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Fuelled to fly ;
Loan growth of ~20%, operating leverage and fall in credit cost will drive banking sector's
profitability over FY12 and FY13. Margins, even with some moderation from their peaks in
3QFY11, would be above/near the average level of FY04-09. Higher recoveries could provide
positive surprise to earning estimates (write-offs were aggressive over FY09 and FY10
to keep reported GNPAs lower). We expect banks to report 20%+ earnings growth on an
aggregate basis and return ratios to be healthy with RoA of 1.1%+ and RoE of ~18%.
Valuations at P/E of 8x and P/BV of 1.3x for PSU banks and P/E of 16x and P/BV of 2.3x for
private banks are at the five-year average multiples, despite strong core operating
performance expected. Our top bets are SBI, ICICI Bank and PNB. In the mid-cap space we
like Indusind Bank and Yes Bank.
Margins robust; to remain above/near FY04-09 average levels
Downward deposit re-pricing, fall in excess liquidity on the balance sheet, better
pricing power (led by a liquidity crunch and a higher CD ratio) and stronger CASA
growth led to a sharp improvement in margins in 9MFY11. Overall, FY11 blended
margins are expected to be ~50bp higher YoY, driving core operating profits.
Given the tight liquidity and rising rates scenario, margins are unlikely to fall in a
hurry, and gradual moderations have been factored in estimates. As FY11 is amongst
the best year of margins for Indian banks, we expect margins to moderate 10-
20bp (bank specific), but to remain above/near the average margins of FY04-09.
Banks that reported higher slippages over the past two years are likely to have
lower margin compression because of expected improvement in asset quality.
Our sensitivity analysis suggests that for every 5bp change in margins, profits will
be impacted by ~3%. With a 1% fall in CASA ratio and a 1% fall in CD ratio,
margins are likely to compress by 5bp and 7bp, respectively.
Asset quality improvement; lower credit cost to drive earnings growth
Banks added higher stressed assets over FY09-11 due to fall out of the financial
crisis and moderation in economic growth. However, incremental trends on asset
quality are positive. Over the last two quarters, the slippage ratio has been coming
down and we expect the trend to continue in 4QFY11 and FY12. In our view, large
corporate and retail delinquencies and slippages from restructured loans have
peaked.
Private banks are well placed in terms of asset quality as retail delinquencies have
peaked and due to conservative restructuring policy adopted in the past.
Banks like SBI, PNB and Union Bank, which posted higher slippages, can surprise
positively with a fall in slippages, higher upgradation and recoveries.
Lower slippages, higher upgradations and recoveries should reduce credit costs
and drive earnings growth. Risk to our call is slowdown in industrial growth led by
possible shocks on crude oil prices and delay in project implementation. Technical
slippages on account of CBS implementation can also lead to negative surprise
for PSU banks.
Our assumptions for slippages and credit costs are conservative. While FY11 earnings
upgrades were led by higher margins, FY12 upgrades will be led by lower credit costs
due to falling slippages, higher upgradations and recoveries.
Operating leverage - a key driver for RoA improvement
PSU banks' operating cost growth will peak in FY11 as full pension provisions for
retired employees and wage revision will be provided for. On a higher base, we expect
opex growth to be limited to 15%, providing banks with strong operating leverage.
Private banks’ operating expenses will rise with wage and rental inflation, and large
scale branch expansion. However, due to strong core operating income, we expect
C/I ratio to remain stable.
Valuations at five-year average multiples; inflation remains a key risk
Banks' core operating performance is likely to be strong led by improving asset quality
and operating leverage. We believe valuations are attractive with stocks trading at
five-year average multiples.
Correction in valuations from their peaks largely discount some of the macro headwinds
such as tight liquidity, a sharp increase in interest rates, high inflation and mixed key
economic indicators like IIP.
Net market borrowing of Rs3.6t for FY12 (including T Bills of Rs150b) is below the
market estimates of Rs3.8t+. Lower-than-expected fiscal deficit is positive for domestic
liquidity and will allay fears of crowding out for private players.
Food inflation, which is showing a decelerating trend, gives confidence of moderation
in inflation. However, turmoil in the MENA region and its resultant impact on oil prices
and inflation is a key risk.
Some of the key regulatory headwinds, such as savings bank deregulation and change
in the status of certain loans granted by banks to NBFCs as priority sector loans
(PSL) etc, are specific risks.
Margins robust; to remain above/near FY04-09 average
Downward deposit re-pricing, fall in excess liquidity on the balance sheet, high pricing
power (led by a liquidity crunch and a higher CD ratio) and higher CASA growth led
to a sharp improvement in margins in 9MFY11. Overall, FY11 blended margins are
expected to be ~50bp higher YoY, driving core operating profits.
Historical evidence suggests that in the initial phase of interest rate hikes, margins
improve as the lending book re-prices faster than the liability side. However, as the
cost of deposits increases with a lag (two quarters), margins start moderating.
Given the tight liquidity and rising rates scenario, margins are unlikely to fall in a
hurry, and gradual moderations have been factored in estimates. As FY11 is amongst
the best year of margins for Indian banks, we expect margins to moderate 10-20bp
(bank specific), but to remain above/near the average margins of FY04-09.
Banks that reported higher slippages over the past two years are likely to see lower
margin compression because of expected improvement in asset quality.
Our sensitivity analysis suggests that for every 5bp change in margins, profits will be
impacted by ~3%. With a 1% fall in CASA ratio and a 1% fall in CD ratio, margins
are likely to compress by 5bp and 7bp, respectively.
Sharp margin improvement YTD in FY11
Against the consensus of margin moderation, banks reported healthy improvement over
the past two quarters, led by (a) a sharp increase in the PLR and the base rate, (b) better
liquidity managment and improvement in CD ratio and (c) strong CASA growth and a lag
impact of deposit re-pricing.
Sharp rise in liability rates leading to concerns about NIM
Concerns related to margin pressure are high due to continued liquidity tightness, fasterthan-
expected rise in wholesale borrowing costs (up ~490bp from March 2010, ~72bp
QTD for six-month and one-year CDs), and a rise in retail term deposit rates by 150-
300bp across maturities.
In a rising interest rate scenario margins improve initially, then moderate
Historical evidence suggests that in the initial phase of interest rate hikes, margins improve
as the lending book re-prices faster than the liability side. As the cost of deposits increases
with a lag (two quarters), margins are likely to moderate. However in the current cycle
timely lending rate hike, strong pricing power and loan growth can provide positive a
suprise for margins.
Margins robust; to remain above/near FY04-09 average levels
While we believe bank margins are near their peaks and expect them to moderate from
1QFY12, the moderation is likely to be gradual rather than sudden. Historically, firstquarter
margins are lower than fourth-quarter margins as banks carry a higher proportion
of priority-sector loans on their balance sheets and credit growth is muted. We believe
FY10 and FY11 have been periods of excess, which led to volatility in margins. We see
average margins over FY04-09 being more sustainable for Indian banks. We expect margins
to decline by 10-20bp in FY12 and ~10bp in FY13. Margins can surprise positively over
average margins over FY04-09 as CASA ratio has improved.
Pricing power, base rate system to provide buffer to margins
We expect banks' loan spreads to be at near current levels or decline marginally (due to
asset liability lag in re-pricing) as (1) CD ratio is optimal and the system per se is operating
at 100% incremental CD ratio providing enough pricing power and (2) automatic
transmission of increased cost of deposits via base rates. Stickiness of loan spreads and
stable/marginal decline in bond spreads (unlike in the previous cycle) will provide a buffer
to margins, in our view.
