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India Financials 2011
Time to catch the falling knife, it's not that sharp
apprehensions of a negative impact of rising rates; from a one-year perspective,
we believe this is a buying and not a reducing opportunity. Although the next few
months could be challenging, we do not see much valuation downside from here.
Our earnings estimate increases after the October-December 2010 results are a
reinforcement of fundamental strength and catalyst for a potential reversal in
sentiment, if the liquidity climate were to turn favourable even at the margin.
Apprehensions may be overdone, and stocks may have fallen enough
Experience from previous cycles, though not extensive, does provide interesting
counter-intuitive conclusions – loan growth does not necessarily fall when lending
rates rise, and bank stocks do not necessarily fall with higher rates. Moreover, our
valuation scenario assessment based on the tight liquidity period of 2007 shows
that while stocks may face potential downside of 0-14% from current levels, they
could rebound by 15-180%. We have deliberately chosen to focus on tight liquidity
situations, excluding the credit crisis period, which was an extreme, and, in our
opinion, not representative of the present.
Liquidity, loan growth, margins, and credit quality on the right track
Our call ensues from four key observations. First, efforts by the government,
banks, and the RBI to alleviate the systemic liquidity deficit have begun to show
results. Liquidity management effectively de-linking from inflation is a big positive
development. Second, loan growth has distinctly improved from c.14% in January
2010 to c.24% now. Third, our analysis shows that most banks stand to benefit
from the lending rate increases already put in place, and there is enough evidence
of pricing power. Finally, credit quality seems to have crossed the hump of 2008-
09, and more so in retail.
Valuations and risks
We value Indian banks’ lending business on the Gordon Growth model, insurance
on appraisal value, asset management on percent of AUM, and other non-banking
businesses on P/E. The key risks for the sector are higher slippages from
restructured assets and continuation of high inflation for beyond six months
leading to more-than-tolerable rate increases.
Stock ideas
Top picks among large caps: Axis Bank, HDFC Bank and Bank of Baroda;
among mid-caps: Yes Bank and Shriram Transport Finance.
Switch from i) SBI to PNB and BoB; ii) Union Bank to Canara Bank; iii) IDFC to
PFC; and REC iv) Kotak Mahindra to Yes Bank.
Investment summary
Indian financials have taken a beating in the last two months, which stands out particularly
after the consistent outperformance in most of 2010. While the beginning was perhaps
triggered by fringe issues like microfinance problems and the bribery-for-loans allegations,
the key concern today is the impact of persistently high inflation leading to higher interest
rates, thereby affecting margins, growth and eventually credit quality. The question
paramount in the minds of investors is how long the liquidity deficit situation continues, and
whether bank stocks have fallen enough to price in these concerns. In this report we address
these issues in detail, and conclude that it is probably time to nibble if not bite into the
sector, as valuations reflect unwarranted levels of pessimism on these counts.
“Lack” of government spending a timing mismatch issue, not an intention to delay
spending
The lack of government spending, which the central bank terms a “frictional” liquidity deficit,
could be alleviated in the next few months through a combination of spending and reduced
borrowing. The government has not provided any indication of cutting down on spending. On
the issue of a policy logjam (caused by controversies during 2010) leading to lack of decision
making on spending, our view is that there are plenty of spending avenues that are eminently
non-controversial, such as food, fertilizer and petroleum subsidies.
Contrary to the conventional belief that a cash reserve ratio reduction is completely ruled out
in an environment of inflation, we also believe the RBI could do a CRR (cash reserve ratio, the
amount statutorily appropriated from banks without any interest payment) cut as well in
March 2011.
Finally, to the extent the government carries over the high cash balances to FY12, there could
be lesser borrowings in the first half of FY12 than there normally are, helped also by
seasonally lower private credit demand.
Deposit growth a product of effort and rates, and both have picked up
The other problem that the central bank likes to classify as “structural” liquidity deficit is, in
our opinion, not structural but cyclical; by that token, it should also be alleviated in the coming
months if not fully disappear. It was caused by low deposit rates for most of 2009 and 2010
and banks aggressively shedding instead of mobilizing deposits. This, coupled with high
inflation, led to a high currency in circulation, and hence the liquidity deficit. Both have
significantly changed for the better – deposit rates have been raised to a point where the real
rates at least in some buckets are positive, and the mobilization effort is back.
Analysis shows NIMs may not compress much, given pricing power
Banks have been able to raise lending rates cumulatively by 75-100bps already in this cycle,
and the speed with which banks have been able to raise lending rates, even in supposedly
competitive markets, has taken us and the Street by surprise.
Pricing power currently exists not just because of the c.800bps gap between lending and
deposit growth rates, but for the following reasons:
The waning of disintermediation that has pushed up asset yields. Reported loan growth
also goes up as CP holdings that are classified as investments get converted into loans.
In this cycle we have noticed a clear tendency on the part of the government to stay
away from interfering with lending rates. We believe the key reason for this is RBI
instituting the base rate system, which has to be based on a cost of funds (among other
things), making the transmission system by and large automatic.
From our impact analysis of the differential rates of increase on loans and deposits on a
“typical” bank, we conclude that margins take a small dip in the first year only to recover
quickly.
Axis Bank, BoB, Canara Bank, HDFC Bank appear best placed in this environment
The above conclusion is a result of multiple analyses: i) the study of margin behaviour during
past cycles of tight liquidity, and, more importantly, thereafter when liquidity is reversed; ii)
banks’ ALM profiles; iii) sensitivity to a 50bps increase on both sides of the balance sheet;
and iv) the impact based on rate increases that have already occurred. The more important
general message from these assessments is that because of pricing ability, the current
environment may be more beneficial to banks than detrimental.
Growth unlikely to be at risk because of higher lending rates
In a rising interest rate environment there is usually concern about high lending rates
adversely affecting growth. However, in the past we have witnessed high loan growth in
periods of high lending rates (and low loan growth during low interest rate periods). Most
bank CEOs recently indicated that another 50-100bps increase in lending rates is unlikely to
have an impact on growth.
Corporate profitability remains a cushion for credit quality
We do not believe the scale of rate increases that we have seen and are likely to see will be
such as to endanger credit quality. Theoretically, as long as a company has a profitability that
is high enough to afford interest payment, the ability to repay debt is not jeopardized. Up to
the late 1990s, corporate asset quality was a big problem in India because in addition to high
interest rates, corporate profitability was poor and corporate India was massively
overleveraged. Available data suggest that the situation has considerably improved. So even
though the gap between profitability and interest rates could narrow, it should still remain
healthy enough to avoid a snowballing into an NPL problem.
Favourable seasoning impact of low growth of last two years
Banking system loan growth over the past two years has averaged 17%, compared with
average growth of 27% over the three years prior to that. The high loan growth of FY06-08
led to some asset quality issues during the credit crisis. However, the favourable seasoning
impact of the relatively moderate growth over the past two years and improving economic
environment lead to us believe that asset quality is unlikely to be a systemic issue in FY12.
Within that, we believe that retail assets are better placed than corporate – credit costs for
predominantly retail banks (HDFC Bank, Kotak Bank, and ICICI Bank) have been declining for
the past three to four quarters.
Decline in credit losses could be a substantive profit contributor in FY12E
Even though NIM may contract by 10-15bps in FY12E over FY11E, this could be more than
offset by a decline in credit costs, which could in some cases be significant. We are currently
estimating credit costs to decline by 5-30bps in FY12E over FY11E. This is another reason
why we view the outlook for retail assets better than that of corporate assets – while the
latter is still showing some areas of weakness, retail seasoning is almost complete, and
credit costs are declining rapidly. Some banks have significantly downsized their unsecured
retail portfolio, which was the key problem area in 2007 and 2008, and some have given it up
altogether. Moreover, in a rather perverse way, inflation is better for retail asset quality as the
realisable value of the collateral goes up.
We estimate limited downside based on lessons from past cycles; risk/reward is
favourable
We have identified January to June 2007 as the previous period of liquidity deficit when
banks were borrowing large amounts under a reverse repo window. We have analysed the
stock price performance during that period to assess potential downside to current levels.
During this period the contraction between the maximum and minimum P/B multiple for
banks under our coverage was between 23% and 44%. In the current cycle, the multiples
have already contracted between 21% and 35% from their peak in October-December 2010.
If we assume similar multiple contractions now as was witnessed in January to June 2007,
then further downside is limited to 0-14%. More interesting, the average P/B valuation for a
six-month period following the liquidity deficit period was 15-179% higher than the minimum
during the liquidity deficit period. Again, if we were to draw a similar analogy for the current
period, then there could be significant upside potential to current levels, making the
risk/reward favourable.
Best picks within large caps Axis, HDFC Bank, BoB; small caps Yes, STFC; switch ideas
Our top picks among the large cap banks are Axis Bank, HDFC Bank, and Bank of Baroda, and
our top pick mid-caps are Yes Bank and Shriram Transport Finance. We upgrade CanBank to
Buy from Hold and downgrade Kotak from Hold to Sell.
We recommend investors switch from:
i) SBI to PNB and BoB;
ii) Union Bank to Canara Bank;
iii) IDFC to PFC and REC; and
iv) Kotak Mahindra to Yes Bank.
Liquidity deficit can change
for the better
Banks have embarked on 2011 with a liquidity deficit that on days has exceeded levels seen
after the 2008 credit crisis . We are more optimistic than that and believe that there are levers available. However, the
January-March 2011 quarter is likely to remain tough for liquidity and hence for banks;
seasonally too, the last quarter of the fiscal year is tight. It could normalize thereafter. This
outlook appears uncannily similar to the situation in 2007 and 2009, though of course due to
entirely different reasons.
