Banks may face additional challenges

Over the short to medium term, valuations are more likely to move down than up

Indian banking is clearly at a turning point. Let's list some of the key changes we will see in the next few years. One, there will be new licences granted fairly soon leading to more competition. Two, the need to conform to Basel III norms will mean that the entire sector needs to raise huge sums of money. Three, banks are being encouraged to look at new instruments such as swaps and other derivatives. Four, the RBI shows signs of tightening its norms with respect to bad loan recognition. Five, new channels such as mobile money transfers are likely to become popular.

Put together, this could push the sector into a new orbit. It will force the existing players to be more efficient in their operations and in their allocation of capital. Given the level of interference public sector banks face, they are likely to fall even further behind their private sector competitors.

The raising of vast sums of Tier 1 capital will be a headache. It could mean stake dilution, which would be a political problem for public sector undertakings. The government simply doesn't have the kind of cash to spare that it would require to maintain the level of current stake holding while re-capitalising to requisite levels. For private banks, the capital needs will be much less and, given higher valuations, they should manage to raise the cash required without too much trouble.

Swaps are part of growing up for the banking sector. Given greater openness on the capital account, more and more corporates and banks will be inclined to use these instruments. They have obvious utility in many instances.

Suppose corporate entity A can get good terms on loans in currency X and entity B can get good terms on loans in currency Y. If A actually needs the currency Y loan and vice-versa , a swap may be beneficial to both and reduce their joint costs. Similarly, being able to swap a floating rate for a fixed one may suit specific companies with specific types of cash flow.

However, swaps are also dangerous and they can lose huge sums if mismanaged. There is no way to learn to use swaps without taking that risk and it is very likely that there will be mistakes made along the way. Banks will have to develop competencies in this area. Investors will have to learn to look at outstanding derivative positions with a microscope and keep their fingers crossed.

The tightening of non-performing asset recognition is, in theory, a good thing. It should lead to cleaner balance sheets. But there will be a transition period when a few shockers are revealed. We might see valuations fluctuate wildly. Again this will run counter to the government's determination to keep bailing out sick state power companies, and so on.

Money via mobile has the potential to utterly change the rural banking landscape and to empower the large number of Indians outside the formal banking system. It has done this across large parts of Africa where banking doesn't have a footprint. Enabling this would be simple enough in theory.

At the regulatory level, all that's required is the permission to make mobile balances fungible. That is, if you have a pre-paid mobile with a cash balance, you should be able to transfer that balance and to withdraw it as cash. Then, a vast array of retail transactions could become cashless. The RBI governor has made it clear that he wants mobile money to become a reality and once the central bank issues guidelines, member banks will have to figure out how they will participate. Going by the African analogy, it's likely to see very rapid growth if it's sensibly implemented.

These are challenges the banking system will have to cope with over the next few years. It's anybody's guess what sort of shake ups these changes will cause to valuations. Some banks will cope better than others of course.

In the short-term, rising inflation, weak currency and the looming taper will keep interest rates high. Reserve Bank of India Governor Raghuram Rajan is very likely to raise rates again. He will certainly not be lowering them. Assuming that the consensus on growth continuing to be slow is correct, banks will also not see a huge jump in credit demand in the next 12-18 months.

In the face of all this, how does one view price trends? The next couple of years could be turbulent. That presents an opportunity as much as a threat. There may be periods when valuations in specific banking stocks slide into deep corrections. In the short-medium term of the next few months, valuations are more likely to move down than up.