Bank stocks performance will be muted in the medium-term

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The liquidity mismatch of small & mid-size US banks is upsetting the world financial market. The grievance is that the imbalance can spillover to the world economy as the banking sector is highly cohesive to the economy. This concern stems from the financial crisis of 2008, when the bankruptcy of large US financial firms triggered a deep global recession.

Well, the good news is that the ongoing issue in the US is of a lesser extent. It is more about the short-term mismatch in the value of assets held by banks compared to the recurring liability payment occurring from depositors.

Simply put, it is a situation in which the free & realizable fund in hand is less, even when the quality of the assets held is of high quality like govt securities. This is because of the fall in the value of the Treasury notes due to the constant rise in interest rates. Example: The current value of a Rs 100 paper expected after a year at a couple rate of 10%, which is Rs 90.90 today, falls to Rs 86.96. When the required market interest rate increases to 15%, leading to a drop in value of 4.3%.

The situation in 2008 was worse due to a drastic loss in the value of assets due to reckless lending to the low-quality of subprime mortgages. Despite the low risk of the situation, there are inherent issues arise on banks and regulator. The banking system is the foundation of any economy. Depositors, taxpayers, and investors were under the impression that the banking sector was safe having cross- examined post the global crisis. But the constant rise of mismanagement reveals the vulnerability of the system.

The management of banks has become tricky, led by constant innovation of new products, high competition, and a constantly evolving world economy. At the micro level, key questions are about management skills, functioning, accountability, and risk management. The performance of the regulator and the functioning of monetary policy have also arisen. It is irresponsible to note that non-large banks in the US are not required to mark their assets to current market value, which is otherwise the case in Europe & India.

Regarding the question of whether there is a possibility of more hidden skeleton in the systems: It is highly unlikely because of the emergency funding facility setup by the FED at 100% value of the collateral treasury even if the current market value is drastically down. However, the undercurrent fundamental issues of high interest rates, a lack of lending opportunities, and a slowing economy will continue to affect banks.

Hence, the performance of banking stocks will be vulnerable in the medium- term, while in the short-term we can have a bounce given the corrective measures. No one is safe from the high interest rate and inflation scenario having an effect on the pricing of equities & the profitability of businesses.

In the last month, the market value of listed US banks has fallen by 20%. It had a heavy effect on European and Japanese bank stocks too. During that period, the Nifty Banks index corrected by ~6%. A direct effect on Indian economy and domestic banks is low due to a varied uprising business scenario. India’s credit growth is double that of US and is expected to grow by an average of 10% this decade. On a broader note, the economy and market volatility are expected to prevail in 2023.

The performance of the banking sector will be subtle. The average valuation of US and European banks has corrected heavily and is currently trading at sub 1x Price/Book-Value ratio, 0.9x and 0.7x, respectively. While the average valuation of Indian banks is at more than 100% premium at 2.1x P/B. The performance of US banks is down by about 30% in the last year, while that of India banks is up by 10%. Sustaining the contrary trend will be a challenge in the medium-term. Currently, we have a neutral rating on the Banking & Finance sector.

Credit growth is strong but slowly dropping. The sector witnessed credit growth of 16.8% YoY in Q3 FY23, compared to 17.2% in Q2. This growth is expected to moderate to 12% in FY24. On the other hand, inflow of total deposits is increasing, led by 13.2% growth in term deposits. With deposit accelerating and loan moderating, it will have an affect on the net interest margin of banks. At present, banks trade at long-term averages valuation, and we expect moderation in the valuation in the medium-term.

First published in The Economic Times

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