Interesting Times

Banks are raising lending rates to protect their margins, after having been compelled to increase deposit rates. Unless liquidity becomes tight, their borrowing costs should not go up further.

Interest rates are rising and how! Last May, few borrowers would have dreamt that within a year, their home loans would be re-priced by as much as 100-125 basis points.

That's the kind of rise retail assets --home loans, car loans and personal loans--have seen in the last twelve months.

Companies are not too happy either: corporate loans have become costlier by about 100-125 basis points. And while banks were passing on their increased costs of borrowing without formally increasing the Prime Lending Rate (PLR), over the last week almost every bank has upped its PLR.

For the time being, the hikes appear to be over. Borrowers can expect some relief in the short term as asset prices are expected to remain steady.

Says Chanda Kochhar, Deputy Managing Director (MD), ICICI Bank, "We have raised both corporate and retail rates by about 100 basis points. We needed to protect our margins which were suffering because we had raised deposit rates. For the time being, it appears that there will be no need to raise deposit rates further as there is no shortage of funds in the system. Liquidity has been comfortable except for some brief periods."

A K Khandelwal, Chairman and Managing Director (CMD), Bank of Baroda, agrees: "I do not see any major movement in lending or deposit rates in the near future, as most banks and have recently upped their PLR as well as deposit rates by at least 50 basis points. Moreover, the central bank has not raised the repos or reverse repos rates, thereby indicating a stable interest environment in the coming -quarter."

The ten-year benchmark today is quoting at a yield of around 7.5 per cent.

Says Ashish Parthasarathy, who heads the Trading desk at HDFC Bank, "We expect the benchmark to trade between 7.2-7.7 per cent this year and any rate increase will be driven by a policy change, ie a hike in the repos or reverse repos rate by the central bank."

Adds V S Rangan, general manager, HDFC, "Interest rates could harden from the current levels if crude oil prices go up further and consequently there is an impact on inflation with the government choosing to pass on the increase to consumers."

However, Rangan believes even if there is a rise, it should not be significant, perhaps not more than 50 basis points in the medium term.

However, banks need not worry about higher rates affecting their business. Says Rangan, "The credit growth continues to be good and a marginal increase in interest rates would not affect the demand for credit. The credit growth may necessitate an increase in the deposit rates. However, the margins are not likely to change significantly from the existing levels."

The demand for housing loans, which are generally of longer tenure, should not be impacted since the effect of a higher interest rate on the monthly installments is very small.

Further, the effective increase will be much lesser if one considers the tax benefits available on the interest paid on housing loans," he adds.

Indeed, even after a stunning growth in the Credit-Deposit Ratio (CDR) of over 60 per cent in FY05 and 70 per cent in FY06, there appears to be no let-up in demand.

Kochhar believes that credit growth in FY07 could be as robust as it was in FY06, even though the base is higher. Disposable incomes are rising and the economy is doing well, so there is a demand for money. As for companies, the huge capital expenditure is creating demand from industry.

According to industry sources, growth in advances have been robust at about 36 per cent in FY06. However growth in deposits lagged behind at 18 per cent as depositors preferred to park their surpluses in instruments such as PPF, NSC and also in the equity markets.

The redemption of India Millennium Deposits in December 2005 worth $7.3 billion and spiralling oil import bills caused a bit of a liquidity crunch for a couple of months.

This forced the banks to raise domestic term and NRE deposit rates by 50-75 basis points in the last quarter to ensure availability of adequate resources. However, they held back from passing on the costs immediately, resulting in crimped margins.

Not surprising then that the banking sector has significantly underperformed the benchmark BSE Sensex for the better part of the rally last year.

While the Sensex has almost doubled to 12,360 points till date, the banking sector has substantially lagged behind giving a return of about 56 per cent in the same period. However investors need not despair since this year could turn out to be better for banking stocks.

According to Jay Prakash Sinha, VP and head of research, Kotak Securities Private Client Group (PCG), "Banking stocks have become lot more safe. The beta--which indicates the risk-- for most of the bank stocks has come down significantly. For example, in the case of Bank of India, it has come down from 1.5 to 1.3 in last on year.

Adds Kanan Shah from Networth Stockbroking, "There does not seem to be a significant downside from the current levels though any sharp appreciation in the prices cannot be expected immediately. Moreover, the positive signals like strong credit growth of over 30 per cent and the PLR hikes augur well for the profitability of the sector."

In FY06, results of most banks, that have been announced so far, have exceeded expectations, with most banks, public or private, reporting strong growth in business (deposits+Advances). 
 

