The condition of India’s macro-economy as well as banking sector remains weak with inflation hovering at 12% levels, the rupee weakening against the dollar, the fiscal deficit widening and persistent fears of an economic slowdown. All this translates into myriad concerns pertaining to the visibility of banks’ earnings growth. Further, the dislocation in global financial space has resulted in either the bankruptcy of the major players (Lehman Brothers Holdings) or voluntary/forcible sell-out of the others (Merrill Lynch, Wachovia, Washington Mutual).

Amidst the rising concerns at the macro level, the business growth at the industry level remained strong in Q2-FY2009. The year-till-date non-food credit growth (till September 19) stands at 26.2%, better than the 22.1% credit growth recorded in that period last year. The healthy credit demand bodes well for the operating performance of the major banks, especially the private sector banks (except ICICI Bank). Going forward, the credit growth is expected to moderate to ~20% levels on the back of the RBI’s monetary tightening actions (multiple hikes in cash reserve ratio and repo rate).

In response to the multiple hikes in the key rates effected by the regulator, banks had hiked their lending rates in August 2008. Also, many banks had increased their term deposit rates in the quarter. Consequently, we expect the net interest margin (NIM) of banks to remain stable sequentially with the possibility of a marginal improvement. However, the pressure on the margin is likely to return as term deposits get repriced at higher rates in the quarters to come.

In addition to the concerns over profitability, worries over the quality of assets of banks are on rise with the recent hardening of the lending rates. The ongoing monetary tightening of the RBI threatens to result in higher delinquencies and hence higher provisioning. For the public sector banks, there is the additional concern regarding the potential change in the repayment behaviour of the agri-borrowers following the announcement of the farmer loan waiver scheme. Therefore, the quality of banks’ assets will remain at the centre-stage and will be keenly watched in this earnings season.

Stock Tips: Considering the above factors, banks look attractive at the current valuations from a long-term perspective. I would recommend HDFC and Axis Bank from the private sector and prefer Bank of India from the public sector.

Source: Sharekhan report