We remain cautious on PSU banks, as we see continued asset quality stress. We think the macro turnaround is not imminent, and this should drive further worsening of the asset quality cycle, with credit costs remaining elevated in FY17e. Flagging PPOP (pre-provision operating profit) earnings limits the banks’ ability to grow out of the problem. We believe the headline valuations are attractive, but weak ROEs (return on equities) provide no support to a bull case even then. We believe SBI is relatively better off and we remain Neutral, with UW maintained on BOB and BOI.
w Asset quality not done: The accelerated recognition from the RBI’s asset quality review (AQR) is a positive for transparency, but will not trigger a turn in the cycle, in our view. Slow growth and high real rates should continue to be an overhang, so we do not see this strictly as a legacy problem. We adjust earnings accordingly, leading to deep earnings cuts (20%+) from both operating profits and provisions on legacy and incremental NPLs.
Resolution and recovery— challenging
The aggressive recognition and classification of accounts have opened the door for faster resolution and recovery of NPAs. On the positive side, promoters seem to be more willing to sell their assets than they were in the past. However, we see some significant challenges and believe that this, too, is dependent on a stronger economy/easier liquidity environment. Our worries are:
(i) Incremental NPLs that are coming through are very lumpy—for many of them, outstanding debt is well above $1 bn. Changing managements on many of these borrowers is challenging given just the sheer size of the businesses.
(ii) Another challenge is the general lack of capital in the system. Domestic liquidity has been tight for some time, making it difficult for local banks or any other player to take on fresh assets. Global liquidity is also not as supportive, especially in the form of risk capital for emerging economies.
(iii) There is a lack of market depth in the stressed asset market and most buyers are quoting low prices. There are very few buyers—partly because of factors 1 and 2 listed above but also because some of the stress is industry specific. In steel, e.g., there are very few industry players who are in a position to take over existing stressed assets; hence, they are quoting low prices.
(iv) We think the turnaround in legacy NPA recoveries will start with smaller accounts—they are generally easier to resolve. The enabling factor for that would be a return of liquidity to the real estate market—many NPAs get resolved on the basis of the value of the underlying property. However, the current property market situation is unfavourable—prices are stagnant, developer balance sheets are stretched, and unsold inventories are high.
wLow PPOP growth: We see significant headwinds to PPOP growth. (i) loan growth will remain muted, given capital constraints and risk aversion in the corporate segment, (ii) margins will stay under pressure from high NPLs, shift to low-yield and continued pressure on CASA ratios, and (iii) there is not enough leverage from cost-income, given the PSUs lag on digitisation (except SBI) and fixed costs tend to be sticky.
w We are cautious on our loan growth forecasts for PSU banks. First, capital constraints limit growth, especially in the higher RW segments. Secondly, the high levels of NPLs have created risk aversion, which could get accentuated by recent events. Thirdly, disinflation has hit core demand for corporate loans and fourth, the PSU banks are losing market share to private banks.
PSU bank margins have declined over the last few years—we do not see that recovering in the near term. The banks have been eroding CASA ratios for some time and that may not turn around soon.
PSU banks have sticky wages given the lack of flexibility in hiring. Also, investments in technology have been lagging which is why the cost efficiencies are not coming through. The smaller PSUs are caught in a negative loop—revenues are sluggish but the need to invest aggressively in technology is very high.
Cheap, but… The attractive headline valuations are offset by a few factors: (i) near-term ROEs (<10%) are in sync with the valuations, (ii) the recent RBI moves may have addressed immediate capital issues, but dilution risks are still real—the banks need to grow if operating earnings are to get momentum. There could be a trading rally if asset quality turns around, but that’s unlikely in the weak macro environment.
Reform a long-term positive: One positive is that the policy environment is moving in the right direction. The strategy seems to have all the bases covered—NPA resolution both short-and long-term and governance reform. In our view, these will yield results in the long term and probably make the next credit cycle less vicious. In the short term, however, the key trigger for the stock would be the asset quality turnaround.
Classification and provisioning
The recent AQR is an important step in the reform process. Indian banks are expected to transition to International Financial Reporting Standards (IFRS) by FY19, and timely recognition and classification under the current IRAC norms is an important step in that process. The pressure of early provisioning will also push banks into reworking their underwriting and risk management processes, as the tail risk of large defaults will not have to be considered. There is, however, some pain from lumpy recognition–balance sheet stress, heightened risk aversion and loss of leverage with borrowers.
Bank boards bureau
The bank boards bureau is an important step toward restructuring the governance structure of the banks. The objective is to professionalise the boards which, in turn, allows the managements of the banks to take operating decisions with the government playing the role of primary shareholder. The impact of this reform will take 2-3 years at least, but should ultimately professionalise the management of the banks. There is a long way to go–getting the bank holding company started, restructuring compensations structures, lateral recruitment and aggressive use of technology are the other key elements in improving the governance structures.