59 Banking License IDFC

8/11/2019 59 Banking License IDFC

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Please refer to important disclosur es at the end of this report

Equity ResearchMarch 20, 2014

BSE Sensex: 21833

Financials

IDFC (Rs114- BUY) Target price Rs138

LIC Housing Finance (Rs230 - BUY) Target price Rs310

Muthoot Finance (Rs158 - BUY) Target price Rs175

Shriram City UnionFinance (Rs1,000 - REDUCE) Target price Rs1,000

Non- bank financials

At rainbow’s endReason for report: Sector thematic

Santanu [email protected] 91 22 6637 7351

Ujjwal [email protected] 91 22 6637 7314

Conventional wisdom always held two possible fates for any NBFC - a glassceiling to growth aspirations or conversion into a bank. ‘The License’ remains, formany observers, the Holy Grail that every NBFC aspires for, in its quest for astable source of large scale funding and access to the regulatory mainstream withaccompanying safeguards. The current guidelines for new banking licenses arefairly demanding in terms of i) branch presence requirements ii) little to noforbearance on priority sector and SLR/CRR requirements and iii) dilution andownership structuring stipulations. With CASA being the centre-stage of existingcompetition in the banking sector and usual urban credit categories fairlycrowded, we feel that the license in its current avatar is not necessarily anunequivocal posit ive for all aspirants. Our analysis o f coverage NBFC applicantspoints out IDFC as a possible beneficiary, defined as likely accretion to steadystate RoE (and possible reduction in CoE), based on assumptions that allow for

strategic implementation uncertainties. LIC Housing Finance, Muthoot Financeand the Shriram group, on the other hand, might f ind that the burden of a bankingmodel in the currently prescribed form, outweighs its benefits. LIC HousingFinance however offers the best indicative IRR to existing shareholder amongstthe applicants analysed, due to a large valuation gap from steady stateexpectations. The conclusions f rom our exercise seem to v indicate, in retrospect,M&M Financial’s decision to not apply and Shriram Groups’s reluctance inmerging Shriram Transport Finance into a bank, even if given a license. Licensebenefits are highly context specific. CASA is no low hanging fruit. The primary motivation factor for any banking

license aspirant is access to CASA funds – traditionally both low cost and sticky. But,as is the case for any goal shared by all industry players – gaining CASA has provedboth difficult and expensive. While garnering more SA clearly remains a strategic

imperative, in our opinion i) sticky SA has proved hard to get without a large retailbase that trusts the brand and relates to it ii) rate advantage has reduced withsavings rate deregulation and iii) operating cost & infrastructure investment sacrificeis not insignificant and does not seem very strongly correlated. With capital marketactivity tepid and business cash flow volumes muted (both revenue slow down aswell as a stretched cash cycle), CA for the banking sector as a whole has fallen from9.9% to 9.2% of NDTL in the last 12 months.

Branch costs and no forbearance on PSL is a big dampener. RBI has stipulatedthat the new banks must have 25% of their branches located in areas with less than10,000 population count in Census 2001. In the Indian context, 10,000 is a verysmall number effectively implying compulsory presence in fairly under-populatedpockets. These branches at least for few years are likely to be a drag on profitability

with little contribution to business on either asset or liability side. Furtherimpediments come from being given just 18 months to comply with SLR and CRRrequirements (in calculating NDTL, we include NCD issued by the companies aswell). Meeting priority sector lending targets will be a challenge for most newentrants as well, although the level of preparedness varies across applicants. In our calculation of RoE scenarios for the various applicants we have conservativelyassumed that any priority sector shortfall is deployed into the RIDF window at 5.5-6%. Amongst the applicants under discussion, Shriram City Union Finance and LICHousing Finance have the strongest priority sector origination capabilities. Weexpect ultimate priority sector regulations will have to adjust to realities of originationcapability and relaxation is almost inevitable.

INDIA



Non-bank financials sector, Mach 20, 2014 ICICI Securities

2

Dilution requirements significantly reduce attractiveness, holding structurecreates complications. The RBI has laid down extremely stringent sequentialdilution criteria for the NOFHC’s (Non Operating Financial Holding Company’s) bankstake with a clear timeline. RoE is likely to remain muted in the initial 3 year period ofbank operation under the current guidelines. The NOFHC will be forced to dilute 60%stake in the bank during this time of weak earnings momentum. The IRR to a currentshareholder depends heavily on valuation multiple on the 3 year exit and our scenario

analysis reveals that the mandatory dilution wipes out significant proportion of the no-dilution IRR. The specified ownership structure complicates this issue by creating thepossibility of a holding company discount from multiple layers of dividend taxation(only one level is pass-through). Some innovative structuring may address this issueto an extent and few possible options (with due caveats and attendant negatives) arei) allocating shares in the NOFHC proportionally to apex NBFC shareholders (subjectto promoters owning at least 51%) ii) reverse merging the apex NBFC entity into theNOFHC and iii) looking at non-dividend alternatives for rewarding apex NBFCshareholders.

Big ticket financial inclusion from incumbents appears like a bet againsthistory. Retail credit in India is a tale of two opposites – a reasonably penetratedurban core and a severely under-penetrated rural periphery. While financial inclusion

in rural locations remains a priority sector focus, apart from niche presence of someNBFCs, penetration of organized credit remains low till date. We feel given the highentry barriers of the rural markets and challenges of rolling out credit to under-penetrated niche customer segments, the new banking license recipients will focus onurban markets (unless they have an existing strength in a niche). To this end theproducts likely to be targeted are expected to be a subset of the following group –mortgages, CV, auto & 2-wheeler loans, education loans, gold loans and unsecuredproducts like credit cards and personal loans. In short, except for licensees alreadyengaged in lending to the bottom of the pyramid, the grand aim of financial inclusion isunlikely to be incrementally served by new licenses in the near future.

Initial pain for all, belated gains for some. Our scenario analysis indicates a cleardrop in RoE for all converts in the first two years, with varied trajectories ofimprovement post this ‘teething’ period. The IRR that a current shareholder of these

NBFCs can expect is obviously a function of current and expected steady statevaluations post conversion, along with timing and attractiveness of dilutions. Our list ofbeneficiaries is defined by value add to the business model (RoE change vs reductionin CoE), rather than IRR possible (based on current valuations) for shareholders ofthese NBFCs (although we present this analysis in a later section).

Quick summary table

Bloomberg

code

Rating Market

cap

(US$bn)

Current

steady

state

RoE (%)

Scenario analysis based – indic ativeLowest

RoE postbank

conversion(%)

5th

year RoEpost bank

conversion(%)

CurrentP/B

(1-yrfwd)

Steadystate P/B

postbank

(1-yr fwd)

IRRbasecase

(%)

IRRbull

case(%)

IRRbearcase

(%)

IDFC IDFC IN BUY 2.9 15.3 9.3 18.2 1.5 1.0 7.0 10.4 3.1LIC Housing Finance LICHF IN BUY 1.9 19.6 11.6 17.3 2.0 1.3 11.8 15.8 7.3

Muthoot Finance MUTH IN BUY 1.0 19.4 9.0 13.2 1.4 1.2 2.3 5.5 (1.4)Shriram City Union SCUF IN REDUCE 1.0 19.9 11.9 16.8 1.8 1.8 6.0 9.6 1.9Source: Bloomberg, I-Sec research




3

TABLE OF CONTENT

CASA is no low hanging fru it ..................................................................................... 4

SA – challenges on both stickiness and cost ........................................... ................... 4

CA – increasingly competitive with falling volumes ..................................................... 5

Looking at history – garnering CASA is a difficult task ........................................... ..... 6

Branch costs and no forbearance on PSL i s a big dampener .................................. 7

Branches that will likely bear little fruit ........................................................................ 7

Almost no forbearance on SLR and CRR ....................... ......................... ................... 7

Priority sector – a riddle, wrapped in a mystery, inside an enigma............................... 8

No promised forbearance, but looks difficult to avoid .................................................. 9

Dilution requirements reduce attractiveness, holding st ructure creates

complications ........................................................................................................... 10

Big ticket financial inclusion from incumbents appears like a bet against history 15

Retail assets – a tale of two Indias – one difficult to reach, the other highly competitive

................................................................................................................................ 15

Successful credit roll-out beyond the me-too segments has needed focus and a steep

learning curve .......................................................................................................... 16

Credit policy of new entrants unlikely to focus on inclusion, save existing strengths .. 16

Initial pain for all, belated gains for some ............................................................... 17

IDFC (IDFC IN, Mcap – US$2.9bn, BUY, TP- Rs138) ....................... ........................ 18

LIC Housing Finance (LICHF IN, Mcap – US$1.9bn, BUY) ........................ ............... 23

Muthoot Finance (MUTH IN, Mcap – US$1bn, BUY)..................................... ............ 29

Shriram City Union Finance (SCUF IN, Mcap – US$1.0bn, REDUCE, TP- Rs1,000) . 34

Annexure 1: Retail segments cr it ical to l ikely di vers if ication plans of appli cants 39

Mortgages a difficult game for low CASA banks ...................... ......................... ........ 39

Autos & 2-Wheelers attractive, but cannot swing the needle ...................... ............... 42

Unsecured lending business in its infancy in India, awaiting large scale proof of concept

................................................................................................................................ 44

Education loans – a policy focus .............................................................................. 45

Gold loans – not a natural product for banks given ticket size and operational

requirements ............................................................................................................ 45

Annexure 2: Index of Tables and Charts ....................... ......................... ................. 47

Prices as on March 19, 2014




4

CASA is no low hanging fruit

The primary motivation factor for any banking license aspirant is access to CASA

funds – traditionally both low cost and sticky. But, as is the case for any goal sharedby all industry players – gaining CASA has proved both difficult and expensive. The

Finance Ministry directive asking PSU Banks to not let bulk deposits cross 15% of

NDTL has ensured that even they will remain in constant pursuit of retail deposits.

SA – challenges on both stickiness and cost

Savings rate deregulation in India since October 2011 wherein RBI allowed banks the

freedom to fix their own interest rates on savings deposits, has ensured that players

like Kotak Mahindra Bank (Unrated) and Yes Bank (BUY, TP - Rs472) has offered 6-7% on savings deposits (backed by aggressive ad spends) in order to gain deposit

market share. While this has helped them garner some share, the problems they faceare:

•

The SA cost advantage is not what it used to be with deposit rates regulatedearlier at 4%.

Chart 1: The discount between SA cost and bulk rates has narrowed

0.0

2.0

4.0

6.0

8.0

10.0

12.0

M a r - 1 0

J u n - 1 0

S e p - 1 0

D e c - 1 0

M a r - 1 1

J u n - 1 1

S e p - 1 1

D e c - 1 1

M a r - 1 2

J u n - 1 2

S e p - 1 2

D e c - 1 2

M a r - 1 3

J u n - 1 3

S e p - 1 3

D e c - 1 3

Yes Bank Kotak Mahindra (Unrated)

IndusInd Bulk deposit rate (3 month CD)

Source: I-Sec research

• Most of the money that has quickly shifted in is rate sensitive money from HNI’s

and corporate float and the basic assumption of a sticky source of funding isgetting questioned.

