The Indian economy has recently stepped out of technical recession. Quarterly performance of India Inc. is hinting at a stronger than expected comeback. Even the banking sector is flashing improved metrics. But, the Covid-19 induced pain is far from over.

Fitch Ratings—the leading international rating agency—in its recent report argues that Indian banks’ financial metrics do not mirror the impact of the pandemic. “The operating environment remains challenging as the sector tries to balance a gradually recovering economy with preserving moderate loss–absorption buffers,” the report says.

The rating agency, in its banking sector performance update for nine–months ended December 2020, pointed out that the pandemic is likely to pose challenges to Indian banks' improving financial performance, once asset-quality risks manifest in FY22.

During the three quarters of FY21, Indian banks reported lower impaired loans and improved profitability due to various forbearance measures and continued large write-offs. “Indian banks—particularly state–owned banks—remained more risk averse than in prior years, which was reflected in their weak credit growth,” the report argues.

In their report, Fitch Ratings’ analyst duo—Prakash Pandey, associate director–financial institutions, and Saswata Guha, director–financial institutions—highlight that the agency expects both impaired loans and credit costs to rise as forbearance and easy–liquidity conditions ease. “Fitch believes the state banks are more vulnerable than private banks, given their participation in relief measures, while their earnings and core capital buffers are weak,” the duo points out.

As compared to 8.5% at the end of March last year, Indian banks' aggregate non–performing asset (NPA) ratio fell to 7.2% by the end of December 2020. However, NPAs exclude unrecognised impaired loans under judicial stay, restructured loans, loans under watch, and loans overdue by 60–plus days, which formed 4.2% of loans.

While average contingency reserves of 0.7% of loans are inadequate to absorb heightened stress, Fitch notes that the private banks are well above the average. Also, the rating agency sees high risk of a protracted deterioration in asset quality with more pressure on retail and stressed small and medium enterprises (SME) loans.

While the NPA ratio marked a decline, the nine–months ending December 2020 also recorded weak credit growth at 4.5% as banks remained risk averse. “Private banks are better poised to tap growth opportunities in 2021 as their higher contingency reserves offer better earnings and capital resilience,” Pandey and Guha note.

According to the duo, the PSBs’ average buffer between pre–provision profits and credit costs is only 1.6% as compared to private banks’ 3.4%. Not just that, the PSBs also have limited core capital buffers, with average common equity tier–1 ratio of 9.8%, in the event of further asset stress, which is unlikely to be remediated solely via the government’s planned capital infusion of $5.5 billion—which works out to 0.7% of risk–weighted assets in FY21 and FY22.

“The plan is well below Fitch's estimated capital requirement of $15 billion to $58 billion under varying stress scenarios,” Pandey and Guha add. The duo are of the view that the strategy to either not lend or lend only to capital–efficient sectors is likely to continue as low market valuations leave PSBs with limited scope to access fresh equity on their own.

The rating agency expects a moderately worse sector outlook for Indian banks for 2021–2022 based on muted expectations for new business and revenue generation, and deteriorating asset quality. And, the government's less-than-adequate recapitalisation plans for PSBs further underscores the risk, which will likely keep risk aversion high among banks amid continuing uncertainty about asset quality and an uneven economic recovery.

Beyond the financials, the going is expected to be tougher for the PSBs. According to a March 3 report from Morgan Stanley analysts, PSBs will continue to lose loan market share given technology changes, strong competition, and a weak internal rate of capital generation.

From valuations’ standpoint, PSBs, at 0.4-0.5 times estimated book value for FY22, do look cheap. But, it may not be the right time to buy the PSBs at large. “There could be near term upside but we prefer large private banks and State Bank of India (SBI) to play the corporate recovery cycle,” the Morgan Stanley analysts point out. For PSBs, excluding SBI, they see structural challenges which will keep return ratios muted, limiting any significant re-rating potential beyond the short cyclical upswing.

While there is no dearth of challenges for the banking sectors, especially the PSBs, it may be too early to go about value shopping the PSB basket at the relatively cheaper valuations that prevail.

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