That’s amazing work Deepak.
How would you rate the NBFC’s strength and focus in the digital space? Any NBFC that you think is ahead of the curve?
Thanks again for the detailed explanation on bank’s fintech strengths.
That’s amazing work Deepak.
How would you rate the NBFC’s strength and focus in the digital space? Any NBFC that you think is ahead of the curve?
Thanks again for the detailed explanation on bank’s fintech strengths.
An enlightening post indeed. Thanks for all the info you have shared.
As for me, I am seriously thinking on the following:
Recently Capital Float raises $45 mn in Series C round led by Ribbit Capital
RBL Bank has successfully built a strong partnership model delivering technology led banking solutions to a variety of companies across the retail as well as institutional space. Capital Float is one one of them.
Interesting times ahead.
vary well written disruption in traditional banking
As u know payment bank and e Wallet do not have margin so not viable at present
p2p lending is having good margin but vary risky
Financial inclusion is I think Adhar base distribution of government benefit low margin business
Issuing card is probably good margin business
I don’t see any disruption with good margin of profit May be its your domain so you can correct me
For me oversimplification of banking profitability is spread between cost of capital and interest earned
Prudent lending is the key for any bank
disclosure invested in kotak HDFC Fedral bank for more than 15 years
One very basic question. Would you not look at P/E ration for bank at all? I know P/B, ROE, NIM, NPA, GNPA, CAR, CASA should be checked for banks/NBFC. But how should one look at P/E
e.g. If P/B is 3.46 but P/E is 50 - Is this not expensive? compared to a bank trading at P/B 4 and P/E 30?
Caution: Another long post. Apologies.
Well I am guilty of showing only one side of the coin in my earlier post on the disruptions in retail banking. As pointed out I should shed some light into what matters for us as an investor in banking. I am sure most of us know how a bank functions and how it makes money. I will try to answer how these disruptions ‘could’ add value to banks and some pointers on how we value such companies.
Liability vs Assets in Banks
Banks take deposits from their customers in the form of current accounts, savings accounts, fixed deposits and recurring deposits. This deposit base is ‘given’ out to the borrowers. So in a very simplistic fashion we can say the ‘debt’ or ‘liability’ which the bank has taken on its books by accepting deposit is invested by giving out loans to customers. The differential rate is the income which the bank makes. So the traditional language of debt in a banking parlance is the deposits base or the liabilities it takes on. The investment of this liability is in loans which are assets for the banks which earn a higher interest rate. A modified balance sheet (leaving equity aside) of a bank will look like:
Income Generation in Banks
From where all and what type of income does a bank have? Banks earn two types of income – interest income and non-interest income also called fee income. A bank when it takes deposits from customers receives float. This float after appropriate adherence to reserve ratios earn an income for the bank. This is called float income. For instance the bank is paying 4% interest to its savings account holder, this is a cost to the company. Basis this it can have a portion of its capital earn money in money market or basis this deposit base the bank lend to a consumer at say 12%. The difference in interests is the Net Interest Income at a high level. The bank has to match duration of its assets to its liabilities so that there is no asset liability mismatch. This is usually done by a team in treasury usually called the Balance Sheet Management Group. For overnight requirements or short term requirements many avenues are present to the banks.
The bank makes interest income from all forms of loans (which are assets to a bank eg home loan, car loan, personal loan, overdraft, education loan, the notorious corporate loans etc). Also from credit cards it makes interest income in case of revolving accounts or default accounts. Do read about revolving accounts.
On the fee income side the bank makes fee on transactions of all sorts whether its cheque issuance, cash collection, remittances, merchant payment acceptance etc. To get a glimpse have a look at the schedule of statement here for YES Bank. You will see both a fee income and an interest income component.
The wholesale side of banking is perhaps the most steady income generator for a bank, investment banking earns a lot of fee income, treasury income is also steady and last the retail side just manages to make money for small banks. But without having retail the wholesale side loses balance. Without retail banking ie deposit base you can’t grow as a bank.
The above section was to just give a background. Pardon me.
Let’s take each FinTech item and see what they can do at an overall level to the income of the bank.
