IAS Gyan

Daily News Analysis

Banking health and the ‘K Curve’ dynamics

24th November, 2020 Economy

Context: As the financial ecosystem navigated one more pothole, with depositors in Lakshmi Vilas Bank Limited (LVB) getting bailed out, the implications of the Reserve Bank of India’s sleight of hand have got all stakeholders thinking about the way forward.

  • While different stakeholders may have their own opinions on the way forward for the financial sector, markets, to a large extent, incorporate those differing views and reflect it in the price performance of individual banks.
  • Such price action of banks can give us very useful insights on how the financial system dynamics are likely to change in the coming years.
  • Focusing on the trends in valuation metrics since the ILF&S crisis can give us some important pointers on how the system is likely to take shape.

What is the market prognosis right now?

A key metric

  • Key metric for financial companies would be the ‘Price to Book Value’ ratio (P/BV).
    • The P/BV holds the mirror on the two critical attributes the market values most: adequacy of current capital and runway available to the entity for profitable growth.
    • A P/BVB 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.
    • 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.

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.

Road map for public banks

  • Coming to public sector unit (PSU) banks, their current governance model depresses valuations.
  • The largest bank in the country is surely part of the Alpha banks as its ability to attract capital and grow profitably is well accepted.
  • The other PSU banks are viewed by the market broadly as a homogenous set with similar business models and skill sets.
  • A new vision needs to be drawn out for these banks to ensure that they have differing value propositions to offer to the economy and market.
  • There needs to be a clear level playing field amongst all banks and the government should move to paying 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.
  • This, coupled with better governance, is the recipe for higher P/BV for PSU banks.

More Alpha banks needed

  • Alpha banks can widen the gap with respect to the rest, thereby widening the K Curve even more and squeezing out the weak banks.
  • Vision, perseverance and consistent execution can make more Alpha bank.