Giving money on credit is considered one of the most significant financial innovations. I remember reading this in the book Sapiens by Yuval Noah Harari; the reason it is so is because people started to believe that the future will be better than the present. This change in mind changed everything. People were ready to delay gratification, loan our money for interest and build lasting civilisation. It is difficult for me to put into words how big this innovation was; it has shaped our whole civilisation and is the primary construct we work on. In some sense, lending has been the key to the beginning of economic growth; currently, it is the pillar of the economy. Banks and such financial institutions are among the most critical sectors for every country and have been a significant wealth creator in India. In this blog, we will analyse what could be the next big wave of wealth creation in this sector: Small finance banks.
The sector has already been a big value creator, but that does not mean it has peaked out. There is a huge opportunity ahead that we all must study. So, let us begin.
Liability side
To understand a bank, you really only need to understand four thing. Assets, liabilities, workings and a few macro factors. Getting a good grasp at these is all you need to evaluate a bank. Let us first begin with the liabilities.
The business of a bank is all about taking liabilities such as deposits at an x% rate, and loaning it out at x+y% rate and pocketing the difference while also managing the risk of not losing the asset loaned out. So, what type of liabilites or deposits do banks get?
CASA: It stands for current account and savings account deposit. This is considered the best the source of funding as it is the cheapest way to get money and also the stickiest of all.
Term deposits: This can include retail deposits and wholesale deposits. Retail deposits are sticker in nature. These too are considered good sources of funding but aren't as cheap as CASA.
Borrowings: Banks and SFBs too borrow money from the market some times. It is mainly visible in NBFCs though as they are not allowed to raise CASA deposits. The methods to borrow money are issuing bonds, borrowing from other banks and also from foreign banks as they could be cheaper in some cases.
Equity dilution:Raising money from equity, too, is a method opted by many. For instance, IDFC First has done a lot of these things. The problem arises because this leads to a dilution in earnings per share because the number of outstanding shares rises. Dilution in earnings means that the wealth you deserve to make will be transferred to the new investors who have invested their capital. People frown upon this, but it's too generalised of a way to look at it. It all depends on the growth that follows after the dilution.
So, as an investor, the most important thing to assess is how cheap these liabilities are. The term for this is called as: Cost of funds. The lower, the better. Generally, Small finance banks have a higher cost of funds as they do not have a very high CASA compared to universal banks. The reason: Universal banks are well trusted and have a srong brand name and hence people prefer to park their money there.
Asset side
The asset of a bank is the money they loan out. These loans will generate interest income and will be what leads to the profitability of the business. There are various types of loans given out to people and corporates. They are as follows:
Loan against property
Home loans
auto loans
commercial vehicle loans
personal loans
consumer durable loans: meant for home products such as refrigerator.
MSME loans:
group loans: mainly practiced by Micro financing companies.
real estate loans
agricultural loans
gold loans
These are largely the type of loans given. However, we can bucket them in two categories.
Secured loans: These types of loans are backed by a collateral and hence if any debtor fails to pay the principal amount, the bank can monetise the asset and recoup some or most of the lost money back.
Unsecured loans: these types of loan are very risky as the banks lose all of the principal amount if the debtor fails to pay back. Loans such as personal loans come under this category are highly risky.
So, this does not end the distinction of loans. We also need to understand another concept as it has been troubling two of the biggest small finance banks lately.
Fixed loan book: In a fixed loan book, the interest you pay does not change irrespective of the changes RBI makes to the repo rate( more on this later.) If the repo rate is decreased, the bank decreases its cost of funds but still makes you pay the same interest and that leads to a higher jump in margins or yields. However, it can be problematic when repo rates rise, as now the cost of funds increases but the interest you charge remains the same. Its a double edged sword which can work both ways, the main problem I have is the stability of earnings decreases.
Floating loan book: In a floating loan book, the interest rate you charge is tied to repo rates. So essentially, it does not matter where the repo rates go as the banks still make the same margin. Its a more stable way of giving out loans.
