Is the honeymoon with the stock markets over for banks?

ISSUE

Medium-term trend bleak

R C BETALA
Managing Director,
Betala Stock Broking Ltd

Indian banking sector has been in thick of action in recent times. The sector's significance lies in the fact that it reflects the health of the economy.

Moreover, banks have a key role in implementing government policies as well as ensuring efficient capital utilisation in the economic framework.

The sector has a pivotal role in industrial investments, mobilising savings and triggering consumption.

In conjunction with the spectacular performance of economy and corporate in FY 2003-04, the results for most of the banks have exceeded the expectations.

But current trends do not augur well for the sector in general and for public sector banks in particular in the short to medium term.

The high profitability of the banks in last one year was primarily driven by treasury income, which can not be taken as a benchmark because of its volatile nature.

The treasury income was primarily driven by falling interest rates and low level of inflation.

The last fiscal saw the lowest level of interest, which helped them increase the return on bonds.

Also low interest rates insured a healthy spread for banks, and afforded raising of capital at low cost.

With inflation topping 5 per cent and oil prices flaring up, raising capital at low rates such as 5.5 per cent will not be possible.

If the inflation rises further, which is likely to happen sooner than later, banks will find it a tough task to maintain the spread between their borrowing and lending rates.

Last fiscal, the 11.5 per cent lending rate encouraged most of the big industries to opt for much cheaper international loans in the form of foreign currency convertible bonds and external commercial borrowings.

Public sector banks are expected to remain distressed as the government is on course to reschedule bad loans to the agriculture sector and extend further credit.

This is going to cause public sector banks pain in the form of high non-performing loans in coming years.

In the last one year, public sector banks benefited from the bubbling stock market which helped them in raising capital in primary market to maintain their capital adequacy ratio.

Such banks will be hard-pressed to find means to maintain the capital adequacy ratio in order to meet the Reserve Bank of India norms, while extending increased credit to the agriculture sector.

The fallacy lies not in the fact that the agriculture sector has high bad loans compared with other sectors, but the difficulty is that the banks are being used by the government for a social cause and hence, completely ignores the economic viability of such moves.

In line with depressed capital market, the banking sector has also suffered an erosion in valuation in the last couple of months.

However, it seems unlikely that any possible upturn in sentiment in the stock market is going to lead to support to public sector bank shares.

Also, the low level of credit offtake is not a very healthy sign for the sector.

In all likelihood, the treasury operations for the bank will not be able to show high net profit for the current year

Moreover, rising inflation will exert further pressure to maintain the spread with very little support from international interest rates.

No reversal in 12 months

RAJAT RAJGARHIA
Head - Research,
Motilal Oswal Securities

The Indian banking sector has been on a re-rating path over the last couple of years. The factors that led to this re-rating were declining low interest rates, improvement in operational efficiency, lowering of non-performing loans and higher retail focus.

In the last few weeks, the stock prices have fallen by an average 30-40 per cent. While this fall was essentially led by the election results, which took investors by surprise, over-ownership of these stocks and weak sentiment towards all state-owned companies also contributed to the decline.

At this juncture, investors are concerned about the profitability of Indian banks going forward because of concerns of interest rates moving up and possibility of adverse the policies of the new government. But little has changed as far as the fundamentals of these banks are concerned.

While we believe that interest rates have bottomed out, we do not expect any major reversal over the next 12 months. The fear that the profitability of banks (especially public sector banks) is at risk due to a decline in investment gains is unwarranted.

Banks have enough cushion in the form of unrealised gains and investment fluctuation reserve to protect any rise up to 200 basis points.

Moreover, in a rising interest rate scenario, net interest margins of banks always tend to move up, as assets gets repriced at a faster pace than liabilities.

We believe that the intent of the government will be to create more lending opportunities for these banks.

This, in turn, could be a boon for banks as they will be able to redeploy the excess government bonds money into loans resulting in higher business income.

In the recently announced farm package, the finance minister has only proposed a growth of agricultural loans, leaving the pricing and risk assessment up to banks.

Most of the banks had seen a growth of over 20 per cent in their agricultural loans in FY2004, and given the good monsoons, a growth rate of 30 per cent looks realistic.

Some of the positives factors that had re-rated the stocks are on course and will result in will continue to benefit in form of higher earnings over the next couple of years. Indian banks have undertaken a significant restructuring over the last couple of years. They have used the bond gains to get rid of the legacy bad loans.

A successful rollout of the technology platform will ensure that banks will be able to bring down their operating expenses in the long run. Today, Punjab National bank has the largest network of branches under the core banking solution while the State Bank of India has the biggest ATM network in the country.

The kind of business opportunities that will be unleashed in the next 2-3 years will benefit banks with a very strong franchise and loyal customer base.

Overall, we believe that the structural changes in the last couple of years have led to a beginning of a new era for Indian banking.

The sector, which also is a proxy to the overall macro environment, has entered a phase of high loan growth, stable margins and low NPAs.

While stocks have been multi baggers in the last 18 months, they still trade at a significant discount to their books, lower single-digit earnings multiple and higher single-digit dividend yields.

Investors with a time horizon of 12-24 months will still be able to make annualised returns of over 25 per cent in the banking sector.