India Equity Research | Banking and Financial Services Sector Update

BANKING
Pension ambiguity - bridging the gap

„ Pension liability pegged at ~INR 330 bn; equivalent to 14% of networth January 10, 2011
There is lot of uncertainty regarding the quantum of obligation that banks will add
to its outstanding retirement liability along with the extent of provisioning for the
same due to Second Pension Option (SPO) and increased gratuity limits. Our in Nilesh Parikh
depth analysis and interactions with banks’ management and various industry +91-22- 4063 5470
experts lead us to conclude that pension liability (pretax) for PSBs (SPO + wage nilesh.parikh@edelcap.com
revision catch up for existing employees under pension) will catapult by INR 330
bn. This translates into a hit of 14% on networth and if allowed to be amortised Kunal Shah
over five years, will imply a hit of 17% on earnings for banks. However, our +91-22-4040 7579
downward revision in earnings estimate is pegged at 3-7% as Street has factored kunal.shah@edelcap.com
in some provision based on pension liability indicated by banks (refer table 1).
Suruchi Chaudhary
„ Employee costs to move up structurally +91-22-6623 3316
We believe PSBs’ cost structure will undergo a structural change with almost the suruchi.chaudhary@edelcap.com
entire workforce falling under the pension scheme now. The servicing costs of
pension is ~24% of basic pay (compared to 10% under CPF), implying a 3-4% Vivek Verma
rise in employee costs. We expect cost/income ratio for banks to move up by 100- +91-22-4040 7576
150 bps and RoEs to be adversely impacted by 40-60 bps as cost escalation is vivek.verma@edelcap.com
structural in nature. Moreover, banks will be exposed to shortfall/surplus on
account of actuarial valuation for the entire workforce.

„ Wage revision catch up not talked about; DA unspoken pressure point

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We arrive at the bank’sfrom
SPO 59.165.151.3 at at
liability (pretax) 2011-01-20
~INR 270 15:28:18
bn (refer EST.
table ISI-Emerging-Markets.
3)
implying that extrapolating Union Bank’s liability only to arrive at SPO obligation
for other banks will lead to an over-estimation. However, what is not much
discussed, is the jump in banks’ liability due to increase in pension obligation for
employees already under the scheme due to the wage revision – we estimate
catch up liability at INR 59 bn (~INR -0.2 per employee). Dearness allowance
(DA) is another unspoken pressure point in bank’s employee cost, given the high
inflation scenario banks are operating in. DA adversely impacts employee costs
due to higher wage bill, pension payout and rise in provisioning for future
retirement benefits. Sensitivity of retirement liability to DA is maximum compared
to other variables like discounting factor, life expectancy etc. (refer table 9).

„ Resolving INR 63 bn to ~INR 270 bn liability conundrum

The moot question at this stage is what caused the quantum jump in SPO liability
to such high levels from INR 63 bn estimated at the time of settlement. While INR
63 bn was based on 2007 salary levels i.e., before the wage hike, our numbers
fully incorporate the current service costs for each year of service in between,
wage hike impact and most importantly the DA increase. The outstanding pension
liability/employee jumped from INR 0.8 mn to INR 1.5 mn, of which INR 0.3 mn
(INR 97 bn for industry) is due to the exorbitant level of inflation, and INR 0.2 mn
each (INR 60 bn) for wage revision and current servicing cost (refer chart 2).

„ Gratuity bill to inch up post revision in benefit limits and wage hike
Effective 24 May 2010, the Gratuity Act, 1972, was amended, increasing the
ceiling on gratuity payable from INR 0.35 mn to INR 1 mn. While the impact of
increased limits on gratuity provisioning is difficult to calculate given different
bank specific policies, we have estimated incremental gratuity liability due to
wage hike and pegged the increase at 16% of outstanding gratuity obligation. We
estimate incremental provisioning on this count at INR 15 bn for the industry
(refer table 7).

Edelweiss Research is also available on www.edelresearch.com,, Bloomberg EDEL <GO>, Thomson First Call, Reuters and Factset. Edelweiss Securities Limited

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2
Table 1: Banks' incremental retirement liability (SPO and Catch up on account of wage revision on pension and gratuity benefits)
Estd # SPO Catch up Total Liab incl int assuming % of Banks FY11E PBT Wage revision Gratuity impact
Liability net of tax % of
Employees liability on PVO pension amortisation over (INR % of PAT employee indicated downward impact on % of PAT
benefit (INR bn) networth
opting for SPO (A) (B) liability bn) cost liability revision gratuity (net of tax)
( )
BFSI

3 years @ 5 years @
Bank (No.) (INR bn) (INR bn) (INR bn) 3 years 5 years (%) 3 years 5 years (%) (INR bn) (%) (INR bn) (%)
12.5% 20%
Allahabad 11,745 10.6 1.1 10.0 11.3 12.0 7.9 8.4 9.8 17.2 11.0 17.7 5.5 (5.9) 0.6 2.9
Andhra 8,343 7.5 1.5 9.0 10.1 10.8 7.1 7.5 12.1 19.7 12.6 19.8 1.2 0.5 3.2
BOB 22,224 20.0 4.6 24.6 27.7 29.5 19.4 20.7 10.3 17.3 11.1 20.9 (5.4) 1.5 2.9
BOI 27,000 24.3 3.5 27.8 31.3 33.4 21.9 23.4 13.0 27.5 17.6 27.5 20.0 1.4 3.6
BOM 7,982 7.2 1.9 9.1 10.3 10.9 7.2 7.7 26.0

