Bankable banks

The public sector bank party seems to be over. After a frenzied rally in 2003, public sector banks have been losing steam steadily. Stock prices have tumbled.

Fund managers have pruned their exposures to PSU banks substantially. Analysts no longer find it fashionable to give stock ideas from this universe. It is almost as if these banks have lost their worth as investment candidates. What has gone wrong?

In one word, it's 'sentiment'. Recent news flows - a key determinant of sentiment at the bourses - have been unkind, making PSU banks look like losers, next only to oil companies.

The first jolt came when the UPA government made it clear that the government will not divest beyond 49 per cent in PSU banks in contrast to what the previous NDA government had planned for these banks - a dilution up to 33 per cent.

The UPA government also demolished the case for higher foreign stakes. That the government would not favour labour reform was another dampener.

A bigger scare was the return to directed lending. The government's move to increase farm lending by 30 per cent (farm credit has to be a minimum of 18 per cent of total lending) is viewed by a section of analysts as a negative.

"Any kind of directed measure will be seen as negative by the markets," says Puneet Srivastav, banking analyst with Enam Financial Services. Directed lending is generally seen as an impediment to higher profitability.

At another level, rising global interest rates (and domestic inflation) have been weighing heavily on bank stocks for quite some time now. This has raised expectations of a rise in domestic interest rates - with rising bond yields mirroring this sentiment.

Can PSU banks weather the storm of rising yields, which will inevitably dent values on their investment portfolios? While the bad news certainly stacks up a bit, there are reasons to believe that these concerns may be overblown.

The worries are counterbalanced by positives, which include sound financials, a steady reduction in non-performing assets due to higher provisioning in recent quarters and better recoveries, and the industry's renewed focus on retail lending. This may just be the right time to go value buying.

Interest rate worries
Inflation has been rising in the past couple of weeks. This has stirred worries on the direction of interest rates. Since the beginning of this fiscal (April, 2004) yields on 10-year benchmark paper have risen from 5.15 per cent to 6.64 per cent (August 11, 2004).

Subsequently, yields have dropped to 6.11 per cent, following reassuring statements from the RBI governor that there may not be any policy-led hike in interest rates in the short term.

If yields do continue to rise despite this, how would banks be affected? Analysts say banks still have some cushion to absorb rising yields. However, considering the pace at which yields are moving, this cushion may soon disappear.

"The real problem will arise by the third or fourth quarter of FY05," says an analyst with a domestic brokerage. For instance, the aggregate portfolio of all banks put together gives a yield of around 8 per cent - while the 10-year benchmark paper yields 6.2 per cent now - signifying a cushion of 1.8 per cent. This means another 70-80 basis-point run up in yields will spell trouble.

Private banks seem to be better placed than public sector banks in this regard because the former have a lower maturity/duration basket. The bonds in the private banks' portfolios, if taken together, have an average duration of 2.5 years whereas their public sector counterparts have an average duration of four years.

According to analysts, private sector banks like ICICI Bank and HDFC Bank brought down their investment portfolio duration well before yields started to shoot up, making their portfolios less risky.

Public sector banks like State Bank of India, Punjab National Bank, Bank of Baroda and Andhra Bank have, however, been unable to lower their portfolio maturity profiles primarily because of their larger portfolio size.

Private banks, with their relatively smaller size, have been able to shorten their durations without much noise. Currently, yields on gilts with a two-year maturity hover around 5.6 per cent whereas the same for four-year paper is 6.1 per cent. This considerably reduces the cushion for public sector banks.

Last fortnight, banks requested the central bank to allow them to make some changes in the accounting treatment of their investment valuation in order to minimise the impact of portfolio depreciation on their profit and loss accounts.

First, they have requested the RBI to allow them to write off bond losses in their 'available for sale' category against accumulations in the investment fluctuation reserve (IFR).

Currently, any portfolio depreciation has to be shown in the P&L account while any appreciation in the value of investments is ignored.

"If banks were allowed to write off depreciation there would be zero impact on their profitability since they have enough in the IFR to sustain another 145-150 basis-point rise in interest rates," says an analyst.

Secondly, banks want a higher proportion (currently 25 per cent) of their investment portfolios to be classified under the 'held to maturity' category as against 'available for sale'.

