The story of PSU banks can be best encapsulated with a comparison of market capitalizations. At current market prices, the market capitalization of all the PSU banks put together is less than the market cap of HDFC Bank. This, despite the fact that HDFC Bank has been in existence for just 22 years while most of the large PSU banks have a history spanning over 70 years. Then what exactly has gone wrong with the PSU banks and would they make a good investment story at current market prices?
What exactly has gone wrong with PSU banks…?
The big challenge for the PSU banks is that they continue to follow a business model that is largely outdated. A focus on branch expansion, vast rural set ups and socially driven lending has made most PSU banks unprofitable. Aggressive lending to large corporates has also worsened matters and the banking industry is currently struggling with an NPA burden of nearly $60 billion. What this sector needs is strong medicine. And that is what the government is planning. There are 3 broad initiatives that may make the PSU banks attractive from current levels.
A solution to the capital problem…
For PSU banks, the problem of NPAs and capital inadequacy are inter-linked. They need capital to expand their asset books but are unable to do that due to the high level of NPAs. As per the Basel III norms that will kick in from 2019, the Indian banks need a substantial infusion of capital. How will the banks manage that? Firstly, the RBI has clarified that the banks will be permitted to use their Revaluation and Currency Translation Reserves as Tier I capital. This will add nearly $55 billion to their balance sheets and largely address the capital inadequacy problem for PSU banks. Secondly, the government has encouraged banks to access the IPO market for raising money. To facilitate the process, the government has kept its disinvestment target at a conservative level of less than half of last fiscal. This will ensure that bank issues do not get crowded out.
Addressing the NPA concern…
This is a slightly more complicated problem. A chunk of the NPAs of the banking industry comes from their loans to the steel and infrastructure sector. Both these sectors do not display any immediate visibility in earnings. The only way out for banks will be take a one-time hit on their books by making a more realistic provision for doubtful assets. The RBI has taken the right step with their Quarterly Asset Review and that will go a long way in getting a clearer understanding of the magnitude of the NPA problem. Once it is written off, then any subsequent recoveries will be a write-back to the profits.
The Kingfisher template will also be viewed closely. There are many such large business houses that are having market capitalization that is a fraction of their total bank borrowing. How the government and the RBI empower the banks to use the legal and policy framework to recover their monies will be critical. All in all, greater transparency in NPA disclosure will eliminate the uncertainty surrounding banking valuations.
Finally, time for restructuring PSU banks…
The government in its latest budget has also taken a small step towards some large scale reforms of the banking sector. Firstly, the PSU banks will be readied for a strategic sale to global investors and IDBI Bank is likely to be used as a template for the same. With banks permitted to capitalize their revaluation reserves, this could be an added incentive for global buyers. Secondly, the government has seriously started looking at the prospects of consolidation among PSU banks. There are a handful of banks which can be positioned as global competitive banks and then there are smaller banks that are purely resulting in duplication of banking services. In the light of a tech-savvy private banking sector and the emergence of payment banks, this model calls for a rethink. Thirdly, once the best banks are identified the government has agreed to give greater autonomy to these banks. That will be critical in making these banks competitive vis-a-vis their private sector counterparts.
A new era for PSU banks….
These may be early days but it surely looks like a new era for PSU banks and the government seems to be quite serious about it. The Indian PSU banking sector will look much leaner after consolidation. If the better-off banks are then given the autonomy to function like their private sector counterparts, there is no reason why they cannot become a serious investment option.
That could be the big story on banking in the coming few years. Most major PSU banks are quoting at single-digit P/E ratios and having a P/BV of less than 1. This is a classic case of undervaluation at a time when large-scale reforms are underway to change the face of PSU banking in India. We do recommend a phased approach to investing in PSU banks as there will be a long period of consolidation before a worthwhile up-move can start. But for long term investors having a perspective of more than 3 years, this could be the right time to start accumulating quality PSU banks. Above all, do not forget the dividend yield story in these banks. Most of these PSU banks also offer attractive dividend yields that are way above the market and industry average. That could be the icing on the cake!