Edelweiss Securities Limited

Canara 25,323 22.8 5.4 28.2 31.7 33.9 22.2 23.7 15.8 27.5 17.6 23.9 23.3 1.3 3.3
CBI 17,513 15.8 4.6 20.4 22.9 24.5 16.0 17.1 26.4 44.5 28.5 25.1 1.1 6.6
Corp.bank 7,673 6.9 0.9 7.8 8.8 9.4 6.2 6.6 8.2 15.1 9.7 24.8 6.0 0.5 2.4
Dena 6,000 5.4 1.4 6.8 7.6 8.1 5.3 5.7 17.3 28.8 18.4 25.3 7.8 0.3 3.8
IOB 14,700 13.2 3.3 16.5 18.6 19.8 13.0 13.9 16.8 58.1 37.2 21.5 19.6 (0.4) 0.8 7.4
Indian 11,466 10.3 3.1 13.5 15.1 16.1 10.6 11.3 11.9 21.2 13.6 23.9 12.5 0.9 3.6
OBC 8,965 8.1 1.4 9.5 10.7 11.4 7.5 8.0 7.8 16.6 10.6 20.3 6.5 (4.3) 0.4 2.0
Punjab & Sind 5,729 5.2 1.7 6.9 7.8 8.3 5.4 5.8 17.1 32.3 20.7 19.8 6.0 0.4 5.6
PNB 31,128 28.0 7.6 35.6 40.1 42.8 28.1 29.9 12.6 20.4 13.1 18.9 25.0 (3.0) 2.3 3.5
Syndicate 18,345 16.5 2.7 19.3 21.7 23.1 15.2 16.2 22.3 29.5 9.0
UCO 13,097 11.8 2.1 13.9 15.7 16.7 11.0 11.7 23.0 29.7 19.0 22.5 10.0 0.7 3.8
Union 17,500 15.7 2.2 17.9 20.2 21.5 14.1 15.1 11.8 21.4 13.7 20.1 24.0 1.6 0.8 2.5
United 8,030 7.2 1.8 9.0 10.1 10.8 7.1 7.5 21.7 47.9 30.6 27.2 7.5 0.4 6.3
Vijaya 6,752 6.1 1.1 7.1 8.0 8.6 5.6 6.0 16.4 33.5 21.4 20.3 0.4 4.5
SBBJ 7,213 6.5 2.1 8.6 9.7 10.3 6.8 7.2 21.6 48.1 30.8 25.6
SBH 7,480 6.7 1.5 8.2 9.2 9.8 6.4 6.9 11.4 22.7 14.5 18.3
SBM 5,903 5.3 1.1 6.4 7.2 7.7 5.1 5.4 18.8 40.6 26.0 29.4
SBP 6,524 5.9 0.0 5.9 6.6 7.0 4.6 4.9 9.9 29.8 19.1 17.2
SBT 7,117 6.4 1.6 8.0 9.0 9.6 6.3 6.7 16.8 33.1 21.2 27.3
Total 303,751 273 59 330 371 396 260 277 14.3 26.6 17.0 22.5 14.3 3.5
Source: Bloomberg, Company, Edelweiss research
Note: 1. Assuming 98% of existing and 75% of retired employees eligible for SPO opt for the same
2. SPO liability arrived at based on INR 0.9 mn/ employee
3. Catch up on account of wage revision for existing employees under pension estimated at 16% of pension Present Value of Obligation (PVO)
4. Catch up on account of wage revision on gratuity liability estimated at 16% of Gratuity PVO
5. Existing additional pension corpus of INR 1.7 bn adjusted against Allahabad Banks’ incremental pension liability
6. Consensus estimates of PAT and Networth used for banks not under coverage (Source: Bloomberg)
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„ Retirement benefits: A Pandora’s box of liabilities

There is lot of uncertainty regarding the quantum of obligation that the banking industry
(public sector banks excluding State Bank of India but including SBI associates) will add
to its outstanding retirement liability along with the extent of provisioning for the same
due to SPO and increased gratuity limits. We have interacted with banks’ management
and various industry experts to understand banks’ salary structures in detail, inflation
(CPI) impact on the wage bill, various assumptions considered for valuation purpose and
tax treatment of the same. Based on this, we have carried out an in depth analysis on
retirement benefit liability of banks and believe that retirement liability (pretax) for PSBs
on an aggregate basis will catapult by ~INR 350 bn (including SPO and wage hike impact
on pension and gratuity obligations for existing employees under the scheme).

Fig. 1: Sources of incremental retirement benefit liability

Eligible serving and

Second pension eligible retired
option employees

Incremental Catch up
Current employees
retirement (Wage hike & DA
under pension scheme
benefit liability impact)

Revised gratuity
limits
All serving employees
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(Wage EST.& ISI-Emerging-Markets.
DA
impact)
Source: Edelweiss research

Table 2: Incremental retirement benefit liability

No. of Industry Liability/employee
Liability
employee liability (INR bn) (INR mn)
SPO 303,751 273.3 0.90
Catch Up 255,183 58.5 0.23
Gratuity 463,899 14.7 0.03
Source: Edelweiss research

Second pension option liability

There is a lot of ambiguity regarding the quantum of SPO liability for the banking
industry considering the whopping revision in estimates submitted by banks to RBI (as
per media reports) vis-à-vis those calculated at the time of the 9th bipartite settlement
(INR 63 bn revised to INR 200 bn). What further complicated the issue was varied
indications provided by banks on their estimated liability despite more or less similar
employee profile and actuarial assumptions.

SPO liability of INR 24 bn indicated by Union Bank of India during its Q2FY11 results, a
revision from INR 12 bn announced earlier, caused further concern on the profitability
and networth hit on banks. Our interactions with market participants suggest that Union
Bank’s estimated liability is conservative and includes the impact of catch up in obligation
of existing employees under the pension scheme due to wage revision/DA rise and
unwinding of interest as the provisioning will be allowed to be spread over a period of
five years. Our calculations also peg the bank’s SPO liability at INR 15.7 bn (INR 0.9 per
employee) implying that extrapolating Union Bank’s liability only to arrive at SPO
obligation for other banks will lead to over-estimation of SPO liability. At the same time,

Edelweiss Securities Limited 3

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we believe, the Street currently is underestimating the impact of high inflation and
structural change (with 100% of employees now being under pension) on banks’ wage
bill and retirement liability.