Timing mismatch between government revenues and spending
should reduce
Government’s unusually high balances with the RBI have been a problem
As Figure 7 shows the balances that the central government holds with the RBI (effectively
out of the system liquidity) have been rising steadily. It is not as though government
expenditure has slackened, but its revenues have been stronger than expected. A bit of that
is due to higher tax collections, but the real disruption was caused by the 3G telecom and
broadband wireless auctions that yielded the government INR1.05tr versus its own
expectation of INR350bn. This kind of an amount does not come back into the system quickly
– the government got the windfall but cannot “plan” windfall spending.
We believe the above problem should sort itself out in a quarter or two. First, much of the
spending tends to be seasonally back-ended in the fiscal year. Second, the government has
to release subsidies for food, fertilizer, and petroleum products where deficits (“underrecoveries”)
have actually been rising.
The flip side of the above is potential for lower borrowing by government
Other than the seasonal decline in government borrowing in the January-March quarter, it is
likely that the government could step off the borrowing pedal for some more time as it draws
the balances down to spend. In addition, government spending is traditionally more on a
back-ended basis for a financial year – by that token itself the spending should go up in the
January-March 2011 quarter. And as we explain below, there is no reason to believe that the
government will consciously slow its spending.
Increase in RBI bond buyback likely, cannot preclude a CRR cut either
In the December 2010 mid-quarter statement, the central bank specifically articulated its
intention to buy back INR480bn of sovereign bonds. Since then, the liquidity situation has
tightened further despite the usual year-end loosening of the government borrowing
programme, and hence we believe that the RBI may up the bond buyback target to infuse
more liquidity into the system. It has also cut banks’ bondholding requirement (SLR) by 1%
permanently to 24%, and given the additional relaxation of another 1% up to April 2011,
which also offers some leeway, though it is not a source of primary liquidity.
Although the consensus view seems to be that it is impossible for the RBI to justify a
reduction in CRR in view of the prevalent high inflation, we believe that is not a given. The
RBI has expressed some frustration at the inability of a central bank to address largely food
driven inflation using monetary tools. It is also obvious that excess liquidity can no longer be
blamed for fuelling inflation, as liquidity is actually in deficit. In addition, the RBI is cognizant
of the potentially destabilising effects of such high levels of a liquidity deficit. So the premise
of “sending the wrong signals” by doing a CRR cut does not necessarily hold.
Greater scrutiny of government spending not as much at risk as perceived
One risk to government spending that is hard to substantiate or quantify is possible delays
induced by the unravelling of scams and cases of financial misdemeanour last year, leading
to greater scrutiny of expenditures. The only source of comfort we have is the finance
ministry’s repeated assertion that it does not intend to report a lower fiscal deficit this year
than it originally projected, implying that spending should be on track. Moreover, there are
lumpy items of regular expenditure (e.g., subsidies) that are in the nature of social sector
programmes where there could be less fear of misdemeanour cases.
Currency in circulation could decline with acceleration of deposit
growth
High currency holdings due to inflation and earlier low deposit rates
The economy appears to have kept sharply increasing amounts of hard cash with itself over
the past year (Figure 8), probably as rising inflation led to higher transaction value
requirements, but, more importantly, because bank savings rates were low.
But now positive real deposit rates seem to be working
The RBI’s repeated persuasion of banks to make real deposit rates positive has finally
worked, with two to three rounds of deposit rate hikes by banks in the last six months (Figure
10). Negative real deposit rates for an extended period were the main distortion that has
affected deposit growth (along with impressive returns from competing assets such as gold
and real estate). Historically there has been a strong correlation between deposit growth and
rates
Of course, the impact can be felt only over the weeks and months and not overnight. There
could be another round of increases, but possibly at different points in time by various banks
instead of clustered together. Deposits have begun to creep up recently
Deposit growth also a function of effort on mobilization, not just rates
We dealt with the deposit growth issue in greater detail in our report titled Question bank:
ten issues, five conclusions dated 13 October 2010. We believe blaming only the rates for
low deposit growth is simplistic. One irony that has gone unnoticed is that term deposits
have been decelerating, whereas CASA (low-cost) deposits have been growing very well. If
rate is the only reason, how can it explain the comparatively faster growth of a segment in
which the real rate has been even more negative?
In our opinion, the real problem is that banks find it difficult to act in a timely manner on retail
term deposit rates, either on the way up or down. For the whole of FY10, most banks were
aggressively shedding term deposits because they were hurt by the negative carry on them
arising from weak loan demand. So deposit mobilization was consciously given short shrift.
The low rate acted as a tool, but the lack of effort mattered more.
This went on for too long, even after credit started picking up in mid-2010. It has of course
started to change – banks, other than having raised deposit rates twice or thrice, have openly
acknowledged the importance of rebuilding the retail term deposit (or fixed deposit)
franchise, which was ignored for the last one and a half years in pursuit of CASA.
However, oil companies’ borrowings can upset the balance
Higher crude prices directly translate to higher deficits of oil companies…
Figure 12 shows the strong correlation between crude prices and OMC burden; however,
note that the deficits are on the rise because after the last quarter recorded in the chart, oil
prices have spiked further and have been higher than USD90/bbl. The chart denotes what oil
marketing companies (OMCs) need to bear themselves, which essentially means borrowing.
So to the extent the government subsidy part arrives late (which is a common phenomenon),
OMCs end up bridging more of the deficit than planned.
The government generally defrays the subsidy with a six-month delay, and hence the deficit
arising from high oil prices in the October 2010-March 2011 period could actually come in the
April-September 2011 period, requiring the OMCs to borrow more than usual.
…and then on to their borrowing demand, which puts more pressure on liquidity
Although oil borrowings are not a significant portion of total bank loans, in times of a liquidity
shortage they can put pressure on the system, especially if oil prices are also on the rise
(Figure 13). The Deutsche Bank oil & gas research team estimates that oil companies may
need to borrow an additional INR250-400bn in the January-March 2011 period – this could
account for up to 25% of incremental loans given by the banking system in the January-
March 2011 quarter.
Impact on margins and growth manageable
Dependence on short-term markets and corresponding interest rates have gone up
Short-term rates have been going up from April 2010
and not recently.
Strapped by high incremental loan-to-deposit ratios, banks have been raising resources at
higher costs (Figure 15) from the certificates of deposits (CD) market, in addition to paying
higher rates for wholesale (“bulk”) deposits and of course card rates for retail deposits.
Banks have been raising more CDs as well in the last few months (Figure 16). These data
come with a lag, and the next release could indicate a further increase. However, the tempo
of the increase could cool off because banks have raised their retail deposit rates and are
focusing more on them.
Pricing power does exist despite “weak” loan growth
The main reason for the above phenomenon is that money is not as easily available as it was
in most of 2010, and 22-24% is not “weak” credit demand growth – the only reason for it
appearing weak is that India became used to seeing 30% loan growth in good times. The
extent of 3QFY11 margin increases reported by several banks came as a positive surprise,
only because banks could adjust lending rates fairly quickly, contrary to the initial
apprehension of banks’ inability to raise lending rates.
Reduction in disintermediation silently brings back some pricing ability
As Figure 17 and Figure 18 show, at least one form of disintermediation (through commercial
paper) is on the wane – the levels were fairly high and offered significant competition to
direct bank credit in most of 2010. CP rates were also quite low, as we have seen in Figure
14. Since banks themselves have been meaningful subscribers to these commercial papers,
overall yields were depressed. Thus, the waning of disintermediation pushes up yields.
Reported loan growth also rises, as CP holdings that are classified as investments get
converted into loans.
Foreign currency loans have also grown strongly, eating into the market share of domestic
loans, and since data releases come with a lag, there is no sign of these borrowings cooling
off as yet (Figure 19). However, one factor that always makes ECBs attractive is the
appreciation of the rupee, for which the tide has turned. So although the interest rate
differential continues to make ECBs attractive, they may be less so now than in late 2010.
Banks have started increasing lending rates, including on fixed-rate products
The speed with which banks have been able to raise lending rates, even in supposedly
competitive markets, has taken us and the Street by surprise
Government and regulatory disposition to lending rate increases have generally been
benign
In this cycle we have noticed a clear tendency on the part of the government to stay away
from interfering with lending rates. We believe the key reason for this is the RBI’s institution
of the base rate system, which has to be based on cost of funds (among other things), needs
to be updated every quarter, and audited. Hence, the transmission system has been by and
large made automatic.
The instance where there have been murmurs of discontent on lending rates is the RBI and
the government suggesting that the margins of Indian banks are too high. The RBI and the
government have voiced their concern on the high cost of bank intermediation many times in
the past. However, even this time around, banks went ahead and raised lending rates after
the RBI’s statement, as the RBI itself acknowledged that there are other costs that
counterbalance the high margins and would lead to moderate (and not exorbitant) profitability
of banks in the regional context.
Impact on specific banks; Axis Bank, BoB, Canara Bank, and
HDFC Bank appear better placed
Prior cycles indicate NIMs dip and then revive within a maximum of two quarters
We have studied two previous examples of tight liquidity situations (June-November 2008
and January-June 2007). The first period is probably not very representative of what we are
seeing today because it was around the time of the global credit crisis, but the latter one
certainly is, in our view. As we see from Figure 21, margins dip for a quarter or two and then
revive sharply. The banks that managed to limit the declines were ICICI, Kotak, Bank of
Baroda, Bank of India, and PNB. HDFC Bank can also be included in this list because its 4.5%
NIM in the March 2007 quarter was a consequence of very adept year-end liability
management, and the subsequent “decline” in the June 2007 quarter was more of
normalization.
