Credit offtake in the system has picked up at the onset of the festive season as we had expected. During the first half, the industry achieved around 35% of the total expected credit offtake for the year (assuming 20% credit growth for FY11). We expect credit growth to improve in the second half of FY11 as busy season has kicked in; sharp increase in short-term rates has led to non-availability of alternative cheaper sources of funds and increase in commodity prices should lead to higher demand for working capital loans.

However, on a full-year basis, the credit growth could be a tad below the Reserve Bank of India target, given that the credit offtake is not yet broad-based (one-third of the incremental credit offtake in the first half of FY11 is from the infrastructure sector).

Graphic: Yogesh Kumar/Mint

Margins may see pressure: Most banks witnessed margin expansion during the second quarter of FY11 on the back of increased prime lending rates coupled with healthy current account and savings account accretion for most banks. However, margins are likely to witness some pressure on account of the recent increase in the deposit cost reflecting into margins with a lag, coupled with higher term deposit rates, resulting into conversion of some low-cost savings bank deposits into term deposits in the coming quarters. While the recent increase in lending rates by certain banks provides some margin respite, banks which benefited unduly (Oriental Bank of Commerce, Andhra Bank and Corporation Bank) on account of sharp decline in wholesale rates could get impacted in a rising interest rate cycle.

Pension liabilities: Based on our estimates, pension costs (arising from second pension option plus increase in existing pension after wage hike) are likely to be around 20-22% of estimated FY11 networth for banks expected to be provided through profit and loss over the next five years. This would translate into nearly 15-17% of profit before tax annually.

While the pension liabilities are likely to act as a drag on the earnings growth, in our view, banks with a large employee base and relatively weak earnings quality, reflected in lower employee productivity, are likely to be impacted more than others (Central Bank of India, United Bank of India, Vijaya Bank and Bank of Maharashtra among others).

While the markets are already factoring in the same, we believe upside risks persist, which could adversely affect earnings.

Asset quality: In our view, public sector banks remain more vulnerable to slippages from the restructured portfolio (average restructured book is at 4.8%), thereby, putting pressure on asset quality. On the other hand, private sector banks seem to be relatively well placed with slippages from retail portfolio nearly peaking out and lower restructured book. However, the recent developments in the microfinance and telecom industry do pose a threat of higher slippages, which could impact earnings growth in the second half of FY11.

Outlook and valuations: In the past one month, Bankex (8% returns) has underperformed Sensex (2% returns). We expected correction in banking stocks due to a negative impact of pension liabilities, deposit rate increase and other reasons but not due to microfinance and telecom exposure related issues. However, the impact of the above mentioned factors will start reflecting in banks’ numbers over the second half of FY11. Actual pension liability could surprise the markets on the upside and, hence, negatively impact state-owned banks only.

Edited excerpts from a report by Prabhudas Lilladher. Your comments are welcome at