Payments by wallets
If you notice my last post I pointed out that banks prefer to be in the payment processing and escrow services fee business. Why? Escrow gives them a huge float income. For instance Paytm maintains say 500 crores with its escrow banker. By payment processing I mean that say when a consumer decides to use his wallet to send money to another bank account then IMPS service for money transfer gets used. For providing this IMPS service the bank charges the wallet operator. Another thing which I referred to is that banks do BIN sponsorship. Say a wallet issuer like Itzcash has an RBL BIN sponsored card. Whenever the card gets swiped Itzcash earns 1.1% of the transaction value and the BIN sponsorship agreement will say that 20% of this income will be that of the BIN sponsor bank. So in essence by virtue of being a bank it gets both fee income and float income by just entering into a BIN sponsorship. Look at RBL they have the most! Likewise banks earn from these fintech payment partnerships. Now coming to the fact of floating a bank wallet like say ICICI Pockets or an HDFC PayZapp (with due respect though Mr Aditya Puri has written off wallets but HDFC has two wallets Payzapp and has investment in Chillr I believe). The advantage these own wallets for banks give is 100% share of the fee income on transactions, they are akin to spends on credit cards. So more the users use their own wallets the better it is for banks. Again let me ask why? The more the user uses the more balances he keeps thus more float income. One more – why should he use the wallet to transact why not withdraw from an ATM and purchase with cash? Leave aside inconvenience, the banks always want customers to use their phones without contacting them to transact. The below diagram shows what the banks are trying to do that is to shift the customer to transact on their own using their handsets. Again why? Because of negligible costs in doing so. Our bank hates it when we walk into their branches!
Also when we talk about payment banks we should not write them off. I was part of the team in Airtel Money which got the license for the Airtel Payments Bank (the first one to get). Payments bank can earn fee income and have potential for cross sell. I believe telcos have an upper hand here as they have the distribution reach which is a huge asset to them in this payment banking space. Also please understand payment banks were created with the aim of financial inclusion. Financial inclusion is a very thin margin business. Thus size matters to a great extent. I am not aware how P2P lending is trying to make money but have some idea.
Now we have asked why we can’t use PE ratio to value banks. I purposely gave the above background on how banks make money. I would earnestly recommend you read Prof Damodaran’s 75 pager on how to value financial companies. I have attached the document but anyways quoting excerpts from it.
When we talk about capital for non-financial service firms, we tend to talk about both debt and equity. A firm raises funds from both equity investor and bondholders (and banks) and uses these funds to make its investments. When we value the firm, we value the value of the assets owned by the firm, rather than just the value of its equity. With a financial service firm, debt seems to take on a different connotation. Rather than view debt as a source of capital, most financial service firms seem to view it as a raw material. In other words, debt is to a bank what steel is to General Motors, something to be molded into other financial products which can then be sold at a higher price and yield a profit. Consequently, capital at financial service firms seems to be more narrowly defined as including only equity capital. This definition of capital is reinforced by the regulatory authorities who evaluate the equity capital ratios of banks and insurance firms. The definition of what comprises debt also seems to be murkier with a financial service firm than it is with a non-financial service firm. For instance, should deposits made by customers into their checking accounts at a bank be treated as debt by that bank? Especially on interest-bearing checking accounts, there is little distinction between a deposit and debt issued by the bank. If we do categorize this as debt, the operating income for a bank should be measured prior to interest paid to depositors, which would be problematic since interest expenses are usually the biggest single expense item for a bank.
The price to book value ratio for a financial service firm is the ratio of the price per share to the book value of equity per share. This definition determined by variables– the expected growth rate in earnings per share, the dividend payout ratio, the cost of equity and the return on equity. Other thing remaining equal, higher growth rates in earnings, higher payout ratios, lower costs of equity and higher returns on equity should all result in higher price to book ratios. Of these four variable, the return on equity has the biggest impact on the price to book ratio, leading us to identify it as the companion variable for the ratio. If anything, the strength of the relationship between price to book ratios and returns on equity should be stronger for financial service firms than for other firms, because the book value of equity is much more likely to track the market value of equity invested in existing assets. Similarly, the return on equity is less likely to be affected by accounting decisions.
Thus while quickly evaluating banks we must look at
I diligently do not follow NBFCs. I used to hold Capital First but have exited it due to certain uncomfortable reasons. Not that it is not worth holding onto. Bajaj Finance I believe has entered into a partnership with Mobikwik. There you go. I see people like Angel Broking and Motilal Oswal going into something like robo advisory where the algo recommends investments/trades/capital allocation. Haven’t seen it up close though. On bank side like I said all private sector banks are doing well in the fintech space. Do not expect them to turn the tables in a year! We Indians love slow, extremely slow and steady pace
Sir I envy you having been an investor in HDFC for 15 years! An awesome investment it would have been.
