Banks: Reward governance, punish pirates?

May 13, 2024
Author: Ajit Dayal

First, an interesting fact.

Since his appointment as Governor of the Reserve Bank of India in 2013, Raghuram Rajan cleaned up the banking system by instructing banks to correctly declare their non-performing loans, take the losses against their capital or net worth and, effectively, forcing the banks to correctly assess, calibrate, and price the risks of granting loans to large businesses or to individuals.

It is because of this courageous clean-up that the banking system in India is one of the soundest in the world. Collectively, the profits - and share prices - of banks have risen manifold as banks now grant loans with a clear objective to receiving back the principal and interest on a loan.

Yet, despite this mammoth achievement, stock markets have punished many large banks by paying lower multiples for the franchises that these banks have painstakingly created. The stock markets are saying that they do not believe the banks can remain profitable - or they may be saying that though the businesses can remain profitable, the management cannot be trusted to run clean enterprises.

Governance and integrity are awarded a premium in any enterprise but more so in a business like banking where money is the raw material and the output.

Table 1: The "We-Don't-Trust-You" Banking crisis?
Price / Book Value (x) MEDIAN CURRENT Approx P/BV in 2019 Change from Median Change from 2019
Kotak Bank 4.06 2.73 4 -33% -32%
HDFC Bank 5.61 2.41 4 -57% -40%
ICICI Bank 2.09 3.00 2 44% 50%
State Bank of India 1.18 1.56 1 32% 56%
AXIS Bank 2.36 2.06 3 -13% -31%
Source: Bloomberg, May 10th 2024

Interestingly, Kotak, HDFC Bank, and Axis Bank are all trading at valuations that are below their long-term, historic median P/BV ratios. When compared with the more recent 2018/2019 pre-Covid era, the numbers do not change much. ICICI Bank went through a governance mishap in 2018/2019 then, with the induction of a new CEO and management team, the valuation multiples have expanded. State Bank of India has been a star performer with the markets rewarding the bank with an increase in its Price / Book Value.

There are many reasons for this duality of paying a lower multiple for a better and sounder business:

  1. Growth of a bank's business may be impacted due to competition from fintechs invading the banking space and more competition from newer banks. Furthermore, to increase penetration into smaller towns, the investments in branches and people will increase and business profitability is still unknown. Stock markets acknowledge the past, but they reward the future;

  2. While the quality of loans has improved, there is a lurking fear that something bad may happen to the economy and there is some leverage in the system due to the rapid growth in 'personal loans and loans against securities. Any hiccup due to a macro / global event like a Lehman collapse or Covid could bring to the surface the hidden rot in the system. Memories of IL&FS still cloud the view of savvy investors;

  3. The perceived questionable quality of the management teams running the bank. All the halo and shine around the 'brand' reputation and 'service levels' of the private banks has vanished. Today, a visit to the branch of most private sector banks is akin to walking into a government office. In addition to the cosmetics and lack of 'feel-good' the multiple missteps of managements and founders who held the reigns of Indian banking have reduced the reputation of many private sector banks to overpaid hustlers.


Hustlers do not get premiums; builders of institutions do.

Before we venture further, a small detour into how banks make money.

Banking is a business of trust.

The raw material for any bank are the deposits they collect from individuals and corporates.

Every time you make a deposit of your pension or your salary in your bank account, you expect it to be there available for withdrawal when you want your money back. You trust the bank to give you back your money whenever you ask for it.

The bank pays you an interest to temporarily use your money, your deposit, to lend it to someone else at a higher interest rate. Banks do not keep all the money you deposit with them in their vaults or in safe bonds issued by the Government of India. No, the banks lend most of your deposits to an individual or a business that needs the money - and aim to make a profit from acting as the intermediaries.

The difference between the interest the banks receive from the borrower and the interest they pay you as a depositor is called Net Interest Margin or NIM.

In aggregate, there must be sufficient fat in the NIM to ensure that, in case a few borrowers do not repay a loan, the total of all interest they have earned from their entire lending offsets the "provisions" they have to make for these bad loans. For a bank with a good "asset-liability management system" (making sure depositors can be repaid when they ask for their money back) and a tried and evaluated "credit assessment system" (making sure they give loans that will be repaid on time), the NIM can be steady across business cycles.

In addition to this NIM, the banks earn fees from their customers for services like credit cards and bank transfers. Fee income is normally stable and predictable.

