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The aim of the project was to understand the Economic Structure and Institutional Playoff of the Banking
Sector with the factors leading to variations in both the economy and the sector. The factors initially in a
top-down hierarchy were divided into phases as follows:

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While doing the institutional analysis, the first step is to understand the global market. The global market
induces impact on some important factors which in turn are highly correlated to the Sector under
consideration. As the global factors are analyzed the next step is to understand the exact economic
sequence in the economy. At times, the globe may be witnessing a major breakdown while the economy
under consideration may be stable and developing rapidly in accordance to its peers. This may include an
in depth analysis of some factors which are directly related to the sector and have been in touch with the
global scenario as well as with the company in consideration. As soon as the economic factors are
analyzed, the next step is to understand the impact of these as well as some inbuilt factors. This
essentially involves the in depth analysis of the company in consideration. Along with sector valuation,
the valuation of the companies are carried out. In order to understand the financial health of the company,
the industry verticals and their ratios are then compared with those of the company.

 

The last 2 years have seen major changes in the global system leading to major imbalances, the
imbalances have largely impacted the factors changing the factors affecting ecosystem. The analysis was
dependent upon the changes developed in the Interest rate Spreads, Global net Exports, Currency
Exchange Reserves have been on the rising trend as due to recession, the globe witnessed a major
economic credit crunch. In my research I was able to find that, one of the root cause of the near recession
was the accumulation of foreign currency reserves by major developing countries like India and China.
The research was based on the fact that developing economies are in need of capital inflows to finance
their projects. The only way was to accumulate the currencies, this lead to openness of these economies
through trade opening, domestic financial liberalization etc. For a developing nation this (openness) is the
only source of capital inflow. Due to poor restructuring and maintenance of these developing nations,
world experienced the Latin American and Asian Crisis in late 20th century. These nations on other hands
have been able to manipulate or undervalue their currency to increase their exports (China).

It can aptly understood to be pro-cyclic in nature but also counter cyclic in working. This self
protectionist environment has lead to many imbalances including deregulation and free fall of commodity
market. All this was attributed to the Financial Development in the developing economies.


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With the outset of the most hard hitting recession since the World War II, many global indicators like
exports, credit and saving, etc. did impact many economic indicators. While doing Institutional analysis,
the various indicators analyzed include:

1.p GDP
2.p Domestic Savings Rate
3.p Interest Rates
4.p Tax rates
5.p Foreign Exchange Reserves
6.p Deficit/ Surplus
7.p Inflation
8.p IIP

After analyzing these indicators, the GDP, Interest Rates, Tax Rates, Foreign Exchange Reserves, IIP and
Inflation majorly affect the Banking Sector. In order to develop the relation there was a need to
understand the business cycles of both the economy and banking sector.

In this graph, the LRAS is the Long Run Aggregate Supply Curve which essentially is the real output
GDP in a fiscal year. The AD define the Aggregate Demand. In times of contraction, the demand may dry
up as there is credit crunch This may shift the AD curve towards left making the equilibrium price down.
In this case prices move down leading to lay-offs, as there is low profit. The only way is to shift the
LRAS towards left. This means the supply has to constrained. As soon as the supply reaches to this level,
the producers have actually cut-off their production. In reverse scenario, the demand may increase
abruptly. This may lead to higher price leading to disequilibrium. In order to bring prices back to
equilibrium, the producers have to increase their production making room for new employment or over
time. This leads to forecast of increasing demand and hence leading to piling up of inventory. In this state
the :RAS shifts to right making the economy to enter the boom state.
In boom phase, GDP increases as there is more consumption, the IIP may increase due to increase in
demand of the products produced. The boom phase may also lead to inflation surging if the supply is not
able to keep in pace with the demand. His may also lead to policies leading to sucking of liquidity from
the economy( increase in interest rates and tax rates). As the exports increase the foreign exchange
reserves increase. The very different is the case with the recession or contraction.

  

Banking Sector has been directly correlated to the economy. The reason being, the central element in both
of these was money transactions. Indian Banking Sector has been moreover isolated from the
Recessionary impacts the money market had witnessed. In 2008, the sector saw mixed valuations with
ICICI Bank being the laggard and Small Cap Banks impressing with their valuations. After recession, the
managements have taken steps to recovery rapidly. The development in the sector has been much faster
then anticipation. Credit growth has been pretty modest in FY2010 with loosening of policies by RBI.
The money lending became cheaper leading to demand in the economy. Consumption (GDP), was lead
majorly by Government Consumption. GDP growth had been strong after recession as the market price
and market cost spread had slackened.

Investment, Credit off-take have been on a rise due to increase in demand pushing recovery in the
economy. On a y-o-y basis investment in Retail increase by nearly 8% where as in wholesale index it was
6%. The time-deposit growth has increased post recession. There was a jerk in the movement during the
European Crisis, but due to sound fundamentals the economy bounced back in this sector.