Other things remaining equal, a lower LDR and incremental LDR indicate better capacity to
grow profitably, in which case the mid-cap banks appear to fare better (Figure 22). However,
these two metrics have to be seen in the light of the capital adequacy, because a highly
capitalized bank can afford to run a higher LDR and incremental LDR (Figure 23). In that
sense, ICICI, Kotak Mahindra, and HDFC Bank are also not badly off.
ALM statements indicate private banks are much better placed
Published data seem to suggest that private banks (with the exception of Axis) have liabilities
maturing slower than assets as also a smaller amount of liabilities maturing in the next one
year than assets (Figure 24 and Figure 25).
However, we would caution investors against reading too much from the above data. First,
this is disclosed only once a year, and the numbers could have changed substantially since
March 2010. Second, the data are based on maturity and not reset frequency, e.g., a loan
may mature in 10 years but have yearly interest rate resets. Third, CASA gets included in
different maturity buckets by different banks, and potentially may vary across years, and that
disclosure is not available. Finally, and more important, the data give no indication
whatsoever of pricing power, i.e., the ability to raise lending rates.
A simple sensitivity of a 50bps yield increase and a 50bps term deposit rate increase is
provided in Figure 26. Axis, HDFC Bank, ICICI, PNB, and SBI are key beneficiaries.Other things remaining equal, this makes the
margin outlook favourable
Analysing the impact: an asymmetric increase can also be margin-neutral
We subject our “model” bank to differential rates of increase on loans and deposits, and
conclude that margins take a small dip in the first year only to recover quickly (Figure 27). This
analysis builds in the complexities caused by loans and deposits having different maturities
and/or re-pricing frequencies.
Our forecasts (Figure 29) take into account our assessment of how each bank is likely to
respond to further interest rate increase in the future. The general trend is of a modest
margin contraction in FY12E over FY11E, not to an extent that warrants concern.
Loan growth not just driven by interest rates
Although the rising rates versus loan demand issue often arises, we do not see much
evidence of that relationship – it seems counter-intuitive but true. For example, for most of
FY10, rates were very low but there was little demand for bank credit, and more puzzling, in
the midst of a massive economic upturn. Likewise, 2007 saw very strong credit demand with
increasing rates. Having said that, banks are apprehensive that more than another 100bps
rise in lending rates may start to pinch some segments of credit demand.
Intuitively, borrowers whose demand is more sensitive to rates are SMEs and midcorporates.
At this juncture, they are not major loan growth drivers; home loans, auto loans
and infrastructure are showing the greatest momentum. These areas are probably less
sensitive to rising rates.
However, the real risk is crowding out by the government, which is also a supply issue and
not a demand problem for private sector loan growth.
Mid-cycle loan growth of 20-22% in FY12E reasonable
The above estimate is a function of:
The RBI’s articulated comfort level (though its first direct estimate for credit growth in
FY12E should come only in early May 2011)
Because we expect deposit growth to pick up from the current c.16% to 18-19% due to
increases in deposit rates and a renewed effort on deposit mobilization, and a 300-
400bps gap between loan and deposit growth is a manageable one (the current level of
c.800bps is not sustainable)
The economy is in a mid-cycle in our opinion, somewhere in between the heydays of
2005-07 and the post-credit-crisis meltdown.
It must be noted that the currently prevailing high inflation provides a floor for loan growth as
the latter is expressed in nominal terms. Moreover, an analysis of real credit growth shows
that it is on a strong upward trend (Figure 32). This has happened in an environment of rates
increasing.
Although investors have already started asking if FY12E loan growth can revisit the lowest
points in history, we believe that is very unlikely, given that we are looking at a period of low
liquidity and high rates, not a crisis (actually the global environment is probably becoming
more favourable). From a historical perspective, the two lowest growth years were after two
global crises – the Gulf War and the Asian Crisis
We would refrain from projecting a system loan growth via the GDP growth route, much
against the common perception, “Loan growth should be 3x GDP growth”. If history is
anything to go by (Figure 34) – and it is a 30-year history – the correlation between the two is
hardly visible.
Margins more important than growth in the short to medium term
Our experience has been that margins are more important than growth as a stock price driver
in the short to medium term (six to 12 months), whereas growth is more significant in the
longer term (more than a year). For example, loan growth was subdued all through FY10, but
stocks performed very well as the sector saw massive margin expansion due to the re-pricing
of high-cost deposits. However, if growth remains weak for an extended time (as it has been
for most of the past year or so), valuations could compress further
Asset quality risks declining
Profitability-interest rate gap remains a buffer against credit
quality deterioration
We do not believe that the scale of rate increases we have seen and likely to see will be such
as to endanger credit quality. Even around the time of the credit crisis, corporates that faced
repayment problems did not complain about high rates but about collapse in demand due to
a serious global problem. Theoretically, as long as a company has a profitability that is high
enough to afford interest payment, the ability to repay debt is not jeopardized (willingness to
pay is a different issue, that has been largely taken care of by the foreclosure law and the
credit bureaus).
The aforementioned may sound simplistic and academic, but we believe it actually works. Up
to the late 1990s, corporate asset quality was a problem in India because in addition to high
interest rates, corporate profitability was poor and corporate India was massively
overleveraged.
Available data suggest that situation has considerably improved (Figure 36). So even though
the gap between profitability and interest rates could narrow in a relatively weaker economy
than last year and rising rates, it should still remain healthy enough to avoid a snowballing
into an NPL problem.
Of course, as mentioned above, all NPL situations of the past were not driven only by
interest rates rising; more often than not, demand is a bigger issue. So though the above
chart would seem to suggest in FY09 there should not have been a problem, banks did go
through some stress (by no means serious, including restructured assets), which was due to
the global crisis that resulted in a FY09 where GDP growth contracted by 250bps. Currently
Deutsche Bank economists are forecasting NO contraction in GDP growth in FY12E, and we
do not perceive a substantive worsening of that outlook. Thus our above analysis broadly
holds in the current cycle.
Occasional credit quality accidents cannot be ruled out, but that is not new
The above does not mean that there will be no awkward quarters for a bank. In the last few
quarters we have seen some banks report chunky slippages. Too much time and energy has
gone into predicting which bank could report a large slippage in a particular quarter, and stock
prices have swayed with that.
We believe that approach just does not work because it is beyond the realm of public
information. The important point to note is that these issues are not systemic. An upgrade
against a slippage could be very quick, leading to a positive earnings surprise as much as the
negative surprise when the loan slipped.
Visible impact of microfinance and 2G licences likely to be manageable
Although the travails of the microfinance industry have been a topic of high-pitched debate in
the last three months, we believe that it will fade from the limelight very soon. The RBI has
permitted banks to restructure their exposures to microfinance. So to that extent, the
vulnerable exposures will not reflect as NPLs. Since as a percentage of the loan book these
exposures are small (1.0-1.5%, see Figure 37), the impact of a haircut on profitability also
should be negligible.
We understand that most banks have lent to 2G licencees with recourse to parent
companies, which are usually reputed domestic and international entities, and many have lent
only to incumbent telecom players. If that is true, then the exposures are not at much risk if
licences were to be cancelled due to the auction controversy (which itself could be a very
extreme step on the part of the government). However, there is little public disclosure on
these issues, and there are banks that have lent based on the licence as the collateral, which
could pose a risk in the event of a cancellation. Figure 38 shows the total telecom exposure
of banks; there is no separate disclosure on how much has been lent to 2G licencees.
Seasoning-related downside minimal due to low growth in the
last two years
We have dealt with the interest rate-credit quality aspect above, but typically the other key
reason for systemic credit quality issues is excessive lending growth (Figure 39 and Figure
40) for an extended period, which ends up overleveraging borrowers and encourages bad
credit decisions. Fortunately, this risk is low, in our view. Loan growth has been decelerating
for a few years now, though the absolute growth may currently be considered high by global
standards. Within that, growth of the riskier unsecured lending has been negligible and at
times even negative.
Restructured assets appear to have worked well through the credit cycle
From the 40-50% slippages estimate at the time of the special dispensation on restructuring,
consensus estimates have decreased to 15-20%. Since the largest portion of moratoriums
for restructured assets would have expired by June 2010 to Sep. 2010, it is reasonable to
assume that restructured assets have gone through the test of viability and unlikely to breach
the 15-20% slippage range (there could be bank-wise exceptions though, but they are few).
Most important, since maximum restructuring was done for the export-oriented industries,
the ongoing global recovery could make that asset class perform even better
We continue to be more positive on retail credit quality in general
The seasoning issue is even starker for the retail segment in which growth almost fell to zero
and has recovered only recently – it is still at a level substantially less than the sector average
(Figure 42). Thus, there is reason to believe that the recent growth in retail is far wellconsidered
than the previous cycle, and potentially even better than the recent corporate loan
growth. Specifically, unsecured retail has not returned to growth and for some banks it is still
declining – this was the key problem area in the previous cycle.
As a consequence of the above, retail banks have been seeing a sharp reduction in credit
costs (Figure 43). Irrational competition in personal loans, credit cards, and two-wheeler loans
(technically secured but in reality behaves more like uncollateralized) that had led to the
underwriting imprudence has just about disappeared.
Credit cost decline in FY12E could be a significant source of
profitability upside
We expect credit costs (here defined as NPL provisions) for most banks to decline as a
percent of loans in FY12E compared with FY11E (Figure 44), providing an impetus to profit
growth, partly compensating for a possible net interest margin reduction. This is mainly a
function of seasoning; retail assets have almost fully seasoned as we explained above, and
export-oriented sectors (which were the most affected in the downturn) are looking up due to
a better global environment. By the end of FY11E, the restructurings of June 2010 should
have come out of the moratorium period as well.
