Bank stocks lost ground last week as Reserve Bank of India's new norms on dividend declaration caused worries of lower pay-outs. But analysts affirm banks still have a strong investment case. The only difference is that the focus will now be on growth, not just dividend yields and low valuations.

If you are worried that the banking story at the bourses is over, don't fret yet. Sure, the sector scrips came in for a terrible hammering last week, following the RBI decree which will result in lower dividend pay-outs. But there is still hope. Plenty of it, in fact, if you believe analysts who think that the RBI's intervention may actually be a good thing.

Even though exit polls were thought to be the big culprit behind the blood bath at the bourses, dividend declaration norms did prove to be the major dampener for bank stocks. The downturn was visible across banking counters and more so at the counters of Federal Bank, Karnataka Bank, Allahabad Bank and Union Bank. But there were crumbs of comfort amidst the pall of gloom.

Banks that passed RBI's test for declaration of dividends held their ground, notably HDFC Bank, Vijaya Bank, Andhra Bank and J&K Bank. ICICI Bank and Punjab National Bank (PNB)did not satisfy the criteria, yet remained firm. But what kept these stocks from slumping further was the hope that at least a majority of banks will be able to meet the RBI's requirements by FY05.

The guidelines

The latest guidelines issued by the RBI regarding dividend declaration state that the regulatory focus would shift from 'quantum of dividend' to 'dividend pay-out ratio'. To declare dividend without RBI's prior permission a bank must have a capital to risk-weighted assets ratio (CRAR) of at least 11 per cent for the preceding two completed years and the accounting year for which it proposes to declare dividend.

Besides, the bank must have net NPAs of less than 3 per cent. The dividend pay-out ratio should not exceed 33.33 per cent of net profits (excluding extra-ordinary items), in any case. Earlier there was no limit on the pay-out ratio, though banks which intended to declare more than 25 per cent had to seek prior RBI approval.

The winners

Going by this criteria, only eight banks listed on the bourses (from both public and private sectors) qualify based on FY03 financial numbers. Analysts say many banks were preparing for high dividends this year, thanks to higher profits. This may not be possible now. Analysts fear that the RBI may ask them to temper pay-outs this year. In fact, it may be in banks' interest to keep dividends modest this year to avoid going to the RBI for approval in the coming years.

There ends the bad news. The good news is that many more banks are likely to join the gang of eligible candidates once their FY04 results are out. The club is expected to expand further even more by FY05.

To date, banks have been concentrating on the 'quantum of dividend' paid which did show an increasing trend whereas the pay-out ratio actually saw a decline.

We considered a period of five years (1999-2003) where the quantum of dividend (for 29 banks) paid out has been steadily increasing whereas average pay-out ratio has been consistently falling.

Take the case of Federal Bank where the quantum of dividend increased from Rs 217 crore (Rs 2.17 billion) in 1999 to Rs 869 crore (Rs 8.69 billion) in 2003 whereas the dividend pay-out ratio declined from 85.77 per cent to 8.27 per cent in the same period.

The same holds true for HDFC Bank where the quantum increased from Rs 2,600 crore (Rs 26 billion) to Rs 8,495 crore (Rs 84.95 billion) while the pay-out ratio declined from 31.55 per cent to 21.92 per cent.

The fact is that over the last couple of years banks have been riding on lower interest rates. Driven by bumper profits emanating from treasury gains, banks have been generous in declaring dividends. Total dividends handed out by listed banks in 2003 were Rs 193,556 crore (Rs 1,935.56 billion) compared with Rs 70,022 crore (Rs 700.22 billion) in 1999. The pay-out ratio during the period has come down from 22.87 per cent to 19.60 per cent.

Going forward, treasury profits may vanish but banks may be under pressure to keep up dividend rates. Analysts say RBI's intention to shift focus from quantum of dividends to pay-outs is only to spare banks from making such irrational pay-outs.

Looked at another way, high dividends are not always in favour of depositors - a higher outflow of dividends will mean lower net worth for the bank. Lower net worth limits the ability of banks to take large exposure.

