India Financials Sector

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1 Asia Pacific/India Equity Research Regional Banks (Diversified Financials IN (Asia)/Banks IN (Asia)) Research Analysts Sunil Tirumalai Ashish Gupta Kush Shah Chunky Shah Prashant Kumar India Financials Sector SECTOR FORECAST Retail loans: A second coming Figure 1: Retail lending segment could be a US$1.2 tn opportunity by 2020E 1,400 1,200 1, Retail loan assets in India (US$ bn) USD 279 bn 15% CAGR USD 440 bn 18% CAGR USD 1175 bn - FY09 FY14 FY20E Small business Gold CV's Auto Mortgage Others Consumer lending: a huge opportunity. We estimate the Indian consumer finance market will witness an 18% CAGR to a US$1.2 tn opportunity by While the market still remains underpenetrated (70%+ of households have no liabilities of any sort), the organised players (banks + NBFCs) have developed diverse products targeted at all segments of the income pyramid, across multiple secured and unsecured loan types. Overall, we believe consumer lending can be a significant growth driver for Indian financials in the coming years. A stronger second innings. While the experience of the last consumer loan cycle ( ) was bitter, we believe that a number of structural changes in the market could allow for a steady, profitable growth in the next few years. Important among these are the rise of credit bureaus (150 mn+ individuals are captured already), multiplicity of new secured loan options, and the emergence of large internal customer bases for most banks to tap into (especially for unsecured lending). To make matters better, the expected fall in rates should spur growth in rate sensitive segments such as mortgages and auto loans. Stock calls. We believe that players with established track records across cycles and leadership positions are best positioned to capture the expected profitable growth in consumer lending. Among banks, our top picks are HDFC Bank, Axis and IndusInd. Among NBFCs, our preference is for Shriram Transport, Bajaj Finance (initiating with OUTPERFORM, and TP of Rs4,350) and LIC Housing. We also initiate coverage on Indiabulls Housing (OUTPERFORM, TP Rs630), SKS Microfinance (NEUTRAL, TP Rs390) and SCUF (UNDERPERFORM,TP Rs1,570). DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 Focus charts and tables Figure 2: Consumer debt levels in India are still significantly lower than those of other countries 120% Consumer debt to GDP (%) 100% Figure 3: Private banks and NBFCs dominate retail lending, and could grow faster than the overall market Breakdown of retail and small business loan assets 80% 60% NBFC 34% Pvt Bank 24% 40% 20% 0% PSU Bank 42% Figure 4: The retail loan segment currently is well diversified with multiple segmental drivers (FY14) Credit card 1% Micro-credit 3% Consumer Durables 1% Gold 5% CV 7% Auto 8% Others 13% Housing 33% Source: RBI, company data, Credit Suisse research Figure 5: Many of the retail demand drivers are sensitive to interest rates 150% 100% 50% Growth in housing sales (YoY %) HDFC Home loan rate (inverse axis) RHS 8.00% 8.50% 9.00% 0% 9.50% -50% 10.00% 10.50% Small business lending (including LAP) 29% Figure 6: Retail exposures of key banks and NBFCs Retail Loans (Rs bn) -100% 1-Jul-08 1-Feb-09 1-Sep-09 1-Apr-10 1-Nov-10 1-Jun-11 1-Jan-12 1-Aug-12 1-Mar-13 1-Oct-13 1-May-14 Source: PropEquity, company data, Credit Suisse estimates Retail as % of total loan assets 11.00% 3, % 3,000 2,500 2,000 1,500 Banks NBFC's 90% 80% 70% 60% 50% 40% 1,000 30% % 10% - 0% India Financials Sector 2

3 India Financials Sector 3 Figure 7: Profiles of key retail lending stocks we like Banks Current Target Upside Rating price (Rs) price (Rs) (%) Retail assets as % of total Why we like? HDFC Bank Proven track record and execution; the largest retail loan book among the private lenders; market leader in car 968 1,178 22% O 48% loans, small business loans (within the private sector), credit cards and personal loans IndusInd Established track record in vehicle loans (across CV, car and two-wheeler); likely to benefit from a turn in the CV % O 43% cycle Axis % O 38% Growing focus on the retail segment ICICI Bank NBFCs % N 40% Among top three retail loan books in the industry; a sharp uptick in growth in recent years (25%+ CAGR); among top three in home loans, LAP, car loans, credit cards HDFC 1,130 1,305 16% O 71% Market leader with an established track record in home loans; likely to benefit from a fall in wholesale rates Shriram Transport 1,042 1,400 34% O 100% Market leader with an established track record in CV loans; likely to benefit from a turn in the CV cycle Bajaj Finance O 94% Top 3 player across consumer durables, personal loans, two-wheeler loans; strong focus on cross-selling allows 3,451 4,350 26% to keep credit costs low LIC Housing Finance % O 97% Top player in home loans; highly leveraged to movement in wholesale rates Indiabulls Housing O 79% Mortgage and real estate specialist, with expertise in the self-employed segment; likely to benefit from a fall in % Finance wholesale rates SKS Microfinance % N 100% The second-largest MFI in India, and the only one listed Rating key: O = OUTPERFORM; N = NEUTRAL; U=UNDERPERFORM. Figure 8: Changes to earnings/recommendations/initiations Stock Rating Target price Change to EPS Comments (Rs) Old New Old New FY15 FY16 FY17 Banks HDFC Bank O O 1,099 1, % 0.9% 2.0% Increases retail loan growth estimate with share increasing to 53% by FY17 IndusInd Bank O O % 3.3% 7.5% Higher loan growth estimate from auto demand recovery and expansion in NIMs ICICI Bank N N % 3.0% 3.8% Slight increase loan growth and NIM estimate Axis Bank O O % 2.9% 3.8% Increase loan growth estimate NBFCs Bajaj Finance NA O NA 4,350 Initiation Expect strong growth to continue, supported by aggressive cross-selling activity LIC Housing O O % 1.9% 7.5% Expectation of higher NIM expansion on the back of lower wholesale rates Indiabulls Housing Finance NA O NA 630 Initiation Attractively valued for strong growth and tailwind from ratings upgrade SKS Microfinance NA N NA 390 Initiation On a firm recovery path but, after the recent rally, the stock looks richly valued SCUF NA U NA 1,570 Initiation Changes in business strategy and high capitalisation should cap returns and earnings growth near term, while the valuation is high

4 Retail loans: A second coming Consumer lending: A large opportunity We see the consumer lending space in India as an US$1.2 tn opportunity for the organised lenders (banks and NBFCs), implying an 18% CAGR over the next six years (up from 15% in the previous five years). Unlike in the past, the coming round of growth will likely be driven by multiple engines as the banks/nbfcs have developed diverse product lines (including multiplicity of secured lending options). Targeted offerings to all sections of the income pyramid could ensure faster penetration (even now, all forms of organised and unorganised finance reach less than 30% of Indian households). In particular, we believe the private lenders (both banks and NBFCs) have opened new loan segments which were hitherto solely controlled by the PSU banks (e.g., small business loans). Overall, we believe that select banks and NBFCs will be able to leverage their expertise and established market positions to grow their retail loan books faster than the market projections we have painted above. A stronger second innings This is not the first attempt at consumer loans by Indian banks the experiences from the previous cycle of were mixed. From a sub-10% share of total assets even as late as 2002, retail loans grew sharply (a 70%+ CAGR) in the above timeframe, including a sharp surge in unsecured lending. What followed was a painful period of high losses. However, we believe the next round of retail lending growth could remain orderly and profitable, due to the multiple structural factors that have evolved in recent years. A number of secured lending options have emerged (such as gold loans and loans against property). Secondly, credit bureaus have matured, and brought a sea change in the banks' approach to retail loans. Credit bureaus help not only in screening at origination, but, probably more importantly, in constant monitoring of portfolio post disbursements (thanks to rich analytics capabilities). Thirdly, the leading banks have grown their own customer bases over the past few years (mostly on the liability side) that they have a ready customer base to tap into (indeed, the bulk of unsecured lending is happening to internal customers of banks, as we understand from our discussions). To add to this fertile environment, the expected fall in rates could trigger higher growth in many rate sensitive segments such as mortgages and auto loans. Indeed, for the wholesale funded entities like NBFCs, the fall in rates could also lead to higher profitability. Strong retail asset franchises to outperform We believe players with established track records across cycles and market leadership positions are best positioned to capture the expected profitable growth in consumer lending. Among banks, we like HDFC Bank (for its proven track record in retail execution, and market leadership in multiple segments), IndusInd Bank (experience and leadership in vehicle financing) and Axis Bank (growing focus in retail segment). NBFCs should also benefit on the funding side, in addition to the underlying growth on the asset side. Our preference is for Shriram Transport (the market leader with a proven track record in CV finance, and at the sweet-spot of a turn in the CV cycle), Bajaj Finance (strong focus on cross-selling should ensure stable asset quality despite industry leading growth) and LIC Housing Finance (a beneficiary of the expected fall in rates). This report features a deep-dive analysis of the competitive landscape, player strategies and profitability profiles of seven sectors that account for over 85% of overall retail loan assets of the Indian banking system based on our interviews with over 30 industry experts (ranging from top management to feet-on-street). Consumer lending space in India could be a US$1.2 tn opportunity for the organised lenders (banks and NBFCs), growing at 18% CAGR over the next six years The experiences from the previous cycle of were mixed...the next round of retail lending growth could remain orderly and profitable, due to the multiple structural factors that have evolved in recent years We believe players with established track records across cycles and market leadership positions are best positioned to capture the expected profitable growth in consumer lending India Financials Sector 4

5 India Financials Sector 5 Sector valuation summary Figure 9: Indian financials valuation summary (Rs) CS Current Target +/- Mkt cap BVPS (Rs) P/B (x) P/adj B (x) EPS growth P/E (x) RoE (%) rating price price (US$ bn) (%) Private sector Rs Rs (%) FY15E FY16E FY15E FY16E FY15E FY16E FY15E FY16E FY15E FY16E FY15E FY16E Axis O % HDFC Bank O 965 1,178 22% ICICI N % Kotak Mahindra N 1,373 1,210-10% Yes Bank O % J&K Bank O % (16) IndusInd O % ING Vysya N % Public sector Bank of Baroda O 1,079 1,215 13% , Bank of India U % PNB N % SBI N % Union Bank U % IOB U % Non-bank financials Bajaj Finance O 3,451 4,350 26% , HDFC O 1,130 1,305 16% IDFC O % (11) (0) Indiabulls O % LIC Housing Finance O % L&T Finance U % Magma O % M&M Finance O % SCUF U 1,983 1,570-21% (2) Shriram Transport O 1,042 1,400 34% SKS Microfinance N % Core business ICICI N HDFC O Note: Priced as of 12 January 2014.

