal bank category is 22 as of end March 2020 with mix of new generation banks (licensed after 1991 economic liberalisation) and old generation banks, which are regional & boutique in nature despite being in universal banking category. GOI & RBI had tough time in managing failures and compelled to bring in PSU banks for resolution. Thankfully, this process at the expense of exchequer & taxpayers monies has come to an end, making (Tier 1) equity investors & Tier 2 (bond holders) to do the sacrifice to extent of balancing the weight of liabilities to realisable value of assets & value of the operating infrastructure.
Game changer moves from RBI Governor Mr.Das with blend of innovation and courage to bite the bullet
The first stroke of SBI-YES Bank reconstruction invited lot of criticism as most couldn’t see the logic, rationale and higher probability of success behind this move. The reconstruction deal made Tier-1 equity investors to take the sacrifice from dilution of value to ₹10 (of face value ₹2) while completely writing off AT-1 (perpetual) bond investors. This action of preferential treatment to equity holders got debated at length, but RBI went by the rules – terms of subscription of AT-1 bonds. The initial success of this transaction is from removal of trust deficit from depositors & creditors, turnaround in financial performance and improvement in balance sheet – all combined, stability in stock price at 12-15 (above the follow-on issue price of ₹12) and looking good for more!
Now, the second shot of DBS-LVB transaction is of different kind – merger with an unlisted bank and newcomer as an universal bank having launched its WOS behind SBM Bank. In this transaction the sacrifice got extended – Tier 1 capital written down to zero and so is Tier-2 bond listings. The sacrifice terms is worse than SBI-YES, but couldn’t be helped when the size is small and the hole is big. I am sure it’s win-win for DBS and depositors & employees of LVB. What’s in it for DBS? It’s an inorganic option to expand presence in South India where the regional connect is high with Singapore. Beyond increase in branch headcount, I do not see great value for DBS from acquisition of LVB’s operating infrastructure – technology, products & services and manpower.
What’s the take-away for stakeholders of the banking sector?
It’s fair that the intent of RBI is to protect the interest of depositors to cut emergence of trust deficit at the bud before getting blown up as systemic issue. The next is to avoid capacity contraction from closure of branches and loss of employment, both directly & indirectly contribute revenues to exchequer. While it provides good comfort to depositors, employees and the Government, it’s not correct to stay complacent, given that the sacrifice can extend beyond Tier 1 & 2 if such instances arises and the hole gets bigger. It’s also caution to smaller banks with market cap of below ₹10000 Crores to avoid high risk – high reward play & over indulgence in unsecured lending.
While Government has cut PSU banks headcount to 12 and likely to consolidate into single-digit during 2021-2024, private banks (in universal banking category) also needs consolidation when boutique category has emerged in the form of Payment Banks and Small Finance Banks, and products specific asset-finance NBFCs. It’s important for UBs to have reasonable balance sheet size and good valuation for capital raising efficiency. Now, only 6 private banks have market cap of over ₹50000 Crores, and consolidation phase need to be led by the 6+1 top-quartile banks (HDFC/Kotak/ICICI/Axis/IndusInd/Bandhan and DBS) to position private sector banks to complement with public sector banks which is poised for accelerating performance in this decade.
While the emerging reconstruction model is the way to go, the success depends on post-acquisition execution having acquired without financial sacrifice. It’s kind of good feel for yours truly that similar kind of deals was executed by SBM Holdings of Mauritius in 2017-2018 in its Kenya foray. First, acquisition of Fidelity Commercial Bank for launch of SBM Bank (Kenya) Limited writing down Tier-1 investments to $1 and absorbing branches, employees and operating infrastructure. Second is mix of financial & operating structure transaction where “bad bank” was left behind with Chase Bank under Liquidation and “good bank” was acquired by SBM Kenya along with most branches, F&P employees, technology and products & services. The pain point for depositors was from sacrifice of 25% of outstanding deposits which is left behind with bad bank. Kenya Central Bank did participate in both transactions retaining the liquidity support for certain period of time in alignment with post-acquisition profitability projections. The biggest difference here is that RBI’s financial sacrifice in these first of its kind transactions (after Centurion Banks transaction of 2002-2003) is zero and limited to that of an investment banker while keeping the transaction good for acceptance to the suitor. It’s job well done which should pave way for consolidation on its own giving priority to continuity & sustainability rather than staying in the race!
Conclusion:
Resolutions of Universal Banks (both public & private) and getting them ready & effective for economic capacity & output expansion is the priority with focus on robust balance sheet, adequate capital and desired credit appetite. While there’s better comfort on bottom-line efficiency, top-line growth will get visible in Q4/FY21 before gaining speed in FY22. The beneficiaries will be the leaders in the upper-half, who shall gain value from now on. The zoom-in focus is lit on SBI, PNB, BOB, BOI, UBI and Canara Bank in the public sector category and HDFC, ICICI, Axis, Kotak, IndusInd and Bandhan Bank in the private sector category, all positioned as suitors in the game of consolidation. Recovery of valuation of banking sector that began in the second fortnight of September 2020 shall remain in force building momentum from start of 2021. It’s tough to set targets, but 52 week & all-time high is pulled into the radar!
Good luck for the great run!
Moses Harding