• The hunt for SA involves investments into branch and ATM expansion to address

convenience for the depositor (with most branches being essentially retail liabilitycollection centres, this rings especially true).

We are not trying to say that garnering more SA should not be a strategic focus of

players, we are just saying that i) sticky SA has proved difficult to garner without a

large retail base that trusts the brand and relates to it ii)rate advantage has reducedand iii)operating cost & investment sacrifice is not insignificant. SA is clearly no low

hanging fruit and for only savings on SA to justify a branch’s existence, the quantumrequired is about Rs300mn.

SA deregulation has

sparked rate

competition fromnew private players

Stickiness of SA

money has been anissue




5

CA – increasingly competitive with falling volumes

Current account money is driven to a large extent by i) degree of excess liquidity oncorporate balance sheets and volume of transaction activity ii) settlement related

funds of capital market transactions. With capital market activity muted and business

cash flow volumes muted (both revenue slow down as well as a stretched cash cycle

for businesses), CA for the banking sector as a whole has fallen from 9.9% to 9.2% ofNDTL in the last 12 months.

Chart 2: CA as proport ion of NDTL is 2/3rd of Mar – 08 levels

0.0

5.0

10.0

15.0

20.0

25.0

30.0

M a r - 0 8

M a r - 0 9

M a r - 1 0

M a r - 1 1

M a r - 1 2

M a r - 1 3

D e c - 1 3

( % )

System ICICI Bank HDFC Bank Axis Bank

Kotak Mahindra IndusInd Yes Bank

Source: RBI; Company data, I-Sec research

Chart 3: Amongst the large banks, CA growth has been strong fo r only Axis

9.4 10.1

24.2

15.3

31.834.2

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

ICICI Bank HDFC Bank Axis Bank KotakMahindra

IndusInd Yes Bank

( % )

Current accounts - CAGR (FY08-9MFY14)


Apart from IndusInd and Yes Bank, CA growth has rarely outpaced asset growth.

CA dependence hasreduced for the

system




6

Looking at history – garnering CASA is a difficult task

Looking at history, we see that FY08 to Q3FY14, amongst the large players only ICICIBank has been able to increase CASA proportion of NDTL, despite having 20%+

branch expansion CAGR (bar SBI) on a reasonable base. Amongst the new

generation private sector banks, IndusInd and Yes Bank have done well, albeit

arguably through price competition on savings rates.

Chart 4: CASA expansion is not a corollary of branch growth

1 ,7 2 0

( 1 , 3 0 7 )

( 3

1 1 )

1 3 1

1 , 6 4 7 1

,2 4 3

( 6 0 4 )

0

5

10

15

20

25

30

35

40

45

(1,500)

(1,000)

(500)

0

500

1,000

1,500

2,000

ICICI Bank HDFCBank

Axis Bank KotakMahindra

IndusInd Yes Bank SBI

C A G

R - F Y 0 8 - 9 M F Y 1 4

( % )

Shift in CASA proportion (bps) CAGR - Branch network (RHS)

Source: Company data, I-Sec research

CASA success not

necessarilycorrelated with

investment into

distribution reach




7

Branch costs and no forbearance on PSL is a bigdampener

Branches that will likely bear little fruit

Financial inclusion was the underlying motivation for calling in new banking licensesby the RBI. To this end, the RBI has stipulated that the new banks must have 25% of

their branches located in areas with less than 10,000 population count in Census2001. In the Indian context, 10,000 is a very small number effectively implying

compulsory presence in fairly under-populated pockets. Needless to say, we remainvery skeptical about the AUM generation capability of such branches and feel thatretail liability inflow is likely to be slow as well. In short, these branches at least for few

years are likely to be a drag on profitability with little contribution to business on either

asset or liability side. This particular regulation was cited by M&M Financials as one ofthe primary reasons for it to drop out of the banking license race.

Amongst the companies we analyse in this report, IDFC is perhaps best positioned

with respect to vulnerability to this regulation, merely by dint of it having 4 branchescurrently and a low need for incremental branches given its likely focus on wholesale

banking.

Table 1: Branch reach preparedness and impact

Proportion ofbranches(%)

Currentop cost/

AUM

Increase in opcost/ AUM on

conversionCurrent

RoAPost bank

RoA(Less than 10k

population) (%) (bps)(post-tax

%)(yr 1

post-tax %)IDFC None 1.0 3 3.0 0.9LIC Housing Finance None 0.4 10 1.8 0.8Muthoot Finance ~10% estimated 4.5 100 3.3 1.2Shriram City Union Finance ~15% 4.3 120 2.8 1.3

Source: Companies, I-Sec research

Almost no forbearance on SLR and CRR

The new banks will be given 18 months to comply to SLR and CRR requirements

which are

• SLR (Statutory Liquidity Ratio) to be maintained at 23% of NDTL (Net Demand &

Time Liabilities)

• CRR (Cash Reserve Ratio) to be maintained at 4% of NDTL (Net Demand & Time

Liabilities)

The SLR portfolio primarily comprises of GOI securities while CRR is kept as zerointerest balance with the RBI. Both of these are essentially negative carry portions of

the asset portfolio of most banks.

In our calculation for the drag that these factors cause on the new bank’s return ratioswe have assumed that even the NCDs that these balance sheets carry will require

SLR and CRR provisions against them. Any forbearance on this will enhance the

banks’ return potential.

Branches inlocations with less

than 10,000population willstruggle to contribute

Only 18 months to

comply with SLR and

CRR




8

Priority sector – a riddle, wrapped in a mystery, inside anenigma

RBI has identified certain under-penetrated sections of the economy where creditpenetration is considered a policy priority. These are agriculture, micro & smallenterprises, export credit and advances to the weaker sections of the society.

Table 2: Priorit y sector classifications

Domestic commercial banks/Foreignbanks with mor e than 20 branches

Foreign b anks (with less t han 20branches)

Total Priority Sector 40% of Adjusted Net Bank Credit (ANBC) 32% of ANBC

Total agriculture 18% of ANBCNo specific target. Forms part of totalpriority sector target.

Micro & SmallEnterprises (MSE)

No specific target. Forms part of totalpriority sector target.

a) Advances to MSE sector will be reckonedin computing performance under the overallpriority sector target of 40% of ANBC; b)40% of total MSE advances should go tounits having investment in plant andmachinery up to Rs1.0mn and micro

(service) enterprises having investment inequipment up to Rs0.4mn; c) 20% of totalMSE advances should go to units withinvestment in plant & machinery betweenRs1.0mn and Rs2.5mn, and and micro(service) enterprises with investment inequipment above Rs0.4mn and up toRs1.0mn


Export credit

Export credit is not a separate category.Export credit to eligible activities underagriculture and MSE will be reckoned forpriority sector lending under respectivecategories.


Advances to weakersections

10% of ANBCNo specific target in the total prioritysector target.

Source: RBI

Alternatively, they could buy priority sector requirement compliant loans and considerthem as fulfilling part of the quota or buy bonds of certain nodal agencies like

NABARD and SIDBI in the RIDF window.

As the Nachiket Mor Committee report in financial inclusion points out, the asset

quality track record of scheduled commercial banks in priority sector lending has been

less than inspiring with NBFCs having done a far superior job. As the following tabledemonstrates, priority sector delinquencies have been higher for banks than other

loan assets.

Table 3: GNPAs of banks : PSL vs. Non-PSL

Priority sector

Non-priority sector0verall Agricultur e MSEFY10 3.2 2.2 3.7 1.6FY11 3.6 3.3 3.4 1.4FY12 4.3 4.3 3.9 1.9

Source: RBI

We feel that priority sector lending will be a challenge for most new entrants as well,although the level of preparedness varies across applicants. In our calculation of RoE

scenarios for the various applicants we have conservatively assumed that any priority

sector shortfall is deployed into the RIDF window at 5.5-6%.

PSL portfolio has

yielded more GNPA

for banks




9

Table 4: Our assumptions on pr iority sector assets post bank-conversion (29.2% assumed to ful lcompliance)

Balance sheet % of prior ity sector assetsSources (current & likely) Current Year 1 Year 2 Year 3 Year 4 Year 5

IDFC Export credit 0.0 3.0 4.0 5.0 6.0 7.0LIC Housing Finance Housing loans 35.0 25.0 25.0 25.0 25.0 25.0Muthoot Finance Gold loans (with agri certificate) 0.0 2.0 4.0 6.0 8.0 10.0Shriram City Union Finance SME, CV loans 50%+ 29.2 29.2 29.2 29.2 29.2

* Balance (from 29.2% of BS i.e. ~40% of ANBC) assumed to be deployed into RIDF each yearSource: Company, I-Sec research

No promised forbearance, but looks difficult to avoid

We expect that although the current guidelines offer scant forbearance to new

entrants in their teething period, ultimate regulations will have to adjust to realities.Forbearance will be especially difficult to avoid in priority sector assets. The reality isthat all banks in India struggle to meet these quotas and are only partially compliant.

Chart 5: Priority sector asset proportion of ANBC

37.2

39.4

40.9

36.3

37.5

35.2

32

33

34

35

36

37

38

39

40

41

42

Public sector Private sector Foreign banks

( % )

FY12 FY13

Source: RBI; I-Sec research

The level of forbearance allowed to each domestic scheduled commercial bank in theyear FY13 is as follows (for those disclosed).

Table 5: Priority sector related exposures

Priority sector loans as % of ANBC RIDF investments as % of ANBCPNB 33.2 UndisclosedBOB 39.3 UndisclosedBOI 37.8 UndisclosedCanara 35.3 UndisclosedSBI 30.1 1.5

Union 35.6 Undisclosed Axis Bank 33.6 4.8ICICI Bank 35.0 10.5HDFC Bank 32.4 Undisclosed


As we stated earlier, we have assumed that all shortfall is directed to the RIDF

window in our RoE scenarios for the banking applicants. To gauge how unrealistically

conservative this is check out the following argument. The total RIDF windowabsorption in FY13 was Rs200bn which is 34% of the current loan book of oneapplicant, IDFC. RBI might have its hand forced regarding forbearance.

Forbearance seemsa foregoneconclusion




10

Dilution requirements reduce attractiveness,holding structure creates complications

The RBI has laid down extremely stringent sequential dilution criteria for the NOFHC’sbank stake (and thereby through it the promoter entity’s stake) with a clear timeline. It

mandates that the NOFHC must dilute down to 40% shareholding in the bank within

the first 3 years (a level they must maintain for the first five years). The shareholdingneeds to come down to 20% in 10 years and 15% in 12 years.

Of this we feel the toughest to achieve will be paring down the NOFHC’s stake in the

bank to 40% in the first 3 years. Once this is achieved, we feel subsequent dilutionstipulations will be easier to meet. The problem is further complicated by the NOFHCstructure itself. In most cases for the listed NBFCs we discuss, the current listed entity

is likely to own the NOFHC, and the business is likely to be transferred two steps

down into the bank.

