Will the sun rise on PSU banks’ return on assets?

banking_300_18317470

India’s public sector banks (PSBs) have been a sinkhole for capital in the past decade, with negative return on asset (RoA) ratios that spoke volumes about their balance sheets. RoA is a metric through which investors can assess how efficiently a firm uses its capital to generate returns.

Starting FY23, the government-owned lenders may finally see the end of the tunnel in terms of the returns they can squeeze out of every rupee of capital invested. For this, lenders would need to power up their loan growth. Bringing down the costs won’t be a problem as provisioning needs have come down. That said, it won’t be easy for these banks to shed their dark days.
PSBs began the 2010-2020 decade with artificially propped up profitability metrics, thanks to a string of forbearance that veiled their balance sheets from India’s crumbling infrastructure lending story. That veil was torn by the regulator as it ended forbearance and forced lenders to come clean on the health of their loan book.

At the end of FY18, the toxic loan pile of PSBs stood at an unprecedented Rs 6.7 lakh crore, six times the stock as of FY13. Provisions soared and resulted in PSBs reporting a whopping Rs 80,000 crore loss on an aggregate basis for Q4FY18 alone. Mergers among PSBs pushed by the government in 2019 as a solution have resulted in somewhat fortified balance sheets.

Even so, PSBs have been losing money rather than earning on their capital simply because of the long-drawn credit cycle where they paid high credit costs due to delinquent loans. In FY20, seven PSBs reported negative RoAs. Of these, four had reported negative RoA for five straight years.

But FY21 and FY22 have been very different for banks in terms of profitability. Amid a pandemic that threatened their core income, PSBs reported one of their best performances. That is because of proactive provisioning against legacy bad assets and aggressive write-offs.

The pandemic only increased the intensity of provisioning among banks. That has paid off with the aggregate net profit of the PSB cohort coming in at Rs 17,666 crore for Q4FY22.

Analysts believe that starting FY23, PSBs would show steady improvement in their RoAs. “Despite lower capital levels, PSB ROEs are still sub-par and below cost of equity. The key drag is from lower NIMs and higher credit costs—likely to improve from FY23 as both improve,” analysts at Bofa Securities India wrote in a note.

Finding loan growth won’t be a challenge as the economic recovery is gaining traction. Bankers have indicated that private capex is looking up, which would increase loan demand. Most PSBs have indicated double-digit loan growth of 10 percent and above for FY23.

While retail loan growth would continue to be the focus, banks would have it easy to grab corporate loan demand. One early sign of this is the increase in their weighted share in credit disbursements to 43 percent during FY22 from a low of 27 percent three years ago.

The research wing of SBI pointed out in a report last month that PSBs have been chipping away at private sector banks’ share in lending. “In the past, whenever credit growth turns the corner and jumps from single digit to double-digit, the share of PVBs (private sector banks) has always jumped commensurately,” the report said. “However, the latest trends indicate that PSBs have been continuously chipping away on the back of a robust asset quality and also some of the credit initiatives that were launched during the pandemic,” it added.

PSBs have been at the forefront of lending to projects, especially infrastructure in the past. Lenders are likely to repeat the performance, perhaps with lessons learnt in the previous cycle.

What is unclear is the rising interest rate cycle’s impact on margins. Analysts at Kotak Institutional Equities warn that it would be difficult for banks to show significant improvement in margins even though the interest rate cycle has turned upwards.

“We believe that spread expansion is quite limited from current levels. Banks need to move down the risk curve either through changes to loan mix, borrower segment, or duration, to maintain spreads at these levels,” they said in a report dated April 16.

Indeed, spreads widened during the pandemic when policy rates were slashed, indicating that banks didn’t pass on the benefits of the low cost of funds entirely to borrowers. Analysts see these spreads narrowing now as deposit rates could move up.

That said, a possible cushion is the fall in credit costs. Simply put, the amount banks lose due to delinquencies could come down, which in turn, would support margins even if they don’t get the bang for every buck they lend.

The upshot is that PSB shares are ripe for rerating, though not all would be equally treated by investors. Analysts still prefer only SBI and Bank of Baroda among PSU bank stocks. Others are still trading at deep discounts to their already eroded book value. While the sun may rise for PSBs, the light may not touch every bank.