Calculation methodology for the base rate
The base rate is the sum of four components (1) cost of deposits; (2) adjustment for
negative carry with respect to CRR and SLR, (3) unallocated overhead costs and (4)
profit margin. The actual lending rate charged to borrowers is the base rate plus borrowerspecific
charges, including product-specific operating costs, credit-risk premium and tenure
premium.
Computation of base rate
Component Methodology
a Deposit cost (%) - benchmark Cost of deposits/fund (major component in calculation
of base rate)
b Negative carry on CRR and SLR (%) Negative carry on CRR and SLR is arrived at in three steps
1. Return on SLR investment = SLR (mandatory) * 364
days T-bill return
2. Effective cost (%) =
[Cost of deposits (%) - return on SLR investment (%)]
deployable deposits share (%)
Deployable deposits = Total deposits - deposits locked in
CRR and SLR
Total deposits = savings + current + term deposits
3. Negative carry (%) = Effective cost - cost of deposits
c Unallocable overhead costs (%) Unallocable overhead cost/deployable deposits
d Profit margin (%) Net profit /total deployable deposits
1. Base rate = a+b+c+d
2. Lending rate = base rate + borrower-specific charges (to be decided by banks)
Source: Company/MOSL
Bond spreads unlikely to decline as sharply as in the previous cycle
In the rising interest rate scenario of FY04-08, PSU banks' loan spreads improved, providing
a buffer to margins despite a fall in bond spreads, removal of interest rate on CRR balances,
netting of amortization of depreciation on HTM investments from interest income. However,
in the second stage of the current cycle loan spreads are unlikely to improve with competitive
intensity. In the current cycle we do not expect bond spreads to decline sharply as most of
the banks are near their minimum SLR requirements and incremental investments are
taking place at a higher yield. Thus, we do not see much pressure on bond spreads.
Incremental margins to moderate, however will remain strong
The factors that pose a risk to margins are: (1) PLR reaching a historical peak, providing
limited capacity for banks to pass on, considering asset quality issues and growth moderation,
(2) fall in CASA ratio with a sharp rise in term deposit rates and (3) moderation in loan
growth (headline growth is likely to moderate from March on a higher base) and a sharp
pick-up in deposit growth (as real interest rates have become positive). We do not see
loan growth moderation as a big risk to earnings as it is more sensitive to margins. At the
industry level, keeping other things constant (1) with a 1% fall in CASA ratio NIM will be
impacted by ~5bp, RoA by ~3bp and (2) with a 1% fall in CD ratio, NIM will compress by
~7bp and RoA ~4bp.
Assumptions for incremental cost of deposits
40% of incremental term deposits from bulk deposits and the rest from retail term
deposits;
Cost of bulk deposits at ~10% and retail term deposits at 8.5% (blended); thus,
blended cost of incremental deposits at 9%;
Yield on loans to improve by 100bp on incremental loans;
Yield on investments to improve by 25bp on incremental investments;
Overall, banks are doing incremental business at 20bp lower margins.
FY11-13 loan CAGR ~20% led by strong economic growth
Rising rates have led to concerns of sharp moderation in credit growth. However, historical
evidence suggests that loan growth has limited correlation with interest rates and a higher
correlation with economic growth. As long as real GDP growth is likely to be 8%+ we
expect loan growth to be strong. Even before the financial crisis, when interest rates
spiked sharply, loan growth was strong. Initial signs slowing economic growth led to
moderation in loan growth over FY09-10 and as things began to improve, growth picked
up. In the near term, on a higher base (strong loan growth in the last fortnight of March
2010 and 3G auction-related outflow in 1QFY10), we expect growth to moderate, after
which it will improve. The factors that will provide the positive delta on growth are:
Strong real economic growth of over 8% (MOSL estimate of 8.4% v/s 8.5% in FY11)
and nominal GDP growth of over 13% (MOSL estimate of 14%). During the last
decade, the average loan growth multiplier with respect to nominal GDP growth was
~1.8x however, in FY10 the multiple was 1.2x. Going by a conservative estimate of
1.2x nominal GDP, loan growth is expected to be at least 17% in FY12/13.
With strong consumption demand and high inflation, working capital requirements are
expected to be buoyant. Rising crude prices will also lead to demand for working
capital loans from the petroleum sector.
Incremental data have been showing encouraging signs, as loan growth is becoming
broad based rather than driven by the infrastructure segment alone.
Growth in agricultural loans (~13% of overall loans) is likely to be strong, led by
government initiatives and a strong monsoon last year. In the FY12 Budget, the
government set agriculture growth target of 25%+ for FY12.
For retail loans (~20% of overall loans) while interest rates have risen, income has
increased accordingly. Penetration in housing loans (~50% of retail loans) is low and
affordability has increased significantly. An expected correction in property prices
and mobility of the workforce also augur well for growth in housing loans.
Deposit growth to rise as real interest rates are turning
positive
Negative real interest rates led to a fall in deposit growth and an increase in currency in
circulation in 1HFY11. With moderation in inflation and a rise in interest rates, real interest
rates are becoming attractive, providing a push to deposit growth. Most banks have
increased term deposit rates by 150-300bp across maturities to garner more fixed deposits
amid tight liquidity conditions and continued strong loan growth.
Asset quality improvement, lower credit costs to drive
earnings growth
Proportion of stressed assets increased over FY09-11, due to fall out of the financial
crisis and moderation in economic growth however, incremental trends on asset quality
are positive. Over the last two quarters, the slippage ratio has been coming down
and we expect the trend to continue in 4QFY11 and FY12. In our view, large corporate
and retail delinquencies and slippages from restructured loans have peaked.
Private banks are well placed in terms of asset quality as retail delinquencies have
peaked and due to conservative restructuring policy adopted in the past.
Banks like SBI, PNB and Union Bank, which posted higher slippages, can surprise
positively with a fall in slippages, higher upgradation and recoveries.
Lower slippages, higher upgradations and recoveries should reduce credit costs and
drive earnings growth. Risk to our call is slowdown in industrial growth led by possible
shocks on crude oil prices and delay in project implementation. Technical slippages
on account of CBS implementation can also lead to negative surprise for PSU banks.
Our assumptions for slippages and credit costs are conservative. While FY11 earnings
upgrades were led by higher margins, FY12 upgrades will be led by lower credit
costs due to falling slippages, higher upgradations and recoveries.
Incremental trend in asset quality positive
Gross slippages have been coming down/stabilizing for PSU and private banks over the
past few quarters. With moderation in retail NPL formation and due to conservative
restructuring adopted in the past, private banks improved asset quality. Slippages for PSU
banks have moderated/stabilized over the past three quarters as most of the stress from
restructured loans and one-off agri-related loans have already dealt with. With most banks
reaching over 70%, NPL coverage and slippages are moderating sequentially, credit costs
is expected to fall. With improved economic growth and expectation of higher upgradation
and recoveries, we expect the positive trend on asset quality to continue.
Sector-specific exposure concerns remain
The recent issues of microfinance, telecom (2G) exposure and rising interest rates have
led to concerns over banks' asset quality. Concerns over the quality of infrastructure loans
have been highlighted by a delay in projects (due to bottlenecks in environmental clearances)
and banks' strong infrastructure loan growth in the past (~37% CAGR over FY05-10).
