The world's most profitable banks can be found in India

India’s economic and credit slowdown is revealing the strengths and weaknesses of its banking sector.

Roiled by unprecedented frauds and surging bad debt, the nation’s state-run banks have returned the least to investors this year.

However, investors’ belief in the potential of Asia’s No. 3 economy shows in the fact that its newest lenders offer the best returns, and a clutch of private Indian banks are among the world’s most expensive.

For instance, AU Small Finance Bank’s return-on-equity, a measure of profitability, was 56% compared with about 15% for China Construction Bank, 11% for JPMorgan Chase & Co and an average 11.3% across 430 global lenders with a market cap of over $2bn.

“India’s banks have had a sharply divided run - while consumer banks are riding the crest of consumption and strong and good quality credit demand, wholesale banks are saddled with restructuring challenges of the economy,” said Aditya Narain, an analyst at Edelweiss Securities.

“More tellingly, credit challenges faced by wholesale banks have led to them becoming significantly risk averse, opening up a very large market for well capitalised and confident retail banks to aggressively make market share gains.”

Fresh challengers

A decision by former central bank Governor Raghuram Rajan to create new banks for the first time in more than a decade have yielded two fresh lenders that investors are bullish about. Singapore’s state investment firm Temasek bought about 5% of AU Small Finance Bank for $147m this month and Goldman Sachs this month-initiated coverage on Bandhan Bank with a buy call.

There’s also about a year to go for national elections, a period during which the government spends more on the hinterland to win votes. Bandhan is focused on the underbanked regions of eastern India.

“This is a high-yield business,” said Jaikishan Parmar, an analyst at Angel Broking. “We expect that Bandhan would continue to grow at a healthy rate and maintain higher net interest margins.”

Indian private-sector banks are also among the most richly valued. HDFC Bank in January became only the third Indian company whose market cap has crossed the 5 trillion-rupee ($73bn) mark and Goldman sees it hitting $100bn by 2020.

The lender last month reported the strongest fee income in the past eight quarters and retail loans form 70% of its total lending. IndusInd Bank trimmed its exposure to companies rated BBB and below to less than 38% from more than 48% a year ago. Kotak Mahindra Bank retained its strong credit growth without worsening asset quality.

The key risk for Kotak Mahindra stems from continued stress in the economy, which could hit demand for commercial vehicles and construction equipment, according to Edelweiss’s Narain. The same could be said for Kotak’s peers as Goldman’s economists trimmed their growth forecast for India amid concerns that woes in the state-run bank sector are worse than thought. Bad loans across government-controlled banks are more than double total market cap.

State Bank of India, the nation’s biggest lender by assets, reported a record $1bn loss for the quarter ended March 31 and its shares have fallen 15% this year, while rival Punjab National Bank reported India’s largest ever bank loss after a $2bn fraud came to light.

Half of India’s 22 state-run banks with 20% of the sector’s total loans are under the regulator’s strict Prompt Corrective Action program. Five more - some 16% of advances - could be brought into the framework that restricts lending and expansion, according to Edelweiss.

Despite the government’s “recapitalisation of public sector banks, they are likely to face challenges to meet the regulatory capital ratios amid mounting credit provisions,” said Karthik Srinivasan, an analyst at ICRA.

The local unit of Moody’s Investors Service estimates lending by India’s overall banking sector will grow about 8% in the year through March 2019, even though private banks will expand credit by some 25%.

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