Turbulence in the Banking Sector: Which Indian Bank is a Safe Bet?

Since the beginning of 2023, tumultuous global and domestic events have increased volatility in the banking sector. Though the general consensus remains that the Indian Banking sector is relatively robust, Indian bank stocks have taken a serious beating this year. One notable bank to look at in these uncertain times is Kotak Bank. Kotak Bank's success story begins with its establishment as Kotak Mahindra Finance Ltd. in 1985. Today, it is one of the most recognized and trusted financial institutions in the country.

It is India's third largest private bank and fourth largest bank overall, with a market capitalization of Rs. 329,958.45 crores.

Let us understand the effects of global and domestic events on the sector and the bank’s future:

Source: Google (NASDAQ: GOOGL ) Finance

Recession Fears:

At the beginning of 2023, the stock market was experiencing high uncertainty as the fear of more steep rate hikes by the Federal Reserve and impending recession grew. While in India, inflation remained well beyond the 4% target of RBI and a moderately high unemployment rate persisted.

Investor Reaction: As investors fled to safer assets, Kotak Bank fell from a high of around Rs. 1930 in December 2022 to Rs. 1830 at the beginning of January 2023.

Rate Hikes on Deposits

The recent steep increase in rates by RBI is directly reflected in the interest charged on most loans given out by banks as they are linked to External Benchmark Lending Rates (EBLR). These external benchmarks include the repo rate, 91-day, and 182-day Treasury bills, etc. Each bank has the option to decide the external benchmark it wants to link its lending rates too.

Positive news for banks:

But the interest paid on deposits in a Bank is not changed as quickly as interest earned from loans given by Banks. Hence, in a rising interest rate environment that we are experiencing currently, banks are able to earn a higher margin of profit due to the increase in the difference between interest paid on deposits and interest earned on loans. Thus, the Net Interest Income is higher.

Though with a delay, from September to February 2023, we saw many banks announce rate hikes on deposits (like FD) to catch up with the increase in rate by the RBI.

Investor Reaction: The market has factored into their valuation the fact that this dramatic increase in profit is short-term and will not be an accurate representation of future income.

Quarter 3 Results

As mentioned above, due to the rising interest rates, the banking sector outperformed both the overall market and other business sectors in the third quarter.

Significant growth was seen in Net Interest Income and Net Interest Margin for the 3rd Quarter.

Advances grew at a tremendous pace, with HDFC and ICICI Bank (NS: ICBK ) advances growing at around 19.50%, and Kotak Bank clocking in at one of the highest growth of 24%. The gross NPA ratio of banks has dropped to a 7-year low of 5 percent, according to the RBI's Financial Stability Report from January 6, and the banking sector is looking strong and well capitalized.

Future Expectations:

But, the market has already factored in the base effect, and to expect a similar result in the quarter would not be prudent.

Hindenburg Fiasco

24th January 2023

Hindenburg’s allegation on Adani Group overshadowed the phenomenal Q3 results of Banks. We saw a significant drop in Bank shares in the few days post the release of the report. Investors were concerned about the exposure of individual banks to Adani Group and unsure of the magnitude of trouble that this report can cause.

No major cause for concern:

In March 2023, Kotak Bank revealed that it has a small exposure to Adani Group and it believes that it is more of a valuation problem than a credit problem. The bank doesn’t see any cause of stress because of the group in the future which is positive news for investors.

Search for a New CEO:

Kotak Bank is a financial institution that has left an indelible mark on the Indian banking sector. Much of this success can be attributed to its founder and CEO, Uday Kotak. Uday Kotak is a visionary leader who has transformed the bank from a small finance company into one of the most respected and trusted names in Indian banking.

On 21st February 2023, the Bank declared that they are searching for a new CEO. Investors are awaiting clarification on the appointment, but it does not seem like a major problem for a bank of this caliber.

Silicon Valley Bank Crisis:

13th March 2023

A specialized bank in the US having exposure of around $175 Billion going bust has become the catalyst to one of the worst falls in the Indian Stock Market in recent times. Silicon Valley Bank catered to a specific set of clients i.e. tech startups and VC businesses. Its failure was more due to misaligned assets and market panic causing your good-old bank run. It has no direct effect or connection to Indian Banks. But, it exposed the ill effects of the dramatic rise in interest rates that the Central banks are carrying out. It was a wake-up call for banks to hedge their exposures more efficiently.

No worries for Indian Banks?

Indian banks are in a good position when it comes to the quality of deposits and the potential effects of mark-to-market losses on held-to-maturity books, according to a study by the large global financial institution Jefferies.

Deposits:

As per the study, greater than 60% of deposits are households' savings deposits which are stickier (duration of 3 to 5 years) than that in the US as people don’t move to Government treasuries' quickly. The debt market in India is not very popular amongst retail investors. 

Assets:

Government bonds make up 80% of all bank investments in securities, and the majority of banks maintain these assets until maturity (72%–78%), therefore a decline in price won't affect these holdings. According to the report, a decline in bond prices will only have a 15% overall impact on public sector banks' capital and a 6% overall impact on private banks.

Effects of ‘Held to Maturity’ Assets on Kotak Bank:

In the study, Kotak Mahindra Bank (NS: KTKM ) held the lowest amount of government bonds at 45 percent under HTM. This is a cause of concern as this percent is significantly lower than most other banks. The assets not held to maturity will have to be marked to market, thus creating losses if the bonds are not efficiently hedged. But, investments form only about 25% of Kotak Bank’s total assets and government securities form around 70% of investments. Thus, overall exposure is low and the adverse effect can be contained.

Effects of rising interest rates on Kotak Bank’s Deposits:

Source: Kotak Bank Investor Presentation for Q3 2023 (as of 31/12/22)

The majority of Kotak Banks' deposits are in Term Deposits which makes it safer as it has a fixed maturity. 33% of deposits in Fixed Rate Saving Accounts will help the bank to plan its asset duration. Current Accounts do not attract interest rates and hence it is beneficial for Kotak Bank to have a moderate amount in existing accounts.

Effects of rising interest rates on Kotak Bank’s customer assets:

Source: Kotak Bank Investor Presentation for Q3 2023 (as of 31/12/22)

It has the most exposure to Home Loans which are considered to be relatively safer assets for a bank. It has a sizable exposure to Corporates as well which can be managed effectively. Other exposures are fairly diversified.

Overall, Kotak Bank’s assets and deposits seem to be placed well for the current monetary environment.

Comparison of Kotak Bank with Other Banks

Source: Annual Reports of Banks

When compared to the top four banks in the nation in the last three years, Kotak Bank has consistently outperformed the competition in terms of net interest margins. This shows better management of its assets and deposits. The bank's ability to keep average Net NPA ratios demonstrates both its stable performance and its carefully managed asset portfolio. In terms of the Price book ratio, Kotak Banks seems slightly overvalued. But given its superior performance in terms of efficiency, the valuation seems fair.

Conclusion

In the past, Kotak Bank has produced great results for its investors, and it appears that it is well-positioned to carry this momentum into the future. The share is being offered at a competitive price due to the recent drop in the market in general and Bank stocks in particular over the past three days. It would be prudent to add this fundamentally well-placed stock to your portfolio at dips.

Disclaimer: Above piece is only for information purposes. Please consult a SEBI Registered Investment advisor before taking any investment decision.