Economic recovery, fewer NPAs to drive banks' re-rating in 2021: Analysts

With corporate asset quality cycle behind and Covid-19 impact fairly contained, analysts at Nomura think front-line banks will see faster-than-expected return on equity (ROE) recovery in 2021

Weathering the Covid-19 pandemic better-than-expected, nursing their balance sheets, and gaining meaningful market share, large private banks and financial institutions are likely to enter a ‘golden age’ in 2021, analysts say. 
 

Private lenders strengthened their capital, built excess provisions, improved liquidity positions, and increased digital adoption to come out strong from the Covid-19 crisis. A combination of these factors, analysts at Morgan Stanley say, will help them gain rapid market share and materially lower cost to income ratios over the next few years.
 

"The macro recovery trends have sustained, and collection efficiency in stressed segments is also improving. The extension of government credit guarantee scheme will further help reduce asset quality stress. Consequently, we lower credit cost estimates at these banks and expect credit costs to normalize in H2-F22/F23," Sumeet Kariwala, equity analyst at Morgan Stanley, said in a recent note co-authored with Subramanian Iyer, Rahul Gupta, and Himanshu Khona.
 

Those at Nomura, meanwhile, expect earnings upgrade to continue on hope that the asset quality impact of Covid-19 may not meaningfully spill over beyond first half of calendar year 2021 (H1CY21).
 

On the macro front, Kariwala says India’s economic recovery gathered pace from the second quarter of FY21 (Q2FY21), and believes the growth to turn positive in Q3FY21. Subsequently, the difference between gross domestic product (GDP) growth and lending rates -- essentially an interplay between revenue growth and funding cost -- points to a strong improvement over next few years.
 

"Indeed, if the macro recovery is sustained, as reflected in high frequency indicators and contained Covid-19 cases, and rates remain accommodative, we expect further upside risk to earnings," analysts at MS wrote.
 

Markets were quick to sense the change, and the same is reflective in the stock prices. Between March 24 (when markets hit their lowest in three years due to pandemic) and October 1, Nifty Bank index underperformed the benchmark Nifty50 index, ACE Equity data show. During the period, the sectoral index advanced 25 per cent on the NSE, as against a 44 per cent rise in the Nifty50 index. 
 

However, better-than-expected Q2FY21 earnings instilled confidence in investors. Between October 1 and December 21, the Nifty Bank index surged 32 per cent relative to a 17 per cent rally in the Nifty50 index. 
 

On similar improving macro expectations, analysts at HDFC Securities expect bank provisions to come down in 2021 after and forecast pre-provision operating profit (PPOP) growth to pick up due to improving credit growth.
 

"Select niche NBFCs with moats in some product segments (auto loans and durables financing) are expected to make a comeback after the past two tough years, post the IL&FS crisis. Valuations leave some room for a re-rating in banks and select financials," it said in a market outlook report.
 

With corporate asset quality cycle behind and Covid-19 impact fairly contained, analysts at Nomura think front-line banks will see faster-than-expected return on equity (ROE) recovery. Utilization of excess liquidity and sustainable opex rationalization will further support PPOP momentum, they say.
 

Another trigger for upgrade, analysts say, could be the capital raise coupled with aggressive provisioning done in 2020. "We believe the current stock of provisions at large private banks are enough, and will help them normalize on credit costs in H1FY22. Mid-sized private banks have followed a similar path, but have relatively lower excess provisions. However, given their strong balance sheets, they will keep credit costs elevated in H2FY21 and normalize on credit costs by H2FY22," said the Morgan Stanley-report.
 

Moreover, improvement in loan to deposit ratio, seen over the past two quarters, is supporting outlook for mid-sized private banks. As regards credit growth, Morgan Stanley says working capital demand from India Inc could improve in FY22 while disbursement of unsecured loans due to increased discretionary demand may see a sharp rebound in the fiscal year. 
 

"Overall, we expect banking system loan growth to accelerate to around 10 per cent in F22e and around 12 per cent in F23e. This will be largely led by private banks who will continue to gain market share," said the brokerage.
 

ICICI Securities, on the other hand, pegs credit growth estimate at 4.4 per cent for FY21E, 9.5 per cent for FY22E and significant spike to 13-15 per cent over FY22-25E as positive trends emerge in private/government capex, aggregate demand, high frequency lead indicators, YTD trends of credit flow, and corporate/government/consumer ability to spend.
 

And as loan off-take would improve in the economy, Morgan Stanley expects margins to improve from FY22 onwards. This, the brokerage says, will be driven by lower NPLs; reduction in excess liquidity; end of lower interest rates ;and improving loan mix towards higher margin loans in FY22.

Investment strategy

Morgan Stanley has raised earnings forecasts/price targets materially given reduced macro tail risks. 

Nomura, meanwhile, prefers frontline ICICI Bank/Axis Bank, and HDFC Bank owing to gaining confidence on contained impact of Covid-19, improving business momentum across verticals, and better visibility of ROE normalization. They assign 10-20 per cent higher multiples across front-line banks and roll forward to FY23F, driving their 15-20 per cent increase in .