Financials: Banking license – a reality for IDFC and BANDHAN

Financials | Thematic

Financials

Banking license – a reality for IDFC and BANDHAN

Please refer to our detailed

report dated 3rd March-14

On tap licensing - opportunity to keep others interested

Event: New set of banking licenses after a decade



Only third time in a history and post a decade, Reserve Bank of India (RBI)

granted “in-principle” approval to two (IDFC Limited and Bandhan Financial

Services Pvt. Ltd) of the twenty five applicants.

The “in-principle” approval granted is valid for eighteen months, within which

the applicants need to comply with the requirements/conditions as stipulated

by RBI to get the license for commencement of a bank.

RBI has also accepted the recommendation of High Level Advisory Committee

(HLAC) to consider the application of Department of Post separately in

consultation with the Government of India.

First View: In-principle approval lesser than expected



Issue of only two in-principle approvals (banking licenses expected) after a long

deliberation is disappointing and lesser than expectation of at least 4-5 grants.

Further, the statement of “learning from this licensing exercise to revise the

Guidelines appropriately and move to give licenses more regularly, that is,

virtually on tap”

could result into long wait for the other applicants/aspirants to

get hold of the universal banking license.

Meanwhile, differentiated banking license, which is likely to be a reality soon,

will be an opportunity for aspirants (like MMFS, SHTF, LTHF, ABNL, BAF).

IDFC: Long term gain; Execution a key; Rating: Under Review



Over a longer period, universal banking platform will provide much needed

stability to growth, earnings and asset quality of the company. Conversion into a

banking entity provides the much needed identity to earn a sustainable, high

RoE to IDFC’s business model. Getting the liability side right and reducing the

cyclicality on the asset side is the key reason for conversion to a banking model.



However, transition period is likely to be a drag on earnings as management

bandwidth will be focused on growing its banking platform. Next 2-3 years could

mean sole focus on getting the banking model right (and rightly so), in turn also

keeping it away from the growth opportunities that may arise.



To reduce the regulatory impact of CRR, SLR and PSL, balance sheet size is

expected to decline in the near term. Balance sheet de-growth, setting up of

branch network, building of PSL book, procuring of talent for banking business

and lower leverage (focus on de-growing balance sheet) will lead to high single

digit ROE in the near term.



Execution capabilities of the IDFC’s management is well tested in Infra financing

business, however due to lack of clarity on banking business plan we put the

stock

Under Review.

3 April 2014

Financials | Thematic

Bandhan: Largest MFI; Best suited for financial inclusion



Bandhan financial services (BFS), is one of the leading players in microfinance

(MFI) space, a key reason for allotment of the in-principle approval by RBI, in our

view.

BFS operates in 22 states with 2,016 branches – predominant presence in West

Bengal (40% of the branch network). As on Feb-14 outstanding loan portfolio

was INR57b (CAGR of ~47% over FY10-Feb-14), with overall borrower base of

5m+. Major investors are SIDBI and IFC.

Not listed.

LICHF: Overhang to come down; expect stock to re-rate



LICHF was one of the key contenders for banking license and uncertainties

related to journey post banking license was one of overhang on the stock. As the

event is behind us we expect stock to re-rate.



LICHF is expected to report a loan CAGR of 17%+ over FY14-16E with a focus on

profitability (earnings CAGR of ~20% over FY14/16E). Asset quality performance

is expected to remain healthy. The stock trades at P/BV and P/E of 1.4/8.5x and

8.6/7.3x of FY15/16. Maintain buy with a target price of INR300 (1.5x FY16 BV)

On-tap license will keep the space exciting; existing banks are attractive



With only two licenses being issued the chances of SA deposits rate war and

aggressive poaching of employees (one of the fear for private banks) gets

reduced, which is positive from perspective of competition.

Banking license is unlikely to be a once in a decade event with RBI aggressively

focusing on tap banking licensing especially for specialized banking operations.

This will open the window of opportunity for the serious contenders like MMFS,

SHTF, LTHF, ABNL, BAF etc.