Now, as we see in the first section, RoE is likely to remain muted in the initial 3 year

period of bank operation under the current guidelines. The NOFHC will be forced todilute 60% stake in the bank during this time of weak earnings momentum. As capitalraise is more likely than a stake sale, new capital will further dilute RoE and potentially

further impact valuations for the next rounds (unless capital is raised at one go).

In the following exercise, we assume each of the new banks to be diluting at the endof the third year at three different multiple scenarios

i) in line with the steady state valuations (P/B as outlined as reasonable by us in

section 1)

ii) at 25% premium to steady state valuations (assuming new shareholders feel that

the capital they bring in can be deployed into the business quickly) and

iii) 25% discount to steady state valuations (assuming new shareholders aredismayed by initially low RoE). In all the three cases assuming a terminal value for

the residual bank holding at the end of 12 years (at steady state P/B multiple), wework out the IRR for the NOFHC (assuming necessary dilutions at the end of 10thand 12th year at exactly the steady state valuation multiple).

Table 6: Scenario analysis – IRR to current shareholder

SteadyState P/B*

CurrentP/B

IRR basecase (%)

IRR - premiumdilution (%)

IRR - bearcase (%)

IDFC 1.5 1.0 7.0 10.4 3.1LIC Housing Finance 2.0 1.3 11.8 15.8 7.3Muthoot Finance 1.4 1.2 2.3 5.5 (1.4)

Shriram City Union Finance 1.8 1.8 6.0 9.6 1.9Source: I-Sec research*post bank conversion

As we see, the IRR for the promoter entity depends heavily on the valuation multipleavailable at the first mandatory dilution. Also, the IRR numbers are low as the NOFHC

is diluting heavily. To illustrate this point, look at how the base case IRR with dilution,compares with possible IRR under the same set of assumptions if no dilution was

necessary.

Stringent dilutionnorms

Initial dilution is most

steep, and in aperiod of low RoE




11

Chart 6: Dilution scenarios impact IRR significantly

(4)

(2)

0

2

4

6

8

10

12

14

16

18

IDFC LIC Hous ing Finance Muthoo t Finance Shriram City UnionFinance

( % )

IRR base case IRR - premium dilution IRR - bear case

Source: Bloomberg; I-Sec research

However, we feel that in reality the dilution of stake will be delayed more than whathas been outlined in the guidelines. If we look at current examples of new generation

private sector banks this becomes very clear. As per the RBI’s 2001 guidelines on

entry of new banks in the private sector, promoters were required to maintain aminimum stake of 40% in the bank at any point of time. Any excess stake over 40%

had to be diluted after one year of the bank’s operations. Also, equity participation bya foreign company as a co-promoter or co-promoter was restricted to 20% within theoverall promoter ceiling of 40%. However, over the course of time we have seen RBI

relaxing some of the requirements on dilution of promoter stake. Classic example

being that of Kotak Mahindra Bank (received the banking license in 2003), whereinthe promoter, (Mr.Uday Kotak) has been allowed to bring down his stake to 20% by

2018 from ~43% currently. Also, RBI has advised the bank that decision on furtherdilution of the promoter stake to 10% would be taken after 2 years when the 20%

requirement is reached in 2018.

Also, there is the small matter of requisite amount of capital market/strategic interestto dilute 60% within the first three years. Diluting at the same valuation, this would

mean equity infusion equalling 1.5x market capitalization. Even assuming a modest

US$2bn pre-money market capitalization for 5 odd incumbents, the total equityrequirement is US$15bn. To put this in perspective, the following chart illustrates how

much equity money has flown into primary equity purchase of Indian banking (bothfresh issuance and stake sale) on an annual basis in the last 10 years. Forbearance

on the dilution criteria is unavoidable in our opinion.

Dilution norms are

unlikely to see fullcompliance




12

Chart 7: Equity inflow into banking in last 10 years

1.8

4.6

0.4

6.9

7.5

1.2

2.9

1.31.7

1.5

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

CY05 CY06 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14

( U S $ b n )

Source: Bloomberg; I-Sec research

Rigidly defined ownership structure poses quite a few issues

The final guidelines from the RBI on how bank ownership can be structured leavesvery little elbow room for flexibility in how the ownership structure will look. Thegeneric structure for an NBFC that seeks a license will look as follows.

Chart 8: Generic likely structure

NBFC

(Applicant)

NOFHC

Bank

Businesstransferred to bank

………..

Other financial business(Non-lending)


A common concern within the market is that will this generic structure imply a holding

company discount at the apex entity level due to the presence of the intermittentNOFHC. The reasons cited in favour of a discount are

1. The dividend from bank to end shareholder of erstwhile NBFC (apex entity) is

likely to pass three possible layers of dividend tax. While one layer will becomeexempt, there is a value loss at the third layer.

2. Value realization in itself will be difficult from the NOFHC as there are restrictions

on capitalization levels and dividends of the NOFHC. The extant regulations aresummarized in the following grey box.

Not much leeway onstructuringownership




13

The capital structure of the wholly-owned NOFHC set up by Promoter / PromoterGroups in Private Sector shall consist of

• a) voting equity shares not exceeding 10 per cent of the total voting equity shares

of the NOFHC held by any individual belonging to the Promoter Group, along withhis relatives (as defined in Section 6 of the Companies Act 1956) and along with

entities in which he and / or his relatives hold not less than 50 per cent of the

voting equity shares, and• b) companies forming part of the Promoter Group whereof companies in which the

public hold not less than 51 per cent of the voting equity shares shall hold not lessthan 51 per cent of the total voting equity shares of the NOFHC.

• The 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 isthat the Holding Company should ring fence the regulated financial servicesentities of the Group, including the bank from other activities of the Group.

• Thus, only non-financial services companies / entities and non-operative financialholding company in the Group and individuals belonging to Promoter Group will

be allowed to hold shares in the NOFHC. Financial services entities whose sharesare held by the NOFHC cannot be shareholders of the NOFHC.

• RBI will have to be satisfied that the corporate structure does not impede the

financial services entities held by the NOFHC from being ring fenced, that it wouldbe able to supervise the bank, the NOFHC, and its Subsidiaries / Joint Ventures /

Associates on a consolidated basis, and that, it will be able to obtain all requiredinformation relevant for this purpose, smoothly and promptly. However, theprimary supervision of the entities held by the NOFHC will be by the sectoral

regulators.

• The NOFHC shall not be permitted to set up any new financial services entity forat least three years from the date of commencement of business of the NOFHC.

However, this would not preclude the bank from having a subsidiary or jointventure or associate, where it is legally required or specifically permitted by RBI.

• (vii) Only those regulated financial sector entities in which a Promoter

Group has significant influence2 or control will be held under the NOFHC.

• The Promoter / 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.

• (ix) Shares of the NOFHC shall not be transferred to any entity outside the

Promoter Group. Any change in shareholding (by the Promoter Group) with

in the NOFHC as a result of which a shareholder acquires 5 per cent or

more of the voting equity capital of the NOFHC shall be with the priorapproval of RBI.

3. Cash flow ring-fencing issues with respect to any conglomerate

We think that the first and second issues have merit to them and will likely imply a

holding company discount of 17%. We do not see any possibility of cash flowsubsidisation between bank and its sister entities and not feel that will contribute to

any holding company discount.






15

Big ticket financial inclusion from incumbentsappears like a bet against history

Retail assets – a tale of two Indias – one difficult to reach, theother highly competitive

With large parts of the wholesale lending opportunity like power, infrastructure underdebilitating stress and existing opportunities in sectors like telecom being yield-

unattractive, retail lending is key to the growth strategy of most private players. Retailcredit in India is a tale of two opposites – a reasonably penetrated urban core and aseverely under-penetrated rural periphery. While financial inclusion in rural locations

remains a priority sector focus, apart from niche presence of some NBFCs,penetration of organized credit remains low till date.

Chart 9: Credit m ix: Urban vs. Rural

14.0 11.2 9.8 7.6 7.4

14.212.7 11.2 9.6 8.9

19.917.5

16.516.0 14.6

51.958.7 62.5 66.7 69.1

0

10

20

30

40

50

60

70

80

90

100

FY93 FY98 FY03 FY08 FY13

Rural Semi-urban Urban Metro


Chart 10: Loan CAGR: FY1993-FY2013 – Urban vs. Rural

16.117.1

18.0

21.6

0.0

5.0

10.0

15.0

20.0

25.0

Rural Semi-urban Urban Metro

( % )


Rural credit has

gone to 7.4% of totalcredit from 14%twenty years back

Metro area loan

CAGR for thebanking system is

550bps higher than

rural at 21.6% overlast 20 years






17

Initial pain for all, belated gains for some

The banking license has always been seen as the ticket to the big league for all

NBFCs with reasonable size by mainstream observers. While there are obvious meritsto this argument – liability diversification critical to stability and regulatory support

being obvious ones – the fine print in extant guidelines relating to receiving a license

in its current form ensure that potential benefit is at least up for debate. M&MFinancial, an investor favourite in India, perhaps provided the strongest evidence insupport of a trade-off being involved in converting into a bank when it dropped out of

the race, despite having significant advantages with respect to complying to prioritysector related requirements. In particular, the following issues are cause for

consternation for a shareholder of a NBFC that could potentially convert into a bank.

1. The guidelines require 25% of branches to be located in areas with populationless than 10,000. With little or no business contribution from most such branches

being a prudent assumption, the cost drag is quite significant.

2. The guidelines offer very little forbearance on priority sector requirements with40% of ANBC being the stipulated minimum exposure. All current banks struggleto meet these stipulations and it does impact RoE expectations when we build in

shortfalls for some of the NBFCs that we evaluate. We assume shortfall

deployment into RIDF at 5.5-6%.

3. The dilution requirements for the NOFHC (Non-operating financial holding

company) are i) stake to be reduced to 40% within 3 years (and maintained at that

level for 2 more years) ii) further to 20% by 10 years and iii) to 15% by 12 yearsfrom the date of commencement of operations. These dilution timelines, especially

clause i), reduce the attractiveness of the license.

4. Due to the NOFHC structure that is mandatory for the bank’s ownership, the apex

shareholder may face problems of a holding company discount.

5. Only 18 month given to comply to SLR and CRR (drag on profitability)

There are many question marks even on the plus side of the ledger book. CASA

funds are no low hanging fruit and the probability of success depends on retail recall,

branch presence, size of balance sheet and corporate relationships. The only benefitthat is near universal for all these NBFCs is actually higher leverage. In the followingsection we analyse the business case for bank conversion in each of the chosen

NBFCs, focusing on

• Asset strategy (based on current strengths)

• Liability strategy (focus on retail funds)

•

Priority sector capabilities• Branch reach and drag from mandatory rural branches

• Balance sheet structure

• Execution risks

• RoE tree for five years post inception, with and without forbearance

• IRR hit from dilut ion requirements

• Likely holding structure

Multiple hurdles for a

new licensee




18

IDFC (IDFC IN, Mcap – US$2.9bn, BUY, TP- Rs138)

Conclusion from our scenario analysis –a big beneficiary provided

initial dilution is at a premium to steady state multiple

As the following analyses show, in the absence of overinvestment into retail liability

sourcing or concentrated pursuit of any particular retail asset class, banking licensedoes look attractive for IDFC. In the absence of forbearance on priority sector

requirements its 5th year RoE is 18.2% vs 14-15% now. With lowered CoE, we arguefor a steady state P/B of 1.5x which is significantly higher than current core multiple of

0.85x. However, the big proviso to the banking license being beneficial is that if 60%dilution is indeed achieved by the third year, the valuation multiple has to be at a

premium to the steady state multiple of 1.5x. If the pre-money multiple is 1.5x (in line

with what we feel can be steady state), IRR achieved over 12 years will be sub-par at7% (vs 19.8% possible in a no dilution scenario). However, only a 25% premium tothis valuation will lead to 10.4% IRR over the same period. The reason we say the

license is beneficial for IDFC is because we feel diluting 60% in 3 years may prove

difficult in real life in the absence of strategic investors who in any case will probably

be more amenable to a premium.