Provision coverage increase exercise largely complete
As Figure 45 shows, except for SBI, the banking system has more or less finished the
regulatory requirement of reaching provision coverage of 70%. This, in addition to higher
NPLs, was a reason for the high credit costs in the past four quarters. The other relief that we
expect is lower slippages in the coming quarters versus the last six quarters due to better
economic conditions.
The central bank has also recently indicated that it may modify the 70% provisioning mandate
and convert that to counter-cyclical requirements. In other words, the focus will not be to
ramp the provision coverage up to a certain number and always maintain it, but to build it in
good times and draw it down in bad times. This may translate to a lower effective number
than 70%, which was decided more as a consequence of the credit crisis. This could provide
relief to some banks that were historically not used to making such high provisions, and
making a 70% provision on every new NPL became onerous for them.
Valuations, stock
performance, and top picks
Correction has brought valuations to reasonable levels
Most stocks have fallen to within one standard deviation, indicating weak sentiment
As Figure 46 through Figure 53 show, stocks have fallen considerably over the last three
months. The fall was more prominent for those financials that are more dependent on
wholesale funding. More important, the reason is not just rising rates – we have had an
unfortunate confluence of several other problems such as the microfinance crisis, telecomauction-
related uncertainties, the bribery-for-loans scam, and the RBI appearing to “talk
down” the margins of Indian banks. Many of these are peripheral to the sector but add to the
bearish sentiment already prevailing.
Assessing the downside case – lessons from prior cycles
Analysis shows stocks can rebound much more than they can go down from here
We have identified January to June 2007 as the previous period of liquidity deficit when
banks were borrowing large amounts under the repo window. We have analysed the stock
price performance during that period to assess potential downside to current levels. [While
liquidity was in deficit even during the June to November 2008 period, we have not
considered that for our analysis here as that was the period of wild swings due to the credit
crisis – and we do not believe that we are anywhere close to that situation in terms of
stress].
During the January to June 2007 period the contraction between the maximum and minimum
P/B multiple for banks under our coverage was between 23% and 44%. In comparison with
current valuations, the multiples have already contracted between 21% and 35% from the
peak in October-December 2010. If we currently assume similar multiple contractions as was
witnessed in the January to June 2007 period, then further downside is limited to 0-14%. For
Yes Bank and PNB, P/B multiple has already contracted more in the current correction than it
did in the previous period.
More interesting, the average P/B valuation for a six-month period following the liquidity
deficit period was 15-179% higher than the minimum during the liquidity deficit period.
Again, if we were to draw a similar analogy for the current period, then there can be
significant upside potential to current levels, making the risk/reward favourable. Hence, we
reiterate that while fundamentals are stressed, valuations are probably factoring more
negatives than necessary
Relationship between stock prices and loan growth, liquidity, and rates
Although in the last cycle corresponding to the global credit crisis, the banks had responded
negatively to the liquidity crunch; in this cycle the performance was very good until about two
months back
Until 2004, banks used to perform distinctly inversely with the movement of rates; after that,
the correlation is not that clear (Figure 57 and Figure 58). In this cycle, the Bankex was
moving along the direction of rates until recently when it turned the other way.
The key message from the above is that “sell banks because rates are rising” may not be a
correct approach. In fact, for most periods from 2004, it would have been incorrect.
However, stronger loan growth usually reflects well on bank stocks (Figure 59). Yet the
relationship is not so strong that a small correction (such as the 24% currently to ~20% we
are expecting for FY12E) in loan growth has to necessarily manifest in underperformance.
Changes to estimates, ratings, target prices, and top picks
We downgrade Kotak Mahindra, upgrade CanBank, lower target prices for Kotak
Mahindra, Union Bank, PFC, REC, and IDFC
Canara Bank: NIM has significantly expanded to 3.21% for 3QFY11, which is the highest in
more than 19 quarters and better than our initial estimates – this provides an adequate
cushion in the rising interest rate environment. The bank continues to grow at rates faster
than the system. While we were earlier concerned about asset quality, the bank continues to
surprise positively - slippages from restructured loan book are c.7%, which is amongst the
lowest among the PSU banks. With the bulk of the moratorium on restructured loans ending
there is lower probability of any major slippage from the restructured book, this coupled with
strong recoveries should help in keeping the credit costs low. The management change has
also been smooth. We have raised our net profit estimates by 8-10% for FY11E to FY13E as
we factor in higher NIM and lower credit costs. For the above reasons, we upgrade our rating
on Canara Bank to Buy from Hold with its target price revised to INR710 from INR670.
IDFC: We have increased our FY11E net profit estimate marginally by 1.4% but have cut
FY12E and FY13E estimates by 4.5% and 7.0%, respectively. The momentum from
infrastructure loans is partly offset by our expectation of the capital markets businesses
remaining weak. We also lower our target price from INR190 to INR150 due to the lower
multiples applied to the lending business (multiple compression due to an adverse interest
rate cycle – we have done that to other stocks as well) as also capital markets businesses for
the same reason. We maintain our Hold rating.
Kotak Mahindra: We have reduced (unadjusted) net profit estimates marginally by 0.8%,
0.7%, and 3.0% for FY11E, FY12E, and FY13E, respectively. However, we have applied lower
target multiples to all the aforementioned businesses, leading to our target price reducing to
INR350 from INR460. Since the bank has a significantly larger component of value coming
out of its capital-market-linked businesses than all other banks, it is likely to be more affected
by the capital market downturn, which usually reflects more strongly in multiple compression
than earnings. Therefore, we downgrade our rating on the stock to Sell from Hold.
PFC: We cut our earnings estimates of FY11E, FY12E, and FY13E by 3.3%, 6.0%, and 7.8%,
respectively, because we believe that some sluggishness in some power projects is likely
(relative to initial expectations) due to environment-related delays. After the application of the
lower multiples, we have cut our target price to INR305 from INR405. We maintain our Buy
rating.
REC: Similar to PFC above, we are lowering the multiples due to which our target price falls
from INR400 to INR305. We maintain our Buy rating.
Union Bank: We maintain our Hold recommendation on Union Bank with our target price
revised to INR350 from INR385. While the operating performance for Union Bank is healthy,
we are still concerned about its asset quality. Slippages are still higher than normal, leading to
higher credit costs. However, valuations seem to be factoring in the negatives and at 1.3x
FY12E P/B, the stock appears fairly valued.
Our recent changes include quite a few estimate increases, few upgrades, no
downgrades
In the January 2011 results season, we upgraded our ratings for LIC Housing Finance and
Bank of India recognizing their severe stock price underperformance and stabilization in some
metrics that we perceived as vulnerable.
During the same time, we had quite a few frontline banks (e.g., Axis) in which we increased
our earnings estimates materially and reduced our target prices. This essentially factors in the
multiple compression of the entire sector due to an adverse interest rate cycle, while at the
same time re-emphasising that the overall outlook has not been jeopardized. We experienced
that for some banks in FY09 as well. This in turn means that if the environment were to turn
positive even at the margin, a stock price recovery due to a multiple expansion can be
significant.
Stock ideas
Our top picks among the large cap banks are HDFC Bank, Axis Bank, and Bank of
Baroda; our top mid-cap picks are Yes Bank and Shriram Transport Finance.
We recommend investors switch from:
SBI to PNB and BoB. The latter two are at similar valuations, have better credit
quality positions, have strong operating expense profiles, and have less pressure on
incremental LDR (BoB is a standout case in this respect in the whole sector).
Union Bank to Canara Bank. While both banks are likely to show good operating
performance, higher slippages are likely to keep credit costs high in the case of
Union Bank.
IDFC to PFC and REC. IDFC has several capital markets businesses that are likely to
remain in a downturn for the next year, and we believe that it is constrained in its
leverage. PFC and REC are in a funds-constrained sector and have significant
domain knowledge, and their sharp underperformance in the last two months has
probably factored in concerns of a slowdown.
Kotak Mahindra to Yes Bank. The non-banking businesses for Kotak Mahindra
Bank continue to face strong sector headwinds, pulling down the overall profitability.
Yes Bank is likely to grow at more than twice the system rate over the next couple
of years with a stable NIM and asset quality. Yes Bank’s P/B multiple has already
contracted by more than the contraction witnessed in previous periods of tight
liquidity and is trading at attractive valuations of 2.0x FY12E P/B and 9.8x FY12E P/E
with FY12E RoE of 21% and earnings CAGR of ~30% over the next two years.
Wholesale funded have suffered the most – good time to revisit
In our opinion, “Sell wholesale-funded, buy retail-funded” is not necessarily a prudent
strategy, though this tends to be the market reaction in times of increasing interest rates.
There are several wholesale-funded companies and banks that have significant pricing power
by virtue of operating in specific segments for which they have accumulated domain
knowledge. There are also non-retail mechanisms for keeping a tab on the cost of funds such
as securitization.
In that context, we like Shriram Transport Finance and YES Bank. Both have fallen significantly
from the peaks but both have demonstrated their ability to deliver fairly solid profit growth in
even far worse times for interest rates. Moreover, in any case, we do not expect this cycle to
get worse than the post-credit-crisis period.
Private banks may fare better than state banks in the current scenario, though hard to
generalize
We have noticed that, historically, in times of rising rates and/or tight liquidity, PSU banks
have underperformed private banks (Figure 60 and Figure 61 provide an example).
We are addressing this issue only because it is frequently raised by investors, though we
increasingly believe that PSU banks may not be a very homogeneous asset class (and neither
are the private banks). Past trends are unlikely to repeat because of the absence of two
factors that typically contributed to the underperformance earlier: a large bond book and
government pressure to hold lending rates. Thus, we continue with our stock-specific
approach.
