Banking sector: Limited upside

RBI’s recent stress tests show while banks seem reasonably resilient, profitability may be affected.

Rising interest rates, sticky inflation and flagging competitiveness of the corporate sector are taking a toll on Indian banks. Since May this year, banking stocks have traded sideways for a variety of reasons. The first quarter results indicate that policy tightening has adversely affected credit growth, with banks curbing their exposure to several sectors. Even as many believe that inflation and interest rates are close to their peaks, analysts believe earnings could well remain under pressure on lower margins and rising non-performing loans.

The Reserve Bank of India’s Financial Stability Report, released in June, says: “A series of stress testing in respect of credit, liquidity and interest rate risks showed that banks remained reasonably resilient though their profitability could be affected significantly. Under severe stress scenarios, banks may face liquidity constraints. Banks need to remain vigilant to the headwinds from the prevailing inflation and interest rate situation which may affect their asset quality as changes in interest rate were found to have the most significant (negative) impact on slippage ratio of the banks.”

In order to avoid risks, banks are shrinking loan books, which is indicative of lower loan growth rate of 18 per cent to 20 per cent, compared to last year’s 21 per cent. Most banks will also find it difficult to maintain net interest margin levels of December 2010, which are slated to decline by 50-100 basis points. Combined with these operational issues, the investment portfolio of most banks are also not yielding gains and lack of treasury gains will lead to muted profit growth in 2011-12.

According to an analysis done by Goldman Sachs, the financial sector displays a high correlation with inflation, interest rates, GDP and IIP. Past trends show that banking stocks tend to peak/bottom four-six months ahead of inflation levels peaking/ bottoming. While investor holdings in the banking sector remain high, current valuations are not at their peak compared to the previous cycle, and hence the Street is not expecting a sharp adjustment. However, since earnings and credit growth will remain under pressure, Goldman Sachs expects stocks to trade in a narrow range.

While the sector is not overvalued, select sector defensives, some private bank stocks are trading at expensive valuations, claim analysts. Despite expensive valuations the market has a bias towards such stocks as they are better equipped to handle spreads compared to their PSU counterparts.