Then there is also the treasury desk where smart traders make money for the bank from buying and selling government bonds and foreign exchange. Here the profits / losses are not easy to predict and are volatile.

Given the many complications and risks of running a bank, a roll-the-dice approach to banking will not do well but a careful, institutional-building approach to banking will be rewarded by long-term investors.

As the valuation numbers in Table 1 above suggest, India's banks are going through a 'trust-deficit'.

During discussions on withdrawing from a commitment to one of my companies, the CEO of India's largest private sector bank told me a phrase that will stay with me forever: 'bania ka hisaab, kitab hai'. And with that he pulled the plug on a signed agreement. What trust and valuation multiple would you award such an approach to institution-building?

The tone at the top, trickles below: a sting operation by Cobrapost in 2016 found that branch managers of HDFC Bank, ICICI Bank, and Axis Bank were willing to help customers turn unpaid cash wealth into legal, "white" money in violation of KYC and Anti-Money Laundering Provisions.

Two years later, the RBI imposed a monetary fine on the three banks but let them off the hook with a 'improve your KYC' statement.

The RBI has also punished banks for poor systems and processes by suspending their right to open branches unless their systems improve. Banks have also been prohibited from on-boarding new customers till they become organized.

Succession planning is a key for any company but more so for a bank - given the trust and faith that is implicit in the relationship between a depositor and a bank.

And once a management team is in place and a successor anointed, the question arises: how will this new successor behave?


ICICI Bank: no lessons learnt?

As Table 1 above indicates, State Bank of India and ICICI bank are two of the large banks which have won the confidence of investors. Their Price / Book Value multiples have increased significantly.

In 2018, then CEO Chanda Kochhar allegedly used her power to sanction a loan for the Videocon group in return for a benefit. After her resignation, the perception was that ICICI Bank is a more reliable bank and its surge in the P/BV valuations reflect that.

Disregarding the premium for good governance, the management of ICICI Bank is trying to buy the 25% of ICICI Securities (ISEC, the broking house that it does not own at a price which is far from fair). If it succeeds despite the opposition to it (Disclosure: Quantum Mutual Fund, which I am affiliated with, is pressing with legal steps) it is theoretically possible that ICICI may buy out its subsidiaries in insurance and asset management at a similar throwaway price for ICICI Bank.

AS of March 31, 2024, ICICI Bank's three listed subsidiaries contribute 13.6% of its overall market capitalization. ICICI Bank has proposed to acquire shares of ICICI securities at a 30% discount to peer valuation resulting in a transfer of wealth of Rs 17.7 bn to ICICI bank shareholders. This gain of Rs 17.7 billion by low-balling the price of the ISEC share results in an addition of 0.2% to the market cap of ICICI Bank (Rs 17.7 bn/ Rs 7,678 bn)

Furthermore, were the management of ICICI Bank to earn a reputation of going against minority shareholders and repeat the unjust behaviour towards ISEC Broking minority shareholders on the minority shareholders of the insurance and mutual fund businesses, ICICI shareholders would benefit by a further 3.3%.

Of course, if the public begins to distrust the actions of ICICI Bank and punishes it with a lower P/BV of where it was in the Chanda Kochhar days this would amount to a 40% drop in the market value of the parent company.

The choice to managements is clear:

  1. Be unfair and shave a few pennies of what you owe to minority shareholders when you buy them out;

  2. Watch the value of your overall franchise as reflected in the Price / Book Value collapse.

It is precisely for this reason that regulators have a clause in the applications to assess whether the management team or the founder of a bank are "fit and proper" or pirates masquerading as bankers building long-term trusted and stable institutions.


Disclaimer and Disclosure: Companies and entities I am affiliated with and mutual funds I am invested in may own some or all of these securities. The data provided here on any security is not a recommendation to buy or sell any security and merely to be seen as illustrations for discussion on the topic being written about.


Ajit Dayal is the Founder of the Quantum Group which includes Quantum Mutual Fund and PersonalFn. Ajit has over 35 years of research and investment experience. An avid writer and speaker, Ajit has been profiled and interviewed by many international and local newspapers, magazines, TV channels and radio shows and is never shy of speaking The Honest Truth. Sign up here to get The Honest Truth delivered every week into your mailbox. It will change the way you think about your investments.

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