Banking Q2 Preview | All-round profit growth likely; deposits to be the differentiator

A strong core

A highlight of the recent performance of banks has been the turnaround in operating profit, mainly led by improvement in the core lending business. Net interest income growth has jumped to double digits now from single digits during the pandemic. This trend is expected to continue into the second quarter and beyond as well.

The boost to core interest income is, of course, due to the sharp rebound in loan growth to 16 percent. Part of the fillip to income is because of the rising interest rate cycle, which has led to banks hiking loan rates. So banks not only are disbursing more loans, but also getting to charge higher interest on them. Early updates by select banks on growth metrics confirm that the strong loan growth is not restricted to a few big lenders but is more widespread.

The non-interest income which was hit by mark-to-market losses may show an improvement as well, according to analysts. Bond yields have fallen during the July-September quarter, which reduces the risk of mark-to-market hit. In fact, analysts at ICICI Securities point out that some banks may write-back provisions against treasury losses. “Given the insignificant treasury knock in Q2, it should support operating profit growth across banks,” they wrote in a preview note.

The margin comfort

A rising interest rate cycle typically gives an initial boost to banks’ earnings through higher loan rates. For the July-September quarter, the 40-basis-point (bps) climb in the weighted average lending rate of banks would show on their books by way of stable to higher net interest margins.
However, the loan mix will be key to the extent of benefits the banks get. Retail-loan-heavy balance sheets would reap higher benefits as corporate loans tend to be priced aggressively. Further, loan books linked to the external benchmark-linked rate (EBLR) have had full transmission of policy rate hikes compared to loans linked to the older marginal cost-based lending rate (MCLR) regime.

Banks having a larger share of EBLR loans may show margin expansion, analysts at ICICI Securities point out. HDFC Bank, IDFC First Bank and ICICI Bank have clear advantages here. State Bank of India (SBI) and IndusInd Bank have a larger share of MCLR loans. Spreads for private banks, which were already elevated, are likely to increase further in the near term, according to Kotak analysts. That said, their deposit growth and re-pricing would be key to differentiate between banks. The deposit differentiator

While credit growth has surged, the growth in deposits hasn’t kept pace for the banking sector. Against a loan growth of 16 percent, deposits have grown just 9 percent. An incremental credit-to-deposit ratio of above 100 percent indicates that banks are offloading their investments or borrowing from the market to keep pace with the loan growth.

Banks that have a larger portion of low-cost current and savings accounts would be clear winners amid tightening liquidity. Again, large lenders such as HDFC Bank, ICICI Bank, and SBI may have an advantage over smaller lenders. Some lenders may depend on high-cost bulk deposits to raise funds. Wholesale term deposits have seen the sharpest spike in rates, point out analysts at ICICI Securities.

“Our small-sample checks indicate that competition for deposits in the market has increased in the past few months as banks look for funds to support their credit growth appetite,” according to Kotak.

In a nutshell, a broad-based loan growth driving core profitability along with steady normalisation of asset quality would support valuations. In all, the July-September quarter performance will give credence to the spectacular rally in shares of banks over the past three months.