Are India’s banks healthier than before? The answer to this question typically involves looking at how much capital banks have and the proportion of problem loans they hold.
While these ratios do reflect the health of banks’ balance sheets and are often involved in finding out the value of a bank, there is no better measure than real-time market valuation to know how strong or weak banks are.
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This is what a study by the Reserve Bank of India (RBI) staff shows. Particularly, the study shows that price-to-book ratio (PBR) of banks is an important indicator of the value of a lender on a real-time basis. So much so that the ratio can be a valuable input in policymaking.
The PBR indicates the market value of the bank relative to its book value. It captures not just the balance sheet metrics but also other intangibles such as efficiency of banks, their franchise value and regulatory costs.
“In other words, driven by intangibles, the market value of banks over and above their book value may have more to do with their performance as perceived by economic agents based on their efficacy in fund utilization, asset-liability management and resolution prospects, among others,” the study said. It is easy to find examples for this. Take the case of public sector banks (PSBs). Lenders owned by the government saw their PBR drop below 1 after the asset quality review (AQR) in FY17. The AQR found a hidden pile of troubled assets in private sector lenders too. But their PBR has been superior to that of PSBs.
One of the reasons could be that investors view private sector lenders as being more efficient and nimble than their public sector peers. Further, given their ownership. Public sector lenders are also viewed as more vulnerable to policy changes. Importantly, the PBR likely captures how strong is a bank’s credit risk evaluation and monitoring, the study said. This could be one key reason for lower valuations for government-owned banks.
“Additionally, PBR can be construed as reflecting the standards of accounting and financial reporting practices in banks,” the study said.
Interestingly, the PBR does not have a very high correlation with the level of capital that a bank has, the study found. This is because the RBI requires banks to maintain a minimum level of capital. As long as banks maintain this minimum level, the market perception is similar for all lenders. But when public sector banks saw far higher erosion of capital and some dropped below the required regulatory minimum, the PBR dropped below 1.
Finally, PBR has a strong correlation with credit-to-gross domestic product (GDP) and output gap, the study found. That means it captures the cyclical ups and downs well in advance. It is clear that not only investors but the RBI too is watching the price-to-book ratio to see how the lenders it regulates are performing.