BT500: Banking's Mid-sized Problem

banking is very good business if you don’t do anything dumb,” advised fabled investor Warren Buffett, who knows a thing or two about making money in the stock market. Yet, history is laced with innumerable anecdotes of banks’ dumbness and their eventual fading into obscurity. Globally, hundreds of banks failed after the global financial crisis as they took risky bets in subprime customers. More recently, three Indian banks—PMC Bank, YES Bank and Lakshmi Vilas Bank—went belly up as their corporate borrowers defaulted on loans. In the banking business, it doesn’t require rocket science to mobilise low-cost public deposits, write loans to retail and corporate borrowers, grow the loan book, and earn interest for customers as well as shareholders. But banks have often thrown conservatism out of the window and embraced high growth to build scale in the fastest possible time.

Barring HDFC Bank, which sits comfortably at the third position in the BT500 list for 2021, there are no role models in the banking business of sustaining growth in market capitalisation (mcap) year after year. The mcap position of some mid-sized banks, especially the promising names, has taken a big knock in the BT500 this year. The Hindujas-owned IndusInd Bank, which had witnessed a complete turnaround under former CEO Romesh Sobti’s tenure between 2008 and 2020, has seen its rank slip from 45th to 58th. RBL Bank, which is yet another story of transformation from being a regional player to a fast-growing pan-India bank, has seen its fortunes tumble from 209th to 245th rank. Bandhan Bank, which has seen the fastest scaling up from a microfinance institution (MFI) to a full-scale bank, fell by a steep 31 ranks to 77th position. The small finance banks have also disappointed investors. Bengaluru-based Ujjivan Small Finance Bank has seen a mass exit of independent directors and its MD & CEO, on the back of deterioration in asset quality post Covid-19. The bank slipped from 267th rank to 397th rank. What’s driving down the market valuations of mid-sized banks?

Anil Gupta, Vice President and Sector Head at credit rating agency ICRA, explains that the pain in the asset quality of mid-sized banks is higher because of the relatively higher share of self-employed borrowers and riskier loan segments as compared to large banks. “The cost of funds is also on the higher side,” he says. Kajal Gandhi, an analyst at ICICI Securities, says competition is also coming in from new-age fintech companies in the banking business. “Some of the retail segments like home loans are also very competitive where size, scale and cost of funds matter a lot. Unless you have a niche in the market or regional dominance, it is very difficult for any full-scale mid-sized bank to make a mark in the current challenging environment,” she explains (see Pain Points).

Yuvraj Choudhary, Research Analyst at Anand Rathi Securities, says retail and corporate depositors were worried as the failures of YES Bank and PMC Bank had hit the smaller banks hard. “Banking is a business of trust and goodwill. Today, a bulk of the depositors park their money in either public sector banks or big private banks because of the safety of capital despite low returns,” Choudhary says.

In the past two years, there has been an outflow of deposits from mid-sized banks. “It was not just retail money, but [also] corporate... Liquidity is also very important for the corporate sector,” says another banking analyst. Clearly, the higher cost of funds in the past had encouraged them to search for high-yield risky loans to earn margins. It also created asset-liability mismatches as withdrawal of such deposits post the YES Bank and PMC Bank debacles impacted them. Reflecting the uncertainty, investors started dumping many of these banking stocks as they feared lower growth going forward because of asset quality deterioration, provisioning pressure and higher cost of funds.

The banking industry’s woes had their origins in the global financial crisis. As economic growth slowed globally in the post-2008 period, banks’ credit growth started decelerating. Credit growth fell from 20 per cent plus in 2007-08 to less than half in 2014-15 (see Twin Trouble). Five years ago, the Reserve Bank of India’s (RBI) asset quality review unearthed the hidden non-performing assets (NPAs) in the banks’ books. The Insolvency and Bankruptcy Code also aggravated the banks’ problems as provisioning pressure increased, impacting profitability.

Sorbh Gupta, Fund Manager-Equity, Quantum Mutual Fund, says banking is a leveraged sector and needs a strong macro tailwind to do well. “Since the past few years, especially after the IL&FS crisis, as economic growth slowed, banks bore the brunt both in terms of deteriorating asset quality and credit growth, especially on the corporate side,” he says. Yuvraj Thakkar, MD of BP Wealth, says the collapse of some banks and non-banking financial companies (NBFCs) has made the banks’ creditors wary of funding them. “There was fear in the market,” says Thakkar. In fact, the banking industry entered the Covid-19 crisis with a very weak balance sheet. “Credit growth was at rock bottom and gross NPAs were very high,” says Ajit Mishra, VP-Research, Religare Broking.

A month before the nationwide lockdown, RBI Governor Shaktikanta Das had warned about the overhang of NPAs. “In view of subdued profitability and deleveraging by certain corporates, risk-averse banks have shifted their focus away from large infrastructure and industrial loans towards retail loans,” he had said, adding that this strategy, while helpful as a risk mitigation tool, had its own limitations. Das was right in his assessment as banks expanded the risky unsecured segment of retail loans, especially personal loans, credit cards, microfinance and consumer durables loans. The outbreak of Covid-19 further aggravated the woes of the banking system. Borrowers such as the self-employed, small businesses and MSMEs were impacted the most.

