Moneycontrol Pro Panorama | Banking party is less exuberant, but not over

The Q2 performance of banks has been just short of exhilarating for the past two years and investors have been understandably euphoric.

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Earnings season is in full swing, and so far, the report cards have been mixed. One sector that has been of keen interest for both domestic and international investors alike is banking.

Emerging from the pandemic, the performance of banks has been just short of exhilarating for the past two years and investors have been understandably euphoric. Decadal low bad loan ratios, a surge in loan growth and fortified capital have backed the 123 percent lip-smacking return the Nifty Bank index posted between FY21 and FY23. Every fund manager has loaded up on bank shares over the past three years and S Naren, chief investment officer at ICICI Prudential AMC, rightfully points out that banks are over-bought. You can catch the full interview here. Naren is not overly worried about banks because “banks are in pretty good shape right now”, but he is among the growing breed of investors who have turned cautious.

Analysts are pointing to the signs of margin compression in the coming quarters for almost every lender. Indeed, banks are getting less bang for every buck they lend and may continue to lose out. That is because even as borrowers are lining up - at least at the retail level - depositors are not matching pace with this. The wedge between deposit growth and credit growth continues to be wide. Depending on the balance sheet heft, various lenders are facing varied degrees of stress.

This brings us to HDFC Bank, which released its second quarter performance on Monday. HDFC Bank’s margins showed a massive 70 basis points sequential drop for the September quarter. This, even when the bank reported a healthy 30 percent deposit growth (impact of merger). For the lender, the main reason for its margins and even its core interest income growth to decelerate was the merger with its parent HDFC Ltd, as our piece here highlights. Since HDFC Bank swallowed essentially the largest housing loan lender, it had to boost its liabilities side as well. To do that, deposits were not enough and hence, the bank borrowed from the market.

In the case of Federal Bank, a mid-sized private lender, margins held up steady, but could come under pressure in the quarters to come. Federal Bank’s deposit growth was healthy at 23 percent, but composition of low-cost deposits warrants a relook. As more and more banks report their quarterly performance in the coming days, the trend of margin compression is likely to be revealed further.

That is not all. Banks have the lowest amount of bad loans right now in decades and analysts warn that this is not sustainable. The reason is the unbridled growth in unsecured retail lending. UBS has downgraded India’s banking sector to a neutral rating and the key risk the brokerage has highlighted is potential increase in bad loans from unsecured lending. UBS expects credit costs of banks to rise 50-200 basis points owing to this risk. Public sector banks are at a greater risk than private sector lenders.

UBS is not alone. The risks from unsecured retail lending were flagged by none other than the banking regulator. The Reserve Bank of India (RBI) in its policy statement on October 6 said banks must monitor unsecured loans carefully.

If there is a worry tomorrow, equity markets have already priced it in today. Considering these concerns surrounding banks, the Bank Nifty is losing its steam and fast. This financial year, the index has gained 9.5 percent, lagging the broader Nifty 50’s surge of 14 percent. Already filled up to their gills on bank stocks, there is less reason for fund managers to load up more. To be sure, the banking party is not over yet.

Lending towards capex is yet to fully take off and there is hope that banks would soon witness businesses lining up for capex. That would ensure a long earnings runway for lenders. Also, despite being overbought, banking valuations are still benign compared with historic levels and offer a strong reason for investors to keep biting. The banking party may be less exuberant, but it is far from being over.

Investing insights from our research team

HDFC Bank falters on profit growth in the first quarter, post merger

KVB Q2 FY24: Valuation remains a draw

Dalmia Bharat Q2: Profitability on the mend

Federal Bank Q2 FY24 – enough headroom to rerate

Cyient DLM: Revenue growth accelerates but margin disappoints

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Aparna IyerMoneycontrol Pro