Confluence of concerns
We initiate coverage on the Banking Sector with a long-term
Underweight and a short-term Neutral stance. We recommend
investors to use the current rally in bank stocks triggered by a surge in
bond prices to reduce overexposure to the sector.
Our negative view stems from a variety of concerns - (1) operating economics of banks
should weaken going forward, (2) asset quality should deteriorate and history tells us that
bank stocks underperform with rising deterioration, (3) bond gains should be much lower
than in the last cycle and of lesser importance vis-à-vis loan book deterioration and (4)
high market borrowing by Govt to fund the rising fiscal deficit during FY10 could prevent
bond yields from falling significantly.
Our Neutral short term view is because RBI recently bought back as well as redeemed
certain bonds due to which there is sufficient liquidity in the bond markets causing bond
prices to surge. We expect bond prices to remain strong in the short term as a result.
Bank stocks being bond proxies should remain strong in the short term.
Weakening operating economics for banks
Banks had significant pricing power during FY09 with rising NIMs. However, we see that
trend changing during FY10. In 1HFY09, banks accepted large amounts of high cost (>
9%) one year plus term deposits in a rising interest rate environment (10 yr G-sec YTMs
crossed 9%). On the other hand, since Oct 08, yields have fallen sharply (10 yr G-sec
yields at 6.4% now) causing pressure on bank to cut lending rates. Given that most loans
in the system are floating rate whereas all deposits are fixed rate, banks face interest rate
mismatch risks of loans repricing faster than deposits with immense pressure on NIMs.
Slowing credit growth and low incremental CD ratio in a low bond yield environment since
Oct 08 should also exert downward pressure on yields and NIMs. Pressure on costs has
been rising with lesser systemic CASA deposits. Also, NIMs get weaker when rates fall,
as CASA deposits do not reprice. We estimate NIMs to contract 20 bps during FY10E.
Lead indicators suggest that asset quality should deteriorate
• Outstanding bank credit to GDP ratio had been ~25% through the 1980s and 1990s
but has increased to 55% over this decade, indicating higher indebtedness;
• Past data suggests that slowdown in exports and weakness in IIP has strong
correlation to asset quality deterioration in subsequent years. With IIP and exports
slowing considerably over the past two quarters, history could repeat itself;
• Analysis of recent quarterly results of 322 non-bank high debt companies out of the
BSE-500 suggest that interest cover and Debt/ EBITDA, key metrics for measuring
debt repayment and servicing capability have weakened to 4.2x and 5.3x from 10.4x
and 2.7x respectively a year back;
Bond gains should be low and should have less significance
(1) The duration of bond books is lower, implying less gains for the same decline in rates,
(2) Bond books are not significantly higher than minimum SLR, (3) Proportion of bonds
under AFS is lower, (4) High investments in bonds during the low bond yield (high bond
price) period of 3QFY09 means lesser capital gains and (5) CD ratio is currently more
than 70%, which was much lesser in the past. Therefore, bond book has lower bearing
than the loan book on a bank’s overall value.
Worsening Govt finances and its high market borrowings
Combined fiscal deficit is expected to cross 11% of GDP during FY10. Government’s net
market borrowing for FY10 is expected to cross Rs. 3tn, net of RBI’s bond buy-back/
redemption whereas the banking system’s demand for incremental SLR is only Rs. 1.6tn
(24% of incremental liabilities). While we are yet to see a demand-supply mismatch due
to significant upfront buyback/ redemption by RBI, we believe that over the course of the
year, there could be significant strain.