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We believe that the Indian banking sector is in its last leg of provisioning for large Non-Performing Assets (peak GNPA% of 13% now at 11%) and is going through its ‘moment of renaissance’. During this cycle the major differentiator of outperformance between banks was their asset quality. Banks with high exposure to certain stressed sectors bore the brunt of the macro-economic slowdown, over leverage and systemic ever-greening resulting in substantial NPAs in the large and mid-corporate segment. Post the asset quality review by RBI (concurrent AQR in 2016); banks seemed to have recognized the majority of the stressed accounts, for which they have made provisions over the last few years.
We believe the NPA cycle has peaked out and we expect lower incremental slippages (peak of 5%) and credit costs (peak of 3.5%), leading to normalization of profitability and improving return on assets and return on equity in the medium to long term. Apart from asset quality turnaround, the key themes taking the centre stage for investment analysis of Indian banks would be (a) solid liability franchise, (b) strong cross-selling capabilities and (c) preparedness to tackle digital disruption.
Over the years, a huge stock of stressed assets was created and piled up in the banking system for various reasons without recognition, culminating in provisioning for such activities. Problems were further magnified by management changes (with some still pending) at quite a few banks.
In order to address this once and for all, RBI carried out an asset quality review (AQR) of bank’s loan books (FY16). This exercise led to the recognition of NPAs which had to be followed up by provisions, downsizing the sector’s profitability and capital requirements. We remain positive on the outlook on slippages and the direction of NPAs in the coming period as early warning indicators are stable and there is a noticeable increase in the pace of resolution of stressed cases referred to NCLT (National Company Law Tribunal is a quasi-judicial body) under the Insolvency and Bankruptcy Code.
Now, for the first time, since FY15, stress in the Indian banking system (gross NPL + standard restructured loans) has declined from 12.5% of its loan books in FY18 to 11.3%. Hence, after 5 years of subdued profitability, led by asset quality issues, coupled with growth slowdown and high competitiveness, we believe that the Indian banking sector is set to redeem itself in FY20. As credit costs normalize, banks which got hit by high NPAs and were de-rated will see RoEs improve and likely see better market valuations.