The cumulative credit of Indian banks stood at Rs 110.46 lakh crore at the end of September 2021.Banks are known as the backbone of an economy because they maintain sufficient liquidity by circulating money in the economy. Banks provide people a platform to park their surplus cash as well as borrow when they fall short. According to the RBI, the cumulative credit of Indian banks stood at Rs 110.46 lakh crore at the end of September 2021.However, India is still an underpenetrated market in terms of banking services primarily due to low level of financial literacy in the country. As a result, the total credit outstanding is just 15% of the total value of all goods and services produced in the country.Private sector banks and public sector banks (PSBs) together make up for the Indian banking industry. For the last two decades, private banks have outperformed PSBs, largely due to better management. In this article, we compare India’s “too big to fail banking behemoths” HDFC Bank and ICICI Bank to see how they stack up against each other.Banks run on a very simple business model. To understand the business model, you need to first understand the operational dynamics of a bank. The basic operational premise of a bank comprises two major operations – accepting deposits and lending to borrowers. Deposits Deposits are the primary source of funds for a bank without which it cannot operate. This is because the bank uses the money it receives from deposits to lend to borrowers. There are different types of deposits that contribute to the overall deposit base of a bank. These include deposits from current accounts and savings accounts (CASA), time deposits (certificate of deposits), fixed deposits, etc. Given its importance, let’s look at the deposit base of HDFC Bank and ICICI Bank and how it has grown over the last five years. Clearly, HDFC Bank has a higher deposit base than ICICI Bank. Also, the former has been growing its deposit base at a faster rate than the latter. HDFC Bank’s deposit base has grown at double digit CAGR of 15.7% over the last five years. This is compared to ICICI Bank’s average growth of 13.4% during the same period. Advances Now, let’s take a look at the other side of the equation which is concerned with loans. Banks use their deposits to disburse loans or advances as they call it in banking parlance. The growth of advances should keep up with the growth of a bank’s deposits. Following table compares advances of HDFC Bank and ICICI Bank. Even here, HDFC Bank’s advances have grown faster than ICICI Bank’s . For the last 5 years, HDFC Bank’s advances have grown at a CAGR of 15.1% compared to ICICI Bank’s 9% CAGR during the same period. For the year ended March 2021, HDFC Bank’s advances were 88.9% of its total deposits whereas this figure was 82.5% for ICICI Bank. Clearly, HDFC Bank is more efficient than ICICI Bank in terms of utilising its deposit base. Net Interest Income (NII)Now, coming to how a bank makes profits, you need to know its major sources of revenue and costs it incurs. Let’s talk about costs first. The banking industry is extremely competitive. A bank wants you to park your money with it and not with its peers. In a bid to acquire more deposits, a bank offers you incentives on your deposits. This incentive is called interest which is calculated as a percentage of your deposits. Interest paid to depositors is a major cost incurred by a bank and constitutes a large chunk of its total expenses. On the other hand, a bank charges an interest on loans offered. Interest earned through loans is a major source of revenue for a bank and constitutes a large chunk of its total revenue. The interest charged to borrowers is always higher than the interest offered to depositors. The difference between the interest earned and interest paid is the bank’s gross income. This differential is also known as net interest income (NII). The following table shows how HDFC Bank and ICICI Bank stack up against each other on these metrics.HDFC Bank’s NII has grown at a CAGR of 14.5% over the last years whereas ICICI Bank’s NII has grown at a CAGR of 12.2% during the same period. Net Interest MarginNet interest margin (NIM) is basically net interest income divided by the total amount of loan disbursed by a bank. It is one of the measures of a bank’s profitability. Therefore, higher the NIM the better it is for banks. The following table shows net interest margin of HDFC Bank and ICICI Bank.HDFC Bank’s higher interest income has translated into higher NIM for the bank. HDFC Bank’s net interest income has been quite stable over years and averages at 4.6%. This is compared to ICICI Bank’s average of 3.2%. Which bank scores well on this important metric?The biggest fear of any bank is its borrowers defaulting on their payment obligations. A borrower may do so willfully or he/she may be unable to fulfill payment obligations due to unforeseen circumstances. An example of willful delinquency would be that of the flamboyant Vijay Mallya who took a massive loan of Rs 700 crore from a consortium of banks led by State Bank of India (SBI) to fund the operations of now defunct airline Kingfisher. An example of the latter would be of Covid-19 pandemic which severely affected the business landscape. Many people lost their jobs which dented their financial position which in turn led to their inability to pay their loans. In