In October 2016, I had written a post about how I let an opportunity to buy HDFC Bank in the middle of 2006 pass by, and why I have never come to regret that decision (the stock has turned into a 10-bagger since then!).

My reasons to miss that stock was my inability to understand the complexities of the banking and finance business, and more importantly that I have never trusted banks to uphold high levels of honesty and integrity in their business operations.

I received a lot of brickbats for that post for castigating an entire sector (and the bank) that has created so much wealth for shareholders in the past, and that constitutes such a big part of India’s stock market capitalization.

Well, I stand by my thoughts which, by the way, are my personal thoughts and are not binding on you to also avoid stocks from the banking and financial services space.

Investing is a personal affair, and what makes me uncomfortable can be comfortable for you, and vice versa.

Anyways, now the question is – Why am I writing a second post on my unwillingness to invest in banking stocks?

As a customer, I’ve had a harrowing experience with my bank (again, HDFC Bank) in recent times, and thus wanted to find a way to vent my anger against the system that banking has come to become – a system that not just compromises on ethics in the way it operates, but is also rigged in favour of the elite (senior bankers, industrialists, politicians, etc.) and often at the expense of its small customers, and sometimes investors and taxpayers.

Before I begin, let me take you back to the last major crises we had in India.

Do you remember the end of 2008? No, not the stock market one. But one when uncertainty had enveloped the real economy in India. Contrary to the ‘decoupling theory’, India was hit by the banking and financial crisis that had its roots in the western world. Small businesses were closing for want of funds. Jobs were at risk. People almost stopped buying real estate, and thus real estate demand collapsed. You remember all that?

Now, do you remember what happened to real estate prices then? Well, they fell for some time and marginally, and then rose again to beat their previous highs.

People weren’t buying real estate that was already expensive across the country, and despite the collapse in demand, realty prices did not fall much.

This defies economies, isn’t it? The price of something is usually determined by its demand and supply. A thing that is in excess supply and faces low demand sees a fall in its price. But Indian real estate defied this in 2008 and 2009.

Here is a chart that explains why it may have happened.

Data Source: RBI
This chart shows the growth in Indian banks’ non-agriculture lending versus growth in lending to commercial real estate sector (real estate companies; not individuals borrowing to buy real estate). See the red line between mid-2008 and mid-2009, when the crisis was at its worst. Even as bank lending to the Indian economy, in general, took a hit, lending to real estate sector surged.

 

In fact, in the month of January 2009, when most of the new construction activity was frozen as demand had collapsed and real estate companies’ balance sheets were stretched, the annual growth in bank lending to commercial real estate stood at 67%, versus 23% growth in non-agricultural lending.

Why do you think this happened? When bank lending to the broader economy had taken a big hit, why were banks still lending more and more to real estate companies?

Let’s invert this question – What would have happened if banks did not lend more and more to real estate companies then?

The straightforward answer is – many real estate companies in India, with their stretched balance sheets, negative cash flows, lack of creditworthiness, and facing a collapse in demand, would have announced bankruptcies. But that did not happen.

No real estate company in India went bankrupt because banks kept their taps of cash open for them, despite knowing that a large part of what they were lending may not come back.

Now the question is – Why would banks do that? Didn’t they check the creditworthiness of their customers – real estate companies in this case – before lending?

Well, if that’s always the case – that banks really check the creditworthiness of their large clients before extending credit – how in the world do you think would India’s top-most banks lend thousands of crores to bad businesses like Kingfisher, Jaypee, Essar, JSW, GMR, and GVK even when they would do endless amount of KYC and sometimes deny lending when you and I go to borrow Rs 10 lac or Rs 1 crore?

Note that, in this case, we are talking about lending to real estate companies that also find support among politicians. How difficult would it have been for politicians to call the big bosses at banks and ask them to lend to save real estate companies they were connected to?

If you can find a mid-level credit manager appraising lending at a bank (search from within your friends, like I did, as they would be honest with you), you would know how lending is often done at the whims and fancies of the bank bosses (and big industrialists, and politicians) than the creditworthiness of the borrowers. And the bigger the lending amount, the bigger is the potential for corruption. This is because senior bankers receive bigger incentives – direct and ‘indirect’ – the bigger the amount of money they lend. Damn the return of the money thus lent.

Enough has been said and written about how banks globally have mishandled their small customers to favour the big ones (Wells Fargo is a recent example). In this case of Indian banks’ lending to non-creditworthy real estate companies during 2008 and 2009, it was your deposit that went on to fund a troubled real estate company, which thus managed to avoid bankruptcy, which helped it keep its property prices artificially high despite weak demand, which ultimately hurt you as a potential buyer who could not afford an expensive property.

If this side of the banking system’s high-handedness isn’t enough, look at the practices of banks who, in their aim to grow profits despite rising bad loans and low recoveries, have fleeced small depositors with charges that have changed frequently and arbitrarily.

