Rally in PSU banks set to continue; biz prospects may improve further in H2

Banks have delivered a standout performance in the July-September quarter of 2022-23 financial year (Q2FY23) despite generally lackluster results across the stock market. Within the sector, PSU banks have outperformed the private sector in terms of share price returns.
 

There are several reasons for the good banking performance. There’s been credit expansion and credit costs have remained low, due to general economic growth and low non-performing assets (NPAs).
 

The Reserve Bank of India (RBI) started hiking interest rates in May 2022 but one could argue that policy rates remain very low, or negative, compared to prevailing levels of inflation. In the early stages of a cycle of interest rate hikes, banks also generate higher net interest margins (NIMs) simply by delaying raising deposit rates. Fee based incomes have also seen higher growth rates.
 

In addition, treasury losses were much lower in Q2, or marginally positive, compared to Q1 (April-June quarter) when the commercial banking sector suffered mark-to-market losses of over Rs 10,000 crore. Most of the improvement in bank balance sheets has come in the PSUs which had weaker balance sheets.
 

If the asset quality improvement is sustained and the economic expansion continues, credit demand will also remain strong. Recent credit demand appears to be spread across a variety of corporate sectors as well as being visible in the retail segment – this is healthy.
 

Many PSU banks are traded at below 1x of their Price-Book Value (PBV) ratios, which implies plenty of room for higher valuations.

The PSU Banks Index traded at around 0.5-0.7x PBV valuations during 2020 and 2021 and the index is just about 1.7x now after a 58 per cent rise in the last 12 months. Private banks are at PBV of 2.3x. Given that key ratios such as return on equity, credit growth, credit costs, etc have improved substantially for PSUs, we’re seeing a convergence -- the differential in performance between top-tier private banks and lower-rated PSU banks is narrowing. Among PSU banks, the second-tier are outperforming market leader State Bank of India (SBI).
 

Going forward, earnings for banks could be driven by strong credit growth, potentially some more near-term NIM expansion, and lower credit costs. However, the uncertain macro and geo-political environment and higher inflation, remain two key risks with the RBI likely to continue raising rates until it can contain inflation at below its target rate.
 

Credit growth was up 5-6 per cent quarter-on-quarter (QoQ) and up by between 18-21 per cent for specific listed banks year-on-year (YoY). The entire commercial banking sector saw credit growth at 15 per cent plus. Given that most loans are at floating rates and further policy rate hikes are expected, the NIM expansion could continue through the second half of FY23 since banks will hike deposit rates with lags.

However, expenses remain high, with banks actively expanding their physical coverage and digitising operations. While banks generally maintained provision buffers, credit costs declined. Credit costs are directly related to NPAs and restructurings so this is a sign of lower NPAs. Gross NPAs are estimated to have reduced by around 70 basis points for PSUs.
 

Consensus earnings estimates and valuations have been raised by most analysts for SBI, Bank of Baroda, Union Bank, Indian Bank and Canara Bank. Punjab National Bank has a question-mark due to higher provisioning. Deposit growth is however, considerably lower than credit growth at the moment, hence banks will have to hike deposit rates going forward. Most sector analysts are bullish on the sector with a 6-12 month-perspective.