RBI has recently launched the new policy of eradication of BPLR by Base Rate. This will lead to a lower
limit being enforced on lending to the clients. The spread which initially used to go to 550 bps has now
been arrested in lower bound and the spread is expected to decrease further.

With the policy of daily payment of interest, the banks with higher CASA may have to pay higher
interest. But CASA ratio would also help the banks to structure the Base Rate below the competitors.
Hence a trade-off has to be developed in this methodology. CRR hike in a sense was to have control over
rising inflation and to keep a check on bubble bursts. This has essentially lead to higher cost of deposits
making it more expensive for borrowers to borrow.

The major hurdle which still stands in front of the Banking Sector is the NPA. These are the assets which
have not been on the source of cash flows since last 3-4 months. During recession, credit crunch lead to
many assets be defaulted making them NPAs. Restructuring is the tool presently used by all banks in
order to develop a methodology to make provisions for the NPAs. In the process isolating themselves
from nay credit crunch in times of payoffs. The restructured loans were on the highest levels in2002 and
2009. Both were times after recession. Since 2006, the credit growth too has been declining, due to
uncertain sentiments still present due to recession and most currently the European Crisis.

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Axis Bank has been very strong on its fundamentals. The Net Profit of the Bank rose very strongly due to
outperforming strategies and developments. The Net Profit was Rs. 2514.52 crore in the fiscal year 2009-
2010. This is almost 38% higher then the last years Net Profit. The EPS was recorded at the high of 65.78
‰ with ROE having a flat movement from 19.93% to 19.89% this fiscal year.
Due to increased demand and supply in the system and with the monetary policies implemented by RBI,
money was pumped in the market to rise the economy out of the crisis. This lead to mass lending in the
market making a jump of nearly 14% in to provide a figure of 15583 crore Rs. as total income in the
present fiscal. The income is predicted to increase by nearly 20% this fiscal. This increase can be
advocated to increasing buying sentiments present in the market and the demand of capital to be invested
to properly adjust to the situations and rise at apace equal or faster then the economy. In the present
context, a rapid growth can be advocated as the policies presently implemented are in favor of demand
increment leading to price rise or more supply.

In the same period, there was an increase in both the operating revenue and profit in the Bank. The
Operating revenue growth was about 35.96% with a figure of Rs. 8950.27 crore. Whereas the Operating
Profit increased at a faster pace to Rs. 5240.25 crore. This indicates cost cutting which can be attributed
to decreasing interest expense and increasing income earned ( both interest and non-interest income).
Majority of Income came from selling of Investments in open market striking a near to 300% rise in the
interest earned in the category.

Total Earning Assets of the Bank increased by more than 20% to Rs. 133,308.75 crore. The NIM was
seen to increase at a rate of 37.26% which is very strong taking in to consideration the industry average.
The increment was vastly attributed to the low cost deposits supported by a sustained growth in bank
deposits, both current and savings. The CASA for Axis Bank was very high, leading to availability of
more low-cost funds for investment and lending making it more easier for the bank to lend at a lower rate
then other competitors.

In synchronization with the RBI policies the lending rate were reduced. This lead to decrease in yield on
earning assets by 101 basis points to 8.72%. The cost of funds on the other hand was much cheaper then
the earnings. The fall was much steeper at 130 basis points to 5.2%. Banks CASA ratio increase by nearly
450 basis points due to increase in current account investment by the customers. The ratio rose from
36.1% levels to 40.39% levels. Also the cost of term deposits fell by 189 basis points to 7.52%. All these
effectively lead to increase in NIM by 42 basis points. Bank added to its reach another 200 branches, with
ATM reach increased by 698 in the current year. All these attributed to increase in sales of the Bank in
the fiscal year dominantly. Due to expansions, Operating cost increased by nearly 30% to Rs. 3709.92
crore.


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With an uncertain environment present in the economy, the Bank faired in its valuations with very strong
growth in every aspect. Net revenues increased by 14% to Rs. 14192 crore. NII and other Income were
prime drivers of the growth in revenues. Growth in income was registered at a higher level with an
increment of 15.7%. The main drivers of this growth are increment in fee and commission charges and
fees from foreign and derivative contracts. Commission Income rose by 15.2% while income from
derivatives rose by 16%. Profits were incurred by selling of some investments in profits ranging to Rs.
345 crore. Similar to Axis bank, the yield was flat till the first 3Q. The actual rise came in the 4Q. Non-
interest income grew at a lower pace. The underperformance was due to the operating constraints. Still
the bank managed to open more 300 branches in fiscal year 2010. The other reason attributed to
underperformance was the rise in the levels of NPA.
Net Profit increased by nearly 31% to record one of the highest profits in the sector. Bank¶s investment
in retail sector was the major contributor of fee revenue. Bank¶s Retail Assets too faired the deals with
strong numbers.