On the asset side, what you need to track are the yields. Yield is the interest % being charged by the bank. The higher the better. However, there is a problem. Who will pay very high interests? people who are not getting loans anywhere else due to x number of reasons will be desperate and ready to pay at any price. Basically, the higher the yields, chances are the higher the risks. Unsecured loans and people/ businesses without a profile or a good credit score are charged a higher interest to make up for the risks the bank is taking.
We can track these risky loans by tracking GNPAs and NNPAs.
GNPAs stand for Gross non performing assets and NNPAs for Net non performing assets. NPAs are loans or assets that have not repaid their interest for the last 90 days. The difference between GNPAs and NNPAs is provisions. What banks do is that they provide provisions for GNPAs in their income statement which means that they are already accounting for the loss of thar capital. NNPAs are the non performing assets which are not accounted for and can translate to actual losses in the form of write offs.
Track this like a hawk because as we go further and understand the income statement of a bank, rising NNPAs can destroy a bank.
How else does a bank make money?
Interest income is the primary income sources of most banks. However, they have multiple other avenues of income which can be very lucrative. So lets look at them
Maintenance and transactional charges: Banks charge people for maintenance fees and other types of transactions such as international transacations and fast track transactions. This is very profitable as there is no cost to it and it all flows down straight to the PAT
Card issuance and distribution : Banks get paid when you issue a credit card or so from them. Moreover, they are also paid distribution fee when they help sell any product from a different company.
Other investments: Banks are not allowed to loan out 100% of their deposits. They are forced to park x% of their deposits with RBI. RBI pays them a certain % of the total assets for parking this cash. this is called CRR or cash reserve ratio and another thing called SLR or statutory liquidity requirements which is parked in liquid assets such as bonds.
Costs of a bank
Interest expended is one of the biggest cost of a bank but we are all aware of that. What other costs does a bank have?
Operating costs
branch set up costs
Marketing costs
technology costs
A key metric to track here is CII or cost to income ratio. The lower the better. However, looking at it in isolation will give a wrong picture. A fast growing business will be setting up multiple branches and invest in technology, so they will have higher Cost to income ratios. Hence, they should be looked at with respect to growth.
Combining it all
Combining everything is essentially what a bank is. Here we will combine everything we studied and see how everything impacts the ROE of a bank and its income statement. Lets begin with the income statement or the ROA tree.
credits: SOIC youtube channel
I can be quite confident in saying that you can understand the income statement of a bank quite well now. Lets finally look at the last few terms and ROE du pont to seal the deal.
NIM or Net interest margins: Yields- cost of funds. If i am loan money at 10% and borrowing at 5%, then my NIMs is 5%. The income earned from this is called Net interest income or NII.
Provisions coverage ratio: How much of your GNPA are being covered by your provisions. Formula is provision/GNPA.
Credit costs: Reflects the actual financial impact of credit risk by accounting for provisions, write-offs, collection expenses, loan restructuring costs, and interest income loss. the formula stands at Provision/ total assets.
Slippages: The incremental addition of GNPA or NNPA in a particular time period.
Disbursements and gross advances: Advances are the total outsanding loan book of the bank. Disbursements are the fresh loans given out in a particular time period(quarter or year).
Optionality of universal bank: SFBs under certain requirements can get a license from RBI to be a universal bank. Currently: AU, Ujjvan and Equitas would be considered the top contenders to do so.
ROE
What exactly is the ROE?
ROE is ROA x Leverage. Generally, people prefer ROA being the driver of ROE but it is fine if its leverage for a bank. The job of a bank is managing their leverage. If they can stay highly levered, maintain a good asset quality and have a decent valuations, you have a multi bagger in your portfolio.
So look for businesses with potential of high ROE, either with increasing leverage or higher PAT.
Macro factors
Banks are strongly tied to the economy of the country. We had earlier mentioned Repo rate which RBI imposes so lets understand how all of this works.
Economy is a fine balance between growing it but by managing the inflation. Economic growth occurs when there is capex or investment from companies and government or there is an increase in consumption.( Net exports play a role too but no need of it right now). So the way to increase consumption and investments is increasing liquidity in the market. If people have more cash or if the cost of capital is low, there will be a higher economic activity and spending.
This can back fire if excess liquidity leads to inflation, which actually detoriates the spending power of people. RBI uses repo rate as a tool to control both.
