India’s banking system has its pockets of excellence and pockets of incompetence, and everything in-between. The regulator, RBI, does a reasonable job but there is also a fair amount of political interference. Commercial interest rates are set by banks themselves, and policy rates, cash reserve ratios (CRR), sector lending limits and sectoral risk-weights are set by the RBI.
But there are hangover regulations pertaining to the number of physical branches. The commitment to priority sector lending at lower rates essentially means banks have to give away a lot of money. Cooperative banks aren’t controlled with any degree of rigour.
The political interference is more blatant with public sector banks (PSB). There are also classic principal-agent conflicts between the best interests of PSBs and of their management. Promotion and other rewards for PSB officers are easier to by if politicians are satisfied, whereas the best interest of a bank lies in creating a healthy balance sheet.
In addition, PSBs bear the brunt of lending to bankrupt entities such as state electricity companies and distressed PSUs like Air India. There are also high levels of moral hazard; a PSB has an assurance of being bailed out in case of trouble.
This results in a dichotomy. As a class, the balance sheets of PSBs are shakier and their key ratios considerably worse than private sector banks. The PSBs are also much lower valued as a group.
Private sector banks take normal commercial risks. They do enter into speculative transactions and they tend to be quicker off the block in terms of entering new business segments. This can result in over-extension and ballooning bad debts and sometimes in exposures to dangerous assets such as forex derivatives.
But the interests of private bank officers and the banks are better aligned and on the whole, the risk management of private banks is better. When private banks have found themselves straying into dangerous territory in terms of high non-performing assets (NPA), they are more likely to diagnose the dangers and change course internally.
The differences in performance and valuation are accentuated during a downturn. In fiscal 2011-12, the gross NPAs of PSU banks grew by over 50 per cent while the gross NPAs of private sector banks grew by 3 per cent. Overall, as a percent of advances, gross NPAs for PSU banks were around 2.5 per cent in 2011-12, while the same ratio was 2.2 per cent for private sector banks.
Apart from recognised NPAs, banks also carry restructured loans. These are sticky corporate debts where terms have been renegotiated through mutual consent.
These are not treated as NPAs on the balance sheet. But they are much more risky than normal advances, offering lower yields and standing a much greater chance of turning bad. There’s been a spate of restructuring requests over the last year and the lion’s share has involved PSU banks as the creditors.
The differences in valuation and share price performance over the past few years is stunning. There are several publicly available indices one can track for the entire banking sector, and for the PSU banking segment. Unfortunately, there is no public index of private sector banks.
The CNX Bank Nifty (which comprises both PSU and private banks) is up about 2 per cent since January 2008, a 55-month period. The CNX PSU Bank Index is down 13.5 per cent over the same period. The average valuation of the CNX PSU bank index has been a PE of 9.3 with a maximum PE of 16 for the basket and a minimum of 4.5. The average valuation of the Bank Nifty is PE 15 and the maximum was PE 27.5 and the minimum, PE 6.25.
One could create an index of private sector banks using either the methodology of weighting by free float (as in the BSE indices) or by total market capitalisation as in the NSE indices used above. But it’s not necessary given the above differences. The private sector banks enjoy valuations twice as high. In terms of capital gains too, they have given far better returns. Given the underlying reasons for the differences, the trend is likely to continue indefinitely.
The RBI's Credit Policy this Tuesday (July 31) will affect the sector as a whole. There may be a rate cut pushing up bank valuations temporarily. Or, the RBI may hold its ground. A rate hike or CRR hike seems very unlikely. Regardless of what the RBI does, the long-term investor can bet that a portfolio of private sector banks will continue to consistently outperform the Bank Nifty.