Despite better valuations, public sector banks are struggling to grow

Why are the shares of public sector banks, excluding the largest lender State Bank of India (SBI), still trading at a discount to their book value, despite a phenomenal rise in shares over the past one year?

The Nifty PSU Bank index has surged 83% during the period against a more modest 28% increase in the Nifty Bank index. The private sector index raked up gains of just 18%. Placed against the 35% of the broader Nifty50, it is clear that public sector banks (PSBs) have been the driver of the gains in financial sector shares.

To start with, PSU bank shares were the most beaten down, even before the pandemic. For perspective, shares of PSU banks had already dropped nearly 30% eight months before the covid-19 pandemic rattled markets in February 2020. PSU bank stocks dropped another 45% by April. The sharp rally that has continued thereafter has made up for this loss, though not entirely. Indeed, some analysts believe that valuations do not reflect the entire optimism.

“We believe the corporate NPL (non-performing loan) cycle has bottomed out, and we expect gradual moderation in credit costs, thereby resulting in improved profitability... Thus, the current valuations of PSU banks (barring SBI) at 0.5–0.7x FY23E P/ABV (price to adjusted book value) do not fully price in the forthcoming RoE (return on equity) recovery as we project earnings to increase multifold in the coming years," wrote analysts at Motilal Oswal Financial Services Ltd in a 21 November note.

Compared with their private sector peers, government-owned lenders have succeeded in bringing down their bad loan pile. For the September quarter, the gross bad loan stock of PSU banks was down 5% from a year ago while that of private sector lenders was up roughly 8%. The National Asset Reconstruction Company Ltd (NARCL) is expected to lighten this load further, giving a boost to earnings per share for public sector banks lenders. With provisioning levels already high, the prospect of carving out huge chunks of profit towards bad loans is low in the coming quarters. The upshot is that PSU banks may show a healthy streak of growth in quarterly profits.

However, perhaps there is a more discerning reason for public sector lenders to still be out of favour in terms of valuation. Despite the fall in bad loans, nearly 9% of the total loan book of public sector banks is non-performing as of September.

More importantly, PSU banks are still starved for balance sheet growth. For the September quarter, public sector lenders, excluding SBI, reported a contraction in their loan book at the aggregate level. Private sector banks, on the other hand, saw their advances grow at a brisk pace of 10%. While management commentary suggests that loan growth may leap in the second half of FY22, it would be a stretch to expect double digit growth.

The growth picture is more precarious when seen over the last decade. Public sector lenders have lost loan market share hand over fist to their private sector peers. Their share (including SBI) is down to 56% in FY21 from 75% in FY11. Much of this can be attributed to the bad loan cycle that is now on the downside. While mergers have fortified their balance sheet to lend, their capital ratios are nowhere close to that of private sector peers.

Now with NPLs coming down, analysts expect growth to accelerate. However, this depends on how fast demand for credit from companies increases. Here, the signs are not as good as they are portrayed. Analysts at Emkay Global Financial Services Ltd expect loan growth to be sluggish.

“We trim our systemic credit growth estimates to 8% from 9% for FY22, factoring in the impact of continued sluggishness in corporate credit on PSBs and a few large banks," they said in a 17 November note. Until balance sheet growth is closer to double digits, PSU banks may find it hard to demand their book value.