Though public sector banks look cheap, their books could get dented further by bad and restructured loans. Some private banks appear a safer bet.

Last year, no one wanted to touch them. By May, they were the market’s favourite ‘value’ picks.

In September, they were back to where they started.

That’s been the story of banking stocks in the last few months.

But despite their wild swings, with banks making up 10 per cent of the investment universe, they are hard to ignore.

So, with ‘taper’ fears behind us and the RBI telling us clearly where rates are headed (Up!), we think some banking stocks are now worth a fresh look. They aren’t the cheapest ones in the market.

Here’s how you can home in on the good buys.

Retail, for loan growth

Loan growth for banks shot up to 17 per cent (year on year) in August 2013, after a subdued growth of 13-14 per cent in the beginning of the year.

But this was mainly on account of companies borrowing more for working capital needs.

As the investment cycle remains sluggish, the sector may close 2013-14 with 13-14 per cent growth against the 16 per cent growth we saw last year. Retail housing loans and agriculture loans (owing to a good monsoon) are likely to be the fastest growing segments.

Banks with a higher exposure to these segments will fare better. Within the corporate and SME segments, banks with more exposure to working capital financing rather than project financing will see better growth.

So, who will benefit? Most private sector banks have higher exposure to retail loans than PSU banks — HDFC Bank, ICICI Bank, Axis Bank and IndusInd Bank, to name a few.

Within PSU banks, SBI, which has a strong retail focus, has not been able to keep pace with its private sector peers in terms of loan growth.

Players such as ING Vysya Bank are focused on the SME segment, and also lend close to 75-80 per cent for working capital financing, thus pointing to steady and secure growth. City Union Bank is another bank that has a similar focus. These are obviously better placed to weather any turbulence.

Low-cost deposits, a plus

Deposit growth for banks may continue to languish at the current 13 per cent through the year.

This may mean a scramble for deposits leaving little room for banks to cut the interest rates they pay.

Banks with a rising proportion of current account and savings account (CASA) deposits would be better placed to make higher margins.

Private sector banks have been able to gain market share in the CASA deposits, which will continue to give them an edge over PSU banks. For instance, ICICI Bank has significantly altered its deposit mix from 2008-09 when its CASA ratio was a mere 29 per cent.

Currently, the bank has a healthy CASA ratio of 43.2 per cent. HDFC Bank also has a strong CASA ratio of 44.7 per cent.

The other factor to consider in a tight liquidity scenario will be the ability of a bank to take up its lending rates quickly.

This will help it keep net interest margins (NIMs) intact. Even banks that rely a lot on expensive short-term deposits will manage well if they have a larger proportion of short-term loans.

City Union Bank offers a good instance of such flexibility. It has 51 per cent of its loans and investments coming from the less-than-one-year category.

This will aid margins in a tight liquidity scenario, in spite of its low CASA ratio of 16 per cent.

ING Vysya Bank and Karur Vysya Bank also have more than half their loans as well as investments in the less-than-one-year bucket. This can offset their equally large share of short-term deposits and borrowings.

With the rise in repo rate and squeeze on liquidity, lending rates will remain on an upward trend for much of 2013-14.

Most banks may see an overall margin decline of 20-25 basis points, with PSU banks likely to be worst hit.

Private banks win

Concerns about bad loans (asset quality) will remain elevated for 2013-14. In the June ending quarter there was a sharp rise in bad loans. Gross non-performing assets for the banking system, which stood at 3.4 per cent of loans in end-March 2013, had risen to 3.8 per cent by end-June 2013.

Galloping NPAs have been a bigger problem for PSU banks, with GNPAs at 4.2 per cent by end-June.

By end of March 2014, GNPAs are expected to rise to 4.4-4.5 per cent. PSU banks may bear the brunt of the rise on account of higher exposure to stressed sectors such as power, construction, textiles and metals.

There’s more. The restructured assets (loans which are rescheduled at the request of the borrower) for PSU banks have shot up from 7.1 per cent in March to 8.3 per cent in June quarter. Overall stressed loans of banks (bad loans and restructured loans combined) may hover at 10 per cent and will continue to drag earnings of PSU banks.

In this scenario, private banks which have a better GNPA (average of 1.8 per cent) and low proportion of restructured accounts (2.4 per cent of loans) appear better bets.

PSU stocks aren’t bargains

Talk of banking stocks, and many investors immediately ask if they can buy PSU banks, many of which are trading at less than half their book value. But as the above numbers suggest, PSU banks may be trading cheap for a reason.

For one, there are non-performing and restructured loans which can dent the existing ‘book value’.

In fact, after adjusting the ‘book value’ of all PSU banks for their entire NPA and a possible slippage of about 30 per cent of their restructured assets, most of them are trading pretty close to their adjusted book value. That’s not really a bargain.

For instance, Bank of Baroda has GNPA close to 3 per cent and restructured assets of 6.5 per cent of loans.

Thus, while it trades at 0.6 times its ‘book value’, after taking into account its stressed assets, the bank trades close to its adjusted book value.

Similarly, Punjab National Bank has GNPA of 4.8 per cent and a huge restructured book of 10.9 per cent. Accounting for them, the stock trades at one time its adjusted book value.

Two, the extent of leverage taken on by a bank also decides valuation (leverage is the ratio of assets to net worth). This ratio indicates how much a bank has lent out vis-à-vis the amount it has in reserve, as capital.

If leverage is high, return on equity should be commensurately high to justify the risk. This is because when a bank is highly levered, it is over-exposed and at risk in case of defaults. This should at least result in higher ROE to trade off the risks.

Here while most PSU banks have a high leverage of around 17 times, they have low ROEs of 13 per cent.

In contrast, most large private sector banks have a high ROE of 18-20 per cent but low leverage of 9-12 times.

Three, capital adequacy ratios for most PSU banks remain weak.

While the government will infuse capital into PSU banks based on need, for stocks which are trading below book value this will only dilute earnings further.

And finally, it isn’t time yet to turn gung-ho on all banking stocks.

With the cost of funds set to remain high and banks having limited ability to raise lending rates because of dull loan growth, bank stocks may trail behind the broader market in the next few months.

It appears best to stay with banks facing limited bad loan risks, strong return on assets and low leverage. On most of these counts, PSU banks lag their private sector peers and will only see a significant turnaround when the economy picks up.

radhika.merwin@thehindu.co.in

(This article was published on September 28, 2013)
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