Banking health and the K Curve dynamics

(GS PAPER-3, INDIAN ECONOMY

SOURCE- THE HINDU)

Context-

Recently, the depositors in Lakshmi Vilas Bank Limited (LVB) were bailed out.  A key metric for financial companies is the  Price to Book Value ratio (P/BV).  The P/BV reflects two critical attributes that the market values most: 

  1. adequacy of current capital 

  2. runway available to the entity for applicable growth 

  •  A P/BV ratio above 1 shows that the market believes that the company can increase and generate Return on Equity (RoE) above the hurdle rate that investors are expecting.  Here, the faster it can grow or the greater the spread of the ROE over the hurdle rate, the greater the P/BV multiple (above 1).

  •   A P/BV below 1 shows that the market either does not believe the bank has recognized all its bad loans or has the business model to deliver returns above the hurdle rate.  This may be due to the bank does not have a good deposit franchise, has bad cost discipline, or has a broken lending model. 

  •  K Curve – There are banks that have a P/BV above 4 while some others have much below 1, even at 0.25.  

  • With NBFCs, the P/BV range is even broader, with some NBFCs being valued in excess of 7.  

  • The growth projections of these entities with dispersed P/BV will be varied, resulting in a classic K Curve. 

  •  In other words, the K Curve propagates the inequality existing between different financial entities in terms of their attributes that determine and present their future growth and profitability.  

  • Widening of the arms of the K‘ would show that the inequality is increasing.  

  • On the other side, narrowing the time span of the K  would suggest the opposite.  

One arm of the K:  

  • Among private sector banks, a couple of banks have already had their P/BV above 3 on a consistent basis. 

o Capital is available in plenty for these banks. 

o Resultantly, the market is betting that these banks will grow much above system average and generate attractive RoE.

o This would imply that these banks would have disproportionate incremental market share on both assets and liabilities.  

  • The next move comes from the set of banks that have had P/BV of above 1.5 for the most period. 

o The market insight on these banks is that they are long-term bets, and have access to sufficient capital. 

o But, these banks have to present a business model that works across cycles. 

o As comfort levels increase on the business model, the P/BV should climb, because a runway for growth is available for these banks. 

  •  Both the given set of banks (Alpha banks) have adequate access to capital and the intrinsic ability to grow market share. 

  •  These banks would form one arm or side of the K. 

o The only constraint for these banks would be their ability to grow their liability franchise.

 o This is so because changes in market share on deposits are much slower than changes on the asset side.  

The other arm:  The other private sector banks have a P/BV of around 1 or much below 1.  

  • For some of them that have demonstrated an ability to raise capital even through COVID-19 times, it is a business model issue. 

o It is also a question of whether they have the strengths to grow profitably in a sustained manner.  The new generation banks amongst these have to demonstrate consistent growth and stability on the liability side for a higher P/BV again.  

Quite a few of the old generation private sector banks have an issue with the credibility of their business model and their ability to generate above hurdle RoE through the cycle.

 o They may have a reasonably stable liability franchise. 

o But, the market perceives issues with their lending practices and thereby, asset quality.

 o That is the reason their P/BV is at very low levels. 

o They need to transform themselves by upgrading technology, add skilled manpower and improve the management quality and governance.

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