Twinkle, twinkle, banking star

	April- September Sept-Oct 2006 2006 Bankex 0.18% 14% Sensex 1.70% 6.90% Source: Prowess, CMIE

Bank stocks are back in favour. Consider the relative performance of the Bankex, the index for the banking sector in India, and the Sensex, the market index. In the six months upto September 2006, the Bankex underperformed the Sensex. In the last one month, the Bankex has outperformed the Sensex. Why so?

I can think of three reasons:

• There are signs of a softening of interest rates over the past month with oil prices trending downwards.
• In April, the RBI, in its annual credit policy statement, declared its intention to slow down credit growth from 30% in the previous year to 20% in 2006-07. So far, that hasn't happened- credit growth year on year upto stayed at over 30%.
• The last quarter GDP growth turned out to be higher than expected-8.9%. This has caused many forecasters to believe that GDP is more likely now to end up at the upper end of the 7.5-8% band they had projected. Bank stocks are a play on the economy, so what's good for the economy is good for bank stocks.

A buoyant economy boosts volume growth, of course, but it helps in other ways as well. Non-performing assets (NPAs) at banks tend to decline- and we must remember that asset quality in Indian banking is at its best today. There is no imminent danger of this being reversed because leverage among Indian firms is at its lowest in years- 1.06 according to Brics Securities. (Indeed, over the past couple of years banks have been effecting impressive recoveries from past NPAs.) The rising proportion of housing loans in the overall portfolio also makes for improved asset quality.

Secondly, when economic activity is high, so are float funds in the system. These tend to lower banks' cost of funds. That explains why banks' net interest margins (the difference between interest income and interest expense as a proportion of assets) have remained steady or even gone up in some instances despite an increase in interest rates. Higher interest rates on term deposits are offset by the lower cost on CASA (current and savings accounts), the proportion of which tends to go up with increased economic activity.

I have said elsewhere that Indian banking enjoys what would be regarded as an 'impossible trinity' in banking- high volume growth, high asset quality and high net interest margins. What I have stated above sheds light on why this is so. Bank investors, rejoice!