Private Banks and NBFCs vs Public Banks: Who wins?

The Banking and Financial Services Industry (BFSI) is unique. You see, irrespective of which sector/industry a company might be in, they have to interact and do business with at least 1 entity from the BFSI industry – most commonly a bank.

The industry is arguably one the most important of them all and forms the backbone of the country. The BFSI industry is responsible for being the custodian of funds of the public as well as large institutions and it is also responsible for efficiently allocating and lending capital to those pockets of the economy that need it the most.

The banking space comprises of Public Sector Banks (PSBs) – that are government-owned, private sector banks and Non-Banking Financial Companies (NBFCs). Let’s look at the industry through a looking glass to identify where opportunities for investors lie.

Overview of NBFCs in India

A non-banking financial company (NBFC) is a monetary institution that performs most of the functions of a bank such as providing loans for various purposes, financial leasing, bill discounting etc. However, unlike banks, NBFCs cannot accept deposits or issue cheques drawn on itself. Normally, a conventional bank accepts deposits and inturn lends out that money as loans for a slightly higher rate of interest – thereby earning a spread – also called interest margin. However, since NBFCs are not allowed to accept deposits, they raise money from banks and mutual funds, which they, in turn, lend out as loans for a slightly higher rate of interest.

Based on the nature of the business, NBFCs can be classified as – asset finance company, loan company, investment company, infrastructure finance institution, microfinance institution, factoring firm, infra debt fund or housing finance company. Bajaj Finance Ltd, Housing Development Finance Corporation (HDFC), Indiabulls Housing Finance., and LIC Housing Finance are some of the popular listed NBFCs in India.

The NBFC sector in India has undergone a significant transformation over the past few years and is today seen as an integral part of the Indian financial system. NBFCs have played a key role in the development of the infrastructure segment. Over the past few years, a significant chunk of debt financing for infrastructure projects has been flowing in from NBFCs. They have also been providing credit to retail customers in underserved and unbanked areas, playing a key part in advancing Governments programme of financial inclusion.

NBFC’s – assets and profits over the years

NBFCs have been building their business in areas like Micro, Small and Medium Enterprise (MSME) finance and mortgage products. This is evidenced by increasing assets of NBFCs as a percentage of banking assets. Moreover, very interestingly, NBFCs usually target underbanked segments of the population. This allows them to earn higher profits compared to banks, leading to a higher return on equity.

ROE comparison – NBFC’s versus banks

2018 was the first time when a crisis in the NBFC sector came to light when some of the big names of the sector started defaulting on their repayment obligations. Having said that, the govt. has been proactive in tackling the crisis in a way that it didn’t blow up to become an economy-wide contagion. Other secular trends like low credit penetration in India compared to other economies and low NBFC credit as a percentage of GDP, when compared to other middle and high-income economies, provides a huge opportunity for NBFCs to grow.

Overview of Private Banks in India

Private sector banks in India include local area banks, payment banks, small finance banks and foreign banks. Most of these banks have been at the forefront of adopting technology solutions like the expansion of ATM networks and internet/phone/mobile banking solutions. They have also been hiring direct selling agents to sell credit products. This has allowed private banks to provide better services and amenities to the customer thereby allowing these banks to offer stiff competition to their public sector peers.

Private banks have certain other advantages compared to public sector banks (PSB).

Compared to 2016, public sector banks have witnessed a drop in their market share – they account for 61% of total banking assets (vs. 75% in 2016) and 58% of total income as of the end of FY18 (vs. 71% in FY16).

Public and Private banks – share of total assets

Moreover, private banks have indeed been growing at a faster rate.

Listed private vs public sector banks – Total income growth comparison

Non-Performing Assets (NPAs)

Higher inflation, cyclical downtrend and the coronavirus pandemic have led to a drastic drop in demand across various sectors. This has led to losses and companies have not been able to service loans that they had availed from banks. As a result, such loans turned “bad” and banks have had to write them off.

Higher bad loans or non-performing assets leads to lower profits and lower return on assets. Increasing bad loans also have a direct effect on the amount a bank is able to lend as loans. If banks are not able to lend a larger portion of the deposits they have collected as loans their future profitability will also be adversely affected.

Though all banks have seen a rise in NPAs over the past 5 years, private banks’ bad loans are lower compared than that of public sector banks (PSB). Gross NPAs of private banks stood at around 5% in 2020. During the same time, NPAs of public sector banks stood at about 9.7%!

The effect of higher NPAs on return on assets is more prominent in the case of PSBs. The average return on assets of PSBs between 2015 – 2019 was -0.46% compared to 1.02% for private banks. This has resulted in lower loan to deposit ratio of PSBs compared to private banks. The average loan to deposit ratio, between the financial year 2015 to 2019, for PSB’s was 65.3% compared to 89.7% in case of private banks.

Expected revival in economic activity, government support wherever required and relatively normal monsoons are all expected to improve prospects of the banking sector going forward. As the Indian economy grows, the one underlying sector that fuels this growth is certainly going to reap rewards.

Within the banking industry, it’s the private sector banks that are relatively well capitalised, more efficient, and poised expected to grow faster than PSBs. Which is why there is a smallcase that includes stocks of the most rewarding & promising NBFCs and Private Banks – which are best positioned to benefit from India’s accelerating economic growth.

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