I think Indian banking sector overall is in a very sweet spot. It is an outlier versus many other regional banking sectors. And a lot of it comes down to the last decade where it hardly saw any growth, especially of GDP. So it was a muted growth last decade, which has now put it in a nice position with respect to growth and with respect to margins as well. The rates are at somewhere midpoint of what you have seen in the last decade. So it is a very nice, comfortable spot for the sector and it should see a very healthy compounding story from here on for the next five to seven years at least.
There was this worry that there could be a bit of a margin compression as well. Is that something that you think will play out incrementally going forward or not too worried about that?
Yes, there will be margin compression. I think on a quarter-on-quarter basis, yes, I expect about 10 to 15 bps margin compression for the sector. But remember that the last year saw an extremely large margin expansion.
So some of those gains will go away and it is driven by three factors; one, you have higher rates now, which means there will be a natural migration away from low cost CASA deposits into term deposits, which increases the bank’s cost of funds.
And within the term deposits, last year saw a muted increase in the rates despite the sharp increase in benchmark rates so some of that gets priced in. So that again drives up the cost of funds. Lastly, the last quarter also saw a stabilization of the rates environment. So you did not have any benchmark rate hikes, which means that the upside on the loan pricing also becomes limited.
So yes, there will be a quarter-on-quarter compression but when you look at it year on year basis, it is still a very healthy increase. And even within the sector, there is going to be some dispersion. So the banks with higher share of retail loans and weaker deposit franchise, by which I mean banks that have to re-price CASA or maybe TDs more aggressively than others, will see a start for compression compared to banks like say an SBI, which has a higher share of MCLR loans and a much stronger deposit franchise. They might see a much lesser or maybe even a slight increase in margins on a quarter-on-quarter basis.
What is your view about the mega merger of the HDFC twins? And now that the merged entity is listed, what is your view with respect to how that is likely to pan out?
We have a positive view on the merger and we think it will be benign from a growth and profitability perspective. In other words, the bank’s trajectory of getting that 17-19% growth and near 2% ROA should not be at risk. That is more on a near term perspective and along with that I think it is great for the bank because it gives them a scale advantage which is almost permanent.
When I talk about scale advantage I am referring to their simple opex to assets ratio which will almost be 50 bps lower than that of their private sector peers and that could be a permanent advantage that the bank carries forward. I think as the deposit costs normalise that scale advantage will begin to shine and that will be a big positive for the bank.
Now, given that the outlook is that there is going to be a limited sequential improvement in profitability, is this isolated to certain types of banks or is it going to be across the board and what is the rationale?
I think sequentially yes the profitability growth would be limited, but it is at a pretty healthy level at this stage and therefore the differentiation will come down to growth eventually and there in terms of EPS growth and there I think the constraint will soon become the deposit gathering ability.
I think this is a big shift away from the last decade story where the underwriting differentiation was all that mattered so banks won or lost depending on how good their asset quality was, but now it comes back to deposits.
Now this deposit competition and the intensity probably starts a few quarters later than what we expected because the first quarter, thanks to the note bans and other stuff you had a much stronger deposit growth than what we anticipated, so the real intensity will probably pick up in the later half of the year and that is when you will start seeing differentiation in growth which then drives to differentiation in the earnings growth for these banks.
Give us a pecking order in terms of the large cap banks that you like, the midcap banks and NBFCs, which are your top ideas right now?
We think the compounding story is largely going to be similar across banks. So, you are talking about high teens compounding of the book value growth. Therefore, the rank order is largely our view on where we see a re-rating potential or the multiples being improved and in that perspective for us the rank order is HDFC Bank at the top where we see with the merger overhang gone in the next few quarters, we see a clear case for re-rating.
Second would be an Axis Bank, where it is still significantly cheaper versus peers and for a reason and as the quality of the franchise improves and bridges the gap with peers, we expect that re-rating to happen for the bank as well.
Third would be SBI amongst the larger banks for two reasons. One, once the corporate credit cycle comes back, which looks more likely to be happening in the next year or so, then SBI stands to benefit significantly versus other banks so that is one reason.
And the second is there is an overhang of capital raise which again, of course, if it goes away, can drive a significant re-rating for the bank. So, these are the top three for us where we see re-rating potential.
ICICI, I think, will continue delivering earnings growth in a very healthy manner, but limited potential for a multiple re-rating from here so that is why it becomes a fourth in our rank order. Now, at this stage with rate hikes probably done, NBFCs could be a cyclical play and so as some of the smaller banks which share the same characteristics of NBFCs in terms of being more sensitive to rates on their cost of fund side, but we think that story is going to get harder and harder as the deposit repricing happens and the margins start compressing for some of these banks.
So, you are staying away you are saying from NBFCs and midcap banks and stay with the large caps?
Yes, I would stay with the large caps for now.