The banking sector is the largest sector in the Nifty 50 with a one third weight. The sector’s stock market returns have disappointed investors by lagging the Nifty 50 in the last five years, which is unusual in a bull market.
To put this underperformance in numbers, take a look at the returns table below.
It is NOT that the sector posted poor financial results or that it did not have individual winners. But market-beating returns came from pockets outside the conventional banking favorites.
- There was significant underperformance of favorites like HDFC Bank, Kotak Bank and IndusInd Bank, which have a combined weight of 42% in the Nifty Bank index
- Corporate focused private banks like ICICI Bank and Axis Bank came back into favour
- There was a shift in market preference in the aftermath of Covid leading to value stocks out-performing growth stocks
However, as things stand today, the banking sector is one pocket where the equation between valuations and fundamentals is very balanced, resulting in opportunities for investors.
The representative sample of seven banks that we have taken up for this results review are quoting at a price to book and PE ratio of 1.6 times and 11 times respectively. This is at less than half of the price to book and PE multiple of 3.6 times and 22.5 times for the Nifty 50. This discount is not deserved, given the financial performance of banks.
Let’s now look into their earnings performance to see why the sector hasn’t fired up and what lies ahead.
We have taken seven banks for this analysis, representing large and mid-sized banks from both the private as well as public sector. This result update does not touch on small finance banks.
Financial Performance
Let’s start with understanding the key numbers for the half year ending September 2024 (H1FY25).
H1FY25 results
(All numbers in Rs. Crore unless specified otherwise)
Core income growth, as reflected in Net Interest Income (NII) growth, has slowed down to single digits for most banks, moderating (Pre-provision operating profit) PPoP and PAT growth in H1FY25.
Barring the other income boost for SBI and Axis in Q2FY25, core income growth as well as PAT growth slowed down. ICICI remains an outlier with PPoP as well as PAT growing at ~15% while Indusind has thrown a big negative surprise as NPA provisions spiked.
This deceleration in core income growth is happening following 3 years of healthy growth as shown below.
The outperformance of some of the private bank and PSU bank stocks can be gauged from their humungous PAT growth, as seen in the table above. The sharp fall in provisions was one of the key drivers of PAT growth, as NPAs dropped (as shown in the graph below) while core income growth remained healthy.
Let’s now decode the drivers and drags on earnings.
Drivers and drags
The core driver of earnings growth in H1FY25 is credit growth, which is still in the double digits. Barring HDFC Bank, most of the banks have reported advances growth in the range of 10-15% in H1FY25, with Canara and Axis at the lower end and others at the upper end.
Despite this double-digit credit growth, the core income (NII and PPoP) of the banks grew only in single digits on account of the following drags.
#1 Compression in NIM
One of the key factors leading to weaker NII growth was the Net Interest Margin (NIM) compression led by the rising cost of deposits.
To give a background as to why this is happening now, the RBI increased interest rates by 250 basis points (2.5%) between May 2022 and February 2023. As 35-40% of the loan books of banks are now linked to repo rates on pricing, the banks immediately passed on the burden to borrowers and benefited from NIM expansion in this period.
But soon, an increase in deposit rates followed. With deposit rates catching up with lending rates, NIMs came under pressure. The repricing of deposits is just getting completed. Meanwhile, competition for deposits as credit growth ran ahead of deposit growth added to woes. All this led to NIM compression over the last few quarters. The chart below shows how NIMs have trended.
As it stands now, the deposit rate repricing is reaching its end and deposit rates have plateaued or even started to come down. But a rate cut at this point could delay any expansion in NIMs, unless deposit rates drop further.
For banks like ICICI and Axis, their increased focus on retail lending has led to structural expansion in NIMs and so it may not fall back to earlier levels. Their NIMs would get impacted if they decide to tweak their Corporate:Retail loan mix in the evolving scenario.
#2 Credit costs are rising
Credit costs are the net loan write-offs that banks have to take up after loan recoveries, if any. One of the key drivers of accelerated earnings growth in the last 3 years for majority of the banks has been falling NPAs, which have lowered credit costs.
That scenario, however, is changing. Bad loan problems are cropping up in select pockets now. NBFCs and banks operating in unsecured retail loans, credit cards and microfinance are seeing a spike in delinquencies in the latest quarter.
In the past, prime customers were the main focus for banks with their salary, savings and current accounts acting as a gateway to service their loan needs. But the last few years of digital revolution has changed the landscape with digital lenders ushering sub-prime borrowers also into the system.
While banks now have the means to assess the cash flows of such borrowers, over-leveraging where borrowers take on multiple loans using the same credentials has emerged a problem. Exposures of the large private banks and PSU banks to such borrowers is small.
But still, private banks such as HDFC, Kotak and IndusInd reported a marginal spike in NPAs in Q2 FY25.
