Getting Stronger With Every Covid Wave

As we now have six quarters of reported financials since the pandemic began, we are getting a clearer picture of the impact of Covid induced disruptions on lenders. Despite the severe second Covid wave, the increase in GNPAs i.e. net slippages for KCP lenders such as HDFC Bank, Kotak Bank and Bajaj Finance during the second wave was almost half of that of the first wave. Similarly, while KCP lenders took 3-4 quarters to get back to 18-20% growth post the first wave, they were able to resume their normal run rate of 20% annualized loan book growth within a quarter of the second wave (at a time when banking system credit was not growing). In this newsletter we quantify the impact of the Covid waves on the KCP lenders and discuss aspects around tech investments, conservative underwriting and superior access to capital which enable KCP lenders to balance asset quality and growth.

Performance update of the live fund

The key objective of our “Kings of Capital” strategy is to own a portfolio of 10 to 14 high quality financial companies (banks, NBFCs, life insurers, general insurers, asset managers, brokers) that have good corporate governance, prudent capital allocation skills and high barriers to entry. By owning these high-quality financial companies, we intend to benefit from the consolidation in the lending sector and the financialization of household savings over the next decade. The latest performance of our PMS is shown in the chart below.

Source: Marcellus Investment Managers, all returns are net of fees and expenses (TWRR); Since inception         returns are annualized; Other time period returns are absolute

Impact of Covid related disruption on the asset quality of KCP lenders

KCP lenders have been able to deal with the impact of Covid on asset quality better than the rest of the industry because of the following reasons:

•    Conservative lending and underwriting practices:

As lending is a long-term business, the outcome of actions taken by lenders today are known only a few years later. To generate sustainable returns across cycles, lenders need to underwrite keeping in mind not only the external environment that exists on the date of the disbursement, but also account for other risks which may arise in the future during the tenure of the loan. KCP lenders tend to follow conservative lending practices irrespective of the external environment, enabling them to grow in a calibrated manner rather than delivering abnormally high growth during good times and degrowth during bad times. For instance, the DNA of conservatism exists across verticals and across various levels of seniority at Kotak Bank. Even Kotak branch employees are well aware of the type of loans which will be accepted within the system and the type of loans which will be rejected thus consistently reinforcing a culture of sound underwriting practices across the organization. Similarly, during 2006-11 many banks aggressively lent money for long term project financing. However, in line with their conservative lending practices, HDFC Bank and Kotak Bank stayed away from project financing despite the ample availability of growth opportunities. This ability to maintain discipline during good times means that KCP lenders suffer less on asset quality during times of economic turbulence. During the past 18 months, the KCP lenders have further tightened their credit filters resulting in collection efficiencies (i.e collections during the month divided by amount due for the month) during November and December 2021 being better than even pre-Covid levels.

•    Healthy risk adjusted spreads leading to strong operating profitability:

KCP lenders have the ability to price risk prudently leading to strong operating profitability (even if we leave provisioning out of the picture). The strong operating profitability of KCP lenders enables them to absorb credit costs during stressful times and thereby keep the balance sheet resilient from any asset quality related shocks. For instance, Bajaj Finance had delivered average net interest margins (NIMs) of 9.8% during FY15-20 and during these five years its average GNPAs were 1.8%. Thanks to Bajaj Finance’s healthy NIMs and strong operating profitability, the firm was able to create provisions of Rs. 6,000 Cr when Covid struck in FY21 and still generate a PAT of Rs. 4,400Cr. As illustrated in the exhibits below, the KCP lenders have been able to wash off most of their Covid related stress pool through the P&L either through write offs or provisions. The residual stress pool highlighted in the exhibits below is including all restructured loans even though it is unlikely that all restructured assets will eventually become NPAs (thus creating the possibility of asset quality writebacks in the years to come).

•    Strong collections infrastructure:

Unlike many newer age NBFCs and fintech players who have shown aggression on the lending side but lack a well-established collections infrastructure, KCP lenders have invested heavily over the years to build a vast collections infrastructure. For eg. HDFC Bank has boots on the ground for physical collection in over 2,900 Indian towns and cities. Similarly, because Bajaj Finance does small ticket unsecured loans, it is important to have a delinquency bucket wise granular collections infrastructure which is able to collect overdues in a cost-efficient manner. Because EMIs in the consumer durable financing business are of a few thousand rupees, if the unit cost of collection exceeds a few hundred rupees then it becomes an unviable business to run at scale. 25% of Bajaj Finance’s staff of ~26,000 employees is in the collections team and they work with hundreds of other collection agencies resulting in relatively better asset quality vs. peers. The KCP lenders have further accelerated their investments in collections infrastructure over the past 6 to 12 months.