RBI permission to restructure MFI loans and the recommendations of the Malegam
Committee are positive for the microfinance industry and banks' asset quality. Our interaction
with banks regarding the 2G exposure suggests the lending was only to incumbent telecom
players, whose financial heath is strong. While the delay in infrastructure projects raises
concerns, profitability has not been impacted significantly and debt servicing capacity is
intact. Consequently, we do not see it as a structural issue for the moment.
Slippages are correlated to economic growth
Historical evidence suggests banks' asset quality is linked to economic growth more than
interest rates. Expected economic growth of over 8% and healthy demand will keep
corporate profitability high enough to afford interest payment and ensure that the ability to
repay debt is not jeopardized. Up to the late 1990s, corporate asset quality was a problem
in India as coupled with higher interest rates, corporate profitability was low and corporate
India was overleveraged.
Better risk management, strong corporate health augur well for asset quality
Indian banks' asset quality has improved over the past decade. This has been led by
improvement in the recovery mechanism (Sarfesi Act, DRTs), asset classification and
provisioning and exposure norms for specific industries or industrial groups, a better risk
monitoring system, and diversification of loans. Besides, corporate health has improved
with a lower debt-to-equity and banks have better collateral securities compared with
those a decade earlier.
Higher proportion of seasoned loan portfolio in FY11
Strong loan growth over FY03-07, with an increasing share of unsecured loan portfolio
and relatively weak credit quality measures resulted in higher NPL accretions over FY08-
10. However over the past 2-3 years loan growth has been moderate, driven largely by
secured lending. This will keep NPL accretion in check. Besides, over the past 2-3 years
a large part of growth has been driven by working capital requirements as the growth of
new projects was muted due to uncertainty in the macro-economic environment.
Slippages from restructured loans near peak
Indian banks in general, and PSU banks in particular, restructured a large quantum of
loans (4-7% for our PSU bank coverage universe) in FY09-10 under the RBI's special
dispensation scheme. Most of the accounts were restructured in 4QFY09 and 1QFY10.
Given a 12-18 month moratorium (in general) and NPL recognition period of 90 days
overdue, most of the fallout from restructured loans is largely over in our view. Till December
2010, banks have reported slippages from restructured accounts in the range of 5-20%.
While there could be account-specific issues, the worst of the asset-quality issue, is behind
us in our view.
Recoveries and upgradations to pick up, drive asset quality improvement...
After a sharp increase in slippages over FY09-11, we expect upgrades and recoveries to
pick up. Slippages over the past two years were driven by extreme stress conditions, an
agricultural debt waiver and slippages from restructured loans. Analyzing SBI's (lack of
available data for the sector in terms of write-offs in reductions for NPA) asset quality
movement, reductions and upgrades picked up after a sharp increase in slippages over the
previous year. Banks have aggressively written off NPAs over the past two years to
show better headline GNPA numbers and recoveries from which will provide positive
delta in earnings.
...and lower credit costs
Credit costs will fall in FY12 over FY11, as most banks are likely to achieve 70% PCR by
the end of FY11, slippages are likely to fall and recoveries and upgrades to improve. SBI,
Union Bank, BoI, IOB, Axis Bank and ICICI Bank are likely to report maximum
improvement as reported slippages were higher over FY10-11. In our view, while margins
are likely to moderate in FY12 over FY11, a fall in credit costs is likely to cushion RoA and
help banks to maintain profitability.
What could lead to a lower-than-expected fall in credit cost?
A sharp moderation in economic growth (our economist expects real GDP growth of
8.4% in FY12 and 8.5% in FY11), negative fallout of the 2G-related inquiry, major negative
surprises on CBS recognition of NPAs and higher than expected inflation will lead to
further monetary tightening and higher interest rates. Nevertheless, we believe our credit
cost estimates are conservative considering the average credit cost over FY04-09.
CBS based NPA recognition may lead to negative surprise
Banks are likely to move to core banking solutions (CBS) based recognition of NPAs by
4QFY11. Indian Bank is the only bank that switched to CBS-led recognition of NPAs in
1QFY11 and reported a sharp deterioration in asset quality. This raised concerns about an
increase in slippages in the sector. Our interaction with bankers suggests they are conducting
trials for systems-driven recognition of NPAs and have not witnessed a sharp increase in
slippages. We believe that on migration, there would be a surge in NPLs, but they would
be largely technical in nature and the proportion of NPAs will fall in one or two quarters.
Operating leverage - a key driver for RoA improvement
Operating expenses growth is likely to be lower than income growth, going forward. While
PSU banks' gross additions to employees are likely to be higher, net additions will fall as a
large part of the workforce is likely to retire over next five years. New employees will join
at the lower end of the scale, which is likely to reduce employee costs. After 100% CBS
implementation, a large part of technology-related costs is expected to fall, providing leverage
on administrative costs as well. While private banks will continue to expand branches and
increase headcount, leading to higher opex, productivity gains and a high focus on cost-toincome
ratio will keep operating expense growth in check.
PSU banks: strong operating leverage demonstrated; likely to continue
PSU banks have done well in terms of reining-in costs, as seen in the improvement in
cost-to-assets and cost-to-income ratios. Our coverage universe of PSU banks has seen
opex-to-average assets declining from 2.3% in FY05 to 1.7% in FY09 (in FY10-11 it
remained largely flat due to provisions for wage arrears and pension). Over the past few
years, banks have built strong IT platforms that enabled them to lower the cost of delivery.
Implementation of core banking solutions (CBS), covering nearly ~100% of their businesses,
has resulted in a fall in employees per branch. This has helped banks to increase their
presence at lower costs.
Pension and gratuity deficit factored in estimates
PSU banks have given a second option to their employees to shift to pension from provident
fund, which resulted in increased pension-deficit liability for banks. Along with pension,
enhanced limit for gratuity for employees led to additional liability. RBI recently allowed
liability due to the pension option and enhanced gratuity limits to be amortized in the P&L
over five years, starting from FY11. The unamortized expenditure carried forward will not
include amounts related to separated/retired employees, which can throw up a negative
surprise in 4QFY11. As banks are likely to provide full provisions towards retired employees
in FY11 itself, it will create a higher base on which we expect opex growth will not be
more than 15%, lower than income growth.
As of 3QFY11, some large banks like BoB, PNB and Union Bank guided for full provision
of gratuity liability in FY11 itself and amortization of pension liability over five years.
These banks have made provisions accordingly. Banks like Andhra Bank and IOB chose
to amortize liability over three years and may choose to write back excess provisions
made in 9MFY11. On a higher base for FY12 (full provisions for the retired employee
pension liability, 20% of the pension and gratuity liability of existing employees, to be
provided in FY11), we expect opex growth to be lower than asset growth and core income
growth, driving operating leverage for banks.
Leaner employee base for PSU banks
Over the past decade the Indian banking system, led by PSU banks, has been gradually
shedding its employee base, becoming leaner and more efficient. Staff costs declined
from 1.5% in FY05 to ~1% in FY10 for PSU banks, demonstrating that PSU banks have
worked hard to weed out inefficiency. However, private staff costs increased from 0.6%
in FY01 to 0.8% in FY10 as they continued to hire more people as they expanded branches.
While over the next few years gross additions for PSU banks are likely to be higher, net
additions will be lower due to a higher number of retirements.