any case, if the payment is overdue for a period of more than 90 days, then the loan becomes a non-performing assets (NPA). because the bank isn’t earning any interest from the respective loan. NPAs beyond a certain limit could drain the fortune of a bank leading to its bankruptcy. To avoid such a situation, it is crucial for a bank to check the creditworthiness of an individual or entity to whom the loan is being offered. The performance of HDFC Bank and ICICI Bank have been exemplary in this space. The following table shows NPAs reported by HDFC Bank and ICICI Bank. It is expressed as a percentage of a bank’s total advances. As can be seen from the table, HDFC Bank has consistently reported lower NPAs. The five year average of HDFC Bank’s NPAs is approximately 0.4% which is the lowest in the industry. It means that if HDFC Bank disburses a total loan of Rs 100 then Rs 0.4 doesn’t come back to the bank. It should come as no surprise that HDFC Bank holds the distinction of reporting more than 20% YoY profit growth every quarter for over 40 quarters. All this while, its net NPAs have never crossed 0.5% of loans!The five year average of ICICI Bank’s NPAs is 3.16% which is nowhere near HDFC Bank. Although the average seems high, it is important to note that ICICI Bank’s NPAs have come down drastically ever since the top level management was changed in 2017 and Mr Sandeep Bakshi was instated as the CEO of the bank. Net ProfitClosely associated with NPAs are provisions. Whenever a bank reports an NPA it has to keep aside a portion of its interest income to provide for the loss incurred due to the respective NPA. Provisions are a major expenditure for banks and impact their net profits significantly. This can be seen in the case of HDFC Bank and ICICI Bank. The following table compares the net profits of HDFC Bank and ICICI Bank. HDFC Bank’s net profits have grown at a CAGR of 15.9% over the last five years. This is compared to ICICI Bank’s net profit growth of 12.5%. ICICI Bank’s net profit growth is slow as compared to HDFC Bank primarily due to high provisions being reported by the bank.Also, HDFC Bank has reported relatively higher and stable margins as compared to ICICI Bank. The following table shows the net profit margins of HDFC Bank and ICICI Bank.Dividend PayoutInvestors tend to invest in companies that pay dividends to their shareholders.Dividend is company’s accrued profits distributed equally among shareholders. A company may pay a dividend when it doesn’t have any immediate expenses to pay for.The following table shows the dividend paid by HDFC Bank and ICICI Bank to their shareholders over the last five years.HDFC Bank has paid an average of Rs 5.7 to each shareholder over the last five years. This is compared to ICICI Bank’s average of Rs 1.4 during the same period.Another dividend metric that investors look at before investing in any company is dividend payout ratio. Dividend payout ratio determines how much dividend a company is paying from its earnings. The five-year average dividend payout ratio of HDFC Bank and ICICI Bank is 12.4% and 9.9%, respectively.Banking outletsPhysical branches are still a preferred mode of accessing basic banking services especially in rural areas. Therefore, physical branches hold importance for a bank’s growth. To ensure last mile delivery of basic banking services, Indian banks serve its customers through third party partners who are also known as business correspondents (BCs) especially in areas where it is not feasible for banks to operate a full-fledged physical branch. As of March 2021, HDFC Bank had a total of 21,364 banking outlets across the world. ICICI Bank had a total of 9,266 banking outlets spread across India as of March 2021. Of the total, 5,266 are physical branches and 51% of the total physical branches are present in rural areas. The remaining banking outlets are BCs. Investments and acquisitionsApart from physical banking outlets, Indian banks have been focusing on developing digital channels to deliver seamless banking experience to customers and reduce their costs. Banks have been investing and collaborating with fintech companies to leverage their technological expertise and expand their reach. HDFC Bank entered into a strategic partnership with Paytm to leverage Paytm’s digital platform and expand its reach in rural markets where Paytm enjoys good rapport with small merchants. This partnership will help the bank to burgeon its retail loan book. HDFC Bank has also invested in Bengaluru based wealth management tech platform Smallcase. Meanwhile, ICICI Bank has partnered with fintech platform Niyo to offer prepaid cards to MSME workers with the objective to rope them under the banking ecosystem. The bank has launched “iMobile Pay” to capture a significant market share in the UPI payment market which is dominated by fintech companies like Phonepe and Google Pay. Return and Valuation ratiosWhile comparing banks, analysts usually use three ratios to find out which is undervalued. These three ratios are return on equity (ROE), return on assets (ROA), and price to book value (P/BV). Return on equity (ROE) tells an investor how much profit a company generates on shareholders capital. It is expressed in terms of percentage. Return on assets (ROA) tells an investor how much profit a company generates on total assets the company owns. Important