indian banks part 2

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Indian Banks Part 2: Performance in 1HFYE2012SECTOR ANALYSIS: 19 DEC 2011, 7:56 PM ET

Asset quality deteriorating, especially for the Public Sector Banks, notably State

Bank of India, due to its more extensive lending to small businesses and farmers.

Impairment charges up YoY for the larger Public Sector banks; more stable or

even lower for the leading Private banks.

Some slippage seen as Restructured Loans become NPAs but most still classified as

performing.

Profitability remains good at the Private banks and moderate at the PSB's, despitethe impairment charges. The slowing Indian economy with still high inflation and

interest rates suggests credit quality will continue to weaken.

Deposit funding strong at most banks but borrowings inside and outside India still

relatively high at ICICI.

Capital ratios look adequate overall, but some banks need more common equity to

keep their Tier 1 ratios above 8% and potentially comply with Basel 3. The need for

the government to invest to maintain its shareholding in Public Sector Banks is a

constraining factor.

Relative Value

The accompanying chart tracks those major Indian banks that have reasonably actively traded

CDS. In terms of trend all the banks have moved together, rising from mid-2011 reflecting

heightened uncertainty in global financial markets and India's own vulnerabilities as a lowly

rated sovereign whose banks and corporates have been fairly active in raising offshore

borrowings. In terms of differentials the four majority government owned banks have moved in

line with each other while ICICI has consistently traded at a wider spread. As the sole private

bank in this group ICICI outperforms by some measures, including at present capital strength,

but it also has a higher reliance of borrowings, including offshore, and its public sector peers

are probably viewed as having close government links and hence a higher probability of state

support, should this be needed. There is little reason to think these relative ranking by the

credit markets will change any time soon.

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There are no differences between the senior foreign currency date ratings of the large Indian

banks as they are constrained by the low Indian sovereign rating of Baa3/BBB-/BBB-. Equity

investors, however, do differentiate them quite sharply. In general the Public Sector

banks (PSBs) have the lowest P/B ratios, notably IDBI, the former development lender that is

in the process of transforming itself into a commercial bank. The private banks have higher P/B

ratios with HDFC Bank the stand-out at 4x, well ahead of Axis at 2x while ICICI Bank's

valuation by this measure is little different from that of the large PSBs.

Performance

In Part 1 we discussed the performance of the banking system up to March 2011. In this

comment we look in more detail at the recent performance of the major Public and Private

sector banks in India.

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On average, net profitability slipped slightly in the six months to 30 September 2011 vs the

same period in 2010, but remained reasonably good. The decline was due to higher

impairment charges as underlying trends remained reasonably positive. The sharp rise in

interest rates over the past year has had differing effects on Indian banks depending on their

willingness and ability to pass on higher funding costs and the speed at which their own

funding reprices. For the group of banks we are analyzing, the NIM was slightly higher YoY as

would be expected on higher rates, especially for banks with large amounts of low-cost

"CASA" current and savings accounts. By our measure the NIM is just below 3% based ontotal average assets. It is widest for State Bank with its larger exposure to the higher risk

segments and retail-oriented HDFC Bank.

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Non-interest income accounts for around 30% of total income, mostly fees. For all the banks

the bulk of their revenues and profits are derived from their corporate banking business as

retail lending is close to 20% on average.

Cost/income ratios are not high at around 44% and costs/assets ratios average less than

1.8%.

At the level of Pre-Provision Operating profit this group of banks is earning a ROA of2.2%. Impairment charges relating to loans and investments are currently absorbing 1/3

of these, equating to 1.3% of loans on average, but as lending accounts for only 60% of

assets for the system, this translates into a manageable burden though one that has

held back net profitability. This group of banks' ROA fell slightly to 1% and the ROE to

14%. The latter figures mask a wide range of profitability, from just 10% for ICICI to 20% for

some of the PSBs. But this has to be viewed in the context of capital ratios, which are currently

very strong for ICICI and rather weak for some of the PSBs see below.

While wary of the ongoing challenges the banks we have spoken to seem to be still

confident of a reasonably good result for the full year to March 2012. This may be so as

asset quality lags the real economy and the key issue remains how far India's economywill slow.

One of the reasons for the slowdown is the stalling in business investment in the wake of the

corruption scandals associated with government contracts and the award of business licences.

