Analysis: One more reason to avoid PSU bank stocks

There will be a near 50% equity dilution over the next five years, and the return on equity will only worsen

Experts say it is best to avoid investments in stocks that are expected to post declining return on equity. This seems logical as the company will have lesser distributable profits to share with its shareholders. Given this logic, public sector banks need to be avoided.

Reserve Bank of India Governor D Subbarao on Tuesday said that the return on equity of the Indian banking system was expected to decline for a short term on adoption of Basel-III norms. Indian banks would require an additional capital of Rs 5 lakh crore to meet the norms by March 31, 2018. Out of this Rs 3.25 lakh crore will be the non-equity capital while Rs 1.75 lakh crore needs to be equity funded.

Given the fact that these banks have a collective net worth of Rs 3.52 lakh crore, there will be a nearly 50% dilution on account of Basel-III. With such high dilution needed over the next five years, it is unlikely that the return on equity will improve in the “short term” as expected by the governor.

The government, being the largest shareholder in these banks, will need to pump in nearly Rs 90,000 crore to meet its commitment. However, if it chooses to dilute its stake to 51% the outgo would be Rs 70,000 crore. The state of government’s financial health is well known; in the previous fiscal it had asked Life Insurance Corporation to pump in money to meet public sector banks’ capital adequacy requirement. Given the slowdown in the banking sector, especially nationalised banks, the return will be delayed.

After Crisil, another credit rating agency Fitch has said that banks’ non-performing loans will rise. Fitch expects it to increase to 3.75% in the current fiscal as compared to their earlier estimate of 2.9%. Stressed assets in the banking system, including unseasoned restructured loans, are expected to reach around 10% by FY13 from 6.7% in FY10.

The task is even more daunting given the fact that over the past five years, Indian banks have raised equity capital of Rs 52,000 crore out of which Rs 22,000 crore was pumped in by the government and LIC. At a time when banks world over are in a crisis and would need money to stay afloat, raising Rs 1.75 lakh crore over the next five years will be a tall order.

It’s best to stick to expert’s advice and avoid investments where return on equity will decline.