Our positive stance on private banks remains as (1) market share gain would

continue and PSU Banks is expected to get marginalized, (2) capitalization and

liability franchise remains as a distinct advantage (3) strong asset quality

performance in midst of most challenging times of the economy and (4) top

management continuity will enable private banks to benefit from up-turn in

economic cycle. Top Picks:

HDFCB, ICICIBC and SBIN.

3 April 2014

Financials | Thematic

IDFC: Long term gain; Near term pain

Balance sheet to decline; Low leverage to drag ROE; Under Review



Universal banking platform to provide stability to operations and reduce the inherent

risk associated with mono-line infra financing business

Strong corporate relationships and existing retail customer base can be leveraged to

build banking business once a regular license is issued

Transition period likely to be a drag on growth, earnings and return ratios; Expect near

term ROEs to come down to high single digits

Execution capabilities of IDFC’s management is well tested in Infra financing business,

however due to lack of clarity on banking business plan we put the stock Under

Review.

Impact on return ratios due to balance sheet de-growth as process of transition begins

INR B

Existing Estimates

FY15

FY16

556

612

5.0

10.0

713

791

6.7

11.0

4.5

10.4

9.7

11.6

32.2

35.8

8.9

11.3

8.1

11.3

3.2

3.3

13.9

14.0

4.3

4.2

Transition impact due to

de-growth

FY15

FY16

477

429

-10.0

613

561

-8.2

-8.5

0.5

2.1

5.1

4.7

30.7

31.9

3.9

3.8

3.2

3.8

3.3

3.8

13.3

12.6

4.0

3.3

% Change

FY15

FY16

-14

-30

-14

-4

-5

-29

-11

-10

-11

To reduce the impact of

regulatory cost IDFC is

expected to reduce the

balance sheet size

Impact on PAT is expected

to be lower due to fall in

balance sheet as leverage

comes down

Loans

Change (%)

Assets

Change (%)

NII

Change (%)

PPP

Change (%)

PBT

Change (%)

PAT

Change (%)

ROA

ROE

Leverage (x)

Source: MOSL, Company



Drag on account of SLR

to be lower as

company already holds

INR70b of G-Sec



Earnings to be lower by

30% and RoEs to be

~10%; not factored

further compression of

RoEs on account of

higher opex



While the above scenario demonstrates the impact of decline in balance sheet

size to reduce the impact of regulatory cost, overall impact is likely to be higher

due to a) higher borrowings required to take care of regulatory cost CRR, SLR

and PSL b) opex related cost due to technology, HR related expenses etc.

While opex related expenses is difficult to ascertain we have demonstrated the

impact of regulatory cost on FY16 balance sheet. Impact of SLR will be relatively

lower as IDFC already hold >INR70b of government securities in the balance

sheet.

Till the time regular banking license is awarded IDFC will have to depend upon

borrowings than deposits to take care of additional funding requirement for

CRR, SLR and PSL. We have assumed 3% negative carry for additional monies

borrowed for SLR and 2% for PSL.

Our back of the envelope calculation suggest that PAT will be lower by 30% than

the base case and ROE will reach to ~10%, factoring in decline in balance sheet

and regulatory cost. Fall in profits do not include the impact of additional opex

to roll out branches

3 April 2014

Financials | Thematic

Additional funding requirement of ~INR200b

BS w/o

additional reg.

req

429

120

561

185

377

BS with

additional

reg.req.

536

429

107

184

134

755

Return ratios to come down to ~10%

Impact of regulatory cost on FY16 numbers

Adjusted PBT post decline in loans

Additional burden due to

CRR

SLR

PSL*

Adjusted PBT post regulatory cost

Tax at 30%

Adjusted PAT

% decline in PAT vs Base case

Adjusted ROE

INR B

31.9

2.3

1.9

2.1

25.5

7.7

17.9

28.8

10.0

Source: MOSL, Company

INR B

Loans

Infra and others

PSL

Investments

G Sec

Equities

Others

CRR

Other Assets

Total Assets

Networth

Borrowings

Old

Add. for regulatory req.

