Banking - Blending contingent liabilities, comfort lies with private banks; Edelweiss

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After having done a threadbare asset quality analysis of funded exposure of banks in our previous report, Woes common, pace uneven, dated November 28, 2011, we replicate the exercise for their non-funded exposure (Contingent Liabilities) and consolidate the two. Though the non-funded exposure is higher for private sector banks (more due to derivatives exposure), on a blended basis the results are not very different. We maintain our stance that private banks are better geared to absorb increased credit costs than SOE banks under stress case scenario.

Contingent liabilities: Private banks bloated on derivative exposure

Private banks run a higher non-funded exposure (1.5x-2.3x of asset book) compared to their SOE counterparts (0.2x-0.7x of asset book). However, the difference is exaggerated due to the higher derivative exposure, which is a gross exposure. When the derivative exposure is converted into credit equivalent amount (CEA), the non-funded exposure is not outsized. Also, for the guarantees and acceptances, we convert the exposure into CEA as per RBI guidelines.

Sensitivity of CL: Private and SOE banks to see similar stress levels

Next, we undertake a similar credit quality screening exercise for banks’ contingent liabilities (CL) by slicing the same into stress sectors with similar assumptions for Probability of Default (PD) as used for the funded exposure. For the derivation of credit costs, LGD assumed is about 70% for guarantees and 40% for acceptances and others. Potential stress (both restructured + slippages) from CL would be of 5%-6% for private banks and 6-7% for SOE banks. Similarly, the LGD would be 170-265bps of CL for private banks and 200-260bps for SOE banks over H2FY12-FY13E.

Combining non-funded exposure: Private banks better placed

Our analysis of the CL, i.e., of Derivatives, Guarantees and Acceptances etc., leads us to believe that even after taking into account potential stress due to CL exposures, private banks are better placed to absorb increase in credit quality costs. However, the incremental impact on PAT and net worth due to inclusion of CL risks is of 6-13% and 1.0-2.5%, respectively, for private banks. Combination of funded and CL exposure under a stress case can impact PAT of private banks by 2%-17% and that of SOE banks by 23%-38% and Networth by 0.5%-5% for private banks and 6%-9% for SOE banks.

Valuation: Maintain underweight on SOE banks

We maintain our stance that stock performance in the near term could swivel more towards perception rather than fundamentals. However, considering the corrected valuations of some private banks, we believe the risk–reward is clearly in their favour. Our top picks are Axis Bank, ICICI Bank, Federal Bank. We maintain ‘REDUCE’ on PNB and‘HOLD’ on SBI.