loans, dividends and dilutions at banks

Here's an interesting read regarding Indian banks. Indian public sector banks have been troubled by both bad management and government restrictions. Whereas, private sector banks are troubled by only bad management. Well, that can be a harsh statement. Let's read that to mean that when these banks are in trouble, we know whom to blame. 

Banking is not an easy business. A well run bank is one which lends prudently ensuring return of capital and adequate interest margin. If this is done on a consistent basis, banking can be a good investment. Unfortunately, we wouldn't know which bank is run prudently, until the tides go away. 

For banks, leverage is the way of doing business where debt-equity ratio is far too high. It seems natural because equity capital is not adequate to carryout lending operations. They have to borrow from depositors and bond-buyers in order for them to increase their asset size. As the asset size goes up, their operating income goes up. When net interest margins are good, return on assets increases, and because of outsized debt-equity, return on equity and earnings per share increase much higher. Therefore, managers aim to increase their loan book as much as possible. That is growth for them.

The story is good. But the problem is, not all banks are well run. If lending is not done prudently, the result is bad loans. However much they try to hide by either not disclosing or not disclosing fully, there will be the day of reckoning. The real bad news is when loans have to be written off. The effect is very harsh on equity; loan write offs can erode equity; in fact, because of low equity base, even a small portion of assets turning bad is enough to wipeout equity.

The second problem with banks, public sector banks in particular, is that they are considered as good dividend payers. We can argue that when equity is low, and bad loans are high, it may not be a good idea for banks to payout dividends. It is a simple idea: If there aren't any free cash flows, there are no dividends. Obviously, managers are aware of the fact that capital markets consider dividends as some sort of signals. When dividends are skipped or reduced, there is reaction to the stock price. Therefore, they continue with the mistake of paying out, or even increasing dividends.

The third problem which of course is a consequence of the first two is raising of equity capital through preferential buyers, or in case of public sector banks, through government capital infusion. Here's the irony: Chasing growth, managers raise more debt; bad loans reduce equity which is already low; and dividends are paid out when there are no free cash flows which bring equity even lower. The result is a very low equity capital base, and the need for capital infusion. The dilution in earnings per share is apparent. This is the-never-ending vicious cycle for banks.

The lessons: Managers should learn that higher coupons cannot make up for a bad loan. It is also obvious that the borrower should have demonstrated capacity to generate both adequate and consistent cash flows to cover both interest coupons and loan capital. For those that lack cash flows, equity financing is the only route. That is why, firms that are in start-up stage or even high-growth stage deserve only low-to-moderate debt-equity ratio. As firms become mature, their cash flows increase and become more predictable; and then they can take on higher debt.

The sooner managers and governments realize this, the better it is for the economy and the investors: If banks operate with a little prudence, and with an internally regulated maximum debt-equity ratio, there is no need to be worried about regulatory capital requirements of the Basel Committee. For banks, growth has to come with a cost; and that is higher reinvestment of cash back into equity in order to sustain the set debt-equity ratio. If there is no free cash, pass dividends.

Managers have never learnt lessons from the past, and the chances are they never will. All we can do as investors is be careful when investing in banks.

There is some consolation, though, in case of Indian banks; they have not indulged in destructive derivative instruments so far.