Hope this quickly written out post made some sense.
Valuing Financial Firms_Damodaran.pdf (103.6 KB)
Suggestions on Valuation Books: McKinsey on Valuation and Damodaran on Valuation.
Hats off to you Deepak.
I personally feel the cards and ATM utilisation will reduce and all banking functions will transfer to smart phone. Ultimately AADHAR + MOBILE no may become your identity and CIBIL also will depend on this. I feel that over a period of time all our free cash flows will be monitored and accordingly loans will be advanced. I think we will have a different days ahead.
Deepak, any idea on WHATSAPP entering the payment solutions and aadhar enabled smart phones?
will generation of black money decrease and tax compliance increase-what’s ur opinion?
I also think telecom providers will have some good days ahead. A good service provider will win the race.
If we notice many banks have already been charging us for ATM transactions. We get a freebie of 5 withdrawals and then you are charged. If you use your HDFC ATM card on ICICI ATM then HDFC has to pay a lot on that transaction (its called reverse interchange, I think its around 17-20 rupees per transaction). So like my dart diagram banks don’t want you to transact on ATMs actually. In fact nobody wants physical cash. My wife is a banker and she was taking care of cash reporting to RBI during demonetization in NCR for a bank. I could see the nightmare she was going through!
I also think this is the future. In 2013 September UIDAI and RBI asked pre paid wallets to do a pilot on Aadhaar based domestic remittance (for financial inclusion pertaining more to payments bank today). At that point of time the response was lukewarm. But since then I have seen Aadhaar being forced upon us and maybe its a blessing in disguise. RBI doesn’t allow Mobile + Aadhaar OTP as an ekyc authentication. If this was allowed I believe it would greatly improve financial inclusion. Aadhaar + OTP allows only linking of Aadhaar or verifying of Aadhaar. To ekyc you have to give biometric details.
Yes in the future our credit scores will all be linked. It’s a matter of time now.
Facebook already has P2P payments on their messenger on their US app. FB also has payment widgets in Malaysia. Google also has send money on email. Whatsapp is also working on P2P transfers in India. They are riding on UPI that’s what the rumour is. In my opinion chat apps getting p2p is better than payments app building chat. Case in point is whatsapp/fb messenger/hike app building p2p vs a paytm/freecharge building chat.
I am not very bullish from a digital payment point of view on telecoms. I feel they are best suited for payments bank though.
Take a bow Deepak.
Highly informative indeed.
I am too keen waiting for that “WHATSAPP” moment quoted by NANDAN NILEKANI.
Once again thanks.
Nice Coverage @deevee Couple of questions from my side if you can throw some light on the same. It will help me and forum members
Since we are all talking about Banking and financial institutions in generals, it is worth noticing Warren Buffet’s view on the Financial institution in General.
Mr Buffet was holding Freddie Mac and Fannie Mae stock(US Mortgage companies), and he sold them in 2000, well before financial crisis happened. In 2010 US FCIC conducted two hours session with Mr Buffets probing his thought process and view about the cause of the 2008 financial crisis.
When the interviewer asked him why he sold Freddie Mac and Fannie Mae- Buffet responded- "They were trying to -– and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort. And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know*. 2010-05-26 FCIC interview of Warren Buffett_1.doc (195 KB)
When you have management which is foxing on achieving growth in Finacial service- be wary- be very very wary. It is very easy for a finance company to grows because there are always borrowers ready to take a loan. So, demand for the debt will always be there. During a good time, it is hard it finds good borrowers, so the companies comprise their lending criteria and grant loan to less creditworthy borrowers. This last for a while, but sooner or later reality catches and the company faces bad debt. It has happened time and again.
The valuation of the finance company (Bank in particular) relies on gross NPA/Net NPA. The company which has pristine NPA, enjoy high premium while rest of the banks have considerable less valuation.
RBL bank in the current form is quite new and it’s books is not seasoned yet. I think time will tell if it can retain the premium valuation, but it depends upon its ability to give quality credit and maintain good growth rates. IN the current environment it is not difficult to maintain growth rate, and you know the quality of loan only in hindsight. Looks at the major PSU banks, the NPA they are reporting is 7-10 years old. So it will be a while before one knows the quality of credit disbursed by RBL.