NUMBER THEORY
Rs crore FY06	Net interest income	Chg (%)	Other income	Chg (%)	Net profit	Chg (%)
Andhra Bank	1169.00	9.30	458.10	-39.20	485.50	-6.70
UTI Bank	1078.00	47.00	729.60	75.00	485.00	45.00
Union Bank	2374.30	15.00	625.10	-18.40	675.20	-6.10
IOB	2067.00	11.40	728.20	-8.90	783.30	20.30
IDBI*	379.90	102.20	1280.50	104.20	560.90	82.50
ICICI Bank	4187.00	47.50	4983.10	45.90	2540.00	27.00
HDFC Bank	2545.80	43.20	1124.00	72.60	870.80	30.80
Dena	722.70	5.30	333.70	72.50	73.00	19.70
Corporation	1226.00	8.60	571.50	1.20	444.50	10.50
Canara	3581.00	2.00	1377.50	-10.80	1343.00	21.10
BOI	2631.00	17.60	1184.40	2.50	701.40	106.30
BOB	245.70	8.30	1191.70	-9.30	827.00	22.20
OBC	1605.10	5.30	552.80	9.40	557.20	-23.30

However, the private banks lead the pack with ICICI Bank recording the highest growth of over 60 per cent each in deposits and advances.

Further, private banks have reported sharp growth in their non-interest income which has boosted their overall profitability. While public sector banks have also reported strong growth in their core business, their net profit growth has been subdued largely due to slower growth in other income and rising operating costs.

The net interest margins (NIM) of the banks have fallen marginally due to the rising cost of funds and falling yield on advances. However, HDFC Bank's NIM has seen an improvement. 
 

EXPLOSIVE GROWTH
FY06 (% Chng yoy)	Deposits  growth	Advances  growth	Net Interest Margin (%)
			FY06	FY05
Andhra Bank	23.10	25.50	3.30	3.60
UTI Bank	26.00	43.00	2.90	2.90
Union Bank	19.80	32.90	3.00	3.30
IOB	14.20	36.00	4.00	4.00
ICICI Bank	65.00	60.00	2.30	2.20
HDFC Bank	53.50	48.10	4.30	4.00
Dena	13.10	24.30	3.00	3.10
Corporation	20.70	29.20	3.60	3.90
Canara	20.70	31.50	3.60	3.60
BOI	19.20	23.30	2.80	2.60
BOB	11.40	41.00	3.30	3.40
OBC	4.90	29.30	2.80	3.20

Despite their large asset bases, banks have succeeded in improving the quality of their loans. As of March 2006, seven out of twelve banks namely Andhra Bank, UTI Bank, Indain Overseas bank (IOB), ICICI Bank, HDFC Bank, Bank of Baroda (BoB) and Oriental Bank of Commerce (OBC) have brought down their NPAs to under one per cent.

Others like Union Bank of India (UBI), Dena Bank, Canara Bank and Bank of India (BOI) have also brought down their net NPAs significantly. This suggests that banks balance sheets are in reasonably good shape.

While the outlook for the banking sector looks reasonably good, one needs to pick and choose.

Says Sinha, "Only those banks that have been able to maintain NIMs and have been able to improve asset quality will do well. Besides, banks whose provisioning requirements are coming down due to most of securities shifted to held-till-maturity category, will benefit. Also, banks that maintain high return on equity will be able to perform better even in a higher interest rate scenario."

Most banks have cleaned up their balance sheets by transfering securities to the Held-to-maturity category. Thus, losses on account of gilts trading should be minimal, even if interest rates rise further. Banks have underperformed the market primarily because investors believed that they would not be able to grow their margins in arising interest rate regime, in which borrowing costs were increasing.

However, with borrowing costs unlikely to rise in the medium term and with several banks are seeing smart increases in their fee incomes, margins should not be under too much pressure. While most banks appear undervalued, some banks like HDFC Bank are expensively valued though its performance has been excellent. 
 

SOME CHEAP, SOME DEAR
	Price /Earnings Multiple		Price to Book value
	FY07(X)	FY08(X)	FY07(X)	FY08(X)
BOB	8.20	6.20	1.10	1.00
BOI	8.20	7.00	1.30	1.20
Canara	7.20	6.30	1.30	1.10
Corporation	10.80	9.50	1.40	1.30
HDFC bank	23.80	18.00	4.40	3.70
ICICI bank	18.80	14.20	2.50	2.20
IOB	7.00	5.80	1.60	1.30
OBC	9.10	7.60	1.30	1.10
PNB	7.60	6.20	1.30	1.10
SBI	13.60	10.40	1.70	1.50
Syndiacte bank	6.20	5.30	1.50	1.20
Union Bank	6.50	5.30	1.20	1.00
UTI Bank	15.10	12.30	2.50	2.40

HDFC Bank trades at 4.4 times and 3.7 times FY07E and FY08E estimated price-to-book value (P/BV)respectively--the highest among all the major banks. The stock has always been richly valued but it should continue to outperform.

ICICI Bank is slightly cheaper than HDFC Bank but again, its results for FY06, have been very good and its growth has been aggressive. ICICI Bank too is likely to outperform the market, as it has been doing. HDFC too has been an outperformer and should continue to do well.

As for other banks,especially the public sector banks, the downside, at this point in time, appears to be limited Among public sector banks, BOB is the cheapest stock whether one looks at it for FY07E or FY08E basis.

However State Bank of India is also trading close to 1.7 times and 1.5 times based on FY07 and FY08 price-book value estimates. These stocks may take time to outperform.