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Indian Banks- The “Tragedy Trade”

12 August, 2009

The tragedy of Indian banking is that most banks are plays on the Government bond cycle (rather than being plays on the thriving economy). Strip out such ephemeral capital gains from Government bonds and most Indian banks posted sub-15% RoE even between FY06-09, the most benign period ever for Indian banks! With Government bond yields now hardening we recommend that investors reassess their exposure to Indian banks.


Over the past five months, whilst we have been Negative on most of the banks that we cover, Indian banks’ share prices have had a stellar run (with the BSE Bankex outperforming the BSE Sensex by 41%). However, investors are now faced with a dilemma.

On the one hand the stock market is on a sustained bull run (driven by heavy inflows of FII capital at a time when India, alongside China, is the only large economy to post 6%+ growth). Since banks are almost universally perceived to be geared plays on the economy and the stock market, the strength of conventional wisdom could push up banks’ stock prices. On the other hand, Indian banks face two fundamental challenges in the coming months:

Poor cross-cycle core banking profits: Cross-cycle ‘core’ banking profitability

data suggests that a number of Indian banks are basically bets on the Government bond cycle (between FY99-09 and FY06-09 Treasury gains accounted for ~35% and ~15% of the reported returns for the fourteen banks covered here). So if Government bond yields are

hardening, banks’ stock prices are unlikely to run up.

A Government spending dependent economic recovery: The Indian economy, like many  thers around the world, is being propped up by Government spending (fiscal deficit expected at 6.8% of FY10 GDP). If one adjusts for this, the Indian economy will grow at a mere 3% in FY10, its lowest growth rate since FY02. This we believe has negative ramifications for the banks’ NPAs, something that has been masked over the past six months by restructured assets (which now account for ~4% of Indian banks’ loan books).


The way forward for investors could be a market neutral long-short trade. One such strategy could be to go ”long” on high quality and relatively undervalued banks (State Bank of India, Punjab National Bank and Bank of India) and “short” the relatively lower quality overvalued banks (ICICI Bank, Bank of Baroda).

Over the past 1, 3 and 5 years, such an equally weighted long-short strategy would have

produced annualised returns of 2%, 21% and 13%.


Over the past five months, whilst we have been Negative on most of the banks that we cover, Indian banks’ share prices have had a stellar run. Since 9th March’09, the BSE Bankex has risen by 134% as compared to the BSE Sensex which has risen by only 95%. Moreover,  Indian banks have very strongly outperformed Emerging Markets more generally. In terms of relative valuations, the Indian Public Sector Banks (PSBs) are now trading at 1.2x FY10E P/BV (up from

0.7x FY10E P/BV as on 9th March’09) and the large Private Sector Banks are trading

at 2.2x FY10E P/BV (up from 1.2x book on 9th March’09).

Our discussions with clients highlight that almost universally, investors see Indian banks as a geared play on the overall growth of the Indian economy. Hence, the theory goes, if the economy is recovering, banking stocks are bound to outperform.


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Ashish Abrol . 6 years ago

I must agree with you that stocks of some Indian banks are overpriced. The reason for my argument though is different from the one put forth by ypu. The run up since March is unsustainable and I very much endorse the long short strategy. I might though recommend a different basket comprising the longs and shorts.

Coming to my points of difference with your article. One of the reasons you have cited in support of your argument is that treasury gains from 99-09 comorised ~35% of profits and between 06-09 comprised ~15% of profits. I would like to make two comments here. Between 99-09, we had periods of softening yields and periods of hardening yields. Given that fact, it appears, the treasuries of banks are sophisticated enough to take advantage of movement in the bond markets, irrespecive of which way it moves. The other point I would like to make is that between 06-09, the interest rates hardened substantially (just as you are predicting is beginning to happen now) and the banks were still able to generate ~15% from treasury income. Why do you feel that this time around the banks will be stumped and will not be able to ride the reversal in bond cycle fortunes?


Nishant . 6 years ago

Reply to Ashish’s comments –

If you look at the treasury profits between the period 06-09, they came from profits in equity and structured products and not so much from the bond desk. Though I would not blame the Indian banks for this situation. Even if they have the capability to manage debt portfolios, the lack of different interest players as well as lack of liqudity in most securities, combined with the high SLR requirements and the absence of a corporate debt market, means, that their debt portfolio returns will almost always be highly correlated with the Government bond cycle.

Ashish Abrol . 6 years ago

reply to Nishant’s comments:

From 06-08, interest rates hardened substantially (~ 250 bps). During this period, banks derived ~15% of profits through treasury operations (per your article). However, you point out this is because they were not really treasury profits from the Fixed income desk but rather from equities and structured products. Therefore, all else being equal (ie. interest rates will firm up over next 12-18 months, SLR will continue to be high as it was in 06-08) why do you feel the banks will not be able to anticipate RBI’s hardening stance and make necessary adjustments to ensure continued treasury profits. Besides, the yield curve continues to be upward sloping and as goes the saying -“even a banker can make money borrowing short and lending long!”

In summary, fixed income volatility is great for smart treasury managers and I feel well managed treasuries (HDFC Bank, SBI, Axis) will continue to reap gains irrespective of RBI’s interest rate policy stance.

Prashant Kotian . 6 years ago

Aditi, I agree some Banks are overvalued. I disagree with fact that the current raly will be sustained as I believed we live in cost push Inflation world. I see Banks like Vijaya Bank & Allhabhad bank doing well. I see capital erosion in Pvt sector as Structured Products is not everyones Cup of Coffee..

Indian Banks- The “Tragedy Trade”

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