banking-health-and-the-k-curve-dynamics

Context: Depositors in Lakshmi Vilas Bank Limited (LVB) recently got bailed out by the RBI. The non-banking financial companies, or NBFCs are also in trouble. 

More on news:

  • The implications of this financial turmoil will reflect on the price performance of individual banks. 
  • Price action of banks in the market can provide useful insights about the financial system dynamics that will change in the coming years. 

‘Price to Book Value’ ratio (P/BV)

  • The key metric for financial companies is the ‘Price to Book Value’ ratio (P/BV). 
  • The P/BV reflects on two critical features: 
    • Adequacy of current capital and 
    • Runway available to the entity for profitable growth
  • Meaning of the values associated:
    • A P/BV ratio above 1 indicates that the market believes that the company can grow and generate Return on Equity (RoE) above the hurdle rate that investors expect. 
      • The faster it can grow above the hurdle rate, the greater the P/B multiple (above 1). 
    • A P/BV below 1, indicates that the market either does not believe the bank has recognised all its bad loans or has the business model to deliver returns above the hurdle rate. 
      • It may be because the bank does not have a good deposit franchise, has bad cost discipline or a broken lending model.
  • There are banks that have a P/BV above 4 while some others are at much below 1, even at 0.25. Some NBFCs have values in excess of 7. 

The K Curve

  • The K Curve depicts the inequality existing between different financial entities in terms of their attributes that determine their future growth and profitability. 
  • Widening of the arms of the ‘K’ would imply that the inequality is increasing, while narrowing of the span of the ‘K’ would mean the opposite.

Alpha banks

  • Private sector banks: Major banks have always had their P/BV above 3 on a consistent basis. 
    • Capital is available in plenty for these banks and the market is optimistic that these banks will generate attractive RoE. 
    • Therefore they have disproportionate incremental market share on both assets and liabilities.
  • Banks having P/BV of above 1.5: These banks have access to sufficient capital.

Both the above sets of banks are called Alpha banks. They would form one arm of the K, having adequate access to capital and the intrinsic ability to grow market share. The only constraint for these banks would be their ability to grow their liability franchise as changes in market share on deposits are much slower than changes on the asset side.

Private sector banks having a P/BV of 1 or below:

  • Business model issue: The new generation banks amongst these have to demonstrate consistent growth and stability on the liability side to earn their stripes for a higher P/BV again. 
  • The market perceives issues with their lending practices and thereby, asset quality. That is the reason their P/BV is at very low levels. 
  • They need to transform themselves by upgrading technology, add skilled manpower and improve management quality and governance.

Way forward

  • For public banks

    • Their current governance model depresses their P/BV.
    • These banks should run in a professional manner with an ability to decide their own destiny. 
    • Along with the government move to consolidate PSU banks into few large banks, these banks must have differing value propositions to offer to the market. 
    • Clear level playing field amongst all banks: Government should move towards transparent and fair compensation for services rendered to various State-sponsored programmes to all players. 
    • PSU banks should be free to adopt human resource practices to on-board lateral talent to fill in skill set gaps and adapt to the new digital world. 
  • More Alpha banks needed: The Alpha banks widen the K Curve and squeeze out the weak banks. However, there is clearly more room for banks to migrate into the Alpha banks set. 

    • For NBFCs, there is no clear path. The more valued NBFCs can become part of the Alpha banks in the long term.

Image source: Wall Street