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India Financials 2011
Time to catch the falling knife, it's not that sharp
It is stress and not distress
We do not concur with the prevailing pessimism on Indian financials onapprehensions of a negative impact of rising rates; from a one-year perspective,
we believe this is a buying and not a reducing opportunity. Although the next few
months could be challenging, we do not see much valuation downside from here.
Our earnings estimate increases after the October-December 2010 results are a
reinforcement of fundamental strength and catalyst for a potential reversal in
sentiment, if the liquidity climate were to turn favourable even at the margin.
Apprehensions may be overdone, and stocks may have fallen enough
Experience from previous cycles, though not extensive, does provide interesting
counter-intuitive conclusions – loan growth does not necessarily fall when lending
rates rise, and bank stocks do not necessarily fall with higher rates. Moreover, our
valuation scenario assessment based on the tight liquidity period of 2007 shows
that while stocks may face potential downside of 0-14% from current levels, they
could rebound by 15-180%. We have deliberately chosen to focus on tight liquidity
situations, excluding the credit crisis period, which was an extreme, and, in our
opinion, not representative of the present.
Liquidity, loan growth, margins, and credit quality on the right track
Our call ensues from four key observations. First, efforts by the government,
banks, and the RBI to alleviate the systemic liquidity deficit have begun to show
results. Liquidity management effectively de-linking from inflation is a big positive
development. Second, loan growth has distinctly improved from c.14% in January
2010 to c.24% now. Third, our analysis shows that most banks stand to benefit
from the lending rate increases already put in place, and there is enough evidence
of pricing power. Finally, credit quality seems to have crossed the hump of 2008-
09, and more so in retail.
Valuations and risks
We value Indian banks’ lending business on the Gordon Growth model, insurance
on appraisal value, asset management on percent of AUM, and other non-banking
businesses on P/E. The key risks for the sector are higher slippages from
restructured assets and continuation of high inflation for beyond six months
leading to more-than-tolerable rate increases.
Stock ideas
Top picks among large caps: Axis Bank, HDFC Bank and Bank of Baroda;
among mid-caps: Yes Bank and Shriram Transport Finance.
Switch from i) SBI to PNB and BoB; ii) Union Bank to Canara Bank; iii) IDFC to
PFC; and REC iv) Kotak Mahindra to Yes Bank.
Investment summary
Indian financials have taken a beating in the last two months, which stands out particularly
after the consistent outperformance in most of 2010. While the beginning was perhaps
triggered by fringe issues like microfinance problems and the bribery-for-loans allegations,
the key concern today is the impact of persistently high inflation leading to higher interest
rates, thereby affecting margins, growth and eventually credit quality. The question
paramount in the minds of investors is how long the liquidity deficit situation continues, and
whether bank stocks have fallen enough to price in these concerns. In this report we address
these issues in detail, and conclude that it is probably time to nibble if not bite into the
sector, as valuations reflect unwarranted levels of pessimism on these counts.
“Lack” of government spending a timing mismatch issue, not an intention to delay
spending
The lack of government spending, which the central bank terms a “frictional” liquidity deficit,
could be alleviated in the next few months through a combination of spending and reduced
borrowing. The government has not provided any indication of cutting down on spending. On
the issue of a policy logjam (caused by controversies during 2010) leading to lack of decision
making on spending, our view is that there are plenty of spending avenues that are eminently
non-controversial, such as food, fertilizer and petroleum subsidies.
Contrary to the conventional belief that a cash reserve ratio reduction is completely ruled out
in an environment of inflation, we also believe the RBI could do a CRR (cash reserve ratio, the
amount statutorily appropriated from banks without any interest payment) cut as well in
March 2011.
Finally, to the extent the government carries over the high cash balances to FY12, there could
be lesser borrowings in the first half of FY12 than there normally are, helped also by
seasonally lower private credit demand.
Deposit growth a product of effort and rates, and both have picked up
The other problem that the central bank likes to classify as “structural” liquidity deficit is, in
our opinion, not structural but cyclical; by that token, it should also be alleviated in the coming
months if not fully disappear. It was caused by low deposit rates for most of 2009 and 2010
and banks aggressively shedding instead of mobilizing deposits. This, coupled with high
inflation, led to a high currency in circulation, and hence the liquidity deficit. Both have
significantly changed for the better – deposit rates have been raised to a point where the real
rates at least in some buckets are positive, and the mobilization effort is back.
Analysis shows NIMs may not compress much, given pricing power
Banks have been able to raise lending rates cumulatively by 75-100bps already in this cycle,
and the speed with which banks have been able to raise lending rates, even in supposedly
competitive markets, has taken us and the Street by surprise.
Pricing power currently exists not just because of the c.800bps gap between lending and
deposit growth rates, but for the following reasons:
The waning of disintermediation that has pushed up asset yields. Reported loan growth
also goes up as CP holdings that are classified as investments get converted into loans.
In this cycle we have noticed a clear tendency on the part of the government to stay
away from interfering with lending rates. We believe the key reason for this is RBI
instituting the base rate system, which has to be based on a cost of funds (among other
things), making the transmission system by and large automatic.
From our impact analysis of the differential rates of increase on loans and deposits on a
“typical” bank, we conclude that margins take a small dip in the first year only to recover
quickly.
Axis Bank, BoB, Canara Bank, HDFC Bank appear best placed in this environment
The above conclusion is a result of multiple analyses: i) the study of margin behaviour during
past cycles of tight liquidity, and, more importantly, thereafter when liquidity is reversed; ii)
banks’ ALM profiles; iii) sensitivity to a 50bps increase on both sides of the balance sheet;
and iv) the impact based on rate increases that have already occurred. The more important
general message from these assessments is that because of pricing ability, the current
environment may be more beneficial to banks than detrimental.
Growth unlikely to be at risk because of higher lending rates
In a rising interest rate environment there is usually concern about high lending rates
adversely affecting growth. However, in the past we have witnessed high loan growth in
periods of high lending rates (and low loan growth during low interest rate periods). Most
bank CEOs recently indicated that another 50-100bps increase in lending rates is unlikely to
have an impact on growth.
Corporate profitability remains a cushion for credit quality
We do not believe the scale of rate increases that we have seen and are likely to see will be
such as to endanger credit quality. Theoretically, as long as a company has a profitability that
is high enough to afford interest payment, the ability to repay debt is not jeopardized. Up to
the late 1990s, corporate asset quality was a big problem in India because in addition to high
interest rates, corporate profitability was poor and corporate India was massively
overleveraged. Available data suggest that the situation has considerably improved. So even
though the gap between profitability and interest rates could narrow, it should still remain
healthy enough to avoid a snowballing into an NPL problem.
Favourable seasoning impact of low growth of last two years
Banking system loan growth over the past two years has averaged 17%, compared with
average growth of 27% over the three years prior to that. The high loan growth of FY06-08
led to some asset quality issues during the credit crisis. However, the favourable seasoning
impact of the relatively moderate growth over the past two years and improving economic
environment lead to us believe that asset quality is unlikely to be a systemic issue in FY12.
Within that, we believe that retail assets are better placed than corporate – credit costs for
predominantly retail banks (HDFC Bank, Kotak Bank, and ICICI Bank) have been declining for
the past three to four quarters.
Decline in credit losses could be a substantive profit contributor in FY12E
Even though NIM may contract by 10-15bps in FY12E over FY11E, this could be more than
offset by a decline in credit costs, which could in some cases be significant. We are currently
estimating credit costs to decline by 5-30bps in FY12E over FY11E. This is another reason
why we view the outlook for retail assets better than that of corporate assets – while the
latter is still showing some areas of weakness, retail seasoning is almost complete, and
credit costs are declining rapidly. Some banks have significantly downsized their unsecured
retail portfolio, which was the key problem area in 2007 and 2008, and some have given it up
altogether. Moreover, in a rather perverse way, inflation is better for retail asset quality as the
realisable value of the collateral goes up.
We estimate limited downside based on lessons from past cycles; risk/reward is
favourable
We have identified January to June 2007 as the previous period of liquidity deficit when
banks were borrowing large amounts under a reverse repo window. We have analysed the
stock price performance during that period to assess potential downside to current levels.
During this period the contraction between the maximum and minimum P/B multiple for
banks under our coverage was between 23% and 44%. In the current cycle, the multiples
have already contracted between 21% and 35% from their peak in October-December 2010.
If we assume similar multiple contractions now as was witnessed in January to June 2007,
then further downside is limited to 0-14%. More interesting, the average P/B valuation for a
six-month period following the liquidity deficit period was 15-179% higher than the minimum
during the liquidity deficit period. Again, if we were to draw a similar analogy for the current
period, then there could be significant upside potential to current levels, making the
risk/reward favourable.
Best picks within large caps Axis, HDFC Bank, BoB; small caps Yes, STFC; switch ideas
Our top picks among the large cap banks are Axis Bank, HDFC Bank, and Bank of Baroda, and
our top pick mid-caps are Yes Bank and Shriram Transport Finance. We upgrade CanBank to
Buy from Hold and downgrade Kotak from Hold to Sell.
We recommend investors switch from:
i) SBI to PNB and BoB;
ii) Union Bank to Canara Bank;
iii) IDFC to PFC and REC; and
iv) Kotak Mahindra to Yes Bank.
Liquidity deficit can change
for the better
Banks have embarked on 2011 with a liquidity deficit that on days has exceeded levels seen
after the 2008 credit crisis . We are more optimistic than that and believe that there are levers available. However, the
January-March 2011 quarter is likely to remain tough for liquidity and hence for banks;
seasonally too, the last quarter of the fiscal year is tight. It could normalize thereafter. This
outlook appears uncannily similar to the situation in 2007 and 2009, though of course due to
entirely different reasons.
