Nick Paulson-Ellis

The economy has been through a rough patch in the past three years, which has resulted in GDP growth slowing down to below 5%. This has adversely impacted the banking system, leading to lower credit growth and increasing asset quality problems. So far, the impact has been limited to state-owned PSU banks, which have borne the brunt of asset quality stress, while private sector banks have remained largely immune to the slowdown. The Bankex fell nearly 10% over the past six months, owing to the particularly difficult quarter for the banking system with a few private sector banks also feeling the pressure of the policy U-turn by the Reserve Bank of India (RBI). Investors started to question the sanctity and safety of private banks as cracks started to appear in their financial performance. So, is it gloom and doom for all banking stocks?

Given the current environment, limiting exposure to banks is recommended. However, exposure to private banks should be a feature of every investor’s portfolio — one just has to be particularly selective at present. Within the private banking space, mid-sized private sector lender ING Vysya Bank is well-placed, given its strong balance sheet, high quality management and strong brand equity. It boasts of a high Tier I capital of 14.3% (Basel 3); strong asset quality (net NPA of 0.2%); and a stable funding profile (CASA of 30%-plus).

A new makeover

The current management team headed by Shailendra Bhandari took over the management of the bank in August 2009 and transformed it from a sleepy regional bank to one of the most prolific private sector banks in India. Under his leadership, the bank’s balance sheet grew at a CAGR of 20%, while net profit grew at a CAGR of 34%. 

 ING Vysya is ahead of most other regional private banks in the race to transform itself into a new-generation private bank. It enjoys the advantages of a lower level of union representation and the benefits that accrue from ING Bank NV’s parentage, namely expansion in non-core markets and strong corporate banking capabilities. In the past three years, the bank has seen increased revenue momentum driven by a strong net interest margin and improvement in asset yields by playing to its strength in the small and medium enterprise business category. Asset quality improved significantly during this period, making it one of the best in the class. These trends will sustain in the future and will aid in return on equity (RoE) improvement, leading to a further re-rating of the bank. 

What is even more impressive is the fact that the bank achieved all this while improving cost efficiencies and successfully re-branding itself as a ‘premium’ bank. Also, it is one of the few success stories of a regional bank moving out of its core market and transforming into a national bank. ING Vysya flawlessly executed a measured branch expansion outside its core markets of Andhra Pradesh and Karnataka and a key ingredient to its success can be attributed to the ‘ING’ brand. The acquisition of Vysya Bank by ING NV is the only example of a foreign bank acquiring a private bank in India. ING NV continued to invest significant capital in the bank at regular intervals (pumping in a cumulative ₹2,320 crore or nearly $375 million over the span of close to 20 years). Since it gained management control of the bank in 2002, ING NV has earned an internal rate of return (IRR) as high as 17% in rupee terms and 13% in dollar terms.

M&A rules

In addition to its solid fundamentals, recent regulatory changes by the central bank should also benefit ING Vysya. Since taking over as RBI governor, Raghuram Rajan has come out with two significant regulatory changes — liberalising branch licensing and permitting foreign banks to operate in India through a wholly-owned subsidiary (WOS). These two policy changes will have a profound impact on the competitive landscape of the banking system in India. In addition to allowing foreign banks to operate as WOS, the RBI has also allowed the subsidiary of foreign banks (subject to regulatory approvals) to enter into mergers and acquisitions (M&As) with any private sector bank in India, subject to the overall foreign investment limit of 74%.

The RBI’s policy changes have shifted the goalposts with regard to M&A in the Indian banking sector. Historically, branch network was the key determinant to arrive at an acquisition multiple, but with the RBI deregulating branch licensing, this metric could now take a back seat. We believe strong liabilities, niche products and a profitable priority sector business will be the key drivers for future M&A. With its foreign parentage and a strong regional presence, ING Vysya makes for a good M&A candidate.

The bank offers multiple possibilities on the M&A front — ING NV further increasing its stake to the permissible 74% FII limit (given the high IRR it earned so far); the parent completely selling its stake to another foreign bank; or the parent selling its stake to a domestic bank. History tells us that market-driven acquisitions in the banking sector happened at a significant premium to book value in India. The two most recent examples of M&A in India — HDFC Bank’s acquisition of Centurion Bank of Punjab in 2008 at 5.4 times and ICICI Bank’s acquisition of Bank of Rajasthan in 2010 at 2.4 times book value — gives us a sense of the potential upside in the event of M&A happening in the sector.

As part of its global deleveraging strategy, the ING group has exited several markets in 2013. In India, too, ING exited its life insurance JV with Exide. However, given that ING NV earned an IRR of 13% in dollar terms, which is in line with its global RoE threshold of 10-13%, we do not rule out the possibility of ING NV further increasing its stake in the bank. 

ING Vysya has successfully differentiated itself from the other regional private banks and is a strong re-rating candidate among mid-sized private sector banks. It currently trades at 1.3 times estimated FY15 P/B, which is a discount to other mid-sized new generation banks such as IndusInd Bank, Kotak Mahindra Bank and Yes Bank, which gives investors an opportunity to take advantage of the valuation anomaly. All these factors, along with an improving RoE profile, stable asset quality, prudent risk management, and M&A possibilities, make the stock a compelling buy.