2024 Outlook: Banking Sector May Witness Mid-long term Growth Amid Asset Quality In Check; Top Stocks To Buy

Banks performed more or less in line with our expectations in Q2FY24, and there were no major surprising results for any of the banks in our coverage. As expected, the banks faced the brunt of a high-interest rate environment, and NIMs were impacted due to the high cost of the funds. However, overall, the banks had improved asset quality and, apart from HDFC bank (due to the merger effect), were decent, in line with the expectations.

The treasury gains, too, were more or less similar to Q1FY24. However, the bank's fee income and processing charges improved due to cross-selling opportunities and increased credit disbursals. Of late, most banks are focusing on strengthening their retail loan book as they generate higher yields, and granularization helps sustain the improved asset quality, which is seen as a positive sign for the industry.

We believe that the rising interest rate environment provided tailwinds to NIMs for most banks, which is unlikely to continue in 2024. However, the positive part for the banking industry is the sustained credit growth, seen post-COVID, that will help banks to post improved profits going forward. We have observed that of late, banks have restructured their product mix and have been focusing on retail and SME segments (>40% of the total loan portfolio) when it comes to the loan portfolio to contain the NIM compression that the overall industry is facing on account of the increase in the cost of the funds. In FY23 and Q1FY24, the banking sector enjoyed higher NIMs due to the lag effect between the cost of lending and the cost of funds. Also, the bank's continuous spending on technological infrastructure is helping them to acquire more granular deposits in addition to accessing underbanked consumers and thus having healthy business growth.

Most of the bank's management was confident that the current double-digit credit growth would be sustained in 2024, in the range of 12%-16%, due to a resilient domestic economy and a gradual uptick in demand from rural areas. Though India faced some patchy monsoons in specific regions, the rural demand is expected to get a boost due to the festive season. We believe that with inflation moderation seen in H1FY24, the credit growth will remain intact in the range of 12%-16% and continue in 2024 as well. The scheduled general election in 2024 will also help boost infrastructure spending, benefiting credit growth.

On the deposit front, most banks had healthy growth in the range of 10%-13% in H1FY24 due to higher interest rates offered by banks and the withdrawal of Rs. 2,000 notes. We believe that deposit growth will stand at an average of around 13% in 2024 across the banks primarily due to increased penetration of the baking system in Tier-II cities and rural areas. This will be supported by the bank's varied strategies to grow deposits by launching different products and expanding branches.

Also, the deposit increase will be aided by digital platforms and tie-ups with the fintech platforms. Although giants of the industry like SBI, HDFC Bank, and ICICI Bank are optimistic that they will deliver deposit growth in the range of 12%-14%, there will be intense competition from peers and regional banks, which may weigh negatively on their guidance. Also, increasing focus on granular deposits will help banks to contain the NIM compression, as spreads would be better for these deposits.

We believe that credit growth will continue in 2024, especially from retail and SME segments due to the resilient domestic economy and an uptick seen in the rural demand. With central elections in 2024, we believe the increase in infra spend will aid credit growth. Although 2023 witnessed a patchy monsoon season in certain regions, most of the areas had a healthy monsoon, which we believe drove the rural demand that remained in slag for some time. This will help banks to grow their vehicle loan segment due to increased demand for commercial vehicles and tractors.

Although most of the 250 bps effect of interest rate hikes has been done, there is still a need to pass it on to deposits. We believe that spreads will deteriorate further in 2024 by at least 20bps-40bps. In comparison to the levels at the start of the rate cycle (Q1FY23), bank spreads are currently up around 19 bps vs 35 bps in Q3FY23 during the peak in spreads. Thus, most of the banks, especially PSBs have passed on the majority of the interest rate spreads.

Though most of the giant banks and mid-tier banks have guided the NIMs to be on a similar line to FY23 ranging between 3.5%, we believe that it would be difficult for banks to achieve, especially after the results of H1FY24. However, NIM compression would be partially offset by the bank's treasury gains, which improved the yield due to interest rate hikes and high demand seen in the fixed-income markets. Though in Q2FY24, revision in the wage hikes ranging from 14%-16% impacted PSBs' operating expenses, we feel exceptionally high opex impact has been abated.

