>Indian Banks (NOMURA)

We initiate coverage of the Indian banks sector with a NEUTRAL view. We believe the key drivers of bank earnings – loan growth, interest rates (bond yields) and asset quality — have turned negative in 4QFY09 and are likely to deteriorate further in FY10E. We expect earnings growth of Indian banks under our coverage to drop 6% in FY10 after a robust CAGR of 21% over FY05-08. While banks are faced with these challenges, we find some comfort in state-owned banks’ valuations, which are trading at below book values, and fast-growing private banks, which are trading at 1-2x FY10E P/BV. We do not see positive catalysts for these banks in the next three to six months, except for policy rate cuts. Rather, we believe incremental newsflow on banks relating to fiscal measures and specific loan exposures turning bad will be negative for bank stocks.

● We initiate coverage of Punjab National Bank (PNB) and Axis Bank with BUY ratings. For State Bank of India (SBI) and Housing Development Finance Corp (HDFC), we recommend a REDUCE. We are NEUTRAL on ICICI Bank, HDFC Bank, Bank of India and Union Bank of India.

● Our target RoEs for these stocks are significantly lower than the banks’ current RoEs (except for HDFC Bank), mainly because we have assumed higher credit costs of 1-1.2% of assets against the current low peak cycle credit costs of 0.4-0.6%.

● We expect the sector’s loan growth to slow substantially to 12.5% after a robust 28% growth rate seen in FY05-08, as we believe slowing foreign capital inflows will weaken domestic demand.

● We expect non-performing loans (NPL) to grow 3x in FY08-11E, with growth in some banks as high as 5-8x. The sharp spike in NPL is likely to be driven by a large proportion of unseasoned loans at 36% of the sector’s total loans.

● We see bank margins contracting. Banks are likely to lose pricing power, as we expect credit demand to remain weak, due to slowing corporate investments and pressure on households. In addition, declining credit deposit ratios and loans repricing faster than deposits will exert pressure on margins.

● A reversal of the bond rally in 4Q09, contrary to market expectations, is likely to trigger losses on banks’ available for sale (AFS) bonds, and erode gains on their heldto- maturity (HTM) portfolios, in our view.

To see full report: INDIAN BANKS