A few months back, veteran banker KV Kamath declared that the Indian banking industry is in the best shape in the last 50 years with regard to asset quality and capital adequacy.
But the bourses are barely reflecting the optimism. The Bank Nifty index has corrected by 12 per cent in the last six months and trades almost flat on a one-year basis. In comparison, the Nifty has shed over 10 per cent in six months, while yearly returns are still in the green, up 5.5 per cent. The underperformance in bank stocks isn’t India-specific; the US and China, where bank stocks are the index heavyweights, are witnessing a similar price action.
Portfolio podcast | How to play banking stocks now?
In fact, Warren Buffett, who made a strong case for owning bank stocks — remember the famous 2016 quote: Banking is a very good business unless you do dumb things — has been heavily offloading his holdings in the sector since 2021. While addressing Berkshire Hathaway’s investors last year, he said, “I like banks generally, I just didn’t like the proportion we had compared to the possible risk if we got the bad results that so far we haven’t gotten”.
World over, the spike from zero interest rates is perceived negatively for banks. Back home, clarity on how the rate hikes will affect banks is expected to emerge in a few months. But, more than the hikes, the question on investors’ minds is: where do we go from here?
We gauge banks under four parameters — loan growth, asset quality, profitability and return profile. Broadly, the positives in these parameters are already baked into their valuations and the absence of trigger for re-rating is quite stark. This may reposition them as value picks instead of growth picks, which they were seen as in their previous avatar from 2017 to 2021. - yes.
Risk to loan growth
Industry growth System-level credit growth has been consistently hovering around the 10 per cent mark since December 2021 and this bodes well for banks. On an average, the top private banks clocked 17 per cent year-on-year loan growth in FY22, while the public sector banks or PSU Banks did nine per cent, closer to the macro reference point. The momentum is expected to be maintained in FY23. But a dissection of growth indicates that retail loans remain the key driver and within this, it’s largely the unsecured portion propelling the numbers.
Data for FY22 indicates that while the retail loan grew by 12.4 per cent year-on-year, secured loans grew by 7.7 per cent year-on-year and the unsecured book grew by 21 per cent. Given that unsecured book tends to be rate sensitive as it is largely discretionary, how they absorb the rate hikes will be critical to watch.
Corporate loans are largely driven by government guaranteed programme or the ECLGS scheme. While loans to micro and small enterprises grew by 21.5 per cent year-on-year in FY22, credit demand from medium enterprises, which were more benefited by the ECLGS scheme, grew by 71.4 per cent. - changed this. Suresh Ganapathy of Macquarie Capital makes an interesting observation. Loan to deposit ratio, which measures the liquidity utilisation of the banking system, stood at 72 per cent in April 2022, lagging the 15-year average of 74 per cent, suggesting that banks are still in a cash conservation mode.
Likewise, credit multiplier — an indicator of how much money is created in the system (or parked as deposits) due to credit creation — has been sub-1x in the last five years. Historically, credit multiplier has been 1.3- 1.4x. Therefore, while the consensus is bullish about an overall improvement in credit offtake, qualitative factors do not support the view. Also, when serious efforts are being made to curb inflation, including the recent rate hike, it would be foolhardy to assume that the rate hikes expected this fiscal wouldn’t impact credit demand. For now, the Street is assuming that banks would maintain the loan growth posted in FY22. But downside risks to this assumption are quite high. June quarter management commentaries would steer investors towards a more doable loan growth in the next 1–2 years.
Limited runway for asset quality improvement
Asset quality is one arena where investors have nothing to complain about. If any, this has been an upward facing chart, with banks, whether private or PSUs, improving the quality of their books quarter after quarter. But does that mean banks are thoroughly insulated? No.
Asset quality is a cycle that hits the loan pocket when there are signs of overheated credit growth or practices and there are signs of a bubble brewing. . The rollovers and restructuring of low-quality corporate borrowers during FY12–FY15 led to the blowing up of corporate loans, the impact of which was felt from FY16 to FY19. But this is also the period when banks upped their game in the retail space and continue to do so. While this is not to suggest that retail loans are the next time bomb ticking, the portfolio calls for caution.