CBS implementation leading to higher efficiency and fall in opex
Since the start of the decade, PSU banks have been improving technology infrastructure,
lowering staff numbers at branches and helping to build the customer base. While the
branch network will remain a key factor for customer acquisition, technology will play a
vital role in reducing opex. As banks have invested heavily in implementing CBS, we
believe benefits in terms of fee income and operating efficiency will continue to accrue,
leading to improved productivity and profitability at a lower cost.
Private banks: opex growth to track income growth
For private banks, growth in operating costs is unlikely to be at higher growth rates of the
past as incremental branch expansion is in low-cost locations. While staff cost growth will
rebound, it will remain lower than past growth trends as manpower strength and
compensations get rationalized. Branch expansion will lead to acceleration in overheads
for private banks. However, improving the proportion of core income will keep cost-toincome
ratio in check.
Significant improvement in core operating profitability
Robust margins, increasing share of fee income, operating leverage and a fall in provisions
(led by lower credit costs and a fall in MTM provisions) have led to significant improvement
in core profitability. Banks' reliance on trading profits has also come down significantly,
which is reducing volatility in earnings growth. We expect further improvement in core
profitability over FY11-13 to drive earnings growth.
Capital not a constraint for growth
Private sector banks are comfortably placed in terms of capital-tier-I ratios for banks
under our coverage. They ranged between 10% and 14% for 9MFY11. For private
banks it is easier to raise capital. The government's commitment to keep tier-I ratio
above 8% and increase in shareholding to 58% will allay concerns of capital for growth
for PSU banks, in our view. The government's shareholding of 58%+ will help banks to
grow their balance sheet without government support over the next 3-5 years, as it will
allow banks to raise capital through the market until the government's shareholding reaches
51% again.
GoI to infuse over Rs200b in FY11, over Rs60b in FY12 in PSU banks
In the past the government infused capital largely through the subscription of preference
shares or IPDI. However, the government's intention to improve its holdings to 58%, is
leading to incremental infusion through the preferential issue of equity shares. In the FY12
Budget, the government committed capital infusion of Rs202b in FY11 (of which Rs102b
has been infused) and Rs60b in FY12 for PSU banks. The announcement of capital infusion
does not include SBI's rights issue, in our view.
Challenging macro environment; inflation remains a key
risk
Sharp rise in crude prices, high inflation a concern
While food inflation, which is showing a decelerating trend, gives confidence that inflation
will moderate, turmoil in the MENA region, and its consequent impact on oil prices and
inflation, is a key risk. Higher global commodity prices will lead to further inflationary
pressure. Higher-than-expected inflation may lead to monetary tightening by the RBI
resulting in a prolonged phase of high interest rates, which in turn could impact growth.
Guidance of lower fiscal deficit but subsidy accounting, higher
disinvestment target are key challenges
Net market borrowing of Rs3.6t in FY12 (including T Bills of Rs150b) is lower than the
estimates of the market and our economist of ~Rs3.8t. Our economist estimates the FY12
subsidy burden to be Rs1.7t v/s the government's estimate of Rs1.4t. As a result, the
MOSL fiscal deficit estimate is 4.8% v/s the budgeted 4.6%. While the disinvestment
target of Rs400b appears challenging in current market conditions, a pipeline of Rs180b
overflowing from FY11 improves the visibility of this target. A higher-than-budgeted fiscal
deficit will lead to higher borrowings and impact domestic liquidity. Negative surprise on
fiscal deficit and government borrowing could potentially cause crowding out of private
borrowing.
More than half the combined liabilities of the state and central governments are held by
banks. The percentage holding has fallen as banks reduced their SLR to take care of
strong loan growth. However, strong deposit growth in FY07-08 and lower credit growth
in FY09 resulted in increased ownership of SLR securities by banks over this period.
Based on our calculation, banks financed an average of 65% incremental combined
borrowings of state and central governments over FY08-10. In FY11, it is expected to fall
to 35% as loan growth has been strong in the year to date. In FY12, we expect the share
of banks' investment in incremental G Sec issuance to be higher as deposit growth is
expected to pick up and remain strong over FY11.
In our base case assumption we expect 40% of incremental financing by banks, which
can easily support 20% loan growth with 18% deposit growth without creating a liquidity
crunch. The government balance with the RBI is ~Rs600b, thus it will have a neutralizing
effect in FY11 or FY12 (based on government spending) for the outstanding liquidity
situation. As per our assumptions 18% deposit growth would be just enough to support
20% credit growth in the system (this is after adjusting for SLR investments @24% on
incremental NDTL in FY12). If the loan growth or net market borrowing by central/state
governments is higher than expected then it will create a liquidity crunch in the system. In
the below table we assess the liquidity situation in the system for FY12.
Regulatory headwinds: savings deregulation; change in status of certain
loans granted by banks to NBFC as priority sector lending
Over the past 24 months the RBI introduced regulatory changes, which impacted earnings.
Some of the changes are: increase in the PCR requirement to 70%, increase in provisions
towards dual rate home loans to 2% from 0.4%, changes in LTV (loan to value) and risk
weighted norms for housing loans (impacting growth), ATM-related fee income and nonallowance
of bank lending to gold financing NBFC as priority sector loans. Apart from
these measures, the RBI expressed its intention to float a discussion paper on saving
banks deregulation and change in status of certain loans granted by banks to NBFC as
priority sector lending (PSL) which will impact (especially private banks). The RBI's
intention to improve regulations for NBFC could lead to more regulatory action, in our
view. Even RBI's concerns on a high systemic CD ratio in the system could result in
introduction of certain measures.
Deregulation of saving rates a key regulatory headwind
On several occasions the RBI expressed its intention to deregulate savings bank deposit
(26% of overall deposits) rates. Our discussions with bankers suggest the deregulation is
inevitable though the timing is uncertain. There is a mixed view in the system with state
owned banks being more in favor of regulated savings deposit rates and private banks
(especially smaller private banks) being in favor of deregulating rates to create a level
playing field.
The impact on profitability, stiffer competition and indirect coverage of costs for social
initiatives are key arguments for maintaining regulated rates while lower real rates, increased
emphasis on technology and customer service are arguments in favor of deregulation.
Our view
Initially, deregulation of savings deposits rates will result in an increase in the cost of
funds in the system, led by competitive forces. However, in our view, there will not be
a significant change in mix in savings deposits, as stickiness of these deposits will be a
function of technology, liability franchise and most important, reach in rural areas.
An important implication of deregulation would be an increase in competition as banks
with low CASA would try to lure depositors by offering higher rates.
Eventually rates will settle down near the six-month deposit rate in the system.
Based on our analysis, every 100bp increase in savings deposit rate will result in a
25bp increase in cost of deposits and 20-22bp margin compression, assuming no change
in lending yields.
Valuation attractive; top picks SBI, ICICI Bank, PNB,
IndusInd Bank, Yes Bank
Despite the macro challenges, banks' core operating performance is likely to remain
strong. We believe valuations are attractive with the stocks trading at five-year average
multiples.
Correction in valuations from their peak largely discounts some of the macro headwinds
such as tight liquidity, a sharp increase in interest rates, high inflation and mixed key
economic indicators like IIP.
Near-term volatility in stock prices is likely to prevail due to uncertainty in the near
term. In such a scenario, a stock-specific approach is crucial. We prefer banks with a
strong liability franchise, niche presence and domain knowledge.
Our top picks are SBI, ICICI Bank and PNB. In the mid-cap segment we like
IndusInd Bank and Yes Bank.
