Future Of PSU Bank Shares

Should you be wary of PSU bank stocks?-TOI

Uma Shashikant | Jun 2, 2014,

The value investment metrics of state-owned banks look promising, but it may not be wise to speculate. 

There are times when speculation comes disguised in the cloak of value investing. The surge in PSU banking stocks is one such recent case study. There is a ring of nobility to value investing — buy a stock that has been beaten down and profit from its revival. When the third quarter results came in December 2013, and United Bank of India seemed to have gone back to the brink, there was despondency in the PSU banking sector. The burden of bad debts was too high in the minds of investors, who pushed the prices down, much below the book value. Low price is a good bait for speculation, not just value investing. 

The value investing play is about the earning forecasts and future prospects, not merely the price. There are no macro justifications in value investing. You do not buy a stock with the hope that a turnaround in the investment cycle will increase the demand for credit and, therefore, benefit PSU banks. Instead, you would look at the balance sheets of the stressed banks and ask what is causing the pain in the books, and what would it take for them to return to good health. The crux of the problem with PSU bank loan books is that defaults were triggered both by the cyclical downturn in the economy and wilful default by many borrowers. Sustainable solutions should, therefore, address the business-level problem. The case of PSU banks should also be contrasted with the books of private sector banks, which went through the same macro and credit cycle, but ended up with lower levels of NPA. 

The problems of PSU banks got worse when they decided to take the CDR (corporate debt restructuring) route to deal with NPAs. This treatment of bad debt, they assumed, can be recovered over time. This route enables postponing the accounting for bad debts and net profits from the hit it would have taken. It was only when the RBI intervened and took away the CDR cover, that it became apparent that the rot was deep. While private sector banks continue to practice stringent provisioning for bad debts, PSU banks characteristically choose to hide behind convenient delaying tactics. 

The fall in prices of PSU bank stocks was very steep when it was known that the NPAs were high enough to need recapitalisation. It is simple math, actually. If a bank had 90 and deposits 10 as equity capital and makes 100 as loans using these funds, in order to stay in good health, it needs the loans to be repaid. The market price of the equity capital reflects the quality of the 100 of loan. If it is expected that only 95 would be recovered and the value of equity drops to 5. So, the steep fall in the price of PSU bank stocks is a direct reflection of the NPAs in the loan book. When market price falls below the book value, it simply reflects the lack of confidence of investors to accept the book value as a correct reflection of how much of the loans would actually be recovered. When the value of the loan book falls below 90, unless the bank is recapitalised, or unless fresh equity capital is brought in, the deposits are in risk. 

So, why is the value story gaining so much ground? If one were to read from the textbook, a PBV lower than 1 means the market price is lower than the value per share stated in the book, and that might be an extreme situation. A value investor looks for a margin of safety, or how much more can the stock fall. When the price is already below the book value, this margin is good. The dividend yield, another value investing metric, is very high for many PSU stocks. This would indicate that the company still makes profits and is able to distribute them, but the market price is too low, taking the dividend yield high. In the PSU banks case, we must remember that this metric is distorted because the government compels them to declare a dividend, given their own fiscal situation. 

How does this situation lend itself to an interpretation from a value investing perspective? If the government recapitalises banks, if the investment cycle returns, if credit growth picks up, if bank ownership changes so that lending gets more stringent, if accounting policies get better, if existing NPAs are written off in reasonable time and if the government divests its holdings, there is scope for appreciation in the price of PSU bank stocks. But so many of these assumptions are at the macro level, not at the business level. The only business indicator of a visibly lower level of NPA in the books of a few PSU banks comes from shutting out credit or from lowering the quantum of credit. Therefore, what is being cloaked as value investing in banks, is actually unabated speculation. 

These macro level policy measures will not happen overnight, nor are they likely to be the priorities of the new government. Most importantly, if there is a macro level change in cycles, investments and credit, the stronger private sector banks will gain much more than the weaker PSU banks. Investors should know that they are taking a speculative bet that things can't get worse than this, and that the government will do something to revive the PSU banks. That is slippery slope and one needs to be very, very careful.
Link times of India

Bank recapitalisation is painful, but necessary-Deccan Herald-02.06.2014

India’s state-owned banks need a government bailout. The country’s wobbly public sector lenders require around $45 billion to put their balance-sheets on a firmer footing, according to a Breakingviews calculator. That’s a bill the new government can ill afford. 

But if it acts fast, it may be able to take advantage of the post-election euphoria to persuade private investors to put up some of the cash.

A recent report from the central bank described India’s 21 public sector lenders, which include State Bank of India, Bank of Baroda and Punjab National Bank, as “fragile”.

That’s the polite term. Several years of slow growth have strained the industry: bad debts in the whole banking sector reached 4.4 per cent of total lending at the end of December, up from 3.7 per cent a year earlier. For state-controlled groups the figure is closer to 5 per cent. And that’s just the dud credits they own up to. Public sector banks, which account for three-quarters of India’s total lending, are notorious for rolling over loans to politically sensitive borrowers. The real figure may be as much as twice as large.

Another worry is problem loans which borrower and bank have renegotiated. In the aftermath of the 2008 crisis, Indian regulators gave banks some leeway in how they treated these “restructured” credits. The predictable result is that the loans in this category trebled in three years, reaching Rs 2.9 trillion ($49 billion) by the end of 2013. 

That’s greater than the official stock of bad debt. A significant proportion is to borrowers who probably cannot pay.

If these two factors weren’t enough of a headache, India is also raising the bar for how much capital banks must hold. The Reserve Bank of India, the central bank, has interpreted new Basel III rules so that lenders must have Tier 1 capital equivalent to 8.88 percent of their risk-weighted assets by 2018, up from 6.5 percent today.

A new Breakingviews calculator, based on RBI data, shows the size of the potential capital hole. Start by assuming 10 per cent of all loans and 45 per cent of “restructured” loans are duds. Then require lenders to set aside provisions worth 70 per cent of the face value of those loans. Finally, make banks hit the higher 2018 threshold for Tier 1 capital today. In this admittedly harsh scenario, India’s state-owned banks would need more than $45 billion of capital – more than half of their existing equity base.

Stock market listings

The government is on the hook for most of this. Though many public sector banks have stock market listings, the state is legally required to maintain a majority stake. Prime Minister Narendra Modi’s new administration may eventually try to ditch that rule, but only if it can get a bill past the upper house of parliament, which it does not control.

The new administration is unlikely to welcome the idea of pumping in more than 2 per cent of GDP into the financial sector. But delay will only make matters worse. The longer that banks hide past mistakes, the fewer new loans they will make. That will restrict the flow of credit, limiting the economy’s capacity for growth, and making the bad debt problem larger.

The government can take steps to minimise the final bill. A large chunk of the bad loans are to infrastructure projects – particularly power plants – that are in trouble partly because they lack the necessary permits. If the new authorities can clear these bottlenecks, some of the bad debt may eventually turn good.

The most promising way to reduce the cost to Indian taxpayers, however, is to bring in the private sector. Institutional investors may be reluctant to buy more common equity while the government is still in control. 

However, banks could issue other forms of capital, such as preference shares, or bonds that are written down in a crisis. India’s recent stock market rally will help: the S&P BSE Bankex index is up 34 per cent so far this year.

Over time, state-owned banks will need more thoroughgoing reform. Many are inefficient and run according to political rather than financial priorities. A wave of consolidation, led by stronger players, could help.

But no amount of restructuring or improved governance can compensate for a shortage of capital. If the new government acts quickly, it could set off a positive feedback loop whereby an improved supply of credit feeds faster economic growth. Delay, and the final reckoning will only be more painful.