The Outperformers 2019

The Prudent Banker

Amid slow growth and poor governance in financial services, Kotak Mahindra Bank continues to steer ahead with a clear growth strategy

It was May 1991. Salomon Brothers, the legendary Wall Street firm, found itself ensnared in a scandal where trader Paul Mozer had been submitting illegal bids for US Treasury Securities, attempting to corner the market by breaching the individual bidding limit. Warren Buffett, who had a $700 million investment in Salomon Brothers, stepped in to untangle the knots. The firm avoided bankruptcy and was, eventually, acquired by Travelers Group.

It seemed like history was repeating itself when Uday Kotak, managing director and CEO, Kotak Mahindra Bank was sought out by the government to steer the beleaguered term-lending institution IL&FS, teetering under a pile of debt. The only difference: Uday Kotak had no ownership interest in the firm. It is just that the 60-year-old banker has become the government’s go-to man to resolve a financial crisis that sent shock waves in the financial markets. The street shaved off Rs.3.5 trillion in market cap between August 2018, when the crisis began, and by end of September when a new board was set up. Kotak’s immaculate reputation as a prudent banker built over the past three decades made him the obvious choice. 

In the world of finance, or in fact everywhere, reputation counts for a lot. “Lose money for the firm and I will be understanding, lose a shred of reputation for the firm and I will be ruthless,” Buffett famously said during the 1991 hearing, recounting his message to Salomon employees, after he took over as interim chairman. Kotak has neither lost money, nor his reputation since he began his career.

Kotak’s exalted status today, of course, had humble beginnings. Starting off as a one-man army organising financing for companies through bill discounting, Kotak has grown steadily in India’s financial sector that has seen several ups and downs with a fairly poor survival rate. Several private financial firms of yesteryears simply shut shop, while many state-owned banks survived, thanks only to the benevolence of the government.

Kotak, on the contrary, quite like Buffett, has built a highly profitable business, following capital preservation as the bedrock. Kotak’s guiding philosophy has been ‘return of capital is much more important than return on capital,’ re-iterated in this year’s annual report.

It’s a virtue the market values highly. Kotak Mahindra Bank’s stock trades at a price-to-book value of 4.95x, one of the highest in the banking sector. Yet, the best is probably still to come as the bank shifts to a higher gear.

The non-bank bank

Despite having converted to a bank way back in 2003, Kotak Mahindra Bank continued to push ahead its existing legacy businesses, including auto loans, securities, investment banking and asset management with gusto, rather than plunging headlong into branch banking or writing large cheques to borrowers as conventional banks did. In those initial years, analysts did not even count Kotak as a serious bank for the same reason. “When we were relatively new in the banking business, attracting savings account customers seemed like a daunting task,” says Kotak. On the lending side, it chose to make safer bets providing working capital finance, trade finance and writing smaller cheques to creditworthy customers. Essentially, it continued to do brisk business, growing steadily without diluting its return ratios, choosing its playing field carefully.

In 2006, he took a contrarian stance that was stunning. While prominent investment bankers sold their business to foreign partners, rattled by the might of global players and the changing complexion of India’s corporate sector in favour of global companies, Kotak decided to do exactly the opposite — buy out the stake from foreign partner Goldman Sachs rather than selling out. That move was not just a demonstration of his confidence and faith in the investment banking and securities business – it was emboldened by the “universal banking” model that the world was veering towards.

On the loans side, several fledging private sector banks such as ICICI Bank and Axis Bank were gaining heft lending to corporates during the bullish years till 2008, but Kotak Bank displayed little aggression. The bank continued to restrict its lending to short-duration loans rather than long-duration ones or infrastructure projects. 

Kotak has always had a nose for profitable deals, but has also been wary when needed. “We are paranoid about risk. We always assess what could do wrong before taking a call. Something that is too good to be true is just that.” Kotak cites the example of a trade in Himachal Futuristic that was brought to him about two decades ago.

During the dotcom boom, Himachal Futuristic along with Global Telesystems, DSQ Software, Pentafour were favoured by many a punter. Around that time, Kotak was offered a transaction that seemed lucrative. Since those days trade settlement took nearly a week, the counterparty wanted to sell a block of HFCL shares to Kotak which could then sell the same in the market. For an immediate payment, the client was willing to pay 1% flat – that would have meant a compounded return of nearly 60-70% per annum, a very lucrative offer. Kotak loved the deal but let it pass, recognising the risk: what if the buyer on the other side was related to the seller and it ended up being a circular trade? Kotak could then be implicated in a stock manipulation case. And that is exactly what happened. The deal was done by another global bank, which was later banned by the regulator from the securities market for two years.

