Financial institutions and risk

November 12, 2007

 update: 09-Nov – A great post on the valuation of financial firms and the diffculty of doing so …see here

I have written on banking earlier. You can find my analysis of allahabad bank here. Most of you must be aware of the subprime crisis. I discussed it briefly here.

Banks and financial instutions by their very nature are highly leveraged organizations. So the risk of bankruptcy and losses is higher with banks. Citibank is one of the largest bank in the world and has seen its stock drop by 35% this year. The CEO has just resigned. You can read all about the crisis here.

So what does citibank and the subprime crisis have to do with banking in india. Well a lot … Let me digress and tell you a short story.

The year is 1996 or maybe 1997. I was starting to invest and saw an article on IFCI (I guess you must have already got the hint or must be thinking ….what a Bozo !). Well, the article said that IFCI is a good opportunity as it was near its 52 week low and had a dividend yield of almost 5-6 % (don’t remember the numbers exactly). So thinking that I had found a good opportunity I promptly bought some stock.

Fast forward: 1998-1999. IFCI is a government controlled institution. Politicians look at it as their piggy bank. So if you are a well connected businessman, launch a project, get funding from IFCI, take your money out and refer the company to BIFR. So by 1999, I think IFCI had more than 12% NPA and was bankrupt. There was hardly any dividend and the stock had tanked by more than 70%.

So the moral is …..

1. Don’t base your investments on someone else’s analysis
2. Investing based only on dividend yields is not a good idea. Investing in financial institution based only on dividend yields is a very bad idea unless the financial institution is sound and can maintain the dividend.

So what has happened with citibank is possible with Indian banks too. Banks have a lot of leeway in hiding bad loans. Indian public sector banks due to political interference can end up with even more and these bad loans or assets come out only later. It is difficult to judge asset quality just from the balance sheet

Added note: I have an NRI friend who had invested in citibank based on the dividend yield. Just out of curiosity I downloaded the AR of the bank and my head started spining. It is more than 100 pages, very complex and very difficult to understand (especially for me and may be the CEO too who got fired for not understanding or maybe underestimating the risks).


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