Banking stocks out in cold

After outperforming the markets for six years, banking stocks have been badly bruised in the recent stock market meltdown. The BSE Bankex, which tracks leading banking stocks and represents 90 per cent of total market capitalisation of all banks, had gained 52 per cent on a compounded annual basis in the period from 2002 to January 2008, trouncing the Sensex gain of 36 per cent. But in the recent stock market downfall since January 14, the banking index has shed 44 per cent of its value. compared to the Sensex losing 25 per cent. Why have investors suddenly deserted banking stocks?

The reasons could be many. Compelled by mounting inflationary pressures, the Central bank initiated a series of hikes in the repo rate and Cash reserve ratio (CRR). . These measures may push up the cost of funds for banks, leading to a possible compression in their Net Interest Margins (NIM is the difference between the income earned on lending and interest paid on deposits by a bank). At the same time, credit off-take, the key to income growth for banks, has also slowed on the back of higher lending rates and an economic slowdown.

There were several other irritants such as the farm debt waiver, Government’s refusal to divest stakes in PSU banks, perception of rising delinquency in retail loans and losses on derivative products structured for clients. This led to a number of banking stocks trading near their 52-week lows. So are the concerns about banking stocks warranted? We take you through recent bank financials for a perspective.

Financial backdrop

Credit growth: After averaging a 30 per cent growth in the last four years, credit growth for the banking sector as a whole has moderated to 21.6 per cent in 2007-08 . Private banking major ICICI Bank reported a loan growth of 16 per cent in 2007-08 (34 per cent in 2006-07), while SBI managed 23.5 per cent in 2007-08 (29 per cent). Higher interest rates, slowdown in retail offtake of loans on the back of specific measures by RBI such as higher risk weights for certain sectors could haver been the reasons for the muted performance

However, individual banks have managed much higher growth rates in their loan book, as higher off–take of corporate loans helped compensate for lower retail off take. For instance, Axis Bank (66 per cent growth in 2007-08), Kotak Mahindra Bank (72.1 per cent) and Yes Bank (49.3 per cent) have shown strong growth numbers for 2007-08. Growth rates in loans for banks over the next few quarters may be considerably influenced by their loan mix. ICICI Bank, for instance, has a high proportion of retail credit, with as much as 58 per cent of advances to retail clients, whereas Axis Bank and SBI have a 21 per cent exposure to retail loans. .

Net Interest Margins: There was a moderation in average NIMs due to factors such as increase in CRR and a reduction in lending rates. NIMs for most individual banks now hover between 2.4 per cent and 3.3 per cent. The key exceptions are Kotak Mahindra Bank (consolidated NIM of 5.6 per cent), thanks to fee-based income from subsidiaries and HDFC Bank (4.4 per cent), due to a higher proportion of low-cost deposits. Maintaining NIMs may remain a challenging task for banks. Upward pressure on lending rates may however persist with the RBI expected to remain in tightening mode over the next few months. Interest rates on select deposits are also trending up, thanks to intensifying competition among banks to source deposits.

Low-cost deposits: Healthy growth in the deposit base may provide more leeway for banks to manage their cost of funds, amidst pressure on lending rates. Most banks did well on this score in FY08. Higher interest rates, shrinkage of other avenues with assured returns and tax incentives have helped strong accretion to bank deposits. Newer private banks such as Yes Bank have enjoyed high growth rates partly due to low base effect and aggressive branch expansion. Among the PSU banks, banks such as SBI, Bank of India and Indian Overseas Bank reported 20-25 per cent growth in deposits. The proportion of low-cost deposits (CASA or current account and savings account balances) is a key lever available to a bank to contain the cost of funds. ICICI Bank’s deposit growth , at 6 per cent, was among the lowest in 2007-08, but the bank has still recorded strong growth in CASA deposits at 27 per cent. Going forward, banks with a higher proportion of low cost deposits may be better placed to withstand pressure on their NIMs. In this respect, average CASA ratio for PSU banks is at 36.5 per cent. Select private banks such as like HDFC Bank (54.5 per cent). Axis Bank (46 per cent) also enjoy strong CASA ratios because of their focus on the low-cost deposits and aggressive branch and ATM expansion.

Capital adequacy: Capital Adequacy is not a key challenge for banks at present, with all listed banks well above the prescribed CAR of 9 per cent. A slew of rights and public offerings and Qualified institutional placements have helped shore up the capital base of many banks. But continued aggressive lending to sectors such as realty and deteriorating credit quality has the potential to dilute capital adequacy. This may require banks to raise additional capital as and when required and banks such as Union Bank and Central bank of India have planned to raise capital this fiscal.

Asset quality: Though Indian banks have shown a long-term trend of declining non-performing assets (NPAs), concerns about credit quality in retail loan portfolio have resurfaced recently. The steady rise in interest rates and rising proportion of unsecured personal loans could well peg up credit risk on lending to retail borrowers; however, there is as yet limited evidence of this in bank numbers. The only recent signals on this score have been the Gross NPAs of ICICI Bank inching up from 2.08 per cent to 3.3 per cent in FY08, said to be because of exposure to unsecured retail credit. SBI too has reported a rise in Gross NPA from 2.92 to 3 per cent in FY08, attributable mainly to retail exposures and SME credit.

Non-interest income: Lending activities apart, banks, particularly in the private sector, have made significant headway in augmenting their fee-based income. Commission, exchange and brokerage form a major portion of non-interest income today for these banks. Fee-income made up 65-70 per cent of non-interest income for private banks in FY08, with 45-60 per cent of the total income itself contributed by non-interest income. PSU banks still earn major income from traditional lending and borrowing activities, but have also started exploring avenues for fee-based income more actively. They have earned 25-35 per cent of their total income from non-interest income in 2007-08. Given the potential for expansion in distribution of financial products and advisory services, there is room for significant growth in fee-based income.

Long-term outlook bright

The long-term outlook for the banking sector, in terms of revenue visibility, remains bright despite the recent slowdown. With the current economic slowdown being attributed mainly to execution-related problems on projects, commercial credit offtake may eventually climb back to healthier levels. Even the current credit growth of 20 per cent plus is healthy enough to translate into reasonable income growth for banks.

Greater caution on retail lending, if exercised by banks, may lead to slower growth in retail credit in the near term, but may be positive from an asset quality perspective. Given that a major portion of India still remains under-banked, segments such as smaller housing loans and SMEs offer growth opportunities. Most banks are also exploring avenues for fee-based income quite aggressively; this has potential to grow at a faster rate than the net interest income. Treasury portfolios, though, may remain vulnerable to the volatile market conditions that are prevalent currently.

Near-term uncertainties also remain for PSU banks about the farm loan waiver scheme announced in the Budget. There is no clarity as yet on reimbursement of loans written off under the debt waivers and the Finance Minister has already made it clear that the loans already written off by the banks wouldn’t be reimbursed.

Though the valuations of banking stocks appear attractive with many of them trading below their book value, a recovery in stock valuations in the near term appears unlikely given the near-term concerns surrounding earningsWith inflation on a steep uptrend, policy rates may not taper down any time in the near future. Though banks are playing a waiting game with respect to the recent repo rate hike, any further hike may leave banks only with two alternatives — increase lending rates and risk slower credit growth; or retain lending rates and manage with lower NIMs. The pressure is all the more with many banks, starting with SBI, hiking their deposit rates to attract more low-cost deposits. The possibility of a sharp upward revision in government borrowings to fund the deficit (as well as oil and fertiliser bonds), also raises fears of a crowding out of private credit.