Banking stocks: Pricing in too much

The run up in stock valuations suggests a far more favourable environment than is probably the case.

Between May and now the BSE Bankex has run up more than 32 per cent while the Sensex has gained around 18 per cent. Indeed banks seems to have enjoyed more than their fair share of gains ever since the mood in the market changed.

But even after adjusting for lower market risk and higher earnings, valuations seem somewhat stretched—in recent weeks nearly all banks have been trading higher than their historical average valuations. While the worst may be over for the economy in terms of a liquidity crisis or even weak credit growth, and while little should go wrong in the next couple of years, there are a worries on a couple of fronts.

As Deutsche Bank points out, the outlook for benchmark interest rates---generally a powerful short-term driver of banks’ valuations----is no longer benign due to large government borrowings and rising inflationary expectations. A high fiscal deficit and consequently larger borrowings and higher interest rates could, therefore, stymie loan growth. Credit is currently expected to grow at around 16-18 per cent in the current year and perhaps by a slightly higher 19-20 per cent next year if the economy revives.

While this is an increase, it’s not enough to justify the expansion in banks’ multiples---the increase high-yielding consumer assets will be moderate and also with better access to capital markets companies will be able to made do with moderated amounts from banks. Certainly a credit off take of 25 per cent or thereabouts don’t seem likely in the near future.

Moreover, net interest margins will remain weak since banks have been lending at lower rates ahead of cuts in deposit rates and the benefit of lower borrowing rates will come in with a lag. Most important, non-performing loans (npls) will rise ---the recent restructuring numbers put out by State Bank of India (SBI) were higher than expected at close to 4 per cent of the loan book if pending applications are considered. In short as Citigroup says, there is a reasonably favourable banking market in place but the step up is only moderate relative to where it was a quarter ago and is not as dramatic as the market would suggest.