Why Banking Funds Are A Good Buy At This Point

The Indian banking and financial sector has gone through an extremely painful period over the last two to three years. The pandemic-led disruptions affected the asset quality and the credit growth of the sector leading to stress and depressed stock prices. However, the sector is slowly picking up in asset quality and credit growth backed by strong growth in the economy and industrial activity in the country.

Interestingly, not just valuations that are favourable at this point, the banking and financial sector offers strong growth prospects. One of the ways to tap this is to pick some high-quality banking funds or schemes. Instead of betting on individual banks, which could be highly risky, banking funds would not only offer diversification but an opportunity to participate in a structural growth story.

How would this unfold?

Typically, banking stocks' performance depends on the stages of the credit growth cycle and asset quality cycle. These two cycles change with the change in economic activity and prospects. The first leg of the re-rating cycle moves around better asset quality while the second leg is driven by the acceleration of credit growth.

The first leg of the cycle

• Improving balance sheet with better asset quality

The first leg of the cycle Second, Indian banks’ balance sheets have improved over the past five years, despite the outbreak of COVID-19 havoc. Led by liquidity and better earnings, the corporate balance sheet has seen a marked improvement. Gross NPAs (including structured advances) have improved from 12.5% in fiscal 2018 to 7.5% in fiscal 2022.

The second leg of the cycle

• Credit growth at multi-year high

Since 2019, the Indian government has been taking systematic supply-side policy reforms and pushing investment-led growth. The aim has been to offer a conducive environment for the private corporate sector. Meaningful reforms like reduced corporate tax rates, fiscal incentives, production-linked incentive schemes for the manufacturing sector, better public infrastructure, and new sectors for private businesses have aided in the growth and development of the Indian private corporate sector.

As a result of this, India’s capex cycle has recovered led by both private and public expenditure leading to higher loan growth. This is expected to accelerate further in light of private capex and economic growth in the coming years.

The result of sustained growth would be better job creation, income growth, better growth opportunities for the retail and SME segment and an overall push for higher credit growth. We have already seen acceleration in credit growth. Credit growth has already hit its multiyear high at around 16% in September. India Ratings recently raised its credit growth expectations to 13% in fiscal 2024 from 10% earlier.

Kick starting a new earnings cycle

Higher credit growth would lead to higher revenue. Moreover, improving asset quality and higher interest rates would kick start strong earnings growth. Indian Banks’ NIMs (margins) are expected to rise over the next two years. Increasing lending rates coupled with lower deposit rates would result in higher margins.

Improving cost: The credit cost reported by private banks in the first quarter of FY23 stands at 50-70bp which is much below the normal levels. Lower system delinquencies, stronger recoveries, and a strong rebound in the retail sector are further adding to the growth of the Indian banking sector. The NPL formation has moderated with most banks now at a cover of 65-80%.

Operating Leverage: Banks enjoy high operating leverage given the high component of fixed cost. Moreover, most of the banks have increased their investment in the past, particularly tech investment increasing overall fixed cost. However, when the credit growth itself is around 14-16%, many of these banks could accelerate growth and with the higher scale, fixed cost would come down leading to higher margins.