Twinkle, twinkle, banking star

	April- September Sept-Oct 2006 2006 Bankex 0.18% 14% Sensex 1.70% 6.90% Source: Prowess, CMIE

Bank stocks are back in favour. Consider the relative performance of the Bankex, the index for the banking sector in India, and the Sensex, the market index. In the six months upto September 2006, the Bankex underperformed the Sensex. In the last one month, the Bankex has outperformed the Sensex. Why so?

I can think of three reasons:

• There are signs of a softening of interest rates over the past month with oil prices trending downwards.
• In April, the RBI, in its annual credit policy statement, declared its intention to slow down credit growth from 30% in the previous year to 20% in 2006-07. So far, that hasn't happened- credit growth year on year upto stayed at over 30%.
• The last quarter GDP growth turned out to be higher than expected-8.9%. This has caused many forecasters to believe that GDP is more likely now to end up at the upper end of the 7.5-8% band they had projected. Bank stocks are a play on the economy, so what's good for the economy is good for bank stocks.

A buoyant economy boosts volume growth, of course, but it helps in other ways as well. Non-performing assets (NPAs) at banks tend to decline- and we must remember that asset quality in Indian banking is at its best today. There is no imminent danger of this being reversed because leverage among Indian firms is at its lowest in years- 1.06 according to Brics Securities. (Indeed, over the past couple of years banks have been effecting impressive recoveries from past NPAs.) The rising proportion of housing loans in the overall portfolio also makes for improved asset quality.

Secondly, when economic activity is high, so are float funds in the system. These tend to lower banks' cost of funds. That explains why banks' net interest margins (the difference between interest income and interest expense as a proportion of assets) have remained steady or even gone up in some instances despite an increase in interest rates. Higher interest rates on term deposits are offset by the lower cost on CASA (current and savings accounts), the proportion of which tends to go up with increased economic activity.

I have said elsewhere that Indian banking enjoys what would be regarded as an 'impossible trinity' in banking- high volume growth, high asset quality and high net interest margins. What I have stated above sheds light on why this is so. Bank investors, rejoice!

Household credit: how India stacks up

Retail or household credit in India has been growing at breakneck speed. In 2000-05, 25% of the incremental credit came from retail credit. For some banks, retail credit has been as high as 50-70% of additional loans. Is this sustainable? Does it spell trouble for banks, meaning, high non-performing assets down the road?

Answer to the first question: we should expect to see a slowing down because growth is now taking place on a higher base. Secondly, demand for credit from corporates has revived strongly, so banks can expect to grow their portfolios with a better balance between wholesale and retail credit.

As for the second question, the IMF's Global Financial Stability Report (September, 2006) has figures and tables that help place household credit in India in perspective.

The salient points in the two figures and one table reproduced above:

• While retail credit has grown strongly in India, growth is still lower than in emerging Asia and emerging Europe.
• Household credit as a proportion of disposable income in India is the second lowest (after Korea) among a sample of emerging as well as mature markets.
• Household leverage in India is the second highest among a sample of countries, after New Zealand.

Should we worry about high leverage in Indian households? Not really. For at least three reasons:

1. The overall figure for leverage is an average across highly indebted rural households and urban ones. It does not give a correct picture of the segments banks are targeting for retail credit- salaried professionals and high net worth individuals
2. Most loans are made against future income, not assets
3. The biggest chunk of retail loans (nearly 50% of retail exposure) is housing loans on which defaults are- and banks have a solid collateral.

The bottomline: household credit in India can continue to grow strongly without posing problems for the banking sector.

Credit growth in India: don't push the panic buttons yet

Rapid credit growth gives regulators an attack of nerves- they tend reflexively to associate these with a coming bust. To regulators, runaway credit growth is a sure sign that bankers are compromising on credit quality and that massive non-performing assets will follow.

Scheduled commercial banks' commercial credit- or 'non-food credit' as it is called- grew at 30.8% year on year in 2005-06. This was on top of growth of 28.8% in same period in 2004-05. There is little sign of a slowdown in 2006-07- in July 2006, y-o-y growth was 32.9%.This appears to have the RBI a trifle worried. It would like to see credit growth slowing down to 20% in the coming year.

I believe this concern is a trifle overdone. It's not aggregate credit growth alone that matters. You need to look at three factors: the composition of credit (especially corporate versus retail, exposure to sensitive sectors); the sources of funds for banks (domestic currency versus foreign currency); and whether there are signs of macroeconomic balances. I argue in my column in the
Economic Times that, viewed in relation to these factors, the credit growth we are seeing does not warrant undue concern.

I didn't have a chance to mention in my column that the RBI itself took a rather benign view of credit expansion in its Report on Trend and Progress in Banking in India (2004-05)- box on page 68. It noted that credit expansion in 2004-05 was more broad-based than in the previous years, with credit to industry and agriculture joining the retail sector in driving the demand for commercial credit. It also noted that NPAs in the retail sector, which has provided some of the impetus to credit growth, are still low- around 2%. "Therefore", the RBI concluded, " if banks put adequate risk monitoring and management systems in place, there should not be much cause for concern for the future, although past performance may not always be a good guide".

This was in the Report released in November 2005. Maybe the RBI reckons that three years in a row of rapid credit growth is a bit too much. Remember, however, that GDP growth continues to be robust.Let me qualify my upbeat assessment by saying that, while credit growth may not pose systemic risks, some banks could be asking for trouble.

At least some of the lending rates point to under-pricing of risk by public sector banks. They have responded to rate cuts effected by some of the savvier private banks. But the private banks know what they are doing. They have systems to measure return on capital for any given borrower, retail or wholesale. Not so the public sector banks. The RBI's response has been to increase risk weights for various retail loans. That should cause errant banks to take a closer look at their pricing. But there could be banks out there that fail to make the link between capital allocation and pricing.

IDBI-UWB Merger

The merger of IDBI with United Western Bank (UWB)is through. IDBI intends to treat UWB as a separate business unit. That makes sense. The arm's length relationship will enable IDBI to cash in on UWB's strengths- high quality customer service, rural loans- without IDBI's having to
tackle the people issues that a merger will entail. Once some of the stressed assets are recovered and UWB is put on a sound footing, the full value of the merger will become evident- and IDBI's price should appreciate.

My initial comments on the merger in my ET column.