Citi's big call: NPA cycle has peaked, banks will outperform

On a similar line, Axis Bank which has been one of the top corporate lenders in FY16 expects the banks credit cost to increase to 125-150 basis points in FY17 against 111 basis points in FY16.

Sridharan said, “It is unlikely that NPA numbers will come down right away. It is still going to take a while.”

Meanwhile, Kotak Mahindra Bank, which has a stronger retail mix of lending,  doesn’t expect any challenges on the growth front.

Manian said the bank’s loan mix between retail and corporate is at 70:30 respectively. He doesn’t expect it to change in the next two years.

He is hopeful of the bank growing faster than its peers in FY17.Below is the verbatim transcript of Aditya Narain, Jairam Sridharan and KVS Manian’s interview with Latha Venkatesh on CNBC-TV18. Q: The banking sector at the moment is performing almost with the Bank Nifty. But, up until two years ago, it was a stand outperformer, an outperformer in the Nifty itself. Do you see the Bank Nifty taking that stance in the years ahead or is it going to be at least for the next two years more a Nifty performer?

Narain: We are pretty positive on the sector, so we do think it is actually going to outperform the rest of the market. Our premise is simple. I think this whole asset quality issue, to some extent, it has made the headlines, it is not numbers, but in many senses, I think it is a little backward looking now. Our general sense is twofold. One, this asset crisis is now behind them. There might be some more recognition that might happen, but the crisis per se is well under check.

The second thing is we actually think you are embarking on a pretty decent up-cycle and we actually call it the new cycle which we tend to believe is going to be pretty extended. It might not be very rapid, it might not have the buzz of the cycle you saw in the early 2000s. But we think it is actually qualitatively going to be better and it is probably going to last a lot longer. So, in that context, we are pretty optimistic on the banks.

That sets the stage for a very interesting discussion if you are expecting a long and healthy cycle for banks. But, you took away my first question. I was wanting to ask you about asset quality. Is it genuinely behind us or do you think we will be paying for past sins for maybe a year more before banks genuinely become attractive?

At the underlying level, in terms of the direction of those underlying assets which have been challenged, we are well and truly past. In terms of paying for the sins, yes you will effectively have credit costs that remain high. You will have this issue of some new stuff tending to come up and to some extent, the resolution is going to be a little slow. But that said the market is factoring in a fair amount of this and so to that extent, you have got to be watchful of following the numbers rather than the underlying trends in assets. And I think the underlying trends in assets is actually more up than down even though it might be a little slow. And that is where the opportunity is.

Q: What is your sense, if your sense is that the worst of the non-performing asset (NPA) is over, then on a valuation basis, you should be buying public sector banks. Maybe we invited the wrong guests. They have already become expensive.

Narain: I do not know how expensive they have become and I also think there are two elements to this whole story, the first is the asset cycle, the second is the growth cycle that will effectively follow at a later stage. And where we tend to be a little bit cautious on the public sector, even though we by and large believe you will make money on them is that the growth cycle is probably going to be a little bit lagged and a little bit inconsistent and a little bit harder to effectively call. So, that is where they do not make the top of our pecking order, though we do believe that from an asset quality perspective, the market has been making too much out of their challenges, those, if not passed are clearly closer to the bottom.

Q: You represent the bank which although a corporate lender has come out looking so much better than other corporate lenders. What is your sense about what Aditya is saying? Is the worst of NPL over and done with? We will have incremental NPLs but at a much lower pace in FY17?

Sridharan: My way of thinking about your question is yes, things have gotten better already, but it is not likely that NPA numbers will start coming down right off the bat. It is still going to take a little while.

Q: Now, your last prevailing number is 1.68 percent and you guided or you gave us a watchlist of about Rs 22,000 crore odd. Now, assuming even half of that actually slips, is that a fair assumption in the first place? Half of it slips?

Sridharan: We have guided that about 60 percent of that will slip over a two year period.

Q: In that case, where do you see, in terms of numbers, your NPA peaking? Will it be 2 percent, because I assume your book, the numerator is also growing?

Sridharan: The NPA numbers will go up. We have not given specific guidance on where it will reach in this particular year. But let me give you a slightly different metric. Our credit cost number was 111 basis points at the end of financial year 2016 and we have guided that it will be in the range of 125-150 basis points in this year. So, clearly we are guiding that that credit cost number will go up in this year. There is a range of about how much it will go up, but it is likely to go up in this financial year.

Q: You will be at 70 percent coverage this year?

Sridharan: Yes.

Q: So that will also I suppose, add to the cost. You have not had corporate exposures that should worry an investor. What is the strategy going forward? For everyone and their uncle, it is getting away from corporates and going into retail and proving to their investors that we are 40 percent retail, 45 percent retail, 50 percent retail. For you, will it be the opposite?