Banks with high net worth can take higher risks that can translate into higher growth. "The RBI may be trying to protect depositors' interests," says Hemindra Hazari, senior vice president, Ask-Raymond James. Much to the displeasure of shareholders? Not really.

Because banks then will strike a balance to keep both depositors as well as share holders pleased. Agrees Sohini Andani, banking analyst with LKP Securities, "The cap on pay-out is a prudent step by the RBI." If banks pay out more dividends, their ability to lend decreases. This does not mean lesser dividends for shareholders because banks have barely been paying more than 33.33 per cent in the past five years.

Another view is that the RBI is trying to put in place stringent practices for banks to help them gear up for Basel II norms that are expected to come into play in FY06. "RBI essentially wants banks to retain capital for further growth," explains Jinesh Gopani, banking analyst with Emkay Share Brokers.

This is where a CRAR of 11 per cent or more will help. Further, NPA requirements of less than 3 per cent augur well for banks in another way. Analysts note that shedding excess baggage will leave room for retail defaults that are expected to hit banks in the next one-two years.

They also point out that these norms will only help banks clean up and look forward to faster growth. Most banks are in fact eyeing NPA levels of 2 per cent and lower by FY05. Banks have already started taking initiatives on lowering their NPA levels, aided by the Securitisation

Act and prudent restructuring of assets.

However, markets are worried. "Fears that the quantum of dividends will reduce in FY04 have affected sentiments," says an analyst with a foreign brokerage house.

However, this is only for the immediate year-end and, if one goes by what analysts say, FY05 should look appealing. "Banks will declare dividends in the range of 25-30 per cent by FY05," says Hazari.

More importantly, banking sector is now all geared in terms of cleaning up balance sheets - reducing NPAs, undergoing restructuring and getting technologically savvy. If this process continues (there is no reason why it should not), we could well be looking at soaring profits as well as better dividend pay-out ratios, say analysts. This also opens up the case for consolidation among banks as weaker banks will find it increasingly difficult to survive.

In any case, analysts say investors cannot just sit on high dividend yielding stocks and be happy anymore. They need to concentrate on banks' growth stories which means hunting around for banks that offer potential high growth.

"Dividends were just a cushion and now it's the growth story that will drive banks," says Gopani. Seconds Puneet Srivastav, banking analyst with Enam Financial Services, "At current levels, investors are not really buying bank stocks for dividends."

The banking sector shall now be viewed as any other industry rather than just dividend yielding stocks. One fall out will be that some mid- and small-sized banks that saw share prices zoom primarily on account of attractive dividend yields may loose their sheen. With the economic boom in the country set to continue, the sector is surely looking for better times ahead.

Growth bets

Consensus estimates from analysts give us a list of some banks that are 'must-hold' for investors looking for growth stories. Topping the list is PSU biggie State Bank of India.

The bank still has analysts maintaining a positive stance. And why not? SBI's size, strength, pro-activity in terms of incorporating technology and thrust on retail make it a representative of the confidant mood in the sector. "Even on valuation terms, the bank still has room for a higher stock price," says Srivastav.

Though SBI has not yet qualified for the RBI norms, it is expected to meet the criteria by FY05. As on March 31, 2003, the bank's NPA stood at 4.5 per cent and its CRAR at 13.50 per cent. At a current price of Rs 642, SBI trades at 6.9 times its FY05 earnings with an EPS of Rs 93.

The main reason cited for growth is a renewed thrust on retail, increasing fee-based income and improving asset quality. Some other banks that figure on analysts' list are Canara Bank (NPA and CRAR are 3.59 per cent and 12.5 per cent respectively as on March 31, 2003), Punjab National Bank (3.86 per cent and 12.02 per cent), Oriental Bank of Commerce (1.4 per cent and 14.04 per cent) and Corporation Bank (1.88 per cent and 20 per cent as on March 31, 2004).

All the above mentioned banks and many more are expected to meet the eligibility criteria by FY05.