When a financial. Will Bankable? stocks. The infra lender s transformation into a bank is long term story

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1 by himali patel Will IDFC Be Bankable? The infra lender s transformation into a bank is long term story When a financial institution wins an in-principle grant of bank licence in our country, how should the investors like you view the development? After all, this was no mean achievement for infrastructure finance institution, IDFC, which along with Bandhan Financial Services, was among the two applicants that were granted licence on April 2 this year. It was not a cakewalk, IDFC beat stiff competition from 25 high profile applicants including corporate houses such as the Tatas, Birlas, Reliance and other major players like L&T Finance. Will this momentous development for IDFC necessarily reward its existing or new investors? Banker s Edge IDFC is currently focused on infrastructure finance which involves emphasising on areas such as energy including power, besides transportation. Naturally, its clients are large corporates and its sources of funds are concentrated. Due to the risks from concentration in terms of clients, products, sectoral exposure and fund sources, IDFC stock s ride has been wavy. Sunil Kakar, group chief financial officer, IDFC says: Historically, the beta of the stock has been very high. A transition into a bank will alter this reality. IDFC plans to get into shorter term funding like working capital among other products, for its institutional clients even as it tries to diversify its clientele from large corporates to add medium and small enterprises to its portfolio and providing loans in sectors other than infrastructure. The opportunity to diversify away from being infrastructure-focused couldn t have come a day earlier for IDFC. Thanks to the slowdown in the economy, lenders in infrastructure have undoubtedly been hurt. In financial year 2014 (FY14) IDFC s loan provision rose by 194 per cent at `604 crore compared to `206 crore in financial year 2013 (FY13). Kakar says: The last few years have given us enough learnings to indicate that no sector has a secular growth story whatever be the shortfall on the demand side. Therefore, we have to build a stable platform that is less prone to risk. Despite the pain, IDFC s non-performing assets position, a bugbear for other institutions such as public sector banks, is anything but alarming at 0.4 per cent in FY14 against 0.1 per cent in FY13. Suruchi Jain, equity research analyst, Morningstar India says: IDFC found out that infrastructure business was cyclical in nature and they wanted a more non-cyclical balance sheet so that they can tide through difficult times. Even as it diversifies its sectoral exposure, IDFC intends to keep lending to infrastructure and take advantage of India s future economic growth. What can be expected to help IDFC 52 OUTLOOK MONEY June

2 warm up get going Hold course Plan Ahead finish first wind down Investors report card How IDFC has rewarded its shareholders Return on Assets (RoA) Return on Equity (RoE) Earning per Share (Rs) FY 2010 FY 2011 FY 2012 FY 2013 FY % 3.00% 2.90% 2.80% 2.50% 15.80% 12.90% 13.00% 14 0% 12.20% Numbers tell a story Pressures in the recent years have impacted IDFC PAT & NII 3,000 30% 2,500 25% 2,000 20% 1,500 15% 1,000 10% 500 5% 0 0% FY 2010 FY 2011 FY 2012 FY 2013 FY 2014 Profit After Tax (`) NII (Net Interest Income) Cost/income varun vashishtha Cost/Income (%) Source : Company is financial management skills which it has exhibited even during the difficult economic conditions of the recent years. Says Jain: Despite low return on equity (ROE), IDFC s high returns on assets (ROA) reflect excellent asset management and provides us with confidence the firm is well-placed to manage the new banking franchise well. Existing infrastructure loan book will give IDFC a head-start as a bank. Says Kakar: Remember, we are currently at a `70,000-75,000 crore balance sheet with `60,000 crore of loans. We will start with `60,000-70,000 crore on the balance sheet on day one. The other major new source of clients for IDFC would come from retail banking which it hopes to build over the years where besides pure banking services, it would provide retail products which all banks do now, be it home, car and other loans. That s not all. One of the reasons for the issue of bank licences by the country s central bank the Reserve Bank of India (RBI), has been giving a fillip to the efforts of taking banking to the unbanked. IDFC plans to get into action in the financial inclusion piece by rising on technology especially mobile technologies to provide banking services that meet the unique needs of this segment such as payments. One critical advantage IDFC will get as it makes a transition to being a bank is that it will be able to access lower cost funds from current accounts and savings account (CASA). It would also have funds freed up with a lower capital adequacy requirement of 9 per cent as compared to its current 15 per cent. These would be somewhat offset by it having to earmark funds to meet statutory requirements for all banks such as cash reserve ratio (CRR) and statutory liquidity ratio (SLR). Kakar says: In about 5-6 x digital.outlookmoney.com June 2014 OUTLOOK MONEY 53

