Traditionally, i avoided financial institutions due to the inherent leverage in its business model. Considering its immense potential for wealth creation, recently i started taking baby steps towards analyzing indian banking sector, its growth drivers, and future potential. In this two-part series, i will document some of the interesting things i learned (Don’t worry, i am not going to bore you with all the financial jargons in analyzing financial stocks 🙂 Rather i would like to pen down some of the ‘aha’ moments during the learning process).
Indian Banking structure:
There are 27 public sector (PSU) banks and 20 private sector banks in India. However, majority of the assets and loan advances are controlled by PSU banks.
[Source: FY 2015 Bank Annual reports. Data excludes unlisted banks such as State bank of Hyderabad & State Bank of Patiala (PSUs) and Catholic Syrian bank & RBL (Private banks)]
Understanding bank’s balance sheet is very crucial. Following is the snapshot of Federal bank’s balance sheet.
Liabilities side is dominated by bank’s Net Worth (Share capital + Reserves & Surplus), bank deposits, and market borrowings.
Assets side is dominated by Investments (Treasury operations) and Advances a.k.a loan advances (both corporate and retail loans). Loan advances are further classified into standard assets and non-performing assets (NPA). NPAs are loan accounts that are not paid for 90 days.
Generally bank’s Net Worth is levered (varies with each bank – approximately 8-12 times) with borrowings (bank deposits & market borrowings) to provide loan advances. In the above example, loan advances of Federal Bank is around 6.6 times its Net Worth. In other words, its entire Net Worth will be wiped out if 15% (1/6.6) of its loan advances turn bad assets and becomes not recoverable. Banks are generally valued at multiples of its book value (i.e. Net worth) depending on the bank’s return ratios and management’s capabilities. Before attaching multiples to Net Worth, we need to ascertain ‘true’ Net Worth by quantifying standard assets and bad assets.
Instead of shortlisting good-performing banks, i inverted the process. First, i wanted to eliminate poorly-managed banks that contains lot of bad assets. Because more the bad assets, lesser will the ‘true’ Net Worth. I considered Net NPA’s and restructured standard assets net of provision as bad assets. I collated each bank’s Net Worth, Gross NPA’s, provisions for NPA’s, Net NPA’s, restructured standard assets (according to me, they are nothing but glorified NPA’s that are ever-greened due to lax attitude of regulator & bankers), provisions for restructured standard assets from its FY 2015 annual report. Lets look at numbers of 24 PSU banks loan advances in two separate sets.
First set of PSU banks:
[Note: I removed SBI from above the chart as its assets are huge and skews the graph. Hard data: Standalone SBI’s Net Worth – 1284 bn and bad assets – 676 bn (Net NPA – 276 bn + Restructured std asset net of provision – 400 bn). But incidentally it has one of the better-managed loan book among PSUs as seen in the charts below. Its bad assets forms 5% of the loan advances only and its Net Worth is approximately twice that of bad assets].
[Note: For example, in the case of SBI, bad assets constitutes 53% of its entire Net Worth].
Second set of PSU banks:
[Note 1: For example, UBI’s bad assets is 2x its Net Worth. If it takes a 50% hair cut out of its bad assets (highly unlikely), its entire Net Worth will be wiped off].
[Note 2: In my twitter page, i shared my preliminary analysis. Here i inverted the ratio to provide better picture. Also, Numbers here are slightly different due to inadvertant minor error. Restructured loan book contains assets from both standard asset and NPA accounts (Thanks to @deepakshenoy for pointing out). I corrected it and included only restructured assets of standard loan book & Net NPA’s for the calculation of bad assets. I also netted of any provisions against those restructured standard assets. Still the numbers are scary 😮 and doesn’t change broader picture much].
As you can see from the above pictures, loan book of SBI and its associates are relatively (Only relatively !!!) better than other PSU banks. Some of the smaller PSU’s like Allahabad bank, Oriental bank of commerce, Punjab & Sind bank, Central bank of India, and Union of India are in dire straits with bad assets/loan advances >15% and its bad assets constitutes 1.75-2x Net Worth.
Equity dilution is principal enemy for the long-term investors in banks. PSU bank stocks are beaten down so much. There could be short-term 30-50% jump depending on developments such as marginal improvement in stressed sectors, extension of leniency by RBI or government package etc. But i am more interested in the long-term wealth creation and being novice in the market, i don’t have the ability to predict on the possible short-term movement. For me, putting finger on the bank’s ‘true’ Net Worth is crucial.
Lets be clear on one thing: None of the bank’s Net Worth is going to ZERO. Either government will re-capitalize or it will merge with relatively better PSU banks. Principal question: What will the hair-cut to the bank’s Net Worth due to the bad assets? According to CRISIL ratings, historically, about 35-40% of the restructured accounts have eventually defaulted. Lets be charitable and factor in 25% haircut.
In addition, bank needs additional capital of 25% to meet Basel-III recommendation and also to meet additional provisioning requirement due to RBI’s change in rules. In total, there is a real probability of approximately 40-50% equity dilution for long term investors.
Based on the above analysis, i eliminated all the PSU banks except SBI. I would re-examine them when all the things like recapitalization settle down. In recent times, i became very skeptical of turn-around stories. Being contrarian is very different from being contrarian & right. Success stories of turn-around stories are filled with survivorship bias. Generally investors who became contrarian early in a turn-around story are not alive to tell their story. My thumb rule for turn-around stories: Have a starter position – Let the management execution & business profitability determine your position size and not your wishful thinking. I would like to stick to this rule even if it means leaving some profits on the table.
In the part-2, i will document some of the interesting things i learned about the private sector banks and technological innovation in banking industry.
I attached data excel sheet. Feel free to download and play with the numbers. Let me know if you come across any mistakes or interesting observations [Note: All the numbers are collected from individual bank’s FY 2015 annual report. I generally don’t attach much to quarterly reports and analyst presentation – lot of things are swept under the mat. 2 Quarters were passed – some of the banks might have raised equity capital, sold bad assets to ARC, or recognized more bad assets – Please keep that caveat in mind].
Looking forward to your thoughts. Cheers 🙂