General observations

The company remains one of the crowd favourites to receive a new banking licensegiven its strong corporate governance track record, professional management

structure and marginal co-mingling risks with non-lending business activities.

Chart 11: Likely ho lding structure

IDFC

NOFHC

BankIDFC AMC IDFC Secur it ies IDFC Al ternat ives

Infrastructure lending businesstransferred to Bank

Source: Company, I-Sec research

Likely asset-liability strategy

Amongst all the companies we analyse in here, IDFC is likely to be least retail

focused in our opinion. We expect branch numbers to go up to 25-30 from 4 currentlyat the outset but do not feel they would try to invest very heavily into an already

crowded retail market. On the assets side, their natural diversification will be into non-

infra sectors of corporate lending and into the SME financing space.

Big beneficiary from

a license in higherRoE and lower CoE

Likely to be a

wholesale bank onboth assets and

liabilities




19

On the liabilities side, savings account money will be difficult in our opinion as it is not

a name with high recall amongst the general Indian populace despite being well

known in financial markets. Garnering current account deposits may be a marginallybetter bet if it rolls out cash management services through the new branches given its

strong corporate relationships. However, total CASA is unlikely to be of sizeconsequence in our opinion. It will most likely remain a wholesale funded wholesale

lending bank.Chart 12: Asset pie (Dec-13) Chart 13: Liabil ity pie (Dec-13)

Projectloans55%

Corporateloans36%

LAS2%

Mezzanine0%

Equity/Pref.shares

4%

Non-funded3%

NCDs66%

Bank loans

11%

ECBs14%

Sub-debt1%

Others8%

Source: Company data; I-Sec research

Priority sector capabilities

A sparse branch network means that priority sector assets may be hard to come by

and accordingly Rural Infrastructure Development Fund (RIDF) proportion will remain

high. Some export credit seems its best bet for priority sector asset origination. We

have not assumed benefits from buying of securitized assets.

Branch reach and drag of mandatory rural branches

For IDFC, we feel the drag of setting up new branches in rural areas will not be large,as it has only four branches at present. As an example, even if it sets up 20 more

branches in key Indian cities, incrementally it will need to set up eight rural branches,

which on a cumulative absolute cost basis is unlikely to make a dent on its businessreturns.

Implications for balance sheet structure

If the banking guidelines are to be complied with in exactitude, the company will have

to roughly double its balance sheet size. The argument is as follows. Currently, 82%of IDFC’s balance sheet is infrastructure loans, none of which will qualify as priority

sector lending which needs to be 40% of ANBC i.e. 29.2% of balance sheet if weassume exactly 23% SLR and 4% CRR (NCD assumed to qualify for SLR or to be

replaced by funds with SLR requirement, and assets used as a proxy for debt for thisindicative calculation). Thus, non-priority ANBC cannot be more than ~44% of total

balance sheet size vs. 82% currently. We assume all-debt funded balance sheet

expansion.

Next to zero PSLcapabilities

Leverage would

have to doubleupfront




20

Key execution risks

The key execution risk in IDFC’s banking business will come if there is over-

investment in building a branch/ATM network for retail or if there is aggressive pursuitof any particular kind of retail assets. We see the probability of success in theseventures to be limited given current strengths.

RoE tree for five years post inception, with and without forbearance

In our calculation of probable RoE scale-up in 5 years from inception, ourassumptions are conservative and guided by the previous discussion on the

company’s likely strategies, strengths and limitations. As expected RoE in year 1drops to 9.3% but recovers to 18.2% by year 5 (vs 14-15% that the current businessmodel allows).

Table 9: Possible RoE scenario vs current model (no PSL forbearance)

Currentbusiness model(steady state)

Post conversion as bank

CommentsYear 1 Year 2 Year 3 Year 4 Year 5SLR as a proportion of liabilities 10.0 20.0 23.0 23.0 23.0 23% of liabilities in 18

months, 20% averagelevel taken for year 2

CRR as a proportion of liabilities 2.0 3.5 4.0 4.0 4.0 4% of liabilities in 18months, 3.5% average

level taken for year 2

Market investment book proportion/ SLR 15.6

9.0 18.2 21.1 21.2 21.4 All liabilities assumedto qualify for SLRmaintenance

Yield on investments (%) 9.0 8.5 8.5 8.5 8.5 8.5

Cash maintained (% of balance sheet)/ CRR 0.4

1.8 3.2 3.7 3.7 3.7 All liabilities assumedto qualify for CRRmaintenance

Infra loans (% of balance sheet) 82.0 57.0 44.4 39.1 36.9 34.7Priority sector loans (% of balance sheet) 0.0 3.0 4.0 5.0 6.0 7.0RIDF balances (% of balance sheet) - to meetthe shortfall in PSL 26.2 25.2 24.2 23.2 22.2

Other loans (% balance sheet) 2.0 4.0 6.0 8.0 10.0Fixed and other non interest bearing assets 2.0 1.0 1.0 1.0 1.0 1.0Yield on Infra loans (% ) 12.30 12.30 12.30 12.30 12.30 12.30Yield on Priority sector loans (%) 0.0 11.5 11.5 11.5 11.5 11.5Yield on RIDF balances (%) 0 5.0 5.0 5.0 5.0 5.5Yield on other loans (%) 11.0 11.0 11.0 11.0 11.0Blended yield on assets (%) 11.5 9.7 9.2 9.0 9.1 9.2CA proportion (%) 0 2.0 4.0 6.0 8.0 10.0CA cost (%) 0.0 0.0 0.0 0.0 0.0SA proportion (%) 0 1.0 2.0 3.0 4.0 5.0SA cost (%) 6.0 6.0 6.0 6.0 6.0Other borrowing cost (%) (NCD residual +bulk deposits) 9.2 9.0 9.0 9.0 9.0Blended borr owin g cost (%) 9.3 9.0 8.6 8.4 8.2 8.0Leverage (x) 5.1 10.0 11.0 12.0 13.0 14.0Spread (%) 2.19 0.67 0.59 0.67 0.91 1.26

NIM on to tal assets (%) 4.01 1.57 1.37 1.37 1.54 1.83Non interest inco me as % of assets 1.60 1.00 1.00 1.00 1.00 1.00

Cost/ AUM for new rural branches (%) 0.9 0.9 0.8 0.7 0.6Proportion on rural branches (%) 25.0 25.0 25.0 25.0 25.0Op cost as a % of assets 0.84 0.76 0.67 0.62 0.60 0.58

Credit cost s as a % of assets 0.55 0.49 0.43 0.41 0.41 0.41Tax rate (%) 29.0 29.0 29.0 29.0 29.0 29.0RoA (%) 3.0 0.9 0.9 0.9 1.1 1.3RoE (%) 15.3 9.3 9.9 11.3 14.0 18.2


~300bps addition tocore RoE in steady

state with minimal

assumptions




21

We have also provided a case where the deployment into RIDF is 10% (as % of

ANBC) lower than extant guidelines due to close to inevitable forbearance. As we see

below, the RoE with forbearance is on an average higher by 400-500bps every year.

Table 10: Possib le RoE scenario vs current model (wi th PSL forbearance)

Currentbusiness model

(steady state)


Year 1 Year 2 Year 3 Year 4 Year 5SLR as a proportion of liabilities 10.0 20.0 23.0 23.0 23.0

CRR as a proportion of liabilities 2.0 3.5 4.0 4.0 4.0

Market investment book proportion/ SLR 15.6 9.0 18.2 21.1 21.2 21.4Yield on investments (%) 9.0 8.5 8.5 8.5 8.5 8.5Cash maintained (% of balance sheet)/ CRR 0.4 1.8 3.2 3.7 3.7 3.7Infra loans (% of balance sheet) 82.0 64.3 51.7 46.4 44.2 42.0Priority sector loans (% of balance sheet) 0.0 3.0 4.0 5.0 6.0 7.0RIDF balances (% of balance sheet) - to meet the shortfall in PSL 18.9 17.9 16.9 15.9 14.9Other loans (% balance sheet) 2.0 4.0 6.0 8.0 10.0Fixed and other non interest bearing assets 2.0 1.0 1.0 1.0 1.0 1.0Yield on Infra loans (% ) 12.30 12.30 12.30 12.30 12.30 12.30Yield on Priority sector loans (%) 0.0 11.5 11.5 11.5 11.5 11.5Yield on RIDF balances (%) 0 5.0 5.0 5.0 5.0 5.5Yield on other loans (%) 11.0 11.0 11.0 11.0 11.0Blended yield on assets (%) 11.5 10.2 9.7 9.6 9.6 9.7CA proportion (%) 0 2.0 4.0 6.0 8.0 10.0CA cost (%) 0.0 0.0 0.0 0.0 0.0SA proportion (%) 0 1.0 2.0 3.0 4.0 5.0SA cost (%) 6.0 6.0 6.0 6.0 6.0Other borrowing cost (%) (NCD residual + bulk deposits) 9.2 9.0 9.0 9.0 9.0Blended borr owin g cost (%) 9.3 9.0 8.6 8.4 8.2 8.0Leverage (x) 5.1 10.0 11.0 12.0 13.0 14.0Spread (%) 2.19 1.20 1.12 1.20 1.44 1.76NIM on to tal assets (%) 4.01 2.10 1.90 1.90 2.07 2.33Non interest inco me as % of assets 1.60 1.00 1.00 1.00 1.00 1.00

Cost/ AUM for new rural branches (%) 0.9 0.9 0.8 0.7 0.6Proportion on rural branches (%) 25.0 25.0 25.0 25.0 25.0Op cost as a % of assets 0.84 0.76 0.67 0.62 0.60 0.58Credit cost s as a % of assets 0.55 0.49 0.43 0.41 0.41 0.41Tax rate (%) 29.0 29.0 29.0 29.0 29.0 29.0

RoA (%) 3.0 1.3 1.3 1.3 1.5 1.7RoE (%) 15.3 13.1 14.1 15.9 19.0 23.2Change in RoE from base case (bps ) 378 416 454 491 493


Dilution requirements reduce attractiveness of proposition

Based on the steady state RoE of ~18%, we feel steady state P/BVPS multiple for the

bank could be 1.5x (lower than a similar RoE retail bank). The following chart

illustrates the impact of the mandatory dilution requirements at the 3, 10, 12 yearpoints since bank operation commencement on the IRR for a current shareholder ofIDFC (assuming P/B multiple stays same as current until conversion). The two later

dilutions are assumed to be at the steady state multiple while the initial dilution is

assumed at three alternative multiples – steady state, a 25% discount and a 25%premium. These are compared with possible IRR in a no dilution requirement scenario

to show the impact of dilution requirements on the bank license attractiveness. Notethat we do not build in a holding company discount. We see that the dilutionrequirements have a disproportionate impact on IRR expectations of the shareholder

as an attractive IRR of 19.8% (in a no dilution scenario) becomes only 7% if the

dilution norms are followed in exactitude in the base case. Also, note that the multipleused for the first dilution is critical, because if it is done at a 25% premium to the

steady state multiple, the IRR improves to 10.4%.