• SPO obligation pegged at INR 273 bn (INR 0.9 per employee)

Based on our retirement benefit calculation and discussions with banks’

management, members of IBA and actuaries, we have estimated industry wide SPO
liability (pretax) at INR 273 bn (INR 0.9 per employee). We believe the retirement
obligation for employees opting for SPO has three components (or sources of
funding) which are as follows:

A. Refund/transfer of banks’ contribution to employees provident fund along with

interest earned on it over the years.

B. Employees’ contribution to the shortfall which was fixed at the time of 9th
bipartite settlement. Serving employees are to pay 2.8x the revised November
2007 pay and retired employees will get additional 56% of banks contribution to
PF and interest thereof.

C. The balance will be borne by banks, a variable element in the entire scheme of
things.

Fig. 2: Employees’ contribution towards SPO

Retired Serving

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Eligible employees
Refund entire contribution by bank to PF Transfer entire contribution by bank to
(On the bank pay roll
along with interest earned on it PF along with interest earned on it
pre September 1995)

Contribute 56% of the above mentioned Contribute 2.8 times revised November
amount towards shortfall 2007 pay towards shortfall

Source: Edelweiss research

We estimate that provident fund refund/transfer will bring on an average INR 0.55
mn /employee and employees’ salary contribution another INR 0.06 mn /employee
on an average. Thereby, banks’ incremental SPO liability will be pegged at INR 0.9
mn/ employee.

4 Edelweiss Securities Limited

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Table 3: SPO obligation @ INR 0.9 mn/employee

Serving opted Retired opted SPO liability
Bank (No.) (No.) (INR bn)
Allahabad 9,859 1,886 10.6
Andhra 7,003 1,340 7.5
BOB 18,655 3,569 20.0
BOI 24,000 3,000 24.3
BOM 6,700 1,282 7.2
Canara 21,256 4,067 22.8
CBI 14,700 2,813 15.8
Corp.bank 6,441 1,232 6.9
Dena 4,500 1,500 5.4
IOB 12,300 2,400 13.2
Indian 9,625 1,841 10.3
OBC 7,525 1,440 8.1
Punjab & Sind 4,809 920 5.2
PNB 27,128 4,000 28.0
Syndicate 15,399 2,946 16.5
UCO 10,994 2,103 11.8
Union 14,000 3,500 15.7
United 6,740 1,290 7.2
Vijaya 5,667 1,084 6.1
SBBJ 6,054 1,158 6.5
SBH 6,279 1,201 6.7
SBM 4,955 948 5.3
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SBP 5,476 1,048 5.9
SBT 5,974 1,143 6.4
Total 256,039 47,712 273.3
Source: Edelweiss research
Note: Assuming 98% of existing and 75% of retired employees eligible for SPO opt for the same

• Assumptions built into our calculation of SPO liability

To arrive at the incremental liability for every employee likely to join a banks defined
benefit pension scheme we have built in a few assumptions which are as follows:

1. Average age: 52 yrs. The average age may appear to be on the higher side
since the average age of the entire banking staff stands at 48 years. However,
since employees who have been extended the SPO were on the bank’s pay roll
prior to September 1995, their average age is bound to be higher.

2. Average salary: November 2010 at ~INR 32k i.e., the combined sum of
basic salary and DA on it. The higher average wage is also explained by the fact
that comparatively senior employees at all cadres of bank employees have been
extended the option.

3. Average wage escalation: 4%. This is in line with actuarial assumptions

made by banks. However, a larger-than-expected wage hike at the end of every
five years proves to be an upside risk to the number.

4. Life expectancy: 15 years post retirement at the age of 60.

5. Inflation rate: 3%. Since DA on basic pension is a direct fallout of inflation

condition, this number is of significant relevance.

Edelweiss Securities Limited 5

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Table 4: Assumptions for estimating pension liability

Particulars SPO Catchup Blended
Avg. age (Yrs) 52 35 49
Avg. current wage (INR) 21,546 14,427 20,047
Avg. Retirement wage (INR) 29,503 38,479 30,878
Inflation rate (%) 4.0 4.0 4.0
Life expectancy (Yrs) 75 75 75
Discount rate (%) 8.0 8.0 8.0
Source: Edelweiss research

Chart 1: Banks to fund 60% of gross SPO obligation vis-à-vis 29% earlier

Before (INR 220 bn) After (INR 450 bn)

29%
37%

59%
60%
12%

3%

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PF refund/transfer Employees’ contribution towards shortfall
Banks' incremental liability
Source: Edelweiss research

• Resolving the INR 63 bn to ~INR 270 bn liability conundrum

Key question that needs to be answered at this stage is what caused the quantum leap
in the liability to such high levels from INR 63 bn estimated at the time of settlement.
While the amount was based on 2007 salary levels i.e., before the wage hike, our
numbers fully incorporate the liability arrived at based on current salary. We attempt
to segregate the jump into three main heads, i.e., current service costs for each year
of service in between, impact of wage hike, and impact of DA during the period to
drive home the point that inflation has the biggest contribution to the wage bill jump.

On a per employee basis, outstanding pension liability/employee jumped from INR

0.78 mn to INR 1.5 mn. Out of this INR 0.73 mn rise, INR 0.21 mn (INR 64 bn for
industry) is due to wage revision and a large chunk of INR 0.32 mn (INR 97 bn for
industry) is due to the exorbitant level of inflation and consequently DA over the
three year period. Balance INR 0.2 mn (INR 61 bn for industry) can be explained in
terms of current service cost.