This is because any depreciation (mark-to-market losses) in securities classified under the latter head has to be provided for in the P&L account, while those in 'held to maturity' category are shown at acquisition cost in the balance-sheet.

The depreciation here is amortised over a period of time. If the RBI allows these changes, rising yields will not impact the profitability of banks unless interest rates start much faster than expected.

Farm credit: threat or opportunity?
Bankers unanimously agree that farm credit is a viable means of growth. They say agricultural lending makes business sense because the rate of interest for farm loans is higher than that for corporates.

"Banks operate on wafer thin margins on corporate credit; so farm credit definitely makes sense," says H N Sinor, chief executive of the Indian Banks' Association (IBA).

Besides, banks which are not meeting the minimum agricultural lending requirements can't really make better returns by lending the same amount elsewhere.

According to RBI directives, banks have to lend at least 18 per cent of their total advances to agriculture (and 40 per cent overall to the priority sector) and any shortfall in this target has to be invested in the Rural Infrastructure Development Fund (RIDF) where interest rates are significantly lower (bank rate or lower).

The higher the shortfall, the lesser the rate of interest. That's one side of the coin. The other side is that most banks do not meet even the minimum agriculture lending limit. Barring PNB, which has lent around 18.49 per cent of its outstanding credit to agriculture, the rest haven't managed to achieve the mandated targets.

Corporation Bank, a market favourite, has the largest shortfall (8.42 per cent), followed by State Bank of Travancore (6.3 per cent) and State Bank (5.2 per cent). Bankers say the ability of a bank to ramp up agricultural lending depends on its geographical spread.

Banks with a strong presence in states like Punjab, Haryana and Andhra Pradesh, which are agriculturally rich, are better placed to capitalise on the rural potential than banks focused elsewhere.

Even so, running rural branches effectively poses a challenge in itself. The cost of servicing rural clients is higher than that of servicing clients in urban and semi-urban areas since the average loan amount availed of by farmers is less.

For instance, Bank of India has 50 per cent of its branches in rural areas but the portion of lending and deposits from these areas is less than 20 per cent of the bank's total lending and deposits.

To top that, farmers' are reluctant to take bank loans since they involve cumbersome paperwork and require security deposits. Farmers prefer to borrow from money lenders instead, albeit at high rates.

However, the government seems to be firm on doubling the flow of agricultural credit over the next three years. Accordingly, the RBI is also taking the right initiatives to accelerate agri-credit growth.

A recent report by the RBI panel on agriculture credit has specified that banks may insist on security only for loans above Rs 50,000 (this was previously Rs 10,000).

"This augurs well since 95 per cent of the loans to farmers are below Rs 50,000," says V Leeladhar, chairman and managing director, Union Bank of India.

Besides, there are some relief and restructuring packages to be offered to farmers which will help them borrow more money with a feasible repayment plan.

"Rural credit makes sense for banks because with contract farming and insurance, banks will not be burdened with NPAs. And bankers are changing their perception about farm credit," says Sinor.

The fact, however, is that none of the public sector banks has been able to leverage its extensive rural infrastructure to create a profitable business model as yet.

While the government is making the right moves to make rural credit profitable, it is up to the banks to grab the opportunity and grow this part of the business before competition catches up. That needs innovation and management bandwidth - sorely lacking in some PSU banks.

Capital inadequacies
One fear among bankers is that once the government's holdings in PSU banks reaches 51 per cent, they may not be able to raise fresh capital. Raising capital may not pose a problem for banks right now since most banks have a comfortable capital adequacy ratio and there is scope for raising additional equity from the markets as long as government holdings do not fall below 51 per cent.

However, once Basel II norms (which will require banks to have a minimum CAR of 12.5 per cent as opposed to 9 per cent currently) come into play by the end of 2006, banks will needs more capital if they have to grow their loan books.

In the developed world, securitisation helps banks to improve CARs by moving loans out of their books, but in India there is less scope for this given the economy's enormous need for capital funding.

"Banks may not have problem raising capital for the next two years, but after that they may face growth constraints," says M Venugopalan, chairman and managing director, Bank of India.

Another worry for the stock markets is this: if government does not chip in with its share of capital contribution, banks will have to generate internal resources to comply with Basel II. This may mean pruning dividends to capitalise earnings. If dividends are restricted, PSU bank stocks may lose some allure as yield plays.

