Indian banks’ share price: Indian banks’ asset quality issues largely resolved: Nilanjan Karfa, Nomura

The budget envisaged some push for digitalization and most analysts seem optimistic about the banking sector. With two years of the pandemic behind us, do you think we are now on a better streak when it comes to asset quality issues? What is your view of banking stocks?
A couple of things work when someone is bullish on the banking sector or BFSI.

One is the relative underperformance of last year. So if the money is to move out of the overvalued or highly valued consumer sector, the internet sector and stay in India, it is entirely possible that on a relative basis the banking sector will do better.

It’s more on the technical side. On a fundamental side, a couple of things work.

Banks are probably the best capitalized in the last 20 years. There should be a broad appetite for growth, provided there is the right kind of demand. While the offer looks pretty good; demand side is a bit of a question mark.

Secondly, if you look at the issues of the last 10 years – around 2018, 2019 these suddenly erupted again with the NBFC crisis and then afterwards with the emergence of Covid – basically the whole size range of notes, from large enterprises to medium enterprises to even small loans to individual loans have been strained.

There will still be a few pockets here and there, but what we have just witnessed over the past 10 years is a complete sweep of leverage across all possible segments of the economy. While there may be pockets here and there, restructurings that have happened, warranty systems (some of which will fail), we’re probably not going to look back on what we’ve witnessed over the past three years. and certainly not in the last six-seven years.

The asset quality issues therefore seem to have been largely resolved, as well as the problems encountered with the loans we have granted in the past. But what will probably matter most is what will generate revenue. This is where there is a bit of debate. It seems to me that a large part of the market is much more optimistic than me. Am I personally super optimistic? The answer is no, but I’m reasonably optimistic.

So will demand come back quickly? It seems a bit unlikely! There has been a significant loss of income in the most important segments of the economy.

Imagine it as a steam engine. If you remember how a steam engine works – for all the wheels to start working in tandem, it takes a little time. There will therefore be wheels which start and then slip without the locomotive moving; the same for the economy, there are different cycles, different ecosystems, interconnections between them. For all to start working again, it will take some time.

How long is hard to say, but we’re on that curve right now. Unless something dramatically worrying comes back on the health front, people will go back to work, to commerce; people need money to survive and it will come back. People will come back and look for revenue generating opportunities which will in turn result in more loans and more fees for banks to start generating revenue. Revenue minus expenses, i.e. operating profit. A reasonable upward swing is possible over the next couple of years.

The combination of larger-than-expected fiscal and government borrowing deficits and tighter oil prices pushed sovereign bond yields higher in the current quarter, although a dovish RBI cushioned the blow to some extent. In terms of mark-to-market impact on cash books, how will banks handle the situation?
There is no navigation; it is a blow that will have to be taken. So to some extent there are conflicting interests.

If you look at the system, on one side there is a government that will have to borrow, mostly in longer-term treasuries and the entities that will subscribe to them; much of it is made up of banks, so banks will have to underwrite higher title deeds.

Higher mandate paper in a rising rate cycle obviously means there will be losses on the existing portfolio. So might as well live with it, but there are counterweights.

For PSU banks, the rise in yields is more relevant than for private sector banks and not least also because the duration of the books for PSU banks is much greater. It is higher than that of private sector banks, and so PSU banks tend to take a bit of their treasury income when rates rise. But on the other hand, there are factors that benefit them on the opex line.

Net-net there is always a negative but the markets tend to ignore it because while a lot of these books are usually held over their lifetime there may be a loss in notional time value but there is has no possible loss. So when markets turn to banks, they typically remove that volatility and then look at core operating income. So as long as this holds, it shouldn’t be a problem unless we see a very strong uptick which is unpredictable.

Let’s come to the situation on the credit drawdown; the loan-to-deposit ratio is still close to a historic low. What is your outlook and what might be your estimate of loan growth for the full year ahead?
It looks like we’re really on the road to recovery, and then if you break down the overall incremental growth or the reasons for the decline, over the last year and a half, the biggest drag actually comes from the large manufacturing sector and in that commodities to such an extent that what used to contribute about 1.5-2% to incremental growth is actually on some kind of minus 2% contribution right now.

I think over the last four quarters, steel companies have reduced their debt by probably Rs two lakh crore (2 trillion). It’s not a small number. My own feeling is that if we manage to do around 8-8.5% odd this year – we’re probably already running around 8.2% at the last date and hopefully if we can get closer to 8.5% – so looking at how much we lost in retail last year, the services segment a bit more and if we break away from that; going from 8.5% to 11% shouldn’t be a big challenge.

Does the market expect it? Maybe not. The markets are probably looking at 10-10.5%. My own expectation is probably 11-11.5%. You might say I’m a little more optimistic.

One of the key themes in the banking space for some time has been corporate governance issues. How is the industry evolving in terms of regulatory spotlight on corporate governance?
It works on both sides. There is a lot of red ink that has gone through because of the multiple failures and I want to be a little careful when I say this, but someone is at fault.

RBI – given what has happened over the past four or so years – is bound to take action and when regulators act, they don’t act with a scalpel. They work with an axe. And I think that’s what happened. What probably helped is that it’s like at low tide you can tell who’s swimming naked. And if there is no growth, two things are possible because if there is no growth; banks, NBFCs, according to which ones have problems, are very easily visible.

Secondly, the type of audits that RBI will have to perform are also less. So it’s probably getting a little easier for RBI to figure out and considering what happened, they’ve been a little stricter as well. Again, let me not judge whether RBI is right or wrong. It’s a regulator.

What is your vision of the NBFC sector? In terms of the restructuring that was done in the first two waves of COVID, what impact would that have?
Everything is already in the price and if you look at the share prices of these NBFCs, many are below the book.

It is more or less well known and if we look at what RBI asks of NBFCs and especially all lending institutions i.e. 90 day NPL recognition and no settlement until all delays are paid, everything is in front of you.

Even an HDFC Limited had NPAs around 30 basis points higher; a Shriram Transport will probably have 78 or 80 bps, someone else will have something else. It is therefore well ahead of us. Yes, there will be restructuring and there has been restructuring. Whether it’s an NBFC or a bank, we should expect 15-20% of that to become delinquent. There won’t be too much of a difference. Basically, it all came to the surface.

One way or another, everyone has a clue. It’s a cycle we’ve been living in for a decade. The problems are therefore well known. Growth is the key factor. If growth returns, many of these issues will be hidden or probably much more easily managed.

What are the best positioned and most fragile sectors in terms of the overall quality of the banking system’s assets?
I want to avoid taking individual names. But let me talk about sectors. Banks are ultimately tied to how other sectors are doing.

So where the revenue-generating action has left off is the segment that is most affected. To this extent, the entire service sector, a large part of the commercial tourist vehicles (buses), everything related to travel and tourism, temple tourism, microfinance.

Without forgetting that if there is no growth, the entire SME sector will be put to the test. I therefore neglect none of these.

These are the real challenges we have to face. If, for example, the GDP projections are not met and the real consumption cycle even slows down from here, then we have a problem. It is an unavoidable problem. Is it currently in the price? Probably not.

Even though the banking sector underperformed last year, I always say the market is a little more bullish than what banks and NBFCs are right now because everyone thinks it’s going to come back to the normal. I am also in a similar camp. If this does not happen, there will be downside risks. As a house, Nomura is actually a bit negative on overall GDP growth and we expect higher inflation and higher policy rates.