Banks, the rising Behemoths of the Indian Economy!

4 Feb 2024 , 08:51 AM

“Banks are to the economy what the heart is to the human body. They cycle necessary capital through the whole, and they are barely noticed until pressure, necessity, or crises”, said Hendrith Smith a prominent banker from the US. This has been proven right, time and again.

Back in 2022, Indian banks witnessed the most impressive performance in over a decade, as numerous financial institutions reported exceptional results and bank profitability reached a 14-year high, characterized by a return on equity of about 12%. In 2023, though, the global banking sector was confronted with challenging circumstances. The industry underwent significant turmoil, triggered by the rapid and extensive fluctuations in interest rates. Many small and mid-sized banks in North America, as well as longstanding institutions in America and Europe, faced considerable strain, prompting some to file for bankruptcy. In contrast, Indian banks demonstrated resilience and stood tall. Withstanding global macroeconomic and interest rate volatility, they remain well-poised to deliver robust financial returns. A substantial portion of the banking system remains profitable, primarily driven by significant growth in the retail and micro, small, and medium enterprises (MSME) lending segments. Consolidation of Public Sector Banks (PSBs) has led to the emergence of larger and healthier institutions. 

It seems though, that this party has only just begun. Several fundamental catalysts are in place (both short-term and long-term) to propel Indian banks to greater heights in the days to come. Let us look at them in detail.

Narrowing liquidity deficit in the banking system: India’s banking system encountered an unprecedented liquidity deficit, as revealed by data on 24^th January, attributed to outflows for tax payments and restrained government expenditures. According to RBI data, the deficit surged to ₹3.34 Trillion ($40.18 Billion) as of January 23, nearly tripling from the month’s commencement.[1] The tight liquidity conditions in the banking system escalated in December 2023 due to advance tax payments. Banking liquidity has been under pressure for over a quarter due to (i) heightened cash withdrawals driven by festival demand and (ii) a deceleration in government spending[2]. The liquidity deficit is expected to diminish in the coming days following the initiation of government spending. Typically, towards the end of the month, government spending rises due to salary and pension disbursements, leading to increased liquidity in the banking system. The liquidity outlook is anticipated to improve with an upswing in FPI inflows, stemming from India’s inclusion in Global Bond Indices. Nevertheless, the Reserve Bank of India will remain vigilant due to the surge in cash circulation ahead of parliamentary elections, despite the commencement of government spending in April 2024 and a relatively subdued credit season.

Broad based and sustainable loan growth: Banking system loan growth has been robust at mid-teens (16% year-on-year as of December 2023 excluding HDFC’s merger), thanks to the confluence of favorable supply-side (improving data availability, best-ever asset quality and bank capitalization, end of capital market disintermediation) and demand-side factors (rising consumption led loan demand and shift from unorganized to formal lending). However, with recent regulatory tightening (increase in the risk-weights on unsecured consumer loans and NBFC exposures) and the RBI’s nudge to lower credit-deposit ratio should drive some slowdown in the loan growth run-rate in IIFL’s view. Analysts at IIFL Capital Services expect banking system loan growth to slow down to 13-14% in FY25. But it should become more broad based and sustainable on the back of (i) capex green shoots driving a pick-up in corporate loan demand, (ii) structural growth potential in MSME as the lenders move from collateral based underwriting to cash-flow based, and (iii) scale back of unsecured lending.

Capex-led corporate loan demand to pick-up: Corporate credit growth has been weak in most part of the last decade, and banks have lost 25pp market share. However, corporate India has been deleveraging (improving debt-to-equity and interest coverage ratios), and the ROEs are at the best levels since the GFC. This is particularly important because capex is driven by the profit cycles. Some green-shoots are already visible with listed companies’ capex growth finally surpassing nominal GDP growth in FY23, and new private sector project announcements rising. These project announcements are also accompanied with a pick-up in fresh sanctions of projects by banks/Financial Institutions. While the fresh sanctions have inched up to 1.9% of banking system loans, pending disbursements are at just 1.4% of loans. Though this is definitely some improvement from what we have seen in the past few years, it is a far cry from the 5-10% levels witnessed during FY10-FY13.

Improvement in capacity utilization: There has also been an improvement in capacity utilization levels. At 76%, utilization level is the best in the last decade. This is important because we find there is a reasonably strong positive correlation (60%) between capacity utilization and overall corporate credit growth. However, analysts at IIFL Capital Services believe improvement in capacity utilization beyond 80% level and a sustained pick-up in GFCF is essential for a structural corporate loan growth recovery.

