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In Q3, we expect the Banking sector to post weaker earnings with softer undertones. The earnings will likely be characterized by: a) softer loan growth (modest system loan growth) and similar deposit growth, b) NIM pressure with sustained funding cost strain and interest income reversal, c) higher slippages in unsecured, MFI and KCC loans (seasonal) and d) subdued recovery trends (shrinking pool), which means net slippages may rise for some. In a nutshell, credit costs may move toward normalization.

Expect variable earnings for private banks, with earnings cuts likely for some private players (having higher MFI and unsecured book), while PSU banks may report a steady quarter. While we expect earnings to be resilient for most frontline private banks, we see softer earnings for a few private banks, making an earnings cut imminent for FY25. For Q3, we favor ICICI Bank, State Bank of India and Karur Vysya Bank, and expect a soft quarter for IndusInd Bank and AU Small Finance Bank (AUBANK IN).

Expect soft growth in Q3; NIM pressure may sustain: Overall system growth for banks has come off materially (system loan growth sub-12%, per latest print). This with sustained liquidity challenges and strained deposit growth will feed into sticky funding cost and continued NIM pressure. We expect a lower CASA ratio for most banks. And would monitor CD ratios – private banks in 85-90% range and PSU banks in 70-75% – and LCR ratio, which will impact deposits.

We see NIM impact from three counts: 1) continued repricing on the back of deposit book (albeit not incrementally material) and sticky incremental deposit cost, 2) higher interest income reversal (higher slippages) and 3) the impact of penal interest (for a few). We expect NIM pressure to sustain. In this context, commentary on turning rate tables and consequent NIM impact would dominate the discussion.

Asset quality – Monitor the impact and commentary on unsecured and MFI segments: Expect overall pressure on asset quality with higher slippages in MFI, unsecured, and KCC segments. MFI slippages could throw in negative surprises even on raised street estimates. Thus, monitor MFI slippages and related management commentary. Add to this, Q3 may be characterized by softer recovery trends (as the pipeline has shrunk), which may lead to rising credit costs. A few banks have sold off MFI stress pool, which may lead to some P&L management, which could render some respite.

Earnings cut imminent for some players: Based on our earnings expectations for Q3, we find earnings cut imminent for some private banks. Within Elara Banking universe, expect PSU banks to report better earnings than private players, led by lower credit cost, lower NIM impact and normalizing opex.

Within Elara Banking universe, we prune FY25E/26E earnings estimates for IndusInd Bank (by ~24%/8%), for AUBANK(by ~5%/4%) and for Bandhan Bank (by ~12%/5%), respectively. So, factoring in the above and more near-term uncertainty, we cut target multiples for IndusInd Bank to 1.3x (from 1.5x), to arrive at a pared TP of INR 1,320 (from INR 1,600) – Maintain BUY.

We cut target multiple for AUBANK to 2.3x (from 2.5x), to arrive at a TP of INR 650 (from INR 680) – We upgrade AUBANK to BUY from Accumulate (given that the stock has corrected >20% in the past three months; elongated pain could pose a risk to the call.

We also pare target multiple for Bandhan Bank to 1.1x (from 1.2x), to arrive at a pared TP of INR 200 (from INR 220) – Maintain BUY. Risk reward is sharply tilted towards frontline private banks with strong earnings resilience and reasonable valuation. The valuations of mid-tier private banks show that valuations are rather full, and a rerating hereon may be slow. Within the PSU basket, we continue to prefer SBI as a top pick.

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