Few things influence a bank’s fortunes as strongly as the direction of interest rates and the condition of its loan book. Traders who monitor the ICICI Bank share price often notice that it reacts to rate commentary from the central bank within moments. Those following the IDBI share price see a different layer of sensitivity, because recovery progress and ownership news enter the picture as well. This article explains, in simple terms, how rates and credit quality combine to shape what the market is willing to pay for a lender.
The Margin Question
A bank’s net interest margin is the difference between its yield on assets (the loans it has made) and cost of funds (the interest it pays on deposits). The former tends to move swiftly with changes in central bank policy rates, while the latter lags. So banks where a significant portion of loans are benchmarked to external rates will see margins widen rapidly on a rate hike, and narrow quickly on a cut
Analysts understand this dynamic, which is why a mere question on whether rates will go up or down is not sufficient. Instead, it asks how a bank’s loans and deposits are structured. If it has plenty of inexpensive savings deposits, it is in a better position to absorb rate changes than a bank which has a large exposure to costlier bulk deposits.
Credit Costs and the Economic Cycle
The second major component impacting profitability is credit costs. This represents the provision a bank makes for bad loans. During periods of strong economic performance, borrowers are able to meet their obligations and provisions fall, while profits rise. When the economy slows down, a few borrowers face stress, raising provisions. Since India’s economy tends to swing between periods of expansion and consolidation, credit costs tend to fluctuate as well. Therefore, banks which lend prudently during periods of prosperity, diversifying their book by avoiding excessive concentration in any one sector or borrower, are better able to ride out a slowdown. Investors understand this, and value lenders with strong balance sheets on which they can rely to withstand turbulence. Often, retail lending – particularly mortgages or loans against income – tends to move in a different cycle than those extended to highly leveraged businesses. By studying the mix of a bank’s book, therefore, investors can gain insights into its potential earnings resilience.
Legacy Burdens and Recovery Paths
When it comes to banks that have battled through a bad loan cycle, the question of valuation is more nuanced. Here, it is not merely a question of how far the clean-up process has gone. Recoveries on accounts, abandoned during bankruptcies, settlements with borrowers, as well as the sale of NPAs all contribute to profits. As provisions decline and bank recoveries rise, there can be a substantial improvement in profitability.
But markets will not reward an improving bank forever, and eventually a growth story has to be put in place. By that, it is necessary for the bank to demonstrate that it has the potential to build a wholesome retail and corporate business, expand its customer base, and improve operating efficiency. Not all lenders that have turned around their balance sheets are able to do so. In the case of such banks, the second rung in the valuation ladder may not be as strong.
Putting It Together as an Investor
When evaluating any bank, always remember to look at rates and asset quality as two sides of the same coin. Strong margins will be undermined by weak asset quality. While strong asset quality and a reasonable margin is a profitable combination, growth may be limited by anaemic margins. The most attractive combination is one where the bank has a strong margin with low credit costs, backed by a solid deposit base. Second, try to make a habit of reading the management’s discussion in any quarterly presentation, focusing on how it expects the loan book to grow, how it sees its deposit trend, and its expectations from credit costs. Cross-referencing these assumptions with actual performance in the subsequent quarter will give a reliable measure of how honest (or otherwise) the management is. Lastly, always remember that valuation is really about meeting expectations. For if markets expect something to happen, the actualisation of this will have an impact on the price. Thus, if expectations are high, even good news may fail to excite, while if expectations are low, even mediocre news may find markets reaching for the buy button.