Time to Shop For Bank Stocks

Ali On Content / 26 Sep 2011

One sector that has been the worst affected in the current market is banking.  May factor have cast a shadow of doubt over its future prospects.

The global macro-economic situation has been generating a sense of deja vu vis-à-vis the scenario of 2008, when we saw one of the worst economic crises after the Great Depression of the 1930s. The sector that was hit the most was the financial sector. The current situation is almost the same, and the only difference this time is that the European banks are in a tight spot, instead of their American counterparts. This is vindicated by Moody's recent down-grading of Societe Generale and Credit Agricole, two of France’s largest banks, over concerns that they hold insufficient capital to withstand a Greek default.

The Indian banking sector has not remained immune to these events, even though it had shown a lot of resilience during the financial crisis of 2008. It seems to be in turbulent waters in the current wave of economic predicament, when fears of a double dip recession are becoming more and more evident. It is for the first time since January 2002 – when the BSE Bankex was introduced – that the index has shown negative growth for three quarters in a row, starting from September 2010 to June 2011, while a fourth quarter of negative growth is possibly in the offing, as it is very unlikely that Bankex will recover 13 per cent in the remaining 10 days of September. The public sector banks that displayed better resilience during 2008 are at the centre of the storm this time.

This is reflected in the performance of the CNX PSU Banks Index (an index that represents 91.27 per cent of the free float market capitalisation of the stocks forming a part of the total PSU banks that are listed), which is down by 27 per cent year till date, compared to an 18 per cent decline in the BSE Bankex (an index that covers the entire banking space). So, where do we go from here? Is it the right time to look at the banking sector and stocks now? Will macro-economic factors affecting the banking space and, in turn, the performance of the banking stocks, fall into place? Here is an analysis of the various factors, and the probable scenario in each of it that is likely to emerge going forward.

Credit Growth

One of the primary reasons for such a fall in the banking index is the slow-down in credit growth. After witnessing a growth of 28 per cent on a yearly basis for the month of December 2010, credit growth has dropped to 20 per cent for the month ending August 2011. If we look at credit growth for the four months ending July 2011, it grew by 21 per cent, and one major contributor to this growth was the industrial sector, which grew by 24 per cent on a yearly basis. The industrial sector accounts for almost 45 per cent of the total non-food credit. Even in this sector, it is the medium-sized industries that saw the fastest loan growth of 35 per cent. Apart from industry, another sector where credit growth was robust in the same period was the non-banking financial companies (NBFCs) that grew by 52 per cent on a yearly basis. Among those that have actually seen a moderation in credit growth is the personal loans segment, which grew by 17 per cent in the same time.

Going forward, we believe that the credit growth rate will further decline, at least for the next few quarters, as the rate hikes by the RBI might act as a deterring factor. However, we do not foresee a sharp drop in credit growth, as had been witnessed during 2008, when credit growth dropped from its peak of 40 per cent in September 2005 to a low of 10 per cent in October 2009.  This is because, if we look at the period between July 2003 and June 2008, we can see that the aver-age monthly credit growth was around 27 per cent, whereas in the current scenario, it is just 22 per cent. What this essentially means is that despite the economy growing at the pre-crisis levels of more than eight per cent, credit growth was not at the same rate, which indicates that there have been very few excesses and banks have been more cautious while lending. This can be exemplified by the drop of six per cent in the credit card lending for the first four month of FY12.[PAGE BREAK]
The movement of interest rates will play an important role in determining the rate at which credit growth moderates in the time to come. However, R M Malla, CMD, IDBI Bank, in a recently-held banking awards ceremony, said, “18 per cent credit growth per se is not a problem for the Indian banking system, even in this environment.” With the rates hikes sure to be a thing of the past sooner rather than later, the scare of credit growth shrinking would surely dissipate.

Interest Rate

Since March 2010, cumulatively, the RBI has hiked the repo rates by 350 basis points (bps), and this is definitely going to increase the cost of doing business, and especially hurt fresh investments, which are likely to see a sharp cut. However, despite such increase in the policy rates, they are still at 8.25 per cent currently, which is below the peak rates of 2008, when the repo rate had reached the level of nine per cent. If we analyse the statement made by the RBI governor, D Subbarao, during the recent policy meet, it seems that one more rate hike could be on the cards. Subbarao does not want to risk being ‘behind the curve’ by a ‘premature’ stop, at a time when inflation is hovering around nine to 10 per cent.Agreeing about the interest rates going forward, Harendra Kumar, Head, Institutional Equities and Global Research, Elara Capital, says, “It will go up by 25 bps more, before we can see a pause in rate hikes.” If we look at the inflation figure, it is highly unlikely that it will come down soon. Manufactured products' inflation is at uncomfortably high levels of around 7.8 per cent, and crude oil prices remain at elevated levels, despite fore-casts of the demand slowing down on account of the building up of inventories in the US economy. Even with normal monsoons, high food prices persist. So, there is every probability that there will be some pause in rate hikes only after another round of hikes in October.