6 Consumer lending: A large opportunity We see the consumer lending space in India as an US$1.2 tn opportunity for the organised lenders (banks and NBFCs), implying an 18% CAGR over the next six years (up from 15% in the previous five years). Unlike in the past, the coming round of growth will likely be driven by multiple engines as banks/nbfcs have developed diverse product lines (including multiplicity of secured lending options). Targeted offerings to all sections of the income pyramid could ensure faster penetration (even now, all forms of organised and unorganised finance reach less than 30% of Indian households). In particular, we believe that the private lenders (both banks and NBFCs) have opened new loan segments that were hitherto solely controlled by the PSU banks (e.g., small business loans). Overall, we believe that select banks and NBFCs will be able to leverage their expertise and established market positions to grow their retail loan books faster than the market projections we have painted above. A US$1.2 tn business opportunity by 2020E Retail loans currently account for ~24% of Indian banking system loan assets, at US$310 bn. We expect this segment to witness a CAGR of 18% over the next six years to become a US$830 bn opportunity. Including loans to small businesses (which are increasingly being approached as retail loans at least by private banks and NBFCs), the market size could reach ~US$1.2 tn by Figure 10: Retail loans account for 24% of total assets (banks + NBFCs) Breakdown of advances 2014 (banks + NBFCs) Small business 14% Agriculture 10% Figure 11: We expect an 18% CAGR in retail loans by FY20 1,400 1,200 1, Retail loan assets in India (US$ bn) 18% CAGR USD 1175 bn Retail 24% Corporate 52% USD 279 bn 15% CAGR USD 440 bn - FY09 FY14 FY20E Small business Gold CV's Auto Mortgage Others Source: RBI, Company data, Credit Suisse estimates Market still remains underpenetrated Consumer debt penetration in India is low Note: (1) Charts based on banks + NBFCs lending; (2) CAGR numbers are on an INR basis. Source: RBI, Company data, Credit Suisse estimates Consumer debt levels in India are significantly below those seen in other emerging and developed economies, suggesting this will remain an important growth driver for the Indian banking system in the coming years. India Financials Sector 6

7 Figure 12: Consumer debt penetration in India is still low 120% 100% Consumer debt to GDP (%) 80% 60% 40% 20% 0% Source: RBI, company data, Recent data from National Sample Survey Organisation (NSSO) show that less than 29% of Indian households have debt of any kind currently, a ratio that has been steadily rising over the years. Figure 13: Less than 29% of Indian households have debt of any form (including from unorganised lenders) 31.0% % of households with cash debt 29.0% 28.5% 27.0% 25.0% 23.0% 21.0% 19.0% 21.7% 23.7% 17.0% 15.0% Source: NSSO Large unorganised market yet to be tapped As per recent data from the NSSO, the banking system (including NBFCs and cooperative banks) accounts for less than 65% of total consumer debt outstanding in India. The share of the unorganised market (primarily money lenders) has been falling steadily, a process which we expect to continue. India Financials Sector 7

8 Figure 14: The unorganised market still accounts for 35% of the consumer debt in India Relatives and friends 7% Commercial Banks/NBFCs 38% Other informal sources Source: NSSO Organised lenders 65% 2% Unorganised lenders 35% Moneylenders 26% Co-op banks/societies 22% Other Formal sources 5% Figure 15: Penetration of consumer debt is lower in the northern, central and eastern parts of the country 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Source: NSSO Product diversity should help drive penetration Consumer lending is one of the youngest segments of banking in India, with true focus emerging only over the past 15 years. Back in the 1990s, retail loans accounted for a minuscule 5% of total bank assets (though there were some specialist NBFCs in specific sectors such as car loans and consumer durables). Further, just two segments (housing and consumer durables) accounted for nearly 80% of all retail loans of banks (Figure 18). Today, a number of new, scalable retail asset classes have emerged that have helped diversify risks over multiple underlying drivers (Figure 19). % of households with debt South West North Central East Figure 16: 18 years ago, consumer lending was ~5% of bank advances Breakdown of banking sector advances 1998 Figure 17: Today, retail loans account for 18% of bank advances Breakdown of banking sector advances 2014 Retail 5% Small business 20% Agriculture 12% Retail 18% Small business 16% Agriculture 13% Corporate 63% Corporate 53% Note: Banks only. Source: RBI, company data, Credit Suisse estimates Note: Banks only. Source: RBI, company data, Credit Suisse estimates India Financials Sector 8

9 Figure 18: In the 1990s, retail lending was dominated by housing and consumer durable loans Breakdown of retail loans: 1998 Figure 19: Today, banks have entered into multiple retail asset classes, with differing drivers Breakdown of retail loans: 2014 Others 21% Others 27% Consumer durables 17% Housing 62% Consumer Durables 1% Credit card 2% Gold 8% Auto 11% CV 7% Housing 44% Source: RBI, Company data, Credit Suisse research Multiple products across the income pyramid Note: The chart above excludes small business loans Source: Company data, Credit Suisse research With recent growth in newer segments such as MFI and gold loans, the organised banking industry now has multiple products to offer to all segments of the income pyramid. Figure 20: Players across the income pyramid on retail lending Annual income Mortgage-10m Credit Card-19m CV Loans-2m 4 wheeler-5m High income 52 mn hh Rs 1,80,000 Banks Middle income Gold-33m Consumer-32m 2 wheeler-17m 67 mn households Low income Rs 90,000 NBFCs 89 mn households Microfin-35m Absolutely poor 39 mn households Rs 45,000 MFIs Private lenders have unlocked small business opportunity, hitherto dominated by PSU banks The small business lending opportunity in our estimate (see chapter 3) is going to be ~US$340 bn by FY20E, making it the second-largest segment behind home loans at nearly 30% of total retail lending opportunity. However, until even five years ago, this segment was primarily catered to only by PSU banks (through working capital loans, overdraft facilities, etc). It is only over the past few years that private banks and NBFCs have entered the small business lending segment with specialised products, such as loans against property, and working capital loans. We believe the factors that helped the growth of private banks/nbfcs into the small business segment include growth of credit bureaus, penetration of banks into these businesses on the liability/fee products side and strengthening of regulatory mechanisms. India Financials Sector 9

10 Figure 21: Private banks and NBFCs have grown their share of small business loans from near zero a decade ago to the 30% level now Share of small business loans NBFCs 15% Pvt Banks 15% PSU banks 70% Source: Company data, Credit Suisse research India Financials Sector 10

11 A stronger second innings This is not the first attempt at consumer loans by Indian banks the experiences from the previous cycle of were mixed. From a sub-10% share of total assets even as late as 2002, retail loans grew sharply (a 70%+ CAGR) in the above timeframe, including a sharp surge in unsecured lending. What followed was a painful period of high losses. However, we believe the next round of retail lending growth could remain orderly and profitable, due to the multiple structural factors that have evolved in recent years. A number of secured lending options have emerged (such as gold loans, and loans against property). Secondly, credit bureaus have matured, and brought a sea change in the banks' approach to retail loans. Credit bureaus help not only in screening at origination, but, probably more importantly, in constant monitoring of portfolio post disbursements (thanks to rich analytics capability). Thirdly, the leading banks have grown their own customer bases over the past few years (mostly on the liability side) that they have a ready customer base to tap into (indeed, bulk of the unsecured lending is happening to internal customers of banks, as we understand from our discussions). To add to this fertile environment, the expected fall in rates could trigger higher growth in many rate-sensitive segments such as mortgages and auto loans. Indeed, for the wholesale funded entities like NBFCs, the fall in rates could also lead to higher profitability. Mixed experience in the past decade's consumer lending cycle Even until 2002, retail loans were sub-10% of total loan assets of Indian banks. However, the boom years of 2004 to 2007 saw a rapid build-up for retail loan portfolios of banks, leading to retail loans quickly reaching a quarter of overall banking assets. Thus, between 2004 and 2007, retail lending accounted for 35% of incremental loan assets of Indian banking system, and retail loan portfolio of the system witnessed a scorching 70% CAGR over these years. This short, sudden surge in growth was followed by a painful and prolonged (5-year) period of consolidation, with the share of retail assets falling to a low of 17.4% in FY12. However, over the past couple of years, retail lending has again picked up in growth, albeit at moderate pace (a 17% CAGR over two years). Figure 22: History of retail lending in India 30% 12% 25% 10% 20% 8% 15% 6% 10% 4% 5% 2% 0% FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 0% Retail loans as % of total bank credit Consumer debt as % of GDP (RHS) Source: RBI, company data, Credit Suisse research India Financials Sector 11

12 experience: Rise in unsecured loans, followed by the overall drop in asset quality While the three years up to 2007 saw a rapid build-up in banks' retail portfolios, the following three years saw the fallout of this reckless growth on asset quality. Overall asset quality metrics showed sharp deterioration, especially on the non-housing retail loan books. Figure 23: Retail-focused banks saw a sharp rise in credit costs over Credit cost for Retail focused Banks (%) Figure 24: Retail NBFCs saw a sharp rise in credit costs between 2007 and 2010, while housing finance companies did not 3.0% Credit Costs (%) Housing NBFC's Retail NBFC's (RHS) 2.5% % % 1.0% 0.5% - FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 0.0% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Note: Includes HDFC Bank, ICICI Bank, Kotak, IndusInd Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research In particular, unsecured loans (personal loans and credit cards) had grown significantly within the retail portfolios, and these showed the sharpest deterioration in asset quality. Figure 25: Share of credit card loans has come off sharply since the last consumer lending boom 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% Credit card loans as % of total retail 2.0% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Source: Company data, Credit Suisse research But stronger, profitable growth ahead With slowing loan growth on the corporate side, the Indian banking system is increasingly focusing on retail loan assets loan growth on retail assets has largely held steady while corporate loan growth has been falling over the past couple of years. India Financials Sector 12

13 Figure 26: Retail loan growth has held steady against slowing corporate loan growth YoY growth in banking system loan assets 25% 20% 15% 10% Figure 27: CS expects the share of retail loans to continue to rise for banks 80 Share of consumer loans (%) FY12 1H15 FY17E % % FY11 FY12 FY13 FY14 Oct-14 Corporate Retail & small business 20 Axis# ICICI HDFCB IndusInd Kotak* Source: RBI, company data, Credit Suisse research Multiple structural factors give confidence on the retail story * Corporate + commercial loans; # Axis incl retail agri loans We believe that a number of structural changes over the past four to five years could ensure that the growth in retail lending that we envisage for the rest of the decade could remain orderly, and prevent some of the excesses of the past cycle. These include the maturing of credit bureaus and growth of large liability customer bases of banks (which become a ready market for lending). In addition, the expected fall in interest rates should accelerate growth. Structural factor #1: Multiple secured products give comfort on growth Banks and NBFCs have withdrawn significantly from the unsecured loan market (personal loans, credit cards, etc.) after the previous cycles' bust. Instead, these unsecured loans have been replaced by secured loan products, as seen below: Figure 28: Unsecured loan products being replaced by secured loan products o Unsecured Personal Loans Ticket Size < Rs 100,000 LTV Unsecured Yield 35-40% Loss Rate 10-15% o Gold Loans Ticket Size ~Rs 50,000 LTV Unsecured Yield 18-22% Loss Rate < 1% o Unsecured Business Loans Ticket Size Rs 1-2 mn LTV Unsecured Yield 17-25% Loss Rate 5-8% o Loan against Property Ticket Size ~Rs 2-5 mn LTV 50-70% Yield 12-22% Loss Rate 1% India Financials Sector 13

14 Structural factor #2: Credit bureaus are well established 150 mn+ individuals' credit history captured It was only in that the Credit Information Companies (Regulation) Act was passed by parliament. Thus, for the better part of the consumer lending boom, banks could rely only on their internal history of customers (which would have been rudimentary, given the low focus on retail loans until then). Instances of multiple unsecured loans being offered to the same borrower were not uncommon. However, credit bureaus in India are now quite evolved. As per RBI data, credit bureaus in India cover ~155 mn individuals (Dec-13) with penetration of ~20% of adult population. While this is still significantly behind the other developed markets, it still is a significantly large database for banks to rely upon. Figure 29: Penetration of credit bureaus at 20% in India 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% US OECD Europe and Central Asia India Middle East and North Africa Source: RBI 80%+ hit rates for many retail lenders In our discussions with lenders, we found that hit rates of new loan applications on various credit bureaus is fairly high (80%+ in many cases). Moreover, over time we believe the awareness of individual credit scores is increasing among borrowers. Overall, we see these trends as helping the banking sector avoid the problems of the last lending cycle. India Financials Sector 14

15 Magma Fincorp HDFC Bank (credit card and PL) Bajaj Finance ICICI Bank (car loans) LTHF Indiabulls HF Kotak car loans SKS Microfinance 13 January 2015 Figure 30: Result of quick CS survey among banks and NBFCs 90% 80% 70% 60% 50% 40% 30% Of every 100 new loan applications, how many profiles find a hit on one of the credit bureaus? Source: Credit Suisse survey Monitoring post origination is probably a bigger benefit One pretty straightforward benefit of using credit bureaus is in credit underwriting at the time of loan origination: most lenders we spoke to have a minimum credit score cut-off below which they do not lend to the loan applicant. However, the credit score happens to be only one of the many factors that go into the credit underwriting decision. What is probably a bigger benefit is the active monitoring of a loan customer post disbursement, using analytics/alerts provided by the credit bureaus. Industry participant insights: Mr Mohan Jayaraman, Country Manager, Experian India Experian is one of the leading credit bureaus in India. Credit bureaus in India The regulatory framework for bureaus in India is very strong, and we have started with both positive and negative information (which makes the database more useful than only negative information collected by bureaus in many countries) mn active credit lines are on the bureaus, spread across mn individuals. This excludes 80 mn+ credit lines across 35 mn customers in specialist MFI credit bureaus. Weeding out overlaps, mn individuals' credit history should be currently captured by credit bureaus in India. Even though credit bureaus (other than CIBIL) are young in India, most of us have availed historical data from members. As a result, an average five-year credit history is available for each individual; however, only the last three years' data is the most relevant. What has changed in consumer lending from the previous cycle of 2008? Credit bureaus have become strong. Underwriting quality has improved significantly, and the quality of people in collections departments of banks/nbfcs has improved significantly. The big problem in 2008 was multiple lending/overleverage. Bureaus will help prevent that today. India Financials Sector 15

