India Banks by Anand Rathi

India Banks
What can drive bank stocks?
Key takeaways
Policy rate-cuts usually aid in bank outperformance. Our brief analysis
of the Bankex (from 2002) reveals that policy rate (repo) cuts have a positive
effect on banking stocks. Since 2002, the Bankex has outrun the Sensex by
an average 3.2% in the month after a repo rate cut. Of the last 15 such
instances, bank stocks have outclassed in 10. Buying bank stocks one
quarter before rate-cut events, however, usually leads to better payoffs, with
the Bankex outperforming the Sensex an average 5.5%.
Asset quality improved in 2HFY13. In our theme report dated 20 Nov’12,
India Banks: IIP recovery in 2HFY13 to lift asset-quality overhang, we had stated that
asset-quality headwinds for banks are likely to subside, led by a likely recovery in
industrial production. In 2HFY13, incremental gross NPA for large-cap banks
was `38.7bn, substantially lower than the `229bn of 1HFY13. Over the same
period, IIP grew 2.1% yoy, better than the 0.1% registered over 1HFY13.
Moreover, in 4QFY13, banks' asset quality improved a shade, with gross NPA
for large-cap banks down 2% qoq to `1,083bn.
Yet, banks underperformed in 4QFY13. Over Jan-Apr’13, policy rates
were cut by 50bps, while gross NPAs of our banking universe fell. However,
despite this favourable combination of lower interest rates and lower NPAs,
the Bankex undershot the Sensex by 6.3% over the same period. A likely
reason for the underperformance could be the ballooning of restructured
loans for large-cap banks - from 4.6% of loans in FY12 to 5.3% in FY13,
and the perception that defaults from these loans could be meaningful in
FY14.
Congenial policy rate and asset quality outlook. With a 75-bp cut in the
repo rate since Jan’13, the RBI has frontloaded monetary easing; this has yet
to manifest itself in lower base rates of banks. Led by softening inflation and
a slow pickup in overall economic growth, we expect the central bank to cut
policy rates by another 50bps in CY13. This is likely to be positive for bank
stocks. Moreover, our chief economist expects IIP growth to rebound from
1.1% in FY13 to 4.4% in FY14. Since there appears to be a strong
correlation between NPA accretion and IIP growth, IIP revival could
translate into lower NPAs and, consequently, manageable incremental credit
costs for banks.
Our sector bias. We prefer banks with a high proportion of low-cost
deposits, which could protect NIM when asset yields fall, and greater tier-1
capital to tap growth opportunities, both highly desirable attributes ahead of
the likely monetary easing. Top picks. ICICI Bank, Yes Bank, ING Vysya
Bank and South Indian Bank

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Policy rate-cuts usually aid banks’ outperformance
Our brief analysis of the performance of the Bankex (from 2002) reveals that
policy rate (repo) cuts have a positive effect on banking stocks. Since 2002,
the Bankex, in the month after a repo rate cut, has outclassed the Sensex by
an average 3.2%. Of the last 15 such instances, banks have outperformed in
10. However, buying bank stocks one quarter before rate-cut events usually
leads to better payoffs, with banks outrunning the Sensex by an average
5.5%.
Bankex outshone in 10 of the last 15 instances of a repo rate cut
Of the 15 such instances of a repo rate cut, the Bankex in the month after
the event outshone on ten occasions. While the Bankex does seem to
outperform more strongly one quarter after the repo rate cut, it has only
done so on six of the previous 15 such instances.
Stronger gains if one buys bank stocks a quarter before the actual repo rate cut
Interestingly, the early bird does get the worm! One stands to make stronger
gains on bank stocks if they are bought one quarter before the actual repo
rate cut. On average, the outdistancing of the Bankex with respect to the
Sensex is 5.5%. One would have achieved these gains two-thirds of the time,
as banks have outperformed the Sensex in eleven of the previous 15
occasions of a rate cut, if one bought bank stocks one quarter before a rate
cut was actually instituted.
Only mild outperformance in the Bankex a month before a repo rate cut
The outperformance in banks tends to be mild a month before a repo rate
cut, which would suggest that the market has already “priced in” the
possibility of the event occurring. Since 2008, in six of the past ten instances,
the Bankex has outperformed one month before the cuts. This would
probably imply that bank stocks’ performance is not entirely dependent on
repo rate cuts, at least in the very short term.

However, post-2009, the Bankex has undershot the Sensex in three instances
out of seven despite repo rate cuts. We have examined these periods in little
more detail to understand the reasons for the underperformance of bank
stocks. On two of the occasions – Mar’09 and Apr’09, asset quality of banks
deteriorated significantly. However, the most recent instances of policy rate
cuts (Mar’13 and May’13) have seen underperformance or mild
outperformance of banks relative to the broader markets. In fact, banks’
asset quality actually improved in Mar’13.

