Retail investors of Lakshmi Vilas Bank on the losing end; 3 rules to follow to avoid such cases

Lakshmi Vilas Bank (LVB) gets a life line. The banking regulator proposes a merger of the troubled bank, LVB, with DBS India which is a subsidiary of an Asian Bank listed in Singapore. As per the deal, DBS India will infuse fresh capital of Rs 2,500 crore to acquire 51 percent stake in LVB.

Though the bank is put under moratorium for 30 days with restrictions on withdrawals, the infusion of fresh capital and the proposed merger would secure depositors of the bank. The LVB bondholders would also benefit as the deal not only ensures repayment of debt but also possible upside from credit rating upgrade on their investments. But alas, the outcome is quite negative for the equity shareholders of the bank.

As per the draft circulated by RBI, the merger will result in entire paid-up capital, reserves & surplus of LVB to be written off. That essentially means that the value of equity shares of LVB will become zero. It does sound harsh on equity shareholders but the bank was pretty much insolvent and the damage to shareholders will not come as a surprise.

In fact, the small investors have repeatedly burnt their fingers by dabbling in troubled banks or penny stocks. Even in case of Yes Bank, the equity shareholders lost significant amount of money though not completely like in the case of LVB where the bank's net worth had turned negative anyway. Similarly, the asset quality issues in public sector banks have destroyed humungous amount of retail investor wealth over the period of time.

On the other hand, investors have consistently earned very handsome returns in the leading private sector banks over the long period of time. So the lesson for recent fiasco in some banks and financial institution (like IL&FS, DHFL, Indiabulls Financial) is simply to stick to quality banking stocks with proven track record.

Banks and NBFCs have highly sensitive to variety of macro variables like interest rates, inflation, liquidity among others. It is not possible for a retail investor to actively track macro variables and the implications of the same on individual stocks. In addition to this, there are micro issues like asset quality, ability to raise funds cost effectively, operational efficiencies etc.

But to keep it simple and easy to understand from retail investors point of view. There are certain thumb rules that can be used to avoid accidents. First, it would be advisable to avoid tier II/tier III banks & financials when there is slowdown or stress in the economy and/or interest rates are going up. Second, it would be better to avoid banks & financial institutions with single-digit return on equity (RoE). Last but not the least, the safe buffer of the bank is reflected in the capital adequacy ratio (CAR). Banks with CAR of 14 percent or more would have decent capital buffer to tide over in the tough times.

(Gaurav Dua, SVP and Head Capital Market Strategy & Investments at Sharekhan by BNP Paribas.)