Kotak’s conservative stance has always paid off. It did in a big way in 2008 as the credit crunch post the collapse of Lehman Brothers went global. Sectors such as power and infrastructure were badly hit, and overall economic growth was plummeting. With the entire banking sector paralysed by bad loans, Kotak had a field day. The bank’s bad loans, including stressed assets, stood at 2.39% in crisis-ridden FY09, but was down to 1.73% by FY10. Its advances grew 25% to Rs.208 billion that year, and the bank clocked its then highest consolidated profit of Rs.13 billion. 

It just went to prove that the bank’s integrated approach was the best model as the cyclicality of the capital-markets businesses was offset by steady growing annuity from the financing and asset management businesses. In fact, by FY11, 75% of the bank’s earnings came from the financing business, 10% from the asset management and life insurance businesses, while the contribution of the capital markets business fell to 15% from 55% in FY08.

The crisis also drilled into banks the importance of savings bank accounts. Large private sector banks such as ICICI Bank, which had relied on wholesale funds, were almost brought to their knees. As the troubled banks got busy repairing their balance sheet, Kotak Mahindra Bank began stepping on the accelerator. It changed direction, capitalising on the vacuum created in the market. 

Over the past five years, its loan book has grown 3x from Rs.663 billion in FY15 to over Rs.2.05 trillion in FY19, outpacing the industry average handsomely, while the bank’s contribution has more than doubled to Rs.49 billion (See: Master of all trades). Surprisingly, Kotak feels more ground could have been gained. “It was a mistake not to aggressively grow our business after the 2008 crisis. We would have been much bigger today. We were too scared,” rues Kotak. Again, that paranoia is what has held Kotak in good stead all along. In hindsight, what the bank has achieved in the past five years, including its acquisition of ING Vysya in 2014, more than compensates for the lost time. 

Now banking

The 2008 crisis had hit home the importance of retail deposits. So, after the deregulation of savings rates in 2011, the bank went on the offensive wooing savers with a higher rate. Following its ‘Why take 4, 6 is more.’ campaign, savings deposits more than doubled to Rs.72.68 billion in March 2013, constituting 48% of its total low-cost deposits. But that was only the beginning. Thereafter, with continuous effort, savings deposits have grown steadily to a whopping Rs.797 billion in FY19.

Currently, the bank’s current accounts and savings accounts (CASA), a key source of low-cost funds, stands at 52.5% as of March 2019 from around 30%, a decade ago. “Stability is critical, and that comes from savings accounts,” says Kotak. CASA plus term deposits of less than Rs.50 million constitutes 81% of the bank’s deposit base, of which, the focus is on term deposits less than Rs.10 million, which has grown by 32% in FY19. Not only is the cost of funds lower on these accounts, compared with the overall cost of deposits, they also allow the bank to cross-sell financial products to a larger base of customers, which now stands at 16 million. For example, in the unsecured credit card business, 90% of the bank’s incremental signups come from existing customers.

The bank’s relentless focus on retail deposits is also evident in the fact that it hasn’t yet tinkered with its 6% rate for savings account deposits between Rs.100,000 and Rs.10 million, despite the repo rate coming off 75 basis points since 2016. It’s only for balances below Rs.100,000 that the rate has been cut from 5% to 4.5%. Says Kotak, “Obviously, we need to make this customer much more engaged with us and, over time, significantly profitable as well. This is our front-end investment which is creating immediate cost pressure but building a very strong base for our future.” According to Kotak, a smart branch strategy combined with digital will ensure that they can expand the productivity of low-cost liability and deposit base.  

Going ‘Phygital’ 

Fundamental to Kotak’s strategy going forward is a combination of conventional branch banking and digital banking. The bank has been aggressive with its digital push. Be it creating a great customer experience through its mobile app or engaging with customers through chatbots or acquiring customers through social media channels such as WhatsApp or Twitter, Kotak is experimenting constantly. The initiative that has really paid off is the 811 campaign — christened after 8/11, the date when demonetisation was announced — which allows customers to open zero balance accounts digitally. It was actually a master move since it costs only a third to acquire digital customers as opposed to signing up physical customers. Even more, servicing these accounts costs next to nothing. 

Though 811 has garnered significant number of accounts – the bank is unwilling to share the exact number – the challenge and opportunity is to get them to increase their balance as well as use the bank’s products. “Raising liability is excruciating hard work over long periods of time. We would love to see our savings account depositors below Rs.100,000 to go beyond that. Therefore, one of our big focus areas is how to deepen these balances per account,” Kotak had stated during an earnings call. 

While digital does bring in customers, physical presence is still something customers can’t do without – that’s why the first part of the ‘phygital’ strategy is more crucial. At 1,500 branches currently, Kotak Mahindra Bank is not exactly looking at going the whole hog. “We do not see going up to 5,000 branches on our own in any organic manner. But we do see ourselves going to 2,000 branches over the next few years,” says Kotak in an interview with Outlook Business (see: page 56). A quick way to get there may be an acquisition, which the bank may have an appetite for, after the successful completion of the ING Vysya merger.

