Banking stocks safest investment option at the moment

Banking stocks safest investment option at the moment

The banking sector may not be the hot spot to be in right now, but watch out for cues on when to get in.

The banking sector has been on a roll over the last couple of years, throwing up huge opportunities for wealth creation on the way.

Consider this: if had you invested Rs 1 lakh in the banking index in May 2007, your money would have grown to Rs 1.9 lakh today, a compounded annual growth rate (CAGR) of 18% compared to Rs 1.3 lakh which you would have got had you invested in the Nifty index i.e. a CAGR of 7% (see chart on performance of banks Vs nifty). During the same period, stocks like HDFC Bank and State Bank of India would have grown your wealth by 24% and 21% on a compounded basis, respectively.

As the Indian economy does well with over 8% growth in recent times, banks tend to be one of the biggest beneficiaries due to the demand for credit and the fact that market conditions are suitable for growing the loan book. In fact, post the global financial crisis of 2008 and 2009, the banking index delivered a return of 82% during May 2009 until October 2010, compared to a return of 40% delivered by the broader market.

"In 2009-2010 banking was the safest bet at a time when everyone had concerns on the market, especially on sectors like telecom due to the competitive intensity or power and real estate due to the infrastructure bottlenecks or oil and gas, which was underperforming," says Ajay Parmar, head, institutional research, Emkay Global Financial Services. This is also due to the strong credit quality of Indian banks, which made them resilient during the global crisis.

In terms of market capitalisation, banking stocks constitute about 26% of the Nifty compared to 10% at its lowest in March 2009.
During this period i.e. May 2009 until October 2010, the returns delivered by the PSU bank index were much stronger at 110%. This can be attributed to the flight to safety away from other assets into PSU bank deposits along with healthy credit growth. Further, PSU banks have a large amount of holding in longer maturity government securities and bonds which did well since the yield on the 10-year benchmark came down from 9.5% to 5.5% in March 2009, indicating a rise in the price of the bonds, leading to a higher mark-to-market profit on their investment portfolio.


However, of late, banking stocks have been beaten down due to reduced credit offtake, pressure on yields etc. which is flowing into valuations causing downgrades in this sector. Since November 2010, these stocks have delivered a negative return of 19% compared to -13% of the Nifty. The PSU Bank index has performed even worse with a negative return of 29%. With the Reserve Bank of India (RBI) raising its key policy rates by 250 basis points (a basis point is a hundredth of a percentage point) since March 2010, there has been an overall increase in the lending and deposit rates in the system.

Although a bank can generate revenue in a variety of ways including transaction fees and financial advice, the main income is through charging interest on the money it lends. It mainly profits from the difference between the average interest it pays for deposits and what it charges on loans, also known as the net interest margin (NIM).

As interest rates rise, credit growth tends to slows down due to higher borrowing costs. In fact, since the beginning of the year credit growth has moderated from 23.3% in January 2011 to 21.9% as of April 2011 and deposit growth has inched up from 16% in January 2011 to 17.90% as of April 2011. Despite this, select private sector banks are not doing badly.

Best banking stocks to invest in
"Although the results declared by banks have been a mixed bag so far. There are pressures on margins for several banks, credit growth has remained strong," says Dipen Shah, senior vice president, Kotak Securities. ICICI Bank, for instance, posted a strong loan growth at 19.4% y-o-y and 4.7% q-o-q, while margins improved from 2.6% to 2.7% partly due to premature breaking of FDs, says Shah.

Banks like HDFC Bank and Axis Bank have been able to grow profits despite the high interest rate scenario, says Rajeev Thakkar, chief executive officer, Parag Parikh Financial Advisory Services (PPFAS).

Axis Bank, for instance, posted a strong loan growth of 36% y-o-y, way ahead of its peers and maintains a guidance of 25% growth going forward. At the same time its deposits grew at 33% but the NIMs contracted by about 70 basis points. Thakkar maintains a buy on Axis Bank at the current price with a 3 year perspective. He also recommends HDFC Bank although he would wait for a lower price before investing.

However, the biggest disappointment has stemmed from the public sector behemoth SBI Bank which declared a 99% drop in profit for the quarter ended March 31, 2011 due to provisioning (an expense set aside as an allowance for bad loans) on teaser loans, providing for pension and gratuity shortfall and higher non-performing assets (NPAs) has shaken the markets.

"The bank's Q4 net interest margin fell to 3.07% v/s 3.61% in the previous quarter and the bank's pension liability provision was much higher which likely reduced book value by about Rs 125 per share", says Shah of Kotak. This could be a precursor for similar things happening in other banks, especially PSU banks, which are saddled with the same issues.