6 Edelweiss Securities Limited

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Chart 2: DA impact is the dominant force behind SPO obligation jump

1.6 0.2 1.5
0.3
1.3

0.2

(INR mn)
1.0
0.8

0.6

0.3

0.0
Pension Current service DA impact Wage hike Total obligation
obligation as cost' over impact
on Nov 2007 2007-2010

Source: Edelweiss research

• >95% of eligible existing and 70-75% of retired employees to opt for SPO

Next, we estimate the number of employees per bank likely to opt for the option,
both serving and retired. The broad assumption is that more than 95% of banks’
existing eligible workforce under the contributory PF scheme and 70-75% of eligible
retirees are likely to opt for the option. Further, the number of eligible serving
employees is assumed at 50% of the workforce wherever the data is not available
and the number
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at 2011-01-20 retirees atEST.
25% ISI-Emerging-Markets.
of the eligible serving employees (based
on 65,000/272,000 industry number).

Edelweiss Securities Limited 7

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Table 5: Number of employees eligible for SPO

Total Under Eligible Eligible Serving Retired
Bank Under CPF Total opted
employees pension serving retired opted opted
Allahabad 20,959 10,899 10,060 10,060 2,515 9,859 1,886 11,745
Andhra 14,292 7,146 7,146 7,146 1,787 7,003 1,340 8,343
BOB 38,071 19,036 19,036 19,036 4,759 18,655 3,569 22,224
BOI 39,202 15,085 24,117 24,117 6,029 24,000 3,000 27,000
BOM 13,673 6,837 6,837 6,837 1,709 6,700 1,282 7,982
Canara 43,380 21,690 21,690 21,690 5,423 21,256 4,067 25,323
CBI 34,826 19,826 15,000 15,000 3,750 14,700 2,813 17,513
Corp.bank 13,144 6,572 6,572 6,572 1,643 6,441 1,232 7,673
Dena 10,525 5,263 5,263 5,263 1,316 4,500 1,500 6,000
IOB 26,732 8,759 17,973 17,973 4,493 12,300 2,400 14,700
Indian 19,642 9,821 9,821 9,821 2,455 9,625 1,841 11,466
OBC 15,358 7,679 7,679 7,679 1,920 7,525 1,440 8,965
Punjab & Sind 9,814 4,907 4,907 4,907 1,227 4,809 920 5,729
PNB 56,928 29,000 27,928 27,928 6,982 27,128 4,000 31,128
Syndicate 27,713 12,000 15,713 15,713 3,928 15,399 2,946 18,345
UCO 23,370 12,152 11,218 11,218 2,805 10,994 2,103 13,097
Union 29,419 14,997 14,422 14,422 3,606 14,000 3,500 17,500
United 15,285 8,407 6,878 6,878 1,720 6,740 1,290 8,030
Vijaya 11,566 5,783 5,783 5,783 1,446 5,667 1,084 6,752
SBBJ 12,356 6,178 6,178 6,178 1,545 6,054 1,158 7,213
SBH 12,814 6,407 6,407 6,407 1,602 6,279 1,201 7,480
SBM 10,112 5,056 5,056 5,056 1,264 4,955 948 5,903
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11,176 5,588 at 2011-01-20
5,588 15:28:18 1,397
5,588 EST. ISI-Emerging-Markets.
5,476 1,048 6,524
SBT 12,192 6,096 6,096 6,096 1,524 5,974 1,143 7,117
Total 522,549 255,183 267,367 267,367 66,842 256,039 47,712 303,751
Source: Edelweiss research
Note: 1. Employees under pension out of total current employees (March 2010) assumed at 50% wherever data not available
2. Retired eligible as a percentage assumed at 25% of current eligible employees (65000/272000)

• Shift in shortfall funding pie

Round one on the cost estimation of SPO began in 2007 when actuaries appointed
by the mutual consent of Indian Banks Association (IBA) and United Forum of Bank
Unions (UFBU) began the exercise. However, the data used then related to 2007 in
terms of salary levels and outstanding Provident fund balances of employees. Since
numbers were calculated on salaries before the 17.5% hike, the industry’s
incremental liability at INR 63 bn appears to be a gross under estimation agreed to
at the time of the joint note signed on 27th April 2010 vis-à-vis our estimate of INR
273 bn on account of SPO.

What is worth noting is that since employees’ contribution to shortfall is fixed, banks
may end up funding 94% of the shortfall vis-à-vis 70% agreed to during the
agreement. The only relief is the increased levels of PF refund in comparison to what
was estimated in 2007 due to the wage hike. We estimate PF/employee as 10% of
the basic salary that the employee is likely to have drawn in his/her past 27 years of
service since the average age has been assumed at 52 years and the employee is
assumed to have started work at the age of 25. The interest earned on the bank’s
contribution of this amount is also taken into consideration. As mentioned earlier,
employees’ average contribution towards the funding shortfall (SPO liability less PFC
contribution) has been fixed at INR 60k/employee during the settlement.

8 Edelweiss Securities Limited

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Chart 3: Banks to fund 94% of shortfall vis-à-vis 70% agreed to earlier

Before (INR 63 bn) After (INR 273 bn)
6%

30%

70%

94%

Bank Employee
Source: Edelweiss research

Wage revision catch up for existing employees under pension

Another important development which impacts banks considerably and is not talked
about much is the jump in banks’ liability due to increase in pension obligation for
employees currently under the scheme due to the wage hike under 9th bipartite
agreement. PVO for pension disclosed in bank’s FY10 annual report is calculated based
on salary as of March 2010, without taking into effect the wage revision settled in July
2010. Hence, in
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2011-01-20 be an additional liability on banks for employees already
EST. ISI-Emerging-Markets.
under the pension scheme. Our estimates peg incremental liability on this account at INR
59 bn (~INR 0.23 per employee), implying 16% rise on PVO disclosed in FY10.

The profile of employees already under the pension scheme is different from those who
are being extended the SPO now. Hence, we estimate the catch up on account of wage
hike for these employees with a different set of assumptions. Since all of them have
joined post 1995, i.e., when the defined benefit pension scheme had become mandatory
for PSBs, their average age and wages will be lower than the banks’ overall average and
significantly lower than employees under SPO. The other assumptions on wage
escalation, inflation and life expectancy, however, remain the same.

