India Banks Monetary Policy: Prudent on Rates, Structural Reforms  Citi

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India Banks
 Monetary Policy: Prudent on Rates, Structural Reforms
 Surprise rate hikes, 50bps each in repo and savings deposits  — RBI hiked
50bps each in repo rates (ahead of consensus) and savings deposit rates (surprise
as discussion paper still pending). Likely impact: a) Raises cost of funds across
banks – savings rate impact 10-12bps, overall (including wholesale) likely over
25bps; b) Should lead to lending rates hikes by banks (25-50bps); and c) Expect
retail term deposit rates to remain unchanged (still higher than wholesale rates).
Overall, while savings deposits will cost more, higher CASA deposits still provide a
lower cost structure and greater cushion to absorb impact of higher borrowing costs.

 NIMs under threat, but so is growth medium term — Net interest margins for the
sector were already under threat, pressure will increase near term. However, we
believe that NIM pressure was already largely discounted over recent weeks and
the more pertinent risk to earnings/valuations will come if loan growth slows down
more than anticipated (on likely higher lending rates, overall macro risks).
 Change in provisioning norms  — RBI also raised loan loss requirements for
NPLs and restructured advances, this follows its recent relaxation of the 70%
provisioning norm. While the immediate impact is to increase loan loss charges
(albeit modestly), the combined effect of these changes will lead to lower
provisioning requirements overall. Structurally Indian banks have low coverage
ratios relative to other regional banks; this could reduce earnings comfort during a
challenging asset quality environment and be a valuation drag.
 Structural reforms: borrowing window, cap on liquid funds, new branches —
There were a few structural measures as well: a) Permanent borrowing window for
additional liquidity support – up to 1% of deposits, 100bps higher cost than repo,
formalizes adhoc extensions till now, impact limited; b) Cap on investments in liquid
funds - at 10% of net worth, will cut  down liquid investments and corresponding
deposits as well, earnings impact limited as excess liquidity scarce currently; and c)
Banks will need to open 25% of new branches in rural areas – providing thrust to
financial inclusion goals. Longer-term positives, but near-term impact likely limited.
 Pipeline, timeline for more reforms intact — RBI is sticking with its announced
plans to introduce more structural reforms (there are a few in the pipeline) including
– new banking licenses, entry of foreign banks, NBFC guidelines, holding company
structures and priority sector requirements. It also accepted the broad regulatory
recommendations of the recent Malegam Committee Report on microfinance.
 Sector view: Add on further weakness, stick to strong deposit franchises —
Structurally, we remain positive on the sector, near term though - valuations and
cyclical NIM pressures are a concern. We would look to add exposure on further
sector underperformance from current levels. Retain our preference for higher
CASA banks with a bias for private banks. Our preferred picks in the sector include
– Axis Bank, SBI and IDFC.


AXIS Bank
(AXBK.BO; Rs1,230.70; 1L)
Valuation
Our target price of Rs1,510 is based on an EVA model using the following key
assumptions: a) risk-free rate of 8.0%, b) long-term loan loss of 120bps per annum
(higher than sector averages, due to greater lumpiness in its loan book growth), and
c) long-term cost-to-income ratio of 42%. We prefer using an EVA-based valuation
benchmark to P/BV because EVA concentrates on the economic value creation of
the bank. We use P/BV as a secondary valuation methodology. Believing that Axis
should trade above government banks and in line with the highest multiples for
large private-sector banks given its ROE, we ascribe 2.75x FY12E P/B to Axis,
equating to Rs1,465.
Risks
We rate Axis Bank as Low Risk, in line with our quantitative risk-rating system, and
to reflect the bank's well diversified loan portfolio and relatively healthy asset quality,
along with its sustained high profitability. Key downside risks to achieving our target
price include: 1) Greater-than-expected asset quality pressures, as Axis has grown
rapidly; 2) Sharp slowdown in rapidly growing fee income; 3) The bank's large share
of wholesale funding could be exposed to tighter funding; 4) Dependence on
treasury returns; 5) A government-related entity is a dominant shareholder in Axis;
any disorderly sale would have an impact on the stock.
Infrastructure Development Finance
(IDFC.BO; Rs135.40; 1M)
Valuation
We value IDFC at Rs174 based on our sum-of-the-parts methodology. We value
IDFC's core lending business at Rs142 per share; we prefer a P/BV multiple of 2.0x
1yr-Fwd BV benchmarked towards the lower band of private banks' target P/BV
multiples, given its sub-15% core ROE. This reflects IDFC's premium positioning in
the infrastructure segment, strong management, long track record of low asset risks
and relatively high growth profile. However, its target multiple is constrained by its
lack of retail asset, liability and distribution franchises relative to premier private
bank franchises. We value the asset management business as a percentage of
assets and value this business at Rs9 per share sub-divided into Rs5 for the private
equity segment (7% of AUMs) and Rs4 for the Stanchart AMC business (4% of
AUMs). We value IDFC's broking and investment banking business at Rs5 per
share based on 15x 1yr Fwd profits. Finally, we also add Rs18 for IDFC's
investment portfolio including the NSE (valued in-line with the last reported
transaction).
Risks
We rate IDFC shares Medium Risk, even as our quantitative risk system, which
tracks 260-day historical share price volatility, suggests Low Risk. While IDFC’s
increasing scale and strong asset quality track record, reduce risks, we believe its
mono-segment lending and inherent exposure to capital markets increase its risk
profile. Key downside risks that could restrict the stock from achieving our target
price include: a) Sharp increases in interest rates; b) Significant slowdown in

infrastructure growth and asset quality; c) Continued softness in capital markets for
a relatively longer period; d) Regulatory changes and a higher tax rate.
State Bank of India
(SBI.BO; Rs2,583.10; 1L)
Valuation
Our target price of Rs3,110 is based on our EVA model, in which we assume a riskfree rate of 8.0%, in line with the market level. Our longer-term loan loss assumption
is 100bps pa (in-line with industry). Our target price for SBI includes a subsidiary
valuation of Rs671: Life Insurance at Rs184 per share, associate banks at 1.25x
1Yr Fwd PBV (Rs391), value for SBI's Asset management business (Rs25, 5% of
assets) and incorporates capital markets subsidiary at Rs72 based on 10x 1Yr Fwd
PE. We also use a sum of parts valuation which values SBI at Rs3,029 per share. In
this valuation, we benchmark the consolidated banking business off a 1.6x 1Yr Fwd
P/BV (1.7x for the parent and 1.25x for associate banks) - a 10% premium to peers.
We also add Rs281 per share for its non-banking subsidiary businesses as detailed
earlier. We base our target price on EVA, as we believe it better adjusts for the
relatively dynamic cost of capital and better captures the long-term value of the
business.
Risks
We rate SBI as Low Risk, in line with CIRA's quantitative based risk rating system.
We believe this is appropriate given the nature of SBI's business, the quality of
management, and the direct government ownership. The downside risks that could
impede the stock from reaching our target price include: (1) A sharp rise in interest
rates; (2) Asset quality concerns given strong loan growth; (3) Lack of liquidity or
deposit growth; (4) Government involvement could be contrary to the interests of
minority shareholders; and (5) A lack of capital to support growth.