The rapid expansion of the financial services sector has been a force behind India’s economic rise. This segment, comprising private- and public-sector banks, non-banking financial services, rating agencies, brokerages and other quasi-financiers, is registering a strong growth rate due to the penetration of banking, plastic-based payment systems, electronic fund movements, and so on.
The dynamics of the banking sector have altered tremendously. It has seen a flurry of companies amalgamating traditional lending models with systems that can reach out to newer segments at lower costs. It’s this expansion of the financial services sector that has been instrumental in delivering considerable performances for investors. An investment of `10,000 on 1 January 2002 in BSE Bankex would be worth `1,76,579 on 18 August 2014. A similar investment in the S&P BSE Sensex would be worth merely `81,299.
So what drives banking performance? The banking sector is a play on economic growth. Its performance and the growth in gross domestic product (GDP) go hand in hand. When GDP growth rates are high, the banking sector witnesses strong credit growth. Between financial year (FY) 2004 and 2007, GDP growth averaged around 9%, which led to a boom in banking services. The Bankex rallied from 3,721 on 31 December 2004 to 11,418 in December 2007, rising nearly 207% in a short time.
At present, the turnaround in the Indian economy seems to have just begun. GDP has bottomed, coming in at sub-5% lately, and all indicators point to a revival in the next few years. Expectations are that the GDP growth could inch closer to the 6.5 percent mark by FY16.
Besides, a reduction in the current account deficit and a steady rupee against other foreign currencies, especially the dollar, lends considerable stability to a bank’s operating environment. During the sharp fall of the rupee in August last year, banks faced considerable tightening as short-term interest rates were raised to aggressively high levels. Short-term liquidity of banks is in a much better shape now.
Asset quality cycle is also expected to improve in the coming years. The big question mark lately on banks’ financial performance has been due to asset-quality issues and capital constraints. The weak economy of the past led to weak asset quality and consequent increase in provisions towards bad loans, hurting their profitability. From April 2011, when asset quality first started deteriorating, the banking sector also began to get de-rated in the market. The issue of stressed loans can be resolved once infrastructure bottlenecks are removed and the investment cycle picks up. Over 60% of the incremental increase in stressed loans is from infrastructure, iron and steel and textile sectors.
But if one looks back, asset quality improvement and a strong and extended growth of more than 20% led to a big re-rating in the banking sector between January 2005 and December 2007. If the banking sector begins to show signs of improving asset quality in the coming quarters, re-rating is possible from the current levels of valuation.
In fact, the budget has also paved the way for a revival in infrastructure spending. Banks are now allowed to raise long-term funds for infrastructure and housing with minimum regulatory pre-emption. For banks, this is a ‘power positive.’
Interest rate cycle in a sweet spot
High inflation tends to keep interest rates elevated and hampers credit-offtake. And with the monsoon being deficient, the expected interest rate cuts may take a while to materialize. However, inflation has been benign lately and if it continues to trend lower, the RBI could lower interest rates earlier. This will lead to a higher credit-off take and treasury gains for banks.
A fall in interest rates spurs companies to borrow and expand as the cost of funds is lower. It makes more projects viable as funds are cheap and also allows companies to make more capital investments in new or existing projects.
Besides, falling interest rates can boost banks’ treasury gains as the value of government securities and other holdings increases in the market. Banks report higher profit due to mark-to-market gains on the government securities that they hold.
For retail consumers, interest exemption on home loan being increased to `2 lakh from `1.5 lakh will boost the fortunes of housing finance companies. New banking licences will initiate a revival in the sector with special payment banks and rural banks being contemplated to increasing financial inclusion.
In the stock market, valuations of banking stocks are not expensive. Most large banks are trading at long-term average price-to-book multiples, while the macro-economic environment improves steadily. This leaves a upside potential in the banking sector.
It’s the implementation of the reforms process and the revival in credit that could be instrumental in delivering above market performance in the next few years. But there are many investment options in the banking space even now. Investors, however, have to be discerning. Investing via mutual funds could help to sift between the better-placed banks and finance companies, and also help to keep an eye on stock valuations, earnings parameters, capital adequacy, asset quality and treasury movements and much else.