Two events that took place last fortnight – the downgrading of SBI by Moody’s Investors Service and reports of alleged financial irregularities at Dhanlaxmi Bank – have raised further questions about the performance of the banking index, which is already underperforming the broader market on a YTD basis. Events like these dent the performance of the entire sector. Readers must be wondering about the impact that these events will have on the banking sector in general, and on the banks involved in particular.

As far as SBI is concerned, it is clearly a case of political inefficiency and policy paralysis. Moody’s Investors Service downgraded SBI’s bank financial strength rating (BFSR), or stand-alone rating, from C− to D+. The revised rating maps to a Baseline Credit Assessment (BCA) of Baa3. One of the reasons cited by Moody’s for such an action was the bank’s high level of NPAs (Non-Performing Assets). As of 30th June 2011, SBI’s gross NPAs touched a three-year high of 3.52 per cent of loans. Compare this with other leading banks, including private and public sector banks in India that have gross NPAs of less than three per cent, barring ICICI Bank, which has gross NPAs of 4.4 per cent. SBI does not even have adequate capital to guard against such high level of NPAs. The bank reported a Tier 1 capital ratio of 7.60 per cent as of 30th June, 2011, against the minimum requirement of eight per cent that the government had committed it will maintain in public sector banks. Other large public sec-tor banks have better capital adequacy ratios, for example, Bank of Baroda, which had Tier 1 capital of 10 per cent at the end of the March 2011.

Now, one must be wondering where the political inefficiency creeps in from. The Government of India being the largest shareholder, with a 59.4 per cent stake in the bank, is unable to chip in its share of capital in the bank, and hence, has not been able to shore up the bank’s capital. This is hurting the bank in two aspects – the credit growth of the bank, as well as the asset quality that remains vulnerable to any large hit in the quality of loans.

According to some media reports, out of the total Rs 12000 crore required by SBI to reach the correct level of capital adequacy (eight per cent), the government is planning to infuse Rs 3000-4500 crore, depending upon the internal accrual generated by the bank. However, details of how such an infusion will take place are still not clear, as the government has not earmarked any such amount in its budget.

In the case of Dhanlaxmi Bank, there are allegations by one of the employee unions, All India Bank Officers’ Confederation (AIBOC), that the bank had allegedly manipulated accounts, had asset-liability mismatches and was excessively dependent on short-term borrowing. Nevertheless, the management has denied all the allegations – it claims that nothing is wrong in the bank’s accounts and that this is an attempt by AIBOC to malign the bank. Regardless of all the clarifications issued by the management, the share price of the bank is still down by 12 per cent since the day the news broke, compared to the banking index and the Sensex, which are up by one per cent and three per cent respectively. We believe that there is no smoke without fire, and the second quarter FY12 results will reveal the exact financial position of the bank. Till then, we recommend that our readers should stay away from the scrip.

Going back to our cover story on banking (DSIJ issue dated Sept 26-Oct 9, 2011, ‘Time To Shop For Bank Stocks?’), where we had mentioned rising interest rates and their probable impact on the asset quality of banks, which will be more visible in case of PSU banks – this was the reason for our recommendation to investors to stay away from PSU bank stocks in general. We had also said that the RBI will hike interest rates once again in its second quarter review of the monetary policy 2011-12 on October 25, 2011, before taking a pause. The inflation figure has constantly remained above 10 per cent in the last 10 months, which is way above the RBI’s comfort level. Hence, we believe that the RBI will maintain its hawkish stance, and will increase key policy rates by another 25 basis points in its forthcoming second quarter review of the monetary policy 2011-12 on October 25, 2011. Moreover, we believe that worst is still not behind us, and the earlier rate hikes will be reflected in the coming quarterly results. Therefore, we reiterate our earlier view of selected ‘buy’ on banking stocks.