Blooming inorganically

Acquisitions have been hard to come by in the banking sector because good assets are never available at a reasonable price. While investment bankers thrive on doing deals, it’s hard to get them to pay up. Kotak Mahindra’s acquisition of ING Vysya in November 2014 was a strategic move that came at a reasonable price. It helped that when ING Vysya was on the block, many banks were preoccupied putting their own house in order. 

The deal not just brought size but also reach in terms of a complementary branch network. “The merger helped us double our branches and expand our network pan-India, with a deeper focus on the south,” mentions Kotak. Importantly, in one stroke, the bank garnered a total of Rs.646 billion in assets and Rs.446 billion in deposits, making it the fourth-largest private sector bank in the country with assets totaling Rs.1.98 trillion and deposits amounting to Rs.1.12 trillion at the time of the merger.

But it’s not size alone that Kotak is chasing. At the time of the acquisition, ING Vysya’s ratios paled against that of Kotak’s — net interest margin (NIM) of 3.46% against 5.05%; return on assets of 1.07% against 2.12%; and return on equity of 8.90% compared with 14.26%. Since then, Kotak Mahindra has been able to achieve substantial cost savings. Before the merger, Kotak’s cost-to-income ratio was 51%, while that of ING was 55%. The year the merger happened, costs escalated with the ratio jumping up to 59% because of additional integration costs, but the ratio has been sliding down ever since closing in on 47% in FY19, lower than what Kotak had before the merger. As rationalisation efforts continue, analysts expect the ratio to settle around 44% in a couple of years.

Other metrics have improved too since the merger. As of FY19, Kotak’s return on assets has improved from 1.6% to 2% while return on equity has risen from 11% to 13%.With bad loans, Kotak was quick to identify ING Vysya’s stressed assets, resulting in a jump in its net NPA. From 0.92% in FY15, net NPA spiked to 1.26% in FY17. But over the subsequent two fiscals, the bank managed to bring down its net NPA to 0.75% as of March 2019.

While the Street expects the bank to grow its NIM at 20% CAGR over the next three years, Kotak said in a recent earnings call. “If we believe we are getting the price for the risk we are taking, we’ll lend and are not obsessed by a number which is 20%, 25%, 30% growth. We are obsessed by the fact that the trouble with stress is it never comes at the time when you lend, it comes two years later.”

HDFC Bank, whose loan book at Rs.8.19 trillion is 4x the size of Kotak’s, earns an NIM of 4.3%, RoA of 2%, RoE of 17% and maintains a healthy book with a NPA of 0.39% — that’s the best in the industry. And that’s probably the way forward for Kotak too. 

With any acquisition, while it may take time to alter the complexion of the book, costs savings can pay off immediately and alter the bottomline. Since he is clear that he won’t make riskier bets, Kotak is naturally more focused on costs. Potential synergies and resultant cost savings, in fact, will be an important factor in the pursuit of future mergers or acquisitions, admits Kotak. “One essential ingredient for an acquisition/merger has to be cost savings,” he emphasises, stating that his bank is ready and willing for a merger or acquisition.

Regulatory overhang

M&A is not only because Kotak wants to accelerate growth. One very important trigger for acquisition is also the RBI’s diktat to reduce promoter holding to 15% by 2020. Kotak has been vocal about his displeasure with the regulation. “Ownership does not necessarily bring about governance,” Kotak had mentioned in an earlier media interaction. As a compromise, Kotak in August 2018, made a proposal to issue non-convertible perpetual non-cumulative preference shares to a set of investors to reduce the promoter stake to less than 20% as mandated by the central bank rules. But the RBI has not given the go ahead as it is of the view that preference shares do not comprise core equity and help promoters retain voting rights. Kotak has moved the Bombay High Court, where the matter is likely to come up for hearing in 2020. 

But the regulatory overhang is proving to be a big worry. This June, when the RBI imposed a Rs.20 million penalty on the bank for not complying with its diktat on ownership guidelines, jittery investors shaved off half a billion from the market cap. Kotak knows the ways of the stock market more than anyone else having built one of the finest securities firms selling Indian equities to both local and global investors. As for investor sentiment, it is hard for them to ignore a bank that is run prudently, profitably and which also offers a great growth canvas. The legal outcome of the case, which is a first in the banking system, is still not clear. Meanwhile, business is only getting better. 