   

In development of forecasts, the tools used depend upon the type of the end-user and also the type of
sector on whom the Valuation is carried out. Valuation of a banking sector requires a firm understanding
of various concepts like Book Value (BV), Adjusted Book Value (ABV). The work in the project was to
forecast the intrinsic or the fair value of the equities in consideration. The Valuation models was also used
to draft the price bands using all the multiples like PABV, PE. The valuations were initially governed by
the Assumptions of growth in various balance Sheet and Income Statement Items. It was on the basis of
these assumptions the future projection were developed.

In the valuation approach, the first method used was $%%&%'()The model used
here was a 2-stage DDM. In first The 2-stage model was used because Banking Sector has a similar
Business Cycle to that of the Economy. The two stage DDM has 2 phases. The first phase is of rapid
growth, the second phase is the phase from where the stable growth is speculated. In this case the first
dividend of the high growth rate period are discounted and added to the terminal value which is a function
of the stable growth rate, the COE and the number of years of high growth period .The approach was used
for both the banks like:

*)p !"#The COE of the Bank was developed using the CAPM method with Rf as 7%, ȕ as
1.22 and Rprem as 6.5%. The COE found was 14.9%. DDM method used was dependent upon
factors like Payout Ratio, ROE, DPS, COE. The Stable growth period starts from 2013. The time
from 2010-2012 is speculated to be in high growth period with a growth rate of 8% followed by
stable growth rate of 6%. The intrinsic value in this case comes out to be 1101.95 Rs. In 2011 the
PE would be then, 20 (EPS = 68). Also the PABV would be, 2.68 (ABV=507).

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"#The COE developed was 12.2%, with Rf as 7%, ȕ as 0.8 and Rprem as 6.5%. With
similar assumption of stable and high growth period as in Axis Bank, the stable growth rate was
9% while that of high growth rate was 11%. On application of the DDM valuation the intrinsic
value or the target value came out to be 1360.44 Rs. The PE for 2011 comes out to be, 15.29
(EPS=72). PABV of 2011 could then be developed as, 2.42 (ABV=437). 


Other methods used are the PE method of forecasting as well as PABV method of forecasting. For the
forecast development the market price of last 4 years was extracted and the required inputs like EPS and
ABV were then given as inputs. The results were then plotted on the graphs with certain degree of
multiples including 2x multiples (for PABV) or 10x multiples (for PE).
˜c,%The model used here is the forecast method. In this case the valuation is dependent on the
PE of the current year, the PE of the next year (forecasted). The values present are then scaled on for the
different multiples of the PE. The graphs thus generated with multiples along with the PE can thus be
used very effectively for valuation. For Axis Bank, the PE multiple would be around 16.66x with EPS
equal to 72. The target value would thus come out to be 1172 Rs. For HDFC Bank, the PE multiple 20.5x
with the forecasted EPS of 68 will again provide the target value of 1363 Rs.

˜ " ,% The model has similar inputs and formulation as the PE model. Just the EPS gets
replaced by ABV. The graphs are generated on the basis of PABV and the PABV bands. The bands
indicate technical understanding of the situation. The PABV can also be developed as (ROE-g)/(COE-g).
The formulation when multiplied with the forecasted ABV for 2011, which is 437, gives the intrinsic
value as 1230. Whereas for HDFC Bank, the intrinsic value comes out to be 1268 Rs with PABV as 2.5x.
In graphical Interpretation the 2.5x of HDFC Bank is a very strong resistance.

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The project also included Pricing Model, Black and Scholes Model, in which the Delta variations were
noted down and the portfolio was reconstructed in order to make the weights of two options similar to
thee benchmark. The Model included the analysis of movement in Delta (change in price of option to
change in premium) with prime formula used was:

˜ -. '%*(/ .'0 ( '%+(

Where:

d1 = ln(S/X) + (R + ı2/2)T

d2 = d1 ± ı*sqrt(T)

The model was used effectively for prediction of short term movements in the price of the underlying.

The last part of the Internship was to analyze the changes in Repo rate and its effects on the two stock
prices. Axis bank was observed to be more volatile with changes in Repo Rates.

˜ 1  The method is used to understand the movement of prices in the stock market.
Using Axis Bank as the Base, since 2009 Jan, Axis Bank has outperformed all the benchmark indices
(BANKEX, SENSEX, NIFTY) along with HDFC bank. Whereas, HDFC bank has been stable and has
risen above benchmark indices but lags behind price movements of Axis Bank. Also drawing Fibonacci
retracements has made it clear that Axis has broken its 123% level and is expected to reach 138£ level
form where a retracement can be expected. Whereas, HDFC Bank has already broken down the 138.2%
level and can be expected to retrace any time the benchmark indices become week.