Focus on districts with stronger deposit growth: Historically, there is a high correlation between deposit market share gains and branches. Analysts at IIFL Capital Services have analyzed the data of banks’ branches and deposits in 550+ districts in India (out of total 766 districts) to ascertain the branch strategies of individual banks. Around 20% of these districts under analysis with high deposit growth (5-year CAGR of >10%) are categorized as ‘fast growing’. Analysts at IIFL Capital Services find that Kotak, Federal and RBL are running a very concentrated branch strategy with several branches in 40-80% of 550 districts analyzed. On a more granular level, these banks do not have a branch in 85-95% of pin-codes where SBI has a presence. However, their branch strategy is rightly geared towards districts witnessing fast deposit growth i.e. the share of branches in these districts is higher relative to other banks with larger distribution network.  It is essential that banks have higher presence in districts exhibiting high deposit growth trends. HDFC has opened 1,100+ new branches in these fast growing districts in the last four years, which is 2-5x of the branches opened by larger peers.  While having a higher branch presence in the ‘fast growing districts’ aid banks’ deposit growth today, it is also necessary to build presence in the ‘districts which have high deposit accretion potential’ to sustain deposit growth momentum in the future. HDFC should benefit from early mover advantage as 45-50% of new branches are in the pin codes where ICICI/Axis are not present. The competition in these areas is mainly from the PSU banks, where making in-roads into loan and deposit products should be relatively easier due to HDFC’s wider product suite and a stronger brand name.

 

Deposit growth lags the credit growth: The difference between the growth rates of credit and deposits has expanded in the first fortnight of January 2024 compared to the final fortnight of September 2023, even though credit growth continues to outpace deposit growth on a y-o-y basis, according to data from the Reserve Bank of India (RBI). As of January 12, 2024, credit and deposit growth stood at 19.93% and 12.84% y-o-y, respectively, resulting in a 7.09 percentage points gap between the two, as indicated by RBI data on the scheduled banks’ statement of position in India. RBI emphasizes that robust balance sheets have facilitated a widespread expansion in lending by banks, with bank credit growth persistently surpassing deposit growth due to sustained demand momentum. Deposit growth trails credit growth as alternative investment avenues, such as non-convertible debentures and equity markets, currently provide higher returns than bank deposits. A more extended analysis suggests a tendency for bank credit and deposit growth to converge in the long term, although they frequently diverge in the short term, according to the report. RBI acknowledges that the rise in interest rates has favored banks, improving their NIM, with the transmission to yield on assets occurring more swiftly than to the cost of funds. However, as the rate cycle approaches its peak, banks’ profitability is expected to face pressure due to increasing valuation losses, heightened risks for asset quality, and moderation in credit growth. [3]

Generative AI to enhance efficiency : Banks have utilized the capabilities of AI and data, incorporating both proprietary and external sources, to empower employees and equip them to handle tasks that were previously beyond their scope. As indicated in a report by the International Data Corp. (IDC), the global expenditure on artificial intelligence is predicted to reach $166 billion in 2023, with the banking sector standing out as one of the major contributors, constituting approximately 13%. This expenditure is expected to escalate to approximately $450 billion by the year 2027. Despite the gradual integration of AI, the banking sector is on the verge of experiencing a significant impact owing to the widespread implementation of generative AI. According to a 2023 report by McKinsey & Co, if fully implemented, generative AI could contribute annual value ranging between $200 billion and $340 billion. This figure is equivalent to 9%-15% of banks’ operating profits. AI strategies have the potential to provide a competitive edge to banks that possess the capacity and flexibility to effectively leverage them. A well-executed AI framework can boost operating revenues by improving employees’ decision-making processes and unlocking the revenue potential of clients, particularly through personalized services and products. Furthermore, a robust AI strategy in banking has the potential to streamline operations, reduce operating expenses, and consequently enhance overall efficiency and profitability, resulting in a substantial positive impact on cost to income ratio. [4] Recently, KV Kamath (Chairman, Jio Fin Services & Chairperson, NaBFID) mentioned that the current high NIMs witnessed in the Indian Banking sector will have to correct as it should be affordable to the borrower. Hence, leaner business process, leaner technology is needed to bring the cost-income ratio down significantly. [5] Analysts at IIFL Capital Services believe Banks with a focus on technology and digitalization are likely to win the race.

Analysts at IIFL Capital Services anticipate that HDFC is positioned to lead in the competition for deposits, having established over 1,100 new branches in rapidly growing districts over the past four years, a figure that surpasses the branch expansion efforts of larger peers by 2-5 times. Other notable winners in this race include SBI, ICICI Bank, and Axis Bank. HDFC’s branch expansion strategy is particularly focused on districts with high nominal GDP but low deposit penetration, indicating a strategic approach to untapped potential. Overall, SBI, BOB, HDFC, ICICI, and Axis have a higher concentration of branches in these districts, offering significant potential for deposit growth. Axis, IndusInd, and RBL have demonstrated the most substantial improvement in liability granularization, especially in retail deposits and CASA ratio. Consequently, analysts at IIFL Capital Services have maintained a positive outlook on the Indian banking sector and anticipate HDFC Bank, SBI, ICICI Bank, IndusInd Bank and Axis Bank to outperform in the future.

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[1] Banking system liquidity deficit hit record high

[2]Tight Banking Liquidity May Warrant More Durable Liquidity Infusion from RBI

[3] Gap between credit growth and deposit growth widens

[4] AI in Banking will be an incremental game changer: S&P Global

[5] Banks will need to learn to do things in a lean way: KV Kamath