Thursday, November 28, 2013

Unbankable- The lure of banking business

The Tata Group finally seems to have got something right. They have withdrawn their application for a banking license. It is perhaps the induction of the new Chairman, who must have had a hardnosed look at it. Tatas had made a hash of Tata Finance with scandals galore. The problem was / is that at the Tata group, some professional managers used to treat companies and businesses like personal fiefs. Maybe the airline business investment is just to humour the outgoing Chairman. I cannot understand why a business house should get in to poor businesses using public money. Personal passions should be explored by using personal money.

What is driving 25 others to remain in the fray is simple regulatory arbitrage. Get a license, tell a story, sell stakes at a fancy price to someone stupid and have a ball. The other way is to inflate all capital costs (real estate to technology) and skim it off. There is no advantage a bank gives as opposed to a NBFC. If you own a bank, you cannot lend to your own group. So what is the lure? Obviously, dreams of a capital market play and/or a continuous siphoning off of money. Give loans, take a bribe. Everything is possible.

When we invest in stocks, we are betting on the premise that we will be able to sell it to someone else at a price. This is the liquidity that stock exchanges provide. We make many assumptions in arriving at what price we are willing to pay. All of these basically boil down to what money (earnings) the company will make from its business. The other big investor (the promoter) also theoretically gets the same benefits, apart from other non financial benefits that may come his way. I am not talking about any money he may make other than the legitimate dividends and the management compensation he gets. His wealth is represented by his share in the market capitalization of the company.

For the promoter, the company is a real asset and he is at full liberty to deal with the profits of the company. He can pay dividends, buy assets or simply keep cash. He can use funds from one company to promote another. In short, he is the absolute master of all the assets of the company. He has a high level of motivation in keeping the company as profitable as he can. The promoter also wants to own as much of the company as he can and he also has the freedom to take the company private by buying out all the shareholders.

Other investors have the confidence that whatever happens to the shares held by the owner, the same fate awaits them. The promoter, within the framework of law, is the absolute master of the company.

I wonder whether this premise can be applied to someone who sets up a commercial bank. A bank is not at all like other industries in respect of ownership. In fact, being an owner of a bank is very demanding and legally complex. Firstly, the Central Bank (RBI) puts a limit on the ownership in a Bank. The main promoter cannot have a clear majority. The day to day functioning, the deployment of the bank’s assets etc all are subjected to guidelines laid down by law. If the promoter has other industries, a bank owned by him cannot lend monies to it.

The profits that a bank makes cannot be disposed at will. Dividend payments have to be approved by the regulator. The regulations cover virtually every aspect, including the remuneration that a CEO can draw. The promoter cannot use the bank’s money to do any single act that is not permitted by the regulator. And there are not many things that are permitted. A bank cannot promote a company n another industry. A banker cannot promote a car manufacturing business.

Of course, instances abound of shady promoters who have bent the law to have higher ownership apart from diverting loans to friends and family. But these cannot be a goal on which one would like to buy shares in a bank as an investor. And of course, we have businessmen who have ‘used’ a bank to push business in other financial services like mutual funds, stock broking or wealth management. They have used banking clout to build and strengthen other businesses. However, in this, the bank shareholders may not be participants.

A bank takes money from various people and lends it to different people for a fixed return. There is no upside on what it lends. If it lends a rupee, it will not get back anything more than a rupee. The book value of the share of a bank represents the value of all its assets (loans) less its liabilities (deposits, borrowings etc). The only difference between a mutual fund and the bank is the fact that a bank has ‘capital’ that is provided by the shareholders is leveraged by some borrowings. The only way to look at a bank is how much does it add to its book value each year, after dividends etc.

The argument is that a bank’s profits grow. So does the NAV of a mutual fund (the debt part surely). A bank has to provide for assets that are stressed. A mutual fund NAV rises or dips as per the market prices. So, if we are paying three times or five times the book value of a share of a bank, is it solely on account of the incremental profits that we expect the bank to show? And these profits are not available for disposal, except in liquidation. No bank will voluntarily liquidate when the going is good. When it liquidates, it is generally because it has blown away all the money in poor lending.

An owner of any business can sell off the business to anyone at any point in time. A bank cannot do that. It can at best merge or sell itself to another bank. Again, we come to who can take the call. Typically, someone with no personal stake in the bank will take the call if it is ‘professionally’ managed or a PSU. Or someone who takes a decision would have reasons beyond the balance sheet to make the corporate event happen. All in all, buying or selling a bank is a cumbersome process and not very exciting.

Thus it does not make any economic sense to either promote a bank or invest in shares of one. What is keeping the happy circle going is a combination of reckless optimism, misguided valuation and benign regulators.

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