VR Logo

Elections & Banking – Red Light Ahead

While private banks are part of any investor’s portfolio, PSU banks have to remain a trading play

The year 2012 has been and continues to be an election-heavy year – with 7 state assemblies completing their terms. Elections are a time when politicians are at their “promising best” – often promising voters rewards in the form of lower power tariffs, waiver of farm loans, and nowadays computers, TVs and other goodies. It is common knowledge that elections spoil rural credit culture: farmers wait for elections for waiver of overdue credit, and are too often rewarded with it. I recently came across a working paper published by Harvard Business School which offers some interesting insights. Authored by Shawn Cole (http://www.hbs.edu/research/pdf/09-001.pdf), the paper establishes some important points which have implications for investing in bank stocks.

Higher credit, but no increase in production
Using data for 32 elections conducted across 19 states over 8 years, Cole establishes that in an election year, agri-credit portfolio of state owned banks (PSU banks) increases 5-10 per cent. Private sector banks, on the other hand, do not reveal any such increase. This increase cannot be attributed to rainfall, population or any productivity-linked variable. Importantly, the paper establishes that increased credit does not result in increased output.

Higher defaults, and write-offs
Another related observation is that while the average increase in credit is 8 per cent, the increase (peak to trough) in defaults increases 16 per cent. While it should be expected that an increase in credit will lead to higher bad loans, the increase of 16 per cent is too high to be explained by just the rise in credit.
Data also reveals that post the election, the bad-loan percentage falls quickly. This is not because recoveries increase – the author suggests that the drop is a result of write-offs that the banks undertake to live up to the pre-election promises made by the politicians.

Higher benefits to areas where election results are uncertain
The areas that seem to get the largest bump up in credit are those that are viewed as being at the margin with regard to the ability of the ruling party to win elections. The study revealed that areas where the ruling party/coalition won by a margin of 15 per cent or more, received almost 5-6 per cent lower credit than those areas where the voting was closer. In other words, bank loans were being used as a means to “buy” votes in “swing” districts.
The “committed” voter received a different reward: he had his loans written off! Where the margin of victory exceeds 15 per cent, “forgiven” loans increase, leading to an almost 27 per cent drop in figures of delayed loans. Other areas, where the ruling party lost, do not witness such largess. The formula seems to be inducement before and reward after.

Implications for investing in banks
The paper re-establishes the notion that politicians will use whatever resources they can to win elections. It also explains why government of the day does not wish to reduce its investment in state owned banks to lower than 51 per cent, despite facing the daunting prospect of having to invest between Rs 1 trillion and Rs 2.5 trillion over the next ten years. This, despite the investment yielding poor returns – dividends to shareholders are lower than borrowing cost; capital gains are notional since policy does not allow equity to be sold since government holding is already near the 51 per cent threshold in many cases. After all, who would voluntarily wish to give up the means of “purchasing” voter goodwill.
Without going into the moral or ethical dilemma that this poses, what does this imply for the average investor?
It has long been known that whenever a new chairman takes charge, there is a sudden jump in the non-performing assets of banks. This is particularly true for state owned banks. SBI offered a great example at the last change of guard. Consequently, investing just after a new chairman takes over is hazardous for investors. Better to wait a couple of quarters for the “clean-up” to be visible.
To this, we now add another tool – whenever an election is due, state owned banks operating in that state will likely witness a sharp increase in agricultural credit in the year prior to the election, followed by increased write-offs. Consequently, investment in such banks is best avoided till atleast 6 months after the elections to enable the write-offs to work through the system.
The current year has seen a revival in the stock market. However, state owned banks have significantly underperformed. A combination of inadequate capital, larger exposure to poorly performing sectors, and consequently, higher re-structured loans have driven valuations to below stated book in most cases. In addition, it is possible that the market is already factoring in the decline that is likely in agri-credit portfolio for reasons stated earlier.
Inefficient capital allocation increase societal costs in many ways. Taxes have to increase to pay for government spend; including the capital required to be infused in banks. This is an indirect transfer from urban to rural India since farmers are not directly taxed. Another impact is lack of accountability of state owned banks for their performance resulting in below par customer experience and higher cost ratios. In a perverse way, the private banks benefit, since they gain a greater share of the market due to better product and service, despite having to work harder to raise capital which is “freely” available to their state owned competitors.
While private banks will form part of any investor’s portfolio, state owned banks have to remain a trading play. Consistent performance for state owned banks will have to wait till the level of government ownership and control falls to lower levels. However, given that politicians across the world attempt to use public institutions for private ends, it will be a long time coming.