Manian: It has been the opposite for us. We have been about 60-70 percent on retail and about 30 percent corporate. That has been our general mix. We do not see the mix dramatically changing over the next few years. Both sides are growing at about the same pace. So, that is the way we look at it next 2-3 years.

Q: What do you see in terms of a loan growth in the next two years and if you can specify the retail and the corporate loan growth.

Manian: At a very macro level, we are still a small bank given the whole sector. So, we do not, if we want to grow the asset book and the loan book, we do not see challenges in growing that. We are still a small share and growing that share should not be difficult. So on a macro basis we think it is possible for us to grow faster than the rest of the industry.

Coming to the mix between retail and wholesale, last couple of years, not last couple of years, last year, our wholesale growth was muted partly because we were also going through our integration issues with the book that we got out of integration. So, we think the retail continues to grow at 15-20 percent is our guidance just now.

If we see the cycle getting better, we can step that up but right now we think 15-20 percent is the number there and corporate also this year we think grows at that kind of rate._PAGEBREAK_

Q: What is your guess in terms of growth and the subsectors?

Sridharan: Firstly, from an industry level perspective or banking sector as a whole, our house view is, and I would love to hear Aditya whether you agree with our house view or not, but our house view is that the advances overall grow at about 12-13 percent for the sector as a whole. Our hope is an 18-20 percent range in terms of the rate at which we want to grow our advances. So, clearly we are thinking about 600-700 basis points over where the sector will grow. That is our aspiration.

In terms of the split between the three, you mentioned earlier that the mix for a lot of players has been changing and for us it has been quite strong. Five years ago retail was 20 percent of our book, today it is 40 percent of our book. So, clearly there have been pretty significant changes over the last six years or so in that mix. We expect that mix to continue to shift a little bit over the next few years and I feel growing retail in the 20s in terms of percentages in the 20-25 percent range is quite doable.

I continue to believe that demand there continues to outstrip supply and corporates as Manian was mentioning, while organically there is not much growth in corporate demand, however there are some meaningful market share shifts that are happening and that gives you the opportunity to grow corporate as well. One expects corporate also to grow in the high teens at least.

Q: I want two quick numbers from you all. Where do you think the margins will be for FY17, the delta, and if you can give me a ballpark number?

Sridharan: 20 basis points lower than last year.

Q: Kotak?

Manian: We think we will maintain the net interest margins (NIMs).

Q: Is this largely because the interest rate cuts will mean more passing transmission?

Sridharan: For us it is also a little bit of if you are going to be a meaningful player in corporate and if you are going to also make sure that you are only lending to the best of corporate because of where we are in the cycle that is actually going to mean that you are going to have to give up a little bit on the margins to get there.

Q: What is your pecking order therefore in terms of the best picks for investors in the banking space?

Narain: I kind of refrain from stocks per se but by and large, we have a very bullish view on the sector. Out of the 17 stocks we cover, we have buys on 13. So, part of it is literally a directional call and we do think it is the private sector that are actually going to lead but within that our bias is towards the asset heavy or the corporate ones simply because valuation adjusted for potential movements in terms of asset quality, that is where the greatest delta is we think over the next 6-18 months.

Q: In your 13 out of 17 banking buys, you are not including the non-banking financial companies (NBFCs)?

Narain: We include the NBFCs we cover.

Q: Would it be like your best buys on NBFCs, private retail?

Narain: No, it is the corporate heavy banks, the private banks, the public banks and then the NBFCs. That is the grouping; there will be differences but as a grouping that is the way it will be.

Q: What is your sense, do you think while overall the pie will grow the banks are going to face some very serious challenges on their margins because of the unified payment interface as well as payment banks and small banks?

Narain: The way I see it is the expansion of the pie will override some of the profitability issues that you could effectively have. That is one bit. So, clearly there will be pretty decent expansion. There will be some profitability issues and that is one thing that is going to be defining part as it tends to play out. You will tend to have some of the market concentration that you have had in the last 10-15 years that will in some senses tend to continue. They are the big boys, the guys who got scaled, the guys who got momentum they will just have better economics. So, their positions will tend to get consolidated.

The third thing that will happen is the velocity of activity in the banking space and the economy is going to go up. So, the flow side of it whether it is payments, whether it is small deposits that will tend to go up. That is going to give an extra edge to the system.

Q: What is your sense, payment interface, payment banks, small banks, which is the biggest threat, how will the world look two years down the line?

Sridharan: All three of them are going to be a unique and really powerful contributors to the economy. So, from a consumer perspective these are all going to be really good things and for the economy as a whole and for the sector as a whole as well in the long run they are going to be extremely good things._PAGEBREAK_

Q: Let us take the technology cum market share challenge from UPI and payment banks?

Sridharan: UPI and payment banks both tackle the same thing which is a payment flow, particularly a payment flow which starts from consumer and goes either to a business or another consumer or to the government. That payment flow is super important because that is in some sense there is no money to be made in the flow itself but fundamentally whoever controls the flow, controls the float.