22

Table 11: IRR calculation table

Steady state P/B 1.53 -yr exit P/B 1.5

Yr 0 Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8 Yr9 Yr10 Yr11 Yr12Proportion of ownership (%) 100 100 100 40 40 40 40 40 40 40 20 20 15RoE (%) 15.3 9.3 9.9 11.3 7.0 18.2 18.2 18.2 18.2 18.2 18.2 18.2 18.2BVPS (base set at 100) 100.0 109.3 120.1 173.9 186.1 220.0 260.1 307.5 363.6 429.9 635.3 751.1 999.1Organic accretion to BVPS 9.3 10.8 13.6 12.2 33.9 40.1 47.4 56.1 66.3 78.4 115.8 137.0

Accretion BVPS from capitalraise 40.1 127.1 111.0Multiple applicable (pre-money)/ current 1.0 1.5 1.5 1.5Market value (Rs) 100.0 260.8 952.9 1498.6Market value owned (Rs) 100.0 104.3 190.6 224.8IRR (%) -12 years 7.0

* Dividends not considered in analysisSource: I-Sec research

Chart 14: IRR scenarios based on dilution

19.8

7.0

10.4

3.1

0

5

10

15

20

25

IRR no di lution IRR base case IRR -premiumdilution

IRR -bear case

( % )





23

LIC Housing Finance (LICHF IN, Mcap – US$1.9bn, BUY)

Conclusion from our scenario analysis – doubts around execution on

potential strengths cloud prospects

As the following analyses show, banking license is not so attractive for LIC Housing

Finance due to decrease in sustainable RoE (17.3% in 5th year vs 19-20% possibleunder current business model). However, the decrease in cost of equity due to shiftinto a banking model is going be much lesser than other players as the business

model is already very low risk. We argue for a steady state P/B of 2.0x due to highconcentration of low risk retail assets. However, the IRR looks attractive at 11.8% dueto current depressed valuations at 1.3x P/BVPS. Banking license thus is no clear

positive for the company, in the absence of assumptions that support a strong SAperformance.


LIC Housing Finance should have been by default the best bet for a low cost deposit

franchise given its brand recall and trust in India. However, weak execution on fixeddeposits introduces many doubts into that thesis playing through.


LIC Housing Finance

NOFHC

Bank(Housing finance

business transferred)

LICHFL AMC

Housing finance businesstransferred to Bank



On retail assets, mortgages are likely to remain the key component in the foreseeablefuture. The parent’s employee, agent and customer ecosystem in itself should be a

ready source of new loan origination and there should be some opportunity todiversify as well into educational loans, auto loans etc. In its current business,wholesale lending component has become very low. We feel the company is unlikelyto become focused on wholesale lending in its new avatar as well if it does receive the

banking license.

Ideally, given the reach of its parent, LIC Housing Finance should be one of thefavourites to carve out a large chunk of the SA pie. However, the same argument

should have applied to its current business as well, where deposits as a source of

Drop in sustainable

RoE, notcompensated bycommensurate CoEreduction, as current

business model isalso low risk

Should have been ashoo in as a SA

champion…butdoubts remain




24

funds remains extremely small compared to its peer HDFC (1% vs 32%). While LIC

Housing in now directed some focus towards this area we find it difficult to be very

optimistic on what should legitimately be a huge strength due to its track record.

Chart 16: Proportion of funds f rom deposits for HDFC and LICHF (5 years)

23.1 23.9

21.1

26.1

32.7

0.6 0.9 0.5 0.5 1.1

0

5

10

15

20

25

30

35

FY09 FY10 FY11 FY12 FY13

( % )

HDFC LICHF

Source: Company

Chart 17: Asset pie (Dec-13) Chart 18: Liabil ity pie (Mar-13)

Individual97%

Project /developer

3%

NCDs60%

Term loans

30%

NHB4%

Sub-debt4%

Others2%



The company will be better placed than many other banks for sourcing priority sector

assets and we expect it to be almost completely self-sufficient if one ignores the sub-classifications within priority sector stipulations.


It has 225 branches and due to none of them qualifying in the less than 10,000

population location category, incremental addition of low population branches will be

at least 75. This will increase operating costs by 10bps as a percentage of loans on

existing 40bps (branch costs are low). We assume very little contribution from suchbranches.

Strong PSL

generation




25


LIC Housing Finance is currently almost self sufficient on priority sector assets (if sub-

classifications) are ignored with roughly 35% of loans being compliant currently. Forthis reason balance sheet expansion on conversion into a bank will be only onaccount of SLR and CRR. However, with current leverage at close to 11x, in the

absence of a capital raise, it will have to go up to ~15x for compliance with SLR and

CRR. We have assumed a steady state leverage of 14x in our calculation whichshould be possible due to lower risk weights on mortgages.

Key execution risks

The key risks for LIC Housing Finance, in its conversion into a bank are likely to be

• Higher than expected wholesale lending business. Its past track record does not

inspire much confidence in us.

• Underperformance of expectations on saving account money, especially ifaccompanied by overinvestment in retail infrastructure

• Foray into specialized retail asset classes like SME and CV loans

• Any major foray into unsecured loans

• Execution risks with respect to ALM management and treasury products and

operations. The scope for a big slip-up that could significantly dent profitability or

threaten stability is much larger with the product design flexibility of a bank than asa housing finance company.

RoE tree for five years post inception, with and without forbearance


company’s likely strategies, strengths and limitations. As expected RoE in year 1drops to 11.6% but recovers to 17.3% by year 5 (vs 19.6% that the current businessmodel allows).

Delta in leverage notas dramatic as otherapplicants

Sustainable RoE of17.3%






27

Table 13: Possible RoE scenario vs current model (with PSL forbearance)

Currentbusiness

model(steady state)




Market investment book proportion/ SLR 1.0 9.3 18.6 21.4 21.4 21.4

Yield on investments/ SLR (%) 8.0 8.5 8.5 8.5 8.5 8.5Cash maintained (% of balance sheet)/ CRR 1.0 1.9 3.3 3.7 3.7 3.7Housing loans(% of balance sheet) - non priority 59.0 60.4 47.7 42.4 40.4 38.4Priority sector loans (% of balance sheet) 35.0 25.0 25.0 25.0 25.0 25.0RIDF balances (% of balance sheet) - to meet the shortfall in PSL 0.0 0.0 0.0 0.0 0.0Non-housing loans (% balance sheet) 2.0 2.0 4.0 6.0 8.0 10.0Fixed and other non interest bearing assets 2.0 1.5 1.5 1.5 1.5 1.5Yield on housing loans - non priority(% ) 11.3 11.3 11.3 11.3 11.3 11.3Yield on Priority sector loans (%) 11.5 11.5 11.5 11.5 11.5Yield on RIDF balances (%) 6.0 6.0 6.0 6.0 6.0Yield on non-housing loans (%) 14.5 12.0 12.0 12.0 12.0 12.0Blended yield on assets (%) 11.3 10.7 10.3 10.2 10.2 10.2CA proportion (%) 0 1.0 1.5 2.0 2.5 3.0CA cost (%) 0.0 0.0 0.0 0.0 0.0SA proportion (%) 0 2.0 4.0 6.0 8.0 10.0SA cost (%) 6.0 6.0 6.0 6.0 6.0

Other borrowing cost (%) (NCD residual + bulk deposits) 9.5 9.3 9.1 9.0 9.0Blended borr owin g cost (%) 9.5 9.3 9.0 8.7 8.5 8.4Leverage (x) 12 14 14 14 14 14Spread (%) 1.80 1.36 1.27 1.45 1.66 1.78NIM on to tal assets (%) 2.59 2.03 1.91 2.08 2.27 2.39Non interest inco me as % of assets 0.25 0.20 0.20 0.20 0.20 0.20Proportion on rural branches (%) 25.0 25.0 25.0 25.0 25.0Op cost as a % of loan assets 0.40 0.50 0.47 0.44 0.44 0.44

Credit costs as a % of loan assets 0.40 0.50 0.50 0.50 0.50 0.50

Op cost as a % of BS assets 0.24 0.43 0.35 0.30 0.29 0.29Credit cost s as a % of BS assets 0.24 0.44 0.39 0.37 0.37 0.37Tax rate (%) 27.0 29.0 29.0 29.0 29.0 29.0RoA (%) 1.7 1.0 1.0 1.1 1.3 1.4RoE (%) 20.8 13.4 13.7 15.9 17.9 19.1Change in RoE (bps) 177 178 179 179 179



Based on the steady state RoE, we feel a steady state P/BVPS multiple for the bankcould be 2.0x (given strong retail presence and potential for CASA). The followingchart illustrates the impact of the mandatory dilution requirements at the 3, 10, 12

year points since bank operation commencement on the IRR for a current shareholderof LIC Housing Finance (assuming P/B multiple stays same as current until

conversion). The two later dilutions are assumed to be at the steady state multiple

while the initial dilution is assumed at three alternative multiples – steady state, a 25%discount and a 25% premium. These are compared with possible IRR in a no dilution

requirement scenario to show the impact of dilution requirements on the bank licenseattractiveness. Note that we do not build in a holding company discount. The 12 year

IRR with dilution looks healthy at 11.8% for the base case but the no-dilution IRR of20.3% highlights the value destruction from the dilution. From a pure business model

perspective the license is not emerging as a big value-add as it reduces sustainablereturn on equity in the absence of strong performance in low cost deposits.

