Interest rate cut can turn around the banking sector

It will depend on RBI's rate cycle projections and could take long

The Reserve Bank of India (RBI) has always been extremely cautious and conservative in handing out bank licences. The award of in-principle clearance for banking licences to IDFC and Bandhan, coupled with the rejection of several applications, shows that the central bank's attitude has not changed. This is reasonable at some levels. A bank must inspire total confidence among depositors. Hence, the need to vet licence applications carefully for trustworthiness, high net worth, etc.

Banking works on the concept of fractional reserves. A bank keeps a fraction of the cash it receives in reserve and lends the rest. Say, a bank receives Rs 100 and it is required to maintain reserves of 10 per cent. It keeps Rs 10 in reserve, and lends out Rs 90. Out of that Rs 90, Rs 81 is lent on, with Rs 9 held as reserve. Out of Rs 81, 73 is lent on and so on.

Fractional reserves magically create more credit. But it also means that if depositors suddenly withdraw large amounts, a bank can go bust. High levels of interconnection between banks means that a run on a single bank can affect the entire banking system.

Banking also lends itself to many types of abuse. If a bank favours an industrial house, it could give that entity a competitive advantage by lending cheap. If a bank is owned by an industrial house, this may become a matter of serious concern. Hence, the reluctance to issue banking licences to industrial houses.

India's banking system has many characteristics peculiar to itself. At one level and in certain places, it is highly competitive. Urban citizens may have a dozen banks within walking distance. Loan markets are also competitive, with banks seeking new opportunities.

But at the same time, India remains under-served in terms of access to bank services. New banks could improve this situation. Roughly 50 per cent of Indians don't have bank accounts and many rural geographical areas have very few banks. New banks might fill geographical gaps. At the same time, they can create employment and enable prosperity by offering formal credit at reasonable interest rates in places where it is not available. The banking system is also under financial stress. Sticky loans have multiplied due to several years of a slowdown. There are a record number of corporate debt restructuring requests in the pipeline. Massive amounts of capital are stuck in unfinished projects. The worst affected are government-owned banks.

All banks also have to beef up their Tier 1 capital to meet Basel III norms. The RBI has extended deadlines for this by a year. Government finances are too stretched to recapitalise PSU banks. Stock market valuations of PSU banks are also low - even if the government is prepared to tap the market for equity. It is not very easy to be a profitable bank in India. Priority sector lending has a 40 per cent quota and, apart from housing (profitable) and education, this includes 18 per cent to agriculture and 10 per cent in "advances to weaker sections". A lot of those loans have to be written off. In addition, banks must maintain a 23 per cent Statutory Liquidity Ratio (SLR). Essentially, this involves lending money to government since Treasury Bills count towards SLR. The cash reserve ratio is 4 per cent. Given all these commitments, even if a bank raises money cheap, it has thin margins.

The Bank Nifty, which includes a mix of six private and six PSU banks weighted by free float market cap, trades at a current PE ratio of 14-15. This is at discount to the overall market PE (about 19). The six PSU banks are available at an average (equal-weighted) PE of 8 while the private banks trade at an averaged PE of 19.3.

IDFC undoubtedly hopes to benefit from the ability to raise cash cheaper and to diversify out of lending only to high-risk, long-tenure projects in infrastructure. Becoming a bank should be useful for IDFC in the long term. In the short term, it will have to hire people, set up branches and learn the ropes about operating in a competitive environment. It's likely to see a deterioration in margins in the near term. Is IDFC worth holding for the long term? Probably, but it may be available cheaper somewhat further down the line. Are beaten-down PSU banks worth buying? Perhaps. The government must eventually recapitalise them. If the RBI's projections about the rate cycle are accurate, the entire banking sector will see a turnaround in the long run. As inflation decreases, interest rates will be cut. But it may be a long process.