"Results declared by banks have been a mixed bag so far. There are pressures on margins of banks."
Dipen Shah
Senior Vice President, Kotak Securities
According to Parmar of Emkay Securities, banks have been cautious about their growth and the primary area of focus is to maintain NIM and quality of assets. As per their recently conducted banking conference, most banks have toned down their growth assumption for 2011-12 to 20% in loan books compared to 25-27% earlier.

"Although spreads of banks have been quite stable since the last three quarters, this is unlikely to continue, which will affect their profit growth", says Anand Shanbhag, executive director and head of research, Avendus Securities.

In 2010 and early 2011, banks benefited largely from the lag in repricing of deposits, which resulted in the NIM expansion i.e. faster rise in lending rates compared to deposit rates. "Once banks enter the later stage of the rising rate cycle the lag will end, thus affecting margins", adds Shanbhag.

A majority of loans that banks offer effectively carry floating rates so when rates are rising, these are re-priced almost immediately. On the other hand, the average cost of deposits does not change that rapidly since deposits are typically fixed until they are up for maturity.

"The cost of deposits for PSBs like Punjab National Bank and Bank of Baroda, for instance, have gone up by 20 basis points whereas the yield on loans has increased by 41 basis points", says Shanbhag.

"Increases in deposit rates have been announced in early 2011, which over the next two quarters will become applicable on deposits that mature and this will begin to cast an effect on profitablity," adds Shanbhag. Parmar agrees. "The lagged re-pricing of deposits and requirement of funds could put pressures of 20-30 bps in NIM in 2011-12", he says.

According to Thakkar, inflation and interest rates are likely to remain elevated for some time because of easy monetary and fiscal policies in developed countries, which is increasing capital flows to emerging markets, fuelling asset prices on the way. Also, supply side constraints and disruptions in commodities like oil are also contributing to the inflationary scenario. The consensus is that rates in India could go up by another 50 basis points this year before cooling off.


In its annual monetary policy, the RBI increased the provisioning on substandard assets from 10% to 15%, doubtful loans from 20% to 25% and asked banks to provide 2% on restructured loans. In this context, PSBs are negatively placed considering restructured loans form almost 5% of their total loans while private sector banks are better placed at less than 1% considering they have been providing conservatively.

According to a report by Espirito Santo Securities, restructured loans were as high as 6.5% for Punjab National Bank and 4.5% for SBI compared to 0.16% for Indusind Bank and less than 0.3% for Yes Bank and HDFC Bank. Although asset qualities of banks do not seem to be under pressure yet, most PSBs could take a hit ranging from 1-2% of their 2011-12 PAT for additional provisioning requirement.

SBI and PNB may see an impact on their profits to the extent of 4-5% considering their higher restructured loan portfolio.

According to Shah of Kotak Securities, private sector banks are better placed than PSBs as their growth rates are expected to be higher because of their focus and they provide better comfort on asset quality. "Private sector banks will have lower NPAs and may face lower slippage on restructured books", he adds.

"Inflation figures and interest rates are likely to remain elevated for some time."
Rajeev Thakkar,
CEO, Parag Parikh Financial Advisory Services
RBI has also increased the savings bank deposit rate by 50 basis points, which according to Espirito will increase the cost of deposits for large PSBs and private sector banks by 10-15 basis points and a lower 1 basis points to 5 basis points impact on deposit costs of new age private banks like Yes Bank and Indusind Bank, due to their relatively low proportion of current account-savings account (CASA) deposits (

Parmar recommends selling stocks like Canara Bank due to its low CASA and rising NPA issues. He expects SBI and Union Bank to underperform considering the changing environment for these stocks.

Shanbhag advises investors to refrain from investing into this sector as of now. "One should ideally wait for the next 2 months until there is more clarity on the macroeconomic front i.e. inflation, corporate results and any announcement from the regulator on further monetary policy tightening", he says.

For an investment horizon of more than 12 months Shanbhag recommends PSBs supported by their high-teens CAGR in earnings, even after adjusting forecasts for the likely rise in NPL provisions and staff costs.

Having said that, their underperformance over the short term is likely to continue considering NIMs for FY12 could face stress if the pace of lending rate hikes were to slow down and the debt-servicing ability of small corporates could wane. For the long term Shanbhag likes stocks like PNB due to its high return on equity (ROE) and Bank of Baroda due to its relatively low NPL ratios and higher RoE compared to peers.

Among the new private banks their top picks remain Indusind Bank and Axis Bank, which are likely to perform well.