Dilution hurts, but

IRR of 11.8% is bestamongst those

applicants that have

been analysed




28



Yr 0 Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8 Yr9 Yr10 Yr11 Yr12Proportion of ownership(%) 100 100 100 40 40 40 40 40 40 40 20 20 15RoE (%) 19.6 11.6 11.9 14.1 8.1 17.3 17.3 17.3 17.3 17.3 17.3 17.3 17.3BVPS (base set at 100) 100.0 111.6 124.9 227.9 246.3 289.0 339.1 397.9 466.9 547.9 964.4 1131.6 1659.7Organic accretion to BVPS 11.6 13.3 17.6 18.4 42.7 50.1 58.8 69.0 81.0 95.0 167.2 196.2

Accretion BVPS from capital raise 85.5 321.5 331.9Multiple applicable (pre-money) 1.3 2.0 2.0 2.0Market value (Rs) 130.0 455.9 1928.7 3319.4Market value owned (Rs) 130.0 182.3 385.7 497.9IRR (%) -12 years 11.8



20.3

11.8

15.8

7.3

0

5

10

15

20

25

IRR no di lution IRR base case IRR -premiumdilution

IRR -bear case

( % )





29

Muthoot Finance (MUTH IN, Mcap – US$1bn, BUY)

Conclusion from our scenario analysis – a massive re-orientation

exercise wil l be a big drag

As the following analyses show, banking license is not so attractive for Muthoot

Finance due to decrease in sustainable RoE (13.2% in 5th year vs 19-20% possibleunder current business model). With lowered CoE (very significant for this particular

applicant in our opinion), we argue for a steady state P/B of 1.5x due to highconcentration of low risk retail assets. In the absence of forbearance on priority sector

requirements the IRR for a current shareholder is low at 2.3%, on the back of currentvaluations at 1.2x P/BVPS. Banking license thus is no clear positive for the company,

in the absence of assumptions that support a strong SA performance or serious

diversification and priority sector asset sourcing, starting virtually from scratch.


Muthoot Finance, as a gold finance NBFC, has been at the eye of a regulatory storm

since 2011. The highly branch intensive gold loan business model is not a naturalcandidate for conversion into a multi-product bank in our opinion although its ability to

serve the purpose of financial inclusion is extremely high. The reason we say this is

because this highly specialized business (where credit underwriting is purely a matterof verification of gold purity) does not prepare the organization for the myriadchallenges that a diversified product suite offers.


Muthoot Finance

NOFHC

Bank

Gold financing business

transferred to Bank

Source: Company, I-Sec research


Muthoot Finance in all fairness is seen as a low probability contestant in this race for

the license in our opinion. Its relative newness in the institutional mainstream and theregulatory approach to gold loan NBFCs, is likely to go against it. However, if it is arecipient we feel the company will find it difficult to shift its portfolio mix away from

gold loans. Any other loan product, retail or wholesale will be pretty much a Greenfieldeffort.

Not a likely

beneficiary in ouropinion

Every new non –gold

loan asset will bepractically a

Greenfield venture




30

On the liabilities side, current account money is likely to be extremely difficult to come

by. However, we see some hope for SA money based on the fact that the company

was a major user of branch level on-tap NCDs (before it was stopped by RBI fiat) thatthe regulator has called surrogate deposits. Clearly its name has recall and trust

amongst a certain investor set (especially in Kerala) who will remain the core targetgroup for savings accounts. Also, the current borrowing costs for the company are

high and even bulk deposits will offer a big saving on interest costs.

Chart 21: Liabili ty pie (Dec-13)

NCDs53%

Bank loans32%

Sub-debt13%

Others2%



Priority sector assets are going to be a challenge as well as gold loans will not qualify

without agriculturalist certification for borrower.


It has ~4,200 branches and reasonable amount of rural presence. We expectoperating cost drag to be less than other players on this count but to an extentnegated by the fact that most costs are branch related and assume first year

cost/AUM to be 5.5% vs 4.5% now.


Muthoot Finance currently has a leverage of 5.8x. For this reason balance sheet

expansion on conversion into a bank will be on account of SLR/ CRR and balancedeployment into RIDF. In the absence of a capital raise, it will have to go up to ~10xfor compliance. We have assumed a steady state leverage of 13x in our calculation.

Key execution risks

The execution risks for the company are huge as it will have to revamp its entire

lending business model from scratch and simultaneously undergo large scale branch

expansion investments. If the savings account inflows are lower than expected, thebreathing room would be even less. Also, unless they can tweak their disbursementprocess to classify some gold loans as agricultural or SME loans, getting priority

sector assets will also be a challenge.

Branch costs drag issubstantial

Multiple execution

risks






32

Table 16: Possible RoE scenario vs current model (with PSL forbearance)

Currentbusiness model(steady state)




Market investment book proportion/ SLR 0.0 9.0 18.2 21.1 21.2 21.2Yield on investments/ SLR (%) 8.5 8.5 8.5 8.5 8.5

Cash maintained (% of balance sheet)/ CRR 7.0 1.8 3.2 3.7 3.7 3.7Gold loans(% of balance sheet) - non priority 86.0 60.3 47.7 42.4 40.2 38.2Priority sector loans (% of balance sheet) 0.0 2.0 4.0 6.0 8.0 10.0RIDF balances (% of balance sheet) - to meet the shortfall inPSL

19.9 17.9 15.9 13.9 11.9

Non-gold loans (% balance sheet) 0.0 2.0 4.0 6.0 8.0 10.0Fixed and other non-interest bearing assets 7.0 5.0 5.0 5.0 5.0 5.0Yield on gold loans - non priority(% ) 21.0 20.0 20.0 20.0 20.0 20.0Yield on Priority sector loans (%) 11.5 11.5 11.5 11.5 11.5Yield on RIDF balances (%) 6.0 6.0 6.0 6.0 6.0Yield on non-gold loans (%) 12.0 12.0 12.0 12.0 12.0Blended yield on assets (%) 18.6 14.5 13.1 12.6 12.6 12.5CA proportion (%) 0 0.5 1.0 1.5 2.0 2.5CA cost (%) 0.0 0.0 0.0 0.0 0.0SA proportion (%) 0 2.0 4.0 6.0 8.0 10.0SA cost (%) 6.0 6.0 6.0 6.0 6.0

Other borrowing cost (%) (NCD residual + bulk deposits) 9.5 9.3 9.1 9.0 9.0Blended borr owin g cost (%) 11.7 9.4 9.1 8.8 8.6 8.5Leverage (x) 5.8 10.0 11.0 12.0 13.0 13.0Spread (%) 6.92 5.11 4.03 3.85 3.97 4.03NIM on to tal assets (%) 8.94 6.04 4.86 4.58 4.63 4.68Non-inter est inco me as % of assets 0.10 0.15 0.15 0.15 0.15 0.15Proportion on rural branches (%) 25.0 25.0 25.0 25.0 25.0Op cost as a % of loan assets 4.50 5.50 5.30 5.10 4.90 4.70


Op cost as a % of BS assets 3.87 3.70 3.01 2.72 2.61 2.50Credit cost s as a % of BS assets 0.17 0.28 0.24 0.24 0.24 0.25Tax rate (%) 33.0 29.0 29.0 29.0 29.0 29.0RoA (%) 3.3 1.6 1.2 1.3 1.4 1.5RoE (%) 19.4 15.7 13.7 15.1 17.8 19.2Change in RoE (bps ) 419 473 528 586 599



Based on the steady state RoE of 13.2%, we feel a steady state P/BVPS multiple forthe bank could be 1.5x. The following chart illustrates the impact of the mandatorydilution requirements at the 3, 10, 12 year points since bank operation

commencement on the IRR for a current shareholder of Muthoot Finance (assumingP/B multiple stays same as current until conversion). The two later dilutions are

assumed to be at the steady state multiple while the initial dilution is assumed at three

alternative multiples – steady state, a 25% discount and a 25% premium. These arecompared with possible IRR in a no dilution requirement scenario to show the impact

of dilution requirements on the bank license attractiveness. Note that we do not buildin a holding company discount. The 12 year IRR with dilution looks really low at 2.3%

for the base case but the no-dilution IRR of 14.4% is reasonable compared to manyother applicants. From a pure business model perspective the license is not emerging

as a big value-add as it reduces sustainable return on equity due to serious operatingcost implications and drag of RIDF deployment. The fact that sustainable P/BVPS of1.5x post bank conversion is close to current P/BVPS of 1.2x further impacts IRR to

current shareholder.

IRR to currentshareholder lowest inthe group




33



Yr 0 Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8 Yr9 Yr10 Yr11 Yr12Proportion of ownership(%) 100 100 100 40 40 40 40 40 40 40 20 20 15RoE (%) 19.4 11.5 9.0 9.8 6.0 13.2 13.2 13.2 13.2 13.2 13.2 13.2 13.2BVPS (base set at 100) 100.0 111.5 121.6 173.5 183.9 208.2 235.7 266.7 301.9 341.8 483.6 547.3 697.0Organic accretion to BVPS 11.5 10.0 11.9 10.4 24.3 27.5 31.1 35.2 39.8 45.1 63.8 72.2

Accretion BVPS from capital raise 40.0 96.7 77.4Multiple applicable (pre-money) 1.2 1.5 1.5 1.5Market value (Rs) 120.0 260.3 725.3 1045.5Market value owned (Rs) 120.0 104.1 145.1 156.8IRR (%) -12 years 2.3



14.4

2.3

5.5

(1.4)(4)

(2)

0

2

4

6

8

10

12

14

16

IRR no di lut ion IRR base case IRR -premiumdilution

IRR -bear case

( % )





34

Shriram City Union Finance (SCUF IN, Mcap – US$1.0bn,REDUCE, TP- Rs1,000)

Conclusion from our scenario analysis – unlikely recipient due to

condi tional application, could be a blessing in disguise

As the following analyses show, the banking license is no unequivocal positive forShriram City Union Finance. In the absence of forbearance on priority sectorrequirements its 5th year RoE is 16.8% vs ~20% now. With lowered CoE, we arguefor a steady state P/B of 1.8x which is same as current multiple. If 60% dilution is

indeed achieved by the third year at the steady state multiple of 1.8x, IRR achieved

over 12 years will be sub-par at 6% (vs 15.7% possible in a no dilution scenario).Thus the banking license is not a clear blessing for the company, despite strong

priority sector strengths.


Shriram Capital, the promoter company of both key Shriram group NBFCs, Shriram

Transport Finance (SHTF IN, BUY, TP-Rs880) and Shriram City Union Finance(SCUF), has applied for a banking license. The CEO of Shriram City Union Finance,Mr Sundararajan has gone on record stating that in the group’s interpretation of theguidelines, Shriram Transport Finance can exist as an independent entity in its

business and their application is specific to transfer of all lending businesses ex- theflagship SHTF into the bank i.e. Shriram City Union Finance. All other businesses like

insurance will be step down subsidiaries of the NOFHC.

In our interpretation of the guidelines, we feel the RBI asks for all lending businessesto be transferred to the bank. Hence, we feel it is very unlikely that SCUF will be the

recipient of a license. The group remains very committed to its view that the business

of Shriram Transport Finance is difficult to fit into the ambit of a bank’s operations. We

are sympathetic to this view, as we see the following issues

• Bank funding is a large part of liabilities and refinance at one go will be difficult/painful

• Close to 70% of the business is in cash

• The need for intensive collection efforts that extend to the customer’ doorstep or

the nearest freight collection point does not fit well into a generic branch’soperating model

• The salary cost per employee is much lower than banks and industry

benchmarking will impact the lucre of the business model

• Constant monitoring of asset valuations needs a focused and specialized fieldforce

• In a way, the company also acts as a go-between for transactions between

interested buyers and sellers of used commercial vehicles. The Automall outletsare testimony to this strategy. This provides a critical exit point for borrowers who

are likely seeing some stress in their business and would like to exit the asset.This exercise may become difficult in a banking architecture.