70–80 per cent of restructured loans during the pandemic are retail loans. . There’s another year left to normalise them. While the pool of restructured loans may be about 1.5 per cent for the top banks and 2–3.5 per cent for others, bank stocks are at a point where even a slight miss on asset quality could cost them dear. Gross non-performing assets ratio is a function of growth. Therefore, a combination of lower-than-anticipated growth and higher slippages from the retail segment could be lethal to absorb at this juncture.
While bank stocks aren’t pricing in this risk, they are cognisant of the limited runway for asset quality improvement as against the sharp improvement seen in FY22. This may particularly be a risk for smaller private banks such as Bandhan Bank, IDFC First, City Union and RBL, where the net NPA ratios, despite the huge write-offs since FY21, are twice more than their FY17 levels — viewed as the best phase of asset quality for these banks.
Core profitability pressured
Amply helped by lower provisioning costs, profitability has improved multi-fold for banks. In fact, the rally from March 2020 to October 2021 was aided by earnings improvement backed by lower provisioning. That the quality of earnings hasn’t improved is worrisome. For instance, the average loan growth for India’s top 10 private banks was 13.5 per cent in FY22. Their net interest income (NII) or core income grew by 13.7 per cent. Excluding ICICI Bank and IDFC First Bank, which saw 21.7 per cent and 31.5 per cent year-on-year NII growth in FY22, NII growth of top 8 banks stood at 10.4 per cent, lagging the loan growth. This points at pressure on the overall yields. HDFC Bank, for the first time in years, saw 20 basis points shrinkage in net interest margin (NIM) in FY22. Axis Bank NIMs have been almost flat since FY20.
It’s pretty much the same for PSU banks. But since they were relatively late to join the retail loans party, the loan volume pick-up, which is evident in the PSU space, is helping them maintain their NIMs near about the FY21 levels despite cut-throat competition. Large banks such as SBI, HDFC Bank and Axis Bank are already finding it difficult on the yields front and this is a good indicator that there is limited scope for further NIM expansion for banks. Therefore, Kotak and IDFC First’s 4.78 per cent and 5.96 per cent NIM in FY22 may just be an aberration.
Return profile lower for mid-cap banks
Earnings per share of PSU banks are at an all-time high. Same is for private banks such as HDFC Bank, Axis Bank and ICICI Bank. RBL Bank, IDFC First and Bandhan Bank are the laggards on this front. The clear distinction between large banks (whether PSUs or private) and smaller private banks makes a convincing case in favour of the former.
To that extent, unlike the stock price rally between 2017 and 2019 that favoured mid-cap banks, they may not be in prominence for the next year or so. Further, large banks may have more room to curtail their provisioning cost, and this may continue to aid their bottom-line growth better than their mid-cap peers. Overall, the trend of improving return profile may continue, particularly for the large banks even if they just about sustain FY22 loan growth.
What to do with bank stocks
Given the four trends playing out, how should investors go about choosing banking stocks? Let’s compartmentalise bank stocks into three baskets — large-cap private banks, mid-cap private banks and PSU banks. Hold on to the large-cap private banks. Whether HDFC Bank, ICICI Bank, Axis Bank or Kotak Mahindra, they have outperformed the broader indices significantly since 2017. But prune your expectations hereon. With loan book size, competition and cost pressures catching up, they may not have a free run like in the past.
Tread cautiously with mid-cap private banks. Whether RBL Bank, IDFC First or Bandhan, the doubt looming over them is whether the worst of asset quality pain is behind them. The unduly high share of unsecured loans is another discomforting factor. PSU banks, barring SBI, are yet to come closer to their 2017 stock price levels. Continuing to trade at beaten-down valuations, these remain stocks for the brave hearts.
But the underlying point across bank stocks is that they may not be the high-return generators that they were earlier. Factoring the loan growth constraints in the near- to medium-term, investors should view bank stocks as steady-state return generators and not as growth options.