16 Growth in credit bureaus: The biggest contributors to growth in credit bureau database are the private banks. Experian receives information for 1.8 mn new loans every month, 60-65% of this coming from the private sector (banks and NBFCs). Of these, 75% would be customers already on the database, while the rest would be new individuals being introduced to the database for the first time. Most lenders contribute data to multiple bureaus it is in the interest of the lenders that other lenders are aware of their customers' indebtedness. Figure 31: India among the few countries with positive and negative credit histories Sources of information Type of information Full (Information shared by banks, retailers and NBFIs) Fragmented (e.g. information shared among banks only or retail only) Positive & negative information High predictiveness (e.g. U.S., U.K., India) Lower predictiveness (e.q. Mexico, Kuwait) Negative Information Lower predictiveness (e.q. Australia, Swaziland) Lowest predictiveness (e.q. Malaysia, Botswana) Source: IFC/RBI Management speaks: Mr Rajiv Sabharwal, ED, ICICI Bank Credit bureaus We would attribute a lot of the recent growth in the retail lending segment to the credit bureaus. For ICICI Bank, there is an overall 70% hit rate on credit bureaus for new loan applications. The use of bureaus at the time of origination is just the first (and probably smaller) benefit. The bigger benefit arises from the use of bureaus for active monitoring of the individual borrower after disbursement, through alerts, skip tracing, analytics etc. Some bureaus specialise in analytics better than others. ICICI Bank is implementing a multi-bureau strategy to choose bureaus based on their strengths on particular parameters for the task at hand. Structural factor #3: Large existing base of customers allows internal sourcing Over the past decade, the top private banks have continued to grow their retail liability franchises, and now each has significantly large customer bases themselves. We believe this provides a ready captive market with available financial history for these banks to cross-sell loan products to. India Financials Sector 16

17 Figure 32: Number of liability customers Figure 33: Growth in customer base for HDFC Bank 30 Number of liability customers (mn) 25 Liability customers ICICI HDFC bank Axis Kotak IndusInd Source: Company data, Credit Suisse research Unsecured lending is tapping into internal customers Source: Company data, Credit Suisse research In our industry discussions, we understand that even the unsecured lending happening now is largely restricted to the existing customer base of the banks. Figure 34: Unsecured loans are mostly sourced from existing customer base (personal loans + credit cards) 90% 85% 80% 75% 70% 65% 60% 55% 50% HDFC Bank ICICI Bank Kotak % of unsecured loans to existing bank customers Cyclical factor: Falling interest rates should accelerate growth In our 10 November 2014 report, Easing liquidity to aid moderation in rates, CS India banks team argued that improving liquidity and the possibility of a rate cut by the RBI could lead to lower rates in the economy. With decline in inflation and improving liquidity, we believe moderation in real life rates is already visible. Wholesale rates have already moderated bp over the past six months on easing liquidity. With loan demand coming down, banks have cut deposit rate (one-year benchmark) by bp. Further, CS' economics team expects a cut in the benchmark repo rate by 50 bp by mid The key factor will be if liquidity deficit turns to surplus and banks move from being a net borrower to RBI to being a net lender as this would result in the operating rate falling closer to reverse repo and another ~100 bp fall in market rates. In addition to the fall in loan demand, healthy BOP surplus and lower government borrowings are turning the liquidity situation benign. India Financials Sector 17

18 The key beneficiaries from such a movement in the rates environment would be strong retail asset franchisees and wholesale funded entities. Some underlying drivers are sensitive to interest rates As the charts below show, some of the underlying drivers for sectors such as mortgages and car loans are sensitive to interest rates in the economy. Figure 35: Housing sales growth is sensitive to interest rates 150% 100% 50% 0% -50% Growth in housing sales (YoY %) HDFC Home loan rate (inverse axis) RHS 8.00% 8.50% 9.00% 9.50% 10.00% 10.50% -100% 11.00% Jul-08 Apr-09 Jan-10 Oct-10 Jul-11 Apr-12 Jan-13 Oct-13 Jul-14 Figure 36: so is car sales growth 70% Growth in car sales (YoY %) 60% SBI 1yr deposit rate (inverse axis) RHS 50% 40% 30% 20% 10% 0% -10% -20% -30% Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan Source: PropEquity, company data, Credit Suisse estimates Source: SIAM, company data, Credit Suisse estimates Thus, the expected fall in rates in the economy could spur consumer demand and hence loan growth for retail lenders. Management speaks: Mr Rajiv Sabharwal, ED, ICICI Bank Outlook on retail lending Overall strategy is to grow the bank 3-4% faster than market growth. Within that, the current focus is to grow retail faster as we see best opportunities here. Retail loans are a little under 40% of total bank assets. Bank remains positive on the opportunities in retail space, and retail should continue to grow faster (20-25%) than bank average. Over the medium term, retail lending could be within 40-50% of total assets. The biggest segment remains mortgages, and the segment continues to grow fast driven by geographic expansion and strengthening of developer relationships. Growth in the auto segment is being calibrated with profitability in mind. The bank is increasing focus on CV and unsecured loans (having stayed away from both segments for a few years). India Financials Sector 18

19 Strong retail asset franchises to outperform We believe that the players with established track records across cycles and market leadership positions are best positioned to capture the expected profitable growth in consumer lending. Among banks, we like HDFC Bank (for its proven track record in retail execution, and market leadership in multiple segments), IndusInd bank (experience and leadership in vehicle financing) and Axis Bank (growing focus in retail segment). NBFCs should also benefit on the funding side, in addition to the underlying growth on the asset side. Our preference is for Shriram Transport (the market leader with a proven track record in CV finance, and at the sweetspot of a turn in the CV cycle), Bajaj Finance (strong focus on cross-selling should ensure stable asset quality despite industry leading growth) and LIC Housing Finance (a beneficiary of the expected fall in rates). We also initiate coverage on Indiabulls Housing (OUTPERFORM), SKS Microfinance (NEUTRAL) and SCUF (UNDERPERFORM). Private banks and NBFCs have a higher share in the retail segment While PSU banks have a dominant share in the overall banking system advances, NBFCs and private banks together account for more than half of the retail assets, as seen in the charts below. Figure 37: Private banks and NBFCs together have a less than 40% share of banking system total assets... (FY14) Breakdown of loan assets of Indian banking system Figure 38: while they have a nearly 60% share in the retail and small business segment (FY14) Breakdown of retail and small business loan assets NBFC 23% Pvt Bank 16% NBFC 34% Pvt Bank 24% PSU Bank 61% PSU Bank 42% Source: RBI, company data, Credit Suisse research The individual retail loan exposures of key lenders are given below. Source: RBI, company data, Credit Suisse research India Financials Sector 19

20 Figure 39: Retail exposures of key banks and NBFCs Retail Loans (Rs bn) Retail as % of total loan assets 3, % 3,000 2,500 2,000 1,500 Banks NBFC's 90% 80% 70% 60% 50% 40% 1,000 30% % 10% - 0% Falling rates: Wholesale-funded entities should benefit We analyse the impact of a falling rates environment on both the asset and liability side below, to see the potential beneficiaries: Liabilities side: NBFCs with higher bond dependence will see the benefit first It is fairly clear that wholesale-funded entities should benefit in a falling rates environment. Cost of wholesale sources of funds (bonds, borrowing from banks, etc) move quicker and sharper than retail sources of funds. However, the actual impact of falling rates on the funding cost of an entity depends on multiple factors: Mix of borrowings: Bond yields tend to react faster than rates on bank borrowings (linked to base rates). On the other hand, a fall in bond yields benefits an entity mostly on an incremental basis (since bonds are fixed rate instruments), while a fall in cost of bank borrowings are applicable on the back book too. Tenure of borrowings: The shorter the tenure of existing borrowings for an entity, the quicker the funding cost will re-price lower. Growth: An entity growing faster will add more of lower cost borrowings to its balance sheet, thus bringing down the overall blended cost of funds faster than a slow growing entity. In our analysis, Bajaj, Indiabulls and LICHF should see the earliest benefit of the fall in wholesale rates, as they are most leveraged to the bond/money market (40-70% of funding), and also shorter tenure/high growth working in favour of Bajaj. On the other hand, once the banks start reducing base rates materially, SKS and Indiabulls could see the biggest delta on cost of funds. India Financials Sector 20

21 Figure 40: Bajaj, Indiabulls and LICHF are sensitive to bond yields; they will see cost of funds benefit before others Change in blended cost of funds for every 100bps fall in bond yields Figure 41: While a fall in bank borrowings could happen with a delay after bond yield drop, SKS and Indiabulls will see most benefits from such a fall Change in blended cost of funds for every 100bps fall in bank base rates - Bajaj LIC Indiabulls SCUF STFC MMFS SKS - SKS Bajaj Indiabulls SCUF MMFS STFC LIC Figure 42: Assumptions driving the above sensitivity analysis Mix of borrowings (%) % of borrowings maturing in one year FY16 loan growth (CS) Bonds Bank Others borrowings LIC 69% 29% 2% 18% 18% MMFS 23% 58% 19% 30% 18% STFC 35% 30% 35% 36% 15% Indiabulls 38% 62% 0% 43% 20% Bajaj 41% 58% 1% 47% 29% SCUF 41% 54% 5% 26% 29% SKS 0% 100% 0% 80% 38% Note: the analysis assumes that the mix of borrowings does not change. Asset side: The mortgage segment should be most sensitive to the loan yield decline, gold/mfi the least Seeing a drop in funding costs is one thing. Whether it can be retained (to improve margins) or passed on to customers (to retain market position/grow faster) is a completely different story. One could argue that segments where the sensitivity of EMIs to lending rates is high should be least likely to hold on to the benefit of a fall in funding costs (since the market would react to a competitor cutting rates). Going by this yardstick, mortgages stand out as being the most sensitive to lending rates (EMI for a typical borrower drops 5.5% for a 100 bp drop in lending rates from current levels). This is thanks to the already low lending rate (a 100 bp cut on 11% mortgage loan is relatively large than on an 18% CV loan), and longish tenures. On the other hand, gold loan EMIs are least sensitive to lending rates (short tenures and high yields). Conclusion HFCs/LAP players such as LICHF, Indiabulls and Bajaj are likely to enjoy benefits of a fall in whole rates earlier than other companies, but this benefit could start shrinking once banks start reducing base rates (thus bringing down mortgage yields). Vehicle financiers such as SHTF and MMFS should see the benefits of a fall in wholesale rates with a lag, but should be able to retain the benefit for a longer period. India Financials Sector 21

22 Figure 43: Gold loan companies most likely to retain benefit of a fall in cost of funds; HFCs least likely 6.0% % drop in EMI for 100bps fall in lending rates 5.0% 4.0% 3.0% 2.0% Special case: regulated spread so all funding cost benefit will be passed on to customer 1.0% 0.0% Gold MFI 2W CV 4W LAP Mortgage LOW Likelihood of passing on funding cost benefit to customer HIGH Prefer leaders with a strong track record HDFC Bank, IndusInd among banks; Shriram Transport, Bajaj Finance among NBFCs We believe select banks and NBFCs are well positioned to benefit from the expected strong growth in retail lending. Our preference is for lenders with established track records in specific segments. Our preferences are given out in detail in the following tables. Our top picks among the banks are HDFC Bank and IndusInd Bank. Among NBFCs, we like Shriram Transport and Bajaj Finance. India Financials Sector 22