Total liabilities

182

573

377

197

561

755

Source: MOSL, Company

Challenges that IDFC is likely to face



Reducing the FII shareholding to 49% from 52-53% currently

Setting up of the NOFHC and transfer of all financial services business to it

Transfer of lending business to banking unit (will require regulatory approvals)

Identifying the talent for setting up banking entity

Identification of locations for setting up the branches and technology related

challenges

3 April 2014

Financials | Thematic

IDFC: Financials

3 April 2014

Financials | Thematic

BFS:Largest MFI; Best suited for financial inclusion

Pan India presence with dominance in Central and Eastern region

Bandhan Financial Services Pvt. Ltd is a non-banking financial institution engaged in

business of microfinance. The company commenced operations in July 2002 and has more

than a decade of experience in lending to the poor – one of the reasons for which RBI

would have issued banking license (objective of financial inclusion).

Business Model, in line with larger Financial Inclusion objective



The company follows a model of individual lending through group formation.

Primary focus of the company is towards micro small and medium enterprises,

micro health, micro education and other micro loans with small ticket sizes

ranging from INR1,000 to INR50,000 at 20-22%. Also, most of these loans are of

shorter tenure 18-24 months.

BFS has presence in twenty two states/union territories with overall branch

presence of 2,016. It has dominance in the state of west Bengal with 802

branches (40% of the branch network). The company has 10m+ client

relationship with 5m being the borrowers.

The company has an outstanding loan portfolio of INR57b (CAGR of ~47% over

FY10/FY14).

Top Management

Mr. Chandra Shekhar Ghosh – Chairman & Managing Director,

has rich experience

of 29 years in the micro finance and development industry. He is a member of many

of the committees and institutions in the micro finance industry including state level

committee on Credit delivery innovation constituted by NABARD. He holds an M.Sc.

in statistics and has attended the HBS-ACCION program on strategic leadership for

Microfinance at Harvard Business School.

Mr. Yogesh Chand Nanda - Director,

has served as the managing director and then

the chairman of NABARD. After his superannuation the Government of India

appointed him as a full time member of the National Commission of Farmers. He

was also appointed as Chairman of ‘Working Group for the formulation of the 11

plan for agriculture credit and the corporative’ by the planning commission.

Major Investors:

(1) SIDBI and IFC

3 April 2014

Financials | Thematic

Appendix: Key highlights from the final guidelines related to

banking license

Regulatory requirement to be compiled with

Corporate structure for setting up of NOFHC



Capital structure of the wholly-owned NOFHC set up in private sector: 1) Any

individual belonging to promoter group and entities in which promoter group

hold not less than 50% of the voting equity cannot hold more than 10% of voting

equity shares of the NOFHC and 2) Companies forming part of the Promoter

Group whereof companies in which the public hold not less than 51% of the

voting equity shares shall hold not less than 51% of the total voting equity

shares of the NOFHC.

NOFHC shall hold the bank as well as all the other financial services entities of

the Group regulated by RBI or other financial sector regulators. The objective is

that the Holding Company should ring fence the regulated financial services

entities of the Group, including the bank from other activities of the Group and

other regulated financial activities of the group.

Financial services entities whose shares held by NOFHC cannot be a shareholder

of NOFHC.

No financial services entity held by the NOFHC would be allowed to engage in

any activity that a bank is permitted to undertake departmentally. However

certain specialized activities, such as, insurance, mutual funds, stock broking,

infrastructure debt funds, etc. to be conducted through a separate Subsidiary /

Joint Venture / Associate structure.

NOFHC shall not be permitted to set up any new financial services entity for at

least three years from the date of commencement of business of the NOFHC.

However, this will not preclude bank from having a subsidiary or JV or associate.

Shares of the NOFHC shall not be transferred to any entity outside the Promoter

Group. Any change in shareholding (by promoter group), wherein shareholder

acquires more than 5% in NOFHC will require prior approval of RBI.

Prudential norms for NOFHC



On a standalone basis, NOFHC may have leverage up to 1.25x of net worth.

Actual leverage should be assumed based on ability of NOFHC to service

borrowings from dividend income.

On a consolidated basis, CAR should be maintained as per Basel II/Basel III

guidelines as appropriate.

