The average P/E of the banking sector dropped from 27 to13 in nine months. At one end, there are PSUs with low PEs, whereas private banks trade at above 20. It’s time for convergence.
Rumours about ICICI Bank going bust due to the supposed exposure of its UK subsidiary to the US crisis spread like wildfire last week. At one stage, long queues outside ATMs (especially in Hyderabad) were matched by a huge spike in Google searches for “ICICI bankrupt”. Things cooled off only after confidence-building statements by the RBI and the finance minister.
Even the soundest of banks are heavily leveraged. No bank is likely to hold much more than the statutory 9 per cent cash reserve ratio. Therefore, if depositors want just a small proportion of their money back, a run is guaranteed. At such moments, rumours spiral out of proportion. If an ATM runs out of cash at such an instant, something that happens even on normal days, people panic.
ICICI suffered a run in Gujarat in 2003. However, that didn’t lead to excessive selling pressure on the stock market. This time around, the fears that somehow, ICICI was deeply enmeshed in Lehman Brothers’ collapse led to a sharper fall.
Indian banking has always suffered from uncertainties. This is mainly because under-regulated cooperative banks go under on a regular basis. Contagion from there is a trigger for trouble across the board. Both the 1992 and 2000 scams involved Coops at the root. Co-ops are under-supervised due to their political sensitivity and hence, they are unlikely to be cleaned up. There is resistance to these institutions being strictly-regulated.
RBI maintains more controls and better surveillance on scheduled commercial banks. When SCBs have imploded, it’s never been uncontrollable. In cases like Global Trust and Centurion, the weak institutions were merged without panic.
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However, RBI will probably have to exercise its regulatory expertise several times in the next fiscal year. Defaults are bound to rise as the business environment gets tougher. There may be further consolidations and mergers as a result. Investors will have to cherry pick the sector, seeking winners.
The past four years saw a boom led by unprecedented GDP growth. It was driven in part by low interest rates in the first genuinely deregulated credit cycle since 1969. Given liberty to set their own rates, banks entered retail financing and offered popular floating rate loans. Many set up a wide range of financial services and offered products such as insurance, mutual funds and securities trading, through subsidiaries. This led to major boosts in fee-based incomes. NPAs dropped.
We are now on the flip side of the business cycle. Rates may peak out soon enough but demand for credit is still dropping. Industrial NPAs are rising. Retail debtors have been hit very hard by rising floating rates and are struggling to service higher EMIs. Businesses that took on cheap debt to fund expansions may now find it difficult to maintain profitability. Defaults have risen in credit card debt, and in personal loans and home loans. This trend may continue.
The chances are, the banking sector will see lower valuations until the cycle and interest rates bottom. In addition, many banks will need to raise Tier I capital over the next couple of years to conform to Basel II norms. That may mean equity dilution and downwards pressure.
Banking is a proxy for the entire economy but it is a high-beta proxy. The Bank Nifty has already dropped from a high of 10,775 in mid-January to a July low of 4,635 – that’s a retraction of 57 per cent and much more than the Nifty’s loss of 40 per cent. The average PE of the banking sector has dropped from 27+ in January to 13 in October.
But there is a caste system in bank valuations. At one end, there are the PSUs such as SBI (10.5), PNB (6.8) and Bank of Baroda (7) – these usually trade at single-digit PEs. Meanwhile private banks like Axis (24), HDFC Bank (33) and ICICI (18) generally trade at above PE 20.
The differences in quality of balance sheets and growth rates are nowhere near as extreme as the valuation differences suggest. The “privates” are also more exposed than the PSUs to the vagaries of default. The valuation differentials should converge. We may see a scenario where profitable PSU banks maintain their price lines while the highly valued private banking sector continues to see price declines.