23 India Financials Sector 23 Figure 44: Profile of key retail lending stocks we like Banks Current Target Upside Rating Retail assets Why we like? price (Rs) price (Rs) (%) as % of total HDFC Bank Proven track record and execution; the largest retail loan book among the private lenders; market leader in 968 1,178 22% O 48% car loans, small business loans (within the private sector), credit cards and personal loans IndusInd Established track record in vehicle loans (across CV, car and two-wheeler); likely to benefit from a turn in the % O 43% CV cycle Axis % O 38% Growing focus on the retail segment ICICI Bank NBFCs % N 40% Among top three retail loan books in the industry; a sharp uptick in growth in recent years (25%+ CAGR); among top three in home loans, LAP, car loans, credit cards HDFC 1,130 1,305 16% O 71% Market leader with an established track record in home loans; likely to benefit from a fall in wholesale rates Shriram Transport 1,042 1,400 34% O 100% Market leader with an established track record in CV loans; likely to benefit from a turn in the CV cycle Bajaj Finance O 94% Top 3 player across consumer durables, personal loans, two-wheeler loans; strong focus on cross-selling 3,451 4,350 26% allows to keep credit costs low LIC Housing O 97% Top player in home loans; highly leveraged to movement in wholesale rates % Finance Indiabulls Housing O 79% Mortgage and real estate specialist, with expertise in the self-employed segment; likely to benefit from a fall % Finance in wholesale rates SKS Microfinance % N 100% The second-largest MFI in India, and the only one listed Rating key: O = Outperform; N = Neutral; U=Underperform; Figure 45: Changes to earnings/recommendations/initiations Stock Rating Target price (Rs) Change to EPS Comments Banks Old New Old New FY15 FY16 FY17 HDFC Bank O O 1,099 1, % 0.9% 2.0% Increases retail loan growth estimate with share increasing to 53% by FY17 IndusInd Bank O O % 3.3% 7.5% Higher loan growth estimate from auto demand recovery and expansion in NIMs ICICI Bank N N % 3.0% 3.8% Slight increase loan growth and NIM estimate Axis Bank O O % 2.9% 3.8% Increase loan growth estimate NBFCs Bajaj Finance NA O NA 4,350 Initiation Expect strong growth to continue, supported by aggressive cross-selling activity LIC Housing O O % 1.9% 7.5% Expectation of higher NIM expansion on the back of lower wholesale rates Indiabulls NA O NA 630 Initiation Attractively valued for strong growth and tailwind from ratings upgrade Housing finance SKS NA N NA 390 Initiation On a firm recovery path but, after the recent rally, the stock looks richly valued Microfinance SCUF NA U NA 1,570 Initiation Changes in business strategy and high capitalisation should cap returns and earnings growth near term, while the valuation is high

24 Taking a deep dive into retail In this report, we take a deep dive into the retail lending side of the banking system in India. We take a closer look at seven sectors that account for over 85% of overall retail loan assets of the Indian banking system housing, small business lending, CVs, autos, gold loans, credit cards and MFIs. Figure 46: Breakdown of retail loan assets by segment (FY14) Credit card 1% Micro-credit 3% Consumer Durables 1% Gold 5% Others 13% Housing 33% CV 7% Auto 8% Small business lending (including LAP) 29% Note: (1) In the chart above and the rest of the report, loans against property (LAP) are included in the small business lending segment and not in housing finance Source: RBI, company data, Credit Suisse estimates A brief profile of the key segments is given below, followed by detailed discussions into each segment after chapter 3 of this report. India Financials Sector 24

25 Figure 47: Top retail lending segments that account for 85% of retail assets Mortgage Auto - 4W Auto - 2W CV's Gold Business Banking MFI FY14 loan book (USD bn) FY20 loan book (USD bn) FY14-20E - CAGR 14.7% 15.7% 13.8% 11.5% 14.1% 16.1% 14.4% Key Players HDFC, LIC Hsg, SBI, ICICI, Axis, Dewan Hsg, Indiabulls RCap HDFC Bank, ICICI, SBI Kotak HDFC Bank, IndusInd, Bajaj, TVS SCUF Shriram Trans, IndusInd, Chola Magma Muthoot, Manappuram, HDFC Bk, South Indian Federal Bank HDFC Bank, ING Vysya, ICICI, SCUF, Capital First, IndusInd Kotak SKS Micro, Bandhan Ticket size Rs 2 mn to 2.5 mn Rs. 500,000 Rs. 45,000 LCV - Rs. 350,000 M&HCV - Rs. 1,650,000 Rs. 40,000 Rs. 2 mn to 100 mn Rs 10,000-12,000 Tenure years 3 years 1 years 3-4 years 3-6 months 3-10 years 1 2 years Yield % 11-14% 20-22% 12-22% 18-22% 12-22% 20-24% RoA 1.5% 2.0% 3% 2.2% 3.1% 2.7% 2.2% Loss Rates bps bps bps bps 10 bps bps 50 bps India Financials Sector 25

26 Retail mortgages: Safe and under penetrated Figure 48: Housing finance market in India Nominal GDP - 15% CAGR Mortgage Penetration - 7.7% to 9.2% of GDP 19% CAGR USD 409 bn Figure 49: Key players in the mortgage industry USD 144 bn FY14 FY20E Source: Company data, RBI, NHB, Credit Suisse estimates Source: RBI, NHB, company data, Credit Suisse estimates Figure 50: Loan characteristics of housing finance Product template Banks Large HFCs Small HFCs Players SBI, ICICI Bank, Axis, HDFC, LICHF Dewan, Indiabulls, RCAP Customer segment Salaried Salaried Self-employed Lending rate % % % Lending rate type Mostly floating Processing fees % LTV 55-65% Ticket size (Rs) Originating tenure Actual tenure Sourcing mn years 5-7 years DSAs, brokers, lenders own sales force Sizing the potential: India is 9-11 years behind other EMs in penetration The size of the housing finance market in India was ~Rs9 tn (US$150 bn) as on Mar-14. The segment has seen a 17% CAGR over the past five years. At less than 8%, India s mortgage penetration (as a percentage of GDP) is quite low compared to those of other countries, including other emerging economies in the region. A look at the past growth in other countries shows that at current penetration levels, India is 9-11 years behind other countries such as China and Thailand. Figure 51: Housing finance growth in India 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 - FY09 FY10 FY11 FY12 FY13 FY14 25% 20% 15% 10% 5% 0% Figure 52: Mortgage penetration levels in India are significantly behind other countries 120% Mortgage as a % of GDP 100% 80% 60% 40% 20% 0% Total o/s Housing Loans (Rs bn) Growth Source: Company data, RBI, NHB, Credit Suisse estimates Source: RBI, NHB, company data, Credit Suisse estimates India Financials Sector 26

27 Figure 53: India is nine years behind Thailand s mortgage penetration Thailand: Mortgage as % of GDP 12.0% 11.0% India is here 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% Figure 54: India is ten years behind China on mortgage penetration China: Mortgage as % of GDP 18.0% 16.0% 14.0% India is here 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Recent regulatory changes and a fall in interest rates could fuel demand for mortgage segment Effective tax rate reduces by ~120 bp will push up demand The tax exemption limit for mortgage interest expense increased to Rs0.2 mn from Rs0.15 mn recently. Also the maximum deduction for principal has been enhanced by Rs50,000. For a customer with a home loan of ticket size Rs25 mn, this implies a reduction in effective interest cost by ~120 bp. Figure 55: Budget has helped reduce effective interest cost by ~120 bp Particulars Loan amount (Rs) 2,500,000 2,500,000 2,500,000 2,500,000 Effective interest rate on home loan 11.80% 6.03% 7.02% 5.80% Source: Indiabulls Banks allowed to raise long-term bonds for housing finance which are exempt from CRR, SLR and PSL requirements. Further, we believe that the expected fall in wholesale rates could spur demand for home loans, as is evident from the close correlation between wholesale rates and home loan growth in the past. A detailed discussion on this is in the following chapter. Figure 56: Housing sales growth is sensitive to interest rates 150% 100% 50% Growth in housing sales (YoY %) HDFC Home loan rate (inverse axis) RHS 8.00% 8.50% 9.00% 9.50% 0% -50% 10.00% 10.50% -100% 11.00% Jul-08 Apr-09 Jan-10 Oct-10 Jul-11 Apr-12 Jan-13 Oct-13 Jul-14 Source: PropEquity, company data, Credit Suisse estimates We expect the mortgage industry in India to grow slightly faster than nominal GDP growth, leading to a US$330 bn market by India Financials Sector 27

28 Market share 13 January 2015 Figure 57: Expect mortgage industry penetration to rise over the next few years 9.5% 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% India mortgage as % of GDP Source: NHB, RBI, company data, Credit Suisse estimates HFCs gaining share The housing finance segment is catered to by both banks and specialised housing finance NBFCs. The banks have a lion s share of the loan assets (60% as of FY3/14). However, note that the share of HFCs has increased steadily from 26% to 40% over the past decade. Figure 58: HFCs have gained share over banks 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% FY09 FY10 FY11 FY12 FY13 FY14 Banks HFCs Banks growth (RHS) HFCs growth (RHS) 35% 30% 25% 20% 15% 10% 5% 0% Figure 59: Key players in the mortgage segment (Rs bn) 2,500 45% FY09 FY14 FY09-14 CAGR (%) 40% 2,000 35% 30% 1,500 25% 20% 1,000 15% % 5% - 0% HDFC SBI LICHF ICICI Axis Dewan Indiabulls Source: Company data, RBI, NHB, Credit Suisse research Profitability: Low risk, low return, leverage helps Source: RBI, NHB, company data, Credit Suisse estimates The competition in the housing loan segment is quite intense, with some of the lowest yields in the retail segment at %, almost as low as large corporate loan yields. The LTVs range from 60% to 70% (LTV is regulated). Most of the market is on floating rate loans. The originating tenure of housing loans are years but the actual tenure is generally 6-10 years as there is no prepayment penalty (per regulations). In light of slowing corporate loan growth, and the apparent ease of their growing mortgage book (given the large ticket sizes and long tenures), banks have focused on housing loans for growth. Current housing loan rates are very close to base rates (Figure 60). Despite low operating costs and credit losses, RoAs tend to be sub -1.5% in the segment. India Financials Sector 28

29 Figure 60: Banks home loan rates are already close to their base rates Figure 61: Credit costs for the mortgage segment have remained low sub 70 bp over the past ten years 0.80% 0.70% 0.60% 0.50% 0.40% 0.30% 0.20% 0.10% Credit Costs IOB BOB PNB Axis Bank ICICI Bank SBI 0.00% -0.10% -0.20% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Base Rate (%) Current Home Loan rate (%) LIC HDFC Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research Importantly, mortgages carry the lowest risk weight among all retail loan asset classes. In addition, Tier 1 requirement for housing finance NBFCs is lower (6%) than that for the other NBFCs (7.5%, to be taken up to 10% by FY17). The lower risk weight allows for higher leverage levels in this business which allows for decent RoE despite low RoAs. Figure 62: Reasonable RoE levels primarily due to the ability to leverage higher Profitability of mortgage biz PSU bank (SBI template) PSU bank (SBI template) HFC (HDFC template) HFC (LICHF template) cumulative incremental incremental incremental Interest income / total assets 9.8% 9.8% 10.7% 10.8% Home loan lending rate assumed 10.3% 10.3% 10.3% 10.3% (monthly compounded) Interest expense / total assets 6.0% 8.2% 8.1% 8.5% Cost of deposits assumed 6.4% 8.6% 9.5% 9.6% NII / total assets 3.8% 1.6% 2.7% 2.3% Fee income / total assets 0.1% 0.1% 0.2% 0.2% Opex / total assets 2.3% 0.5% 0.3% 0.4% Credit cost / total assets 0.3% 0.3% 0.1% 0.1% Pretax profit / total assets 1.2% 0.9% 2.5% 1.9% Taxes / total assets 0.4% 0.3% 0.8% 0.7% ROA 0.8% 0.6% 1.6% 1.3% Leverage RoE 15.0% 11.1% % Notes: Fore details on the assumptions, refer our report on the Indian Mortgage Sector, 20 May India Financials Sector 29

