What makes HDFC Bank the bank it is today? Why does everyone buy it?

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Reading Time: 7 minutes


HDFC
bank is the most expensive banking stock in the world in terms of price to book
value. What makes it get that valuation? Let’s find out!

Ray
Dalio, hedge fund manager at Bridgewater Associates (one of the world’s largest
hedge fund) always breaks complex mechanisms or processes into sum of the parts
(Fun Fact – He used this very approach when McDonald’s wanted to launch McNuggets).

We
will do the same to find what a Bank takes in (input) and what it gives out
(output). This will help us understand how a bank functions in a very simple
manner!

HDFC Bank’s input is the deposits they take from savers. (Cost of funds represents the rate of interest they give to their deposit holders which are savings accounts, term deposits, and other deposits.)

HDFC Bank’s output is the loans they give to borrowers. (The weighted average
cost of lending to borrowers)

The
difference between the loan rate and the deposit rate net of all the other
expenses is what they earn in simple words.

Reason 1 – Lending is
all about betting on the leader.

When someone bets on a banking stock, one bets not on the horse but completely on the jockey. Everyone has branches (some have more and some less) and everyone has the same raw material (deposits), and hence it is imperative that the person steering the horse is a person you can bet your house on! When the promoter of a bank is excellent like Aditya Puri he will create rules in a way that the bank and minority don’t get hurt. If you think I am just going on and on about only good things of HDFC Bank let me give you the best example which tells the ground of ethics and carefulness this bank is built on.

Everyone
knows that Aditya Puri, who sits at the helm of HDFC Bank, has built HDFC Bank
into India’s most valuable bank by the bank’s efficient risk management
framework which has only benefited shareholders all along. He was recently asked why he refused loans to his
“friends” Vijay Mallya and Nirav Modi, both now fugitive offenders
that owe large sums of money to banks. He said, “Somebody in Mallya’s
office will tell you, every time the call came from me, Mallya gaali deta tha
(he used to abuse). His blood pressure would go up”. He was referring to how HDFC
bank declined Mallya’s requests. “Friendship and banking are not co-related. If
you are a bad risk, you are a bad risk. You can be my good friend, I can give
you coffee and send you away.” He added that both Mallya and Modi had come
to him for a loan, “I gave them coffee and told them that I will consider
the loan.”

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Coming to the Altico liquidity crisis, we saw that the HDFC bank enchased its security while other banks kept waiting for restructuring and other terms. This was very much at the dismay of SBI and when interviewed Aditya Puri said: “He is only there for the protection of interests of his deposit holders, offer competitive rates and if anyone does not behave in a proper way, he is there to kick them.” While we know him as the master strategist at HDFC bank, this episode also sheds light on the ruthless side of his which is essential since Lending is a difficult business and difficult times can call for difficult strategies.

Reason 2 – Both Cost of funds and loan rate amongst the
lowest.

For Q2FY20 (September 2019 quarter) for all the banks I had complied cost of funds, and here is how the top bank which is HDFC Bank stacked up against its peer set-

Just notice one thing here that HDFC Bank’s cost of funds (CoF) is one of the lowest in the whole Banking industry at 5.3% while the majority of the other banks’ CoF is much higher than that!

Coming
to the personal loan rates of HDFC Bank, we see it is at 10.75%-13%.

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https://qphs.fs.quoracdn.net/main-qimg-c45940f7869270215297009d000b4942

And
now coming to the personal loan rates of another mid-sized Bank, we see it is
at 17.5%-24% and other additional charges of 2 to 2.5% taking it to over 25%!

https://qphs.fs.quoracdn.net/main-qimg-ca72537b708d5ff4c030f2816707ca2f

Now ask yourself, if you are a good borrower with good credit history, good repayment history, and stable cash flows, why would you ever go to another Bank who has a 20-25% loan rate when you can get a loan at 13%?

Herein
lies the answer, a good borrower will always go to HDFC Bank borrow at good
rates and pay them back. However, a less quality borrower will go to lower
sized banks or any other bank and avail the loan at higher rates as some of the
stringent quality checks of HDFC Bank may have made the borrower ineligible.

So in HDFC Bank, this process becomes a full circle with good lending, good repayment, and good profits. For other banks that do very aggressive lending without stringent checks, their lending to borrowers becomes a game of probability with the loans becoming NPAs sooner or later. (They will come out as NPAs during tight liquidity market conditions or economic down cycles. We all know of a bank that had NPAs coming out continuously which is starving for capital now.)

Reason 3 – The branch network is unparalleled

HDFC Bank is one of India’s leading private banks and was among the first to receive approval from the Reserve Bank of India (RBI) to set up a private sector bank in 1994. Today, HDFC Bank has an unmatched banking network of 5,345 branches and 14,533 ATMs spread across 2,787 cities and towns. Here is a depiction of its branch reach –

Reason 4 – During the
IL&FS crisis (Oct 2018), they weren’t affected at all.

HDFC Bank before and After IL&FS Crisis –

Quarter / Month GNPA in Rs Cr NNPA in Rs Cr GNPA in % NNPA in %
June 2018 9539 2907 1.33% 0.41%
September 2018 10098 3028 1.33% 0.40%
December 2018 10902 3301 1.38% 0.42%
March 2019 11224 3215 1.36% 0.39%

Observations – We see that HDFC Bank’s GNPA and
NNPA percentages were largely unchanged which shows how well the company was
cushioned against the IL&FS crisis in terms of both liquidity and asset
quality.

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The bank’s stellar performance and stable asset quality during the time of crisis are commendable.

Here is another bank’s NPA before and after IL&FS
Crisis –

Quarter / Month GNPA in Rs Cr NNPA in Rs Cr GNPA in % NNPA in %
June 2018 1741 762 1.15% 0.51%
September 2018 1781 788 1.09% 0.48%
December 2018 1969 1029 1.13% 0.59%
March 2019 3947 2248 2.10% 1.21%

Observations – We see that this Bank’s GNPA and
NNPA percentages were continuously increasing and notice the number of NPA (in
Cr) which shows hints of lenient lending. GNPA and NNPA more than double!

Only when the tide goes out (in our markets tide going out meant the
liquidity tightening from the money markets) do you discover who’s been
swimming naked. – Warren Buffet.

Reason 5 – Savings rate amongst the lowest due to its
trust, excellent performance history, and promoters

The current interest rate offered on funds in a Savings Account is 4% per annum for HDFC Bank while for other banks it ranges from 5-7%! Here is the deposit number of HDFC bank as of December 2019 –

While
here is the deposit number for one of the banks offering higher interest rates

Confused? One bank offers a lower interest rate and still has deposits growing, while one has a higher interest rate but deposits still shrinking? The answer lies in Trust and brand name! HDFC Bank has never cheated its depositors or gotten cheated( by way of default through NPAs ) from its borrowers.

All of the above factors are quite
visible in its share price! (Split, dividend not even included)

This is why HDFC Bank is HDFC bank and is a darling of investors from FIIs with thousands of crores under their assets and retail investors with thousands of rupees in their demat account!

Hope you liked reading this article,

Aditya Kondawar

Disclosure – Please do not construe this article as a piece of investment advice. It is written simply for educational purposes.

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Aditya Shah
Aditya Shah is a SEBI-Registered Investment Advisor. He is the founder of Hercules Advisors that invests for the long term in high quality publicly listed Indian companies at reasonable valuations.
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