Private Banks and the Credit Cycle.

Understanding the boom and bust of bank lending

2 min readPublished
A cargo delivery tricycle parked on a sunlit Indian street, piled high with a towering, leaning stack of cardboard boxes tied with a rope, illustrating the risk of overloading before hitting a bump.
The Boom and Bust of Bank Lending

How the credit cycle shapes the strength of private banks.

The story

Imagine a small business owner, Rohan, who took a loan from a private bank to expand his textile unit during the boom. Now, with interest rates rising, he's struggling to repay.

The credit cycle is the expansion and contraction of bank lending over time. It's a natural part of the economy, but can be challenging for banks and borrowers alike.

During the boom phase, banks lend aggressively, and profits rise. However, bad loans build silently, like a time bomb waiting to explode.

In the bust phase, borrowers default, and profits sink as banks set aside provisions to cover the bad loans. This is when the true test of a bank's strength comes.

Private banks with strong deposit bases weather credit cycles far better than their peers.

Analogy

Two shopkeepers' tale

Consider two shopkeepers, Ramesh and Suresh. Both have identical businesses, but Ramesh takes a large loan to expand. In good times, Ramesh's profits soar, but in bad times, the loan magnifies his losses. This is how debt can amplify both the good and the bad.

The Leverage Effect.Business Math
In good times, debt multiplies profits. In bad times, debt multiplies losses. Choose your balance wisely.

Why this matters

Understanding the credit cycle and private banks' role in it can help you make informed investment decisions. By investing in strong private banks, you can potentially benefit from their ability to weather credit cycles.

Lock it in

Where people go wrong

  1. Assuming low NPAs today means zero future loan defaultsNPAs can rise suddenly during a credit bust, catching investors off guard.
  2. Chasing high credit growth banks ignoring loan quality risksHigh credit growth can be a sign of reckless lending, leading to future defaults.
  3. Ignoring deposit base stability while focusing only on loan bookA strong deposit base is crucial for a bank's stability during a credit cycle.
If you only remember three things

  1. Private banks weather credit cycles better with strong deposit bases

  2. Unsecured retail credit growth can signal future stress

  3. AQR and IBC reforms helped banks clean up balance sheets

Investors tend to extrapolate the current phase infinitely, ignoring that easy credit always plants the seeds of the next crisis.
Shekar
Shekar
During a boom, we treat temporary tailwinds as permanent growth. That's when bad loans are born.