30 Figure 63: Positioning of key players in the home loan space 18.0% 16.0% 14.0% Urban, salaried Urban, self-employed Semi-urban, Rural % % 8.0% % SBI LICHF HDFC Axis Bank Indiabulls RCAP SCUF Dewan MMFS - Yield on home loans Ticket Size (Rs mn) (RHS) HFCs: Could benefit from falling wholesale rates We note that banks home loan rates are already close to their base rates (Figure 60). So the chances of increased competition from banks due to the above factor are low. But, on the other hand, lower wholesale rates could help HFCs. Indeed, leading HFCs such as HDFC and LICHF (both AAA rated) are now far less dependent on bank borrowings than in the past. For a detailed discussion on the impact of a fall in wholesale rates, see discussion in the second chapter. Figure 64: HDFC and LICHF are relying less on bank borrowings for funding... Share of bank borrowings in funding mix 35% 30% 25% 20% 15% 10% 5% 0% Figure 65: and sourcing more from the bond market Share of bonds in funding mix 80% 70% 60% 50% 40% 30% 20% 10% 0% HDFC LICHF HDFC LICHF Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research India Financials Sector 30

31 Small business lending/lap: Funding entrepreneurs Figure 66: Growing interest in small business lending Nominal GDP % Target segment revenue growth multiple 1.3x of GDP Debt to Rev - Increase by 200 bps LTV - Unchanged 17.8% CAGR USD 346 bn Figure 67: Leading small business lenders USD 130 bn FY14 FY20E Source: RBI, company data, Credit Suisse estimates Source: RBI, company data, Credit Suisse estimates Figure 68: Loan characteristics of small business lending Cash credit/ working capital loans Long-term loans secured by business assets Key players PSU banks like SBI, PNB; Pvt Private banks (HDFC Bank, ICICI Bank, banks like ING Vysya ING Vysya); NBFCs (Bajaj, SCUF, RCAP) Customer segment Small businesses Small businesses with good track record of a few years Secured/unsecured Unsecured (sometimes secured by Secured (by plant and machinery and/or plant and property) promoter property). Detailed cash flow analysis of the underlying business usually undertaken Loans against property NBFCs (IndiaBulls, Bajaj); Private banks (HDFC Bank, Axis, IndusInd) Business owners with self-occupied residential property Secured by the above mentioned property. Cash flow checks on underlying business not so critical Lending rate 11-14% 13-16% 12-14% Lending rate type Fixed Fixed Fixed LTV NA 50-65% 40-50% Ticket size (Rs) mn 1-20mn mn Average tenure (yrs) < Sourcing DSAs DSAs, CAs DSAs, CAs Sizing the potential: GDP growth likely to pick up, expect small businesses to grow faster The micro, small and medium enterprises (MSME) of India together account for 8% of GDP, 45% of manufactured output and 40% of exports (Source: 2010 PM task force). This is largely an unorganised industry, with ~50 mn firms employing over 100 mn people in sectors as diverse as retail trade, textiles, food and beverages, hospitality, auto repairs, furniture, etc. Over time, the importance of these units has been recognised and greater focus been accorded to this segment. Even the term MSME is strictly defined by the MSME Development Act of However, penetration of formal finance into the MSME sector is considerably low. The last available formal numbers from the government (the 4 th MSME census of 2007) show that less than 13% of all MSME units in the country have access to finance/credit. Our own analysis with more recent data shows that levels of debt in small enterprises in India is significantly below that of listed small cap stocks (here we use 210 companies on BSE with sales in the range of Rs100 mn to Rs2 bn as small cap companies). Despite such low penetration levels, the small business lending segment is already as large as the housing finance segment, and is much larger than other retail segments with higher penetration levels (like CV and Auto finance), indicating that this will remain a crucial segment for the banking system for a long time. India Financials Sector 31

32 Figure 69: Low finance penetration among MSMEs (2007 MSME census) 40% 35% 30% 25% 20% 15% 10% 5% 0% % of MSME units with loans MSME finance - low penetration Debt/Sales Debt / equity Debt/Gross fixed assets Figure 70: Leverage levels at small enterprises continue to remain low even in FY14 120% 100% 80% 60% 40% 20% 0% Debt as % of sales BSE: 210 companies with revenues in the range Rs100mn to Rs2bn Total MSME segment Source: Ministry of SME, company data, Credit Suisse estimates Source: Bloomberg, RBI, Ministry of SME, company data, Credit Suisse estimates Given the close linkage of these small businesses with the economy, it is not surprising that the overall growth in this segment had slowed (the chart below shows that growth in bank loans to micro and small enterprises has slowed in recent years). Figure 71: Key industries within small business segment (FY14) Metals 2% Textiles 2% Furniture 3% Autos 4% Hotes & Restaurants 4% Others 19% Other Business 4% Other Services 6% Food & Beverage 7% Apparel 9% Source: Company data, Credit Suisse research Retail Trade 40% Figure 72: Slowdown in loans to small enterprises 60% 50% 40% 30% 20% 10% 0% Small business lending growth YoY % Small business loans (Rs bn) Source: Company data, Credit Suisse research 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 - Figure 73: Sizes/market potential of some segments within SME Segment No. units (mn)\ Industry revenues Organised (%) (US$ mn) Retail , Food processing , Restaurants , Printing/publishing , Diagnostic labs 0.1 1, Dental clinics 0.1 1,000 With GDP growth having bottomed, we expect small businesses to outpace overall GDP growth. With penetration low at ~12%, and increased presence of banks and NBFCs in rural and semi-urban centres, the organised sector should see strong loan growth from this segment. Most banks have increased their focus on the small and mid-corporates segment. While we have assumed 15% growth in nominal GDP, we believe that this segment will grow ~1.1x GDP growth, on account of an increased share of the organised India Financials Sector 32

33 sector and faster growth by these companies. We assume that the debt/revenue level for the small enterprises will grow from 38% to 40% by FY20. Each lender defines the segment differently The scope of the small business lending segment varies significantly across lenders, with the same nomenclature referring to different categories at each firm, as seen below. Figure 74: Conflicting nomenclature on business loans at various lenders Lender Nomenclature Description Typical customer Bajaj Finance Business loan Unsecured loans, ticket size sub Rs2 mn Axis Bank LAP Loans against property; average ticket size Rs23 mn Commercial Small manufacturing units; average ticket size Rs200 mn Auto component vendors Emerging Enterprises Enterprises with sales of less than US$1 mn Group LAP Loans against property; ticket size usually less than Rs25 mn HDFC Bank Business banking Secured loans of average ticket size Rs5 mn Restaurant owners, small taxi fleet operators, doctors, lawyers, etc SCUF SME Secured/unsecured loans of ticket size up to Rs1 mn Grain merchants, pharmacies, grocers, plastic recyclers etc Indiabulls LAP Loans against property; average ticket size Rs8 mn Small businesses based in cities, looking for funds to expand business Capital first SME Secured by cash flows on business and property; average ticket size Rs10 mn Traders, small time manufacturers, suppliers etc Religare SME LAP Loans against property; average ticket size Rs10 mn, five-year duration Services/manufacturing business with 3-4 years of existence SME Working capital loans Unsecured WC loans; average ticket size Rs3 mn Services/manufacturing business with 3-4 years of existence Reliance Capital LAP Loans secured against property - borrower is individual business owner; average ticket size Rs8 mn Manufacturing/services companies with up to Rs200mn revenues SME Loans secured against plant and machinery - borrower is the firm; Manufacturing/services companies average ticket size Rs10 mn with up to Rs200mn revenues ICICI Bank Business banking Loans secured by business assets; average ticket size Rs10-20 mn Small businesses in the neighbourhood of branches LAP Loans secured by residential property; average ticket size Rs8 mn; reported as part of mortgage loan book SME Loans to enterprises with revenues up to Rs3 bn; average ticket size Rs1 bn+ Kotak Bank Emerging corporate loans Loans secured by business / residential property; average ticket size Rs mn Businesses with turnover of upto Rs3bn LAP Loans secured by residential property; average ticket size Rs5 mn; reported as part of mortgage loan book Focus on self employed nonprofessional customers SME-Working capital Secured revolving loan facility given to SMEs; average ticket size Rs20-25mn SME-Business loan Unsecured term loans; average ticket size Rs1.5mn ING Vysya Business Banking/SME LAP Working capital loans, secured by business assets; average ticket size Rs22 mn Loans against property; average ticket size Rs22 mn; reported as part of home loan segment SBI MSME Loans up to Rs500 mn in ticket size; usually secured by business assets For the purpose of this report, we restrict the definition of small business loans to loans with a ticket size of less than Rs50 mn. These account for ~44% of total MSME loans as reported by RBI. Traders (steel, pharma, etc), food processing units, FMCG distributors, etc Traders (steel, pharma, etc), food processing units, FMCG distributors, etc India Financials Sector 33

34 Figure 75: We focus on small business lending of up to Rs50 mn which form ~44% of total MSME lending of Rs18 tn in the country Ticket size < Rs50mn (focus of this report) 44% Ticket size > Rs50mn 56% Source: RBI, Credit Suisse research Management speaks: Mr Mahesh Dayani, Country Head, Retail Assets, ING Vysya Bank The SME segment for ING Vysya is ~Rs220 bn in loan book (~52% of total loan book). Market structure: The SME loan segment today is ~Rs18 tn (US$300 bn) in size. The space is dominated by the PSU banks and the rural/co-operative banks. Private banks and NBFCs probably have a less than 10% share of the market. 60% of the lending happens through short-term working capital loans, and the rest through term loans. ING Vysya's business: ING Vysya has a better mix than the market as working capital loans form 90% of the loan book. ING Vysya Bank has an average ticket size of ~Rs22 mn, at yields of 12-13%. 75% of loan book is towards SME in the services sector (25% from manufacturing sector primarily food processing). Traders form ~40% of loan book (includes distributors and traders across diverse segments such as FMCG, steel, and pharma). Typical yields for ING Vysya are %. ING Vysya sources customers from the existing database/referrals and does not rely on DSAs. The operating costs and loan losses are lower in the SME segment compared to the overall bank, and the profitability higher. How are private banks different from PSU banks? PSU banks have the strength of relationship over multiple years, and immense local knowledge. But private banks score on service levels. LAP The LAP business has become popular starting India Financials Sector 34

35 RCAP SCUF Bajaj ING Vysya Indiabulls Chola PNB BOB BOI Kotak HDFC Bk L&T Fin ICICI SBI Magma HDFC IndusInd LICHF Axis 13 January 2015 PSU banks are yet to start the LAP business in a significant way, and it is primarily the private sector as of now. LAP accounts for ~13% of the SME segment for ING Vysya (and ~50% of the mortgage segment as reported). Advantages of banks over NBFCs Banks usually insist that the borrower also maintains all his business transactions through the current accounts with the same bank. This helps in better monitoring of the loan. This helps banks foresee any problems in the borrower's loan servicing capability. PSU banks dominate, but that is more from compulsion of PSL Given that lending to small businesses is an explicit sub-target within priority sector targets, it is not surprising that PSU banks dominate the small business lending space, just like they dominate the overall banking space. Figure 76: PSU banks dominate in lending to small businesses (FY14) Share of small business loans NBFCs 15% Figure 77: Some NBFCs have specialised in the small business lending space in recent years (FY14) 70% Small business loans as a % of total loans 60% 50% 40% Pvt Banks 15% 30% 20% PSU banks 70% 10% 0% Source: Company data, Credit Suisse research However, we believe the lending models of the PSU banks differ significantly from those of the private banks and NBFCs. PSU banks' lending to small businesses usually tends to be in the form of working capital loans, overdraft facilities or cash credit facilities. These lack the long-term nature of term loans that the private banks and NBFCs offer to the businesses. The perceived risky nature of these borrowers is likely the reason for PSU banks not lending on longer tenures to this segment. India Financials Sector 35

