Amidst growing uncertainty over consumer demand and economic signals, the banking sector continues to grow. While the credit offtake did not grow as expected, earnings too disappointed during the March quarter, says Kotak

The banking sector continues to grow, amidst growing uncertainty over consumer demand and economic signals. Despite the Reserve Bank of India’s (RBI) decision to cut repo rates in January, credit offtake did not grow as anticipated. Most importantly, earnings disappointed too. It grew only 6% year-on-year (y-o-y) according to Kotak Institutional Equities (Kotak) research report.
 

Kotak said, “Our cautious outlook remains on the (banking) sector. While growth moderates, buoyant net interest margins (NIMs) due to a sharp decline in interest rates will drive NBFC earnings.”
 

The earnings growth has disappointed this season, which prompted many investors to take a cautious approach to investing in the financial sector, especially banking. Earnings grew just 6% y-o-y, which meant Kotak has taken a subdued forecast of banking. One of the pertinent issues, which Moneylife has talked about in the past (Public sector banks - Loans turning bad), is the issue of non-performing assets (NPAs) that could endanger the financial system and spill over to the real economy. Kotak said, “Earnings growth is likely to be subdued at 10% CAGR over FY2013-15E due to slower revenue growth (less than15% CAGR), increase in cost-structure and elevated provisioning costs for dynamic provisions, improvement in coverage ratio and NPL/restructured loans.”

The integrity of banks balance sheet is felt more in public sector banks than private banks.  “The divergence in operating performance (earnings, revenue and loan impairment) continued between public and private banks,” Kotak said in its report. According to the report, overall cost-income ratio increased to 48% from 45% in 4QFY13 for public banks while private banks reported a modest increase to 44% from 43% in December 2012.
 

More important is how bad loans have affected the balance sheet of banks. Kotak said, “The next leg of loan impairment being likely to emerge in the large corporate portfolio as balance sheets of these companies show a high degree of stress.” Most private banks reported slippages of between 0.9% and 1.5% of loans. Indian Overseas Bank saw 5% in slippages, while Punjab National Bank (4%), Andhra Bank (4%) and Oriental Bank of Commerce (3%). “Overall slippages were marginally lower at 2.6% of loans with slippages primarily from the SME and large corporate portfolio. Most banks continue to report better performance in the agriculture and retail portfolios—a key comfort,” said Kotak. It is pertinent to keep an eye on how the monsoon is this year even if forecasts remain optimistic, as agriculture sector largely depends on it.
 

When a loan is likely, or is estimated, to go bad, banks usually restructure it. When the incidence of restructuring is high, it is time to worry. The Kotak report said, “Credit costs were at elevated levels to factor the revised restructured guidelines and write-offs. Fresh restructuring was high but the new guidelines helped to show a decline in outstanding restructured loans.” Even though restructuring can be negative over the short run, it could prove beneficial in the long run as balance sheet is gradually rid of toxic loans.|
 

More worryingly, the overall banks’ deposit base is found to be shrinking. One of the important parts of a bank’s business model is the deposit base. This is because this is the source of income for banks to lend to others (albeit at a higher rate) and make profit on the differential. When it is shrinking, they have less to loan out. Despite the Reserve Bank of India’s (RBI) cut in repo rate in January (and subsequently again in May) credit off take did not take off as anticipated.

However, on the brighter side, Kotak is optimistic on the prospects of some NBFCs, mainly because of increased credit off take and decline in interest rates. The report said, “We believe a sharp decline in interest rates in the bond markets over the past two months will drive earnings over the next few quarters even as loan growth will moderate and NPLs rise. We raise our target price by 1%-3% to roll over to June 2014 (rolling 12 months).” Credit off take in this sector is, surprisingly, strong, growing between 16%-37%. However, an auto and infrastructure slowdown could stymie NBFC growth, according to Kotak. Bad loans continue to be an issue for NBFCs though, with Kotak stating: “With improvement in collections in 4QFY13, several NBFCs reported a sequential decline in NPAs. However, on a yoy basis, NPL increased for several players.” Amongst NBFCs, Kotak is optimistic on IDFC, LIC Housing Finance, Magma Fincorp and Bajaj Finserv.
 

Amongst non-NBFCs, it likes ICICI Bank and SBI. The report said, “Among private banks, we like ICICI Bank (steady growth, strong CASA and high tier-1 ratio) and maintain our negative view on HDFC Bank (expensive valuation). Among public banks, we like SBI but note that earnings/growth performance in the current quarter is discomforting.”