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Analyzing the impact of rise in interest rates on margins – Re-iterate positive view on the sector
Margin pressures have increased due to: (a) tight liquidity conditions, and (b) unexpected move by SBI to increase retail term deposit rates by 50-150bp.
While we believe that 2QFY11 margins are at peak, we rule out a sharp fall in margins. Banks with high CASA deposits will experience lower pressure on margins.
G-Sec yields have hardened across maturities, leading to fear of higher MTM provisions. At 8.1% 10-year G-Sec yield, MTM impact on FY11E PBT is just 2-3%.
The liquidity situation is likely to ease in 4QFY11, with the impact RBI's OMO, improvement in real interest rates, and increased government spending.
Given the sharp rise in borrowing cost (wholesale and retail), maximum interest rate increase is expected to be 50bp from hereon. As banks have increased PLR, the liquidity situation is expected to improve; concerns over sharp compression in margins are overstated in our view. Our top picks are ICICI Bank, SBI and Yes Bank. Risk to our call: continued tightness in liquidity in 4QFY11, leading to elevated G-Sec yields and higher cost of funds.
Analyzing the impact of rise in interest rates on marginsRe-iterate positive view on the sector
Liquidity stress aggravated in 3QFY11, led by (1) strong credit growth, (2) lack of government
spending and increase in the government's balance with RBI, (3) lag impact of RBI's
monetary tightening, and (4) net FII outflows. Tight liquidity led to a sharp increase in
wholesale borrowing cost and G-Sec yields, leading to fear of pressure on banks' margins
and MTM provisions on bond portfolios. SBI's 50-150bp increase in deposit rates across
maturities aggravated fears relating to margin pressure and led to a 7-8% decline in the
MOSL-Public Sector Bank Index and a 2-3% decline in the MOSL-Private Bank Index.
Our study indicates that margins could contract by 5-10% and this is already factored in
our estimates. Our analysis suggests that a 20bp rise in G-Sec yields will have just 2-3%
impact on FY11E PBT. We maintain our positive view on the sector.
Concerns relating to margin pressure have increased…: Concerns relating to margin
pressure have increased due to: (a) tight liquidity conditions (net repo of ~Rs1t in last
fortnight and ~Rs800b QTD) and faster than expected rise in wholesale borrowing cost (up
~350bp YTD, ~120bp QTD and ~50bp in last fortnight for 1-year CDs), and (b) unexpected
move by SBI to increase retail term deposit rates by 50-150bp across maturities.
…but our analysis indicates just 5-10% impact on margins in 2HFY11: While we
believe that 2QFY11 margins are at peak, we rule out a sharp fall in margins - there is
sufficient pricing power in the system (incremental CD ratio at ~100%; banks have recently
raised PLR by 50-75bp, and increased base rate by 25-50bp). Our analysis indicates 30-
60bp increase in deposit cost. With ~25bp increase in yield on loans, margins could fall 5-
10% from current levels, which is factored in our estimates. Banks with high CASA deposits
and lower proportion of bulk deposits will experience lower pressure on margins.
G-Sec yields have hardened; however, MTM impact is just 2-3% of FY11E PBT: On
the back of tight liquidity situation and improving loan growth, G-Sec yields have hardened
by 10-45bp across maturities, leading to fear of higher MTM provisions on investment
portfolio. ~20% of the portfolio of most large PSBs is in the AFS category, with duration of
2-2.5 years. At 8.1% 10-year G-Sec yield, the MTM impact on FY11E PBT is just 2-3%.
Our economist expects liquidity situation to ease and 10-year G-Sec yield to fall to
7.7%: The liquidity situation is likely to ease in 4QFY11, with (1) the impact of three
rounds of RBI's open market operations (OMO) of Rs120b each being felt, (2) expectation
of further OMO of Rs240b in the rest of FY11, (3) improvement in real interest rates driving
up deposit growth, and (4) increased government spending (o/s balance of Rs700b-900b
with RBI). On the back of improving liquidity situation, lower government borrowing and
expectation of fall in inflation, G-Sec yields are likely to fall to 7.7% by March 2011.
Sharp margin compression unlikely; re-iterate positive stance on sector: Given the
sharp rise in borrowing cost (wholesale and retail), maximum interest rate increase is
expected to be 50bp from hereon. As banks have increased PLR, the liquidity situation is
expected to improve; concerns over sharp compression in margins are overstated in our
view. Our top picks are ICICI Bank, SBI and Yes Bank. Risk to our call: continued
tightness in liquidity in 4QFY11, leading to elevated G-Sec yields and higher cost of
funds.
Liquidity stress aggravated in 3QFY11, led by (1) strong credit growth, (2) lack of
government spending and increase in the government's balance with RBI, (3) lag impact
of RBI's monetary tightening, and (4) net FII outflows. Tight liquidity led to a sharp increase
in wholesale borrowing cost and G-Sec yields, leading to fear of pressure on banks' margins
and MTM provisions on bond portfolios. SBI's 50-150bp increase in deposit rates across
maturities aggravated fears relating to margin pressure and led to a 7-8% decline in the
public sector bank index and a 2-3% decline in the private bank index. Our study indicates
that margins could contract by 5-10% and this is already factored in our estimates. Our
analysis suggests that a 20bp rise in G-Sec yields will have just 2-3% impact on FY11E
PBT. We maintain our positive view on the sector.
