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Asset quality pain largely behind; all eyes now on growth acceleration

* One-off gains help PSBs maintain strong profitability; private banks’ performance shade better than Q1: Despite some softness in margins and partial impact of the change in pension rules, PSBs reported strong profitability on the back of a one-off recovery from DHFL and contained provisioning due to lower fresh NPA formation. That said, we believe growth still remains weak and PSBs need corporate growth acceleration. Among PSBs, SBI, Canara and Indian were clear outliers. BOB also reported a strong bump-up in profits, barring a slight upset on growth. Among private banks (PVBs), large PVBs continued to report divergent and relatively stronger performance. ICICI was a clear outlier, followed by HDFCB, which reported better growth/asset quality vs. Q1. Axis continued to disappoint on growth/margins. IIB reported reasonable numbers despite accelerated provisions on Vodafone, but recent CG-related issues hurt the stock. Among small/mid-size banks, Federal was a clear outlier, while KVB/CUBK reported better-than-expected performance on profitability/asset quality. Bandhan was a major disappointment as the bank upfronted provisions on its stressed MFI portfolio, thereby slipping into a massive loss.

* Consumer retail credit growth picking up; await acceleration in commercial retail and corporate growth: Within consumer retail, mortgages remained the key growth driver, with signs of growth normalization seen in card/PL as banks shed risk-aversion to some extent. Car finance growth was sluggish due to underlying weak volumes (impact of chip shortage), while MFI/TW continued to struggle with asset quality issues. Within commercial retail, CV remained the laggard, and higher fuel prices could delay a full-scale growth pick-up. Business Banking/SBL segments should see acceleration as asset quality risks recede. Corporate growth remained sluggish due to underutilization of capacities and deleveraging, forcing few PSBs to cut growth guidance by 100-200bps. Though, the sanction pipeline is building up from sectors such as textiles, petrochemical, chemical and steel. We trim our systemic credit growth estimates to ~8% from 9% for FY22, factoring in the impact of continued sluggishness in corporate credit on PSBs and a few large banks.

* Stress formation to ease in H2 and so do provisions: Q2 was marked by sequential moderation in stress formation, mainly led by retail, and more so for large PVBs/PSBs. However, stress still remains elevated in select retail segments such as CV/CE, TW, MFI and SBL/SME, reflecting in weak asset quality for select banks like Bandhan, Ujjivan and RBL. Within corporates, Srei Group was finally recognized as NPA, with banks creating 50-70% provision (SBI@100%). PSBs expect NARCL transfer to further reduce the corporate NPA pool. The restructuring pool inched up across banks mainly under the resolution framework 2.0, mainly in retail/SME, as most banks chose to extend it liberally. However, most banks expect the relapse rate to be low at 20-30% but at >50% for MFIs. Overall, we expect NPA ratios to moderate due to lower slippages and higher recovery/woffs as most banks, barring a few small private banks, sit on a comfortable provision cover.

* All eyes now on growth acceleration: With the asset quality pain largely behind, banking stocks would hereon largely track growth. Rising inflationary pressures may raise prospects for a rate hike, but we believe the policy response will be measured as economic growth also needs to be anchored to a comfortable zone. In our view, improving underlying consumption demand and asset-quality normalization should support growth. We expect large banks with higher consumer credit portfolio to be the early beneficiaries. Among large banks, ICICI remains our top pick, followed by SBI, HDFCB and Axis. We like IIB too as we see a turnaround story with strong provision/capital buffers in place, though better handling of management changes and evergreening allegations in BFIL would have been appreciated. Among small/mid-size banks, we like Federal, Indian Bank and Equitas SFB.

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