September 29, 2008

Analysing ICICI bank – from a depositor’s perspective

The major events over the last few weeks created a small scare for some of the Indian banks. The fear was the level of exposure to the Lehman Brothers bankruptcy and the ongoing credit crisis.

Considering that a lot of us including my family and me have our savings with ICICI bank, I decided to have a look at the Annual report of the bank in detail. Following is the analysis of the bank from a depositor’s perspective (and not an investor’s perspective).

Some positives
The bank raised 20000 Crs in 2007. As a result of the issue, the CAR (capital adequacy ratio) now stands at around 14%. The bank has an annual profit of around 4150 Crs and a consolidated profit (including subsidiaries) of around 3100 Crs.

ICICI has several subsidiaries. In aggregate the subsidiaries are making losses, mainly due to the insurance sub. Due to the insurance accounting (expensing the policy expenses in the current year), the insurance subsidiary has been showing increasing losses as it grows. However the subsidiary has value, which is growing. In all, my personal estimate for the valuation of subsidiaries is around 23000 Crs, which is around 30% of market cap and almost 50% of book value

The bank has been in the limelight due to the losses incurred by the collapse of Lehman brothers. This has been a case of availability bias. The market has been focused on the dramatic instead of the important (as usual).

The derivative related losses (dramatic) incurred by the bank have been to the tune of around 887 Crs which have been charged to the P&L statement (marked to market) and around 203 Crs, which have been charged to reserves.

AS 30 accounting requires mark to market accounting (and P&L pass-through) for certain derivatives and reserves adjustment for others (read AS30 to understand the details).

At the same time there has been a rise in the Gross NPA from 4850 Crs to 8350 crs. This increase is more important for the bank and its valuation as retail assets account for around 60% of the bank’s assets. However the market did not react strongly to this important change as it is hidden in the Balance sheet. The NPA have increased further in the current quarter. In addition the provision are around 55% of Gross NPA. So there is still an exposure of around 3500 Crs, which could hit the P&L in the future.

accounting is pretty complex
Bank accounting and especially derivative accounting is complex. It is very difficult to make out whether the bank is making or losing money on its entire derivatives exposure at any point of time. The bank discloses the total notional exposure which is atleast 1000 times or more of the net exposure. The profit or loss is a multiple of the net exposure. So it is difficult to figure out the profit or loss on the derivative book based on the bank disclosures alone.

In addition mark to market accounting is also misleading. It is equivalent to drawing your personal profit or loss based on change in share prices. If you think a stock is worth 100 rs, and you bought it for 50 rs and the price dropped to 30, how will you account for it ?

Mark to market accounting says, report a loss of 20 now. If the price jump to 70 in the next quarter then reverse this loss and report an ‘income’ of 40. However you may choose to ignore these swings and say I intend to hold the share for next 3 years and believe the market is mispricing the stock in the interim.

So what is the truth ? frankly there is no objective truth. It depends on the specific instrument and circumstances. Accounting requires being conservative and hence the loss of 20 in the current quarter.

This is the kind of complexity we are dealing with derivatives. The bank may very well have losses on the portfolio or they may right in saying that these are only notional losses as the underlying credits are still intact.

are there solvency issues ?
I think there are no solvency issues for the bank based on the current losses and statements from the bank. The bank has reduced the credit derivatives by almost 800 Mn usd. This does not mean that the bank will not have losses in the future due to derivatives. There is a huge derivatives exposure (notional) on the banks balance sheet.

As of March 2008, the fair value for the derivatives was positive and for interest swap is midly negative (page 116) , so the bank is not losing money on those derivatives (as of march 2008) . However this value may turn negative in the future.

However the point to remember that the bank is making around almost 1000 crs per quarter on a standalone basis. In addition it has a high capital cushion and assets in the form of subsidiaries. So there is a decent amount of capital cushion to absorb any of these losses. There is always a risk of unknown losses hiding in the balance sheet in the derivative books due to black swan events. I frankly cannot evaluate and estimate those losses from publicly available documents.

Finally the trump card for the bank is the concept of ‘Too big to fail’. Do you think the Indian government would risk allowing the bank to fail (second largest bank in the country) and jeopardize the financial system?

valuation based on book value ?
I am amazed at the simplistic valuations done by a lot of people and analysts. For ex: ICICI is selling at X times book value and hence it is a buy !! If you read the Annual report, you will realise the complexity of this company. It would be silly to value the bank based on book value alone
The bank has assets (subsidiaries) and risk (derivative exposure) which are quite difficult to estimate (atleast for me). A simple book value based valuation is a foolish way to value this bank.
The minimum analysis to arrive at the final valuation is to value the bank and its subsidiaries. The derivative exposure and other liabilities need to valued separately and the net value should be derived from the difference. Luckily, investing in stocks is not like exams where I will get flunked for not answering a question. I can always pass on the stock.


Mahendra Naik said...

Hi Rohit,

Great analysis. I too feel unsure whether the stock is an investment candidate, due to its agressive policy of lending which might increase NPA's. Housing and real estate prices are widely expected to fall and this could create the proverbial black swan effect. But I don't think that depositors have a reason to panic just yet. As you rightly pointed out we need to keep a keen watch on the emergence of a black swan, which can upset all calculations.

Rohit Chauhan said...

Hi mahendra
my take is that icici is too complex to analyse. so if it is possible to invest in simpler businesses ..then why bother

as buffett says - unlike diving, the market does not pay you by the level of diffculty. you get paid equally for a simple to understand business as a complex one.

so icici in my case goes into the 'too diffcult' bucket


VISHNU said...


Cash held in Banks are backed by Government but the money market funds are not. (I am not sure though)

Hence I have equally distributed the surplus cash into ICICI Bank , HDFC bank, HDFC fixed deposits and ICICI Liquid Fund and UK pounds into CITI and ICICI.

I think ordinary investor should diversify their money into two three solid banks and their FDs and some in Money Market funds


Rohit Chauhan said...

Hi vishnu
the cash in bank and deposits are insured for a princely amount of 100000 rs. the rest is at risk if the bank goes under