36 Industry participant insights: Branch Manager at SME branch of SBI, Central Mumbai About the branch's business The branch has a loan book of Rs4-4.5 bn. Most loans are short-term working capital lines, though the branch has started doing the LAP business in a small way. Loan size is capped at Rs500 mn per borrower, and the average ticket size for this branch is ~Rs50 mn. The branch does not have approval/sanctioning powers. All loan applications need to be sanctioned/approved by the central committee (one in Mumbai). New loan applications usually take 4-6 weeks to process. The branch uses a rating scale of 1 to 16 to rate all customers, and for applicants with poorer ratings more collateral is asked for (the poorest rating attracts 100% collateral i.e., usually the LTV is more than 100%). For ticket sizes of Rs100 mn+, the branch prefers rating by an external agency. The interest rate charged depends on the rating, and ranges from 11% to 18%. The collateral is usually inventory, receivables, property of company/promoter, etc. The branch has two relationship managers for small enterprises (ticket size less than Rs50 mn, 60 accounts) and one RM for medium enterprises (ticket size Rs50 mn+, 30 accounts). Sourcing usually happens through referrals from existing customers or from the head office. NPA is ~30% of loan portfolio, though the manager is quick to point out that overall SBI NPA level is much below this figure. Customer profile Customers are usually traders (steel, medical equipment, etc) or small manufacturers. Many exporters are also present (this branch offers forex services, too). Many textile companies are in the sub-rs50 mn category. All customers conduct their day-to-day transactions through current accounts maintained at the branch. Earlier there was no restriction on the location of the customer to whom a branch could lend to. But recent rules restrict the business with only customers from the locality of operation of the branch. Operating model: Some private banks and NBFCs have a specialised focus on small businesses. Of late, LAP has become prominent Some of the NBFCs and private banks have a significantly larger exposure to the small business segment, and have developed specialised lending models to the small business segment. These involve longer-term loans secured against: business fixed assets (to fund business expansion or purchase of new equipment), or the promoter's residential property. The longer term ensures continuity/visibility of credit for the borrower vs short-tenure lines from the PSU banks. In particular, loans against property have gained prominence in the past four to six years. Loans against property: Attracting attention NSSO data show that the largest asset by value owned by Indian households continues to be real estate related (90%+ of all assets owned). In recent quarters, one type of small India Financials Sector 36

37 business loan, loans against property (LAP), has become popular. Here, loans are extended to promoters of small businesses against the promoters' own property (usually the self-occupied residential property). These are also called home equity loans. Figure 78: Real estate accounts for over 90% of assets owned by Indian households (2013) Land 64% Building 29% Note: Data excludes holdings in Bullion as this is not captured in the survey. Source: NSSO: Financial assets 3% Others Vehicles 2% 2% A few private banks and NBFCs have been operating in the LAP market for four to five years. In fact, for some of the lenders, LAP is the dominant way of lending to small businesses. Figure 79: Private banks and NBFCs lead in the LAP business 140 LAP book (Rs Figure 80: For some players, LAP is a significant part of overall small business lending (Rs mn) 300,000 Business Banking LAP 250, , , ,000 50, HDFC Bank ICICI ING Vysya Kotak Reliance Cap IndusInd Bajaj We also notice that for a number of financiers, LAP has been the primary driver of retail loan growth in recent years. India Financials Sector 37

38 Figure 81: Some NBFCs have seen a bulk of their growth in retail loan books from the LAP segment 90.0% Share of LAP in incremental retail loan book in FY % 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Capital First IndusInd Chola Bajaj Indiabulls Axis This segment has gained a lot of attention in recent quarters from almost all lenders. The attractiveness of the sector lies in the fact that while operating costs and credit losses are believed to mirror the home loan segment, the yields are typically higher than mortgages leading to higher profitability. Thus, even mortgage players like LICHF are becoming interested in the LAP business. Figure 82: LAP yields are typically higher than in home loans, with underlying cost structure being similar 18.0% Yield on home loans Yield on LAP 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% LIC Indiabulls HDFC/HDFC Bank Axis Rcap Industry participant insights: Head of Sales, LAP segment, Mumbai region, leading private bank The person has been in the LAP market in Mumbai for over eight years. Mumbai LAP market Mumbai is one of the largest LAP markets in India, with Rs7-8 bn disbursement per month (the market is tracked mostly on a disbursement basis and not on a portfolio basis by the sales teams). HDFC Bank (along with its subsidiary HBL) is the largest player with Rs bn disbursements per month. India Financials Sector 38

39 The other important players in Mumbai are Kotak (Rs mn per month), Axis Bank, ICICI Bank, few foreign banks (Rs mn per month each). Among NBFCs, Bajaj Finance and Capital First are key players (Rs mn per month each). Customer profile Almost all borrowers are businessmen/self-employed. The profile includes manufacturers, traders, exporters, importers, steel manufacturers, and transporters % of the money raised through LAP actually gets re-invested into the real estate market. Business model Banks usually lend up to 60% LTV, while some NBFCs go higher (70-80%). The valuation of the property is usually done by a mix of internal and external valuers. The lowest of the two values (internal/external) is taken for LTV purposes. Banks usually lend at %, while NBFCs operate at %. However, recently, some NBFCs reduced their lending rates bringing themselves closer to the banks. Business is sourced either through DSAs or branch referrals. DSAs charge % of the loan amount. Since processing fees is only %, there is an immediate upfront loss if a DSA channel is used. While HDFC Bank has a large share of branch led business, the rest of the market usually has a 70% share of DSA channel. Management speaks: Shaubik Sengupta, Head of SME Lending, Reliance Capital LAP market Competition has become very aggressive over the past few months, e.g., Religare and Yes Bank in SME lending and Bajaj in LAP. HDFC Bank is the largest player in LAP. Rs400 bn of incremental disbursements ex- PSU banks. Business profile No corporate lending, only retail and SME. Focus on MSME clusters, like Pune which is an auto cluster and Hyderabad being a pharma cluster. Are a mix of from manufacturing and services sectors, being in the business for 5-10 years. Within SME, the equipment retail segment is high yielding and growing fast which could improve profitability. NPAs are at 1.5% for LAP, 2.5% for SME and 4% for CVs. Targeting 50% mortgage + LAP, 30% SME and 20% CV and others, with a full-year loan growth estimate of 10-15%. India Financials Sector 39

40 Industry participant insights: Jairam Sridharan, Head of Retail Lending, Axis Bank Business banking Until now, most of the small capital requirements were being met by friends and family, and co-operative banks. The share of organised sector was relatively small. Customers in business banking are generally restaurant owners, small fleet operators, doctors, etc. LAP 70-80% of loans are typically secured, with the exception of some smaller ticket size loans. Large ticket size LAP has been seeing significant pressure. LAP is a channel-based business, and DSAs tend to move customer lenders. Below 12% yields profitability is quite thin. Profitability: Could come under pressure in LAP In general, the profitability in small business lending is higher than the other large retail lending segment, home loans. Competition in the LAP segment is rising leading to NIM compression the returns here could be approaching those of home loans. Rising competition could either lead to compression in yields, or an increase in LTV (i.e., assumption of more risk). However, non-lap business loans (secured by the underlying cash flows, receivables, plant, machinery and the inventory that has been funded), which requires understanding of the borrower's business, are seeing comparatively benign competition (for example, pure play mortgage companies like LICHF are not focusing on this segment of business loan). Figure 83: Profitability profile in small business loans As % of assets LAP Business lending Interest income 13.0% 14.0% Interest expense 9.0% 9.0% NII 4.0% 5.0% Fee income 0.1% 0.1% Opex 0.3% 0.5% Credit losses 0.3% 0.5% Pre-tax RoA 3.6% 4.1% Tax 1.2% 1.4% Post tax RoA 2.4% 2.7% India Financials Sector 40

41 Figure 84: Market position of various lenders on LAP 18.0% 25.0 Figure 85: Market position of various lenders on smallbusiness lending 20.0% % % % 12.0% 10.0% 8.0% 6.0% LIC Bajaj Finance Axis HDFC Bank Capital First Indiabulls Religare Rcap % 14.0% 12.0% 10.0% 8.0% 6.0% HDFC Bank Axis Religare Bajaj SCUF Yield on LAP Ticket Size (Rs mn) (RHS) Yield on business loans Ticket Size (Rs mn) (RHS) Management speaks: Mr B Sriram, MD, National Banking Group, SBI Mr Sriram oversees a business unit that accounts for 45% of SBI's domestic loan assets, across SME, agriculture and retail. The discussion below focusses on the SME segment. SME segment at SBI SBI had an SME loan book of Rs1.8 tn as of Mar % of the portfolio is balance sheet funding, while the remaining 30% is what SBI calls 'risk mitigated' loans, which are primarily asset-backed loans. Loan ticket size is capped at Rs500 mn, and the average ticket size should be in the range of Rs mn. The portfolio sub-rs10 mn is ~Rs420 bn. LAP was started very recently at SBI. NPAs situation, and corrective measures SME NPAs are running at ~9.5% at SBI. Cash flows are stuck at various parts of supply chains, leading to delayed payments for SBI's SME borrowers. However, management believes that stress in the SME segment has not peaked. NPAs could start declining after manufacturing growth picks up. The recovery could take 3-4 quarters. SBI has commissioned a consultant to reposition the SME portfolio with a new strategy. Technology is being used increasingly in the operations. Earlier SME borrowers would take a loan from SBI but maintain current accounts at other branches, making it difficult to track cash flows. However, now SBI insists on having a current account with itself. Management speaks: Mr Rajiv Sabharwal, ED, ICICI Bank Small business lending ICICI Bank has two products for small businesses: SME loans and loans against property. The target segment for each is usually different from the other. In the LAP segment (housed under and managed by the mortgages team), the LTV is lower than industry average. Ticket sizes are Rs8-10 mn. Sourcing may involve DSAs. India Financials Sector 41

42 In the SME loan segment, lending is usually in the form of working capital loans. Loans are secured by hard assets such as real estate, deposits etc. Sometimes they are in the form of term loans as well. Ticket sizes are Rs20-30 mn. The evaluation of the business is far more detailed than in the case of LAP. Sourcing is usually in-house through branches (the idea is to cater to businesses in the vicinity of the branch). The yields in the two segments are similar, though LAP is facing some downward pressure due to competition (primarily from the NBFCs/HFCs). LAP vs home loans LAP yields are higher than home loans (by bp). Ticket sizes in LAP are bigger (Rs8-10 mn vs Rs3.5-4 mn in home loans). Also, disbursement in LAP happens in one shot (as against construction linked disbursement in home loans). The prepayment/churn levels in LAP are lower than in home loans, because of the absence of prepayment penalty in home loans. Thus, realised tenure in both home loans and LAP are similar. Credit costs are not very different, neither are other operating costs. Thus, profitability in LAP still remains significantly higher than home loans. India Financials Sector 42

43 CVs: Recovering from the bottom Figure 86: CV market should recover from the recent sluggish growth Volume growth - 16% CAGR ASP - 5% CAGR LTV - Unchanged USD 30 bn 12.7% CAGR USD 62 bn Figure 87: Key players in CV financing FY14 FY20E Figure 88: Loan characteristics of CV financing Product template New CVs large fleet New CVs small fleet/srto Used CVs Key players HDFC Bank, ICICI, Kotak IndusInd, Sundaram, Chola, Shriram, AU Finance Tata Motors Finance Customer segment Large fleet owners with 100+ trucks Small fleet owners with 5-10 trucks Owner-drivers with 1-4 trucks Lending rates 10-12% 14-16% 18-22% Lending rate type Usually fixed, sometime floating linked Fixed Fixed to base rate for super large fleet LTV 80-90% 80-90% 70-80% Ticket size (Rs) mn per truck mn per truck mn per truck Average tenure 3-4 years 3-4 years 3-4 years Sourcing Direct relationship with large fleet owners Dealer agents, DSAs, own sourcing Brokers, own sourcing Sizing the potential: Organised finance already accounts for 75%+ the market The CV finance segment has a clear segmentation between new and used (second-hand) CV financing. In our analysis, ~52% of the CV loans today are against new/first-hand trucks. The yields, perceived borrower risks and even lender preferences differ significantly between the two segments. Figure 89: Penetration of organised finance into a new CV market is nearly complete (Sep-2014) Share of new and used CV financing Used CV - others 20% New CV - organised 48% Used CV - organised 28% New CV - others 4% India Financials Sector 43

