Mid-sized private banks are known to throw up some surprises by defying general industry trends. In the past six months, these private banks have seen a Price to Book (P/B) rerating. Stocks like Karnataka Bank and Karur Vysya have given returns of 116% and 87% respectively in the past 52 weeks, while it was negative returns of 24% for Bandhan Bank. 

The Nifty Bank index constituting larger public and private banks have seen a more modest growth of 7.64%. Mid-sized private banks are a different ball game altogether. Their size gives them the agility to manage changing interest rate cycles with little to no impact on profitability. Recently announced Q3FY23 results provide insights into the changing playing field for these banks.

Deposit growth for Bandhan Bank, RBL Bank outpaces advances growth

A recent report from the RBI suggests that Indian banking credit growth has outpaced deposit growth. But newer banks are bucking the trend. Banks like IDFC First Bank and Bandhan Bank have seen their deposit franchise grow at a much faster pace than advances. They are more dependent on fresh deposits for loan growth than traditional banks with a higher deposit base. If the growth in deposits slows down, credit growth takes a backseat.

The current trend in the banking industry is increasing the credit-to-deposit ratio (CD). Banks have increasingly used their deposit base to fund credit growth. The same is true for established mid-sized private banks like Karnataka Bank and Federal Bank . 

But for newer banks like Bandhan Bank, IDFC First, RBL Bank and Karur Vysya, the trend has either flatlined or dropped.

Traditionally, newer banks have depended on bond issuance and inter-bank borrowing to fund their advances. As savings accounts are the cheapest source of funding for banks, they have increased their savings and deposit rates to attract more customers. For instance, IDFC First Bank provides 6.25% interest on savings accounts, while SBI provides a maximum of 3%. 

Even with higher rates, the newer banks are struggling to increase their savings account base. Customers are moving out of savings accounts and locking in higher interest rates in term deposits. The same is reflected in the CASA ratio of private banks.

Cost of deposit increases as CASA falls for private banks

IDFC First Bank has the highest CASA ratio in the banking industry. The rising trend in interest rates has impacted the CASA ratios of all the banks. The impact has been higher for banks like Bandhan Bank and IDFC First Bank, which are dependent on CASA for lower costs of funding.

RBL is the only bank that has been able to maintain the increasing trend of CASA accounts. It is also one of the highest interest rate providers for savings accounts at 6.50%. Federal Bank and Karnataka Bank have also seen a drop in CASA accounts but at a slower pace.

The sudden drop in CASA accounts has shot up the cost of deposits for newer banks. Karnataka Bank is the only exception with a steady 4.49% cost of deposits for the past three quarters. Bandhan Bank and RBL Bank’s cost of deposits have shot up by 70 bps and 74 bps respectively since the start of FY23.

Private banks face stiff margin pressure

An increase in cost of funds has limited the net interest margin (NIM) for Bandhan Bank and RBL Bank. Private mid-sized banks thrive in a low-interest scenario. When interest rates go up, the flexibility of private banks to price their loans wane. As a result, larger banks with lower interest rates will see an increased influx of customers. The increase in the cost of funds coupled with an inability to price loans leads to margin pressure on mid-sized private banks.

IDFC First Bank saw the maximum NIM expansion of nearly 50 bps in the past two quarters, while Bandhan Bank’s contracted by 150 bps. Other banks have seen only small changes in NIMs. Going forward, high NIMs will be difficult to maintain as the deposit pricing starts to catch up. This will put pressure on NIMs once the interest rate starts seeing a downtrend.

NIMs of Bandhan Bank and IDFC First Bank are highly elevated. Most larger banks’ NIMs cannot go beyond 5% because of size and asset quality limitations. Banks like Bandhan are able to have such high NIMs on account of higher yields on advances. Higher yields can be achieved when the end borrower’s credit score is at a lower level. This brings back the question of asset quality. It can be seen that banks like Bandhan have a high level of non-performing assets (NPAs).

Improved asset quality needs more provisioning

Most mid-sized private banks had a higher level of NPA compared to larger private banks like HDFC Bank or Axis Bank at the start of FY22. Post that, smaller banks reduced their gross NPA levels. Karur Vysya Bank has reduced its gross NPA at a rapid pace over the past eight quarters. At the end of Q3FY21, its gross NPA stood at Rs 3,842 crore and then dropped to Rs 1,674 crore by the end of Q3FY23.

For other banks, the fall in gross NPA percentage is on account of higher credit growth. Credit growth outpaced NPA slippages by a very high margin, resulting in a lower gross NPA percentage. Bandhan Bank's NPA is still at a higher level compared to its peers.

Bandhan Bank is proactively provisioning for its NPA. It has one of the highest Provision Coverage Ratios (PCR) in the industry. Karur Vysya tops the list with a PCR of 90.87%.

According to RBI guidelines, the recommended provision coverage ratio for banks is 70% or  above, but it is not mandatory. RBI wants banks to proactively provision for NPAs rather than depending on recoveries. Higher provisioning impacts the profitability of banks. 

Federal Bank and RBL Bank have the lowest PCR. IDFC First Bank has maintained itself at an optimal level, balancing profitability and provisioning.

Mid-sizes private banks well equipped to absorb losses

Higher provisioning eats away the Capital Adequacy Ratio (CAR) buffers of a bank. RBI mandates banks to maintain the CAR above 11.70% and CAR above 14% is considered to be safer. Higher CAR helps banks absorb provisioning/losses.

Most mid-sized banks have CAR above 15%, except for Federal Bank. Federal Bank needs to raise more funds to be in a safer zone. Most other banks are well protected even in case of higher NPA slippages.

RBI has been very vocal about the Expected Credit Loss (ECL) framework. A recently released discussion paper on ECL framework for provisioning by the RBI proposes to change that and book provisions before the loan defaults. Accordingly, riskier loans may start seeing provisioning even before the actual default. The current provisioning methodology will completely shift to the ECL framework in the next five years. However, banks are allowed to design systems to determine stress in loan books before the actual default.

Federal Bank, with low PCR and lower CAR, will face profitability pressure once the ECL framework comes into effect. Karur Vysya and Bandhan Bank will be in a comfortable position with PCR above 90% and CAR buffer above 17%. 

This analysis by Trendlyne is meant for investor education - to help understand companies and make informed investment decisions on their own. It should not be considered an investment recommendation.