Until the Adani fiasco, the bank sector was the star performer in the past two years. The Nifty Bank has given absolute returns of 26% from Jan 1, 2021, till date, while Nifty 50 gave 21%. Nifty Bank’s major heavyweights are private banks and State Bank of India (SBI). The underperformance of private banks has overshadowed the growth in public sector banks as well. Nifty PSU Banks gave 97% returns in the same period. 

Exponential growth in PSU Banks’ profitability, coupled with valuation rerating, caused the PSU Bank index to double in the past two years.

PSU Banks are the driving force behind the Indian economy, with their deep rural penetration. Implementation of Direct Benefit Transfer (DBT) schemes, coupled with awareness and outreach, has led to an increase in customer base for PSU banks. This is reflected in the overall growth of the banking system. Larger banks with higher assets and networks have seen the maximum growth in the past two years. 

It’s worth noting that the Nifty PSU Bank underperformed Nifty 50 in the longer term. In the past five years, Nifty 50 has given an absolute return of 65%, while it was 18% for Nifty PSU Bank.

PSU banks have room for further lending

PSU banks’ deposits have grown at a CAGR of 6.44% in the past two years, while advances grew at 11.62%. PSU banks’ deposits stand at a staggering Rs 113.3 lakh crore, while advances are at Rs 83.8 lakh crore at the end of Q3FY23. PSU banks grew skeptical of lending after the NPA crisis from 2017 to 2020. Most of the deposits were parked with the RBI at a lower interest rate. With the economy opening up after Covid on lower interest rates, PSU banks went on a lending spree.

Note: Values in Rs lakh crore

The growth in advances was achieved on the back of a higher deposit base. The credit deposit (CD) ratio has steadily increased in the past nine quarters. PSU banks currently have a CD ratio of 73.90%, while most private banks are above 80%. A higher CD ratio implies efficient utilization of the deposit base and a higher net interest income (NII). If PSU banks were to reach a CD ratio of 80%+, we can expect another round of rapid growth in advances.

However, at this juncture, higher interest rates will curtail the growth of advances. The CD ratio is expected to remain the same or decline owing to an increase in deposits, Since higher interest rates attract more term deposits -  Customers move money out from current account and saving accounts (CASA) into term deposits.

Margins to be under pressure going forward

CASA is traditionally the cheapest source of funding for banks. Customers moving away from CASA deposits increases the cost of funding. Lately, all banks have been seeing an increase in the cost of funds. 

PSU banks’ CASA ratio dropped from its peak of 43.05% in Q4FY22 to 40.05% in Q3FY23. This is in line with the increase in repo rates by the RBI from April 2022. RBI increased the repo rate by 250 bps in FY23. CASA ratio is expected to drop further as interest rates peak by the end of FY2024. This will increase the borrowing cost of banks, putting pressure on their margins.

PSU banks' margin has seen an expansion of 80 bps in the past three quarters. However, higher margins are difficult to sustain as the repricing of deposits starts taking effect. 

More loans on floating interest rates will be an advantage when there is a trend of rising interest. This will have an adverse impact when the rates decline by the end of FY24. 

 Note: Values in Rs crore. NIM is calculated as a ratio of net interest income to advances

PSU banks have seen the NII grow at 18.37% CAGR in the past two years. The growth in advances, coupled with margin expansion, led to a higher growth rate of NII for PSU Banks. Going forward, contraction in margins and a slowdown in advance growth will adversely impact NII.

NPAs decline on the back of higher provisions and better recovery

Asset quality has been a concern for PSU banks in the past five years. Post Covid, PSU banks saw another spike in non-performing assets (NPA). However, this time, PSU banks have managed to bring down the NPA drastically. Gross NPA declined by 27% in the past eight quarters and net NPA by 43%. Gross NPA, as a percentage of advances, stands at 5.56% at the end of Q3FY23. Net NPA percentage is at 1.41. The gross NPA  percentage of private sector banks is in the range of 3-4, whereas net NPA percentage is 1-1.3. PSU banks are on the higher side in terms of gross NPA.

 Note: Values in Rs crore. NPA % is calculated as NPA as a percentage of advances

The lower net NPA percentage is on account of higher provisioning undertaken by banks. Most of the PSU Banks have Provision Coverage Ratio (PCR) greater than 70% (as prescribed by RBI). Banks have provisioned Rs 1,23,360 crore in the past four quarters, a decline of 7% YoY.

 Note: All values in crore

Higher provisioning has been eating away at the profitability of PSU banks.  This has improved in recent quarters – in Q3FY21, provisions were 58% of the net interest income. However, it dropped to 31% at the end of Q3FY23. Going forward, banks are expected to maintain similar provisioning levels, considering RBI’s implementation of the Expected Credit Loss Mechanism (ECL).

Lower provisions drive profitability

An increase in NII and lower provisioning are driving PSU banks' profitability. PSU banks have seen profitability soar by 10 times in the past nine quarters. The growth is higher due to the lower base. Most of the PSU banks were loss-making (except a few large ones) till the end of FY20. With lower provisioning, banks have turned back to green.

Note: Values in Rs crore

Nifty PSU Bank valuation sees an upward trend

The recent Adani fiasco has pushed the valuation of PSU banks to the downside. The three largest PSU banks, viz., SBI, Bank of Baroda and Punjab National Bank altogether have an exposure of Rs 40,000 crore in the Adani Group. These three stocks have major weights in the Nifty PSU index, dragging it further down. However, the Price to Book (P/B) valuations are still higher than historical averages.

Nifty PSU Bank was trading in the P/B range of 0.7-0.75 from Q1FY22 to Q2FY23. But it has increased to 0.9-1 in the past couple of quarters due to factors like an increase in advances, higher CD ratio, NIM expansion, improved asset quality and lower provisioning. 

P/B rerating, coupled with growth in the book value of PSU banks, have led to PSU banks' astounding outperformance with respect to the broader index. Going forward, PSU banks' contraction in margins along with a slowdown in advance growth will put pressure on profitability. However, this will be partly offset by lower provisions, keeping the growth going, but  on the lower side.