Safety in a ‘champion’ index

Banks’ unique position that allows access to low-cost capital makes them a safe investment option, but threats lurk

When it comes to investing in Indian stocks, a few names such as TCS, HUL, Britannia, Nestle and ITC constantly provoke interest. However, interestingly over the last decade, it is neither the FMCG industry nor the IT sector that has outperformed the Nifty 50 index, but rather the banking sector. As seen in the accompanying graph, the Nifty Bank index has predominantly outpaced the Nifty 50 since 2008.

According to the RBI, the number of scheduled commercial Indian banks includes 22 private sector banks, 11 small finance banks, and 12 public sector banks. In stark contrast, the U.S., which has merely one-third of our population, has 2,108 banks in total. Additionally, it should be noted that the top five banks in India dominate the share of the total deposits and transactions.

Concentration risk

Concentration of significant market share in the hands of a few leads to behaviour where independent firms may likely act in cohesion to ensure profit maximisation. A significant barrier to entry into the industry further spurs such behaviour.

The RBI has meticulous rules and is very conservative in distributing large-scale commercial banking licences, as can be seen by the sparse number of banks. These large banks also keep the financial system in order by lending to and borrowing from each other.

Therefore, as American economist Irving Fisher said, the collapse of even a single bank would wreak havoc in the financial system, as has been observed in the U.S. on multiple occasions. The RBI is aware of this and will go to great lengths to ensure no bank collapses, leading to an added layer of safety for banks as investments. The bailout of a troubled bank has been exhibited with great certainty if one may recall the Yes Bank fiasco.

Among the several advantages that banks enjoy, the most significant is the access to big finance from their banking peers, and from the RBI, which acts as the lender of the last resort.

‘Low-risk bets’

This places banks in a unique position to receive cheap capital, as most of their asset books are liquid and therefore considered low risk. They have access to low-cost capital through the ability to open current accounts and savings accounts. Fractional reserve banking — in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal, to help expand the economy by freeing capital for lending — also allows them to create money temporarily.

It’s not just the markets that recognise banks’ dominance, but also NBFCs that want to enter the arena due to the superior benefit of access to low-cost capital. Capital First, an NBFC, merged with IDFC Bank to create the merged entity IDFC First Bank on December 18, 2018.

At the time of merger, their loan book was ₹1.03 lakh crore. Capital First effectively gained access to low-cost capital to supplement its existing retail client base further. This was also a way for it to circumvent the need to possess a banking licence. There is also word in the wind of another NBFC following this path — Clix Capital is said to be in talks with Suryoday Small Finance Bank, to eventually join this elite group of banks, which highlights the attraction that the sector holds for aspirants. The graph comparison understates the dominance of banks because the Nifty 50 also consists of banking stocks. This means that the performance of banks has beaten the general market by a far more significant margin than is evident. This also highlights an important point — the market favours businesses with a steady cash flow stream in the long run.

Nonetheless, it is prudent to understand that the banking business is resilient, but not immune to threats. This banding together of entities in the banking system can end in the future due to a plethora of reasons, the principal one being innovative and cutting-edge fintech companies making significant inroads into India.

U.S. scenario different

Small finance banks, which offer far more competitive rates, also bring an element of competition and healthy behaviour to the table. The eventual and much-needed liberalisation of the banking sector might also end the dream run. The U.S. has liberalised its banking sector immensely, resulting in the large number of players in the game there. Although most of the market share still belongs to the 10 largest banks, it is clear from the market performance that the banking sector (which underperformed the S&P 500) is nowhere as dominant as it is in India. Regardless of these threats, banks, at least for the time being, will continue to enjoy advantages that no other industry can.

(Anand Srinivasan is a consultant. Sashwath Swaminathan is a research associate at Aionion Investment Services)

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