The impact of rate hikes will be reflected with a lag effect, and there-fore, we need to analyse how the past increase has impacted the banks’ deposit and credit rates. According to a report by CARE Ratings, the repo rate has increased by 125 bps since May to the end of July. The average base rate for banks had increased by an equivalent amount, while deposit rates (the average for more than one year maturity) increased by around 40 bps. Therefore, if we assume that credit growth remains at the RBI’s target level of 18 per cent (year till date it has surpassed this level) and a 17 per cent deposit growth rate, this will have a positive impact on the banks’ financials. However, the real benefit will depend on the timing and degree of rate hikes taken by the banks.

Of course, this is assuming that credit growth will remain at that level. Till now, after 11 hikes (that is, before the September hike), the credit growth has remained at the 20 per cent level, and therefore, does not seem to have suffered much of an impact. There is however an argument that the recent fall in the IIP reveals that credit growth may fall. The IIP growth for July 2011 came in at 3.3 per cent, which was significantly lower than the 8.8 per cent Year-on-Year growth recorded in June 2011. The July IIP growth has been the lowest in 21 months. The sharp dip in the IIP growth was caused by the weak growth in the manufacturing sector and a steep decline in the capital goods sector, that saw a de-growth of 15.2 per cent.[PAGE BREAK]
All this indicates a slowing capex cycle, and therefore, moderation of credit growth in the coming quarters. Nevertheless, if we dig a little more into the IIP numbers, we find that the situation is not as scary as it appears to be on the surface. Take a look at the following numbers, and they will tell you different story. In terms of industries, seven out of the 22 industry groups showed a decline during July 2011, as compared to 13 out of 22 in June 2011, on a yearly basis. If we remove the capital goods segment from the IIP that has a weightage of around 10 per cent and has been very volatile, the IIP growth figure will come to about 6.5 per cent, which again, is not very good, but is definitely better than 3.3 per cent. At the most, the interest rate hike will push the investment cycle for another quarter.

There are some other numbers that also indicate that the situation is not so gloomy. Take, for instance, the advance tax figures. Except for a few, all the major companies, including some of the banks, have seen their advance tax numbers going up. Therefore, we believe that though the interest rates are increasing, the impact is not as severe as it is perceived to be. Nevertheless, one ratio that truly gets impacted due to the rising interest rate, is the asset quality of the banks and a rise in the non-performing assets. So, how does the quality of assets impact banks?

Asset Quality

The asset quality of Indian banks has consistently improved over the past few years. Gross non-performing loans (NPL) on an aggregate basis have come down from around five per cent of gross advances during 2005 to the cur-rent level of around 2.2 per cent, and more importantly, have been stable since the last one year. If we look at the figure during 2008, it remained almost flat. One of the factors that helped it remain stable was the higher number of loan restructurings during 2008-09, which artificially kept NPLs at a relatively lower level. During the crisis of 2008, the RBI was proactive and provided a leniency window, which made it easier for the banks to perform, as most of the slippages were restructured, rather than getting classified as NPLs. However, in the last couple of quarters, there has been some increase in NPLs.   This primarily was the case for PSBs, which shifted to the automated NPL recognition norms, and not due to a worsening of the underlying asset quality. In the June 2011 quarter, PSBs saw a 0.6 per cent sequential rise in the net NPL/net worth ratio to 12.2 percent, while it decreased for new banks to 2.9 per cent. Also, the outstanding gross NPLs of PSBs increased by 11 per cent sequentially, as against a one per cent increase for new banks.

If we look at the outstanding restructured loans as a percentage of net loans, we find that it stands at 4.5 per cent in the case of PSBs, as compared to less than one per cent for the private sector banks. Therefore, going forward with any slowdown in the overall economic activity will increase the stress on assets for PSBs, but it will remain at a comfortable level for private sector banks, due to their superior credit monitoring and better quality of diversified loan book. So, the major concern for the banks (especially PSBs) now is their asset quality, which might further deteriorate with a recent rise in the interest rate and a slowing economy. As M D Mallya, CMD, Bank of Baroda, said in a recent IBFA award ceremony, “We have not reached a level nationwide, where we have to be concerned about the overall asset quality. I do agree that there will be incremental delinquency, but it will not be difficult to absorb.” In addition to asset quality there are also concerns about the treasury income that is going to get impacted, but,  as Kumar puts it, “As far as treasury income is concerned, it will impact the P&L, but the adjustments have already been made.” How many of these concerns have been factored into the stock prices of the banking companies?[PAGE BREAK]
Valuation
When we look at the drop in the valuation of the BSE Bankex, like price to earnings or price to book value, it is sharper than the fall in the index itself. This means that the valuation has taken a sharper beating, and is trading below its long-term average. The BSE Bankex is currently trading at price to book value of two, whereas the median since October 2007 is 2.45. One of the reasons for this may be the expectation that in the next few quarters there will be more pain on the asset front for the banks, and hence the adjustments in the book value. Nonetheless, if we look at the asset quality during 2008-09 and 2009-10, we do not see much deterioration in the assets of the banks in the aggregate level for the private sector banks.