As illustrated in the exhibits below, the net slippages and stress pool creation during the first Covid wave was significantly higher than during the second Covid wave. This difference was despite the moratorium available to borrowers during the first Covid wave. The recent investments in collections infrastructure, strong operating profitability and sound underwriting practices of KCP lenders will continue to mitigate the asset quality impact of any subsequent waves of Covid. Some of the examples of initiatives taken by KCP lenders is as follows:

1.    Bajaj Finance went live (in Q2FY22) with its new productivity app for debt management service for ~9K employees and ~34K+ agency resources. The app enables agency staff onboarding, cash receipting, training, communication, compliance features, dialer integration and call recording. The app also enables agency staff to help customers with a host of service-related queries. Also, In Q2 FY22, the company increased its employee strength by over 2,000 to support collections infrastructure and its growth stance.

2.    Similarly, Kotak Bank went aggressive on its hiring stance for supporting both collections and growth stance, the bank added over ~4K employees alone in Q2FY22 (~10K added employees in FY21). To continue with its sound underwriting practices, the bank remained fairly conservative on unsecured consumer credit amidst both the waves of covid and found comfort in growing the secured mortgage piece. Post covid 2.0, the bank saw green shoots emerging and went aggressive growing unsecured credit at ~10% QoQ in Q2FY22.

Source: Marcellus Investment Managers, Company Financials; Note: The opening GNPA on the left chart refers to FY20 exit GNPA

Source: Marcellus Investment Managers, Company Financials; Note: The opening GNPA on the left chart refers to FY20 exit GNPA

Source: Marcellus Investment Managers, Company Financials; Note: The opening GNPA on the left chart refers to FY20 exit GNPA

Impact of Covid related disruption on growth of KCP lenders

•    Well capitalized to capture growth opportunities:

KCP lenders are well capitalized with Tier-1 capital being higher than pre-Covid levels for most lenders. This enables KCP lenders to capture growth opportunities without worrying about equity fund raises and dilution in the near future. For instance, Kotak Bank, HDFC Bank and Axis Bank have been exploring the acquisition of Citi’s retail business in India for $2Bn. Post Covid, not many other Indian banks are in a position to evaluate such large inorganic growth opportunities to consolidate market share.

•    Investment in digital infrastructure and technology:

As highlighted in the July, 2021 KCP newsletter (click here to read), Bajaj Finance’s digital transformation 2.0 is likely to be one of the most radical transformations for a large lender. The key theme is to create an app based omni-channel ecosystem which will provide flexibility to customers to move online to offline and vice versa in a frictionless manner. Transformation 2.0 will enable Bajaj Finance to not only double its existing customer base but also mine the wallet share of its existing customers in a cost-effective manner. As customers have started moving online, KCP lenders are investing in technology to engage with customers online, acquire customers online and disburse loans online. Such investments were accelerated post the first Covid wave which resulted in a lower impact on growth and a rapid resumption of normalcy for KCP lenders during the second Covid wave.

•    Easy access to low-cost deposits/debt:

KCP lenders are able to raise debt/deposits at a low cost even during challenging times. For instance, even when Yes Bank was put under moratorium in 2020, HDFC Bank and Kotak Bank despite being private sector banks saw a huge inflow of low-cost deposits. Resultantly, post Covid Kotak Bank has been able to reduce the rates it offers on Savings (SA) deposits to less than 4% from the 6% it earlier used to offer. Similarly, even through the first wave of Covid, Bajaj Finance was able to raise money from banks, through deposits and from the money market at competitive rates despite having a large unsecured loan book. This access to low-cost debt across market cycles enables these lenders to grow their loan book consistently. This also helps KCP lenders deliver market share gains during tough times when other lenders are struggling to raise debt/ deposits.

As illustrated in the exhibits below, the KCP lenders have been able to rebound to normalized growth levels within a quarter of the second Covid wave. Access to low-cost funds, investments in technology and excess Tier-1 capital will lead to such resilience and continued market share gains for KCP lenders.
Source: Marcellus Investment Managers, Company Financials

Source: Marcellus Investment Managers, Company Financials

Source: Marcellus Investment Managers, Company Financials

The ability of the KCP lenders to grow their loan books at a healthy rate over the next few years without raising fresh capital is underscored by the table below which shows just how strong their balance sheet position is INSPITE of the KCP lenders provisioning for NPAs far more aggressively than large public sector banks.

Source: Marcellus Investment Managers, Company Financials; Note: Above details are as of Sep’21; PCR includes all provisions (specific/floating/general etc.)   *PCR includes only specific provisions for BoB.

Note: HDFC Bank, Kotak Bank and Bajaj Finance are part of many of Marcellus’ portfolios.
Regards,
Team Marcellus
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