A question that remained unaddressed in the last Q letter to Partners was “Why do we not own any Mid-sized Banks?”
Banks can be attractive businesses to own as they enjoy natural growth tail winds of growth while delivering 15-18% ROE. However, over the last decade, only 3 Banks (representing < 15% of Industry Assets) have delivered over 15% PAT growth or above 15% ROE consistently.
Clearly, Banking is not an easy business. It is not hard to understand why. Banks are highly leveraged entities. Leverage results in fragility as errors are amplified. Hence, the road to wealth creation in Banks must be rooted in conservatism as only conservatism will ensure sustainability/predictability of profits.
The ability to be conservative is rooted in the strength of the deposit franchise. A low cost deposit franchise allows a Banks to choose its credit risk. The cost of deposits is the primary influencer of a Bank’s profit sustainability (other than the thought process of the management team)
This is where Mid-sized Banks are disadvantaged. They have no “Right to Win” vs their larger peers.
· Mid-sized Banks have higher Cost of Funds vs leaders (HDFC, ICICI, Axis, Kotak) by ~50-90 bps. This makes it very difficult for them to compete in low risk Retail products.
· Hence, relatively higher cost of Funds necessitates Mid-sized Banks to take on more credit risk to earn the same spread and ROE; and therefore is a riskier/tougher business model to execute. For example, if a Bank is disadvantaged on Cost of Funds by 50 bps, it needs to lend to one lower credit notch at the same credit cost to achieve the same ROE- that is a tough ask.
· Lower credit rated sectors also require more capital consumption and hence more Equity
· The big banks are getting stronger. The incremental volume deposit share of HDFC, ICICI and Axis Bank was ~34% in H1 FY 20 vs 14% in FY 14.
Mid-sized Banks may find niches where large banks cannot compete – the segment size may be too small or the segment may be difficult to serve. However, that is possible when a bank’s size is small. It is not an easily scalable model. Moreover, technology is narrowing that edge. While we may change our mind in future, we are comfortable with our choices at present.