In my view, the stock is running ahead of time. HDFC Bank, Kotak Banks have a history of 20+ years behind them, which RBL bank in the current form does not have. However, it has ingredients to be a good stock.
"…And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know*
Good point. At the same time. RBL is not a large financial institution. Management has been repeatedly saying they are able to grow faster because of low base.Further, we need to keep a the NPA levels as suggested rightly. And above all there are newer opportunities emerging as pointed in lot of detail by Deepak which is RBL is capturing , and infact at top 2 of capturing those.
On the books you mentioned, kindly share the Amazon/Flipkart links…
This is because there are different books, editions, similar titles… and dont want to end up purchasing the wrong books, as they are expensive too.
On API Banking
Banks such as YBL, RBL, Kotak etc. are packaging their banking facilities to the external corporate clients as ‘API Banking’. It is nothing but an integration between their systems and the clients systems. Rather than giving manual requests it is systems of the client and bank speaking to each other. If you understand API I am sure you would clearly understand what this is. If you don’t know what APIs are then read this. Also have a look at these two videos - YBL API Banking, RBL API Banking. On the income side it is again back to what I said earlier its mainly float income from liability deposit of the client partner and fee income from transactions.
Honestly I did not understand the second point. Please could you help.
Since there is a nice but light debate on RBL from an investment point of view. I liked what Vishal Bharati mentioned about low base. In 2010 May if I recall correctly RBI shifted calculation of Savings Deposit interest rate to a daily calculation from least in a quarter and then few months after I think it allowed banks to offer any rates to their customers. YBL was in a very favourable position to immediately raise interest rates on savings deposits but ICICI and HDFC didn’t change anything as far as I remember for obvious reasons. At YBL we raised the rates to 7% and Kotak to 6% (which they advertised heavily). Will not go into the details how base rate is used to derive savings and term deposit rates and the management calls which are made. Like I mentioned before go back to old annual reports of YBL you will be surprised to see the CASA ratio. From ~6% or so then to today at ~37%. The whole focus of the bank was on getting deposits and we spent all our energies there. Simultaneously their loan book kept increasing, again have a look at the old reports.
My personal take is that RBL is charting a very similar trajectory as YBL just that the digital world on retail side is different today (to which they are coping up quite well) and on the asset side of corporate their asset quality ratios are quite good, they are trying to raise money and hopefully this crucial area is executed well.
Well none of us can forecast with utmost accuracy what the future of the corporation will be. But let’s hope for the best and atleast visualize the worst. That’s the key to happiness as per Epicurus
But both valued at priceless.
p.s. I got Damodaran’s book as part of my b school but I have read only the 5th edition of McKinsey. The 5th ed. is freely available now I think.
All the best.
I will try to rephrase my second question. RBL was focussed on Financial Inclusion from 2012-2013 if I am correct as I watched some videos from management. Can RBL cross sale its products to the lower income clients which they have garnered through Financial Inclusion?
I could find one other similar book by mckenzie… 6th edition, university edition and similarly priced.
Would you know the difference as compared to the book in your link.
The difference between YBL and RBL is fee based income. For first 6-8 years (more or less) YBL 50% of income was fee-based. For a young bank, the fee based income is great, because the bank get’s without using the raw material (e.g money). I have not tracked RBL closely so far, so cannot comments much, but I suspect it may not be higher.
Another thing to consider is return ratios for YBL ROE (20+) and ROA (1.7+). RBL’s return ratios are not great. So as compared to YBL’s looks expensive and overvalued to me.
Perhaps I could not get my point across. I meant that the business trajectory is the same that is they are approaching it in a similar fashion. Do refer the charts I have posted sometime back on this thread.
You are rightly saying on the valuation front it might look costly. But which of the private bank is undervalued I am not able to figure out
disclosure: YBL is the largest contributor in my portfolio
Thanks for the rich guidelines and references on Valuations. I also follow Aswath Damodaran and have huge respect on his knowledge and teaching style.
Though i am strong believer of valuation methodology (fundamentals, intrinsic values etc.) sometimes my thoughts are diverting to quality companies growing at faster pace (like Bajaj Finance, Eicher Motors etc.) and proves me Valuation alone will not help always!!! Like you stepped into fairly/slightly over valued “YBL”
Whats your view on quality companies growing at faster-pace and market is comfortable rich valuation for considerable amount of time? (e.g. Eicher Motors, Bajaj Finance, D-Mart, RBL Bank etc.)