The six-year bull run for private banks and NBFCs (CY14-20) could take an extended pause. The macro shock of CY20 could narrow the investible universe for lending financials to 6-7 stocks, with lower returns than before. Investors, therefore, may have to hunt for new set of sectors and companies, to drive the next leg of the broader market rally. There is an outlier possibility that these high-quality lenderscould innovate themselves out of this sector stress, but we would wait to see evidence of that before ramping up our positions.

Long-Term Disruption

The extended moratorium and lockdown sets the Indian lending industry back by at least half a decade. The disruption to incomes and the damage to credit culture could see banks and NBFCs pull back on retail lending. Slowing growth could be accompanied by compressed margins. The more immediate problem is, though, the likelihood of a sharp credit cycle in retail lendingfor the first time in over a decade. Lower valuations for the sector could persist, and the continuous compounding story is at risk. This is potentially a roadblock to macroeconomic recovery and a drag on the broader market.

The disruption to the lending industry could go beyond to just an FY21 blip in earnings. It creates structural impediments to growth, as underwriting processes will have to be tightened in response to the FY21 disruption. 

Credit cycle: There are two facets to the impending NPL problem. First, the extended lockdown and GDP contraction damages borrower income and serviceability of the loans. Lenders to self-employed and lower-income groups could be hurt disproportionately, but prime lenders are also likely to see pain. Second, the extension of the moratorium hampers lenders’ collection efforts and hinders recoverability, leading tolarger haircuts. A one-time restructuring, without the moratorium, would have given the lenders more control. The risk is that the hard-won improvement in credit culture across retail and wholesale will be lost in this maelstrom. The second could be the more lasting damage to the sector.

Slower retail growth: The improvements to underwriting models in the last five years could now be lost. The moratorium sullies the data so the banks may have to resort to more cumbersome underwriting practices for the next 1-2 years. Turnaround times could increase and hamper lenders’ ability to fulfil. The bigger problem is, of course, that borrower incomes are at severe risk. The addressable market for retail loans, especially unsecured, could become shallower and lenders may have to slow down to control the risks.

Margin impact: Unsecured retail will bear the brunt of the growth slowdown, given the disproportionate risk it carries. This will hurt bank NIMs, as they pivot to low-risk lending. Sure, banks will have offsets from lower cost of funds and opex ratios, but the net impact on ROAs could still be a negative.

Capital buffers and ROE compression: The heightened risk environment and NPL uncertainty could compel banks to raise capital to fortify their balance sheets. Lower leverage ratios could be a reality for the next 3-4 years. This may add to the structural compression on ROEs, in addition to the ROA pressures from lower risk. 

Credit risk viability: The repeated credit cycles of the last ten years may raise questions on through-cycle viability of high-risk lending in India. Credit aversion in wholesale lending was anyway acute after the AQR and the IL&FS episode andcould now spill over to the retail segment. This will narrow the lending industry and stifle credit to many segments, sending the economy into a low-growth orbit for many years.

Market concentration: One positive for investors is that market concentration will become acute. We see 4-5 banks and 1-2 NBFCs cornering the incremental market for the next few years. Many lenders at the lower end, who were operating on the self-employed or subprime segments, will struggle for any growth for the next 2-3 years. This is despite the abundance of liquidity in the medium term.

New Valuation Paradigm

Indian lenders’ valuations had been out of sync with most global lenders. The three factors driving the premium valuations are all worse off than they were six months ago – which could cap sector valuations.

1. ROEs structurally down: Lenders may pare back their exposure to the riskier and most profitable segments, in the new post-COVID world. This could compress ROAs and ROEs structurally, even after credit costs return to normalised levels in FY22. It may be difficult for banks to regain past valuations when profitability is weaker.
2. Growth: Asset growth could also decelerate in the medium term, with demand constrained by income compression and supply by banks’ risk aversion. The first order impact is EPS growth, but there is a corollary. Lenders have been compounding BVPS faster than ROE by periodic capital-raise at premium valuations. Without underlying asset growth to support the incremental capital, there could be a disproportionate impact on BVPS growth.
3. Risk perception: The high-quality lenders will see a credit cycle for the first time in more than ten years. That may have a lasting impact on the implied COE – it remains to be seen if investors look through the FY21 credit cycle and continue to perceive these franchises as low-risk. Lack of alternative opportunities and short investor memory may result in COEs coming back down – it is too early to predict this now. It remains a risk, however.

The alternate view

The leaders in this sector have withstood disruption and proved the sceptics wrong, many times over in the last few years. Competition from fintechs, demonetisation, GST and the broader macro stress have all buffeted the industry but the major players have come out strong. They have done this on the back of a robust customer franchise, strong risk control and aggressive innovations in processes and technology. The six-month moratorium, however, would be tough to come back from. We would rather wait for evidence of that resilience and pay a premium for these stocks, than be tempted by the cheaper valuation when the risk is so deep.

Broader Implications

Impediment to macro recovery: The risk aversion could have a broader macro impact. Slower credit growth is an impediment to economic recovery, and history has shown us that the two are interlinked over the medium term. There could be a lopsided impact on SMEs and lower-income populations, which would hurt broader consumption and drivers like uptrading in some segments. The impact could, therefore, go beyond the weaker headline growth – there would be nuances for consumption patterns.

Overhang on markets: The 4-5 market leaders across banks and NBFCs are likely to remain businesses that thrive over the longer term. Investors, however, will have to be mindful not to extrapolate past valuations and, more importantly, live with lower return expectations from this sector. Given the weightage of the sector in the broader indices, this could be a drag on broader indices for the medium term.

Active managers should diversify their sector exposures. The buy-and-hold strategy in high-quality lenders may not deliver the same risk-adjusted returns of the past, and a fresh set of companies could drive returns for the next leg of the markets. Managers will also have to be more willing to churn their portfolios to look for fresh opportunities.