Repo rate is essentially the rate at which RBI loans money to banks. If there is low liquidity in the country, RBI will reduce their rates so banks can borrow capital at a lower price and forward this to consumers, so they get the benefit of this.
The opposite occurs when there is inflation, RBI makes it expensive to borrow money so the borrowing reduces and hence liquidity decreases.
Banks play a pivotal role here, and naturally if the lending rate is high, the advances growth is low. So, low interest rates aid in the growth of banks. But be careful of very fast growing banks. No one says no to money, the problem arises when its time to pay back.
What is a small finance bank?
So basically, SFBs were created to increase the penetration of credit in rural areas. These businesses have to focus a big part of their loan book on priority sector and have a higher capital adequacy ratio. Since they can take deposits and can open smaller cost effective branches like NBFCs, SFBs can maintain strong growth rates and also maintain a cost effectiveness in their operations.
Key metrics to track
Asset quality: You need to keep a hawk eye like look on the asset quality of Banks. This will make or break the bank. Under asset quality, you should also assess the secured/unsecured loan book which helps during down cycles, fresh slippages as they can signal a coming deteriorating asset quality and the segment/geography wise break up. Concentration in single geography or a product can a cause of concern in the future as uncertainites are many. I know it is a lot to ensure, but it gets simple once you start reading them regularly.
NIMs or Net interest margins: Under this, you will get the idea of how is the asset side and liability side working. Are raising deposits getting expensive? or are the yields falling?NIMs will help you understand the sources of fund and what type of product is the fund being deployed in.
ROE: Look for businesses which can potentially expand their ROE. Consistently high ROE or ROA is a key trigger for rerating. The reason HDFC bank and Bajaj finance command high valuations is because of their consistently high ROE.
Management: Management DNA is the single most important factor in lending. No one will say no money, so it is very easy to grow the loan book. The problem will arise when its time for payback. Hence, it is important to have a conservative management who can grow but while maintaining a good asset quality. A red flags in management will be when RBI appoints their own person to the board. This implies that RBI does not trust the board.
Optionality to be a universal bank: Small finance banks have the potential to be a universal bank by follwoing a few requirements and with the approval of RBI. Currently, AU small finance bank is probably the strongest contender for a universal bank license but a few others like Equitas and Ujjivan can achieve it.
Analysing these banks
If i were to go deep in all the SFBs, the blog will end up becoming a few hour long read.
I will try to keep it short and crisp and use the key metrics to analyse the banks. Lets begin.
The analysis I give are subjective in nature and I might have a bias in the positions I am holding. I would encourage you all to delve deeper and text me about what you have studied or have doubts in, I will be happy to help you.
AU and Equitas both had a fixed loan book and hence suffered when the RBI increased repo rates. Due to this, both have been suffering NIM compression. Although we can expect rate cuts soon, it is a very speculative thing, and I would not build a thesis on it.
Moreover, Equitas has taken up a significant floating provision this quarter to reduce its NNPA number below 1%. With this, it becomes the third bank after AU and Ujjivan to become eligible to apply for universal bank as it completes all the eligibilities.
I also find Equitas to be undervalued. The reason is that it has a decent ROE of 14-15% (post adjustment), ROA above 2%, secured loan book, 20-25% guidance and is geographically diverse. Owing to these multiple criterias, it should be close to the valuations that AU offers.
Continuing with other businesses, we will notice a fall in ROE of multiple businesses especially Ujjivan. The reason is that last year was a benign time for these unsecured lenders and they basically made a killing. The ROE is normalising to what it should be.
In my opinion, I find Jana and Suryoday to be quite attractive. They have maintained a good asset quality and are guiding for a good growth while also focusing on increasing their secured loan book. Suryoday's guidance and asset quality are very impressive. Utkarsh too has been quite impressive with what it has delivered. A guidance of 30% seems promising and that too at such good valuations.
ESAF is a business I would completely avoid. The GNPA has shot up, The ROE is dismal and i do not see much improvement happening in the coming times.
This marks the end of the article, please feel free to contact me in case of any doubt or feedback. Subscribe if you love the content!
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