3 Tech to be a Key facet In an interview with Udayan Ray and Himali Patel, Sunil Kakar, group CFO, IDFC, shares details of IDFC s plans and ambitions as it begins transforming itself into a bank x What are the major areas of transformation IDFC will undergo as it moves towards becoming a bank? When we become a bank two things will happen. One is that sectoral exposure will get diversified from only infra to all sectors. The other will be from product perspective. We will be able to provide term lending, to short term loans like working capital financing, bill discounting and all the regular products. In a strategic framework, it is sectoral and product diversification and asset concentration risk. We are currently dealing with large corporates. We can have mid size and micro, small and medium enterprises (MSMEs) and diversify clients in the institutional segment too. Then, there is the retail or individual segment both for assets and liabilities. The third part of the diversification strategy is to diversify geographically or financial inclusion which is spreading into Tier II to Tier VI towns. But, financial inclusion is not necessarily a geographical cut. You can have financial inclusion even in Tier I towns. In about 5-6 years, we should have per cent in current account and savings account (CASA). This is a marathon, a long test match, not a T20 match. x One of the things that being a bank allows you is access to low cost deposits. How will you leverage it? There are two parts to it. One is the cost of funds. The other is a more stable and diversified base for liabilities. Today, it is very concentrated, 20 people supply 80 per cent of the funds. Tomorrow, by diversifying the sources of liabilities, you are reducing risk. Over time, it will build up. x Over the long term, your stock price is unlikely to witness jagged movements. Do you agree? Historically, the beta of the stock has been very high. It is very volatile. That is because of concentration. The more you diversify, lesser the volatility. To that extent, being a bank provides us with a more stable platform to provide financial services. The last few years have given us enough learnings to indicate that no sector has a secular growth story whatever be the shortfall on the demand side. Therefore, we have to build a stable platform that is less prone to risk. My personal view is that you can play this game of a niche player up to a certain size. After that, you start feeling the pinch. 54 OUTLOOK MONEY June

4 warm up get going Hold course Plan Ahead finish first wind down One of our biggest strengths today is financial capital x Diversification of segments that you talked of should allow cross-selling which is typically very profitable. What is your take on it? The goal is to diverisify and cross-sell to client. But, all this is happening today too. One has to balance this with competitive intensity. So, you got to find empty spaces where you can meet client s needs better. Or spaces, where client needs are not met such as the inclusion and the payments section in the Tier IV, V and VI towns. x What would be your strategy towards technology investments? Last set of banks came ten years ago and have a legacy there. However, technology has moved leaps and bounds. For example, mobile is the most preferred source today. Technology would be a key differentiator. We are going to focus very heavily on how we can enable technology to serve the end client better. And, it will be evolving. So, we have the advantage of being able to leapfrog. There are two parts to it. First, if I may be allowed to use the word India which is the proven sector and in urban India. The other is the Bharat or emerging markets of India where financial services are still at a lower level. The advantage will come from technology and the higher level of capital we have. One of our biggest strengths is financial capital. This business, the stability, the trust runs on the basis of capital. x You hope to augment this as you go along? It depends on how the growth takes place. As we speak, we don t really need more financial capital at least for the first 5-7 years of the bank. But, we do need human capital. We are definitely well capitalised. Currently, our capital adequacy ratio is north of 20 per cent, where most banks are struggling to hold even10 per cent. In absolute terms, our net worth is `15,000 crore and that gives us a significant advantage for playing the game. x How does a new player like IDFC set branches without it being a financial drain? Of course, it will be a challenge from the operational perspective. We will need to pace it through. Obviously, initially it will be a cost. x What kind of bank will IDFC be, aggressive or conservative bank? I would rather use the word prudent. We have been and continue to be optimistically cautious. So, you have to find the right balance. Asset quality and ensuring that the balance sheet is strong is a prime driver for us. Growth and profitability are the outcomes. You are using public money and have to ensure that the principal is safe. What return you give is secondary. x digital.outlookmoney.com June 2014 OUTLOOK MONEY 55

