SOE (state-owned enterprises) banks were up 17% in the past month (8% YTD), but is it another flash in the pan? To own these, we need to see stronger economic growth than in our base case?and a large capital infusion. Our base case is some improvement, but not enough, so SOE banks should continue to trail private banks.
Improvement in the asset quality cycle: Will it solve all the problems for SOE banks?
In our view, the peak of India?s NPL (non-performing loan) formation cycle is now past. New impaired loan formation is likely to slow from F1Q15 onwards.
Though it?s likely to be past peak, we still expect new bad loan formation to remain higher than normalised levels for the next two years. This, plus low coverage on existing bad loans, would keep credit costs high for the SOE banks. Key for them is a significant pickup in economic growth, which could drive lower NPLs.
Retirement-related costs will also be a drag on ROA (return on assets): SOE banks are not making full provisions for retirement (higher mortality and salary escalation). The provisions for wage hikes are also below the likely increase, in our view. Provision pickup is likely to keep costs high. This, coupled with higher credit costs, would be a drag on ROA.
Capital will be the overriding overhang for the next 4-5 years: Basel 3 implementation coupled with weak profitability implies that banks will have to constantly raise capital. Our coverage banks will likely need about $25 bn of capital by F19 over and above internal generation?a very tall order. Fully diluted ROE for SOE banks is in single digits. The upside would be if the state does a big capital infusion and takes out bad loans.
SOE banks are unprofitable, under-provisioned and undercapitalised?we prefer private banks: Our target price increases for SOE banks reflect lower bear case probability and lower credit costs. However, despite this, we see 25-30% downside except for BOB. On the other hand, private banks with large capital buffers should do well in a moderate recovery, gaining share and (as economic concerns recede) enjoying multiple expansion.
?Morgan Stanley
