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The valuation explanation challenge

We view the recent outperformance of large private banks over other lenders as a flight-to-safety argument. The asset quality seems less worrisome than feared, with a recovery visible in segments such as unsecured loans. Hence, the upward normalization of credit cost might be slower than expected earlier, thereby making the risk-reward premise quite favorable outside of large private banks. We like Axis Bank and SBI in this framework given the recent underperformance. Bandhan can be a play on recovery in microfinance.

Large banks have outperformed when the best earnings are behind them

The recent outperformance of large private banks over others (mid-tier private banks, regional banks, SFBs and PSU banks) has come at a time when their peak earnings performance might be already behind. We observe the following trends: (1) Loan growth has slowed with no near-term drivers of recovery, (2) deposit growth remains sluggish and (3) no reduction in deposit rates despite rate cuts, thereby indicating potential disappointment in near-term NIM.

Keeping an optimistic view of the future can partially explain outperformance

We could explain this from two sides: (1) We are past the worst performance on growth for large private banks such as HDFC Bank and Axis Bank. As liquidity conditions improve, there is a probability that the frontline banks that have fewer concerns would lead growth in the initial stages of recovery. (2) Asset quality and growth remain an area of concern that is likely to persist. (3) On a relative basis, the risk-reward is favorable for large private banks as compared to other sectors in the market.

Flight to safety explains this performance, but it is not a strong argument

The common factor that explains the outperformance of HDFC Bank, ICICI Bank, Cholamandalam Finance and Bajaj Finance as compared to Axis Bank suggests that investors are looking for stocks that can have fewer large negative surprises (similar to the microfinance crisis or the recent case of IndusInd Bank). However, the flight-to-safety argument has its own idiosyncrasies. As the fears recede (as they always do at some point), the re-rating argument becomes stronger. The rally in corporate banks is a classical case-in-point, where we could risk overstaying on the safety argument. The best approach is to look at asset quality, growth and profitability, and refer to the same through the valuation framework. From that perspective, it is harder to justify a sustenance of the outperformance by large private banks hereon. We don’t see asset quality as a serious area of concern for banks. We would want to believe that the microfinance stress would be behind us in FY2026E. We believe that the stress in unsecured loans has been lower than initially feared, and its impact was seen primarily on players who had a higher share of lower-ticket or shorter-duration loans as compared to the typical portfolio of private and PSU banks. Growth and NIM are still a work-in-progress, which would imply that the current outperformance may not sustain. We like Axis Bank and SBI with this framework, while we maintain our positive business outlook for ICICI Bank.

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