With the world’s two top global rating agencies having divergent views about the Indian banking industry, investors in this sector are bound to get confused. Just a day after Moody’s Investors Service downgraded its outlook on India’s 64 trillion banking sector from stable to negative, rival rater Standard and Poor’s (S&P) raised its assessment on the Indian banking system by one notch to group 5 from group 6. Its banking industry country risk assessment (Bicra) is scored on a scale of 1 to 10, with 1 representing the lowest-risk banking systems. So which rating agency do you believe? Should you invest in banking stocks? Questions such as these would be paramount in the minds of investors looking for an opportunity in this sector. However, rating is not the only criterion to look at when assessing a sector. Look at parameters specific to that sector as well. For instance, if you were to analyse the performance of oil and gas sector, you would need to look at the refining margin, among other things, for the sector. It is essential that you consider some variables when assessing the banking sector, too.


What may not work

Non-performing assets: In its bid to control inflation, the banking regulator, Reserve Bank of India (RBI), has raised policy rates by 525 basis points (bps) since March 2010. One basis point is one-hundredth of a percentage point.

With the hike in key policy rates—the rate at which RBI lends to the bank (repo) and the rate at which RBI accepts deposits from the bank (reverse repo)—loans have become dearer by 300-400 bps.

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This, in turn, has resulted into a sharp increase in the level of non-performing assets (NPA). Loans on which a customer—individual or institutional—stops paying dues to the bank comprise NPAs. At the end of the second quarter, the total NPAs of 37 listed banks put together stands at 1.06 trillion compared with 79,078 crore in the corresponding period last year, a rise of close to 32%.

Led by State Bank of India (SBI), the country’s largest lender, most government-owned banks have reported a sharp increase in NPAs. For the second quarter ended 30 September, SBI reported a 46% rise in NPAs to 33,946 crore. Similarly, during the second quarter of 2011-12, Punjab National Bank, the second largest government-owned bank, reported a jump of 29% in its bad loans to 5,150 crore. In terms of businesses, government-owned banks account for close to 70% of the overall banking industry. Even some private sector banks, including largest private sector bank ICICI Bank Ltd, has reported a rise in NPAs.

Also See | The banking story (PDF)

And if rates continue to remain high, given a slowing economy, the level of bad loans is expected to rise further. “If the economy slows down, there would definitely be stress on the asset of the banks. Project execution would get delayed and that in turn would result in delayed payments, rise in restructuring or may even result in higher NPAs," says S.C. Sinha, executive director, Oriental Bank of Commerce.

In fact, this is the main reason why Moody’s has downgraded the Indian banking system to negative. Agrees Shanu Goel, head (research), Bonanza Portfolio Ltd, a broking house, “Due to rising interest rates and slowing economy, bad loans may continue to increase even during the next few quarters and hence we have a negative outlook on the banking sector at the moment."

Pressure on margins: Regardless of the sharp increase in bad loans, most of the banks have managed to maintain their net interest margin (NIM). NIM is the difference between the interest banks receive on their advances and the interest they pay to depositors. Higher the NIM, the better it is for the banks.

In fact, some banks have reported a sharp increase in their NIMs. During the second quarter, SBI reported NIM of 3.79% compared with 3.43% a year ago. Incidentally, this is SBI’s highest NIM ever.

But whether banks will be able to maintain high NIMs remains a question. With the deregulation of savings bank deposit rates, it is expected that banks would pay higher interest to depositors. Savings deposit accounts for roughly 25% of the overall deposits and paying higher interest on the same may affect their NIM adversely. Says Jagannadham Thunuguntla, strategist and head of research, SMC Global Securities Ltd, a New Delhi-based brokerage firm, “Banks are likely to increase interest on savings bank accounts sooner or later and since they are in no position to pass on the increased cost to customers as it would lead to higher NPAs, their NIMs would be under pressure."

According to a research report by SMC, as on 31 March 2011, the total savings account bank balance in the entire banking system was 14.46 trillion. Assuming that the interest on savings bank go up by 1%, all the banks put together would be required to pay an additional 14,469 crore to customers. Apart from savings rate, there are other issues. The SMC report points out that the total profit before tax during FY11 of all banks put together is 1,12,612 crore. Hence, the additional interest burden would reduce the profitability of the banking sector by 12.85%.