Exposure norms: No credit or investment exposure to promoter group entity or

outside group entities expect those held under it

Exposure norms for the financial entities (ex-bank) held by the NOFHC



The financial entities held by NOFHC shall not have: A) Any credit and

investments exposure to the Promoter Group entities or individuals associated

with the Promoter Group or the NOFHC. B) Shall not make investment in the

equity / debt capital instruments amongst themselves. C) Cannot invest in

equity instruments of other NOFHCs

3 April 2014

Financials | Thematic

Corporate governance of the NOFHC



NOFHC shall not have a Director on the board a person who is a Director in any

other NOFHC or a bank other than a banking company under it.

At least 50% of the Directors of NOFHC shall be totally independent of the

Promoter or Promoter Group entities and their major customers and major

suppliers (10% annual sales and purchase taken together).

Ownership and management shall be separate and distinct in the NOFHC, the

bank and entities regulated by RBI.

Norms for the new banks

Requirement of the new bank



The bank should fully comply with the reserve requirement (SLR + CRR) from the

date of commencement of operations.

The bank shall comply with the priority sector lending targets and sub-targets as

applicable to the existing domestic banks. For this purpose, the bank should

build its priority sector lending portfolio from the commencement of its

operations.

The bank shall open at least 25% of its branches in unbanked rural centers

(population up to 9,999 as per the latest census) to avoid over concentration of

their branches in metropolitan areas and cities which are already having

adequate banking presence.

The Board of the bank should have a majority of independent Directors

Bank shall maintain arm’s length relationship with Promoter / Promoter Group

entities, and the major suppliers and major customers of these entities.

Capital requirement and equity holding for bank



Minimum capital requirement:

Initial minimum paid-up voting equity capital for

a bank shall be INR5b. The NOFHC shall hold a minimum of 40% of the equity

capital of the bank which shall be locked in for a period of five years from the

date of commencement of business of the bank.

NOFHC holding excess of 40% in the bank shall be brought down to 40% within

three years from the date of commencement of business of the bank. The

shareholding by NOFHC shall be brought down to 20% within a period of 10

years, and to 15% within 12 years from the date of commencement of business

of the bank.

No single entity or group of related entities, other than the NOFHC, shall have

shareholding or control, directly or indirectly, in excess of 10% of the paid-up

voting equity capital of the bank.

The Promoter Group entities / individuals associated with Promoter Group shall

hold equity investment, in the bank and other financial entities held by it, only

through the NOFHC.

Bank as well as NOFHC will be required to maintain a minimum capital adequacy

ratio of 13% of its risk weighted assets (RWA) for a minimum period of 3 years

on a standalone and a consolidated basis.

Banks promoted by Groups having 40% or more assets / income from non-

financial business will require RBI’s prior approval for raising paid-up voting

equity capital beyond INR10b for every block of INR5b.

3 April 2014

Financials | Thematic

Foreign shareholding in the bank



Foreign shareholding (Including FDI, NRI and FII) in new private sector banks

shall not exceed 49% for the first 5 years from the date of licensing of the bank.

No nonresident shareholder, directly or indirectly, individually or in groups, or

through subsidiary, associate or JV will be permitted to hold more than 5% paid

up equity capital of the bank for the period of 5 years from the commencement

of business of the bank.

After 5 years aggregate foreign shareholding would be as per the extant FDI

policy.

Additional conditions for NBFCs promoting / converting into a bank

The NBFCs eligible to for a license will have three options



Activities undertaken by the NBFC are not permitted to be undertaken by banks,

In such cases, the activities undertaken by the NBFC which banks are allowed to

undertake, will have to be transferred to the new bank

If all the activities undertaken by it are allowed to be undertaken by a bank then

convert the NBFC into a bank. However In such a case, the NBFC shall have a

minimum networth of INR 5b

Convert the NBFC into a bank and divest the activities which banks are not

allowed to undertake departmentally. In such a case, the bank shall have a

minimum networth of INR5b.

Under the above options promoters will have to set up NOFHC. RBI will consider

allowing the bank to take over and convert existing NBFC branches into bank

branches only in Tier 2 to 6 centers

Existing branches in Tier 1 centers can only be converted with prior permission

of RBI and subjected to condition of opening 25% of these branches in

unbanked centers.

3 April 2014

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