Timing mismatch between government revenues and spending
should reduce
Government’s unusually high balances with the RBI have been a problem
As Figure 7 shows the balances that the central government holds with the RBI (effectively
out of the system liquidity) have been rising steadily. It is not as though government
expenditure has slackened, but its revenues have been stronger than expected. A bit of that
is due to higher tax collections, but the real disruption was caused by the 3G telecom and
broadband wireless auctions that yielded the government INR1.05tr versus its own
expectation of INR350bn. This kind of an amount does not come back into the system quickly
– the government got the windfall but cannot “plan” windfall spending.
We believe the above problem should sort itself out in a quarter or two. First, much of the
spending tends to be seasonally back-ended in the fiscal year. Second, the government has
to release subsidies for food, fertilizer, and petroleum products where deficits (“underrecoveries”)
have actually been rising.
The flip side of the above is potential for lower borrowing by government
Other than the seasonal decline in government borrowing in the January-March quarter, it is
likely that the government could step off the borrowing pedal for some more time as it draws
the balances down to spend. In addition, government spending is traditionally more on a
back-ended basis for a financial year – by that token itself the spending should go up in the
January-March 2011 quarter. And as we explain below, there is no reason to believe that the
government will consciously slow its spending.
Increase in RBI bond buyback likely, cannot preclude a CRR cut either
In the December 2010 mid-quarter statement, the central bank specifically articulated its
intention to buy back INR480bn of sovereign bonds. Since then, the liquidity situation has
tightened further despite the usual year-end loosening of the government borrowing
programme, and hence we believe that the RBI may up the bond buyback target to infuse
more liquidity into the system. It has also cut banks’ bondholding requirement (SLR) by 1%
permanently to 24%, and given the additional relaxation of another 1% up to April 2011,
which also offers some leeway, though it is not a source of primary liquidity.
Although the consensus view seems to be that it is impossible for the RBI to justify a
reduction in CRR in view of the prevalent high inflation, we believe that is not a given. The
RBI has expressed some frustration at the inability of a central bank to address largely food
driven inflation using monetary tools. It is also obvious that excess liquidity can no longer be
blamed for fuelling inflation, as liquidity is actually in deficit. In addition, the RBI is cognizant
of the potentially destabilising effects of such high levels of a liquidity deficit. So the premise
of “sending the wrong signals” by doing a CRR cut does not necessarily hold.
Greater scrutiny of government spending not as much at risk as perceived
One risk to government spending that is hard to substantiate or quantify is possible delays
induced by the unravelling of scams and cases of financial misdemeanour last year, leading
to greater scrutiny of expenditures. The only source of comfort we have is the finance
ministry’s repeated assertion that it does not intend to report a lower fiscal deficit this year
than it originally projected, implying that spending should be on track. Moreover, there are
lumpy items of regular expenditure (e.g., subsidies) that are in the nature of social sector
programmes where there could be less fear of misdemeanour cases.
Currency in circulation could decline with acceleration of deposit
growth
High currency holdings due to inflation and earlier low deposit rates
The economy appears to have kept sharply increasing amounts of hard cash with itself over
the past year (Figure 8), probably as rising inflation led to higher transaction value
requirements, but, more importantly, because bank savings rates were low.
But now positive real deposit rates seem to be working
The RBI’s repeated persuasion of banks to make real deposit rates positive has finally
worked, with two to three rounds of deposit rate hikes by banks in the last six months (Figure
10). Negative real deposit rates for an extended period were the main distortion that has
affected deposit growth (along with impressive returns from competing assets such as gold
and real estate). Historically there has been a strong correlation between deposit growth and
rates
Of course, the impact can be felt only over the weeks and months and not overnight. There
could be another round of increases, but possibly at different points in time by various banks
instead of clustered together. Deposits have begun to creep up recently
Deposit growth also a function of effort on mobilization, not just rates
We dealt with the deposit growth issue in greater detail in our report titled Question bank:
ten issues, five conclusions dated 13 October 2010. We believe blaming only the rates for
low deposit growth is simplistic. One irony that has gone unnoticed is that term deposits
have been decelerating, whereas CASA (low-cost) deposits have been growing very well. If
rate is the only reason, how can it explain the comparatively faster growth of a segment in
which the real rate has been even more negative?
In our opinion, the real problem is that banks find it difficult to act in a timely manner on retail
term deposit rates, either on the way up or down. For the whole of FY10, most banks were
aggressively shedding term deposits because they were hurt by the negative carry on them
arising from weak loan demand. So deposit mobilization was consciously given short shrift.
The low rate acted as a tool, but the lack of effort mattered more.
This went on for too long, even after credit started picking up in mid-2010. It has of course
started to change – banks, other than having raised deposit rates twice or thrice, have openly
acknowledged the importance of rebuilding the retail term deposit (or fixed deposit)
franchise, which was ignored for the last one and a half years in pursuit of CASA.
However, oil companies’ borrowings can upset the balance
Higher crude prices directly translate to higher deficits of oil companies…
Figure 12 shows the strong correlation between crude prices and OMC burden; however,
note that the deficits are on the rise because after the last quarter recorded in the chart, oil
prices have spiked further and have been higher than USD90/bbl. The chart denotes what oil
marketing companies (OMCs) need to bear themselves, which essentially means borrowing.
So to the extent the government subsidy part arrives late (which is a common phenomenon),
OMCs end up bridging more of the deficit than planned.
The government generally defrays the subsidy with a six-month delay, and hence the deficit
arising from high oil prices in the October 2010-March 2011 period could actually come in the
April-September 2011 period, requiring the OMCs to borrow more than usual.
…and then on to their borrowing demand, which puts more pressure on liquidity
Although oil borrowings are not a significant portion of total bank loans, in times of a liquidity
shortage they can put pressure on the system, especially if oil prices are also on the rise
(Figure 13). The Deutsche Bank oil & gas research team estimates that oil companies may
need to borrow an additional INR250-400bn in the January-March 2011 period – this could
account for up to 25% of incremental loans given by the banking system in the January-
March 2011 quarter.
Impact on margins and growth manageable
Dependence on short-term markets and corresponding interest rates have gone up
Short-term rates have been going up from April 2010
and not recently.
Strapped by high incremental loan-to-deposit ratios, banks have been raising resources at
higher costs (Figure 15) from the certificates of deposits (CD) market, in addition to paying
higher rates for wholesale (“bulk”) deposits and of course card rates for retail deposits.
Banks have been raising more CDs as well in the last few months (Figure 16). These data
come with a lag, and the next release could indicate a further increase. However, the tempo
of the increase could cool off because banks have raised their retail deposit rates and are
focusing more on them.
Pricing power does exist despite “weak” loan growth
The main reason for the above phenomenon is that money is not as easily available as it was
in most of 2010, and 22-24% is not “weak” credit demand growth – the only reason for it
appearing weak is that India became used to seeing 30% loan growth in good times. The
extent of 3QFY11 margin increases reported by several banks came as a positive surprise,
only because banks could adjust lending rates fairly quickly, contrary to the initial
apprehension of banks’ inability to raise lending rates.
Reduction in disintermediation silently brings back some pricing ability
As Figure 17 and Figure 18 show, at least one form of disintermediation (through commercial
paper) is on the wane – the levels were fairly high and offered significant competition to
direct bank credit in most of 2010. CP rates were also quite low, as we have seen in Figure
14. Since banks themselves have been meaningful subscribers to these commercial papers,
overall yields were depressed. Thus, the waning of disintermediation pushes up yields.
Reported loan growth also rises, as CP holdings that are classified as investments get
converted into loans.
Foreign currency loans have also grown strongly, eating into the market share of domestic
loans, and since data releases come with a lag, there is no sign of these borrowings cooling
off as yet (Figure 19). However, one factor that always makes ECBs attractive is the
appreciation of the rupee, for which the tide has turned. So although the interest rate
differential continues to make ECBs attractive, they may be less so now than in late 2010.
Banks have started increasing lending rates, including on fixed-rate products
The speed with which banks have been able to raise lending rates, even in supposedly
competitive markets, has taken us and the Street by surprise
Government and regulatory disposition to lending rate increases have generally been
benign
In this cycle we have noticed a clear tendency on the part of the government to stay away
from interfering with lending rates. We believe the key reason for this is the RBI’s institution
of the base rate system, which has to be based on cost of funds (among other things), needs
to be updated every quarter, and audited. Hence, the transmission system has been by and
large made automatic.
The instance where there have been murmurs of discontent on lending rates is the RBI and
the government suggesting that the margins of Indian banks are too high. The RBI and the
government have voiced their concern on the high cost of bank intermediation many times in
the past. However, even this time around, banks went ahead and raised lending rates after
the RBI’s statement, as the RBI itself acknowledged that there are other costs that
counterbalance the high margins and would lead to moderate (and not exorbitant) profitability
of banks in the regional context.
Impact on specific banks; Axis Bank, BoB, Canara Bank, and
HDFC Bank appear better placed
Prior cycles indicate NIMs dip and then revive within a maximum of two quarters
We have studied two previous examples of tight liquidity situations (June-November 2008
and January-June 2007). The first period is probably not very representative of what we are
seeing today because it was around the time of the global credit crisis, but the latter one
certainly is, in our view. As we see from Figure 21, margins dip for a quarter or two and then
revive sharply. The banks that managed to limit the declines were ICICI, Kotak, Bank of
Baroda, Bank of India, and PNB. HDFC Bank can also be included in this list because its 4.5%
NIM in the March 2007 quarter was a consequence of very adept year-end liability
management, and the subsequent “decline” in the June 2007 quarter was more of
normalization.
