Falling banking stocks have been the talk of the country for some time now. Know why they are falling and how to pick the right bank stock to invest in at these low prices that could create wealth for you.

What is the major problem that the Banking Sector is facing?

We are well acquainted with the fact that the banks mainly earn from lending the money we deposited to the industries. In the past few years banks have accumulated a lot of NPA (Non-Performing Assets) because of which they are incurring huge losses.

What are NPA’s?

When borrowers fail to make interest or principal repayments for 90 days, banks classify that loan as a Non Performing Asset. NPA’s can be further categorized into Substandard, Doubtful and Loss Assets depending on how long the non-payment has continued and how much riskier they have gotten and accordingly banks are statutorily required to keep a percentage of their profits as provisions for these NPA’s.

Why did the banks accumulate such high NPA’s?

In the last few years the earnings of the industrial sector in India have remained weak due to the global and domestic economic environment. Particularly, a lot of steel and power companies have taken huge loans but are currently incurring losses owing to macro cues and are thus unable to payback. For instance, imported steel from China costs much less than its domestic counterparts which combined with a downturn in global commodity prices and lack of demand has caused even large scale big Indian steel giants to incur losses.

Are all NPA’s on account of corporate losses?

The answer to this is a definitive ‘No’. Not all NPA’s are because of the economic situation and there are also Wilful Defaulters in the list. According to RBI, a Wilful Defaulter is someone who does not repay even when they can or has not used the money for the purpose it was borrowed for or siphoned off the funds or disposed the assets that were pledged against the loan.

Do some banks have more exposure to NPA’s than others?

Yes, different banks have different levels of exposure to NPA. In general Public Sector Banks (PSU) have more exposure to NPA’s then private sector banks.

Which banking stock to pick should one want to indulge in bottom fishing?

Banking stocks have been falling constantly and some of the big bank stocks have fallen 30% to 40% in a very short time. It is said that if you try to catch a falling knife then you will only hurt yourself. However there are some banks which have comparatively less exposure to NPA’s and better fundamentals and have still fallen due to sentiments and uncertainty. These bank stocks may be available at attractive prices and present a good opportunity for making profits. Below are some important factors to look into (not in any order), which will help you distinguish between different bank stocks and identify which one has stronger fundamentals with less risks associated and will be a value deal to bottomfish.

1. Price to Book Value Multiple of Banks (P/BV) – When it comes to banks this ratio is a better indicator of whether the share is overvalued or undervalued than the price to earnings ratio. To understand why let us first understand what this ratio stands for. It is computed by dividing the market price of a share by the book value of a share. The book value of a share is (total assets – liabilities) ÷ number of shares and represents the net worth per share.

For the banking industry liabilities are basically the public deposits they have which they owe to the depositors. This money when loaned to industries generates revenue in terms of interest earned for the bank and thus the loans banks give form its assets. Unlike other industries, where book values may be recorded at historical costs, book value of a bank is marked to market and is thus a good indicator of the assets held by the bank.

2. Price to Adjusted Book Value – This is a more conservative variant of the P/BV ratio discussed above where adjusted book value is used instead of book value. Here the net NPA’s are deducted from the book value of the bank. This is more relevant now in the current scenario.

3. Capital Adequacy – Banks need capital to give fresh loans so that they can grow their business. Thus, capital is an important aspect of the banking business and directly related to growth. Capital adequacy has two aspects, quantitative and qualitative. Quantitatively, RBI requires banks to maintain their capital adequacy ratio of total capital funds to risk weighted assets at 9%. However banks keep a higher ratio than that so that they can continue lending. Qualitatively a portion of the bank’s capital is Tier 1 which is the core capital formed from shareholders funds and a portion is Tier 2 capital formed of supplementary capital like subordinated term debt, undisclosed reserves etc.

When banks have huge amounts of bad loans it erodes their capital and like in the current scenario they need recapitalization. This can be effectively done by raising fresh capital through issue of shares, getting a bailout package or recapitalization from the government, change in policies and regulation and growth in business.

4. Gross and Net NPA – Gross NPA is the total NPA exposure of the bank. Net NPA is the amount of Gross NPA less the provisions set aside, claim not adjusted and interest in suspense account for that NPA. Before investing one should see the Gross and Net NPA exposure of banks and its impact on its fundamentals.

5. Slippages to NPA – According to RBI the slippage ratio is calculated as (Fresh accretion of NPAs during the year ÷ Total standard assets at the beginning of the year) ×100. Here standard assets are the good loans at the beginning of the year. Thus, slippages indicate fresh loans that have turned bad during the year.

6. Return on Equity (RoE) – Return on Equity or Net worth is computed as Net Profit ÷ Shareholders Funds. The more the rate of return, the more edge the bank has over its competitors. If the ratio is healthy because the bank is able to earn a higher interest spread or do a more profitable business, which generally is the case then it is good but however if the ratio is abnormally high just because the bank has very high debt compared to equity then it may indicate high risk and instability.

7. Quality of collateral asset – Once loans given by banks turn out to be bad the only resort left with banks is to recover it to maximum extent from the asset that was pledged as collateral. Collateral is like their safety cushion to cut losses from bad loans. Thus, if the quality of assets used to back loans are stressed or subservient then the banks won’t be able to recover their losses.

Measures being taken by RBI and the Government to clean the balance sheets of the banks

The RBI has asked banks to make provisions for visibly stressed assets in 3^rd and 4^th Quarter of FY 2016 so that the balance sheets of these banks are clean off the mounting NPA’s and they can start afresh. The proposed deadline for a complete clean-up is March 2017. RBI has also introduced a Strategic Debt Restructuring scheme which would empower banks to convert a part of their loans to equity and sell it. The RBI has recently revised the capital adequacy norms in the favor of banks like including revaluation reserves in the Tier 1 capital which earlier formed part of the Tier 2 capital. This ease in the capital adequacy norms is intended to reduce the recapitalization requirements marginally.

The Government has set aside Rs. 25,000 crores in this budget for recapitalization of PSU Banks. The same amount is promised for next year and the government has been assuring that further capital requirements will be met, however whatever is done till now is far from the required amount of recapitalization.

What should be your strategy to invest in the banking stocks?

Banks are the backbone of an economy and everybody knows that the pain is only short or medium term at most and in the long term they are going to boom in business. However there is a lot of risk in investing into banks without researching as there is a lot of uncertainty with respect to NPA’s, restructuring, recapitalization etc.

Thus if one is a long term investor they should analyze the banks based on the factors listed above and pick which one they want to invest into. However, if one is a short term trader, one should buy on bearish dips and sell on rallies as this range-bound volatility (based on technical analysis) is expected to continue in the near term. This is mainly because banks earn from loans given to industries and till industrial earnings continue to be weak the real problem can’t be solved fully.

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