Edelweiss Securities Limited 9

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Table 6: Catch up due to wage hike for existing employees under pension
Present value of obligation (PVO) Catch up on PVO
Bank (INR bn) (INR bn)
Allahabad 6.9 1.1
Andhra 9.1 1.5
BOB 28.6 4.6
BOI 21.8 3.5
BOM 12.0 1.9
Canara 33.6 5.4
CBI 28.6 4.6
Corp.bank 5.7 0.9
Dena 8.6 1.4
IOB 20.5 3.3
Indian 19.4 3.1
OBC 9.0 1.4
Punjab & Sind 10.8 1.7
PNB 47.2 7.6
Syndicate 17.0 2.7
UCO 13.2 2.1
Union 13.6 2.2
United 10.8 1.8
Vijaya 6.5 1.1
SBBJ 13.0 2.1
SBH 9.0 1.5
SBM 7.0 1.1
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SBT 10.0 1.6
Total 361.7 58.5
Source: Edelweiss research

Gratuity bill to inch up post revision in benefit limits and wage hike

Effective 24 May 2010, the Gratuity Act, 1972, was amended, increasing the ceiling on
gratuity payable from INR 0.35 mn to INR 1 mn. In the current practice, gratuity
payment is based on the higher of the two amounts prescribed by the bank specific
gratuity rules and the Gratuity Act, 1972. Currently, on an average gratuity
liability/employee for PSBs stands at INR 0.2 mn. While the impact of increased limits on
gratuity provisioning is difficult to calculate given different bank specific policies, we have
estimated incremental liability due to wage hike and peg the increase at 16% of
outstanding gratuity obligation. The last wage hike saw a substantial rise in the basic pay
scale across all categories of bank employees. Since gratuity payout is linked to basic
pay at the time of retirement, the liability for the same has too jumped significantly. We
estimate incremental provision (pretax) on this count at INR 14.7 bn for the industry.

10 Edelweiss Securities Limited

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BFSI

Table 7: Wage hike impact on outstanding gratuity benefit obligation

Total Incremental Liability net of tax
Bank
employees (No.) liability (INR bn) benefit (INR bn)
Allahabad 20,959 0.6 0.4
Andhra 14,292 0.5 0.4
BOB 38,071 1.5 1.1
BOI 39,202 1.4 0.9
BOM 13,673 0.4 0.3
Canara 43,380 1.3 0.9
CBI 34,826 1.1 0.8
Corp.bank 13,144 0.5 0.3
Dena 10,525 0.3 0.2
IOB 26,732 0.8 0.5
Indian 19,642 0.9 0.6
OBC 15,358 0.4 0.3
Punjab & Sind 9,814 0.4 0.3
PNB 56,928 2.3 1.6
Syndicate 27,713 0.0 0.0
UCO 23,370 0.7 0.5
Union 29,419 0.8 0.5
United 15,285 0.4 0.3
Vijaya 11,566 0.4 0.3
Total 463,899 14.7 10.3
Source: Edelweiss research

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„ Retirement provisioning likely to be amortised over 3-5 years
Banks have requested RBI and ICAI to allow them to spread the increased provisioning
costs over a period of 3-5 years. Also, given that the dent on networth will be around
14%, it is unlikely that the entire amount can be absorbed in one year. The spacing out
of retirement costs also allays concerns on the tax deductibility of these expenses to
some extent as retirement costs above 27% of the salary costs are not eligible for tax
benefits and can lead to creation of Deferred Tax Asset (DTA).

Accounting treatment

Incremental liability on all the three heads, i.e., SPO, catch up for existing pension
scheme employees, and increased gratuity limits falls under the nature of ‘past service
cost’ under both (Accounting Standard) AS 15 and (International Accounting Standard)
IAS19. Under both the standards, the cost needs to be immediately recognized in the
current year itself. There are not too many differences between the standards since AS-
15 (Revised 2005) was a step towards transition to IAS 19. A key benefit that banks will
have post the transition will be with respect to actuarial gains and losses. Actuarial gains
and losses primarily arise due to changes in assumptions used to arrive at retirement
benefit liability. While under AS-15, the gains or losses must be recognized in the Profit
& Loss account in the same year, IAS 19 allows corridor approach whereby the amount
can be spread over the expected remaining working lives of the then active employee
participants. This approach is suggested with a view that over a long term the actuarial
gains and losses may offset each other.

„ Hit of 14% on networth; dent earnings by 17%

Our pension liability (pretax) estimate of INR 330 bn implies a hit of 14% on networth
and if allowed to be amortised over five years, will imply a hit of 17% on earnings of
PSBs on an average. Amongst banks, we believe hit will be relatively higher for IOB,
Syndicate Bank, Central Bank of India (though some of them have accordingly provided
for it in H1FY11) whereas Union Bank may surprise positively against their indicated

Edelweiss Securities Limited 11

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BFSI

liability. In our assumptions we have considered tax benefit on the full liability which may
not be the case (restricted to 27% of the salary cost).

However, downward revision in earnings estimates will be pegged at 3-7% as Street has
factored in some provision based on pension liability indicated by banks (their internal
rough cut estimates). Banks also have absorption ability for incremental liability since
the impact of AS-15 transition liability hit will be absorbed fully by FY12.

D o w n l o a d e d b y i n - i i m l s i n g h f r o m 5 9 .

12 Edelweiss Securities Limited

D o w n l o a d e d b y i n - i i m l s i n g h f r o m 5 9 .
  