While the government and the RBI offered a loan moratorium, one-time loan restructuring, regulatory forbearances, and government guarantees on loans, the stress in the system is currently hidden. “There has been pressure on people’s livelihood and since the credit growth in the past few years has been driven by retail lending, it’s feared that banks could face asset quality pressure in that segment,” says Gupta of Quantum. He adds that the pandemic and ensuing lockdowns made the investors worried about the economic slowdown and possible wave of delinquencies. “Since the asset quality in most cases emerges after a lag (this lag becomes longer due to moratorium and restructuring windows) long-term investors tend to be a little more careful in investing in the sector after a macro shock,” he says.

Let’s now look at how some of the mid-sized banks are planning and strategising to come out of the current woes.

Indusind bank had seen a good turnaround since the management change in 2008 under Sobti. In the past couple of years, however, the bank faced stress in its corporate book, especially real estate and telecom. “The bank has a large book of MFI and vehicle finance, which was severely impacted due to the two Covid-19 waves, especially the collections,” says an analyst.

Continuing with Sobti’s strategy of a three-year business cycle, the bank, under his successor Sumant Kathpalia, started its fifth three-year cycle, 2020-2023, with the theme “scale with sustainability”. The new areas identified are affordable housing, supply chain, logistics and MNCs for working capital loans. The acquisition of MFI Bharat Financial some three years ago is also helping the bank expand in rural areas. “There is a huge opportunity on the merchant acquiring side of the business in rural areas,” Kathpalia told the investor community recently. In terms of existing businesses, the bank has ambitions to grow in the vehicle business. For instance, it is betting big on the LCV (light commercial vehicle) segment. It has ambitions to increase its LCV market share from 13-14 per cent to 20 per cent in the near future.

In its two-decade journey, Kolkata-headquartered Bandhan Bank started as an MFI, became an NBFC in 2006 and transformed into a full-scale bank in 2015. Investors lapped up its stock. But challenging political developments impacted its financial performance. The Covid-19 outbreak and lockdown further created uncertainly in the microfinance business. As the second Covid-19 wave has waned, the bank is witnessing substantial recovery in collections. Bandhan Bank seems to have cleaned up its NPAs by making provisions and booking a huge loss of Rs 3,008 crore in Q2 of FY2021-22. It has plans to tap the network of recently acquired affordable housing firm Gruh Finance to increase its share of mortgages. “We have envisaged diversifying our portfolio both in terms of products and geographies, for which we have already worked in that direction and expect the results soon,” said Bandhan Bank MD & CEO Chandra Shekhar Ghosh after the recent results, adding that the bank is confident of achieving its normal business growth very soon, if there is no third Covid-19 wave.

RBL Bank, which was facing asset quality issues in the corporate book before Covid-19, saw stress levels rising in its retail portfolio, especially micro retail and business borrowers, MSMEs, credit cards, etc. in the past two years. The bank is focussing on higher provisioning for stressed loans, cutting down corporate exposure, shifting lending to higher-rated companies, and growing retail CASA deposits. Its focus is also on mortgages, gold loans, and tractor and two-wheeler loans. The biggest negative for RBL is the one-year extension granted to MD & CEO Vishwavir Ahuja till next June instead of for three years. Investors fear a leadership risk as Ahuja not only built the management team, but also steered RBL from a regional non-entity to amongst the top mid-sized banks.

Bengaluru-based Ujjivan Small Finance Bank had a good run in the past 15 years, first as an MFI and then as a small finance bank. The Covid-19 outbreak exposed the business model of many small finance banks as a bulk of the portfolio was in unsecured micro loans. In the past year, the bank saw the mass exit of directors including MD & CEO Nitin Chugh. Its gross NPAs, together with restructured loans, crossed 15 per cent of total advances. The bank’s profitability has also taken a hit because of high provisioning. Meanwhile, it has set up a good foundation of digital transformation, but there are business challenges. Recently, its holding company, Ujjivan Financial Services, decided to merge the firm with the bank, which is its subsidiary. While this will help in meeting the RBI’s lower promoter stake guidelines, there will be integration challenges in the short term.

Clearly, the mid-sized banks are already on a course correction effort. The current phase is not the end of the road as financial services is a hugely under-penetrated market. It is just that a bad cycle, which started a decade ago, has resulted in asset quality deterioration. “Slow credit growth post-Covid-19 also gave an opportunity to many of these private banks to correct their liabilities structure by increasing their share of retail deposits,” says Gupta. Many banks are using this opportunity to focus on high-rated corporates, short-term working capital loans and niche segments where they have domain expertise. “We are seeing a trend of banks moving away from unsecured or high yield business to a more secured portfolio. This change is getting reflected in the margins, which are under pressure,” says Gaurav Jani, analyst at Centrum Institutional Equities.

However, margins will get protected if there are interest rate hikes in future. “We will be soon entering into a rate hike cycle. In a rising interest rate scenario, banks will benefit as the floating (or MCLR) interest rates in home- and other loans will be reset. Lending rates are always reset faster than deposit rates,” says Gandhi of ICICI Securities. Gupta of Quantum hopes that if the economic recovery continues and banking results improve in asset quality and credit growth, investor confidence will return and the sector’s performance will catch up with the broader indices.

Banking stocks will then probably get back to their stratospheric levels. But remember Buffett’s words: “Never invest in a business you cannot understand.” And this holds true for both bankers and investors.

@anandadhikari