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Q2FY20 review of Banks: Operating metrics improved further

Pvt banks continued to gain market share in loans & deposits.

In aggregate, banks (35 banks, ~85% of the system) improved their operating metrics further in Q2. Higher provisions led to lower bottom lines but also lower Gross NPLs, though the liquidity tightness has cast a shadow over quick recovery hopes. Pvt banks continued to gain market share in loans & deposits. Our top picks: Axis, ICICI, SBI, and HDFC Bank.

Write-offs & increasing provision coverage drive net stress reduction: Sector stress peaked in FY18 at 12.4%, tapering to 10.1% as of Q2FY20-the reduction mostly the result of write-offs (~Rs 2.2 trn in FY19 & ~Rs 0.8 trn in H1FY20, cumulatively ~28% of opening gross NPL) and increasing provision coverage. Overall, banks have beefed up their PCR from ~50% in FY18 to ~63% in Q2FY20. NPL formation has come off for the sector, though private-sector banks have posted an increase because of liquidity tightness in select sectors/segments.

Emerging risks-hopefully not a contagion: Since August 2018, repayment risks have emerged, affecting the overall NBFC segment. Initially viewed as liquidity risk, we believe that weakness prevails despite the RBI/government taking measures to infuse confidence.

Credit ratings: The interest coverage ratio for the entire corporate (ex-financials) group declined to ~5.6x in Q1 FY20, the lowest in the past 14 quarters. The 'A' rated corporates seem most at risk of credit rating downgrades given their elevated debt serviceability ratios. The simple credit ratio (upgrade to downgrade) and the debt-weighted credit ratio posted steep declines in H1FY20.

Retail growth weakens: Indeed, system credit growth (incl. NBFCs) has come down to ~7.2% (vs 15% in Nov 2018) and bank loan growth, too, has declined-weaker growth in pockets of retail loans, a slowdown in the trade credit segment and muted corporate growth. Retail loan growth continues to be driven by housing and unsecured personal loans.

NIMs have positive bias: Banks took large deposit rate cuts (~50 bps YTD) to ensure NIMs are protected in a falling rate environment. As rates stabilise, NIMs should expand as loans reprice faster than deposits. Lower net NPLs through higher writeoffs or recoveries incl. NCLT ones should aid NIMs further.

Core profitability better: Core profitability and NIMs across SOEs and private banks improved further, and we expect this trend to sustain through FY21.

Portfolio choice: We like banks with high provision cover on corporate NPLs, stronger liability franchise and large enough operating profit to digest asset-quality surprises from emerging risks. We prefer Axis, ICICI, SBI and HDFC Bank as RoE normalises in FY20-21e.