• SEPTEMBER 28, 2007

Banks: What's fuelling growth?

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. We herein explore some of the key reasons for the change in the investment outlook for the sector and gauge the future prospects.

Tech savvy: Banks have been investing in technology, including the 'core banking' software, ATMs, internet banking and electronic funds transfer. The new private banks lead the field, for instance, the ratio of ATM per branch was 3 times for these banks, compared to 0.3 times for their public sector counterparts. The large and widespread branch network of government banks often pose a challenge to deploying technology, with branches in rural areas accounting for 38% of their network (but only 11% of deposits) compared to 5% of branches for the new private sector banks.

Capital expenditure: Loan growth in FY05 and FY06 was led by retail lending, primarily for residential mortgages, passenger cars and two wheelers. Loans to the manufacturing sector picked up from FY07 when the investment cycle picked up momentum with the growing domestic corporate demand. While the share of consumer loans has increased, the loan portfolio of Indian banks remains reasonably diversified and unsecured retail loans are estimated at less than 5% of total loans.

Which sectors borrowed most in FY07?
Sectors (%, YoY)
Commercial real estate 4
Construction 49
Metals 35
Retail 34
Textile 34
Housing 32
Agriculture 31
Food Processing 24
Engineering 15
Source: RBI

Not just treasury: Non-interest income, especially treasury income, which had evolved into an important source of revenue in FY03 and FY04, was eventually hit by the rise in interest rates. The share of non-interest income in banks' total income declined for the second year in succession to 17% in FY06, from a peak of 21% in FY04. Banks have since then focused on improving fee income, particularly through distribution of third-party investment and insurance products. The share of fee income to total income has improved from an average of 10% in FY04 to 15% in FY07 for public and 20% in FY04 to 25% in FY07 for private sector banks. Further, market risk on investments had reduced following a reduction in the government securities portfolio in the available-for-sale (AFS) category and a reduction in the portfolio duration.

Lighter costs: While operating expenses have, as a legacy, been the bone of contention for the PSU banks, the tables have turned. While the private sector banks are trying hard to retain employees and compete with the foreign banks to have access to talent, most PSU banks are getting partially relieved of the burden due to the natural attrition (retirement) of nearly 5% of their employees every year. Despite the technology expenses having risen, overall, the cost to income ratio for the sector fell to less than 50% in FY07 thanks to rising net interest income on the back of loan growth.

Quality upheld: The NPA levels of Indian banks have improved significantly since FY02 thanks to aggressive write-offs and recoveries during a benign credit cycle, backed by improved credit appraisal processes and better creditor rights. The improved asset quality numbers are partly cyclical in nature, and with rising interest rates affecting the repayment capacities of borrowers, NPA ratios have started rising for many Indian banks. Having said that, the net NPA level of 3% for the sector along with reasonable provision coverage for most banks does not make a cause for significant concern in the medium term.

Resistance to global meltdown: The recent turmoil in the US markets due to subprime mortgages defaults has left Indian banks largely untouched due to lack of exposure. Only the larger banks that have an international presence have exposure in foreign currency assets (6% of total assets in FY07) primarily in the form of loans. Notwithstanding this, going forward, deeper penetration of unsecured credit products (like credit cards) and alignment to its global peers will require the Indian banking sector to adopt better risk appraisal strategies to keep such crisis at bay.

Nonetheless, there are challenges too...
The meager proportion of vulnerable unsecured consumer loans together with the equity infusion during the last two years is unlikely to raise the solvency risk of Indian banks (measured as net NPAs to networth), significantly, from the current level of around 10%. Nonetheless, Indian banks face the challenge of maintaining profitability even as rising interest rates start to affect the borrowers' repayment capacity. The need for infusing further capital will also remain strong and having plans to raise sumptuous amounts of capital from both the domestic and international markets, any sustained deterioration in global liquidity could affect growth prospects. Further, while most banks have effected structural improvements in their risk management capabilities, a lot is left to be desired before the modeling approaches under Basel II can be validated.

The future outlook for the sector therefore remains stable, though a few of the smaller banks remain vulnerable to a gradual squeeze-out by competition.

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