Other things remaining equal, a lower LDR and incremental LDR indicate better capacity to
grow profitably, in which case the mid-cap banks appear to fare better (Figure 22). However,
these two metrics have to be seen in the light of the capital adequacy, because a highly
capitalized bank can afford to run a higher LDR and incremental LDR (Figure 23). In that
sense, ICICI, Kotak Mahindra, and HDFC Bank are also not badly off.
ALM statements indicate private banks are much better placed
Published data seem to suggest that private banks (with the exception of Axis) have liabilities
maturing slower than assets as also a smaller amount of liabilities maturing in the next one
year than assets (Figure 24 and Figure 25).
However, we would caution investors against reading too much from the above data. First,
this is disclosed only once a year, and the numbers could have changed substantially since
March 2010. Second, the data are based on maturity and not reset frequency, e.g., a loan
may mature in 10 years but have yearly interest rate resets. Third, CASA gets included in
different maturity buckets by different banks, and potentially may vary across years, and that
disclosure is not available. Finally, and more important, the data give no indication
whatsoever of pricing power, i.e., the ability to raise lending rates.
A simple sensitivity of a 50bps yield increase and a 50bps term deposit rate increase is
provided in Figure 26. Axis, HDFC Bank, ICICI, PNB, and SBI are key beneficiaries.Other things remaining equal, this makes the
margin outlook favourable
Analysing the impact: an asymmetric increase can also be margin-neutral
We subject our “model” bank to differential rates of increase on loans and deposits, and
conclude that margins take a small dip in the first year only to recover quickly (Figure 27). This
analysis builds in the complexities caused by loans and deposits having different maturities
and/or re-pricing frequencies.
Our forecasts (Figure 29) take into account our assessment of how each bank is likely to
respond to further interest rate increase in the future. The general trend is of a modest
margin contraction in FY12E over FY11E, not to an extent that warrants concern.
Loan growth not just driven by interest rates
Although the rising rates versus loan demand issue often arises, we do not see much
evidence of that relationship – it seems counter-intuitive but true. For example, for most of
FY10, rates were very low but there was little demand for bank credit, and more puzzling, in
the midst of a massive economic upturn. Likewise, 2007 saw very strong credit demand with
increasing rates. Having said that, banks are apprehensive that more than another 100bps
rise in lending rates may start to pinch some segments of credit demand.
Intuitively, borrowers whose demand is more sensitive to rates are SMEs and midcorporates.
At this juncture, they are not major loan growth drivers; home loans, auto loans
and infrastructure are showing the greatest momentum. These areas are probably less
sensitive to rising rates.
However, the real risk is crowding out by the government, which is also a supply issue and
not a demand problem for private sector loan growth.
Mid-cycle loan growth of 20-22% in FY12E reasonable
The above estimate is a function of:
The RBI’s articulated comfort level (though its first direct estimate for credit growth in
FY12E should come only in early May 2011)
Because we expect deposit growth to pick up from the current c.16% to 18-19% due to
increases in deposit rates and a renewed effort on deposit mobilization, and a 300-
400bps gap between loan and deposit growth is a manageable one (the current level of
c.800bps is not sustainable)
The economy is in a mid-cycle in our opinion, somewhere in between the heydays of
2005-07 and the post-credit-crisis meltdown.
It must be noted that the currently prevailing high inflation provides a floor for loan growth as
the latter is expressed in nominal terms. Moreover, an analysis of real credit growth shows
that it is on a strong upward trend (Figure 32). This has happened in an environment of rates
increasing.
Although investors have already started asking if FY12E loan growth can revisit the lowest
points in history, we believe that is very unlikely, given that we are looking at a period of low
liquidity and high rates, not a crisis (actually the global environment is probably becoming
more favourable). From a historical perspective, the two lowest growth years were after two
global crises – the Gulf War and the Asian Crisis
We would refrain from projecting a system loan growth via the GDP growth route, much
against the common perception, “Loan growth should be 3x GDP growth”. If history is
anything to go by (Figure 34) – and it is a 30-year history – the correlation between the two is
hardly visible.
Margins more important than growth in the short to medium term
Our experience has been that margins are more important than growth as a stock price driver
in the short to medium term (six to 12 months), whereas growth is more significant in the
longer term (more than a year). For example, loan growth was subdued all through FY10, but
stocks performed very well as the sector saw massive margin expansion due to the re-pricing
of high-cost deposits. However, if growth remains weak for an extended time (as it has been
for most of the past year or so), valuations could compress further
Asset quality risks declining
Profitability-interest rate gap remains a buffer against credit
quality deterioration
We do not believe that the scale of rate increases we have seen and likely to see will be such
as to endanger credit quality. Even around the time of the credit crisis, corporates that faced
repayment problems did not complain about high rates but about collapse in demand due to
a serious global problem. Theoretically, as long as a company has a profitability that is high
enough to afford interest payment, the ability to repay debt is not jeopardized (willingness to
pay is a different issue, that has been largely taken care of by the foreclosure law and the
credit bureaus).
The aforementioned may sound simplistic and academic, but we believe it actually works. Up
to the late 1990s, corporate asset quality was a problem in India because in addition to high
interest rates, corporate profitability was poor and corporate India was massively
overleveraged.
Available data suggest that situation has considerably improved (Figure 36). So even though
the gap between profitability and interest rates could narrow in a relatively weaker economy
than last year and rising rates, it should still remain healthy enough to avoid a snowballing
into an NPL problem.
Of course, as mentioned above, all NPL situations of the past were not driven only by
interest rates rising; more often than not, demand is a bigger issue. So though the above
chart would seem to suggest in FY09 there should not have been a problem, banks did go
through some stress (by no means serious, including restructured assets), which was due to
the global crisis that resulted in a FY09 where GDP growth contracted by 250bps. Currently
Deutsche Bank economists are forecasting NO contraction in GDP growth in FY12E, and we
do not perceive a substantive worsening of that outlook. Thus our above analysis broadly
holds in the current cycle.
Occasional credit quality accidents cannot be ruled out, but that is not new
The above does not mean that there will be no awkward quarters for a bank. In the last few
quarters we have seen some banks report chunky slippages. Too much time and energy has
gone into predicting which bank could report a large slippage in a particular quarter, and stock
prices have swayed with that.
We believe that approach just does not work because it is beyond the realm of public
information. The important point to note is that these issues are not systemic. An upgrade
against a slippage could be very quick, leading to a positive earnings surprise as much as the
negative surprise when the loan slipped.
Visible impact of microfinance and 2G licences likely to be manageable
Although the travails of the microfinance industry have been a topic of high-pitched debate in
the last three months, we believe that it will fade from the limelight very soon. The RBI has
permitted banks to restructure their exposures to microfinance. So to that extent, the
vulnerable exposures will not reflect as NPLs. Since as a percentage of the loan book these
exposures are small (1.0-1.5%, see Figure 37), the impact of a haircut on profitability also
should be negligible.
We understand that most banks have lent to 2G licencees with recourse to parent
companies, which are usually reputed domestic and international entities, and many have lent
only to incumbent telecom players. If that is true, then the exposures are not at much risk if
licences were to be cancelled due to the auction controversy (which itself could be a very
extreme step on the part of the government). However, there is little public disclosure on
these issues, and there are banks that have lent based on the licence as the collateral, which
could pose a risk in the event of a cancellation. Figure 38 shows the total telecom exposure
of banks; there is no separate disclosure on how much has been lent to 2G licencees.
Seasoning-related downside minimal due to low growth in the
last two years
We have dealt with the interest rate-credit quality aspect above, but typically the other key
reason for systemic credit quality issues is excessive lending growth (Figure 39 and Figure
40) for an extended period, which ends up overleveraging borrowers and encourages bad
credit decisions. Fortunately, this risk is low, in our view. Loan growth has been decelerating
for a few years now, though the absolute growth may currently be considered high by global
standards. Within that, growth of the riskier unsecured lending has been negligible and at
times even negative.
Restructured assets appear to have worked well through the credit cycle
From the 40-50% slippages estimate at the time of the special dispensation on restructuring,
consensus estimates have decreased to 15-20%. Since the largest portion of moratoriums
for restructured assets would have expired by June 2010 to Sep. 2010, it is reasonable to
assume that restructured assets have gone through the test of viability and unlikely to breach
the 15-20% slippage range (there could be bank-wise exceptions though, but they are few).
Most important, since maximum restructuring was done for the export-oriented industries,
the ongoing global recovery could make that asset class perform even better
We continue to be more positive on retail credit quality in general
The seasoning issue is even starker for the retail segment in which growth almost fell to zero
and has recovered only recently – it is still at a level substantially less than the sector average
(Figure 42). Thus, there is reason to believe that the recent growth in retail is far wellconsidered
than the previous cycle, and potentially even better than the recent corporate loan
growth. Specifically, unsecured retail has not returned to growth and for some banks it is still
declining – this was the key problem area in the previous cycle.
As a consequence of the above, retail banks have been seeing a sharp reduction in credit
costs (Figure 43). Irrational competition in personal loans, credit cards, and two-wheeler loans
(technically secured but in reality behaves more like uncollateralized) that had led to the
underwriting imprudence has just about disappeared.
Credit cost decline in FY12E could be a significant source of
profitability upside
We expect credit costs (here defined as NPL provisions) for most banks to decline as a
percent of loans in FY12E compared with FY11E (Figure 44), providing an impetus to profit
growth, partly compensating for a possible net interest margin reduction. This is mainly a
function of seasoning; retail assets have almost fully seasoned as we explained above, and
export-oriented sectors (which were the most affected in the downturn) are looking up due to
a better global environment. By the end of FY11E, the restructurings of June 2010 should
have come out of the moratorium period as well.
