The business of banking is simple. 1) Borrow cheap 2) Lend high 3) Grow at high rate 4) Recover the money lent. The basics of these facets are briefly discussed below: –
1) BORROW CHEAP
- Current & Savings Accounts (CASA) and Market Borrowings are the main sources of funds for banks. CASA accounts are a relatively cheaper source of borrowing for banks since current accounts carry nil interest and savings bank rates are low. Market borrowings rates move in line with interest rates of the economy.
- At present, when the economy interest rates are high, strong CASA franchise is a big competitive advantage. For example, a large bank like HDFC, which has @ 50% of its borrowings through CASA (at say 3% rate) and 50% market borrowing (at say 7% rate), the average borrowing cost works out to 5%.
- But for a small bank like DCB with 25% CASA and 75% market borrowing, average rate works out to 6%. This gives larger banks 1% cost advantage over smaller banks.
- In the next few quarters, economy interest rates are expected to fall. Assuming they fall to 5%, taking the above example, large banks’ cost of borrowing would work out to 4% while that of a smaller bank would fall to 4.5% thereby reducing the advantage by half. DCB being a smaller bank would be a beneficiary when interest rates fall.
2) LEND HIGH
- Lending rates depend on the risk that the loan carries. Unsecured loans, sub-prime loans, credit card loans etc carry significantly higher rates than secured loans like housing finance, vehicle loans, loan against gold etc.
- If a bank lends only to risky borrowers, its lending rate would be very high but so would be the risk attached to these loans. Conversely, if a bank lends only to very safe borrowers, it will not make too much money. Hence banks need to balance between these two buckets to achieve a decent risk-return portfolio.
- DCB has 85% secured loans in its portfolio and balance 15% unsecured portfolio earns it high interest. This gives comfort regarding its asset quality.
3) GROW AT HIGH RATE
- Banking is essentially a business which requires conservative mindset. High rate of growth in loan book generally does not happen without overlooking credit worthiness of the borrowers. And this rarely ends well.
- In Indian context, a good conservative bank can be expected to grow at say 1.5x the nominal GDP growth rate. Higher growth would raise doubts about credit appraisal systems. Lower growth would suggest that the bank is not taking enough risk.
- DCB loan book grew at 22% CAGR between FY 2011 to FY 2020. During Covid growth took a hit. Now the management is guiding the growth rate to resume its trajectory of 20-22% which appears to be reasonable considering the rate at which the Indian economy is expected to grow.
4) RECOVERY THE MONEY LENT
- It is easy to give money, but the real test is getting it back. Banks with poor credit appraisal and recovery processes fade quickly. Hence it is critical to invest only in those banks which do not chase growth for short-term gains.
- Top notch bank like HDFC had 1.3% Gross Non-Performing Assets (GNPA) and 0.3% Net Non-Performing Assets (NNPA) as of Sep 2023.
- DCB Bank’s GNPA and NNPA are higher at 3.2% and 1.04% respectively as of Sep 2023 (vs 4.3% and 1.97% in FY22) and remain a key metric to watch.
In Dec 2023 DCB’s promoter Aga Khan Fund announced investment of around 83 crores in DCB Bank through preferential issue at Rs 137 which is at a premium to its current market price of Rs 130 thereby inspiring confidence. On the valuation front, DCB is trading below its book value whereas most of its comparable peers like AU Small Finance, City Union Bank, CSB are trading at 2-4x their book value. If DCB is able to walk its talk of 20-22% growth with continued reduction in NPA’s, it could become interesting especially when interest rates start falling. Fun Fact – Its promoter Aga Khan Fund was also the promoter of HDFC Bank.