Next Trigger

In a way, FY19 marked a new milestone for the bank – its balance sheet (total assets) crossed the Rs.3-trillion mark, while advances grew a little over Rs.2 trillion. Ironically, 2019 also marks the 50th year of bank nationalisation, but the state of affairs at public sector banks (PSBs) leave a lot left to be desired. Close to five PSBs have come under the PCA (prompt corrective action) ambit of the RBI. Similarly, the IL&FS crisis has pulled the rug from under the NBFC sector’s feet. The liquidity crunch has forced many NBFCs to go slow on fresh advances, even as the top 10 players have collectively lost over Rs.1 trillion in market cap over the past one year. 

Kotak puts the new challenge in context: “Earlier, the problems in the real sector spilled over to the financial sector, now it’s the reverse. 2019 and 2020 will see a cleansing process, post which, we will come out stronger.” Despite a challenging macro environment, the management expects healthy growth in advances. “We expect over 20% growth this fiscal with sustained growth across retail, corporate and commercial,” says Kotak.

Over the past five years, the bank’s loan book growth has been quite robust. There has been a significant increase in the retail loan book (comprising home loans and loan against property (LAP), small business, personal loans and credit cards, and business banking) that has grown 4x from Rs.221 billion to Rs.920 billion, while the corporate loan book has gone up 3x from Rs.202 billion to Rs.618 billion (See: When opportunity knocks). Within the retail book, growth in small business and personal loans was the highest — rising more than 5x from Rs.62 billion in FY15 to Rs.331 billion. The home loans and LAP book at Rs.407 billion has grown nearly 3x. Interestingly, Kotak has been critical about the way other financial firms have been valuing real estate collateral and sees that as a risk. Being cognizant of overvalued collateral, one can safely presume that Kotak Mahindra’s book is steering clear of such risks.

Kotak continues to bat for safe pockets of opportunity even if they are small. Kotak Mahindra Prime clocked Rs.240 billion in revenue in FY19 by primarily offering car loans and dealer financing. But there is now a slowdown in passenger vehicle sales and, to counter that, the bank’s subsidiary is looking at diversifying into two-wheeler loans. The bank is also planning to get into consumer durables financing. On how big the business would be, Shanti Ekambaram, president, consumer banking, said in an earnings call: “These are small ticket loans and reasonably short tenure of around six months, so the book is just building. We will have to wait a few quarters.” It’s really banking as usual. But what is usual at Kotak itself is a bit unusual. 

Disruptive growth

Uday Kotak believes in the Holy Trinity. This world would not maintain its perfect balance unless Brahma, Vishnu and Shiva – the creator, preserver and destroyer co-existed. The same applies to companies too. “You need all three in your ecosystem. Brahma, who is constantly focused on creation and new opportunities (for example, consumer durables and two-wheeler finance); Vishnu, to ensure continuity and growth (existing businesses); and Shiva, to creatively destroy to stay relevant,” he says.

Kotak has ensured the holy trinity gets due respect at the bank. “Given the complexity of our firm, there are many pieces that may not make sense at some point. Over the past five years, there have been a number of internal divisions that we have merged and also some businesses where we took a tough call.” That’s Shiva’s territory. For example, in the commercial heavy vehicles business, the bank dramatically cut exposure when the risk was high. In the credit card business, the management took a hard call to grow the business internally and not through “agents at the airport giving out credit cards”.

Today, the bank’s most valued subsidiary, Kotak Life, has come of age. The embedded value of the life insurance business in FY19 was Rs.73.06 billion, against Rs.58.24 billion a year ago. The value of new business for FY19 was Rs.7.99 billion, against Rs.5.22 billion in FY18; the bank’s VNB margin is at 36.9%. “Our margin is probably the highest in the life insurance industry,” says Kotak. Analysts peg the value of the insurance business at Rs.100 out of the total sum of the parts valuation of Rs.1,500 for Kotak Mahindra Bank. The asset management and car-financing business are pegged at Rs.90 and Rs.80, respectively. Investors fancy the bank given its multiple growth drivers — a stable annuity business to balance the ups and downs in the capital markets linked businesses, cost efficiencies driven by technology and the ability to capitalise on the India growth story.

With a market cap of Rs.2.8 trillion, the country’s fourth-largest private bank has been compounding return at 35% since it turned into a bank in 2003 against 16% for the benchmark Sensex. In the calendar year thus far, the stock has fetched 17% return versus 10% for the Sensex. At over 4.25x estimated FY21 price-to-book, the stock is not exactly cheap and significantly more expensive than HDFC Bank, which trades at 3.4x estimated FY21 price-to-book. The bank’s track-record of focusing on risk-adjusted return combined with the vast runway for growth created by bad banks makes Kotak perfectly poised to pick, choose and grow its book profitably. While investor optimism is high, Kotak sees banking as a tough business to be in. “The financial sector appears glamorous, but it is fundamentally very fragile. Therefore, it is crucial that a firm has the simplicity and humility to say that this is a very difficult real-life business.”