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Fuelled to fly ;
Valuation attractive; top picks SBI, ICICI Bank, PNB,
IndusInd Bank, Yes Bank
Loan growth of ~20%, operating leverage and fall in credit cost will drive banking sector's
profitability over FY12 and FY13. Margins, even with some moderation from their peaks in
3QFY11, would be above/near the average level of FY04-09. Higher recoveries could provide
positive surprise to earning estimates (write-offs were aggressive over FY09 and FY10
to keep reported GNPAs lower). We expect banks to report 20%+ earnings growth on an
aggregate basis and return ratios to be healthy with RoA of 1.1%+ and RoE of ~18%.
Valuations at P/E of 8x and P/BV of 1.3x for PSU banks and P/E of 16x and P/BV of 2.3x for
private banks are at the five-year average multiples, despite strong core operating
performance expected. Our top bets are SBI, ICICI Bank and PNB. In the mid-cap space we
like Indusind Bank and Yes Bank.
Margins robust; to remain above/near FY04-09 average levels
Downward deposit re-pricing, fall in excess liquidity on the balance sheet, better
pricing power (led by a liquidity crunch and a higher CD ratio) and stronger CASA
growth led to a sharp improvement in margins in 9MFY11. Overall, FY11 blended
margins are expected to be ~50bp higher YoY, driving core operating profits.
Given the tight liquidity and rising rates scenario, margins are unlikely to fall in a
hurry, and gradual moderations have been factored in estimates. As FY11 is amongst
the best year of margins for Indian banks, we expect margins to moderate 10-
20bp (bank specific), but to remain above/near the average margins of FY04-09.
Banks that reported higher slippages over the past two years are likely to have
lower margin compression because of expected improvement in asset quality.
Our sensitivity analysis suggests that for every 5bp change in margins, profits will
be impacted by ~3%. With a 1% fall in CASA ratio and a 1% fall in CD ratio,
margins are likely to compress by 5bp and 7bp, respectively.
Asset quality improvement; lower credit cost to drive earnings growth
Banks added higher stressed assets over FY09-11 due to fall out of the financial
crisis and moderation in economic growth. However, incremental trends on asset
quality are positive. Over the last two quarters, the slippage ratio has been coming
down and we expect the trend to continue in 4QFY11 and FY12. In our view, large
corporate and retail delinquencies and slippages from restructured loans have
peaked.
Private banks are well placed in terms of asset quality as retail delinquencies have
peaked and due to conservative restructuring policy adopted in the past.
Banks like SBI, PNB and Union Bank, which posted higher slippages, can surprise
positively with a fall in slippages, higher upgradation and recoveries.
Lower slippages, higher upgradations and recoveries should reduce credit costs
and drive earnings growth. Risk to our call is slowdown in industrial growth led by
possible shocks on crude oil prices and delay in project implementation. Technical
slippages on account of CBS implementation can also lead to negative surprise
for PSU banks.
Our assumptions for slippages and credit costs are conservative. While FY11 earnings
upgrades were led by higher margins, FY12 upgrades will be led by lower credit costs
due to falling slippages, higher upgradations and recoveries.
Operating leverage - a key driver for RoA improvement
PSU banks' operating cost growth will peak in FY11 as full pension provisions for
retired employees and wage revision will be provided for. On a higher base, we expect
opex growth to be limited to 15%, providing banks with strong operating leverage.
Private banks’ operating expenses will rise with wage and rental inflation, and large
scale branch expansion. However, due to strong core operating income, we expect
C/I ratio to remain stable.
Valuations at five-year average multiples; inflation remains a key risk
Banks' core operating performance is likely to be strong led by improving asset quality
and operating leverage. We believe valuations are attractive with stocks trading at
five-year average multiples.
Correction in valuations from their peaks largely discount some of the macro headwinds
such as tight liquidity, a sharp increase in interest rates, high inflation and mixed key
economic indicators like IIP.
Net market borrowing of Rs3.6t for FY12 (including T Bills of Rs150b) is below the
market estimates of Rs3.8t+. Lower-than-expected fiscal deficit is positive for domestic
liquidity and will allay fears of crowding out for private players.
Food inflation, which is showing a decelerating trend, gives confidence of moderation
in inflation. However, turmoil in the MENA region and its resultant impact on oil prices
and inflation is a key risk.
Some of the key regulatory headwinds, such as savings bank deregulation and change
in the status of certain loans granted by banks to NBFCs as priority sector loans
(PSL) etc, are specific risks.
Margins robust; to remain above/near FY04-09 average
Downward deposit re-pricing, fall in excess liquidity on the balance sheet, high pricing
power (led by a liquidity crunch and a higher CD ratio) and higher CASA growth led
to a sharp improvement in margins in 9MFY11. Overall, FY11 blended margins are
expected to be ~50bp higher YoY, driving core operating profits.
Historical evidence suggests that in the initial phase of interest rate hikes, margins
improve as the lending book re-prices faster than the liability side. However, as the
cost of deposits increases with a lag (two quarters), margins start moderating.
Given the tight liquidity and rising rates scenario, margins are unlikely to fall in a
hurry, and gradual moderations have been factored in estimates. As FY11 is amongst
the best year of margins for Indian banks, we expect margins to moderate 10-20bp
(bank specific), but to remain above/near the average margins of FY04-09.
Banks that reported higher slippages over the past two years are likely to see lower
margin compression because of expected improvement in asset quality.
Our sensitivity analysis suggests that for every 5bp change in margins, profits will be
impacted by ~3%. With a 1% fall in CASA ratio and a 1% fall in CD ratio, margins
are likely to compress by 5bp and 7bp, respectively.
Sharp margin improvement YTD in FY11
Against the consensus of margin moderation, banks reported healthy improvement over
the past two quarters, led by (a) a sharp increase in the PLR and the base rate, (b) better
liquidity managment and improvement in CD ratio and (c) strong CASA growth and a lag
impact of deposit re-pricing.
Sharp rise in liability rates leading to concerns about NIM
Concerns related to margin pressure are high due to continued liquidity tightness, fasterthan-
expected rise in wholesale borrowing costs (up ~490bp from March 2010, ~72bp
QTD for six-month and one-year CDs), and a rise in retail term deposit rates by 150-
300bp across maturities.
In a rising interest rate scenario margins improve initially, then moderate
Historical evidence suggests that in the initial phase of interest rate hikes, margins improve
as the lending book re-prices faster than the liability side. As the cost of deposits increases
with a lag (two quarters), margins are likely to moderate. However in the current cycle
timely lending rate hike, strong pricing power and loan growth can provide positive a
suprise for margins.
Margins robust; to remain above/near FY04-09 average levels
While we believe bank margins are near their peaks and expect them to moderate from
1QFY12, the moderation is likely to be gradual rather than sudden. Historically, firstquarter
margins are lower than fourth-quarter margins as banks carry a higher proportion
of priority-sector loans on their balance sheets and credit growth is muted. We believe
FY10 and FY11 have been periods of excess, which led to volatility in margins. We see
average margins over FY04-09 being more sustainable for Indian banks. We expect margins
to decline by 10-20bp in FY12 and ~10bp in FY13. Margins can surprise positively over
average margins over FY04-09 as CASA ratio has improved.
Pricing power, base rate system to provide buffer to margins
We expect banks' loan spreads to be at near current levels or decline marginally (due to
asset liability lag in re-pricing) as (1) CD ratio is optimal and the system per se is operating
at 100% incremental CD ratio providing enough pricing power and (2) automatic
transmission of increased cost of deposits via base rates. Stickiness of loan spreads and
stable/marginal decline in bond spreads (unlike in the previous cycle) will provide a buffer
to margins, in our view.
