The market capitalisation of HDFC Bank has just crossed that of the State Bank of India (SBI), making it the most valuable (listed) financial services firm in the country. Aditya Puri and team have done a fantastic job over the years, and richly deserve all the fame and success they are now receiving.
HDFC Bank is also proof that you can create huge wealth for all stakeholders, by building a first-class business in a first-class way, without cutting corners. In less than 20 years, the top management of HDFC bank (all seasoned banking professionals) have created over $25 billion of market capitalisation (shareholder wealth), highlighting the attractiveness of Indian financial services and also the wealth creation possible if you are able to scale a business in India. It is because of companies like HDFC Bank that global investors still have some interest in India, hoping to find the next such value creation engine. Few emerging markets have such success stories, and India has more than one, giving us the reputation of being a market which rewards stock picking.
While HDFC bank is a huge success story, the fact that it is now seen as more valuable than SBI, (which has a 20 per cent market share of the Indian financial system), and a huge franchise is also a reflection of how poorly investors perceive public-sector banks. Most PSU banks are trading at or below book, compared to about 3.5 times book for HDFC Bank. Part of the reason for the valuation gap is a government-ownership discount, which is pervasive across sectors; but it is more than just that.
Most investors have serious concerns about the asset quality of PSU banks and are convinced that NPA (non-performing assets) numbers are understated. As many former bankers point out, properly calculated, stressed assets for the banking system are already over 8 per cent of loans (a multi-decade high). This is based on the official NPA and restructured loan figures (adjusted for recoveries). Most investors continue to hear murmurs of rampant evergreening of loans, with a lot of anecdotal evidence pointing to asset quality being far worse than the reported numbers. (For example, I am aware of a very large infrastructure company which has not serviced any of its debts for over seven quarters now, yet is still not an NPA in any bank balance sheet.) There is also a feeling that the RBI has moved the goal post and loosened the provision and recognition norms for banking assets in general (backing away from the 70 per cent minimum coverage ratio) and for the infrastructure and real estate sectors in particular (two major sources of asset quality stress). Over and above this we have the weakening in the credit culture in rural areas due to the bank loan waiver, as well as the mess at the state level, with huge bank exposures to state electricity boards, distribution companies and other state-backed entities, secured through state guarantees which nobody has the guts to test.
Indeed, 85 per cent of the asset quality issues of the banks are due to infrastructure, real estate and priority-sector obligations, and none of these areas seem to be getting any better. In fact the bulk of the credit issues in the power sector are still in front of us, with very limited restructuring in this space till now. Even for SEBs (state electricity boards) only about 35 per cent of the banks’ exposure to these entities has been restructured till now. Many investors feel the true NPA picture (including restructured assets) would be in the region of 10-12 per cent of loan assets.
If true, this is a scary number and one which should give even policy makers sleepless nights. It also implies that many PSU banks are not trading at book, as the headline numbers imply, but at far more expensive valuations, as the book itself is significantly impaired. The market in its wisdom is not giving these stocks away as some may think: they may actually be trading at similar valuations to their private-sector peers, after adjusting the book value.
There is also the perpetual fear of government interference in the running of the banks. Calls from Delhi to clear loans, give restructuring on terms very favourable to existing promoters, or just write off rural loans still seem to be happening. At the first signs of a poor monsoon, Karnataka announced a new farm loan waiver. It seems inevitable that more states will follow. There is a huge temptation on the part of politicians to use the banks to win votes and give out freebees. This will only be more in focus as we get into election season.
The seemingly continuous cycle of a new chairman coming into a bank and then having to take a big one-time write-off for past asset quality issues does not create confidence among investors that they are seeing the true asset quality picture in current reported numbers.
PSU banks also have a serious upcoming human-resources challenge, with the average age of their workforce in the late 40s.
The regulators have also decimated the profitability of various pieces of the financial services industry over the last few years and thus shrunk the profit pool for financial services. First we had Sebi go after the mutual funds and insurance sectors, destroying the manufacturer margins as well as severely denting the economics of third-party distribution. Then gold loans and microfinance came into the regulators’ cross-hairs, and their business models will have to be re-jigged. The whole capital markets piece is bleeding, with no signs of profitability — and the RBI has significantly tightened priority-sector norms, making these targets much harder to achieve without self-origination of assets. Thankfully the RBI seems to have pulled back on the new non-banking financial corporations’ priority sector and securitisation guidelines, or even that sector may have undergone a profit shock.
The Indian banking sector has huge upcoming capital needs, both for growth and regulatory reasons. The RBI seems determined to ensure that our banks meet, if not exceed the upcoming Basel 3 norms. If valuation remains at these below-book levels, how will these banks scale up their operations without massively diluting existing shareholders? How will the government maintain its stake, given the capital needs? No investors will go near these banks, if they know they are bound to get diluted by large new capital issuance at or below book value.
Unless the asset quality issues are sorted out I don’t see how these banks will break out of their current valuation range. If they are unable to attract equity capital, who will fund all the growth we hope lies ahead of us? We want the private sector to fund half of the trillion-dollar infrastructure build out we are targeting in the upcoming Five-Year Plan. Without a functioning long-term bond market, and restrictions on foreign debt flows, banks will have to provide the bulk of these funds. Already many commentators have pointed out the difficulty in getting equity for this infra build out, but even debt looks tough.
We need the banks to come clean on their asset quality, recapitalise and rebuild investor confidence. Then they will be able to raise equity capital at a valuation multiple reflecting the growth opportunities available to the Indian financial system.
The writer is fund manager and CEO of Amansa Capital