Manas Chakravarty: Banks don't join the party

This is the time to separate strong banks from the weak

While India Inc celebrates yet another quarter of spectacular results, much of the banking sector has been conspicuously absent from the party.

Most banks have turned in third quarter results that showed either weak or negative growth on a year-on-year comparison. A couple of banks "" Syndicate Bank and Bank of Maharashtra "" have even shown losses.

To be sure, there have been honourable exceptions such as State Bank of India (SBI) and HDFC Bank, but good results have been few and far between.
 

Q3 RESULTS
YEAR-ON-YEAR PERCENTAGE GROWTH IN:
	NII	OP	NP
ALLAHABAD BANK	38	0	62
ANDHRA BANK	-10	-9	-23
BANK OF INDIA	4	-29	-67
CANARA BANK	7	-11	-26
CORPORATION BANK	3	39	43
INDIAN OVERSEAS BANK	14	-3	14
UCO BANK	22	30	-59
SYNDICATE BANK	21	3	LOSS
UNION BANK	28	11	-61
VIJAYA BANK	6	-20	-49
SBI	32	88	20
PNB	17	-24	21
BANK OF MAHARASHTRA	6	LOSS	LOSS
UTI BANK	26	-1	35
HDFC BANK	23	36	31
ICICI BANK	43	13	18

That's not really what was expected. Of course, it was well-known that banks had to provide for depreciation on their securities portfolio because of the rise in interest rates, and everybody knew that profits on sale of investments would be scarce.

But that's an old story, and more recently, there had been more positive hopes for the sector.

Market expectations

There were several reasons for the optimism. First, bank credit growth has been exceptional, the highest in a decade. Banks had also raised interest rates on housing loans "" all this would lead to growth in interest income.

And while deposit rates too have risen, the rise in lending rates applies to all loans, while the higher deposit rates are applicable only to new deposits.

Profits were also supposed to be boosted by the fact that bond yields did not move up much during the quarter, and the depreciation on the securities portfolio was much less than in Q2.

Moreover, with the economy continuing to improve, the non-performing assets (NPA) position was not expected to get any worse, which means that the burden of provisioning too would be lower.

This rather cheerful view of bank performance was widely endorsed by the stock market, with bank stocks running up smartly during the last quarter of 2004.

The BSE Bankex hit an all-time high of 3,657 on January 5, possibly in anticipation of good results. The Bankex has handsomely outperformed the Sensex in the past one year, rising by 21 per cent compared to the Sensex's 9 per cent.

Surprisingly, however, in spite of the less-than-stellar financial results, the Bankex has continued to move in tandem with the broader index, losing just 2.5 per cent in the past month, compared to a loss of 2.2 per cent in the Sensex.

It's not too difficult to guess the reason "" Dalal Street believes the reason why some banks haven't done well is because of the one-time hit they've taken by shifting their gilts portfolio to the "Held to Maturity" (HTM) segment.

The implication is that, once they've insulated the major part of their portfolio from any upward movement in interest rates, the positive factors mentioned above will kick in.

What's more, bank valuations are still low, and the government has fanned expectations of allowing higher foreign stakes on the one hand, and of consolidation on the other.

But is that story valid? There's little doubt that one big reason for the dent in bank bottomlines has been the hit that banks have taken by marking their securities to market.

Banks like Union Bank of India, UCO Bank, Bank of Maharashtra and Syndicate Bank have seen their bottomlines crumble on this account. The consolation is that this is a one-time provision, and a bank that has already shifted its securities to the HTM category will soar, phoenix-like, in the next quarter.

That's precisely what happened to UTI Bank, for instance "" it performed miserably in Q2, because of shifting its portfolio to the HTM category, and, rid of that burden, has performed creditably in Q3.

Net interest income

Meanwhile, we should expect banks' core income to pick up substantially, thanks to the record growth in credit. A look at the accompanying table, however, shows a rather mixed picture.

While some banks have seen their net interest income rise sharply, on a y-o-y basis, others have posted growth in the low single digits. One reason is that several banks have sold off their investments, and as a result, their interest earnings on investment have dropped.

Corporation Bank, whose net interest income grew just 3 per cent y-o-y, despite a 39 per cent increase in its credit book, is a prime example, with total interest earned being actually lower than a year ago.

Moreover, its not enough just to increase interest earned "" interest costs have also to be kept down. At Andhra Bank, for instance, interest expended as a percentage of interest earned went up from 53 per cent in Q3 of FY 04 to 57 per cent in Q3 of FY 05.

Bank of Maharashtra and Syndicate Bank are other banks that have seen this squeeze in margin.

Except for Andhra Bank, whose interest from advances has fallen, all the banks in the sample have shown a y-o-y rise in net interest margins. That picture changes, however, if we compare Q3 net interest margins with those of the previous quarter.

Andhra Bank, Corporation Bank, Syndicate Bank and Bank of Maharashtra all show a sequential decline in net interest income. Interest expended as a percentage of interest earned has increased sequentially for all these banks.

The implication is that not every bank has been able to grow its interest earnings rapidly enough to offset rising deposit costs.

Operating profits

The second column of the table shows that while banks have in general been able to increase net interest income on a y-o-y basis, quite a few have shown negative growth in operating profit.

That's easy to understand, because operating profits include profits on sale of investments, which have been very little in the last quarter.

In other words, the banks that show negative growth in operating profits are those that have not been able to grow their core business enough to offset the lower income from treasury.

Corporation Bank was one of the exceptions, its income from sale of investments being very strong in Q3, FY 05. That enabled it to show 39 per cent growth in operating profits, despite a marginal 3 per cent rise in net interest income.

(Bank of Maharashtra's operating loss is also unique, because it chose to take the hit on its transfer of securities to HTM as an operating expense, instead of adding to provisions, as most banks have done. If it had done the latter, its operating profits would be in the black, although its net loss would remain unchanged).

Net profits

Finally, many banks have been able to lower their provisioning, thanks either to already having shifted a part of their portfolio to the HTM category in the earlier quarter, or because their NPAs have come down and they no longer need to make large provisions.

This is exactly what has happened in the case of Indian Overseas Bank and Corporation Bank, for instance.

SBI, however, made substantially larger provisions, both for depreciation in investments as well as for NPAs, which is partly why its net profit growth is so much lower than its growth at the operating level.

(The other reason is low tax provisions in Q3 of the previous year). Note that Allahabad Bank's large growth in net profits is entirely on account of a write-back of tax.

Private sector banks faced the same problems as the public sector ones. HDFC Bank's interest expended as the percentage of interest earned went up from 42.8 per cent in Q2 to 43.5 per cent in Q3, indicating a slight squeeze in margins.

Higher expenses dragged down UTI Bank's operating profits. Federal Bank's provisions and contingencies increased, lowering net profits by 66 per cent y-o-y.

The saving grace is that NPAs continue to come down. However, net NPA percentages went up in Andhra Bank on a y-o-y basis, while they are higher than at the end of the second quarter at Union Bank and Bank of Maharashtra.

In sum, most banks have not been able to grow their core business strongly enough to offset the loss of treasury income. Others have been hit by rising deposit rates.

The worry is that this has happened over a period during which banks have had record credit growth, and interest rates have remained relatively benign, which means that the picture may not improve much going forward

At the same time, banks like SBI and ICICI Bank have done very well indeed. In short, the time when a rising tide lifted all boats for the banking sector is history.

And as Warren Buffet once remarked, it's when the tide goes out that you realise who's been swimming naked.