Provision coverage increase exercise largely complete
As Figure 45 shows, except for SBI, the banking system has more or less finished the
regulatory requirement of reaching provision coverage of 70%. This, in addition to higher
NPLs, was a reason for the high credit costs in the past four quarters. The other relief that we
expect is lower slippages in the coming quarters versus the last six quarters due to better
economic conditions.
The central bank has also recently indicated that it may modify the 70% provisioning mandate
and convert that to counter-cyclical requirements. In other words, the focus will not be to
ramp the provision coverage up to a certain number and always maintain it, but to build it in
good times and draw it down in bad times. This may translate to a lower effective number
than 70%, which was decided more as a consequence of the credit crisis. This could provide
relief to some banks that were historically not used to making such high provisions, and
making a 70% provision on every new NPL became onerous for them.
Valuations, stock
performance, and top picks
Correction has brought valuations to reasonable levels
Most stocks have fallen to within one standard deviation, indicating weak sentiment
As Figure 46 through Figure 53 show, stocks have fallen considerably over the last three
months. The fall was more prominent for those financials that are more dependent on
wholesale funding. More important, the reason is not just rising rates – we have had an
unfortunate confluence of several other problems such as the microfinance crisis, telecomauction-
related uncertainties, the bribery-for-loans scam, and the RBI appearing to “talk
down” the margins of Indian banks. Many of these are peripheral to the sector but add to the
bearish sentiment already prevailing.
Assessing the downside case – lessons from prior cycles
Analysis shows stocks can rebound much more than they can go down from here
We have identified January to June 2007 as the previous period of liquidity deficit when
banks were borrowing large amounts under the repo window. We have analysed the stock
price performance during that period to assess potential downside to current levels. [While
liquidity was in deficit even during the June to November 2008 period, we have not
considered that for our analysis here as that was the period of wild swings due to the credit
crisis – and we do not believe that we are anywhere close to that situation in terms of
stress].
During the January to June 2007 period the contraction between the maximum and minimum
P/B multiple for banks under our coverage was between 23% and 44%. In comparison with
current valuations, the multiples have already contracted between 21% and 35% from the
peak in October-December 2010. If we currently assume similar multiple contractions as was
witnessed in the January to June 2007 period, then further downside is limited to 0-14%. For
Yes Bank and PNB, P/B multiple has already contracted more in the current correction than it
did in the previous period.
More interesting, the average P/B valuation for a six-month period following the liquidity
deficit period was 15-179% higher than the minimum during the liquidity deficit period.
Again, if we were to draw a similar analogy for the current period, then there can be
significant upside potential to current levels, making the risk/reward favourable. Hence, we
reiterate that while fundamentals are stressed, valuations are probably factoring more
negatives than necessary
Relationship between stock prices and loan growth, liquidity, and rates
Although in the last cycle corresponding to the global credit crisis, the banks had responded
negatively to the liquidity crunch; in this cycle the performance was very good until about two
months back
Until 2004, banks used to perform distinctly inversely with the movement of rates; after that,
the correlation is not that clear (Figure 57 and Figure 58). In this cycle, the Bankex was
moving along the direction of rates until recently when it turned the other way.
The key message from the above is that “sell banks because rates are rising” may not be a
correct approach. In fact, for most periods from 2004, it would have been incorrect.
However, stronger loan growth usually reflects well on bank stocks (Figure 59). Yet the
relationship is not so strong that a small correction (such as the 24% currently to ~20% we
are expecting for FY12E) in loan growth has to necessarily manifest in underperformance.
Changes to estimates, ratings, target prices, and top picks
We downgrade Kotak Mahindra, upgrade CanBank, lower target prices for Kotak
Mahindra, Union Bank, PFC, REC, and IDFC
Canara Bank: NIM has significantly expanded to 3.21% for 3QFY11, which is the highest in
more than 19 quarters and better than our initial estimates – this provides an adequate
cushion in the rising interest rate environment. The bank continues to grow at rates faster
than the system. While we were earlier concerned about asset quality, the bank continues to
surprise positively - slippages from restructured loan book are c.7%, which is amongst the
lowest among the PSU banks. With the bulk of the moratorium on restructured loans ending
there is lower probability of any major slippage from the restructured book, this coupled with
strong recoveries should help in keeping the credit costs low. The management change has
also been smooth. We have raised our net profit estimates by 8-10% for FY11E to FY13E as
we factor in higher NIM and lower credit costs. For the above reasons, we upgrade our rating
on Canara Bank to Buy from Hold with its target price revised to INR710 from INR670.
IDFC: We have increased our FY11E net profit estimate marginally by 1.4% but have cut
FY12E and FY13E estimates by 4.5% and 7.0%, respectively. The momentum from
infrastructure loans is partly offset by our expectation of the capital markets businesses
remaining weak. We also lower our target price from INR190 to INR150 due to the lower
multiples applied to the lending business (multiple compression due to an adverse interest
rate cycle – we have done that to other stocks as well) as also capital markets businesses for
the same reason. We maintain our Hold rating.
Kotak Mahindra: We have reduced (unadjusted) net profit estimates marginally by 0.8%,
0.7%, and 3.0% for FY11E, FY12E, and FY13E, respectively. However, we have applied lower
target multiples to all the aforementioned businesses, leading to our target price reducing to
INR350 from INR460. Since the bank has a significantly larger component of value coming
out of its capital-market-linked businesses than all other banks, it is likely to be more affected
by the capital market downturn, which usually reflects more strongly in multiple compression
than earnings. Therefore, we downgrade our rating on the stock to Sell from Hold.
PFC: We cut our earnings estimates of FY11E, FY12E, and FY13E by 3.3%, 6.0%, and 7.8%,
respectively, because we believe that some sluggishness in some power projects is likely
(relative to initial expectations) due to environment-related delays. After the application of the
lower multiples, we have cut our target price to INR305 from INR405. We maintain our Buy
rating.
REC: Similar to PFC above, we are lowering the multiples due to which our target price falls
from INR400 to INR305. We maintain our Buy rating.
Union Bank: We maintain our Hold recommendation on Union Bank with our target price
revised to INR350 from INR385. While the operating performance for Union Bank is healthy,
we are still concerned about its asset quality. Slippages are still higher than normal, leading to
higher credit costs. However, valuations seem to be factoring in the negatives and at 1.3x
FY12E P/B, the stock appears fairly valued.
Our recent changes include quite a few estimate increases, few upgrades, no
downgrades
In the January 2011 results season, we upgraded our ratings for LIC Housing Finance and
Bank of India recognizing their severe stock price underperformance and stabilization in some
metrics that we perceived as vulnerable.
During the same time, we had quite a few frontline banks (e.g., Axis) in which we increased
our earnings estimates materially and reduced our target prices. This essentially factors in the
multiple compression of the entire sector due to an adverse interest rate cycle, while at the
same time re-emphasising that the overall outlook has not been jeopardized. We experienced
that for some banks in FY09 as well. This in turn means that if the environment were to turn
positive even at the margin, a stock price recovery due to a multiple expansion can be
significant.
Stock ideas
Our top picks among the large cap banks are HDFC Bank, Axis Bank, and Bank of
Baroda; our top mid-cap picks are Yes Bank and Shriram Transport Finance.
We recommend investors switch from:
SBI to PNB and BoB. The latter two are at similar valuations, have better credit
quality positions, have strong operating expense profiles, and have less pressure on
incremental LDR (BoB is a standout case in this respect in the whole sector).
Union Bank to Canara Bank. While both banks are likely to show good operating
performance, higher slippages are likely to keep credit costs high in the case of
Union Bank.
IDFC to PFC and REC. IDFC has several capital markets businesses that are likely to
remain in a downturn for the next year, and we believe that it is constrained in its
leverage. PFC and REC are in a funds-constrained sector and have significant
domain knowledge, and their sharp underperformance in the last two months has
probably factored in concerns of a slowdown.
Kotak Mahindra to Yes Bank. The non-banking businesses for Kotak Mahindra
Bank continue to face strong sector headwinds, pulling down the overall profitability.
Yes Bank is likely to grow at more than twice the system rate over the next couple
of years with a stable NIM and asset quality. Yes Bank’s P/B multiple has already
contracted by more than the contraction witnessed in previous periods of tight
liquidity and is trading at attractive valuations of 2.0x FY12E P/B and 9.8x FY12E P/E
with FY12E RoE of 21% and earnings CAGR of ~30% over the next two years.
Wholesale funded have suffered the most – good time to revisit
In our opinion, “Sell wholesale-funded, buy retail-funded” is not necessarily a prudent
strategy, though this tends to be the market reaction in times of increasing interest rates.
There are several wholesale-funded companies and banks that have significant pricing power
by virtue of operating in specific segments for which they have accumulated domain
knowledge. There are also non-retail mechanisms for keeping a tab on the cost of funds such
as securitization.
In that context, we like Shriram Transport Finance and YES Bank. Both have fallen significantly
from the peaks but both have demonstrated their ability to deliver fairly solid profit growth in
even far worse times for interest rates. Moreover, in any case, we do not expect this cycle to
get worse than the post-credit-crisis period.
Private banks may fare better than state banks in the current scenario, though hard to
generalize
We have noticed that, historically, in times of rising rates and/or tight liquidity, PSU banks
have underperformed private banks (Figure 60 and Figure 61 provide an example).
We are addressing this issue only because it is frequently raised by investors, though we
increasingly believe that PSU banks may not be a very homogeneous asset class (and neither
are the private banks). Past trends are unlikely to repeat because of the absence of two
factors that typically contributed to the underperformance earlier: a large bond book and
government pressure to hold lending rates. Thus, we continue with our stock-specific
approach.
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