Another example of stress can be seen in credit cards. For SBI Cards, increased credit costs affected profitability in Q2FY25, with credit cost (impairment losses and bad debts) climbing by 63% year-on-year and 10% quarter-on-quarter. It has been witnessing worsening asset quality over the last four quarters with Gross and Net NPAs spiking from 2.43% and 0.89% respectively in Q2FY24 to 3.27% and 1.19% respectively at the end of Q2FY25. Other banks’ credit card divisions (which are not separately reported) may have also seen similar stress.
To highlight specific banks where credit costs are posing a problem, consider IDFC First and IndusInd. For these two banks, the micro finance book caused provisions to spike and took a toll on their profitability. RBL took a hit on both credit cards and micro finance loans.
While many PSUs so far have continued to improve their asset quality through H1FY25, it is likely that credit costs may eventually rise for these as well.
#3 Regulatory brakes
Apart from returning credit costs in a few pockets, the regulator applying the brakes on credit growth in a few segments have also turned headwinds for banks. The banks were flush with liquidity in the aftermath of Covid to push growth. But as liquidity started to unwind and deposit costs started to rise, the credit to deposit ratio also started to rise.
Meanwhile the HDFC-HDFC bank merger and competitive deposit mobilization scenario made the regulator view tightening credit-deposit ratios as a risk factor. RBI’s inspections of specific banks and digital lenders revealed problems of evergreening and borrower overlaps in the case of unsecured loans.
Apart from cracking down on specific banks to curb such practices, RBI also raised risk weights on consumer and credit card loans, apart from banks’ lending to NBFCs with unsecured loan exposure in November 2023.
Its recent action against a large micro-finance institution (MFI) and few NBFCs raise further concerns around this segment of unsecured credit. Forced to make higher provisions and stop the conventional practice of rolling over loans, MFIs and Small Finance Banks (SFB) with MFI exposure have reported a collapse in net profits in Q2FY25. ESAF SFB has reported a net loss of Rs.190 crore in Q2FY25 Vs a net profit of Rs.140 crore in Q2FY24 while Equitas SFB saw its net profit plummeting 93% on higher provisioning for its micro finance exposure.
Furthermore, the regulator is also considering higher upfront provisions for project loans and increased liquidity coverage ratios to make up for higher deposit volatility caused by online banking. These factors have led to markets turning wary of high-growth banks and NBFCs, for the fear that growth in itself can invite regulatory actions.
A combination of these factors discussed above is taking a toll on the growth and valuation of banks. However, the impact of these factors is material only for a few banks such as IndusInd, IDFC First or RBL.
What lies ahead?
The cyclical recovery in the banking sector began in the later part of 2019 when asset quality issues peaked. While Covid acted as a stress test, banks came out strongly after that and posted stellar growth between FY21 and FY24.
Currently, bank balance sheets are healthy, and the Tier 1 (Equity) capital adequacy of all major banks are well above 14% (barring SBI at 11.5%). The asset quality of the banks is also the best in the last 14 years. This places them in a good position to tap markets to raise funds for growth.
This suggests that the banking sector is now going through temporary headwinds, including the regulatory overhang, which look likely to abate over the next year.
- The NIM compression is transitory while the credit cost may not be a major concern for secured lenders and larger banks. It is unlikely that the spill-over effects of unsecured credit will haunt the banking system or top banks in terms of asset quality. There could be growth moderation in terms of NBFC credit exposures, co-lending exposures, personal loans, and so on following the curbs on disbursements.
- The category of banks susceptible to a major shake-up at this point is small finance banks (SFB) where the exposure to the troubled micro finance segment is very high. Outside these, it could be a passing phase for the sector and earnings prospects could turn brighter with pick up in credit growth and as headwinds on margins fade.
- In the last decade, bank credit was not driving capital formation due to corporate de-leveraging. Even the recent capex boom was driven by the government. The banking system is still awaiting private capex take-off in a major way and that could act as a driver of the next leg of credit growth.
Here’s how bank valuations stack up now:
Note: Standalone price to book value after deducting value of subsidiaries, rough estimates.
These valuations already discount any negatives in terms of lower growth, further margin compression, a marginal spike in credit costs and the resulting impact on profitability. This makes the risk-reward quite favorable for investors now. For investors who are eyeing this sector, it is advisable to go for the top private and public sector banks in the current scenario for following reasons:
- Healthy mix of corporate, secured and unsecured book and ability to tweak the mix
- Smaller hit likely on unsecured book due to prime customer base, in the event of unsecured credit risks worsening
- Marginal exposure to the troubled micro finance sector
- Healthy capital adequacy and return ratios
- Valuations not high for the safety and quality they offer
Please see Prime Stocks for our recommendations from the banking sector, including ETFs for a diversified exposure.
