Banking stocks at crossroads

The performance of the banking sector is closely tied to that of the economy. With the economy on the upswing once again, analysts expect the banking sector to do well over the medium term. Investors must bear in mind that this is a cyclical sector. During the bear phase of 2008-09, the Sensex fell by 61 per cent. During that phase the BSE Bankex declined by 70 per cent. When the markets rebounded (the bull rally lasted from March 9, 2009 to June 23, 2010), the BSE Bankex gained 203 per cent compared to the Sensex's gain of 118 per cent, thereby compensating investors more than adequately for their earlier loss.

In the last one month (May 23, 2009 to June 23, 2010), BSE Bankex has given returns of 6.69 per cent compared to the Sensex's 7.81 per cent. The best-performing index during this period, BSE Auto, gave a return of 12.82 per cent.

Positive drivers of earnings
As the economy turns around (the high Q4FY10 GDP number and the IIP number for April attest to this), it is expected that credit disbursement will increase, which in turn will enable banks to improve their core earnings. According to Vaibhav Agrawal, vice-president, research and banking, Angel Broking, “Cyclically, the sector is headed for an upturn, with credit growth estimated to increase to 20 per cent year-on-year in FY2011E (a conservative 2.4 times estimated GDP growth).” He expects credit demand from the private sector to move to a higher trajectory. “Since industry will require capacity expansion to meet higher domestic demand, banks will get an opportunity to lend to industry,” he says.

According to Robin Roy, associate director-financial services, PricewaterhouseCoopers, “A higher GDP growth will have a domino impact on infrastructure and on feeder sectors like real estate, construction, engineering and services.” He adds that banks have ample liquidity, so credit growth will not be an area of concern.

Overall Agrawal expects the banking sector to be an outperformer, thanks to the recovery in domestic demand.

Negative factors at work
In the current scenario, two factors could have a negative impact on the stock market performance of the banking sector. The first being a possible rise in banks' non-performing assets (NPAs). Another factor is the uncertainty over how strong the pickup in credit demand from the private sector will be. Roy believes that private sector demand for credit for meeting its investment goals will depend on a host of factors: interest rates, rupee-dollar exchange rate (corporates could examine the feasibility of external commercial borrowings as an alternative to bank loans), the price of oil internationally, and so on. Even the strength of the global recovery would have a bearing on private-sector credit demand , he says.

Impact of rising rates
Rising interest rates tend to have a negative impact on banks' bottomlines. On the one hand, banks suffer mark-to-market losses on their treasury holdings when rates go up (though the effect of this can be minimised through active treasury management). Rising rates could also affect their net interest margins. Roy is of the view that the days of benign rates are gone and banks will have a challenge maintaining their net interest margins (NIMs). He says: “The main challenge would be to reprice assets suitably, especially the longer tenure books comprising mortgages and term loans.”

Agrawal has a different view. According to him, a tighter monetary policy will not dampen credit demand. Interest rates, he says, are almost 300 basis points (bps) lower than their previous peak, leaving enough headroom for rate increases meant to anchor inflationary expectations without hampering growth. He further adds that in a rapid-growth environment, the impact of higher interest rates on credit demand is not substantial.

Fear of NPAs
Roy believes that the banking sector will face pressures on account of higher NPAs. Some of these NPAs will be from the retail loan segment while the rest will come from the restructured loans of public sector banks (PSBs).

Agrawal concedes that the risk of rising NPAs does exist. He says: “PSBs could see another couple of quarters of pressure from their large quantum of restructured accounts. Beyond that, asset quality is expected to start improving across the sector.” Given capital constraints, smaller PSU banks are unlikely to grow their balance sheets fast. He also expects some banks to show positive surprises in bottomline growth as NPA costs decline.

What should you do?
In the scenario that prevails currently - rising credit demand accompanied by a likely increase in interest rates -investors should look for banks that have a high CASA (current account savings account) ratio. A high CASA ratio lowers a bank's cost of fund. Usually banks with a larger branch network tend to have a higher CASA ratio. In a rising interest rate scenario, invest in banks with low-tenure treasury holdings tend to suffer lower mark-to-market losses.

Agrawal suggests that banks with faster branch expansion (typically 15-20 per cent compounded annual growth rate for private banks, 10-12 per cent for SBI) backed by a strong customer proposition should be the ones you should look at. Also, core income should contribute a high proportion of their total income. A higher fee income to assets also indicates a high return on equity.

Stock recommendations
Agrawal recommends the following: “We have strong conviction about the three large private banks: HDFC Bank, Axis Bank and ICICI Bank. Among PSU banks, we recommend a switch from Punjab National Bank (higher credit risk, expensive valuation) to SBI (healthy branch growth driving retail deposit growth, strong fee income, and trading at a cheap valuation after the recent sharp underperformance). We have recently changed our view on Bank of India from sell to accumulate after significant underperformance. We also see moderate upside in Dena Bank, due to the advantage of a high 35 per cent CASA ratio in a rising interest rate environment. In the old private bank space, we prefer Federal Bank for its fundamental strengths over peers due to the following factors: low-cost NRE deposits, manageable Dubai exposure of less than 2 per cent and backed by strong collateral, and cheap valuations after substantial underperformance over the last six to nine months.