Table 8: Banks incremental pension liability (SPO and Catch up on account of wage revision on pension)
SPO liability Catch up on Total liability Liab incl int assuming Liability net of tax FY11E FY11E % of FY11E PBT
% of PAT
(A) PVO (B) (A+B) amortisation over (INR bn) benefit (INR bn) Networth PAT networth downward revision
Bank (INR bn) (INR bn) (INR bn) 3 years @ 5 years @ 20% 3 years 5 years (INR bn) (INR bn) (%) 3 years 5 years (%)
Allahabad 10.6 1.1 10.0 11.3 12.0 7.9 8.4 71.2 15.2 9.8 17.2 11.0 (5.9)
Andhra 7.5 1.5 9.0 10.1 10.8 7.1 7.5 51.9 11.9 12.1 19.7 12.6
BOB 20.0 4.6 24.6 27.7 29.5 19.4 20.7 167.7 37.3 10.3 17.3 11.1 (5.4)
BOI 24.3 3.5 27.8 31.3 33.4 21.9 23.4 150.3 26.6 13.0 27.5 17.6
BOM 7.2 1.9 9.1 10.3 10.9 7.2 7.7
Canara 22.8 5.4 28.2 31.7 33.9 22.2 23.7 124.6 26.9 15.8 27.5 17.6
CBI 15.8 4.6 20.4 22.9 24.5 16.0 17.1 54.0 12.0 26.4 44.5 28.5
Corp.bank 6.9 0.9 7.8 8.8 9.4 6.2 6.6 67.2 13.6 8.2 15.1 9.7
Dena 5.4 1.4 6.8 7.6 8.1 5.3 5.7 27.5 6.2 17.3 28.8 18.4
IOB 13.2 3.3 16.5 18.6 19.8 13.0 13.9 69.0 7.5 16.8 58.1 37.2 (0.4)
Indian 10.3 3.1 13.5 15.1 16.1 10.6 11.3 79.0 16.6 11.9 21.2 13.6
OBC 8.1 1.4 9.5 10.7 11.4 7.5 8.0 85.6 15.0 7.8 16.6 10.6 (4.3)
Punjab & Sind 5.2 1.7 6.9 7.8 8.3 5.4 5.8 28.3 5.6 17.1 32.3 20.7
PNB 28.0 7.6 35.6 40.1 42.8 28.1 29.9 198.2 45.8 12.6 20.4 13.1 (3.0)
Syndicate 16.5 2.7 19.3 21.7 23.1 15.2 16.2 60.3 10.6 22.3
UCO 11.8 2.1 13.9 15.7 16.7 11.0 11.7 42.3 12.3 23.0 29.7 19.0
Union 15.7 2.2 17.9 20.2 21.5 14.1 15.1 106.8 22.0 11.8 21.4 13.7 1.6
United 7.2 1.8 9.0 10.1 10.8 7.1 7.5 28.9 4.9 21.7 47.9 30.6
Vijaya 6.1 1.1 7.1 8.0 8.6 5.6 6.0 30.3 5.6 16.4 33.5 21.4
SBBJ 6.5 2.1 8.6 9.7 10.3 6.8 7.2 27.9 4.7 21.6 48.1 30.8
SBH 6.7 1.5 8.2 9.2 9.8 6.4 6.9 50.1 9.5 11.4 22.7 14.5
SBM 5.3 1.1 6.4 7.2 7.7 5.1 5.4 24.0 4.2 18.8 40.6 26.0
SBP 5.9 0.0 5.9 6.6 7.0 4.6 4.9 41.5 5.2 9.9 29.8 19.1
SBT 6.4 1.6 8.0 9.0 9.6 6.3 6.7 33.4 6.4 16.8 33.1 21.2
Total 273 59 330 371 396 260 277 1,620 326 14.3 26.6 17.0
Source: Bloomberg, Edelweiss research
Note: 1. SPO liability arrived at based on INR 0.9 mn/ employee
2. Catch up on account of wage revision for existing employees under pension estimated at 16% of pension Present Value of Obligation (PVO)
3. Existing additional pension corpus of INR 1.7 bn adjusted against Allahabad Banks’ incremental pension liability
4. Consensus estimates of PAT and Networth used for banks not under coverage (Source: Bloomberg)
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Edelweiss Securities Limited
BFSI

13
 
BFSI

„ DA: The unspoken pressure point

In our opinion, given the high inflation scenario banks are operating in, employee costs can
increase significantly. The effect of DA is understated in context of the rise in the employee
cost that it can contribute to. DA affects the remuneration costs on the following counts:

• Salary payout: High inflation which further fuels the DA as a percentage of basic pay
directly increases the wage bill of banks periodically. To put things in context, since its
resetting in November 2002, DA moved from 5% of basic salary to only 19% over a
four year period. However, post this, high inflationary environment saw it rise to as
high as 72% in the next four years beginning 2007. Even post resetting after the
recent wage hike, it forms 46% of basic pay for three months ending January 2011.

• Wage hikes: The five yearly wage hikes take into consideration the inflation over
the past five years. High inflation leads to a higher than regular hike in the basic pay
scales of bank employees. Given the fact that basic pay is used in determining banks’
obligation towards employees’ retirement benefits, a more than regular hike in basic
pay scale has a multiplier effect.

• Pension costs: Since DA transfers inflation to pension costs of retired employees, it

is another area to watch out for (retired employees are paid base pension along with
DA over it which is reset every six months).

Fig. 3: DA has a multiplier effect on wage bill

High
current
salary
payout
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High Higher
current DA retirement
pension Impact provision
payout cost

Higher than
regular hike
at the end
of 5 years

Source: Edelweiss research

„ Employee costs: Undergoing structural change

Until now for retirement benefit purposes, approximately 50% of banks’ employees were
under the ‘defined benefit scheme’ while the other half was under the ‘defined
contribution scheme’. Post the second PSO the retirement benefit scenario will undergo a
massive change with almost the entire PSU banking staff being covered by pension
scheme (as mentioned earlier, more than 95% of eligible serving employees are likely to
have opted for the scheme and ~70%-75 of eligible retired employees). Although
employees joining post 1 April 2010 are not extended any choice and are compulsorily
under the New Pension Scheme (defined contribution), we believe their proportion in the
overall banking staff will not be substantial as hiring is happening mainly to replace
retiring staff and not to increase headcount.

