As India’s economic activity picks up pace after being in deep freeze during Covid, investors have been hunting for sectors that can ride this recovery.
But as credit is the lubricant that fuels that every economic boom (and causes the busts that come after), banking is the ideal sector to play the Indian economy’s return to a secular growth phase, after Covid. This is why we think this is a good time for investors with a medium to long-term perspective to have an allocation to Exchange Traded Funds (ETFs) tracking the Nifty Bank Index, which is made of 12 leading banks from the private and public sectors. Here’s the rationale for this call.
# 1 Credit growth is returning
Growth in both top line and core income for banks depends heavily on loan book expansion. Loan book growth, in turn, is highly correlated to levels of economic activity. After expanding by 42% in absolute terms between FY12 and FY17, India’s real GDP grew by a mere 12% in absolute terms between FY17 and FY22, thanks to a slowdown followed by Covid. Slowing credit growth even as banks were wrestling with a stockpile of bad and restructured loans from the previous boom made it difficult for banks to report either reasonable net interest income growth or profit and Return on Equity (ROE) numbers. This was a big contributor to the Nifty Bank index, the proxy for the sector, significantly underperforming the Nifty50 and other sector indices in the last 3 and 5 years.
But the economy is now in the process of returning to normal activity, with signs of animal spirits returning in reviving durable and auto sales, freight movement, GST collections, energy and electricity demand and improving IIP and PMI numbers for manufacturing and services. Presently, agencies such as IMF, ADB and RBI expect India’s real GDP growth to revive to 7.2% - 7.4% in real terms and 15% - 16% in nominal terms. In the previous boom (2003-2008), large Indian banks managed to grow their loan books at over 1.5 times nominal GDP growth. But repeating that kind of growth appears quite difficult in today’s economic and interest environment. However, investors can certainly expect bank credit to expand at double-digit rates from here.
More than rate movements, it is loan book growth that holds the key to strong bank earnings growth, as expanding loans allow banks to more easily write off legacy bad loans, provision for new slippages, take on more risk through high-yield lending and source capital to bankroll their operations. The data below demonstrates the impact of returning credit growth on the Net Interest Income (NII) of the top banks in the Nifty Bank Index.
#2 Credit is getting broad-based
During Covid and just after, Indian banks were left with only one segment that was seeing brisk offtake of loans and that was their retail customers. This led to all banks, NBFCs and new digital lending players all chasing the same segment of customers, namely the individual borrower seeking home, vehicle, personal and microfinance loans. With all the lenders essentially chasing a limited set of retail borrowers with good credit scores, there was bruising competition on lending rates, with secured segments such as housing loans seeing a squeeze on both yields and net interest margins (NIMs). The last few months have however brought evidence of credit growth in the economy getting more broad-based. Not only have industries begun to scale up working capital borrowings, services rebounding from the Covid-hit are seeing strong credit offtake on the back of reviving transport, hospitality, trade and communications. This shows in monthly RBI data on growth in credit to different sectors. With credit offtake firing on all cylinders, banks are now in a position to be more choosy about their retail borrowers and have better pricing power on passing on higher costs to their borrowers, to protect NIMs. This article based on RBI’s recent Financial Stability Report captures how banks are shifting away from subprime retail borrowers.
# 3 The slate is clean on NPAs
For much of the past decade, analysts looking at Indian banks focussed mainly on their bad loans, restructured loans, the provisions and write-offs towards these and the ability of the banks’ capital buffer to absorb this. But having written off their past NPAs (Non-Performing Assets) in gradual doses, tried their hand at recovery through the IBC and taken a very cautious approach to new project lending - domestic banks have finally managed to put their legacy NPA problems behind them this year.
RBI’s recent Financial Stability Report for June 2022 noted that Indian banks’ asset quality was at a six-year high by March 2022, with gross NPAs declining from a peak of 11.2% in FY18 to 5.9% in FY22, net NPAs from 6% to 1.7%, with provision coverage improving to 70.9% and the ratio of write-offs to gross NPAs at 20%. Large private banks were best placed on all these parameters. The expected spike in bad loans during the pandemic and the moratorium period didn’t materialise, with even retail loan NPAs remaining under check.
