Indian banking sector poised for strong upcycle amid favourable macros: Morgan Stanley's Sumeet Kariwala

Sumeet Kariwala, Executive Director of Financials Equity Research at Morgan Stanley

The Indian banking sector is in early stages of a strong upcycle, supported by normalisation of credit costs, steady loan growth, and expected healthy earnings trajectory, said Sumeet Kariwala, Executive Director of Financials Equity Research at Morgan Stanley.

Out of the banking pack, Kariwala preferred large private lenders over state-owned banks from a long-term perspective. However, he also added that the PSU banking stocks have more catch-up left as valuations remain attractive, supported by strong macro-economic indicators.

Edited excerpts from the interview

Q. What is your overarching view on the entire banking pack post the fourth quarter earnings because asset quality seems to have normalized and some lenders have seen their asset quality in fact at multi-quarter highs, right? What are your thoughts? How would you view the entire banking space post the fourth quarter earnings season? 

Sumeet: The banking sector is in still early stages of a strong up cycle. You will see some normalisation of credit cost and margins, but I think over the next three to four years, the earnings, consensus earnings will get surprised positively. I think the NPL cycle is still quite young, there has not been significant lending that has happened down the quality curve in the retail and SME segment.

On the corporate segment, you are still to lend, we are still to see a private corporate capex cycle. So, overall, I think the NPL cycle will remain benign and credit cost will remain below normalised levels.

Margins, in my view, have peaked over last three to four quarters. There will be a gradual moderation that we see over the next three to four quarters and we will see a slightly accelerated one if there is a rate cut cycle which we are not assuming right now. Low growth will remain strong, retail and SME is holding up well.

At some point of time, private corporate capital expense will translate into bank credit growth over the next two, three years. So I think from a two, three year perspective, this 15-16 percent number will sustain. Obviously, what we need to watch is two things. One is on deposits where I think a meaningful part of the challenge is cyclical. As inflation moves lower, as the government starts to spend, you will see the power growth pick up over the next few years.

If you look at last two years, the power growth has accelerated from 11 percent to 13 percent and I think so that has been despite a tight liquidity environment because real deposit rates have improved and I think they'll continue to improve. So the power growth hopefully coming back should mean that we are able to see a very strong loan growth cycle with benign asset quality and earnings continue to surprise positively.

Q. You mentioned that private capex hasn't really picked up and cost of funds are on the higher side as well, right? But despite that, would you be constructive on the private bank space now and do you think they are actually poised to take the lead from PSU banks? 

Sumeet: Yeah, this is a good question. A lot of people have asked us on private versus PSU banks and generally what we've seen is that as we come out of a slowdown and we've seen that in the 2003-2007 cycle as well, the state-owned banks got more impacted because of the corporate NPL cycle then and now. And if you think about when we were coming out of the cycle and if you look at the earnings expectations for some of these banks, they were very low.

When you look at valuations, they were trading at historical lows and so on. And when you think about the upside that these banks could have provided with respect to earnings and valuations, it was massive. And this is why a lot of money has moved into these stocks and private banks have underperformed.

And this is what happens with quality banks in the first stage of a re-rating cycle. If you look at the valuation gap now between private and SOEs, they've come off and they are at very attractive levels. Over the next three years, I don't expect public banks to materially disappoint on earnings.

They're doing well on earnings. They have some room to re-rate as well. But what I've seen is that over the next two, three years, the important factor will be revenue growth where our assessment is that private banks as a basket can surprise more than the state-owned banks.

And this coupled with the starting point of valuations, we think the returns that you could see at private banks could be far better.

Q. But do you think PSU banks still have more catch-up to do in terms of valuations compared to private sector peers? 

Sumeet: So, if I look at historical valuations and depending on the state-owned bank that we're talking about, there could be room to catch up because the macro cycle is still quite strong. So, I'm not saying that you will see state-owned banks start to re-rate.

There's no macro concern which is going to weigh on overall bank earnings. So, they will continue to do well. The call that we're trying to take, is that who can outperform more? Who can re-rate more? And that is where our call on private banks over state-owned banks.

Q. In terms of cost of funds, when do you expect that to peak out? Do you think deposit repricing is almost done now or do you think there will be some more pressure as analysts have also been pointed out that the RBI may not be in a hurry to cut rates? 

Sumeet: So, our house economics doesn't expect any rate cut in calendar year 2024 or 2025. So, we're not assuming any rate cuts in the near term. On deposit costs, there are two reasons why deposit cost is moving up.

One is the term deposit rates have continued to reprice higher and that is still happening. You've seen some banks raising deposit rates over the last two, three months. And I think that is still to flow through and which means that you will see deposit rates continue to inch up and I think that this will happen at least over the next two, three quarters.

The other thing which is happening is that the share of CASA deposits, the low cost deposits, that continues to move lower. And in a high interest rate environment, CASA growth will take time to catch up to overall deposit growth. And that is another pressure point.

So, will deposit cost peak anytime soon? I would not be in that camp. The only point which I'll make is that the pace of increase in deposit rates will be slower than what you saw in fiscal 2024. But there will be a continued increase in deposit rates at least over the next two, three quarters.

Q. What's your take on the entire NBFC space given the recent spate of crackdowns that we've seen by the RBI? Now, data shows these loans have fallen from high 20s in November to 17 percent in April. After all the recent actions, do you think RBI now may ease up a bit on the NBFC space? And anything that you are liking within the NBFC pack? 

Sumeet: On unsecured loans, there has been a meaningful moderation in the growth run rate. Some of that is conscious by the management because they're trying to focus more on underlying credit risk. Some of that is partly to do with the base because if you look at fiscal 2022 and 2023, as we came out of COVID, there was a sharp increase because the base was very low.

So, I think the unsecured loan growth is normalizing and this is happening across the system, the banks, NBFCs, FinTechs and so on, which I think is a good move and RBI did mention that they've been tracking this and things are moving broadly in line with their direction. So, I'm not really worried about unsecured asset quality at the system level. There could be some players which might get impacted, but at the system level, I think the trends are okay and with respect to income growth, job creation, job losses in the formal sector, which is where the unsecured lending happens, some of these leading indicators are working very fine.

So, my understanding of the RBI move is that they're trying to be proactive, which is a very good sign and I don't think we are sitting on any potential unsecured in pay cycle at the system level over the next 12 to 18 months.

Q. Last question, you've already pointed out that private banks may have a greater surprise element. So, within the private banking lot, would you advise sticking to the large cap names or would you say your portfolio should be a mix of both large cap and mid cap private banks?

Sumeet: Yeah, we like private banks across the space, but yes, we have a liking for large private banks versus smaller private banks.

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