Business Standard

SBI tremor for financial stocks

Devangshu Datta  |  New Delhi 

There is scope for considerable downgrades of Bank Nifty.

The extraordinary provisioning of State Bank of India in Q4, 2010-11 has caused a downshift in the street’s perception of financial stocks. The market expects some dip in performance whenever a new person takes charge at a public sector undertaking (PSU) bank.

There is usually a “new broom sweeps clean” routine. The balance sheet is “cleaned up” and later, window-dressing is applied, so as to show improved performance during the new chairperson’s tenure. This agent-principal conflict between institutional interest and the interests of the chairperson, is caused by the way in which promotions and post-retirement employment opportunities are doled out.

But SBI’s results wiped off 99 per cent of profits, which is shocking, even allowing for a new broom effect and a big hit due to gratuity being written off in one shot. Also, SBI is, with reason, seen as the financial trading arm of the government.

So, the accounts must have had tacit clearance from the Reserve Bank of India (RBI) and the FM. Indeed, the FM has stated that he’s worried about non performing assets (NPAs). Given that this happened while interest rates are still rising, it not surprisingly, triggered a sector-wide sell off with a focus on hammering listed PSU banks.

Could there be a genuine problem with sticky loans? Is there a specific problem with the real estate sector, where every bank has big exposures? If so, where should valuations for financial stocks stand?

The answers to the first two questions are both yes. The answer to the third question depends on an assessment of the dimensions of the problem. In any slowdown or recession, NPAs increase. The RBI’s norms on NPA recognition and provisioning have reduced both discretion and political interference in loan disbursals and hence, stopped utter profligacy. The competition from a vibrant private banking sector has also forced PSU banks to clean up their processes.

But credit assessment systems lag. A growing middle-class with few inhibitions about pledging future income is driving credit growth and many banks and NBFCs have been aggressive in lending to individuals. The financial sector lacks decent models for judging both, the credit worthiness of individuals and the likely level of gross NPAs across the system.

If white-collar incomes stagnate or layoffs occur, aggressive financiers could run into serious trouble. The worst case scenarios would be real estate. Most banks have been aggressive in mortgaging because they assume the loan is secured by the property. When clearing the maximum equated monthly instalment (EMI) limit for a borrower, banks assume he will not suffer any future loss of income, or overuse alternate forms of credit. They also assume real estate values will not fall.

Given rising rates, lenders must either extend loan tenures or raise EMIs. The latter is difficult given that initial EMI rates are set quite aggressively – so, they will have to extend tenures as indeed, has occurred earlier

If property values fall significantly and rates rise, it makes sense for borrowers to default. For example, say a mortgage was issued a year ago, at a rate that has now increased by 150-200 basis points. The mortgage was secured against a property that is now down 20 per cent in value.

The borrower may just hand the property over and cut his losses. If this happens on a large scale, banks and housing finance companies would be stuck with a portfolio of devalued real estate holdings, worth much less than the nominal value of mortgages outstanding. Ironically, the tardy justice system could play a positive role in preventing such a scenario. Foreclosure is practically impossible to implement on any large scale. So lenders are much more likely to negotiate terms they know borrowers can meet.

Another systemic weakness could also be a strength. All real estate values have big black components. The actual value may be 50-100 per cent higher than the official value. So the buyer’s commitment is much higher than recorded on paper and this makes default less likely.

NPAs are likely to rise, even if implosion seems unlikely. Perhaps due to investors fearing this, the Bank Nifty has seen a much larger correction than the Nifty since November 2010. Since financials have big weights across the broader indices, a continuing slide in this sector will drag most of the stock market down with it.

Financials will lead the recovery, as and when it occurs. The Bank Nifty has moved through a valuation low of PE 6.2 and a high of PE 27.4 since January 2006, with average values of 15-16. It’s at PE 16.8 now. There’s room for considerable downgrades. I’d get enthusiastic about increasing exposure to financials only if the Bank Nifty dropped below PE 12.

First Published: Sun, May 29 2011. 00:51 IST