Also, other income is seeing healthy traction due to cross-selling opportunities by banks and robust growth in retail loans and credit cards. This, in totality, will help banks to deliver healthy net profit in 2024. As the banking industry as a whole has seen a sizeable reduction in NPAs and improvement seen in recoveries and upgradation of bank loans, credit costs are likely to be moderate and help in improving the net profits in the range of 10%-15% in H2FY24.

With most large and mid-tier banks having a buffer in their capital adequacy, there is likely a minor impact on these banks after the recent RBI master circular to increase risk weights. Also, bank contributions to NBFCs are mostly in single digits in the range of 4%-8% and we believe that large banks such as SBI, BoB, HDFC Bank, ICICI Bank, and Axis Bank are not likely to be impacted. However, banks such as Bandhan Bank and RBL Bank will face the brunt of the increase in risk-weighted assets (RWAs).

Over the years, the banking industry has learned from its mistakes, and with the help of the RBI, its asset quality has dynamically improved. This can be primarily attributed to three reasons: 1) Stringent guidelines by the central bank; 2) Prudent internal credit policy and risk management by banks; and 3) timely provisions for non-performing assets. We do not see any major impact concerning ECL provisions, which are expected to be implemented by the RBI in 2024, as most banks have started making provisions in advance starting in 2023.

With the domestic economy flourishing, the banking industry has a key role in strengthening the economy. With greater accessibility of banks, mainly due to digital platforms, we believe that they will be able to increase their profits in the medium to long term and witness improvement in their RoAs and RoEs with the asset quality in check.

We believe that from the fundamental perspective, certain banks will perform in 2024 even after the rally in banks in 2023. Our top picks are:

State Bank of India: We do not see any challenge in the uptrend of credit costs in 2024 due to its balanced loan portfolio, and we expect credit costs and asset quality to remain stable in 2024. Additionally, the bank's management indicated that the NIM is expected to stay stable around the current level. However, the cost of funds will likely continue to be marginally upward over the next few quarters. Still, it will likely be offset by an improvement in the yield (led by some residual MCLR-linked re-pricing) and an improvement in the credit-deposit ratio. Also, with healthy capital adequacy, we do not see the bank's need to raise further capital to comply with the RBI's circular on risk-weighted assets. The bank currently trades at 1.5x FY25E book value and we value the stock at 1.7x FY25E book value to arrive at a target price of Rs 690 per share.

HDFC Bank: On the asset quality side, we feel all adjustments due to the one-off event of the merger and transition from IND-AS to I-GAAP have been taken care of in H1FY24. Going forward, due to the bank's legacy of healthy credit profiling, we do not see any further deterioration in its asset quality and expect it to be stable. With the bank's focus on branch expansion in semi-urban and rural areas, we feel the bank is poised to perform better in the forthcoming quarters. Also, due to the bank's vast branch network, its subsidiaries can access large cross-selling opportunities, thus indirectly supporting the topline growth. Stock is trading at only 15x FY25E earnings and 2.3x FY25E book value of Rs 700 per share. In the last five years, earnings have grown at 17% CAGR while market cap growth is only 9% which implies significant PE debate even when the company continued its high double-digit growth journey. Thus, we expect the stock to achieve a target of Rs. 2,300 in the long term.

Karnataka Bank: The bank has shown a remarkable turnaround by delivering healthy RoA and RoE aided by improvement in asset quality. With continuous growth in advances, we believe that the bank will witness an improvement in net interest income in 2024. With asset quality remaining stable in the medium to long term, we believe that the bank will deliver healthy return ratios in 2024, and our outlook remains positive. Historically low valuation multiple was given to the bank because of low ROA and ROE. In FY22, ROA was 0.6% and ROE was 7.4% while in FY23, it was able to cross 1% ROA and 15% ROE which looks sustainable going forward. This can potentially be a strong re-rating candidate and we expect the stock to achieve a target of Rs. 280 in the medium term.

City Union Bank: Despite a slow start in H1FY24 compared to its peers in the industry, we are confident that the bank will achieve growth in mid-double digits in 2024. This will likely help the bank to sustain NIMs and support the bank's return ratios. Also, due to improved recoveries surpassing the slippage, we believe that the bank has further scope for improvement in its asset quality. Going forward, the bank will likely see a substantial reduction in the credit costs and the NPAs getting back to pre-COVID levels, thereby reducing the provisions required substantially and improving profitability. The bank currently trades at 1.2x FY25E book value and we value the stock at 1.4x FY25E book value to arrive at a target price of Rs 179 per share.

Disclaimer

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