Calculation methodology for the base rate
The base rate is the sum of four components (1) cost of deposits; (2) adjustment for
negative carry with respect to CRR and SLR, (3) unallocated overhead costs and (4)
profit margin. The actual lending rate charged to borrowers is the base rate plus borrowerspecific
charges, including product-specific operating costs, credit-risk premium and tenure
premium.
Computation of base rate
Component Methodology
a Deposit cost (%) - benchmark Cost of deposits/fund (major component in calculation
of base rate)
b Negative carry on CRR and SLR (%) Negative carry on CRR and SLR is arrived at in three steps
1. Return on SLR investment = SLR (mandatory) * 364
days T-bill return
2. Effective cost (%) =
[Cost of deposits (%) - return on SLR investment (%)]
deployable deposits share (%)
Deployable deposits = Total deposits - deposits locked in
CRR and SLR
Total deposits = savings + current + term deposits
3. Negative carry (%) = Effective cost - cost of deposits
c Unallocable overhead costs (%) Unallocable overhead cost/deployable deposits
d Profit margin (%) Net profit /total deployable deposits
1. Base rate = a+b+c+d
2. Lending rate = base rate + borrower-specific charges (to be decided by banks)
Source: Company/MOSL
Bond spreads unlikely to decline as sharply as in the previous cycle
In the rising interest rate scenario of FY04-08, PSU banks' loan spreads improved, providing
a buffer to margins despite a fall in bond spreads, removal of interest rate on CRR balances,
netting of amortization of depreciation on HTM investments from interest income. However,
in the second stage of the current cycle loan spreads are unlikely to improve with competitive
intensity. In the current cycle we do not expect bond spreads to decline sharply as most of
the banks are near their minimum SLR requirements and incremental investments are
taking place at a higher yield. Thus, we do not see much pressure on bond spreads.
Incremental margins to moderate, however will remain strong
The factors that pose a risk to margins are: (1) PLR reaching a historical peak, providing
limited capacity for banks to pass on, considering asset quality issues and growth moderation,
(2) fall in CASA ratio with a sharp rise in term deposit rates and (3) moderation in loan
growth (headline growth is likely to moderate from March on a higher base) and a sharp
pick-up in deposit growth (as real interest rates have become positive). We do not see
loan growth moderation as a big risk to earnings as it is more sensitive to margins. At the
industry level, keeping other things constant (1) with a 1% fall in CASA ratio NIM will be
impacted by ~5bp, RoA by ~3bp and (2) with a 1% fall in CD ratio, NIM will compress by
~7bp and RoA ~4bp.
Assumptions for incremental cost of deposits
40% of incremental term deposits from bulk deposits and the rest from retail term
deposits;
Cost of bulk deposits at ~10% and retail term deposits at 8.5% (blended); thus,
blended cost of incremental deposits at 9%;
Yield on loans to improve by 100bp on incremental loans;
Yield on investments to improve by 25bp on incremental investments;
Overall, banks are doing incremental business at 20bp lower margins.
FY11-13 loan CAGR ~20% led by strong economic growth
Rising rates have led to concerns of sharp moderation in credit growth. However, historical
evidence suggests that loan growth has limited correlation with interest rates and a higher
correlation with economic growth. As long as real GDP growth is likely to be 8%+ we
expect loan growth to be strong. Even before the financial crisis, when interest rates
spiked sharply, loan growth was strong. Initial signs slowing economic growth led to
moderation in loan growth over FY09-10 and as things began to improve, growth picked
up. In the near term, on a higher base (strong loan growth in the last fortnight of March
2010 and 3G auction-related outflow in 1QFY10), we expect growth to moderate, after
which it will improve. The factors that will provide the positive delta on growth are:
Strong real economic growth of over 8% (MOSL estimate of 8.4% v/s 8.5% in FY11)
and nominal GDP growth of over 13% (MOSL estimate of 14%). During the last
decade, the average loan growth multiplier with respect to nominal GDP growth was
~1.8x however, in FY10 the multiple was 1.2x. Going by a conservative estimate of
1.2x nominal GDP, loan growth is expected to be at least 17% in FY12/13.
With strong consumption demand and high inflation, working capital requirements are
expected to be buoyant. Rising crude prices will also lead to demand for working
capital loans from the petroleum sector.
Incremental data have been showing encouraging signs, as loan growth is becoming
broad based rather than driven by the infrastructure segment alone.
Growth in agricultural loans (~13% of overall loans) is likely to be strong, led by
government initiatives and a strong monsoon last year. In the FY12 Budget, the
government set agriculture growth target of 25%+ for FY12.
For retail loans (~20% of overall loans) while interest rates have risen, income has
increased accordingly. Penetration in housing loans (~50% of retail loans) is low and
affordability has increased significantly. An expected correction in property prices
and mobility of the workforce also augur well for growth in housing loans.
Deposit growth to rise as real interest rates are turning
positive
Negative real interest rates led to a fall in deposit growth and an increase in currency in
circulation in 1HFY11. With moderation in inflation and a rise in interest rates, real interest
rates are becoming attractive, providing a push to deposit growth. Most banks have
increased term deposit rates by 150-300bp across maturities to garner more fixed deposits
amid tight liquidity conditions and continued strong loan growth.
Asset quality improvement, lower credit costs to drive
earnings growth
Proportion of stressed assets increased over FY09-11, due to fall out of the financial
crisis and moderation in economic growth however, incremental trends on asset quality
are positive. Over the last two quarters, the slippage ratio has been coming down
and we expect the trend to continue in 4QFY11 and FY12. In our view, large corporate
and retail delinquencies and slippages from restructured loans have peaked.
Private banks are well placed in terms of asset quality as retail delinquencies have
peaked and due to conservative restructuring policy adopted in the past.
Banks like SBI, PNB and Union Bank, which posted higher slippages, can surprise
positively with a fall in slippages, higher upgradation and recoveries.
Lower slippages, higher upgradations and recoveries should reduce credit costs and
drive earnings growth. Risk to our call is slowdown in industrial growth led by possible
shocks on crude oil prices and delay in project implementation. Technical slippages
on account of CBS implementation can also lead to negative surprise for PSU banks.
Our assumptions for slippages and credit costs are conservative. While FY11 earnings
upgrades were led by higher margins, FY12 upgrades will be led by lower credit
costs due to falling slippages, higher upgradations and recoveries.
Incremental trend in asset quality positive
Gross slippages have been coming down/stabilizing for PSU and private banks over the
past few quarters. With moderation in retail NPL formation and due to conservative
restructuring adopted in the past, private banks improved asset quality. Slippages for PSU
banks have moderated/stabilized over the past three quarters as most of the stress from
restructured loans and one-off agri-related loans have already dealt with. With most banks
reaching over 70%, NPL coverage and slippages are moderating sequentially, credit costs
is expected to fall. With improved economic growth and expectation of higher upgradation
and recoveries, we expect the positive trend on asset quality to continue.
Sector-specific exposure concerns remain
The recent issues of microfinance, telecom (2G) exposure and rising interest rates have
led to concerns over banks' asset quality. Concerns over the quality of infrastructure loans
have been highlighted by a delay in projects (due to bottlenecks in environmental clearances)
and banks' strong infrastructure loan growth in the past (~37% CAGR over FY05-10).
