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Banking on Growth

Indian banks are well regulated, generally resilient and have withstood the global downturn well. But should you be buying?

This article appeared in the 15 December - 14 January, 2009 edition of Mutual Fund Insight.

Banking, as a sector, has clearly been in the news.

After the credit crisis of 2008, investors in India began to warm up to banking stocks this year and sector specific funds have delivered impressively. Even regular equity diversified funds began to take significant exposure to Financial Services and Banking. But is there any substance to this bullish stance? A lot of the speculation revolves around the changes that will be brought about in the sector.

Reports stated that the government plans to move a bill early 2010 to amend a law allowing foreign investors in private banks to have voting rights in proportion to their shareholdings.

Furthermore, the finance ministry is keen on fewer and larger public sector banks. Naturally this sparked speculation with investors and traders short listing Bank of Baroda, Bank of India, Canara Bank and Union Bank of India as the acquirer banks while Vijaya Bank, UCO Bank, Allahabad Bank and Andhra Bank were the potential targets.

As stock prices began to reflect this speculation, the Reserve Bank of India (RBI) clearly stated that consolidation was not “the need of the hour”. The central bank put an emphasis on financial inclusion, rather than bank consolidation, and spoke of the need to see banks strengthen their capital base to usher in better risk management and improve efficiency.

More pertinent is whether or not the sector out of the red. Over the past 12 months, the banking sector has been through a sharp adjustment in the credit cycle. After a big boom during 2004-07, credit demand decelerated significantly. Typically, credit growth lags the industrial production (IP) growth recovery. With IP growth having gone up in the last few months, credit growth too is expected to recover. Nominal bank credit growth is projected to be close to nominal GDP growth during the quarter ending December 31, 2009. But there is still cause for concern on this front. Credit growth till date has been slow, much less than the 18-20 per cent target of the RBI. While recovery may take place in the second half, it might not be in the projected range that people are expecting.

Even if credit growth takes place, it will be a while for banks to be clear of potential non-performing assets (NPAs). Banks utilised the relaxation of norms by the RBI to roll over assets, but the risk exists that they could potentially still become bad loans.

In the shorter term, banking stocks could also get hit if interest rates rise. Rising inflation will lead to tightening and interest rates and yields going up. This does not hold well for banks since they take a hit on the investment book. A rise in interest rates will see credit get more expensive, demand peter down and provisioning getting tighter with the risk of defaults. Fortunately, the market has already factored in this scenario. But should banking stocks get hit, investors need not panic. In the long run, the sector is long on potential.

The Indian banking sector is one of the most well regulated globally. Moreover, the scope for growth is immense. India is very under-penetrated as far as financial services are concerned. A ballpark estimate is that the banking sector typically grows at 2.5x the growth rate of the economy. So, if the economy grows at 8 per cent, the banking sector could grow at 20 per cent. So if you want to be part of this growth, take a look at the actively managed funds in this space.