44 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 FY24 FY25 FY26 FY27 FY28 FY29 FY30 13 January 2015 In our view, penetration of organised finance in new CV purchase is near complete, with just the Top 12 lenders accounting for nearly 90% of the market. The used CV market, however, still has a large unorganised segment. We believe overall organised finance penetration into the CV market is 75%, and unlikely to go up significantly soon. Thus, growth in the loan book will mirror underlying CV industry growth. Truck penetration in India is quite low, and at least 15 years behind other emerging markets such as Indonesia, which shows the structural potential for CV sales. Figure 90: CV penetration in India lags that of other countries significantly CVs per 1000 pop Figure 91: India will take 15 years to reach current CV penetration of Indonesia, assuming steady 15% growth in sales each year 14,000, ,000, Indonesia in ,000, ,000, ,000,000 India in ,000, ,000, Annual sales (CV units) LHS CV penetration (CVs per 1000 pop) RHS Source: Road transport authorities of respective countries, SIAM, Credit Suisse estimates However, this is also a highly cyclical industry, with the cycles coinciding with economic cycles in the country. With the pick-up in CV sales, CV financiers should see strong growth in their loan books. Figure 92: MHCV sales growth appears to have bottomed 100% 12 m Moving Average M&HCV's growth Figure 93: Freight rates have been rising in recent quarters 105,000 Freight rates (Rs) for round trip 16 ton load 85,000 50% 65,000 0% -50% 45,000 Delhi-Mumbai Delhi-Kolkatta Delhi- Hyderabad Delhi-Chennai Delhi- Bangalore FY12 FY13 FY14 YTD FY15 Nov-14 Source: SIAM, Company data, Credit Suisse research With the pick-up in overall economy, we expect a pick-up in CV sales. We expect truck penetration to increase from 4.4 per 1,000 people in FY14 to 7.1 per 1,000 people in FY20E, driven by a ~14.4% and 19.9% sales CAGR in LCV and MHCV, respectively, along with a ~5% ASP CAGR. This translates into a 12.7% CAGR on the loan book. India Financials Sector 44

45 Figure 94: Expect CV penetration to go up from 4.4 per 1,000 population to 7.1 by FY CV penetration per 1000 people FY14 FY15E FY16E FY17E FY18E FY19E FY20E Players are positioned in different segments Shriram Transport Finance remains the largest truck financier in the country, with a loan book almost equal to the next three lenders combined. Some NBFCs (particularly Tata Motors Finance and Chola) have grown their CV loan books aggressively over the past four years. Figure 95: The larger lenders accounting for 40% of industry have seen a sharp slowdown in their loan book growth 80% 60% HDFC Bank ICICI IndusInd Kotak Shriram 40% 20% 0% -20% -40% FY11 FY12 FY13 FY14 Source: Company data, Credit Suisse research However, we note that overall CV loan growth for leading players has slowed considerably in recent years, mirroring the downtrend in underlying CV demand, and overall weakness in the economy. With signs of a revival in CV sales (particularly MHCV sales), we believe that growth rates for CV financiers could start improving in the coming quarters. Profitability: Used CV > SRTO > large fleet While used CV financiers get higher yields/nims vs new CV financiers, this is offset by higher credit and operating costs in this segment. The large fleet financing market, on the other hand, is the most competitive on rates and as a result enjoys lower profitability despite lower opex as well as lower credit costs. India Financials Sector 45

46 Figure 96: Profitability across segments within CV financing As % of assets New CVs large fleet New CVs small fleet/srto Used CVs Interest income 12.5% 16.0% 18.5% Borrowing costs 8.3% 9.9% 10.8% NIMs 4.2% 6.1% 7.7% Processing fees 0.5% 0.5% 0.5% Operating expenses 1.5% 2.1% 2.3% Credit costs 0.6% 1.0% 1.8% PBT 2.6% 3.5% 4.1% Tax 0.9% 1.2% 1.4% ROA 1.8% 2.3% 2.7% While Shriram focuses on the used CV segment, the large banks focus on the large fleet segment. Other NBFCs and IndusInd Bank focus on the SRTO segment. Figure 97: Market position of various lenders in the CV segment 23% 21% Large fleet Small road transport operators Used CV 19% 17% 15% 13% 11% 9% 7% 5% HDFC Bank Indusind Magma Chola RCAP Sundaram SHTF Yield on CV loans Management speaks: SV Parthasarathy, Head, Vehicle Finance, IndusInd Bank Key players in the CV financing market IndusInd has an 11% market share in new CV financing and is among the Top 2 along with HDFC Bank. The other key players are ICICI Bank, Axis Bank, and NBFCs. PSU banks are quite small in CV financing, and together have probably a less than 10% market share. HDFC Bank and ICICI Bank are strong in the large fleet segment. IndusInd focuses on the small fleet (5-20 vehicles) segment. Market cycles CV cycle usually last 4-5 years, and typically coincides with the economic cycle. Management believes that the current situation is ripe for an upturn in the CV cycle. Much of the excess truck capacity in the country has been absorbed. India Financials Sector 46

47 Impact of a recovery will be two-fold: (1) pick-up in growth here the large fleet owners will act first and hence those lenders will see the uplift earlier than small fleet lenders; and (2) improved collections. IndusInd expects growth in CV disbursements to pick up from Mar-15 quarter. Expected CV sales for FY16 are ~300, ,000 (up from 200,000 in FY14, and 100,000 in 1H FY15). Use of credit bureaus IndusInd checks for credit scores on all cases. More than 70% of new loan applications are from repeat customers, so the hit rate for IndusInd on credit bureaus is very high. Management believes that the rise of credit bureaus has worked wonders on consumer behaviour, too (for instance, NPAs in the two-wheeler segment have fallen from 4% to 2%, largely attributable to the bureau awareness). Overall, management does not see much difference in the database sizes of various bureaus, and the differentiation, if any, is on analytics and data acceptance rates. Other topics Used CV financing is ~20% of CV loan book for IndusInd, and growing fast. Management speaks: Mr Rajiv Sabharwal, ED, ICICI Bank CV loans ICICI Bank operates in the large fleet segment, where the stress has been the least. CV yields are bps above base rates Growth in recent months has been driven by replacement demand, primarily by the fleet segment, and actual expansion of fleet is yet to take place. India Financials Sector 47

48 Auto loans: Competition keeping yields/returns low Figure 98: Expect a 16% CAGR in the car loan segment Volume growth - 14% CAGR ASP - 5% CAGR USD 33 bn FY % CAGR USD 90 bn FY20E Figure 99: Key players in auto financing Source: Company data, Credit Suisse research Figure 100: Loan characteristics of auto loans Product template PSU bank Pvt banks NBFCs Two-wheeler loans Key players SBI HDFC Bank, ICICI Bank, MMFS, Magma, SCUF, Bajaj, HDFC Bank, SCUF, Kotak, Axis Bajaj Finance IndusInd Customer segment Salaried, Urban Salaried, Urban Self Employed/Rural Mass Lending rate % % 13-14% 18-20% Lending rate type Fixed Fixed Fixed Fixed Processing fees % 1.00% 1.00% 2.00% LTV 75-85% 75-95% 70% 70-80% Ticket size (Rs) mn Avg tenure (yrs) Sourcing Dealers, DSAs Dealers, DSAs Dealers, DSAs, Own sourcing Dealer's commission % Sizing the potential: Pent-up demand to drive pick-up in volumes Penetration of organised financing in car sales in India is fairly high, at 75%+. Thus, auto financing industry growth trends should theoretically largely reflect the underlying car sales trends. Car penetration in India, at 15 per 1,000 people, is significantly lower than other countries. This suggests good long-term growth potential. Dealers India Financials Sector 48

49 Figure 101: Car penetration in India is less than major markets' 600 Car penetration per 1000 people Figure 102: so is two-wheeler penetration 40 2W penetration per 100 people Source: World Bank, Credit Suisse research Source: World Bank, Credit Suisse research While car sales are less cyclical than truck sales in India, they do get impacted by the consumer sentiment. The passenger vehicle market, after four years of flat volumes, has started to show signs of increased demand. Growth has picked up over the past five months after almost three years of subdued demand. Figure 103: Demand to pick up after four years of stagnant volumes 3,500 Passenger Vehicle (Cars+UVs) 3,000 2,500 2,000 1,500 1, % 30% 25% 20% 15% 10% 5% 0% -5% -10% Figure 104: Growth over the past few months has picked up after three years of subdued demand 30% PV Volume growth (YoY %) 20% 10% 0% -10% Volume ('000) Growth (YoY %) -20% Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13 Jul-13 Dec-13 May-14 Source: Company data, Credit Suisse research We assume car penetration in India will rise from 15 in FY14 to 25 per 1,000 pop by FY20E, leading to a 14.5% CAGR in volume in 4Ws (and we also build in 13.5% growth in the 2W market). Assuming a ~5% ASP CAGR, stable LTVs and tenures (three years), this translates into a 17.9% CAGR for the car loan market, increasing from US$33 bn to US$90 bn. Private banks still dominate the car financing market Top three players for the passenger vehicle financing market account for over 50% of the market share. However, after that, the market is quite fragmented with almost all the banks actively present in the auto financing market. As a result, competitive intensity is higher compared to the other retail segments (probably with the exception of housing finance). Banks dominate the car loans segment with HDFC Bank, ICICI, SBI and Kotak accounting for the major share. Within rural markets, MMFS has gained prominence due to its widespread network. India Financials Sector 49

50 HDFCB SBI ICICI Kotak Axis MMFS Magma BOB PNB Canara Indus BOI Union SCUF Bajaj 13 January 2015 Industry participant insights: Mr Vyomesh Kapasi, CEO, Kotak Prime Car Finance Market structure 70-72% of cars are bought on finance in India, thus finance penetration is fairly high. The average ticket size for the market is Rs400, ,000, with 80-85% LTVs. Yields are typically in the % range. The biggest player in the car finance market is HDFC Bank, followed by SBI, Kotak and ICICI Bank, not in any particular order. The used car market is still largely unorganised, with probably 30-40% transactions involving financing of some form. Lending rates here are bp higher than in new cars. Operations More than 50% of the business comes through dealership tie-ups. Most major lenders have tie-ups with OEMS for dealership referrals. Usually, Kotak also funds the dealers' inventory The next largest source of business for Kotak is its own database of past customers. Impact of credit bureaus Repossessions in car loans are rare nowadays. This is because the delinquency levels have improved significantly over the past 4-5 years. A large contributor towards this improvement is the rise of credit bureaus. Kotak gets 80-85% hit rate on the credit bureaus for its new loan applications Further, customers are conscious about credit bureaus and there is a marked improvement in consumer behaviour in recent years. The two-wheeler segment is, however, less crowded, with HDFC Bank, IndusInd, Bajaj, TVS and SCUF accounting for ~85-90% of the total market. Figure 105: Key players in the car financing market 350 Four wheeler loan book size (Rs bn) Figure 106: Key players in the 2W financing market 40 Two-wheeler loan book size (Rs bn) Bajaj Finance HDFC Bank SCUF IndusInd Source: Company data, Credit Suisse research Profitability in car loans lower compared to other retail segments Source: Company data, Credit Suisse research PSU banks have been aggressive in the car loans segment especially on lending rates. SBI is offering car loans at the lowest rate (at ~10.5%) with most other PSU offerings in the range of % as well. Private banks have been relatively less aggressive in pricing (11-12%), but have tried to compete by offering higher LTVs. NBFCs operate in India Financials Sector 50