On the contrary, if they are liberal with payouts (many public sector bankers look at the dividend rate as a benchmark for performance and hence do not like to downsize dividends), they could face capital constraints. The trade-off between dividend and growth will remain unless the government changes its stance. "The government will have to change with times," says Sinor.

Competition, people issues
Competition has been a matter of concern for all PSUs. Banks are no exception. In the past few years, however, PSU banks have been actively pursuing the retail segment, trying to mimic the success of private sector banks in this space.

Result: PSU banks have also seen their retail assets grow by around 25 per cent per annum over the last couple of years and this rate could accelerate to 33 per cent in FY05. Whether it be home loans, personal loans, credit cards or ATMs, PSU banks have been ramping up fast.

Almost all public sector banks have entered bancassurance tie-ups and have taken up mutual funds distribution. This could augur well for these banks as their reach in smaller towns and rural areas is better than most private sector banks.

But analysts point out that while retail lending can enhance profitability, they can be more risky for banks without the relevant monitoring capabilities. "We exercise caution as personal loans are susceptible to defaults," says Venugopalan.

Another perennial problem is a bloated workforce, which has not only increased costs but also efficiency. Salary costs have jumped 36 per cent to Rs 1,8416.94 crore (Rs 184.169 billion) in 2004 from 1999.

However, the government has ruled out more voluntary retirement schemes. Once the amortisation of the earlier round of VRS expenses is completed in FY05, banks will be ready for another round of VRS. But only if the government gives the go-ahead.

The staff issue is, however, getting resolved slowly as banks have seen only retirements and few recruitments in more than a decade-and-a-half. "The problem of excess staff will get corrected in the next two-three years," says Leeladhar.

According to him, barely 25 per cent of the current staff in Union Bank is needed for front-end jobs since there has been computerisation. Thus, the bank has been deploying excess staff towards other streams like marketing, recoveries and retail lending where there is a need for more manpower. "We will need to replace workers who retire with more skilled personnel," reiterates Venugopalan.

The real issue is at the top. Since managements of public-sector banks change every three-five years, leadership is perennially a problem area. Sinor says the issue of governance is, in fact, a far greater issue than tenure.

"There are too many pressures that sometimes put a non-deserving person at the top," he says. "There is lack of long-term planning and strategising in public sector banks," says Srivastav.

It is perhaps fair to say that, by and large, many PSU banks lack sound leadership and management vision, and this is what has shackled their ability to compete well.

Financially, PSU banks still look strong
While there is now a greater tinge of pessimism surrounding PSU bank counters, their balance-sheets are looking pinker by the day.

For the past five years, financials have been consistently improving, aided by the regular drop in interest rates - till recently. Though salary costs have been rising, PSU banks have matched the performance of private players on most functional and operational metrics.

Net profit: PSU banks, contrary to what they had once been, have garnered impressive profits. Key profit drivers include treasury income, retail loans and better cost management which helped banks improve efficiencies. The combined net profit of 19 listed public sector banks rose 185 per cent to Rs 13,983.33 crore (Rs billion) in 2004 from 2000.

Treasury income, one might argue, has been the main driver of profit growth. But the fact remains that most of the treasury income was used for provisioning and did not flow into net profits. Some banks have been increasing their fee-based incomes steadily.

In FY04, State Bank of Patiala, Andhra Bank, Syndicate Bank and PNB increased their commission incomes by more than 15 per cent. Having said that, there are worries about earnings sustainability going forward.

With interest rates slated to rise sooner or later, treasury income will not be sustainable. Since there are hardly any unrealised gains left in the banks' investment portfolio, earnings will come under pressure.

Non-performing assets: The NPAs of PSU banks have shown a commendable decline over the past five years. Apart from the fact that the Securitisation Act has enabled banks to secure assets from creditors, banks themselves have been making more serious efforts to recover NPAs. The upturn in ailing sectors of yesteryears like steel and textiles has aided recoveries.

