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Why are bank stocks rising?

Why are bank stocks rising?
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First Published: Sun, Mar 06 2011. 10 27 PM IST
Updated: Sun, Mar 06 2011. 10 27 PM IST
Since the presentation of the budget on 28 February, Sensex, India’s bellwether equity index, has risen 4.44%. Bankex, the exchange’s banking index, has risen even higher—5.18%. Many of the listed banks, in fact, have risen much higher than the sectoral index. What prompted the rally in bank stocks?
An analyst with a foreign brokerage says finance minister Pranab Mukherjee’s announcement that the Reserve Bank of India (RBI) would issue the guidelines for new banking licences before end-March and a proposal to amend the Banking Regulation Act to pave the path for new bank licences is the reason behind the rise of bank stocks.
I am not convinced with this argument. If indeed RBI allows new banks to be set up, that will intensify competition and the existing players’ margin will be under pressure. They will also be threatened on the human resource front as the new banks will poach talent.
To retain talent, the existing banks will have to pay more to their employees and that will push up their wage cost. They will have to be more innovative and spend on technology to introduce new products and tap new opportunities. All these will definitely benefit consumers, but cannot be a positive for the bank stocks at this point.
What else did the budget offer that could have encouraged investors to rush to buy bank stocks? Mukherjee has announced a series of measures that has demonstrated his commitment to financial sector reforms even though all of them are not new.
For instance, he has proposed to introduce the Public Debt Management Agency of India Bill in next fiscal to set up an independent debt office in the finance ministry. So far, RBI has been managing government’s debt. He has also attempted to liberalize the portfolio-investment route by allowing overseas investors to invest in Indian mutual funds.
To ensure funds flow in the infrastructure, he has proposed to raise the limit of foreign institutional investors’ (FII) exposure in bonds of five year or more maturity fivefold, from $5 billion (Rs22,500 crore) to $25 billion. With this, the overall limit of FII investment in corporate bonds is being raised to $40 billion.
He has also allowed this class of investors to invest in unlisted corporate bonds with a three-year lock-in period. During this period, however, FIIs will be allowed to trade in these bonds among themselves. The current FII exposure to corporate bonds in India is modest and they will not rush to invest here overnight but Mukherjee has created a ground for larger FII play in a critical segment.
He has also promised to push through all pending financial sector regulations, including the Insurance Laws (Amendment) Bill that proposes to push up the foreign stake from 26% to 49%. The government has not been able to pass this Bill in face of stiff political opposition.
The minister walked the talk by getting the cabinet nod on liberalizing the banking laws three days after the budget. The Bill, expected to be introduced in the ongoing budget session of Parliament, seeks to give voting rights to shareholders in accordance with their equity holding and allow banks to raise money through instruments such as preference shares which they cannot do now.
Currently, voting rights are capped at 1% in public sector banks and 10% in private banks, irrespective of their actual shareholding. The Bill also proposes to give power to RBI to supersede a bank board if the regulator is not happy with the way it functions. RBI had insisted on this right as a precondition to allow industrial houses to set up banks.
These are indeed positive measures in terms of mapping the direction of financial sector reforms, but I am not sure how much they have contributed to the bullish sentiment for bank stocks. In fact, bank stocks are not alone that have risen more than the Sensex post-budget. The automobile and reality sectors have risen even higher than the Bankex and all three are rate-sensitive sectors. This means the market has got a signal from the budget that interest rates will not rise as much and as fast as it was expected till recently.
When rates rise and money becomes more expensive consumers delay their decisions to buy cars and homes and prefer to wait till the rates come down. In a higher interest scenario, banks suffer as the value of their bond portfolio gets eroded and they need to set aside money to make good the value erosion. Technically, this is called mark to market, or valuing a financial asset in accordance with their market value and not the price at which it was bought.
When rates rise, incidents of loan defaults also arise as relatively weaker corporate borrowers find it difficult to service the high interest cost. Once a loan becomes bad, banks need to set aside money and that dents their profitability.
Why will RBI go slow in raising rates? Mukherjee sees three reasons behind that. First, the monetary policy always works with a lag effect and the measures already taken by the central bank will moderate inflation. Second, since inflation rate has been very high in the current fiscal, it is bound to come down next fiscal on account of the base effect. Finally, good monsoon next year will have a positive impact on food prices.
Mukherjee, in fact, sought the blessings of Lord Indra “to bestow timely and bountiful monsoons”. Even if Mukherjee has Indra’s ear, RBI governor D. Subbarao should not rest on his past measures and bank on the arithmetic of base effect to fight inflation. Time is not yet ready to press the pause button. Even if RBI halts its policy rate hike, banks will raise their loan and deposit rates.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to bankerstrust@livemint.com
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First Published: Sun, Mar 06 2011. 10 27 PM IST