Greetings from Team Carnelian!! Hope you are doing well.
Last month investors across the globe were engulfed with heightened fear caused by the collapse of financial institutions Silicon Valley Bank (SVB) and Credit Suisse. The key question troubling investors globally as well as back home are:
Will it have a contagion effect in todays’ connected world?
Is this a repeat of the 2008 financial crisis?
Is it the start of the problem or end of the problem?
How is Indian banking system placed?
What impact will this have on Indian economy?
While all the above questions are relevant, from a domestic investors perspective, the most relevant one is its likely impact on the Indian Banking system and the economy. Before analyzing the impact and jumping to conclusions, it is of paramount importance to get to the root cause of the problem. We are all aware of the principle:
Assets = Liabilities + Equity
While the above principle should hold true if one follows the HTM (hold to maturity) principle, we all know that both assets and liabilities fluctuate every moment, thereby impacting equity. A large impact can, however, lead to the emergence of two types of risks - Permanent & Temporary.
Type A - Permanent: Real value of assets < Real value of external liabilities – Incurable
Type B - Temporary: ALM risk: Time to realise assets > time to pay liabilities - can be cured with time & lifeline support.
While Type A event is not curable without amputation (hair cut for stake holders), Type B event arises due to a temporary dislocation in valuation which can be managed with timely external support. If timely support is not extended, then it will eventually turn into a Type A event as distress selling of assets below their intrinsic value will create an imbalance. It is therefore the job of the regulator to make a timely distinction between permanent and temporary risk and provide the necessary lifeline support to temporary risks. Timely action will also save the economy from a contagion effect.
Therefore, the key question to address is:is it a Type A or Type B event, how is the regulator extending timely support & the likely contagion effect.
A deep dive into the balance sheet of Indian banking system coupled with the constructive role being played by the regulator, gives us enough confidence that the Indian Banking system is on very strong wicket, on account of
Limited International exposure of banks this time around compared to the last financial crisis
Comfortable debt to equity with corporates vis-à-vis 2008
Very strong liability franchisee backed by granular deposits
Limited M2M impact on investments as a large part of the assets are in loans and advances with floating interest rate
Well capitalised and good provision coverage ratios
Moreover, our regulator has demonstrated proactiveness in dealing with Type B events. Timely credit guarantee extended by the Government of India to Financial institutions for MSME lending during Covid 19, saved the economy from liquidity and real NPA crisis. Financial institutions were also allowed OTR for temporarily stressed borrowers, resulting in no real NPAs for the banking system.
Where did it start from?
Silicon Valley Bank (SVB) – the 16th largest US Bank, and Signature Bank (SB) – the 18th largest US bank, collapsed back-to-back in a short span of 15 days.
Over the past few years, SVB used its deposits to buy bonds worth billions of dollars. Given the interest rate hikes by Fed over the last 1 year to manage inflation, the value of these bonds came down materially. On the other hand, the bank had deposits which were of shorter tenure. A Classic text-book case of asset liability mismatch occurred resulting in Type B event. Deposits for SVB were mainly wholesale deposits and the customers started redeeming their deposits fearing a bank collapse - this led to a run on the deposits. Eventually with the regulator’s intervention, the bank was closed, and the deposits/assets were bought out by First Citizen Bank of US. This was followed by the closure of Signature bank (SB) wherein a similar case emerged as depositors rushed in to withdraw their deposits. Again, the regulator intervened, and all of SB’s loans/deposits were acquired by Flagstar Bank.
The above was followed by Credit Suisse saga leading to a sharp decline in confidence, sending its stock and bond prices tumbling, and customers rushing to pull their money from the bank. Regulators feared that the bank would have problems if not dealt with; was subsequently acquired by UBS. However, USD 17 bn worth of bonds were written down. The impact of these write downs (of AT1 Bonds) on other financial institutions is yet to be seen.
However, unlike the Lehman crisis, this time around, the regulator has been proactive as seen in both the above cases and has taken prompt action. We need to see whether this suffices, or the regulator has more work to do. In case a further casualty occurs (Type B event), regulatory action will be key in deciding the fate of the financial system/economy (Type A event).
How safe is the Indian banking system?
Before we analyse the various data points, let’s rewind a bit; the vulnerability of the Indian banking sector has already got challenged umpteen number of times in the recent past and we have come out strongly:
IL&FS crisis followed by DHFL and Reliance capital insolvencies
Yes Bank crisis
Covid uncertainty testing the asset quality
Loans granted to one large corporate house
All through these, the Indian regulators have been proactive in managing the crises to avoid any significant impact on the economy. Even rising inflation was proactively well handled by the regulators compared to major global regulators where inflation went to levels never seen before in the last few decades.
Limited International Exposure and Low Corporate Debt presently vs financial crisis period
The international exposure of banks this time around is very minimal as compared to exposure they had during the financial crisis time.
Lot of corporates also had international exposure through debt which was used for acquisitions and were also levered. Big overseas acquisitions were talk of the town then – Tata’s had acquired Corus, Hindalco had acquired Novelis, Suzlon had acquired REPower systems, Tata Motors had acquired Jaguar Land Rover and many others. Corporates this time around are not only less levered in comparison to the financial crisis but also international exposure is insignificant.
Strong liability franchise with granular Deposits:
A reason why an SVB-like failure is less likely in India leading to banking sector crisis is that domestic banks have a different balance sheet structure. In India we have deposits which are more granular and dominated by retail as evidenced in the deposit mix of top banks.
Retail deposits form 55-60% of total deposits for Pvt. Banks and 67% for PSU banks:
Indian Banks share of term and savings deposits:
Limited M2M loss impact due to large part of asset side in loans and advances:
Loans and advances ~ 65% of asset side:
In our Dec 2022 letter, we highlighted that the banks are well capitalised, NPA issues are behind and better availability of data would lead to improved underwriting. Retail credit growth is already robust and corporate credit growth has started catching up – this will lead to good overall growth for the next 3 to 5 years. There could be intermittent slowdown on the pace of growth and NIM’s getting rationalised but the long-term growth trend should continue. Unforeseen events can derail this, but as said earlier, we would be better off.
Impact of this on the Indian economy?
Having said all, if a major global scale blow up happens, Indian markets are likely to feel the tremors of this for sure but those will be Type B risk, not Type A risk. Our markets will be quick to bounce back. India’s economy is unlikely to face any major disruptive impact due as India’s demand drivers, inflation is well placed and hardly dependent on those of west. An impact of the global slowdown/financial crisis, (which we think is a low probability) on Indian growth would not be a long lasting one and we would be better off in comparison to others – and thus, we continue to believe that India is poised to enter a high growth phase and it will be India’s decade!