Also, banks increased their NPA provisioning substantially, thanks to super-normal treasury gains due to buoyant debt markets. Banks that significantly reduced their NPA levels include Allahabad Bank (from 12.24 per cent in 2000 to 2.37 per cent in 2004), State Bank of Bikaner and Jaipur (from 10.14 per cent to 1.24 per cent) and PNB (from 8.52 per cent to 0.98 per cent). Currently, PNB, Vijaya Bank and Andhra Bank have net NPAs of less than 1 per cent while Oriental Bank of Commerce has zero NPAs.

Net interest margin: Margins of public sector banks have always been above par. Net interest margins of these banks have moved up from 30.32 per cent in 2000 to 39.76 per cent in 2004.

But analysts are of the opinion that spreads will now come under threat with the gap between lending and borrowing declining. "To keep their spreads, banks will have to cut deposit rates," says Srivastav.

Cost-to-income ratio: The average cost-to-income ratio of public sector banks improved to 0.71 in 2004 from 0.85 in 2000, owing to the lower interest rate scenario and better cost-control measures. This ratio is better than that of some of the private sector banks. It shows that public sector banks are trying hard to stay competitive.

The future
According to analysts, a thrust on retail lending, concentration on the rural economy and control on costs will be the key growth drivers for these banks.

Analysts say the reduction in employee and transaction costs will help these banks improve efficiency and margins, while farm credit - where interest rates are better - will drive growth going forward. With approximately a third of the country's gross domestic product (GDP) coming from agriculture, there is a huge potential for growth and PSU banks should be able to capitalise on this.

And the winners are....
Given the above positives and concerns, five public sector banks emerge as good value picks. Not only are their financials sound but given their reach and growth, they sure can give their private sector counterparts a run for their money. The five banks are: PNB, Oriental Bank of Commerce (OBC), Corporation Bank, Vijaya Bank and State Bank of Bikaner and Jaipur.

PNB tops the list with the lowest interest expended to interest earned ratio of 53.41 per cent. It also has a low cost-to-income ratio of 0.68 and its NPAs are down to an impressive 0.98 per cent as on March, 31, 2004.

PNB not only gains on the financial front but also on the lending side where it is one of the very few banks to have aggressively extended credit to the farm sector - its agriculture lending as a percentage of the total stood at 18.49 per cent at the end of FY04. PNB, thanks to its strong presence in some of India's agriculturally rich states, is best poised to make rural credit a profitable proposition.

OBC definitely deserves a mention since it tops the list on low cost-to-income ratio (0.62 ) and net NPAs (zero per cent, before the GTB merger). The recent takeover of GTB has done good things for OBC.

The latter has added an extra 103 branches of GTB, in turn ensuring a wider reach for itself while gaining access to all GTB's customers. The move is definitely beneficial for OBC since it already has zero per cent NPAs and thus has the capacity to undertake doubtful assets of GTB.

According to analysts, the estimated excess of liabilities over assets is likely to be around Rs 1,500 crore (Rs billion). This will essentially be the amount that OBC shareholders will be paying for acquiring GTB assets (less the amount of tax shield that it will get for the accumulated losses).

The estimated cost of acquisition is then likely to be around Rs 975 crore (Rs billion). Considering the fact that GTB's total income for FY04 was Rs 515.25 crore (Rs billion), the acquisition will be almost 1.3 times the income. At Rs 13 a share (before the RBI moratorium) the market valued GTB at a paltry Rs 158 crore (Rs billion).

But any acquisition through the market would not only have increased the price of the share, but the acquirer would also have to fill the Rs 1500 crore (Rs billion) hole. In other words, OBC appears to have got GTB at a rather competitive price.

At least four of the five banks mentioned figure in the sound financial parameters exercise. State Bank also needs a special reference here. Though it may not exactly figure in the best ratios list, the behemoth continues to remain a favourite with analysts.

The reason cited is that come what may SBI will continue to grow with the economy and given its sheer size, there is no close competition. At present, its valuations too seem compelling.

While the large private sector players seem to have got their fair share of valuations - ICICI Bank has a P/E of 11.61 and HDFC Bank around 20 - SBI's P/E is lower at just around six. The others also have reasonable P/Es - PNB has a P/E of 5.76, OBC 6.07, Corporation Bank 7.17, and Vijaya Bank 4.3.

At these P/E levels, the risks of investing in some public sector banks are lower than one may imagine, given the recent bout of bad news about them.