Exclusive Interview | Bad bank a step in the right direction, says Morgan Stanley’s Sumeet Kariwala

The asset quality challenge owing to Covid, though reducing, remains uncertain, particularly in the retail/SME (small and medium enterprises) segment, and will depend on how the upcoming Covid waves, if any, play out. Moreover, the second Covid wave has put more stress on weaker borrowers that availed of restructuring/ECLGS (Emergency Credit Line Guarantee Scheme) in the first Covid wave and may see higher slippages than what was earlier expected.

Our base case for the system is relatively sanguine, given the likely turn in the corporate non-performing loan (NPL) cycle. Indian banks have already gone through a deep corporate NPL cycle and there hasn’t been any significant lending over the past many years. This drives our conviction on moderation in corporate NPLs, which will help offset potential challenges in the SME/retail segment and cap any sharp spike in bad loans.

What is your view on the financial system’s stressed assets situation with respect to different lending groups – PSU banks, private lenders and NBFCs?

There are two determinants to the stressed asset situation at various lending groups – one, potential exposure to sectors that are disproportionately impacted by Covid, and two, the pace of provisioning by the respective lender/lending group.

We have seen NBFCs/mid-sized private banks to be more impacted than the large private/SoE (state-owned enterprise) banks in the current cycle – this is owing to relatively higher exposure to unsecured, SMEs and vehicle-financing at the former. The positive is that many large lenders have ensured significant upfront provisioning, which is helping them to manage credit costs well. We expect some lead lag in credit cost moderation, but believe that the financial year 2023 will see a material reduction in credit costs for the banking system in aggregate.

How helpful will the idea of a bad bank be in real terms (asset reconstruction companies have existed for long)?

The bad bank implementation by the government, while delayed, is a step in the right direction. There are multiple ARCs in India, but most of them are focused on relatively smaller-ticket loans. The incorporation of a bad bank with a sovereign guarantee on security receipts is a positive and will impart credibility plus a likely floor on asset recoveries.

A number of large NPLs with good recovery potential are already executed via the bankruptcy code and the potential recovery run-rate on incremental NPLs could be relatively lower. Overall, we believe that corporate loan underwriting, NPL recognition and recovery process have significantly improved in India over the past five years and will be positive over the medium term.

What will be the next trigger for growth for banks, given that growth has been muted even in a lower interest rate regime?

System loan growth in India has been muted even prior to Covid largely owing to the corporate segment – the capacity utilisation has been fairly volatile, led by multiple macro challenges over the past decade weighing on credit demand. Retail, on the other hand, has done well, given significant under-penetration but got impacted in recent years owing to Covid waves.

We have noted that demand re-acceleration was strong in retail as the economy stabilised – this was also helped by limited job losses in the formal sector as well as the timely implementation of the ECLGS scheme by the government which supported SMEs. We remain constructive on loan growth revival to above pre-Covid levels over the next year in this backdrop (assuming no severe Covid waves hereafter). Moreover, we believe corporate balance sheets have improved and as the economy stabilises, there will be a continued pick-up in working capital demand and that will also lead to higher corporate capex over the medium term (not to forget, credit growth is a lagging indicator).

How big is the threat for banks from fintech and digital lenders (grabbing fee income, taking a share of retail credit)?

Digital lending is the future and will be done by both the incumbents as well as the fintechs. The digitisation of data, both in urban and interior India, has led to a significant expansion in available datasets. Moreover, the datasets are increasingly getting democratised and will be available to all post-customer consent. We see a significant rise in digital loan originations by large fintechs and the likes who have built significant engagement with potential financial service consumers. As a consequence, their market share in digital distribution of financial services will go up materially (though would vary by the product).

On digital lending, we are seeing a lot of collaboration between banks and fintechs and we see that as a win-win model. Both banks and fintechs have differentiated advantages and co-lending can drive synergies. Not to forget the fintechs that are trying to lend on their own balance sheet – the potential is huge given significant under-penetration in India.

However, the success over a cycle would depend on building a strong underwriting process as well as collection capabilities. While initially all lenders will do well, we will know the stronger ones when the tide turns.

How are foreign investors looking at the Indian BFSI (banking, financial services and insurance) space right now?

The Indian financial space has been a significant overweight position for foreign investors and they continue to remain interested. The discussion is fast-moving from potential asset quality risk to the pace of loan growth/PPoP (Pre-provision operating profit) acceleration as Covid-related challenges subside. This will be the key upside catalyst for financials over the next six months. In this context, the severity of a third Covid wave, if any, will be key to watch.

Further, we see increased focus by investors on ESG (environmental, social and governance) initiatives at Indian banks, progress on digital banking as well as potential impact from the rise of fintechs. These factors will continue to gain more prominence in driving relative stock performance within financials.

Is PSB privatisation a good idea? The government has announced its intent to privatise two banks this year, but no progress so far.

The privatisation of SoE banks is supposed to take time due to a variety of challenges, apart from Covid. However, if we look at the pace of private banks loan market share, there has been significant acceleration in recent years.

Private banks have increased loan market share by >10% pts to ~35% over the past five years ending FY21. This compares to an increase of ~7% pts during the preceding five years. We expect this to continue as private banks have been able to accelerate their market share in deposits as well. Further, the number of new differentiated bank licences issued by the RBI as well as technology-led innovation in the private sector will catalyse private sector market-share gains.