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Will banks' earnings drop?
Shobhana Subramanian
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January 18, 2005

Between now and next January, more than half a dozen banks would have tapped the stock market to raise equity. The best of them, like HDFC Bank [Get Quote] or UTI Bank [Get Quote], might opt for ADR issues in the hope of getting a higher premium for their stock.

But Indian investors, too, can share the spoils. A back-of-the-envelope calculation shows that around Rs 7,500-Rs 8,500 crore (Rs 75-85 billion) worth of bank paper is expected to hit the local market in the next 12 months.

The Delhi-based Punjab National Bank [Get Quote] has said it is looking at mopping up around Rs 3,000 crore (Rs 30 billion) while Oriental Bank of Commerce [Get Quote] (OBC) and Bank of Baroda [Get Quote] are hoping to pick up Rs 1,500 crore (Rs 15 billion) each. Private sector banks like Centurion Bank, too, are hoping to cash in on the positive sentiment at the bourses.

Most banks don't have a choice. Strapped for capital, the banking system would require around Rs 16,000 crore (Rs 160 billion) of additional capital over the next two years - and this can happen only with an expansion of their equity base.

In the process, the equity base could get diluted anywhere between 12 per cent and 30 per cent. Which means that the earnings per share would fall immediately, though the extent of the fall, once again, would differ from bank to bank. Analysts expect earnings to grow 15-25 per cent on expanded equity during FY06 (See table)
Comparative valuations
 Price (Rs)Adj. BV (Rs)EPS growthRoE (%)Adj. P/BVPrice target
FY05EFY06EFY06/04 (%)FY05EFY05EFY06EFY05EFY06E
SBI [Get Quote]578.45577.00667.0014.0018.301.000.80638.00747.00
Canara Bank [Get Quote]192.05154.00192.0012.0025.501.201.00267.00336.00
Corp. Bank314.15215.00252.0015.0013.701.501.20365.00430.00
ICICI Bank [Get Quote]351.20171.00195.0012.0015.402.001.80427.00486.00
HDFC Bank515.00140.00159.0024.0018.503.703.20490.00556.00
ING Vysya601.00344.00408.0029.000.101.701.50


UTI Bank188.0070.0087.0021.0021.102.602.20


Centurion Bank18.002.204.20



Andhra Bank [Get Quote]78.2550.0058.0016.0031.501.601.3097.00115.00
* Based on FY07E adj. book                                                                         Source: SSKI estimates

The immediate compulsion for the issues: fast growing asset books and the urgency to meet the Basel II capital adequacy norms - a stringent international standard which states that banks must have a minimum capital adequacy ratio of 12. 5 per cent -- by FY07.

Consider this: Credit growth in the banking system has been an unprecedented Rs 64,600 crore (Rs 646 billion) in the third quarter of FY05. And in two consecutive quarters banks have lent more than Rs 1,00,000 crore (Rs 1,000 billion) - the incremental credit-deposit ratio in the last six months has been over 100 per cent.

So, after overloading themselves with government securities for almost three years, bankers are going back to their core business -- lending.

Since government securities are risk-free and, therefore, require no capital to be held, bankers could manage with the existing capital. But with loan growth picking up, they need to shore up their capital base.

Where is the money going? Mainly to retail consumers, who avail themselves of the bulk of these loans.

So far, consumers seem to be in no mood to borrow less, especially when it comes to home loans, where tax sops and reasonable asset prices are encouraging people to own their homes.

In fact, anxious about ballooning retail credit, the central bank recently upped the capital requirements for such loans to 75 per cent from 50 per cent, though it said it would be only a temporary measure.

But, with industry continuing to grow well, as reflected in the higher capacity utilisation of cement or steel units, companies, too, are asking for larger amounts of working capital, including small and medium enterprises.

Banks today are in far better shape than they were a couple of years ago. Fat profits earned from trading in government securities in a falling interest rate regime have allowed them to clean up their books - essentially by writing off or providing for non-performing loans (NPLs, or dud loans).

Today, gross NPL levels of around 7 per cent of advances, and 60-70 per cent coverage levels for bad loans, are a huge improvement over the situation five years ago.