I wrote about my harrowing experience with HDFC Bank’s fraudulent charges on Twitter recently. And it’s not the first time that I was fleeced by this bank, with whom I’ve had a 14 years’ relationship, which I am looking to end now.

 

Anyways, how I have been fleeced isn’t much considering this fraud perpetrated by HDFC Bank on its ‘preferred’ clients. As detailed in this post, the bank sent emails to its preferred clients offering them the services of a virtual relationship manager, for which a fee of Rs 100 per quarter would have been charged. Now, this wasn’t the fraud. The fraud was that someone from their business development team had this brilliant idea of placing a “opt out” link near the end of the email to ensure that if the recipient did not read the email and did not opt out of this service, he was automatically considered an opt in (in short, silence meant consent), and would be levied this fee.

 

Call this the heights of being unethical and deceitful. But that’s how so many banks have acted over the years, rarely in the interest of its customers, especially the smaller ones. (See here – Moneylife’s petition against banks fleecing depositors)

And, by the way, I have not even touched upon another area where banks’ maligned interests come to fore – the rampant misselling of financial products like insurance policies to gullible customers.

Here I remember the 24% annual return from mutual funds and insurance that Bollywood actress and singer Suchitra Krishnamoorthi was guaranteed by HSBC a few years back, and where she lost a large part of her money. As is known now, the bank used confidential information about the hefty deposit in Ms. Krishnamoorthi’s savings account and began to market bad investments to her.

Not just celebrities, countless small depositors have lost their hard-earned savings investing in bad financial products mis-sold to them by their bankers and relationship managers.

How Deep is the Malaise?
Tamal Bandyopadhyay wrote a nice article in Mint recently on corruption levels in the Indian banking system. You would be aghast at some of what he wrote –

…the pressure on giving loans without proper risk assessment mounts on senior executives just ahead of their interviews for promotion. If they don’t oblige, the risk of missing promotion is high. The senior executives also run the risk of being transferred to places not to their liking if they reject a loan proposal, recommended by the boss.

The current boss of a government-owned bank has recently told his executives to sanction loan proposals that he recommends (of course, verbally) and not bother about whether they will turn bad. His philosophy is: As long as the loan book is growing, none should bother about non-performing assets as bad loans as a percentage of overall loans can be contained through aggressive loan growth.

Tamal also wrote –

Instances of borrowers taking care of a senior banker’s child’s education overseas or picking up the tab for wedding reception of the daughter and even honeymoon at Bali are not rare. Similarly, a real estate firm may not mind selling a flat to senior bankers at a hugely discounted price to ensure speedy appraisal of the loan process. There are also borrowers who offer “annuity” to bank chiefs after their retirement to express their gratitude for the support extended to them in appraisal of loan proposals and disbursements of loans.

The annuity comes in the form of annual holidays, chauffeur-driven cars and guest house or hotel accommodation at certain cities.

Now, this is not to say that all banks are deceitful or all bankers indulge in corruption. I have seen and known honest, hard-working bankers. But the fact remains that banks in India, like globally, remain hotbeds of corruption. And the malaise is deep..very deep.

Whom to Blame?
Blame the misaligned incentives for the same. A banker is awarded a bonus or incentive not for making high quality, but high quantity loans. Relationship managers are incentivized when they meet their targets for the number of insurance policies and other investment products they sell, not whether what they sell are good for customers or not. Branch bankers are incentivized for the number of accounts they get in, forget the way they manage the relationship with account holders.

What Henry Ford said about the American banking system long time back stands true even today, in America and in India –

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

And what America’s founding father Thomas Jefferson said also remains true to the core –

I sincerely believe…that banking establishments are more dangerous than standing armies.

The irony is that, despite all their misdoings, banks are often not allowed to fail (their stocks may go to zero, but they still survive). This is because repercussions of a bank failure would be felt on the economy.

Then, those perpetrating crimes at banks – who are often at senior levels – don’t go to jail. So, even when banks may pay steep damages for their misdoings, don’t expect any senior executives to be criminally indicted.

In other words, it’s a system that’s totally rigged in favor of the banking elite, and it’s often at your expense…as a customer, investor, or taxpayer.

It’s a Bizarre System
They’ve created a system whereby we entrust our hard-earned savings to banks that never miss an opportunity to abuse that trust. Look at it this way. When we make a deposit at banks, we become their unsecured creditors. And in exchange for taking on that counterparty risk, the banks provide us almost zero transparency in what they’re doing with our money (like bailing out real estate companies or lending to other unscrupulous promoters).

Even still, they are protected by the government and are not allowed to fail, especially when they grow large to shake up the entire economy.

So, forget understanding their complex financial statements, I personally don’t find any compelling reason for investing in a business that’s tainted and often does not treat its employees and customers well. There are hundreds of other untainted and simple businesses I would rather look at.

I prefer investing that helps me sleep peacefully at night. In that pursuit, I am fine missing out on the wealth creators some banks may become.

Banks and financial institutions find a place only in my “too hard” and “too terrible” baskets. But as I mentioned above, it’s purely a personal choice.