However, there was a marginal increase of net NPL (NNPL) for the public sector banks. For 22 private sector banks, the NNPL decreased from 1.29 per cent in FY09 to 1.03 per cent at the end of FY10. For the PSBs (including SBI and its associates), the NNPL increased from 0.94 to 1.1 during the same period. Therefore, we think that the concern of asset quality is not that alarming. Hence, we believe that a fall in valuations is more than any actual similar deterioration in the fundamentals of the banks.
The drop in the PE multiples of Bankex reflects that there is an expectation that earnings may decline in the coming quarters. If we look at the margins of the banks, we believe that the net interest margins of most banks have bottomed out, and would start improving from Q2 FY12. If we look at the net profit of banks in the CNX PSBK for FY11, we see that it was 6.6 per cent below the street expectations, and one bank that contributed the most was SBI, which saw a 99 per cent drop in its profits. Nevertheless, for FY12, the consensus estimate is for a fall of nearly three per cent in earnings, whereas the fall in the PE of Bankex is much more than that, and again signifies that it is trading below its fundamentals.

Now, let us look at the capital base of the banks, so as to understand their ability to expand further and withstand any impact of bad asset quality. For both private banks as well as PSBs, it is way above the required level of Basel II norms, and it is interesting to note that it has improved for PSBs since FY09. At the end of FY11’s median, the capital adequacy ratio (CAR) for the private banks and PSBs was 14.97 and 13.41 respectively, compared to 15.01 and 13.13 at the end of FY09. Hence, we can safely assume that the Indian banks are adequately capitalised.

Further, see how the BSE Bankex has performed before and after the financial crisis of 2008-09. If we take the fall of Lehmann Brothers in September 2008 as a pivotal factor during the last financial crisis, the Bankex fell by 40 per cent till the start of March 2009, following which the stock market started recovering. However, it took six months for the Bankex to fall by 40 per cent, whereas it recouped that fall within the next three months. In May 2009 alone, the Bankex moved up by 40 per cent, compared to a rise of 26 per cent by the Sensex. Another important thing to note is that though banking is a rate-sensitive sector, the last time when the interest rates were going up during April to July 2008 (when it increased by 100 bps to nine per cent), the fall in the Bankex was just four per cent.[PAGE BREAK]
Even after the interest rates were brought down to five per cent by the end of January 2009, there was no rise in the Bankex. This was essentially due to the difficult global conditions that were prevalent at that time. In the current scenario too, the fall in the Bankex is mainly attributed to a few banks having a higher weightage in the index. For example, SBI and ICICI have a weight of 15.03 and 27.44 per cent respectively in the index, and are responsible for two-thirds of the fall in the index since the start of the year. Three banks (all of them new private sector banks) out of 14 in the index that have given positive returns year till date. Therefore, we believe that even the fall in the banking stocks is not all that pervasive, and is largely limited to some of the PSBs.

Conclusion
From the above discussion, it is clear that though the situation is bad, it is not as precarious as is perceived to be for the banking sector. The credit growth will moderate, but will be above the RBI expectation of 18 per cent. We believe there will be some pain going forward, in terms of the asset quality of banks, and especially for PSBs that have a lower provision coverage ratio (PCR) (around 55 per cent, compared to more than 60 per cent for the private sector banks at the end of June 2011), and the loan book exposed to some of the vulnerable sectors, like power and real estate. However, if we take a look at the entire banking sector, we find that the PCR has been improving since the last six quarters, and is currently more than 60 per cent. This provides comfort, considering that the banks are well prepared to face any sharp deterioration in their asset quality.

We believe that the RBI should now take a pause, as monetary policy alone cannot control the monster of inflation. It has to be equally reciprocated by fiscal measures from the government. Currently, it seems that the private sector banks are better placed to face the challenges than the PSBs. Though the situation on the ground seems to be scary at least for now, the long term view on the banking sector on the whole remains positive.

The drop in the valuation seems to be more than the fundamentals. Remember that post the Lehmann Brothers’ crisis, it was the banking stocks that recovered the most and the fastest. Finally, we are appending a list of banks that we believe would navigate the current turbulent times in a better way, providing higher returns to investors going forward.

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