14 Edelweiss Securities Limited

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BFSI

Under the CPF, banks contribute 10% of employees’ basic pay to the provident fund
whereas under the pension scheme the contribution stands at approximately 24% of
basic pay. Also, under the defined benefit scheme banks need to make good for the
shortfall in the fair value of plan assets (FVPA) vis-à-vis present value of obligation
(PVO) as per actuarial calculations at the end of every financial year. The vectors which
drive the additional contribution and can throw occasional surprises are as follows:
• Employee life expectancy
• Inflation during the year and estimates going forward
• Wage escalation
• Wage hikes which happens every five years
• Attrition rates
• Expected return on plan assets
• Discount rates

Our analysis suggests that sensitivity of pension liability to DA is maximum compared to

other variables like discounting factor, life expectancy etc (refer table below). A 1% point
change in assumption for CPI can change pension obligation by 19%. At the same time, if
salary escalation is revised to 5% (from base case of 4%), the pension obligations goes up
by 10%. However, 50bps change is discount rate is likely to impact obligation by 8%.

Table 9: Sensitivity of pension liability to its various assumptions

Salary escalation Base case 4%
Chg in % points Increase in pension liability (%)
1.0 10.4
2.0
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3.0 34.2

CPI Base case 3%

Chg in % points Increase in pension liability (%)
1.0 19.0
2.0 41.4
3.0 68.1

Discount rate Base case 8%

Chg in bps Increase in pension liability (%)
(100) 18.5
(75) 13.5
(50) 8.8
(25) 4.3
25 (4.1)
50 (8.0)
75 (11.8)
100 (15.3)

Life expectancy Base case 75 years

Chg in years Increase in pension liability (%)
1 yr 4.5
2 yrs 8.8
5 yrs 12.9
Source: Edelweiss research

Edelweiss Securities Limited 15

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BFSI

If DA is revised only for one year (instead of structural change in CPI assumption), the
wage bill is expected to go up by 8% for every 1% rise in CPI.

Table 10: CPI needs to be closely watched as it severely impacts the wage bill
Increase in CPI in FY12 Base case 3%; DA of 52%
Chg in CPI in % points Increase in wage bill (%)
2.0 8.0
3.0 12.3
5.0 20.4
Source: Edelweiss research

In our opinion with inflation yet to come to low levels and majority of staff under the
pension scheme, we expect cost/income ratio for banks to move up by 100-150% points
and RoEs to be adversely impacted by 40-60bps. Moreover, we believe banks’ downward
trajectory of opex/assets can see a turn as the cost escalation is structural in nature.

Chart 4: Retirement liability to arrest decline in employee costs/assets

1.6

1.4

1.3
(%)

1.1
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1.0

0.8
FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11E

Employee costs/assets
Source: Edelweiss research

16 Edelweiss Securities Limited

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BFSI

ANNEXURE
„ Background on the SPO
When the pension scheme was introduced for the banking industry as second retirement
benefit in lieu of Contributory Provident Fund (CPF) in 1993, existing employees were
given the choice to either shift to the pension scheme or to stay under the existing CPF.
Later, when Bank Employees' Pension Regulations, 1995, was introduced, it became
mandatory for all bank employees to be covered by the pension scheme.

However, many employees who were earlier extended the choice (between CPF and
pension) and opted in favour of CPF later understood the benefit of DA flowing into
pension and various other benefits under the defined benefit scheme and hence wanted
another chance to shift to the pension scheme. After years of tussle, the bipartite
settlement was inked between Workmen Unions and Officers’ Organisation on 27th April,
2010 to allow another option to those who were in the service of banks prior to 29th
September 1995 and did not opt for pension when offered. In lieu of this, United Forum
of Bank Unions (UFBU) had to agree to the implementation of the New Pension Scheme
(NPS) for bank employees joining post 1st April, 2010. NPS is a defined contribution
based pension system under which banks will contribute 10% of pay and DA towards
pension.

„ Procedure to make the transition

According to IBA, ~2,72,000 existing and ~65,000 retired employees will benefit under
the SPO. To enroll under the pension scheme, employees (serving or retired) have to
refund the bank’s contribution to their provident fund along with interest earned on it.
D o w n l o a d e d Also, their
b yadditional
i contribution
n - i was i mfixed l ats30%i ofn theg estimated
h f r obetween
shortfall m 5 9 .
plan assets and pension obligations based on valuation by actuaries appointed by mutual
consent between IBA and UFBU for 9th bipartite settlement.

Edelweiss Securities Limited 17

D o w n l o a d e d b y i n - i i m l s i n g h f r o m 5 9 .
  
Table 11: Valuation metrics

18
Price M Cap Adj. bk Adj. bk P/ABV P/ABV EPS EPS ROE ROE P P/E P/E Div yield Rating Relative
FY11E FY12E FY11E FY12E FY11E FY12E FY11E FY12E FY11E FY12E FY09
BFSI

(INR) USD mn (INR) (INR) (x) (x) (INR) (INR) (%) (%) (x) (x) (%)
State Owned Banks
Allahabad Bank 203 1,981 153 192 1.3 1.1 34.1 43.9 23.4 24.6 6.0 4.6 2.7 BUY SO
Bank of Baroda 849 6,746 444 540 1.9 1.6 101.9 119.8 24.4 23.6 8.3 7.1 1.8 BUY SO
Indian Overseas Bank 130 1,547 111 128 1.2 1.0 13.7 19.8 11.3 14.7 9.5 6.6 1.5 Hold SU
Oriental Bank 359 1,961 335 402 1.1 0.9 60.0 73.3 18.9 19.7 6.0 4.9 2.5 BUY SU