RBI permission to restructure MFI loans and the recommendations of the Malegam
Committee are positive for the microfinance industry and banks' asset quality. Our interaction
with banks regarding the 2G exposure suggests the lending was only to incumbent telecom
players, whose financial heath is strong. While the delay in infrastructure projects raises
concerns, profitability has not been impacted significantly and debt servicing capacity is
intact. Consequently, we do not see it as a structural issue for the moment.
Slippages are correlated to economic growth
Historical evidence suggests banks' asset quality is linked to economic growth more than
interest rates. Expected economic growth of over 8% and healthy demand will keep
corporate profitability high enough to afford interest payment and ensure that the ability to
repay debt is not jeopardized. Up to the late 1990s, corporate asset quality was a problem
in India as coupled with higher interest rates, corporate profitability was low and corporate
India was overleveraged.
Better risk management, strong corporate health augur well for asset quality
Indian banks' asset quality has improved over the past decade. This has been led by
improvement in the recovery mechanism (Sarfesi Act, DRTs), asset classification and
provisioning and exposure norms for specific industries or industrial groups, a better risk
monitoring system, and diversification of loans. Besides, corporate health has improved
with a lower debt-to-equity and banks have better collateral securities compared with
those a decade earlier.
Higher proportion of seasoned loan portfolio in FY11
Strong loan growth over FY03-07, with an increasing share of unsecured loan portfolio
and relatively weak credit quality measures resulted in higher NPL accretions over FY08-
10. However over the past 2-3 years loan growth has been moderate, driven largely by
secured lending. This will keep NPL accretion in check. Besides, over the past 2-3 years
a large part of growth has been driven by working capital requirements as the growth of
new projects was muted due to uncertainty in the macro-economic environment.
Slippages from restructured loans near peak
Indian banks in general, and PSU banks in particular, restructured a large quantum of
loans (4-7% for our PSU bank coverage universe) in FY09-10 under the RBI's special
dispensation scheme. Most of the accounts were restructured in 4QFY09 and 1QFY10.
Given a 12-18 month moratorium (in general) and NPL recognition period of 90 days
overdue, most of the fallout from restructured loans is largely over in our view. Till December
2010, banks have reported slippages from restructured accounts in the range of 5-20%.
While there could be account-specific issues, the worst of the asset-quality issue, is behind
us in our view.
Recoveries and upgradations to pick up, drive asset quality improvement...
After a sharp increase in slippages over FY09-11, we expect upgrades and recoveries to
pick up. Slippages over the past two years were driven by extreme stress conditions, an
agricultural debt waiver and slippages from restructured loans. Analyzing SBI's (lack of
available data for the sector in terms of write-offs in reductions for NPA) asset quality
movement, reductions and upgrades picked up after a sharp increase in slippages over the
previous year. Banks have aggressively written off NPAs over the past two years to
show better headline GNPA numbers and recoveries from which will provide positive
delta in earnings.
...and lower credit costs
Credit costs will fall in FY12 over FY11, as most banks are likely to achieve 70% PCR by
the end of FY11, slippages are likely to fall and recoveries and upgrades to improve. SBI,
Union Bank, BoI, IOB, Axis Bank and ICICI Bank are likely to report maximum
improvement as reported slippages were higher over FY10-11. In our view, while margins
are likely to moderate in FY12 over FY11, a fall in credit costs is likely to cushion RoA and
help banks to maintain profitability.
What could lead to a lower-than-expected fall in credit cost?
A sharp moderation in economic growth (our economist expects real GDP growth of
8.4% in FY12 and 8.5% in FY11), negative fallout of the 2G-related inquiry, major negative
surprises on CBS recognition of NPAs and higher than expected inflation will lead to
further monetary tightening and higher interest rates. Nevertheless, we believe our credit
cost estimates are conservative considering the average credit cost over FY04-09.
CBS based NPA recognition may lead to negative surprise
Banks are likely to move to core banking solutions (CBS) based recognition of NPAs by
4QFY11. Indian Bank is the only bank that switched to CBS-led recognition of NPAs in
1QFY11 and reported a sharp deterioration in asset quality. This raised concerns about an
increase in slippages in the sector. Our interaction with bankers suggests they are conducting
trials for systems-driven recognition of NPAs and have not witnessed a sharp increase in
slippages. We believe that on migration, there would be a surge in NPLs, but they would
be largely technical in nature and the proportion of NPAs will fall in one or two quarters.
Operating leverage - a key driver for RoA improvement
Operating expenses growth is likely to be lower than income growth, going forward. While
PSU banks' gross additions to employees are likely to be higher, net additions will fall as a
large part of the workforce is likely to retire over next five years. New employees will join
at the lower end of the scale, which is likely to reduce employee costs. After 100% CBS
implementation, a large part of technology-related costs is expected to fall, providing leverage
on administrative costs as well. While private banks will continue to expand branches and
increase headcount, leading to higher opex, productivity gains and a high focus on cost-toincome
ratio will keep operating expense growth in check.
PSU banks: strong operating leverage demonstrated; likely to continue
PSU banks have done well in terms of reining-in costs, as seen in the improvement in
cost-to-assets and cost-to-income ratios. Our coverage universe of PSU banks has seen
opex-to-average assets declining from 2.3% in FY05 to 1.7% in FY09 (in FY10-11 it
remained largely flat due to provisions for wage arrears and pension). Over the past few
years, banks have built strong IT platforms that enabled them to lower the cost of delivery.
Implementation of core banking solutions (CBS), covering nearly ~100% of their businesses,
has resulted in a fall in employees per branch. This has helped banks to increase their
presence at lower costs.
Pension and gratuity deficit factored in estimates
PSU banks have given a second option to their employees to shift to pension from provident
fund, which resulted in increased pension-deficit liability for banks. Along with pension,
enhanced limit for gratuity for employees led to additional liability. RBI recently allowed
liability due to the pension option and enhanced gratuity limits to be amortized in the P&L
over five years, starting from FY11. The unamortized expenditure carried forward will not
include amounts related to separated/retired employees, which can throw up a negative
surprise in 4QFY11. As banks are likely to provide full provisions towards retired employees
in FY11 itself, it will create a higher base on which we expect opex growth will not be
more than 15%, lower than income growth.
As of 3QFY11, some large banks like BoB, PNB and Union Bank guided for full provision
of gratuity liability in FY11 itself and amortization of pension liability over five years.
These banks have made provisions accordingly. Banks like Andhra Bank and IOB chose
to amortize liability over three years and may choose to write back excess provisions
made in 9MFY11. On a higher base for FY12 (full provisions for the retired employee
pension liability, 20% of the pension and gratuity liability of existing employees, to be
provided in FY11), we expect opex growth to be lower than asset growth and core income
growth, driving operating leverage for banks.
Leaner employee base for PSU banks
Over the past decade the Indian banking system, led by PSU banks, has been gradually
shedding its employee base, becoming leaner and more efficient. Staff costs declined
from 1.5% in FY05 to ~1% in FY10 for PSU banks, demonstrating that PSU banks have
worked hard to weed out inefficiency. However, private staff costs increased from 0.6%
in FY01 to 0.8% in FY10 as they continued to hire more people as they expanded branches.
While over the next few years gross additions for PSU banks are likely to be higher, net
additions will be lower due to a higher number of retirements.