Asset quality improved in 2HFY13
In our theme report dated 20 Nov’12, India Banks: IIP recovery in 2HFY13 to
lift asset-quality overhang, we had stated that asset-quality headwinds for banks
are likely to subside, led by a likely recovery in industrial production. In
2HFY13, incremental gross NPAs for large-cap banks were `38.7bn,
substantially lower than the `229bn of 1HFY13. Over the same period, IIP
grew 2.1% yoy, better than the 0.1% registered over 1HFY13. Moreover, in
4QFY13, banks' asset quality improved slightly, with gross NPA for largecap banks down 2% qoq to `1,083bn.
Gross slippages (fresh additions to NPA) of large government-owned banks
have risen 1.5x in the past four quarters, from 1.8% of loans (annualised) in
Mar’12 to 2.4% in Mar’13. Excluding SBI, gross slippages have risen 2.4x in
the past four quarters, from 1.7% of loans (annualised) in Mar’12 to 3.7% in
Mar’13. However, these slippages appear to have peaked in Sep’12 and are
now on a declining trend


Yet, banks underperformed in 4QFY13
Over Jan-Apr’13, policy rates were cut by 50bps, while gross NPAs of our
banking universe declined. However, despite this favourable combination of
lower interest rates and lower NPAs, the Bankex undershot the Sensex by
6.3% over the same period. A likely reason for the underperformance could
be the ballooning of restructured loans for large-cap banks, from 4.6% of
loans in FY12 to 5.3% in FY13, and the perception that defaults from these
loans could be meaningful in FY14

Congenial policy rate and asset quality outlook
With 75bps cumulative cuts in the repo rate since Jan’13, the RBI has
frontloaded monetary easing, though this has yet to manifest itself in lower
base rates of banks. Led by softening in inflation and a slow pickup in overall
economic growth, we expect the central bank to cut policy rates by another
50bps in CY13, which is likely to be positive for bank stocks.
Moreover, our chief economist expects IIP growth to rebound from 1.1% in
FY13 to 4.4% in FY14. The revival in the IIP is likely to have led to lower
NPA as there appears to be a strong correlation between NPA accretion and
IIP growth. On most occasions in the past, sliding IIP growth led to an
increase in NPA, and vice-versa. We believe that the asset-quality cycle is
likely to have reached its peak in terms of asset-quality deterioration. While
the Indian economy is seeing decelerating IIP growth, it is expected to
rebound in 2HFY14. Our chief economist expects IIP growth to rebound
from 1.1% in FY13 to 4.4% in FY14. The likely improvement in industrialproduction growth would lead to lower NPA in 2HFY14 due to the lag
effect of NPA formation on asset quality. Credit costs are likely to be lower
as asset-quality headwinds ease.
From Jan to Jun’13 bank stocks undershot the Sensex; while the Bankex
registered ~7% losses, the Sensex fell ~4%. This underperformance was
likely driven by higher incremental restructuring in 2HFY13, despite a 75-bp
rate cut over the same period. The underperformance possibly implies that
risks associated with asset deterioration have been priced in. While
perceptions of default risk would continue until asset quality actually
improves or shows signs of stabilizing, an easing interest-rate environment
and lower incremental NPAs could be congenial to price movements of
banking stocks.

Sector bias to banks with high tier-1 capital, high CASA share
While most bank stocks are trading near the mean of their past valuations,
we see scope for further valuation upsides for select banks. Rising business
growth, steady margins and the likelihood of lower NPAs could support
valuations. We prefer banks that are better placed to manage the likely
monetary easing cycle ahead with a high proportion of low-cost deposits (to
protect NIM when asset yields are likely to fall) and high tier-1 capital (to
benefit from growth opportunities when credit demand accelerates). A
further re-rating in the near term, in particular for PSU banks, is also likely if
the government infuses capital at favourable valuations (equal to or higher
than book value). Top picks: ICICI Bank, Yes Bank, ING Vysya Bank and
South Indian Bank.
We have a Buy on ICICI Bank, Punjab National Bank, Axis Bank, IndusInd
Bank, Yes Bank, IDBI Bank, Federal Bank, Indian Bank, Indian Overseas
Bank, Jammu & Kashmir Bank, ING Vysya Bank, Karur Vysya Bank, South
Indian Bank, City Union Bank, Vijaya Bank, Karnataka Bank and DCB
Bank.
We have a Hold on HDFC Bank, Bank of Baroda, Union Bank of India and
Andhra Bank.
We have a Sell on State Bank of India, Canara Bank and Bank of India.
Key risks to our call
Slower-than-expected growth rate of the Indian economy. Our
economist estimates India’s GDP to grow 5.8% in FY14. Any downside to
this growth forecast would mean less-than-estimated credit demand.
Tight fiscal policies and no monetary easing. We expect 100bps policyrate action in CY13, with the RBI likely to focus on keeping liquidity
comfortable. No monetary easing or tight fiscal policies could lead to lowerthan-anticipated earnings for banks in the short term
Higher-than-expected increase in re-structured-loan defaults. A higherthan-expected increase in re-structured-loan defaults could trim banks’
earnings in FY14 as provisions for bad loans would increase