The banking sector is generally an excellent barometer of economic health. If the economy is doing well, bank credit volumes will rise and there will be fewer bad loans. Economic stress will show up quickly in the form of loans going bad and recession will lead to a falling credit volume.
The Indian banking system has seen stress over the past few years. There has been a slowdown. In addition, many infrastructure projects with massive debt exposures have stalled. Plus, high inflation has meant high interest rates, driving up borrowing costs for banks and reducing the demand for credit.
As a result, credit growth has dropped to the lowest level in 15 years. There have been a record number of requests to restructure stressed loans and also a record amount of loans going sour. According to various assessments, close to ₹7,00,000 crore is stuck in stalled infrastructure projects alone. Around 12 per cent of all assets held by the banking sector have gone bad, or 'sticky', and these could still be rising.
Cleaning up balance sheets is now a high priority and banks also have to recapitalise. There are global norms for prudential lending and capitalisation and it is important that Indian banks meet these, given the increasing importance of trade in India's GDP.
The latest prudential limits (so-called Basel III norms) have been raised, and assuming minimal credit growth rates of 10 per cent or so, Indian banks need over ₹2,50,000 crore in fresh equity. That requirement will also grow if credit growth expands at a faster rate, since lending norms are tied to owned capital.
The RBI had set a timetable for meeting Basel III norms. That timetable has now been postponed because bank balance sheets are stressed. In particular, one major bank owner cannot meet its equity obligations and that owner has consistently subscribed less equity than promised.
The major owner is the government. India's PSU banks disburse approximately 75 per cent of the lending and hold around that much of total outstanding assets. What is more, the government is extremely reluctant to sell or further dilute its stakes in the banks it owns.
Over 90 per cent of the bad loans in the system are with PSU banks. While upgrading India's sovereign rating, credit rating agency Moody's pointed out that the Indian banking sector is in bad shape. The IMF has also stated that India's banking sector is more vulnerable than that of most emerging markets.
Given all these woes, we might have expected investors to be bearish towards the banking sector. But that's not the case. 'Everybody' expects a turnaround or at least some improvements as economic activity picks up. Inflation is easing down and RBI started cutting rates early this calendar year. Those rate cuts should continue and banks would be the major beneficiaries.
The Bank Nifty, or CNX Bank Index, is the most popular banking index. Over the past few years, it has marginally outperformed the Nifty. The correlation between the financial index and the Nifty is high. This is not surprising since banks and financial services have 32 per cent weight in the Nifty itself. The Bank Nifty is also high beta - again, not too surprising because financial stocks tend to be more sensitive than the general basket.
This financial sector index is highly traded with extremely liquid futures and liquid options markets. On the surface, trading the Bank Nifty should be an excellent method of keeping exposure to the banking sector. The Bank Nifty has 12 stocks with weights according to free float. Seven of these are private banks and five are PSU banks.
In the long-term, India's inherent economic strengths should make the banking sector an attractive play. Yes, there are problems and there are also cyclical issues. But both can be fixed. The cyclical issue may already be improving.
What is tricky is the way in which the Bank Nifty methodology favours private sector banks over PSU banks. This makes it unrepresentative. As mentioned above, PSU banks own about 75 per cent of the assets in the banking system but their combined weight in the Bank Nifty was only 16 per cent as of March 31, 2015.
The standard free float methodology really favours private banks, which have much larger publicly owned shareholdings. As the table indicates, SBI is only fourth in the Bank Nifty weights table and PSU majors like PNB, BoB are placed lower than much smaller private banks.
The market also values private sector banks and public sector banks very differently. This is very clear. The Bank Nifty index has an averaged P/E of 18.5 (weighted by free float). The PSU Bank Index has an averaged P/E of 11.5.
The PSU Bank index is not in itself traded as a liquid index. But it is a good representation of the PSU banking sector, with the 12 largest banks included and weighted according to free-float. Individually speaking, the stocks are liquid.
The difference between the performance of the two indices is striking.
The Bank Nifty is up 39 per cent over its January 2013 values. The PSU Bank Index is down 11 per cent from its January 2013 values. Naturally that underperformance is also visible versus the Nifty.
The differences become even clearer if we look at the valuations of individual banks and compare top private banks with top PSU banks. The unweighted average P/E for private banks is 22, while the unweighted average for PSU banks is 7.88.
The reasons for valuation differences are easily understood. Private banks have cleaner balance sheets, more efficient operations with higher revenues per employee, fewer employees, less trouble with unions, better loan-assessment systems, better fee-generation systems, etc. They don't suffer from government interference and micromanagement. Private banks are also growing faster. They need relatively little to meet Basel III and most private banks will meet the deadlines comfortably.
However, PSU banks represent 3/4th of the entire sector, and hence their performance will ultimately determine the sector's trajectory. Improvements in PSU bank financials would have much larger positive impacts. Cyclical issues such as weak demand for credit, high impaired assets (outside of infrastructure), high interest rates will improve, if given time.
But PSU banks will need to receive that ₹2,50,000 crore worth of recapitalisation as soon as possible and policymakers will have to engineer a turnaround in infrastructure in order to rescue them.
The government will also have to ensure professional autonomy of PSU banks. Delays and opacity in appointing senior officers have caused leadership issues. The temptation to use PSU banks to issue loans that will later be 'forgiven' is another area of interference. Reforms would need to tackle these issues.
There is a genuine possibility of PSU bank equity dilution, even though that will require a major shift in the mindset. Investors are wary of higher floats and this could be another reason for lower PSU valuations.
As an investor, this is interesting. Private banks are more attractive in many ways but they also have much higher valuations. PSU banks are struggling but they have low valuations. They could run up a long way on turning around.
Should the investor rely on the tried-and-tested private banks or look to score a bigger long-term return, buying into the distressed PSU bank sector? That question will fetch many different answers.
The writer is an independent financial analyst.