The leading banks that make up the Nifty Bank index have fared particularly well on this score with GNPAs at less than 4% and NNPAs at sub-1% by the recent June quarter.
With most banks raising capital to tide over the pandemic, they are also flush with capital to fund loan book growth. Private banks boasted CRARs of 18.9% and all banks 16.7% by March 2022, nearly twice the statutory requirement of 9%.
#4 Profitability gets a lift
With net interest income back in growth mode, NIMs holding fairly steady until March 2022 due to excess CASA and lower provisioning, the leading banks have reported very strong profit growth in the last four quarters. (SBI’s profits in the June quarter have been dented by treasury losses on government securities even as core income growth has remained strong).
This turnaround is however not reflected in bank stock prices, as markets believe that a rising rate scenario could see bank NIMs take a sharp hit. The fear seems to be that as RBI withdraws surplus liquidity from the system and hikes policy rates aggressively even as competition for CASA returns, NIMs will tend to be squeezed, impacting profitability.
These risks do exist. RBI has withdrawn much of the surplus liquidity it pumped into banks during Covid. It has hiked its policy rates by over 140 basis points in just the last four months to rein in inflation. These hikes are yet to pass through to banks’ cost of funds, even as NBFCs and SFBs have sharply hiked their deposit rates. This has showed up in the sharp slowdown in CASA growth for leading banks in April-June 2022 quarter.
But in our view, the banks that make up the top weights in the Nifty Bank Index are systemically large banks with a high share of retail and corporate clients, which can win back their CASA share on offering more competitive rates. In the last three years, they’ve also transitioned a high proportion of their retail loan books to floating rate loans which get automatically reset with a rise in rates. With inflation coming off highs, RBI too is expected to slow down its pace of hikes in the latter part of FY23. We believe the sharp rise in cost of funds is likely to lead to a shake-out in non-bank players and SFBs offering retail and high-yield loan products. This should help the large banks hold their NIMs steady even if they are unlikely to expand.
Going forward, we expect mid-teens loan growth for the leading banks (not at a multiplier of nominal GDP but perhaps matching it), with steady NIMs and NPA provisioning.
#5 Waning fintech threat
One of the key reasons for de-rating of banking stocks in the last couple of years was the belief that new-age fintech players, lending apps and NBFCs would actively eat into the banks’ share of young customers and retail borrowers through their innovative products, ultra-friendly user interfaces and innovative product structuring. But RBI has lately sent out many a signal that it is not quite comfortable with fintech players or unregulated entities, even if tied up with banks or NBFCs at the back-end, encroaching into the banks’ turf. After stating in its FSR that it plans to reduce regulatory arbitrage between banks and fintech players, it has recently been walking the talk on this front too.
It recently issued 2 clarifications – on barring the loading of credit on mobile wallets and pre-paid instruments and this week on digital lending players. These clearly suggest that RBI would not like fintech players to replicate or compete with the core lending activities of banks and NBFCs under its watch, nor would it like them to foray into areas not allowed to these regulated entities. While this is an evolving issue, it suggests that the threat to leading banks from the fintech players encroaching into their turf may recede.
The long patch of poor loan growth and asset quality issues, and current doubts about how banks will weather a rising rate scenario have resulted a sharp de-rating in bank stock valuations from their peak of about 65 PE and 3.6 times book value (for the Nifty Bank index) to a PE of 18 and P/BV of about 2.5 times currently (Aug 11 2022). This makes for a good entry point into the Nifty Bank Index. You will find more details on its constituents and history here.
Our recommendation & how to invest
While there are several ETFs playing on this index (check Prime ETF Ratings for ETFs based on Bank Nifty), we prefer Nippon India Nifty Bank BeES (NSE ticker:BANKBEES) owing to its good track record and reasonable secondary market liquidity. Its TER is 0.19% and it enjoys very low tracking error.
You can consider investing some amount as lumpsum now and follow it up with 1-2 tranches more on market falls. Avoid SIPs in this ETF. We would not recommend high exposure to this index. You should also be aware that as a cyclical sector, this index will be subject to high volatility. Use this as a tactical entry point.