Banker's guide to building a robust institution

By Rudy Gopalakrishnan


The impending issuance of new bank licences has generated considerable hype in recent months. This article attempts to answer two questions. What has been the strategy of the two banks that were awarded bank licences a decade ago? And, what management lessons can we learn about the value creation opportunities in Indian banking sector?

If we look at the two most successful entrepreneur-driven banks in India in the last decade, we see strikingly different approaches in the way these two banks were built, but can conclude that both built great value. One built half its portfolio in the retail segment and the other half in the corporate segment, unlike other banks that have large corporate loans forming the majority of their loan mix.

The other bank licence winner extended only corporate loans to clients. Now, everyone knows PSU banks are inefficient, but one statistic says it all: one man can build a 55,000-crore credit book by lending pretty much to the same customers whom PSU banks lend to, charge its clients higher interest rates relative to competition and, most importantly, have zero non-performing assets.

But leaders of new banks need to question what their strategy will be. Many believe that a mix of an underpenetrated banking system combined with an industry where 75% of the players are inefficient (PSU banks) makes the Indian banking industry an attractive investment opportunity. They are right. Can this really be their principal strategy? Do other leaders think they have the same self-belief and crushing work ethics that the promoter of the bank they cite has? I doubt it.

Also, what have been the key elements of the value-creation process of Indian banks? An analysis of the book value growth of banks over the last decade shows that more than 50% of their book value growth was driven by accretive dilutions and the balance through core retained earnings.

What is clear is if someone wants to create value in Indian banking, the bank needs to be consistently valued at or above 2-3 times its book value, as dilution will be inevitable every 2-3 years due to higher growth rates.

The need for capital on a consistent basis is what sets the banking sector apart from other industries. This implies new banks need to build institutions that investors understand and respect, given this determines how much value banks create.

The understanding of a bank comes from articulating a strategy of how exactly a bank is different from other players. The answer cannot be that "we thrive by taking advantage of the inefficiency of PSU banks". The market will not pay high earnings multiples for such stories across the business cycle. You could still win without a tangible competitive advantage, but you would need to pray that a serious down cycle does not last long given your stock price will always trade down to book value if this happens, making dilution a significant risk.

The respect a bank commands is driven by the perception of investors on whether banks are building an institution or simply furthering the reputation of a great banker.

This comes across in how leaders conduct themselves both within and outside their banks, how they treat their employees, how strong their leadership bench strength is and how basic decision-making happens in the bank. This point is relevant not just for new bank licence winners, but also for leaders of existing financial companies.

What the new crop of banks and their leaders build and how they build it will determine how much value they ultimately create. If you are in doubt, just ask yourself why Kotak Mahindra Bank and HDFC Bank are the two most-highly-valued banks in India today in terms of their earnings multiples despite the challenges facing the Indian banking sector today. Those banks that build an institution will realise that the value-creation process is far more lucrative than they would have imagined.

And then, of course, there will be those who will be left holding a 10% stake in a bank a decade from now wondering what all the hype of getting a banking licence was all about.

The writer works for a large FII. Views are personal.