The fortunes of Indian banks have improved considerably over the past year and the same has been adequately visible in the underlying valuations of the stocks from the sector that have led the market rally, particularly in the past six months. Although the beginning of 2007 saw banking stocks lag as investors envisaged the brunt of the rise in interest rates on their net interest margins and treasury books, sentiments improved with better spreads. Following are some of the key aspects that will guide the sector's fortunes in 2008:
Basel II: 2008 is set to be an inflection point for the Indian banking sector as the players in the sector equip themselves with adequate capital and risk appraisal methods to comply with Basel II guidelines by March 2009. While the risks of sub prime delinquencies trickling down into the books of Indian banking entities continue to loom large, sophisticated risk appraisal methods are expected to bring forth the much-desired transparency. Government owned banks are expected to adopt novel methods of capital rising given the stickiness of their promoter holding.
Equity dilution: Banks have estimated the application of Basel-II norms by FY09 to have an impact of 1% to 1.5% on the capital adequacy ratios (CAR). None of the banks have reported sufficient details of the credit profile of their assets to enable accurate assessment of the impact. It is also possible that some banks may enjoy a release of capital arising from a superior credit quality. FY07 results of Indian banks under our coverage indicate that most have total CAR of at least 11%. However, banks that are short of capital or carry the risk of lowering their Tier-I CAR below 6% (statutory requirement) due to higher risk weightage, are de-risking themselves by accumulating additional capital to meet the exigencies.
Banks that are expanding market share do not seem to be spared from the broader trend of declining asset profitability. There are two opposing forces that act on the return on asset (ROA) of a bank that is expanding market share by leveraging new equity. An aggressive chase of new business could depress margins and the ROA. Substitution of high-cost deposits by equity could, in the near term, improve margins.
Consolidation: Given the RBI's guidelines for opening up the sector to foreign players by 2009, we could see plenty of activity on the consolidation front as well. The same will call for a change in the mindset of PSU banks and gradual alignment in the operating metrics of the public and private sector banks for the larger benefit of the sector.
Moderate growth: The growth rate in excess of 25% clocked by the banking sector in its advance book over the last two years might not hold true in FY08 as the high base along with lower offtake due to firm interest rates is expected to moderate it. While the private sector banks will continue to outperform the sector growth due to its well-diversified portfolio, the public sector entities are expected to witness a considerable slowdown. The increased slippages in the retail book will also continue to dissuade banks from adopting an aggressive strategy on this front.
Delinquency pockets: Monetary tightening in the last 12 months has lifted banks' lending rates significantly. Despite the recent 0.5% cut in the mortgage-lending rates, they continue to rein nearly 4% above the bottom (close to 2001 levels). Similarly, the steep interest rates on personal loans and credit cards have begun to erode the asset quality of banks. The NPA levels of Indian banks have risen by 0.5% to 1% in the past 6 months. Any unexpected aftershock of the global credit turmoil can only worsen the situation.
Holding structure: The RBI has proposed a new structure for the holding companies of banks in response to applications made by ICICI Bank and SBI - for setting up intermediary holding companies for their key non-bank operations. The regulator has expressed its discomfort with regard to creating intermediate holding companies and has suggested exploring the possibility of creating banks or financial holding companies (BHC/FHC) on the lines of financial structure operating in the US. While the RBI's discussion paper on this issue is subject to deliberation, we envisage that the immediate impact of this will not be on the regulatory norms but on the banking entities' desire to cash in on their subsidiaries. If the RBI maintains this stance in 2008, it will for the time being derail the plans of divestment of the insurance and AMC subsidiaries of both ICICI Bank and SBI.
While we remain positive on the prospects of the banking sector over the medium and long term, investors need to be wary of valuations while taking their investment decisions and prepare themselves to withstand some momentary volatility that the sector will offer over the next couple of fiscals.