India Banks and Finance – Positive: Daiwa

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Sector thesis: asset-quality concerns likely to subside
We have a Positive rating on the India Banks and Finance Sector. We believe that
NPL recoveries will be the key theme for the next year as an improving economic
environment would provide support for the banks’ efforts in this area. Public sector
banks (PSBs), in particular, have seen high amounts of fresh NPLs over the past
two years, with recoveries as a percentage of the previous two years’ fresh NPLs at
a multi-year low. The banks are now focusing even more on recoveries, which we
believe will be reflected in improvements in asset quality.


We expect the industry’s NIMs to be stable in 2H FY11, but see some pressure
from 1Q FY12 onwards, especially for the PSBs. The use of the base rate as the
benchmark lending rate may ensure the faster transmission of policy rates in India,
and we believe that in the case of a tightening interest-rate environment, the banks
will see less pressure on NIMs than in previous rising interest-rate cycles. We
expect liquidity to ease for the banking system as the money lent to the telecoms
companies for the 3G spectrum auctions returns to the system, and deposit growth
moves closer to our forecast of 20% loan growth for the banking system as a whole
over the next year. Overall, we expect the performance of the banks to remain
strong in FY12, driven by the low provisioning requirement.
Structural outlook: three-year view
The financial industry is among the best-regulated sectors in India, and probably in
the world. As such, we do not expect any major regulatory changes. However, we
also expect certain key reforms: the granting of banking licences to industrial houses,
and an increase in the FII limit for the PSBs. An industrial house is currently not
permitted by the regulator, the Reserve Bank of India (RBI), to own a bank. However,
the RBI is now considering granting banking licences to these entities. We believe a
consequence of such a move would be that many non-banking financial companies
would either convert into banks or float a new banking entity. This would
undoubtedly lead to an increase in competition, but we believe that the regulator, for
the sake of conservatism, might impose restrictions on net worth and network. We
think financial inclusion (improving the penetration rate of the banking industry, by
getting more of the population into the banking system and increasing bank use in
under-banked areas), will be one of RBI’s main criteria for granting new licences.
In our view, increasing the FII limit for the PSBs (currently 20%) would not only
improve the PSBs’ valuation multiples but also provide an additional opportunity
for the easy divestment of banks with high government stakes. While the
consolidation in the banks sector over the past few years has been restricted largely
to private sector banks, going forward we believe there would be some
consolidation activity in the PSB space. The State Bank of India (SBI) started the
ball rolling by merging two of its associate banks, and over the next couple of years
should seek to merge the remaining five. To put things into perspective, the
combined size of SBI’s associate banks is bigger than the second-largest PSB in
India. Consequently, we expect SBI to expand in size and believe it could easily be
among the biggest banks in the world in terms of asset size.

Based on Daiwa’s forecast for India’s GDP to range from 7.5-7.8% YoY over the
next couple of years, we forecast loan growth for the banks sector to range from
20-24% YoY. Increasing economic activity and capex would boost corporate loan
demand and a rise in individual consumption expenditure would boost retail-loan
demand. We see the issue of attracting, training and retaining talent as a key
challenge for the banks, especially the PSBs.