Even K. C. Chakrabarty, deputy governor, RBI, while speaking at Bancon 2011, the annual bankers’ conference, hinted that NIMs of some banks would be under pressure due to savings rate deregulation. “It is possible that it may temporarily affect banks’ net interest margins, especially in the case of the high Casa (current and savings account) banks," said Chakrabarty.

However, some experts believe that banks would not increase interest rate on savings bank deposits immediately. “The possibility of revising interest rate on savings at present is remote but if credit offtake increases, banks may increase rates to meet enhanced demand," says Sinha.

Any drop in NIMs will hit the profitability of banks and thereby their stocks.

Economic situation: In its annual policy statement as well as in its first quarter review in July, RBI projected a gross domestic product (GDP) growth of 8% for the current fiscal. However, amid hardening interest rate and weakened global economic situation, the Indian economy, too, is showing signs of a slowdown. The Index of Industrial Production for September has fallen to 1.90% from 4.04% in August. Considering these and other factors such as gloomy global economic situation, the apex bank revised the projected growth downwards to 7.6% in the second quarter monetary policy review.

“A prolonged slowdown in advanced economies would also weaken the growth prospects of emerging market economies," said RBI in its recent quarterly review.

In its September 2011 World Economic Outlook, the International Monetary Fund scaled down its projection for world GDP growth to 4% for both 2011 and 2012 from its earlier (June) projections of 4.3% and 4.5%, respectively.

While on one hand the slowing economy may lead to higher NPAs, on the other it would mean slower credit growth than what was expected earlier. “Credit demand is showing signs of slowdown but we need to wait for some more time to assess whether banks would meet the projected 18% credit growth as was anticipated earlier," says Arun Kaul, chairman and managing director, UCO Bank.

Slowdown in economy as well as credit growth does not augur well for banks.

What may work

Inflation and interest rate: Despite a sharp increase in policy rates, the monthly inflation for the last few months has continued to be in double digits, which is above the RBI projection of 7% for the current fiscal.

“It is likely that RBI may pause the interest rate hike spree now but an immediate reduction in policy rates is unlikely as inflation continues to remain high," says A.K. Gupta, executive director, Canara Bank. Putting a brake on the interest rate hike cycle may prove to be a big relief for banks.

Recent regulations: Even as banks were expanding their credit at a fast pace, the regulator was keenly watching the developments. And it has taken steps to ensure there is no systemic risk in the banking system.

In the recent past, RBI has increased provisioning requirement for banks in case of teaser loans and for exposure in the real estate sector, among others. When provisioning is increased, banks have to set aside more capital and that hampers the ability of banks to lend. Generally, the regulator increases provisioning for sectors that are considered risky so as to deter banks from lending to those sectors.

This are the primary reasons why S&P has upgraded the Indian banking system despite dismal economic situation and increasing bad loans. The rating agency has noted that regulation in India is in tune with global standards. This signifies that the banking sector may be up and running as soon as the world and domestic economies are back on track and the present is just a passing phase. If India’s GDP is to continue to grow at 7-8%, then the banking sector must perform.

Should you buy now?

Undoubtedly the banking industry is passing through a rough patch. Bad loans are increasing, the economy is slowing down and credit growth may remain weak. Returns from banking stocks may not be great at present and may even be negative in the short term.

But for the long term, it may be a good time to invest since the sector is not facing any systemic risk and regulations are in tune with international standards.

Since most of the news is already priced in, valuations are looking attractive. With the belief that good news will take time to come, these low prices can continue for a while.

“The economy is slowing down and hence RBI may pause. But at the same time, inflation continues to remain high and if there is further spike, RBI may continue its tightening policy. In crux, how the interest rate cycle pans out is uncertain and so would be the movement in banking stocks. But if country has to grow 7-8% in the future, banking sector would have to grow by 20%. Thus for long-term investors, the time is perfect to take exposure to banking stocks," says Kaushik Dani, head (equity), Peerless Funds Management Co. Ltd.

Since there could be some more downside left, it is better to invest through systematic investment plans rather than putting in a lump sum.


PDF by Sandeep Bhatnagar/Mint