Amid the furore, politicians and officials have become reluctant to make decisions for which

they may be subsequently criticized, leading to policy paralysis and uncertainties for

businesses. It has been suggested that while it may not be "back to business as usual" after

these scandals, the approach of elections in 2012 will focus the minds of politicians on the

need to end the paralysis and get the economy growing. Unfortunately, the most recent reform

measure proposed by the government, to increase efficiency in India's retail sector by reducing

restrictions on large firms, turned into a spectacular own-goal for the government which wasforced into a humiliating retreat amid opposition from vested interests and many politicians.

This does not bode well for the decisive leadership that would help India emerge more strongly

from current economic challenges.

Asset Quality

The combination of slower growth, higher inflation and high interest rates have impacted credit

quality, in particular in the small business sector and some farmers. This is affected the PSBs,

especially SBI, to a greater extent than the Private banks such as HDFC and Axis. This is also

true of ICICI whose trend in NPAs is fairly stable while lending has grown so its NPA ratio has

come down. But it has come down from a high level as ICICI is still working through the bad

debt overhang resulting from its overly enthusiastic involvement in India's own unsecured

consumer lending debacle in the mid-2000s. Since then banks have become far more cuatious

towards such lending. As can be seen from the table, loan restructuring is also a bigger issue

for the PSBs than it is for the Private banks, whose reserve coverage ratios for NPAs are

generally higher.

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The accompanying table shows the ratio of Gross NPAs to "Total Customer Assets" a

measure that includes not only loans but also some bonds and other credit instruments. This

highlights the increase in NPAs at the PSBs in the six months to September 30 and the

relative stability at the Private banks.

For the near term, however, the weakening trend in asset quality is likely to continue as

the global economic uncertainty combines with the political hiatus in India to damage

confidence and borrowers continue to struggle with high interest rates until the RBI

cuts rates once inflation starts to subside. The depreciation of the Rupee is also adding to

the pressures on Indian companies that have borrowed foreign currencies or have to pay

foreign currencies for their imputs. These pressures should be widely spread across the

system but the PSBs led by State Bank of India have a larger exposure to weaker sectors and

are suffering disproportionately. ICICI has by far the largest proportion of foreign currency

funding and lending.

th

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So far, however, we are not seeing a material negative impact on real estate values, at least

not in Mumbai where prices recovered strongly after a brief drop during the global financial

crisis.

Funding

The banks are largely funded from domestic deposits and the largest banks have been

particularly successful in attracting demand (or current accounts) and savings deposits

usually referred to as "CASA" which have the multiple advantages of being low cost and

stable.

As former development lenders, ICICI and IDBI have been striving to build up their deposit

bases, with some success. But it is notable (data as at 31 March) that borrowings account for a

larger proportion of their total funding and for ICICI borrowing outside India accounts for 17%

of its total balance sheet. ICICI has a higher proportion of lending outside India at almost 30%of the total. ICICI has slightly reduced its overseas borrowings in the first half of FYE2012 and

its overseas subsidiaries, notably in the UK, have also reduced assets and borrowings.

Management notes that its overseas lending and funding are generally well matched so that

maturing obligations could be settled with the repayment of maturing loans - assuming the

borrowers are able to generate the necessary cash or to refinance with other lenders.

Capital

As we noted in Part 1, the RBI believes Indian banks to be reasonably well capitalized under

current arrangements (they apply Basel 2, using the standardized approach for credit risk and

are working towards IRB) and to be well positioned to implement Basel 3. All the banks are

well ahead of their official regulatory requirement of Tier 1 6% and total CAR 9%, but some are

short of or not far above the de facto target of 8% Tier 1, suggesting some equity capital

raisings are needed by some of the PSBs and possibly by Private banks such as Axis. ICICI

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Send

has unusually strong capital ratios having raised a large amount of new equity in 2007 and

then not geared up as rapidly as expected. State Bank of India is in need of more common

equity but this would require the government to invest to maintain its stake and, as we noted in

Part 1, the perennial problem in India is getting the government to act in a timely manner,

especially if it involves making signficant sums of money available.One point to note is that at

the interim stage banks do not count retained earnings for the year to date so to that extent

their capital ratios at 30 September are somewhat understated.

David Marshall

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