Want to short public sector banks? Look beyond Nifty Bank

Most traders track the banking sector by using the Nifty Bank as a proxy financial index. This makes sense in some ways. The derivatives of the Nifty Bank index are highly liquid and heavily traded. The index includes all the major listed banks. It is also highly sensitive to fluctuations in interest rates and treasury yields, and generally responds to news about the sector.

 

But, the Nifty Bank is not a good representative of the sector in many ways as well. Like all the major indices on the National Stock Exchange (NSE) and BSE, it is constructed on a free-float method. This means private banks, with relatively large free floats, get larger weights in the index construction. A further point of distortion is caused by the fact that the private banks like HDFC, ICICI, Kotak Mahindra, YES, IndusInd, etc., are all extremely highly valued by the market. Indeed, HDFC Bank is among the most expensive bank stocks in the world in terms of valuations. Hence, private banks have extremely high weight in the Nifty Bank index.

 

This is completely at odds with the relative ratio of credit disbursal in the sector. Private banks disburse less than 30 per cent of bank credit, while the public sector banks (PSBs) disburse the rest. However, PSBs are very tightly held, reducing their free float. PSBs are also valued at low valuations on the stock exchange. Hence, they have an extremely low weight in the Nifty Bank. This makes the Nifty Bank index a less reliable indicator of happenings within the sector. The index can go up on the basis of a good move in one high-weighted private bank even on a day when several PSBs register sharp losses.

 

Unfortunately, while indices that track only the public sector banks exist, these are not liquid and well-traded. So, there is frequently a big divergence in the movement of the Nifty Bank and the Nifty PSU Bank Index, and there is no way for a trader to easily arbitrage this difference directly. In contrast, the Nifty Bank and the Nifty Private Bank tend to have well-correlated movements but the Nifty Private Bank Index is not liquid.

 

The divergence in the financial stability of PSBs and the private banks is quite significant. Most PSBs have terrible balance sheets, with huge outstanding non-performing assets (NPAs), and massive stressed assets, as well. Private banks are in much better shape. This is reflected in the fact that many PSBS trade well below their official book value, while most private banks trade at several multiples of book value.

 

Apart from having huge NPAs to contend with, most PSBs will also need massive infusions of capital to make the Basel-III norms. Private banks are much better placed though they also need some capital. The sector will obviously see much volatility over time.

 

An investor could pick and choose stocks carefully. A trader might want to buy some stocks and short either the index futures or the futures of some specific banks. A trader shorting the right PSBs could make money even if the public sector banks went belly-up. This would be a useful hedge. It would also be useful if a trader could short some bank futures while going long on the Nifty Bank as a hedge.

 

It is a great pity that the PSU Bank index is not liquid enough to hedge that specific sub-sector. That is where most of the short-selling will be concentrated. The author is a technical and equity analyst