The Promise and Perils of the Financial Industry: Dispersion of Returns and Opportunities for Investors
The financial services industry is a curious beast. It’s been around for thousands of years, with the practice of lending and borrowing money dating back to ancient civilizations such as Greece and Rome. Hence, it’s often easy to assume that firms with a long track record must have some intrinsic quality that allows them to weather economic storms and adapt to changing markets. But as we’ve seen time and again, that’s not always the case.
Take Lehman Brothers. The investment bank had been in business for over a century before it went bankrupt in 2008, sparking a global financial crisis. Or consider Barings Bank, which was founded in 1762 and had a history stretching back over 230 years before it went bankrupt due to unauthorized trading by one of its employees.
So why is the financial services sector so prone to turbulence? Perhaps it’s the result of a confluence of factors: A complex array of financial instruments and markets, the intricate web of relationships between different institutions, and the ever-evolving regulatory landscape. Or maybe it’s just bad risk management and fraud. But one thing is certain: in the financial services industry, even a sound balance sheet is not enough to guarantee success.
The collapse of Silicon Valley Bank serves as a timely reminder of the same. The liquidity crisis that led to SVB’s collapse was caused by a mismatch between the duration of its assets and liabilities, but allegations of poor management and weakened regulations also contributed to the loss of trust in the institution. As a result, customers, primarily consisting of technology startups, began to withdraw their deposits, exacerbating the crisis. The perception of the bank’s financial health was just as crucial as the reality, and the concentrated customer base accelerated the spread of negative perceptions, resulting in a quicker withdrawal of funds. This case serves as a reminder that a strong balance sheet alone cannot guarantee success in the financial services industry. If customers do not perceive an institution as financially sound, a loss of trust can be devastating.
In 2018, India faced the IL&FS crisis that sparked a liquidity crunch, affecting the financial sector for over a year. The default by IL&FS Financial Services on some loan repayments and commercial paper redemption obligations sent shockwaves through the commercial paper market, leading to large-scale liquidity withdrawals from mutual funds. Non-banking financial companies (NBFCs) with wholesale/structured finance books, such as Dewan Housing Finance (DHFL), Indiabulls group, and Reliance Capital, were hit hard, facing an extreme asset-liability mismatch. The crisis later spread to banks such as Yes Bank, which had significant exposures to these groups.
The Yes Bank crisis caused concerns in the financial system, with the RBI orchestrating a recapitalization due to larger-than-expected problems. While the financial sector was grappling with the aftermath of the Yes Bank crisis, the COVID-19 pandemic emerged as a new crisis. The asset quality crisis was particularly severe as the lockdowns and disruptions to economic activity impacted borrowers’ ability to service their loans. Smaller players, especially those with higher exposure to semi-urban areas, were particularly vulnerable, and many of their borrowers, who were self-employed or worked in the informal sector, had their incomes significantly impacted by the pandemic.
The larger banks were better positioned to navigate the crisis thanks to their diversified loan portfolios and higher capital buffers. They were able to provide relief measures to their borrowers and manage the increase in non-performing assets. The type of borrowers also played a significant role in determining the impact of the crisis on the different banks. Those having a higher proportion of corporate and high net worth borrowers being less impacted than those with a higher proportion of retail and small and medium enterprise borrowers.
Despite the challenges faced by India’s financial sector in recent years (both asset and liability side), the promise of the sector remains strong. The vast untapped market and increasing demand for credit and financial services offer tremendous potential. However, the sector’s cyclical and disruptive nature means that not all financial companies have been able to perform well, despite significant growth in assets and lending. This is a reminder that while the structural promise of the sector is undoubtedly present, it does not guarantee success for every player. To illustrate this point, take a look at the chart below.
It showcases the distribution of return data for companies in the financial sector in the BSE 500 index from 2010 to 2022. The lines on the chart span from the 25th percentile to the 75th percentile, with the median depicted by a teal line in the middle. The length of the vertical lines indicates the variability in returns within the financial sector for any given year. The average difference between the 25th and 75th percentile for those thirteen years was a staggering 44%.
It is clear that there is significant variability in the returns among financial companies, with some experiencing negative returns and others achieving substantial growth. The chart underscores the importance of careful analysis and informed decision-making when investing in the financial sector. While this variability may be concerning, it also presents as an opportunity for investors who have the ability to navigate the sector’s challenges and minimize obvious errors.
As Charlie Munger famously said, “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” In other words, while one may not be able to magically pick the best bets every year, avoiding the obvious mistakes over time should lead to outperformance in the long run.
This article is written by Mehul Jani, Parijat Garg and Dhruv Maniyar.
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