Tight liquidity conditions led to a sharp rise in wholesale borrowing cost
Tight liquidity conditions (net repo of ~Rs1t in last fortnight and ~Rs800b QTD) led to
sharp increase in wholesale borrowing cost. Short-term borrowing cost for banks in bulk
markets, which had hit the bottom in September 2009, has increased by ~350bp YTD,
~120bp QTD and ~50bp in the last fortnight for 1-year CDs. This is a key concern for
margins, as banks will have to rely on bulk deposits till retail deposit growth picks up with
rise in interest rates.
Expect liquidity conditions to improve in 4QFY11
Liquidity conditions are likely to remain tight in December 2010 on the back of advance
tax outflow and continued strong credit growth. Our economist expects liquidity situation
to ease in 4QFY11, with (1) the impact of three rounds of RBI's open market operations
(OMO) of Rs120b each being felt, (2) expectation of further OMO of Rs240b in the rest
of FY11, (3) improvement in real interest rates driving up deposit growth, and (4) increased
government spending (o/s balance of Rs700b-900b with RBI). Further movement in
wholesale borrowing cost will depend upon proactive management of liquidity by RBI.
However, we expect bulk deposit rates are likely to peak out in 3QFY11.
Steps taken by RBI to improve liquidity in the system
RBI allowed banks to avail additional liquidity support under the LAF to the extent of
up to 2% of their NDTL.
RBI has so far announced an OMO for purchase of government securities amounting
to Rs360b during FY11.
RBI/GoI also pruned the first tranche of December borrowing to Rs60b from Rs110b
announced as per borrowing calendar
Deposit growth to rise with higher term deposit rates and falling inflation
Negative real interest rate led to fall in deposit growth and increase in currency in circulation
in 1HFY11. With fall in inflation and rise in interest rates, real interest rate is becoming
attractive which will provide push to deposit growth. Most of the banks have increased
term deposit rates by 50-100bp across maturities to garner more fixed deposits amidst
tight liquidity conditions and expectation of strong credit growth in 2HFY11.
SBI has raised deposit rates sharply
In an unexpected move, SBI increased deposit rates by 50-150bp across maturities. Its
sharpest increase is in the shorter maturity basket of 46-90 days, where the rate has been
increased by 150bp to 5.50%. The peak rate of 8.75% will be available in the 8-10 year
basket. SBI's interest raters are highest in the system and other banks have started catching
up. Given 175bp increase in interest rates in last 12 months, we expect maximum increase
of 50bp in interest rates from hereon.
Incremental CD ratio at 100%; banks have sufficient pricing power
While we believe that 2QFY11 margins are at peak, we rule out a sharp fall in margins.
Banks have sufficient pricing power; incremental CD ratio is ~100%. PNB, BoB, ICICI
Bank and HDFC Bank have recently raised their PLRs by 50-75bp. Some of the small
banks have also announced increases in PLRs. Immediate impact of increase in PLR will
help to negate pressure on margins
Lending rate increase has followed deposit rate hike
Unlike the previous cycles, lending rates have increased immediately post increase in the
deposit rates by banks, protecting the margins. There is fear in the market that NIM will
come down sharply post increase in deposit cost, similar to the situation post the financial
crisis period. During the financial crisis period, banks had started offering 10% retail term
deposits to meet the credit demand and to build up liquidity. However, post 3QFY09,
banks' margins collapsed as (1) loan growth moderated, (2) excess liquidity built up in the
balance sheet, as high interest rates led to strong deposit growth - monies were parked in
reverse repo, with negative carry, and (3) lag impact of rise in deposit cost was felt.
Banks started taking corrective actions by (1) sharply cutting deposit rates and moderating
deposit growth, and (2) improving their CD ratios. Excess liquidity in the system also
helped to reduce bulk deposits, in turn lowering cost of deposits. We believe FY10 and
1HFY11 are the periods of excesses, which are being corrected, resulting in wild
fluctuations. To gauge the long-term sustainable margins, we look at the average margins
over FY04-09. For most large-cap banks, 2QFY11 margins are 8-10% higher than the
average margins over FY04-09. While we expect this to be corrected, we do not anticipate
a sharp fall from current levels.
Our analysis indicates just 5-10% impact on margins in 2HFY11
Our analysis indicates 30-70bp increase in deposit cost. Assuming ~25bp increase in lending
yields; margins could contract 5-10%, which is factored in our estimates. Banks with high
CASA deposits and lower proportion of bulk deposits will face lower pressure on margins.
Our methodology
Based on ALM pattern of FY10, we have analyzed the proportion of deposits to be
repriced in 2HFY11 (we assume entire repricing will relate to term deposits)
Based on our expected deposit growth, we arrive at incremental deposits to be mobilized
in 2HFY11, 25% of which would be from CASA deposits. We have factored in lower
proportion of CASA deposits, as interest rates have become attractive for term deposits.
We have factored in 70% of the portfolio to be repriced with increase in lending rates.
We factor in 125bp rise in cost of term deposits to be repriced in 2HFY11. Our blended
cost of term deposits is 7.5-8.25% for the deposits to be repriced in 2HFY11. Rise
may be higher in case of banks where the proportion of bulk deposits is high.
Conclusions
With 25bp increase in yield on loans, margins are likely to fall 10-40bp or 5-10% for
the banks under our coverage.
With 50bp increase in yield on loans, margins are likely to fall maximum 15bp or 5%
for the large banks under our coverage. For most of the banks margins are likely to be
stable if yield on loans improves 50bp
Banks with low CASA and high proportion of bulk deposits are likely to be impacted
the most, in our view.
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