A virtuous cycle playing out
Lenders got hit with a lot of uncertainty in 2020 which continued through FY21. It is only after the emergence of common knowledge that COVID related dislocations and lockdowns were surely past us that the sector started recovering from the doldrums. As the environment started tending towards normalcy, banks saw a gush of low cost deposits through FY22. The base for a healthy credit environment was finally set with many factors coming together – the current level of GNPA and NNPA is the best we have seen since 2015 in India. Now as interest rates are set to peak out, the bogey of MTM hit to bond portfolios too should soon be behind us.
Almost every lender out there has been printing healthy credit growth for FY23, the common trend is that deposit growth has lagged this but this is to be expected after 2 years of healthy deposit growth for the overall system. While banks continue to provision as per historical GNPA trends, recoveries and upgrades have been keeping credit cost well below the guidance for most banks. The best confirmation of the management view on the credit environment comes from their actions – some of the biggest banks in the country have been opening branches aggressively and guiding for higher Cost to Income over the next 12 months. Lenders usually tend to embark on aggressive expansion in two scenarios – either when they believe they are in a favorable credit environment for the next 2-3 years or when we are closer to the peak of a good cycle when the management starts getting affected by FOMO.
So which one is it right now?
All indications point to the first scenario rather than the second one. Large banks have been proactively creating contingency provisions, knowing well that they can afford to do so right now. ICICI Bank and Axis Bank are sitting on such provisions to the extent of 1% of their assets, this bucket can easily keep the growth momentum going for a few quarters even if the asset quality suddenly turns foul in any of their lending pockets. Predictably, the best banks (in the sense of capital market perception) have been the worst performing stocks for the past 2-3 years. In a benign credit cost environment (in the words of HDFC Bank management), it is tier 2 lenders who see the best delta on asset quality, earnings and stock market returns.
Summarizing common trends from Q4 investor calls –
- Every lender aggressively went after home loans and mortgages in FY21 and FY22, to the extent that pricing became very competitive and the spreads bare minimum. Now the rush is for gold loans, microfinance loans, digital loans to the SME segment, credit cards & personal loans
- In a rising rate environment, capital market prices in yield movement immediately while banks take time to reprice deposits. Loans however get repriced for new rates almost immediately. The analyst community has hence been calling for peaking out of NIM’s as the deposit book of banks gets repriced for peak rates through FY24. Increasing the yield on advances without increasing the risk in asset quality is neither prudent not possible beyond a point
- Coming off the lows of COVID, tax collection in India is only getting better. GST and Income tax collections continue to be on a secular upward trend, digitization of this scale tends to make credit underwriting more reliable and easier. Lenders will only increase their tech & digital spends in this endeavor, leading banks are already spending 8-9% of overall operating expenses on Tech
- Cost to Income will take a hit when new branches are opened, bank branches typically take 2-3 years to breakeven. Predictably the market is willing to take this at face value when it comes from HDFC Bank but wasn’t willing to believe IDFC FB management when they were shouting their throats hoarse on this 2 years ago
- The trend of recoveries and upgrades might continue to stay healthy and keep quarterly provisioning low through FY24
- Customer acquisition through digital channels will only pick up pace, cross selling though will happen through branches and relationship managers. A fast growing wealth management franchise remains one of the best indicators that a bank is able to tap into the affluent segment. Citi was the pioneer at this in India, they started wealth management when nobody even knew what it was
- While the environment for wholesale lending is far better than it was 5 years ago, pricing there is still not lucrative for banks as the power balance is still in favor of large corporations. This may change only if private capex picks up pace as expected, then corporate lending can be done at scale and at healthy spreads – this can increase earnings delta for corporate banks massively as the cost structure is more favorable in this pocket
- Every bank wants to build a granular retail liabilities franchise and a healthy retail asset book but this calls for upfront investments in people, processes and technology. Whether one issues 2 lakh cards of 20 lakh cards, the technology infrastructure needed is the same though there are volume linked costs
In terms of our preference, we continue to look only at reasonably priced banks relative to their business strength. Price/Book is high for some banks for a reason and low for a few others for good reasons. Price to Book can never be a firm, tangible assessment of the attractiveness of a bank. We believe that a few banks outside of the Big 5 can see a non linear expansion in earnings through FY24, operating leverage can significantly move the needle on earnings for banks once the business scales up beyond the breakeven point for a retail franchise. In a benign credit cost environment the market cares more about growth than about risk management. Once the tide turns the market cares only about risk management and starts to worry about balance sheets.
We believe it is time to sit tight with investments that have already been made into lenders, now is the time to reap the benefits of staying patient through FY21 and a good part of FY22. It is also a good time to study emerging business models and understand the trends & risks that can shape banking for the next decade to come. We believe there are risks in the new lending book (yet to be seasoned) that banks have built post 2020, they will get revealed at some point of time as the credit cycle matures. In the quest for growth, accidents tend to happen for lenders; the only questions are when and to what extent.
At the right time we would prefer to switch to the more safer, proven lenders but we believe there is still some time to go for that. We would not be surprised if NBFCs & MFI deliver better returns compared to banks but buying into single segment, geographically concentrated lenders isn’t something we wish to do even if the expected return is high. We do track Bajaj Finance and Chola Investments even if they aren’t represented in the attached tracker.