A question we introspect on significantly is whether the next stage of value migration in Banking will be from Private Banks to Digital players.

Our working hypothesis at present: well-run Banks will grow aggregate profits; however, their valuations will drift downwards as ROEs will decline. 

We continue to believe that well run Banks will continue to grow their profits over the next few years.

• Even as Banks are getting challenged on Fee Income, they are benefitting from increasing financial inclusion and market share gains from weaker players. 
• Additionally, they continue to drive down Operating cost reductions which support any margin pressures.  
• Moreover, the lack of depth in Corporate Bond markets meant strong uncontested loan growth opportunity would continue to play out.  
• And most well run Banks have perhaps over provisioned for Covid related loan losses.

We don’t see threats to profits from Digital players in the short term as we don’t see a viable business model in payments or lending Fin Techs.  Technology companies will need to partner Banks for a fee to create win-win outcomes.  And the RBI will never prioritize innovation over need for financial stability by allowing easy access to deposits.   

However, as we track this space, we believe ROEs of Banks will gradually decline over time as Technology firms attack Fee incomes.

• Banks market share and yields on traditional Fee Income products like MFs are declining – both due to regulatory diktats and pressure from Digital players. 
• Zerodha is now the dominant leader in broking, with Bank run players not in leadership positions.
• And entrenched positions provide a good way to attack other profit pools.  Zerodha is now launching Mutual Funds.

Over time, we fear Technology firms will make legacy moats less relevant by reducing friction costs and making it easier for customers to access products across Banks.  This will impact margins

• Banks have the advantage of sticky low-cost savings deposits.  This is not because Banking lends itself to “wilful loyalty”.  It is hard to find customers who evangelize a Bank.  Customers stick around because it’s a pain to migrate service providers.    However, over time the low-cost deposit moat (on Savings and FDs) gets less relevant if customers can move money seamlessly across Banks without friction costs.  For example, consumers can now use Google Pay to book high-interest rate FDs digitally – without needing to open a savings account with Equitas Bank.  Risk is also a consideration in Deposits and this should not be a strong concern at present.  But it signals direction and intent of Tech firms.
• As purchase decisions are moving to on-line channels with data on credit quality becoming widely available, privileged access to customers or data is no longer an advantage.  The power will shift to the market-place from the lender who will ask for a fee in return for “order flow”. Ant Group cornered 20% of China’s short term consumer debt before regulators in Beijing intervened, perhaps due to Jack Ma’s faux pas.
• Hence, Digital has not only created more transparency on costs but over time can reduce share of customer wallet thus reducing the margin banks can earn per customer.

And at some point, Operating leverage will reduce

• The challenge with Banking is that customers want great service but are unwilling to pay for the same.  The lead bank in any relationship may get right of first refusal, but must match the lowest price anyone else can offer.   
• And as Banks need to keep taking cost out to be competitive, it creates a vicious service experience where the relationship is transactional and which results in customers spreading their wallet across Banks.  My home loan is with Standard Chartered, Credit card with HDFC Bank, Solidarity’s Current account is with ICICI, and we use Kotak Bank as a custodian.  It never ceases to surprise me why none of these Banks have ever asked us what they need to do to get a 100% of our wallet.
• At some point, there will be a limit on cost cuts and hence Operating leverage will decline

And over time this will lead to lower ROEs and lower valuation multiples

• We believe of leading Banks like HDFC Bank will trend to 15-17% from 18-20% today. 
• Mid-sized Banks are competitive disadvantaged and will earn about 12-13% ROEs due to their scale and Cost of funds disadvantage.

Summary hypothesis

• Its too early to make a case for large scale value migration to Digital players.  Banks have access to customers, strong balance sheets, regulatory protection and ability to reinvest. They are responding aggressively with Digital initiatives and partnering with Technology firms and re-imagining costs (for eg how many branches do they need).  
• Short term profit trajectory of well-run Banks we own will continue to be strong as growth, Operating leverage and provisions are all in favour.
• Regulators in India are unlikely to permit FinTech’s to access deposits without a license or do anything innovative that threatens systems stability. 
• However, over time, margins and ROEs will marginally decline as traditional moats weaken or become less relevant as Fin Tech’s keep pushing boundaries.
• Hence, valuations one is willing to pay for Banks may de rate from long term averages.

Implications for Solidarity from a fund management perspective

Stock price returns for Banks will depend on how Banks can delay or prevent ROE decline.   With valuations of leading franchises at long term averages, the market does not believe in margin and ROE decline as a threat at present.  

However, disruption happens “slowly and then quickly” with multiples de rating well before profits (Thermal coal or car batteries as a good example in India).  One needs to balance acting ahead of an event while recognizing the probability that the feared disruption in margins may not happen. 

We are allocators of capital.   We have thought it appropriate to reduce the fair multiples for Banks down the road when we do our IRR estimates.  This has resulted in us reducing our position sizes from about ~25% weight we held two years ago to ~15-20% at present so we can allocate capital in themes where we have more conviction on both longevity of growth and ROE expansion.  For new accounts, we are down to ~15% weight.

Investing decisions are not one-way doors.  One can always revisit their stance.  If we find ourselves constantly questioning our investment stance on a company or the position size of a sector, the prudent course of action in our view is to reduce the position to a more palatable size as these decisions are reversible. 

We will continue to track developments and make necessary adjustments as needed.