5 warm up get going Hold course Plan Ahead finish first wind down Up Next Stock Pick: Ravet pg 58 THE BANKING MAKEOVER How IDFC will diversify to transform itself into a bank PRODUCT From just term lending to providing full range of banking services CLIENT Large corporates to all institutional and retail segments years, we should be per cent in the CASA. Experts following the growth trajectory of players who last got banking licences argue that this is easier said than done. Says Vijay Agrawal, joint general manager, CARE Ratings: Last banking license which YES bank got, after a decade of experience, its CASA percentage is around 20 per cent. This means to build a 20 per cent CASA it had taken 10 years. With lower capital adequacy requirements IDFC will be able to raise its net interest margins (NIMs), Kumar Saurabh Singh, associate partner, Khaitan & Co. says: Access to public deposits will enable IDFC to lend at profitable margins keeping financing costs down, which would eventually push its bottom-line higher. In addition to this, there would be the advantage of IDFC being well capitalised. This will mean that IDFC will not need to raise capital for the first 5-7 years of its transition. SECTORAL Being infra-focussed to exposure in all sectors FUNDING SOURCE Concentrated sources to widespread CASA The Challenges Rome wasn t built in a day and IDFC s turning into a bank will take many years. The first 18 months from April 2014 would be marked by corporate restructuring efforts which includes reducing the exposure of foreign institutional investors (FIIs) to under 50 per cent from the current per cent. IDFC will then embark on a its nine-year plan to make its transition into bank with the focus in the first three years being on putting systems, people, processes and branches in place. This would be followed by scaling up of operations in 2-3 years phases. Internally, IDFC sees its transition to becoming a bank being akin to taking part in marathon. Despite this outlook, there will be no looking away from its many challenges. One of them has to be getting the right quality and amount of manpower. The good news for IDFC investors is that it is aiming to be more of a conservative bank focusing on manageable growth and is thus, unlikely to face the manpower mess some other banks have faced in their quest for growth. The next challenge would be scaling up via branch expansion. While opening branches in unbanked areas will mean substantial outgo impacting its financials, it will face stiff competition in areas where public and private sector banks already operate. Says Jain: One area where we don t have much experience is in brick-and-mortar branch banking. And, in managing that there is not just upfront cost involved but also operating cost on an ongoing basis. Of course, IDFC could work around this challenge by smartly using technology to provide banking services and containing costs. Besides, it could innovate cleverly in its offerings to better meet existing consumer needs and unmet consumer needs. IDFC will face the same competitive intensity in new areas of banking it enters especially in retail banking. It will also have to reckon with restrictions in terms of priority sector lending. Pankaj Agarwal, assistant vice president, institutional equities, Ambit Capital opines: ROEs would take a beating due to requirement on SLR, CRR and priority sector requirements and would come down to about per cent (from the current 12.2 per cent). End note. IDFC s share prices saw sharp appreciation following the grant of banking licence, and then a sudden drop immediately as investors sought to capitalise and exit. But, the true impact on financials will unfold over the next three years. During this period, investors are unlikely to receive any rewards, with indicators such as ROE likely to go down. Clearly, IDFC s banking story is a long term one and only those who are looking ahead should be buying into it. himali@outlookindia.com 56 OUTLOOK MONEY June