Banking health and the ‘K Curve’ dynamics

Context:  Focusing on trends in valuation metrics provide clues to the need for more number of stronger banks.

Way to measure the strength of a Bank:

• Using  ‘Price to Book Value’ ratio (P/BV): based on two critical attributes the market values most: adequacy of current capital and runway available to the entity for profitable growth.
• P/BV > 1 = market believes that the company can grow and generate expected Return on Equity.
• P/BV <1 = low market sentiments due to bad loans.
• Using the K curve: It depicts the inequality existing between different financial entities in terms of their attributes that determine their future growth and profitability.
• Widening of the arms of the ‘K’ implies an increase in inequality.
• K curve is wider in the case of Non-Banking Financial Company (NBFC)when compared with banks.

Division of banks using K-curve:

• 1^st Arm of K curve: following two sets which can be considered as “Alpha Banks” (few in number)
• With P/BV>3: Capital is available in plenty for these banks.
• With P/BV>1.5: Have access to sufficient capital by demonstrating a business model that works across cycles.
• 2^nd Arm of K curve: With P/BV <= 1, banks may be able to raise capital but had issues related to business model. For e.g. old Public Sector Banks (PSBs).

Road map for Public banks to make higher P/BV ratio

• Change the current governance model: that depresses the valuations of PSB so that they would better reflect their in­trinsic strengths when the banks are run in a professional manner with autonomy.
• Participatory consolidation of banks: a new vision needs to be drawn out for these banks to ensure that they have differing value propositions to offer to the economy and market.
• Create a level playing field for all banks: for participating in the government’s payment of compensation for services rendered to various State-sponsored programmes.
• Provide freedom: To adopt human resource practices to on-board lateral talent in filing skillset gaps and adapt to the new digital world.
• Create more Alpha Banks: Although this move will increase the inequality among banks, for the economy to grow faster, we need more than the current handful of Alpha banks to propel it.

Conclusion: For the wheels of the economy to grind faster and higher, we need more than the current handful of Alpha banks.