More recently, when treasury profits evaporated after the interest rate cycle turned suddenly and sharply, the central bank bailed them out by allowing them to park gilts in what is called the held-to-maturity (HTM) category and take a one-time hit by providing for these losses through the profit and loss account.

Also, it means they need to keep smaller amounts of money in the Investment Fluctuation Reserve (IFR) -- a sum earmarked to cushion losses in treasury trades. HDFC Bank, UTI Bank, Corporation Bank [Get Quote], PNB and BoI have opted to transfer securities to the HTM category and have booked losses on that account.

Equity issuances on the anvil
 New issueMkt cap
$ mn
Mar '04
Rs mn$ mn
UTI Bank6,5671501,006156.4
Dena Bank [Get Quote]*2,16048191295.2
Allahabad Bank [Get Quote]2,50057601106.3
Syndicate Bank [Get Quote]3,00069687106.8
Oriental Bank15,0003451,485239.9
Source: CLSA Asia-Pacific Markets                    * Public issues are already announced

Will banks be able to lend profitably? As of now it appears so because they have several things going for them:

Given the favourable environment, banks should grow their asset books by around 25 per cent in FY06. Since trading in securities is unlikely to yield the kind of windfall profits that it did, the growth, for most banks, would have to be led by loans to industry and the retail sector.

The other growth driver would be fee income. The share of fees - from insurance sales, credit cards and fund management, guarantees and so on - to total bank income is also on the rise. ICICI Bank, for instance, virtually doubled its fee income in H1FY05.

While fees for banks still largely emanate from corporate customers, contribution from retail clientele should increase. Over the next few years fees should account for as much as 30 per cent of bank incomes, in line with international levels.

So far, there has not been too much of an increase in lending rates possibly because companies have managed to raise money overseas and also because there is competition for quality assets.

However, banks are having to borrow at higher costs - almost all banks have raised deposit rates by 25-50 basis points. In fact, deposits for the system as a whole saw slow growth of just Rs 21,509 crore (Rs 215.09 billion) in Q3FY05 - reportedly one of the slowest growth rates since 2000.

Looking ahead, it appears unlikely that deposit rates will fall, especially since there are other fixed-income products offering better returns. Thus, the repricing story -- by which banks were borrowing at lower costs as interest rates fell and which helped them to maintain or increase spreads - is now over.

The only way banks can hope to improve spreads now is to lend at higher rates. This would ensure that net interest income (the difference between interest earned and interest spent) and, consequently, the net interest margin (net interest income as a percentage of average deposits) do not suffer.

Moreover, while there may be enough opportunities to lend, competition for quality assets is keen - especially for fee-based businesses where a large portion comes from corporate accounts.

Also, though the loan books have been cleaned up, banks will need to be cautious while handing out fresh loans to make sure they do not pile up poor quality assets again.

This is particularly true for retail assets, which have seen explosive growth. So, though lending opportunities abound, only banks which lend prudently and are able to keep borrowing costs in check are going to be winners.

Meanwhile, there have been concerns in the past about whether or not banks will have to pay a premium when they return equity shares to the government. Government's dilly-dallying on this aspect caused immense volatility in bank stocks a year ago.

However, the government appears to have decided that it wants its equity shares back at a premium. So banks, it seems, will not be able to retain the premium that they raise on shares to be returned to the government. But the market does not seem to be perturbed about the issue this time around.

Given the strong market sentiment, banks raising fresh capital today will be able to do so at a much higher premium than they could have envisaged a year or even six months ago.

To that extent they are gainers and so are investors. To begin with, those that are able to raise equity at good premiums (low cost money) will have an edge.

Bankable rally?

Between June 2003 and December 2004, banking stocks have given outstanding returns to shareholders.

Sample this: PNB has returned a staggering 360 per cent, OBC and Andhra Bank nearly 150 per cent each and the private sector UTI Bank and Kotak Mahindra Bank [Get Quote] over 250 per cent each. Even SBI, in which foreign institutional investors can together hold only 20 per cent, is up 85 per cent.

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