51 segments where either risk is higher (salaried customers) or the cost of operations are higher (rural and semi-urban) and hence charge higher yields. Given aggressive pricing in car loans, profitability is relatively low compared to other segments. Figure 107: Auto loan profitability levels lower compared to other products As % of assets Banks NBFCs 2W loans Interest income 11.5% 15.0% 20.0% Interest expense 8.2% 8.8% 8.8% NII/total assets 3.3% 6.2% 11.2% Processing fees 0.2% 0.2% 0.2% Dealer's commission 0.3% 0.5% 0.5% Opex 0.8% 2.0% 3.0% Pre-provision profit 2.5% 4.0% 7.9% Credit cost 0.8% 1.4% 3.5% Operating profit 1.7% 2.6% 4.4% ROA (%) 1.2% 1.7% 3.0% Figure 108: Market positioning of various players in the auto loan segment 30.0% 25.0% Urban Rural 2wheelers 20.0% 15.0% 10.0% 5.0% Kotak (car) SBI (car) MMFS (car) IndusInd (2W) SCUF (2W) Capitalfirst (2W) Bajaj (2W) Yield on auto loans Industry participant insights: Senior management personnel in car finance, MMFS Market structure Yields on used cars are ~500 bp higher than new cars. DSA channel is well established in the used car market. In Pune, the number of used car transactions would be similar to the number of new car sales. 70% of new cars are sold on finance, compared with 50% for used cars. HDFC and ICICI have been in the used car financing market for a while. HDFC Bank is the largest, while ICICI has become aggressive in the used car space. HDFC would offer lower interest rates. Operations Use of CIBIL in most cases, with an 80% hit rate. Percentage of rejections has gone up from less than 10% to 20% now. Have ~32% market share within M&M car sales, HDFC and Chola have ~5-6% share. NPAs had gone up in the past 3-4 months, during the festive season. India Financials Sector 51

52 Gold loans: Growth should follow regulatory clarity Figure 109: Loan growth at 10.6% over the next six years, to lag the retail sector % of gold pledged with banks - 5% to 8% LTV - Up from 50 to 60% USD 61 bn Figure 110: Apart from a couple of NBFCs, the market is dominated by banks 50 16% CAGR USD 25 bn FY14 FY20E Figure 111: Loan characteristics of gold loans Product template Banks NBFCs Key players South Indian Bank, Federal Bank Muthoot, Manappuram, SCUF Customer segment Mass segment with gold jewellery available to pledge Mass segment with gold jewellery available to pledge Lending rates 12-15% 18-22% Lending rate type Fixed Fixed LTV 60% 70% Ticket size (Rs) 80, ,000 40,000 Average tenure 3-6 months 3-6 months Sourcing Branch walk-ins Branch walk-ins Sizing the potential: Likely to lag the retail loan market Estimates from RBI state that there is 18,000-19,000 tonnes of gold in India, 65% of which is in rural India. Gold is typically seen as an important savings instrument that is liquid and can be converted into cash instantly to meet any urgent needs. While there are no formal statistics, our industry discussions indicate only ~1,000 tonnes of gold is with lenders in terms of collaterals for loans. Customers are generally of walk-in type. The end-use of ~40% of the loans is towards small and micro businesses, while ~30-35% is used towards agri-related businesses. While 5-10% is towards small fleet operators, the balance 15% is towards personal expenses (hospital expenses, school fees, etc). Companies are now starting to lend towards the purchase of consumer durable items as well. While the traditional pawn broking business (where the customer just sells the jewellery with no guarantee of getting it back intact at a later date) has been in existence for ages, the focus of this section of the report is on the practice of borrowing against gold as a collateral, where the borrower is sure of recovering the original asset intact upon the completion of the loan. Estimates from RBI suggest that the formal gold loan market is ~US$25 bn in size. The gold loan market has seen some slowdown on account of intervention by the RBI on NBFCs, and volatility in gold prices. The top five players saw their loan book shrink 16% YoY in FY14 (after witnessing a 57% CAGR over the preceding three years). India Financials Sector 52

53 Figure 112: Growth in gold loans has slowed considerably in recent years 300 Muthoot Manappuram South Indian HDFC Bank Federal Bank Rs bn FY09 FY10 FY11 FY12 FY13 FY14 Source: Company data, Credit Suisse research However, we expect growth to resume slowly on the back of stability in gold prices, and RBI's comfort with the current state of the sector (evident in the raise in LTV limit to 75% from 60% in Jan-14). With current estimates of ~19,000 tonnes of gold in India, we build in a 4% CAGR, assuming 800-1,000 tonnes of gold imported each year (i.e., the current annual run-rate) and price of gold remaining flat. We build the quantum of gold on pledge to go from 5% to 8% by FY20, along with a gradual increase in LTV to ~60% (from 50% currently). This leads to a ~16% CAGR in growth for the gold loan industry. Figure 113: We expect 7.5% of all gold in India to be pledged with banks by FY20 (from 5% currently) 27,000 25,000 Unpledged Gold (MT) Gold pledged with banks/nbfcs (MT) 23,000 21,000 19,000 17,000 15,000 FY14 FY15E FY16E FY17E FY18E FY19E FY20E Geographic diversification could drive growth Over the longer term, growth could be driven by a geographic diversification: south India still accounts for a significant share of the gold loan business, as seen from loan concentration of the gold loan NBFCs in this region. As per RBI, south India accounted for 80-85% of the gold loans market in India in India Financials Sector 53

54 Figure 114: Muthoot and Manappuram have the majority of their loans in the south (Sep- 2014) East 6% West 14% North 14% South 66% Source: Company data, Credit Suisse research The gold loan market is dominated by banks, who command a 71% share. However, individual banks are actually smaller players in the market compared to the specialist NBFCs. The largest gold loan portfolios are with specialist gold loan NBFCs Muthoot and Manappuram respectively have a 15% and 6% share in the formal market. Industry participant insights: Mr Oommen Mammen, CFO, Muthoot Fincorp Market structure ~18,000 tonnes of gold in India, of which ~1,000 tonnes is pledged. The organised NBFC market size is ~Rs400 bn, while the banks command ~Rs1,000 bn. The unorganised market could be 2-3x the organised market. Banks do agri gold loans to fulfil the PSL requirements. Loans are taken for various end-uses (small businesses: 40%, agri: 35%, auto and tractor: 10% and others [hospital or school fees]: 15%) Operations NBFCs could give a gold loan in 5-10 mins compared to slower processing times for banks. Small value and large number of loans make the business difficult for banks. Operating model: Low credit loss but high opex The yield on gold loans is relatively high for a secured loan business, at 16-22% with LTV varying from 65% to 75% on value of gold; higher LTVs typically command higher yields. While the tenure of these loans varies from a few days to longer-term loans of up to a year, the average tenure generally ranges from three to six months. NBFCs normally do not charge any processing fees on loans, while some banks do. The operating costs in this business tend to be high, due to the following factors: The ticket sizes are usually small and the volumes high. The nature of the business requires a wide reach in terms of physical branches; Muthoot has the fifth largest branch network across all banks and NBFCs. India Financials Sector 54

55 Figure 115: Muthoot has the largest branch network among NBFCs, comparable to some large PSU banks 18,000 No. of branches 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 - Source: Company data, Credit Suisse research Requirement for staff to be highly skilled in gold jewellery valuation. Credit losses are generally low in the business (the NBFCs we studied have seen loss rates in the range of 0-10 bp over the past few years). The sentimental value attached to the specific pieces of jewellery pledged, as well as the sub-75% LTV, ensure low loss rates. Gold loan companies saw pressure on profitability, with the fall in gold prices Sharp drop in gold loan prices With the sharp increase in gold prices, in 2Q12 and 3Q12, gold loan companies had lent aggressively, with loan-to-value ratios touching ~90%. In 4Q13, there was a sharp decline in gold prices (-16% from January to April). The decline in gold prices led to the value of collateral not covering the loan value, resulting in an increased number of customers not servicing their loans. The increase in default led to auctioning of the gold held by the gold loan companies, and with the decline in gold prices, this led to a loss on the sale of these gold assets. RBI tightens norms for gold loan companies In Mar-12, RBI came out with several regulations for the sector. One of which was limiting the LTV to 60%, and a frequent and more transparent method of valuing the gold. This limit was subsequently raised to 75% in Jan-14. Sustainable RoA of 3% On a sustainable basis, this sector could have a RoA in the range of % (while banks could enjoy lower funding costs vs NBFCs, we also believe this is largely negated by the lower yields that banks traditionally charge in the segment). India Financials Sector 55

56 Figure 116: Gold loans profitability As % of assets Banks NBFCs Interest income 15.0% 20.0% Interest expense 8.2% 9.9% NIM 6.8% 10.1% Opex 3.0% 5.0% Credit losses 0.1% 0.1% Pre-tax RoA 3.7% 5.0% Tax 1.2% 1.7% Post tax RoA 2.5% 3.4% Figure 117: Positioning of various lenders on gold loans 24% 22% 20% 18% 16% 14% 12% 10% 8% 6% South Indian Bank SCUF Muthoot Manappuram Yield on gold loans Ticket size (Rs) RHS India Financials Sector 56

57 Bandhan SKS Spandana Janalakshmi Share Ujjivan Equitas Satin Asmitha Muthoot GFSPL 13 January 2015 Microfinance: Banking the unbanked Figure 118: Loan growth of over 14.4% in the next six years No. of customer - 9% CAGR Addressible segment penetration - 45% to 70% Loan per customer - 8% CAGR USD 12 bn 18.1% CAGR USD 32 bn Figure 119: SKS is the only listed MFI at the moment; Bandhan recently got a banking licence 70 GLP - FY14 (Rs bn) FY14 SHG MFI FY20E Figure 120: Operating profile of the MFI industry Key players Customer segment Secured/unsecured Microfinance NBFC-MFIs like Bandhan, SKS Rural self-employed women Unsecured Lending rate 20-24% Lending rate type LTV Fixed Ticket size (Rs) 10,000-12,000 Avg tenure (yrs) 1-2 Sourcing Sizing the potential: Less than half the market has been touched NA Group referrals Banking penetration in India continues to be low, and in particular, the rural poor are largely excluded from formal banking services (leave alone formal credit access). It is this gap that the microfinance institutions and self-help groups try to fill. Figure 121: Banking penetration still low 80% 70% 60% 50% 40% 30% 20% 10% % of households availing banking services 0% Rural Urban Total Source: Company data, Credit Suisse research Specialist Micro Finance Institutions (MFIs) and the bank-led self-help groups (SHGs) model together cater to around 85 mn borrowers (after taking into account overlaps), with India Financials Sector 57

58 an average loan ticket size of ~Rs8,400. Thus, the micro-credit industry has an ~US$11.8 bn loan book, with a 60% share held by banks and the rest with NBFC-MFIs. Figure 122: Micro credit customers in India (mn) 120 SHGs MFIs Figure 123: Size of microcredit industry (Rs mn) 800,000 SHGs MFIs 700, , , , , , ,000 - Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Source: State of sector report, MFIN, RBI, Credit Suisse research Source: State of sector report, MFIN, RBI, Credit Suisse research While the industry has stabilised post the AP MFI crisis and started growing again, we believe penetration levels are still low. Of the total 247 mn households in the country, 52% or around 128 mn have an annual income of under Rs90,000. The average household size in India is 4.9 people. Further breaking it up, women per household is 2.4. Limiting the target microfinance borrowers to only adult women, in these low income (less than Rs90,000 annual income) households, translates into a potential client base of 182 mn, given the national average of 1.4 adult women per household. This number will increase as more girls reach the age of 18 and are eligible as earning members. After the AP crisis in 2011, microfinance has again reached the pre-crisis levels at ~100 mn households. With SHGs having a client base of mn and MFIs reaching 34 mn and an estimated 19 mn overlap between the two, it implies an untapped market size of about 100 mn (55% of the total potential clients). Figure 124: Less than 50% of the addressable market has been tapped by the micro-credit industry Figure 125: Estimated market potential for the MFI industry across various agencies Estimated microfinance credit (in USD bn) Vijay Mahajan (Basix Chairman) CS estimate Intellicap (based on regional demand) EDA rural report Intellicap (by population segment) The microfinance industry loan book was ~US$11.6 bn in 2014 (60% of this with the SHGs). The total potential size of the microfinance market is estimated at US$40-50 bn by various industry studies (Figure 125). Based on our customer potential of 182 mn, at the current average loan size of Rs 8,400 per customer, the estimated market size potential is US$25 bn. But we note that the average loan size has seen a CAGR of 14% over the past two years. Assuming a Rs12,000 average loan size (not too aggressive, in our view, and well below the Rs15,000 limit for one-year loans) the market potential comes to US$36 bn. India Financials Sector 58