No clear gain frombanking license






36

Chart 24: Asset pie (Dec-13) Chart 25: Liabil ity pie (Dec-13)

SME49%

SME - Gold18%

Auto11%

2 wheelers17%

Personal4%

Consumerdurables

1%

NCDs34%

Bank lo ans50%

Retaildeposits

3%

Sub-debt13%



Priority sector is going to be a major strength for the company with both internalgeneration capability and a ready source from its sister company Shriram TransportFinance.


The company already has ~15% branches in the less than 10,000 population locationcategory and thereby better positioned than most on this count. However, the fact

also remains that most operating costs are branch related. We expect current 4.3%cost/ AUM to up by 120bps on first year of conversion. Sharing of manpower orinfrastructure with Shriram Chits will have to stop, and will need some fresh

investments.


If the banking guidelines are to be complied with in exactitude, the company will have

to increase leverage to 10x in the first year from 7x effective leverage now, as the onlyincremental investment is SLR/CRR with the company being self-sufficient on prioritysector assets.

Key execution risks

We feel that the risk of the company to over-stretch investment in branchinfrastructure is low (although the number will be high) as it will have to make large

investments in any case. Negative surprises can come from targeting products withlimited current experience – large scale corporate and infrastructure loans, which isunlikely in our opinion.

RoE tree for five years post inception


company’s likely strategies, strengths and limitations. RoE in year 2 drops to 11.9%

but recovers to 16.8% by year 5 (vs 20% that the current business model allows).

Substantial cost drag

Risks fromdiversification are

key




37

Table 18: Possible RoE scenario vs current model (no PSL forbearance)

Currentbusiness

model(steady state)


CommentsYear 1 Year 2 Year 3 Year 4 Year 5SLR as a proportion of liabilities 10.0 20.0 23.0 23.0 23.0 23% of liabilities in

18 months, 20%average level taken

for year 2

CRR as a proportion of liabilities 2.0 3.5 4.0 4.0 4.0 4% of liabilities in 18months, 3.5%

average level takenfor year 2

Market investment book proportion/ SLR 0.0 9.0 18.2 21.1 21.2 21.2 All liabilitiesassumed to qualifyfor SLR support

Yield on investments/ SLR (%) 8.5 8.5 8.5 8.5 8.5Cash maintained (% of balance sheet)/ CRR 5.0 1.8 3.2 3.7 3.7 3.7 All liabilities

assumed to qualifyfor CRR support

Loans in existing segments (% of balancesheet) - non priority

94.0 53.0 40.4 35.1 32.9 30.9

Priority sector loans (% of balance sheet) 0.0 29.2 29.2 29.2 29.2 29.2RIDF balances (% of balance sheet) - to meetthe shortfall in PSL

0.0 0.0 0.0 0.0 0.0

New segment loans - non priority (% balancesheet)

0.0 2.0 4.0 6.0 8.0 10.0

Fixed and other non interest bearing assets 1.0 5.0 5.0 5.0 5.0 5.0Yield on existing segments - non priority(% ) 21.0 20.5 20.5 20.5 20.5 20.5Yield on Priority sector loans (%) 18.0 18.0 18.0 18.0 18.0Yield on RIDF balances (%) 6.0 6.0 6.0 6.0 6.0Yield on new segment non-priority loans (%) 11.5 11.5 11.5 11.5 11.5Blended yield on assets (%) 20.1 17.1 15.6 14.9 14.7 14.5CA proportion (%) 0 0.5 1.0 1.5 2.0 2.5CA cost (%) 0.0 0.0 0.0 0.0 0.0SA proportion (%) 0 2.0 4.0 6.0 6.0 6.0SA cost (%) 6.0 6.0 6.0 6.0 6.0Other borrowing cost (%) (NCD residual +bulk deposits)

9.5 9.3 9.1 9.0 9.0

Blended borr owin g cost (%) 11.7 9.4 9.1 8.8 8.6 8.6Leverage (x) 7.0 10.0 11.0 12.0 13.0 13.0 Requirement

derived fromSLR/CRR

Spread (%) 8.44 7.73 6.48 6.15 6.08 5.95NIM on to tal assets (%) 10.11 8.67 7.30 6.88 6.75 6.61Non interest inco me as % of assets 0.30 0.15 0.15 0.15 0.15 0.15Proportion on rural branches (%) 25.0 25.0 25.0 25.0 25.0Op cost as a % of loan assets 4.30 5.50 5.30 5.10 4.90 4.70 Almost all current

operating costs arebranch related


Op cost as a % of BS assets 4.04 4.80 3.96 3.53 3.29 3.06

Credit cost s as a % of BS assets 2.26 2.23 1.97 1.88 1.88 1.88Tax rate (%) 31.0 29.0 29.0 29.0 29.0 29.0RoA (%) 2.8 1.3 1.1 1.1 1.2 1.3

RoE (%) 19.9 12.7 11.9 13.8 16.0 16.8Source: I-Sec research


Based on the steady state RoE of ~16.8%, we feel steady state P/BVPS multiple for

the bank could be 1.8x. The following chart illustrates the impact of the mandatory

dilution requirements at the 3, 10, 12 year points since bank operationcommencement on the IRR for a current shareholder of SCUF (assuming P/B multiplestays same as current until conversion). The two later dilutions are assumed to be at






39

Annexure 1: Retail segments cri tical to l ikelydiversif ication plans of applicants

Mortgages a difficult game for low CASA banks

The large secular growth opportunity and low asset quality concerns of the housingfinance segment have attracted most large lenders of consequence in India to it. The

players can be classified into three broad categories – scheduled commercial banks

(SCB), housing finance companies (HFC) and cooperative & regional rural banks(RRB).

Chart 27: Mortgages market share scenario

CommercialBanks, 61.4

Housing Finance

Cos., 38.6

Source: NHB, RBI, I-Sec research

Apart from few niche opportunities, housing finance remains a pretty modest spread

business with current yields hovering between 10.25-11.25% for incremental loanswith the possibility of 25-50bps extra earnings on the existing book. State Bank of

India, because of its extensive CASA franchise-driven low cost of funds, remains themarginal price setter in the market. Amongst the banks, SBI, ICICI Bank, Axis Bankand PNB are large players while HDFC and LIC Housing Finance (LICHF) are the key

housing finance players.




40

Table 20: Loans outstanding and market share

(Rsbn)

Dec-13 Dec-12 % YoY growth Market share (%)BanksSBI 1,351 1,132 19.4 20.0ICICI Bank 666 540 23.2 8.1 Axis Bank 410 327 25.6 5.5PNB 160 137 16.7 2.9

Bank of Baroda 184 152 21.0 2.4Bank of India 72 61 18.9 1.6

HFCsHDFC 1,309 1,052 24.4 15.4LIC Housing 838 699 20.0 10.0Dewan Housing* 379 243 55.8 3.8Indiabulls Housing 285 178 60.2 3.3PNB Housing 94 58 61.6 0.9GRUH 65 50 30.8 0.7Can Fin 54 36 49.1 0.5Repco Housing 36 28 26.8 0.4Mahindra Housing 12 8 54.6 0.1Shriram Housing 3 1 305.7 0.0Reliance Capital 21 28 (25.3) 0.3

Note: Market share based on total o/s housing loans as of March 31, 2013

*Part of Dewan Housing’s growth is inorganicSource: Company data, RBI, NHB

CV loans in a vicious cyclical downturn – need specialized skills

in the best of times

The commercial vehicle (CV) segment in India grew at a CAGR of 15.3% duringFY03-FY13, primarily driven by the light commercial vehicles (LCVs) sub-segment.

This is a reflection of the overall healthy economic momentum during this period,

leading to higher passenger traffic, freight movement and construction-relatedactivities. Restrictions on movement of heavy vehicles in many cities have also aidedthe growth of LCVs. There is no doubt that the long term opportunity is large.

Table 21: Potential financing opportunity in India CV market

Commercial vehicles FY12 FY13 FY14E FY15E FY16E FY17ENo. of M&HCVs sold (mn) 0.35 0.27 0.20 0.21 0.24 0.27% annual growth 8.2 (23.2) (25.3) 5.0 14.0 14.0No. of LCVs sold (mn) 0.46 0.52 0.45 0.47 0.55 0.64% annual growth 30.2 14.0 (14.3) 5.0 16.0 16.0 Average sale price of M&HCV (Rs) 1,600,000 1,680,000 1,680,000 1,764,000 1,869,840 1,963,332 Annual price increase - M&HCV 5.0 0.0 5.0 6.0 5.0 Average sale price of LCV (Rs) 600,000 600,000 600,000 630,000 667,800 701,190 Average price increase - LCV 0.0 0.0 5.0 6.0 5.0Loan-to-value ratio 60.0 60.0 60.0 60.0 60.0 60.0M&HCV finance market (Rsbn) 335 270 202 223 269 322% annual growth -19.3 -25.3 10.3 20.8 19.7LCV finance market (Rsbn) 166 189 162 179 220 267% annual growth 14.0 -14.3 10.3 23.0 21.8

Source: I-Sec research, Company data

However, the situation has been very challenging in the past 2 years. The medium

and heavy commercial vehicle (M&HCV) sub-segment has witnessed a slump duringthis time (especially FY13-14) given the material deceleration in GDP, mining ban in

Karnataka and Goa, and slump in construction activities across the country. Off late,

the only bastion of relative strength LCVs, has also cracked with sales numbers inQ3FY14 dropping.




41

The key stress points from the loan point of view are,

• Resale values have dropped significantly with price discount for a 2-year oldvehicle dropping 50%+ in some cases (high tonnages). This creates moral hazard

for the borrower as on an asset mark-to-market basis, his equity becomes small.

• Freight utilization levels have remained low as economic activity has stalled. The

bigger the vehicle, as a rule of thumb, worse has been the situation.

• Freight rates have not kept pace with diesel price hikes, especially on busyindustrial routes

• LTV has remained high, compounding moral hazard issues for the borrower

Chart 28: CV asset quality – securi tized pools

Source: India Ratings

While the cyclical stress will reduce in time, the asset class in itself presents unique

challenges.

