Bank Stocks- which to buy- New incumbents or existing ones

Tough Going for New Banks? (This appears in the latest issue of Moneylife)

If you have to buy a banking stock, the odds are in favour of buying an existing one rather than a new one because banking is a tough business

There are as many as 26 aspirants for the business of banking and the Reserve Bank of India (RBI) is supposed to grant licences to seven of them? At least, that seems to be the message of the finance minister P Chidambaram to RBI. Why seven? Why not five or why not 12 or why not all 26, if they meet the criteria laid down by RBI? Well, one day, we will find out. Hopefully, the new governor will make it an ongoing process rather than an occasional one. I fail to understand why there should be some special time windows for selling or issuing these licences. The bureaucrats and the politicians conspire to keep things complex and mysterious. That is the way we work. Transparency is for speeches. There is no good governance practised by the government or the regulators.

Let us look at the few private licences that were issued the last time: Times Bank, Centurion Bank, Bank of Punjab, Global Trust Bank are four names that come to mind, which folded up and were sold. If they had done well, they would surely have been around. The ones that survived are HDFC Bank and Kotak Bank. Axis Bank is a strange animal, having been promoted by Unit Trust of India and was lucky to have been led by the hard-nosed Dr PJ Naik. ICICI and IDBI were forced transitions of elephantine institutions and not greenfield ventures. And Kotak is known more for its capital market business than for banking. In my book, it leaves HDFC Bank and Axis Bank as the sole winners in the banking space since financial liberalisation started in 1992.

Among the new applicants, there are a few who have had problems in running non-banking finance companies (NBFCs). Will they be excluded by the government? The mutual fund arm of one of the aspirants ran afoul of the Securities and Exchange Board of India (SEBI) in the past but SEBI has been very generous in giving it a new mutual fund licence after having shut down the old one. So regulators are very indulgent and, unless the Supreme Court intervenes, past conviction on offences is no bar to entering the business where, once upon a time, trust was the key word.

Whatever happens, there are some consequential investment decisions to be taken. Most of the promoters would be listed companies. And their main purpose for opting for a bank licence is to play the valuation game in the capital market and access to low-cost funds (as deposits) rather than any fascination for banking per se.

Banking does not give the promoter any control over the cash flow. It cannot lend to group companies, cannot declare dividend without RBI approval and cannot appoint a director without RBI approval. So, obviously, the licence is a play on valuation that the analysts will give for owning a bank. A well-run bank, like HDFC Bank, can fetch a fancy four times the book value; even if you do a bad job, it still could be twice the book value! And if it ends up with a fraud, some bank will be forced to take it over as allowing a bank to fail can have negative political repercussions. In any case, it will be a few years before a fraud comes to light.

These new banks will compete in the same main cities, I guess. Unless, of course, RBI turns very radical and says that they cannot open in metro cities until they have opened a minimum number of rural branches, in the name of financial inclusion. Operating rural branches in the private sector is an unviable and losing proposition and no one will do it by choice. If there is sufficient money in any town or village, you can be sure that banks will reach there. Many NBFCs are already out there and one can be sure the public sector banks are already have a presence.

And these new banks, if they are going to be in the metro cities, are all going to drive up rentals and salaries for the top and middle level bankers. Stock options for a lucky few will be large drivers. A director in a bank has to have his salary approved by someone sitting inside RBI who is on a government salary. There is one NBFC where the CEO earns more money in a year than he earned in his entire lifetime of service with the promoter company. Should the NBFC get its banking licence? Forget the obscene salary he is getting, he may not even get approval as a director for the bank.

It is going to be an interesting race. Should the licence go to one of the NBFCs that already have a few hundred to a thousand-odd branches, they will simply seek conversion of their branches into banks. They are clearly at an advantage. Even if one of the licensees were not to have any branch, it might be very tempting for it to acquire the branches of an NBFC that has been denied the licence. Most large NBFCs are keeping small branches alive only in the hope of getting a bank licence. If they are denied the licence, selling those branches to a new kid on the block should surely fetch them a good price. If this were to happen, it would be interesting to see what the mandarins at RBI would do.

Whilst a few new private banks would come up, there is also an old generation of private sector banks that seem to have forgotten to grow or are simply content with what they are. These include Lakshmi Vilas Bank, South Indian Bank, Karur Vysya Bank, etc, although some others, like Federal Bank, are trying to grow fast. In the meanwhile, two private sector banks that seemed to have run into rough patches are trying to put their house in order, namely, DCB and Dhanalakshmi Bank.

Against this backdrop, one wonders what any new entrant would do. I also recall that a couple of applicants had failed NBFC businesses. To be a relevant player, what these private sector banks will need to build is trust which a bank like HDFC has built up. Winning big business and staying profitable is not going to be an easy task. The new entrants are going to be faced with higher costs compared to those of the existing players.

Technology is going to be the single biggest investment these new banks will have to make and it is very expensive, especially if it is imported.

To be quick off the block, they will need experienced people. So, they will have to have a mix of senior retired people from the public sector to run their operations and snatch some stars to run their IT and credit. Sound lending holds the key and there is not much talent around to ensure a correct mix of risk and return. Bankers who mistake sound credit decision-making with fancy terms like ‘risk management’ are going to pay a price.

I would be betting more on banks promoted by industrial houses (if they are licensed) rather than standalone players. They would be the ones with ability to bring in large amounts of capital. The NBFCs that have applied for licences, to my mind, do not have what it takes to run a bank over the long term. They are perhaps more interested in starting and then make an exit by selling out to a foreign or a domestic player. The NBFCs that have applied are already leveraged and pumping meaningful sums of equity into banks is going to be tough.

For investors, picking and choosing is not going to be easy. Further, it is unlikely that anyone will offer equity at a fair or reasonable price like HDFC Bank did when it got listed. So if you have to buy a banking stock, the odds are in favour of buying an existing one rather than a new one.