>India Banks (CITI)

Asset Quality: Testing the Stress

■ Where will NPL’s go? It’s a tough one — a) We say 4% (2.3% currently); b) Analyst estimates range from 3-6%; c) Banks don’t have a fix on numbers – but all suggest a meaningful escalation; and d) Historical peak is 25%. We don’t believe anyone has the answers – but we pose questions, and try to answer them.

■ When will book values erode? At 9% NPLs — The sector breaks even at 8.7% NPL levels – to reach this level NPLs will have to rise 4.5x current levels. We believe this scenario is still far off and therefore unlikely to play out. However, NPL range for individual break-evens is quite wide (between 6-27%).

■ How much do earnings get impacted? 20% for every 1% rise in NPLs — With every 1% rise in NPLs: a) Earnings are hit about 20%; b) Assuming 50% loss rate, charge-offs rise 100bps; c) ROEs decline by 2.5ppt; and d) Book values are pulled down by 2.5%. We currently factor an avg 130bps of credit charges.

■ What happens if NPLs rise to 7%? — 7% is above the highest end of current street estimates and can be seen as a potential stress case. At 7%, NPLs will rise to 3.5x of current levels and will result in: a) Sector earnings declining 73%; b) Banks still make some returns, albeit a low 4%; c) Book values are still 6% higher than current levels; and d) Loan losses rise to 310bps (2.5x current levels).

■ What about restructuring loans? — It does complicate reporting and makes it harder to gauge the underlying health of assets; leads to an understatement of reported NPLs (will likely be lower than our estimates). In our 4% sector NPL estimates, we implicitly assume 20-30% of restructured assets turn into NPLs.

■ Who are the most exposed? Government banks, ICBK, Axis — Government banks in general are more vulnerable to rising NPLs: a) Will erode book earlier (8% NPLs vs 11% for private); and b) Have more earnings impact for each 1% rise in NPLs (21% vs 17%). CBI and Canara are the most vulnerable; SBI the least (most earnings cushion). ICICI is more exposed from an earnings perspective. It "only" needs a trebling of NPLs before earnings are wiped out but has a much larger capital cushion – a 1% rise in NPLs impact book value by 1.5% (2.5% avg). After ICBK the largest impact on earnings is felt on Axis (among private banks).

■ Concerns might be overdone; remain overweight — We expect NPLs to rise meaningfully and remain an overhang. However, we believe concerns might be overdone and possibly factored into stock prices. Maintain overweight on banks.

To see full report: INDIA BANKS