• Continuous need for asset valuation & monitoring

• At the point of origination, registration needs to be verified for no encumbrance

• Pricing and LTV tends to get aggressive in good times, creating opportunity forlarge stress in a downturn

• Incumbent NBFCs and few banks have large market share and significantcustomer reach supported by specialized skills






43

Table 22: Market opportunity estimation

Passenger cars FY12 FY13 FY14E FY15E FY16E FY17ENo. of cars sold (mn) 2.63 2.69 2.58 2.79 3.12 3.56% annual growth 4.3 2.2 -4.0 8.0 12.0 14.0 Average sales price per car (Rs) 284,315 331,438 351,324 372,404 394,748 418,433% annual increase in sales price 6.8 16.6 6.0 6.0 6.0 6.0Penetration - Organized Finance 75.0 75.0 75.0 75.0 75.0 75.0

Size of potential passenger car market (Rsbn) 748 668 680 778 924 1,116Loan to Value (LTV) Ratio 75.0 75.0 75.0 75.0 75.0 75.0Potential financing requirement 561 501 510 583 693 837% annual growth -10.7 1.8 14.5 18.7 20.8M&HCV finance market (Rsbn) 335 270 202 223 269 322% annual growth -19.3 -25.3 10.3 20.8 19.7LCV finance market (Rsbn) 166 189 162 179 220 267% annual growth 14.0 -14.3 10.3 23.0 21.8


Two wheelers an interesting opportunity, but small in size

Chart 30: Domestic sales of two wheelers

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1

F Y 1 2

F Y 1 3

9 M F Y 1 4

( % )

( m n )

Two-wheeler sales Annual growth (RHS)

Source: SIAM, I-Sec research

The growth outlook for the sector remains intact in the medium and long term, themain drivers being:

• Enhanced impetus on the rural economy by the Union Government and other

stakeholders. Budgetary support to socio-economic programmes like MGNREGSremains high and there seems to be a renewed focus on the agriculture sector.The Planning Commission envisages 4.0% annual growth in agri-output during the

12th five year plan (2012-17).

• Increasing dealer network in the rural and semi-urban hinterland coupled withaggressive roll-out of new products at competitive prices.

• Innovative financing schemes by NBFCs like direct cash collection

• Rural sales have contributed approx. 40% of the total domestic sales in the lastcouple of years and are expected to increase going forward. Overall, key theme inthe sector would revolve around tapping the unexplored rural market andincreasing penetration in urban areas primarily via product launches. For example,

after stagnating for many years the scooter market has started to look up again

especially in the more urbane market. One point of caution for the typical bank

loan product in this segment is upfront dealer incentives of 4-5%, which skew theloan economics despite high yields.




44

Finance penetration remains low in the two wheeler market

The 2 wheeler financing market is estimated at Rs83bn and expected to grow at a

CAGR of 17.6% over FY13-17E. The penetration rate for organised financing isestimated at 20% with LTV of 75.0%

Table 23: Potential f inancing opportuni ty in 2 wheeler market

FY13 FY14E FY15E FY16E FY17ETotal 2 wheelers sales (mn) 13.8 14.8 16.5 18.9 21.9% annual growth 2.9 7.0 12.0 14.0 16.0

Avg. sales price per vehicle (Rs) 40,000 40,000 40,800 42,024 43,285

% annual increase in sales price (Rs) 0.0

2.0

3.0

3.0

Penetration rate (%) 20.0 20.0 20.0 20.0 20.0

LTV ratio (%) 75.0 75.0 75.0 75.0 75.0

Potential financing requirement (Rsbn) 83 89 101 119 142% annual increase 7.0 14.2 17.4 19.5

Source: SIAM, I-Sec research

Unsecured lending business in its infancy in India, awaiting largescale proof of concept

Credit cards loans comprise just 0.5% of total bank loans or 2.4% of retail loans forthe banking system (as of Dec-13), with the private sector and foreign banks (themajor players) going cautious on this segment post the financial crisis of 2008. During

FY07-08, outstanding credit card loans more than doubled given the economicmomentum and has slowed down considerably since then with spiking of credit costsand risk aversion on part of the larger players. Some of the prominent foreign players

such as Deutsche Bank have completely exited this segment. Having burnt theirfingers, banks have tightened their risk management systems with preference forexisting customers with savings accounts. Access to CIBIL scores have also helped

significantly in new customer acquisition and some of the new generation banks suchas IndusInd are aggressively building their market share in the segment.

Personal loans as a product has been growing at a fair clip, growing at a CAGR of14.3% since FY09 in a period when credit card outstanding actually declined 12.9%.

CIBIL has played a critical role in greater acceptance for this product from the banking

system.

Chart 31: Growth has stopped in credit cards… Chart 32: …but personal loans has thr ived

(40)

(20)

0

20

40

60

80

100

120

0

50

100

150

200

250

300

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1

F Y 1 2

F Y 1 3

9 M F Y 1 4

Credi t card loans (Rs bn) % YoY growth (RHS)

(40)

(30)

(20)

(10)

0

10

20

30

40

0

500

1000

1500

2000

2500

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1

F Y 1 2

F Y 1 3

9 M F Y 1 4

Personal loans (Rs bn) % YoY growth (RHS)





45

Education loans – a policy focus

Education loans comprised 1.1% of total bank credit or 5.9% of personal loans as ofDec-13 and since FY07 have grown at a CAGR of 22.5%. Traditionally, public sectorsbanks have been the most prominent players in this segment given their focus oninclusive banking and well established presence in the hinterland. Loans uptoRs0.4mn are classified as priority sector lending (PSL) and comprises ~96% of the

total outstanding education loans (as of Dec-13). Such loans do not require anysecurity with the parent classified as a joint borrower. SBI is the market leader ineducation loans with share of ~25% followed by Punjab National Bank at 7.1%.

An uncertain job market of the last few years, along with steep rise in educationrelated expenses (with salary levels stagnating) has meant that delinquencies in thissegment are rising. In the FY14-15 interim budget, the Govt. of India has announceda moratorium for all education loans taken upto March 31, 2009 and outstanding ason Dec 31, 2013. GoI will take over the liability for outstanding interest as onDecember 1, 2013, with the borrower paying interest for the period after January 1,2014. This move is expected to benefit ~0.9mn borrowers and the liability on thegovernment would be around Rs26bn.

Chart 33: Educational loans growing fast Table 24: SBI Student Loan Scheme

0

5

10

15

20

25

30

35

40

45

0

100

200

300

400

500

600

700

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1

F Y 1 2

F Y 1 3

9 M F Y 1 4

Education loans (Rs bn) % YoY growth (RHS)Loans upto Rs0.4mn Base rate + 350bps

Loans between Rs0.4mn to 0.75mn Base rate + 375bps

Loans above Rs0.75mn Base rate + 175bps

Source: SBI; I-Sec research


Gold loans – not a natural product for banks given ticket sizeand operational requirements

The concept of loan against gold was largely present in South India and was driven bymoney lenders, NBFCs and select regional banks till late 2008 when the three large

NBFCs – Manappuram, Muthoot Finance and Muthoot Fincorp entered into a pan-

India expansion spree. While easy availability of funding through the securitisation

route was the key catalyst, low-cost operating models also helped in hectic branchexpansion across the country. This was followed by strong media campaigns withpopular brand ambassadors with the primary aim of positioning gold as a readysource of liquidity and implicitly attacking the stigma attached to pledging gold.

While South-based banks upped the ante by competing aggressively in the gold-loanspace, most large banks considered it as an operationally difficult business till asrecent as 2012 – key deterrents being low ticket sizes and elaborate operating

requirements in the form of requiring a valuation expert, having a strong-room and




46

handling cash. The strong overall growth and low credit costs prompted the large pan-

India banks to look at lending against gold as a growth area. While SBI, PNB, Axis

Bank and other large players primarily saw it as a secured route to achieve theiragriculture lending targets, HDFC Bank started growing its gold-loan business

aggressively over 2011-12.

Over the past 2 years, a host of private sector banks have started disbursing loansagainst gold as a retail product. Axis Bank, IndusInd Bank, ING Vysya Bank, Yes

Bank and ICICI Bank are the key players to have announced the launch of thisproduct. For most of them, it is a phased launch, wherein the product has beenlaunched in select branches, especially in the metros.

With specialized NBFCs LTV competitive once again, we feel that beyond a certainbalance sheet size, this product cannot form a large part of a commercial bank onaccount of operational intensiveness and ticket size related constraints.




47

Annexure 2: Index of Tables and Charts

Tables

Table 1: Branch reach preparedness and impact ............................................................. 7

Table 2: Priority sector classifications ....................... ......................... .......................... ..... 8

Table 3: GNPAs of banks: PSL vs. Non-PSL ......................... ......................... .................. 8

Table 4: Our assumptions on priority sector assets post bank-conversion (29.2% assumedto full compliance) ...................................................................................................... 9

Table 5: Priority sector related exposures......................................................................... 9

Table 6: Scenario analysis – IRR to current shareholder ......................... ....................... 10

Table 7: The tradeoff between buying now or later ......................... ......................... ....... 14

Table 8: A few success stories ........................ ......................... ......................... ............. 16

Table 9: Possible RoE scenario vs current model (no PSL forbearance)........................ . 20

Table 10: Possible RoE scenario vs current model (with PSL forbearance) .................... 21

Table 11: IRR calculation table....................................................................................... 22

Table 12: Possible RoE scenario vs current model (no PSL forbearance) ....................... 26

Table 13: Possible RoE scenario vs current model (with PSL forbearance) .................... 27



Table 16: Possible RoE scenario vs current model (with PSL forbearance) .................... 32 Table 17: IRR calculation table....................................................................................... 33



Table 20: Loans outstanding and market share .......................... ......................... ........... 40

Table 21: Potential financing opportunity in India CV market ........................ .................. 40

Table 22: Market opportunity estimation ....................... .......................... ........................ 43

Table 23: Potential financing opportunity in 2 wheeler market ....................... .................. 44

Table 24: SBI Student Loan Scheme ............................................................................. 45




48

Charts

Chart 1: The discount between SA cost and bulk rates has narrowed ........................ ....... 4

Chart 2: CA as proportion of NDTL is 2/3rd of Mar – 08 levels ....................... .................... 5

Chart 3: Amongst the large banks, CA growth has been strong for only Axis ................... 5

Chart 4: CASA expansion is not a corollary of branch growth ....................... .................... 6

Chart 5: Priority sector asset proportion of ANBC ....................... ......................... ............. 9

Chart 6: Dilution scenarios impact IRR significantly ........................ ......................... ....... 11

Chart 7: Equity inflow into banking in last 10 years ......................... ......................... ....... 12

Chart 8: Generic likely structure ..................................................................................... 12

Chart 9: Credit mix: Urban vs. Rural ......................... ......................... ......................... .... 15

Chart 10: Loan CAGR: FY1993-FY2013 – Urban vs. Rural ..................... ....................... 15

Chart 11: Likely holding structure ......................... ......................... ......................... ........ 18

Chart 12: Asset pie (Dec-13) ....................... ......................... ......................... ................. 19

Chart 13: Liability pie (Dec-13) ........................ .......................... ......................... ............ 19

Chart 14: IRR scenarios based on dilution...................................................................... 22


Chart 16: Proportion of funds from deposits for HDFC and LICHF (5 years) ................... 24


Chart 18: Liability pie (Mar-13) ....................................................................................... 24









Chart 27: Mortgages market share scenario ......................... ......................... ................ 39

Chart 28: CV asset quality – securitized pools ....................... ......................... ................ 41

Chart 29: Growth rates across different passenger car segments ......................... .......... 42

Chart 30: Domestic sales of two wheelers ......................... ......................... .................... 43

Chart 31: Growth has stopped in credit cards… .................... .......................... ............... 44

Chart 32: …but personal loans has thrived ........................ ......................... .................... 44

Chart 33: Educational loans growing fast ....................................................................... 45




49

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