CBS implementation leading to higher efficiency and fall in opex
Since the start of the decade, PSU banks have been improving technology infrastructure,
lowering staff numbers at branches and helping to build the customer base. While the
branch network will remain a key factor for customer acquisition, technology will play a
vital role in reducing opex. As banks have invested heavily in implementing CBS, we
believe benefits in terms of fee income and operating efficiency will continue to accrue,
leading to improved productivity and profitability at a lower cost.
Private banks: opex growth to track income growth
For private banks, growth in operating costs is unlikely to be at higher growth rates of the
past as incremental branch expansion is in low-cost locations. While staff cost growth will
rebound, it will remain lower than past growth trends as manpower strength and
compensations get rationalized. Branch expansion will lead to acceleration in overheads
for private banks. However, improving the proportion of core income will keep cost-toincome
ratio in check.
Significant improvement in core operating profitability
Robust margins, increasing share of fee income, operating leverage and a fall in provisions
(led by lower credit costs and a fall in MTM provisions) have led to significant improvement
in core profitability. Banks' reliance on trading profits has also come down significantly,
which is reducing volatility in earnings growth. We expect further improvement in core
profitability over FY11-13 to drive earnings growth.
Capital not a constraint for growth
Private sector banks are comfortably placed in terms of capital-tier-I ratios for banks
under our coverage. They ranged between 10% and 14% for 9MFY11. For private
banks it is easier to raise capital. The government's commitment to keep tier-I ratio
above 8% and increase in shareholding to 58% will allay concerns of capital for growth
for PSU banks, in our view. The government's shareholding of 58%+ will help banks to
grow their balance sheet without government support over the next 3-5 years, as it will
allow banks to raise capital through the market until the government's shareholding reaches
51% again.
GoI to infuse over Rs200b in FY11, over Rs60b in FY12 in PSU banks
In the past the government infused capital largely through the subscription of preference
shares or IPDI. However, the government's intention to improve its holdings to 58%, is
leading to incremental infusion through the preferential issue of equity shares. In the FY12
Budget, the government committed capital infusion of Rs202b in FY11 (of which Rs102b
has been infused) and Rs60b in FY12 for PSU banks. The announcement of capital infusion
does not include SBI's rights issue, in our view.
Challenging macro environment; inflation remains a key
risk
Sharp rise in crude prices, high inflation a concern
While food inflation, which is showing a decelerating trend, gives confidence that inflation
will moderate, turmoil in the MENA region, and its consequent impact on oil prices and
inflation, is a key risk. Higher global commodity prices will lead to further inflationary
pressure. Higher-than-expected inflation may lead to monetary tightening by the RBI
resulting in a prolonged phase of high interest rates, which in turn could impact growth.
Guidance of lower fiscal deficit but subsidy accounting, higher
disinvestment target are key challenges
Net market borrowing of Rs3.6t in FY12 (including T Bills of Rs150b) is lower than the
estimates of the market and our economist of ~Rs3.8t. Our economist estimates the FY12
subsidy burden to be Rs1.7t v/s the government's estimate of Rs1.4t. As a result, the
MOSL fiscal deficit estimate is 4.8% v/s the budgeted 4.6%. While the disinvestment
target of Rs400b appears challenging in current market conditions, a pipeline of Rs180b
overflowing from FY11 improves the visibility of this target. A higher-than-budgeted fiscal
deficit will lead to higher borrowings and impact domestic liquidity. Negative surprise on
fiscal deficit and government borrowing could potentially cause crowding out of private
borrowing.
More than half the combined liabilities of the state and central governments are held by
banks. The percentage holding has fallen as banks reduced their SLR to take care of
strong loan growth. However, strong deposit growth in FY07-08 and lower credit growth
in FY09 resulted in increased ownership of SLR securities by banks over this period.
Based on our calculation, banks financed an average of 65% incremental combined
borrowings of state and central governments over FY08-10. In FY11, it is expected to fall
to 35% as loan growth has been strong in the year to date. In FY12, we expect the share
of banks' investment in incremental G Sec issuance to be higher as deposit growth is
expected to pick up and remain strong over FY11.
In our base case assumption we expect 40% of incremental financing by banks, which
can easily support 20% loan growth with 18% deposit growth without creating a liquidity
crunch. The government balance with the RBI is ~Rs600b, thus it will have a neutralizing
effect in FY11 or FY12 (based on government spending) for the outstanding liquidity
situation. As per our assumptions 18% deposit growth would be just enough to support
20% credit growth in the system (this is after adjusting for SLR investments @24% on
incremental NDTL in FY12). If the loan growth or net market borrowing by central/state
governments is higher than expected then it will create a liquidity crunch in the system. In
the below table we assess the liquidity situation in the system for FY12.
Regulatory headwinds: savings deregulation; change in status of certain
loans granted by banks to NBFC as priority sector lending
Over the past 24 months the RBI introduced regulatory changes, which impacted earnings.
Some of the changes are: increase in the PCR requirement to 70%, increase in provisions
towards dual rate home loans to 2% from 0.4%, changes in LTV (loan to value) and risk
weighted norms for housing loans (impacting growth), ATM-related fee income and nonallowance
of bank lending to gold financing NBFC as priority sector loans. Apart from
these measures, the RBI expressed its intention to float a discussion paper on saving
banks deregulation and change in status of certain loans granted by banks to NBFC as
priority sector lending (PSL) which will impact (especially private banks). The RBI's
intention to improve regulations for NBFC could lead to more regulatory action, in our
view. Even RBI's concerns on a high systemic CD ratio in the system could result in
introduction of certain measures.
Deregulation of saving rates a key regulatory headwind
On several occasions the RBI expressed its intention to deregulate savings bank deposit
(26% of overall deposits) rates. Our discussions with bankers suggest the deregulation is
inevitable though the timing is uncertain. There is a mixed view in the system with state
owned banks being more in favor of regulated savings deposit rates and private banks
(especially smaller private banks) being in favor of deregulating rates to create a level
playing field.
The impact on profitability, stiffer competition and indirect coverage of costs for social
initiatives are key arguments for maintaining regulated rates while lower real rates, increased
emphasis on technology and customer service are arguments in favor of deregulation.
Our view
Initially, deregulation of savings deposits rates will result in an increase in the cost of
funds in the system, led by competitive forces. However, in our view, there will not be
a significant change in mix in savings deposits, as stickiness of these deposits will be a
function of technology, liability franchise and most important, reach in rural areas.
An important implication of deregulation would be an increase in competition as banks
with low CASA would try to lure depositors by offering higher rates.
Eventually rates will settle down near the six-month deposit rate in the system.
Based on our analysis, every 100bp increase in savings deposit rate will result in a
25bp increase in cost of deposits and 20-22bp margin compression, assuming no change
in lending yields.
Valuation attractive; top picks SBI, ICICI Bank, PNB,
IndusInd Bank, Yes Bank
Despite the macro challenges, banks' core operating performance is likely to remain
strong. We believe valuations are attractive with the stocks trading at five-year average
multiples.
Correction in valuations from their peak largely discounts some of the macro headwinds
such as tight liquidity, a sharp increase in interest rates, high inflation and mixed key
economic indicators like IIP.
Near-term volatility in stock prices is likely to prevail due to uncertainty in the near
term. In such a scenario, a stock-specific approach is crucial. We prefer banks with a
strong liability franchise, niche presence and domain knowledge.
Our top picks are SBI, ICICI Bank and PNB. In the mid-cap segment we like
IndusInd Bank and Yes Bank.
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