Rising bad loans cause for concern: Morgan Stanley

ANALYST'S VIEW

Lower rates (especially wholesale) and non performing loans (NPLs) in consumer credit category are likely to be themes for the next few months. Hence we favour rate-sensitive financial entities such as HDFC, IDFC and state-owned banks- SOEs). State Bank of India is our top pick. However, we would be wary of banks with large consumer books (ICICI Bank and HDFC Bank) as we think their credit costs could increase meaningfully.

Interest rates have fallen from their peak and are likely to remain benign. Wholesale costs are down about 300 basis points from the peak, despite a recent hike in reserves by the Reserve Bank of India. At the same time, lending rates have stayed high, implying spread expansion for wholesale funded institutions.

SOE banks should also benefit as long tenure bonds are likely to remain stable. This bodes well for stock performance as the market still treats these names as bond proxies. It should also enable expansion in Net Interest Margin (NIM) as some bonds in Held to Maturity (HTM) category are currently earning negative NIMs "� and that will reduce.

Consumer credit quality is likely to weaken further "� we have already seen a spike in retail NPLs at ICICI Bank (up 106 per cent YoY in F1Q08). We expect NPLs to keep rising "� the book is significantly unseasoned (almost the entire non-mortgage retail book has been created in the last year-and-a-half) and large chunks are originated by third-party agents (almost two-thirds of all retail loans originate via this route).

The slow down in retail loan growth may drive higher NPLs "� thus keeping credit costs high for banks with large consumer books. From a structural perspective, we also like the private banks. However, their near-term performance is likely to be tepid due to credit issues.