point to note is loans are assets for banks and ROA is calculated as a ratio of net income to its total performing (generating interest income) assets. For banks, ROA of 1% is a benchmark and anything beyond that is considered excellent. Price to book value (P/BV) indicates the price an investor is willing to pay for each rupee of a company’s book value.HDFC Bank outperforms ICICI Bank in terms of ROE and ROA. HDFC Bank trades at a higher P/BV than ICICI Bank primarily because the market is giving higher value to HDFC Bank’s consistent performance. Clearly, HDFC Bank is a little overvalued here but for the right reasons. Impact of Covid-19When the lockdown was announced to curb the spread of the virus, banking stocks plunged the most. Stock prices fell in the anticipation that NPAs would shoot up significantly. However, the Reserve Bank of India (RBI), was quick to announce a slew of measures which helped the borrowers and the banks to face the brunt of the pandemic. To start with, the RBI announced a six month moratorium on loan payments. This measure helped banks report lower than expected NPAs and consequently stem their losses. Also, the RBI executed long term repo operations so that the banks can borrow from the RBI at a minimum rate of 4% and lend it forward to those in need. This measure ensured that sufficient liquidity was maintained in the economy and the economic engine isn’t hindered due to non-availability of required capital. For the first two quarters of the financial year 2021, although the banks reported lower NPA figures, they also reported flat or negative revenue and profit growth. However, demand revived in the third and the fourth quarter as restrictions were eased and festival season dawned upon the country. Home loans were the major demand driver in the retail category due to lower interest rate regime and softening real estate prices. In the wholesale category, banks financed the increased working capital requirements due to high input cost and freight cost. Thanks to this revived demand, Indian banks closed the year on a healthy note.Future prospectsA large part of India is still credit averse. A lot of people in India see loans and credit in a bad light. As a result, India lags behind developed nations in terms of credit. India’s total outstanding loans to gross domestic product (GDP) is just 15% compared to 80-100% in its western counterparts. So India has got a lot to cover and there is a lot of headroom for growth for Indian banks. Let’s look at some of the possibilities of how India may achieve higher credit growth and financial inclusion. To start with, as companies adopt China plus one strategy, they see India as an obvious alternative. The Indian government too is looking at this opportunity to make India as the biggest manufacturing hub in the world. Small and medium enterprises (SME) would play a crucial role in making India a manufacturing hub. Hence, SME financing could be a great opportunity for banks to grow their loan book.Also, it is expected that people currently working in the agriculture sector would shift to the manufacturing sector once the sector starts growing. Therefore, rural markets would present a new wave of growth for banks to ride on. However, digital, and financial literacy remains a big challenge. Banks have to tackle this issue if they wish to leverage the untapped potential of the rural market. Last but not least, due diligence remains a key for any bank’s success. Any bank which follows a quality due diligence framework and keeps a check on its bad loans will emerge as a leader. HDFC Bank is a perfect example of this. To sum up, HDFC Bank and ICICI Bank being the top players in the industry are poised to grow as the overall industry grows. Equitymaster’s viewWe reached out to Tanushree Banerjee, Co-head of Research at Equitymaster for her view on both banks. Here’s what she had to say…While the regulatory scenario for fintech’s is still evolving, there is no doubt that the sector offers massive opportunity. Both, the incumbents i.e. the existing tech focussed banks like HDFC Bank and ICICI Bank as well as the new age players with niche innovative fintech offerings, have room for growth.Which is better? If we compare the two banks on credit growth then both banks are growing their loan book almost at an equal rate across the interest cycle.However, if we compare them on the credit quality, HDFC Bank is far ahead than ICICI Bank. HDFC Bank has reported consistently lower and stable NPAs across the interest cycle whereas ICICI Bank’s credit quality has fluctuated a lot and is relatively unstable. On the net interest margin front too, HDFC Bank scores better than ICICI bank. However, ever since the management of ICICI Bank was overhauled with Sanjay Bakshi taking charge, there has been a drastic improvement in the bank’s performance. It’s inching closer towards HDFC Bank in terms of financial performance. This is something that needs to be noted. Though this article might have made things easier for you, we strongly recommend you to check the fundamentals and valuations of both these companies on your own.Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.(This article is syndicated from Equitymaster.com)(This story has not been edited by NDTV staff and is auto-generated from a syndicated feed.)
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