City Union Bank is the oldest private sector bank in India, started in 1904 as Kumbakonam Bank in the Tamil Nadu city of the same name. It was primarily started as a bank to serve the banking needs of farmers and traders in the surrounding region.
The bank has the distinction of being among only 10 banks which have been consistently profitable and paid dividends for over 100 years of operations. For a bank to survive and thrive for such a long period of time, there need to be very strong risk management practices, as a bank is probably the riskiest type of company around and even a small misstep can lead to devastating results.
We will cover some of the important reasons why City Union Bank has been successful all these years. But before that, let us understand in brief what a bank does and how it earns profits. Essentially, a bank collects deposits in the form of current accounts, savings accounts, FD, etc., and lends the money to the right set of borrowers who have the need for the money, willingness, and ability to pay back the loan. The difference in interest rates lent to borrowers and paid to depositors(net interest income) is where the bank makes its money from. They also make some additional income(non-interest income) broadly split into 2 types
- Commission, fees for processing transactions, loans, and selling any additional services like insurance, mutual funds, etc.
- Money earned from investments in government bonds (mandated by RBI to maintain a certain % as investments)
The income the bank makes from net interest income and non-interest income should be greater than all expenses for it to be profitable. The expenses could be split as
- Operating expenses i.e. paying employees, rent of branches and other buildings, etc.
- Bad loans (any borrower not paying back principal and interest)
Let us see how CUB has been able to successfully demonstrate superiority over peers in each of the above to deliver best in class risk-adjusted margins
CUB is a niche lender focused on MSME, traders, and agriculture. These are segments that are generally not targeted by the big banks and hence, these credit-starved segments generally yield higher interest rates on loans in comparison to the salaried class.
CUB has a high proportion of retail deposits, visible in their concentration of top 20 depositors below. Also, the bank has been focusing on garnering higher CASA (Current account savings account) deposits, which are very sticky and low-interest cost.
CUB has been consistently making other income of around ⅓ of net interest income. Overall, this is an area where the bank is on par with other MSME-focused banks, though much lower than larger private sector banks, which earn a good amount of fee income through credit cards, etc.
CUB has amongst the lowest operating expenses (cost to income ratio) among its peers. One important reason is the lower salary per employee in comparison to peers, yet 0 union issues in the last 115 years of operations, which is a rare feat considering other banks of similar history.
One potential area of improvement is to improve business per branch, as it seems to be lagging in comparison to the competition.
a. CUB has amongst the most granular borrower profile
b. CUB does mostly secured loans only (99% of loans are backed by collateral; usually by immovable property like residential). Hence, even if borrower defaults, historically they have been able to recover 70% of the money through selling off collaterals
c. High granularity in terms of industries lent to. The top 10 industries account for only 24% of total loans
With these steps, they have been able to consistently maintain very good asset quality resulting in very low bad loans (credit costs)
Above all of these, the management quality needs to be super good to continue executing on a daily basis without mis-steps.
Consistency in leadership: Only 7 CEOs in 115 years!! This has led to consistency and focus of strategy towards MSME, traders and agriculture primarily focused on Tamil Nadu(64% of advances, 80% of deposits)
Conservativeness - asset quality over growth: CUB has delivered growth above industry credit growth in most of its last 25 years except in 1999-2001, 2006-07, 2014-15. These years were right before the industry went into bad loan crises.
The bank resisted lending to infra companies during the late 2000s when most of the public sector banks went overboard on lending to them. CUB has stuck to working capital loans (66% of total loans) over the years.
Corporate governance: CUB has the highest number of independent directors on the board (89%); has high disclosure in terms of product, industry exposure
Strong execution: Looking at the management’s guidance in terms of loan growth, bad loan expenses, expectations on return ratios, and their delivery on the same in the last 5 years, CUB has been bang on most occasions barring FY2021 when COVID hit.
- High credit costs due to COVID: CUB has higher than usual credit costs during COVID as MSME (the primary borrowers of CUB) has been one of the most affected segments. This has been one reason why the stock has still not recovered to pre-COVID levels.
- High restructured loans: CUB also has the highest amount of loans restructured(change in loan payment terms; usually a sign of caution that it might turn out to be NPA in future). But, this was the situation during the last cycle in 2009-10 also and CUB came out of it with very few restructured loans moving to NPA.
- Increasing competitive intensity: The larger private sector banks have turned quite aggressive in luring MSMEs as they see a big opportunity there. With the level of technology at the disposal, the value proposition that HDFC Bank, ICICI Bank, etc. provides to MSME companies can affect the long-term structural growth rate of CUB.
But, it is during headwinds, that we get good deals. City Union Bank has proved over the years that it is a steady compounder and given the near-term headwinds is available at quite an attractive valuation.