Q: So, you lose float, you could lose float?

Sridharan: That is what one should worry about. If you lose control of all the flows and if you lose control of the information that is who is the customer paying to and what are the customer's needs. If you lose those things then there is a risk that you lose the float.

Now, if you think that that is the thesis then it is not very clear to me that a payment bank like structure where the floats are capped whether they can naturally take away a whole lot of that share. They will certainly take away the share on the flows but can they take away the share on the float is not clear given that there is a natural capping regulatorily. Now that regulatory cap might change tomorrow but as of today that cap feels like that might prevent a revenue from actually being generated at that end. That said, there is a good opportunity for banks to even work with some of these other entities and say, let us partner up. If you are coming up with a cool new disruptive technology to make this happen or you are linking this with another part of the consumer's life like their cell phone usage or whatever it is then let us come up with something which is a partnered solution where we give the customer what he wants and we find a way to split the revenue pool. So, that is another way it could actually develop.

Q: Is Axis Bank tying up with any payment bank?

Sridharan: We are talking with all of them and we are quite happy to actually engage in any sort of meaningful conversations on partnerships as they evolve. As you can see there are some movement that is going on in terms of how people are looking at that space. So, we will have to see where things stabilise.

Q: Do I get this right. The advantages you may be able to reach a larger number of people whom you can give loans perhaps riding on the payment bank. The disadvantages, your float could decrease so Current Account, Savings Account (CASA) is under threat?

Sridharan: One other piece that I would also say is sales of financial products like mutual funds and insurance etc which they payment banks would also - I am sure- would want to do and the banks already do and there is a meaningful part of our revenue pool, that will also be competed on.

Q: Do credit care incomes fall a bit?

Sridharan: Not really, the bigger question rather than credit cards is going to be debit cards. You asked about UPI earlier and some of these newer technologies are much more likely to impact debit card flows rather than credit. Credit tends to be larger ticket flows, a particular different kind of clientele etc, debit is an everyday purchase, small ticket. That is the one which is much more likely to get competed away. 

Q: I agree but I know of a lot of startups who are offering basically person-to-person (P2P) loans at probably crashing rates, at much cheaper rates. 

Sridharan: But you know how that story is going globally. That story is not ending well. 

Narain: Also I think there is going to be a mark difference between the risks side and the non-risk side. I actually think the expansion is going to be on the non-risk side, non-capital risk or non-credit risk side rather than on the risk side at least in the early part of the cycle. 

Manian: The way I look at it is, like Aditya rightly said, I think there will be expansion of the market in the sense the unbanked side or even the cash to banked transaction side. I think that expansion will be significant with this kind of development and therefore that will definitely overall grow the market and therefore the shares you are talking about are in a different framework then; that is one. 

Second, on the payment side, on the transaction banking side, there will be some disruption. Having said that, the economics of the payments standalone is something that we have to figure a way ahead. Unlike the universal banks which have generally ability to cross subsidise across products, payment products with respect to loan products, credit cards and multiple products, the ability of the payment banks which are solely dependent on payment as a mechanism to make money so therefore it is quite possible that they look at the economics differently and it may not actually cause the level of disruption that we are actually thinking about. 

So, I think these we have to figure a way ahead. My belief is that banks will also, even the regular banks, will also step up on the payment side of the business and probably offer the kind of products that payment banks could offer.Q: I am asking you because you guys have shown the way in terms of being able to integrate and buy and integrate, will there be a temptation to buy a small bank or does the payment bank obviate remove the need for buying small bank?Manian: It’s too early to talk about buying payments banks they are yet coming in place.Q: Buying small bank?Manian: It’s too early to think about them they have to set up and we have to see what they bring for us for example we are already a significant player on the retail side, we have a large business there. We will wait and watch. On the payments bank you know that we already have a tie up with one and we are talking about others on a commercial basis as well. We can work together with them right now, right now I won’t think about buying them.Q: Will small banks that have gotten listed have gotten listed at very attractive valuations. Do you think that this trend will continue for a bit I am sure more of the small banks are going to get licence. First of all are they in your buy list and is their more juice?Narain: Two things we don’t cover them, so I don’t really have a hard view on that but your second point in terms of whether more of them will come to the market I think most definitely. You are clearly going to get more supply and at end of the day the initial argument, this is going to expand the market hugely. I don’t think you are going to have the standout valuations that you had in the past. There will tend to be some sort of convergence of valuations over the medium to longer term. It’s just that some of them will grow very differentially and some of their return structures will tend to be very different that’s where you will get outperformance between segments of banks and individual banks rather than just everyone going up the same way, but in terms of small banks - you will see more supply of paper.Just one thing I might want to add is a lot of the banks who look at small finance banks at some point in time of their evolution. It will be tend to be more of an asset side story rather than a liability or distribution side story.