Edelweiss Securities Limited

Pun. Natl. Bank 1,152 7,926 599 748 1.9 1.5 145.4 187.3 25.4 26.7 7.9 6.2 2.0 BUY SP
SBI (stand alone) 2,547 35,299 1,064 1,434 2.4 1.8 183.4 227.8 16.6 17.5 13.9 11.2 1.2 HOLD SP
SBI (Cons) 2,318 32,120 1,240 1,646 1.9 1.4 242.1 294.7 - - 9.6 7.9 1.3 HOLD SP
Syndicate Bank 105 1,196 104 123 1.0 0.9 20.2 25.8 18.8 20.5 5.2 4.1 2.9 BUY SP
Union Bank 313 3,452 193 247 1.6 1.3 43.5 60.4 22.5 25.3 7.2 5.2 1.8 BUY SO

Private Sector Banks

Axis Bank 1,255 11,224 448 532 2.8 2.4 80.7 103.4 19.0 20.7 15.5 12.1 1.0 BUY SO
Federal Bank 375 1,397 297 335 1.3 1.1 37.3 46.6 12.9 14.5 10.0 8.0 1.3 BUY SO
HDFC Bank 2,152 21,810 530 616 4.1 3.5 85.9 113.4 17.1 19.6 25.0 19.0 0.6 Hold SP
ICICI Bank 1,014 25,418 462 504 2.2 2.0 45.4 57.8 9.8 11.6 22.3 17.5 1.2 BUY SO
ICICI Bank# 819 20,523 358 400 2.4 2.0 45.4 57.8 - - 18.5 14.2 NA BUY SO
ING Vysya Bank 328 864 198 227 1.7 1.4 26.5 33.7 13.5 15.1 12.4 9.7 0.8 BUY SP
Kotak Mahindra Bank# 413 6,625 146 170 2.8 2.4 20.6 25.2 16.5 16.0 20.0 16.4 0.3 BUY SP
Karnataka Bank 151 442 134 148 1.1 1.0 12.1 23.7 8.6 15.7 12.5 6.4 2.7 Not Rated
South Indian Bank 28 546 15 17 1.9 1.6 2.6 3.2 18.3 19.4 10.8 8.8 14.5 BUY SP
Yes Bank 261 1,977 110 137 2.4 1.9 21.0 29.0 20.9 23.4 12.4 9.0 0.6 BUY SO

Speciality Finance
HDFC Ltd 654 20,885 123 152 5.3 4.3 23.5 28.4 20.8 20.7 27.8 23.0 1.1 Hold SP
HDFC Ltd# 637 20,359 70 97 9.1 6.6 23.5 28.4 20.8 20.7 27.1 22.4 1.1 Hold SP
LIC HF 170 1,763 88 107 1.9 1.6 20.0 24.3 24.9 24.8 8.5 7.0 8.8 Reduce SU
IDFC 164 5,216 73 85 2.2 1.9 8.7 11.1 14.3 14.1 18.8 14.8 0.9 HOLD SU
Manappuram Finance 131 1,195 27 37 4.9 3.6 7.6 11.7 34.4 36.3 17.3 11.3 - HOLD SU
Power Finance Corporation 291 7,298 132 153 2.2 1.9 22.3 27.0 18.0 18.9 13.1 10.8 1.5 BUY SO
Reliance Capital 612 3,281 347 378 1.0 0.8 43.3 39.2 13.1 10.8 8.1 7.8 - Hold SP
Rural Electrification Corp 268 5,766 129 152 2.1 1.8 24.6 30.5 15.7 14.4 10.9 8.8 2.4 BUY SO
SREI 102 259 114 124 0.9 0.8 12.1 14.5 10.9 11.9 8.4 7.1 1.0 Under Review

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Shriram City Union Finance 544 587 236 287 2.3 1.9 46.9 57.6 21.1 21.5 11.6 9.4 0.7 BUY SO
Price Date 10-Jan-11 # adjusted for subsidiaries

Source: Edelweiss research

 
BFSI

Edelweiss Securities Limited, 14th Floor, Express Towers, Nariman Point, Mumbai – 400 021,
Board: (91-22) 2286 4400, Email: research@edelcap.com

Vikas Khemani Head Institutional Equities vikas.khemani@edelcap.com +91 22 2286 4206

Nischal Maheshwari Head Research nischal.maheshwari@edelcap.com +91 22 6623 3411

Coverage group(s) of stocks by primary analyst(s): Banking

Allahabad Bank, Axis Bank, Centurion Bank of Punjab, Federal Bank, HDFC Bank, ICICI Bank, IOB, Karnataka Bank, Kotak Mahindra Bank,
OBC, SBI, Yes Bank, IDFC, HDFC, LIC Housing Finance, PNB, Power Finance Corporation, Reliance Capital, SREI Infrastructure Finance,
Shriram City Union, Syndicate Bank and Union Bank.

EW Indices Recent Research

1,400
Date Company Title Price (INR) Recos
1,250 03-Jan-10 Banking Fresh round of deposit
rate hike; Sector Update
1,100
21-Dec-10 REC Modest pace of 313
disbursements; margins
950 to sustain; Visit Note

14-Dec-10 BFSI RBI Trends and progress-

800 key takeaways;
Sector Update
6-Jan-10 6-Jul-10 6-Jan-11
13-Dec-10 Punjab and Valuations attractive; 113-
EW Banks and Financial Services Index Nifty Sind Bank IPO Note 120

Distribution of Ratings / Market Cap

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Rating Interpretation
Edelweiss Research Coverage Universe
Buy Hold Reduce Total Rating Expected to

Buy appreciate more than 15% over a 12-month period

Rating Distribution* 116 45 12 176
* 3 stocks under review Hold appreciate up to 15% over a 12-month period
> 50bn Between 10bn and 50 bn < 10bn
Reduce depreciate more than 5% over a 12-month period
Market Cap (INR) 110 53 13

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