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* Superlative growth, margins boost profitability for banks in 2Q – More so for PSBs: Systemic credit growth remained strong (at 18%), as also for most PVBs/PSBs led by healthy traction in retail loans, charging up corporate growth as well. Margins surprised positively for most banks (10-60bps QoQ), mainly due to improving LDR, faster asset repricing in the EBLR/MCLR regime and lower NPA drag. This, coupled with strong fee traction, led to healthy core-profitability growth across banks. Treasury performance improved vs 1Q, as G-Sec yields cooled down, thus reducing the drag on PPoP growth. Asset quality continued to improve, leading to lower LLP and thereby helped the bank to deliver its best-time profitability/RoA. Among large private banks (PVBs), ICICI Bank reported strong earnings growth despite an additional contingent buffer of Rs15bn, taking it to 1% of loans – the highest in the industry. Axis lagged on the growth front, but surprised positively with a margin uptick for a second quarter in a row. Among small/mid-size PVBs, IIB disappointed a bit on the margins front, possibly due to its higher share of fix rate book. However, Federal Bank, CUBK, KVB and Ujjivan SFB reported a strong beat on earnings. Bandhan Bank registered weaker than expected profitability due to asset-quality clean up, but a meaningful uptick is likely in 4Q. Yes Bank, too, reported a miss on earnings, due to higher provisions. Among PSBs, BOB, SBI, Union Bank and Canara Bank surprised positively on growth/earnings, while PNB disappointed due to higher provisions.

* Deposit growth lags and thus needs to accelerate while managing margins: The latest systematic credit growth looks strong at 18% YoY, but may moderate a tad as festive-season demand ends and some impact of rate hikes sinks-in during 3Q. That said, 4Q being seasonally strong for corporate growth, should see growth stay in the healthy zone. Thus, most banks have raised their credit growth estimate for FY23 by ~200-300bps. In contrast, deposit growth till now has been far slower, at 9.5%, partly due to a conscious strategy by banks to first absorb internal liquidity; this thereby leads to slowdown in raising deposit rates. However, we believe banks would now turn slightly aggressive on raising deposit rates to fund the credit demand which should have some impact on the alreadyhigh margins. That said, we believe the improving LDR (mainly for PSBs) and re-pricing of MCLR loans will continue to support margins in 2H, leading to better core-profitability.

* Asset quality shows improving trend, with no immediate signs of fresh stress, barring in MSME/small business segments: Amid stress-flow from the restructured pool, banks continued to report net negative slippages due to better recovery trends and ability to write-off, given the strong provisioning buffers. This, along with strong credit growth, led to a sharp 70bps QoQ reduction in GNPA ratio for PSBs to 5.8% and a 30bps reduction for PBVs to 2.9%. Within retail, recovery trends seems to be strong and the bounce rates are under control with no fresh signs of stress as of now. MFI too is witnessing a better collections trend, but for Bandhan, which reels due to the impact from the Assam floods. The SME/SBL segment remains somewhat stressed and thus needs to be closely monitored. The NARCL transfer of corporate NPAs is likely to begin soon and could thus lead to further reduction in NPAs for select PSBs. Some corporate NPAs under NCLT too are nearing resolution and should thus further drive-down the corporate NPA book for banks. Thus, we believe that the receding NPA formation and most banks sitting on higher specific PCR should lead to continued lower LLP and thus support profitability.

* Banks’ purple patch to continue amid a strong growth/margins delivery, while valuations have some room to nudge up: Despite the recent run-up, we believe select banks still offer a blend of growth and value and, thus, will continue to outperform. Among private banks, ICICI remains our top pick, as it offers a strong balance of higher growth/RoE, unseen in the past, and a safety buffer with a strong capital/provision cover, while valuations (2.3x FY24E ABV) too still have some scope to inch-up. Axis Bank at 1.6x FY24E ABV and IIB at 1.5x FY24E ABV too offer a good value play. HDFCB has recently benefited from technical factors, but the merger structure remains an overhang. Among mid-/small-cap PVBs, CUBK, Federal, KVB and Equitas remain our preferred picks. PSBs in general, after a long time, have emerged strong in terms of growth/margin delivery, while NPAs are falling at a faster click. In addition to this, most PSBs are still trading at well below the +1 std deviation P/BV and are thus finding favor with investors. Within PSBs, SBI at 1.1x FY24 ABV offers an attractive, structural long-term buy, while we also prefer BOB and Indian Bank, given their ability to deliver healthy return ratios, capital buffer and sub 1x valuations.

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