Executive Summary

Executive Summary

We are bullish on Indian banks, as we see that robust credit growth and improving fundamentals to
drive earnings for the next few years. We believe current valuations of state owned banks are compel-
ling, which are trading at a negative implied growth in earnings. We expect strong growth for private
sector banks, as they ride the current economic growth wave and benefit from positive demographics.

Credit expansion to continue: projecting 21% CAGR over FY06-08E

The strong 24-month credit run continues, with advances growing at 30% CAGR during FY04-06E. The
Indian economy’s hunger for bank funding is not yet satiated, so momentum is expected to remain strong.

We believe the economic drivers of this growth, in the form of:

• strong demographic drivers of credit demand,
• underleveraged households and very low retail credit penetration,
(retail credit penetration is still low at under 10% of GDP)
• Upturn in the investment cycle and increasing working capital requirements of the corporate
sector,
• investment requirements of the fast growing Infrastructure segment
- would continue the credit momentum. We believe that these drivers are intact and should support
21%+ growth over the next two years and 15%+ growth over a longer time frame.
Contrary to the popular belief that there would be a significant slowdown in credit growth due to the
resource crunch, we believe banks would have sufficient funds to grow at attractive rates.
Liquidity crunch – non concern
We believe the liquidity crunch – which was triggered by the IMD redemption in Dec ’05, is a short term
concern and expect the liquidity scenario to normalize with unwinding MSS and increased government
spending. We expect liquidity to remain stable as we believe RBI will infuse liquidity through LAF or a cut
in reserve ratios (SLR, CRR). As we write, market liquidity is back in the positive (as market measures
it through LAF balance) from a negative INR 150 bn during February-March 2006.

Receding pressure of provisions

Lower incremental NPAs and reduced risk on bond portfolio should entail lower pressure on earnings
going forward. We expect lower incremental NPAs due to strong current economic momentum and
structural improvement in loan recovery mechanisms (SARFAESI etc). In the past one year Indian
banks have reduced the market risk on their bond book to an extent by reducing investments, reducing
the duration of the book and by shifting bonds from marked to market to held till maturity (HTM). We
expect total provisions for our universe to decline from 100bps of assets in FY05 to 50bps in FY07E,
which would result in improved return ratios.

Compelling valuations
State owned banks valuations imply a negative growth in earnings.
Private sector banks - growth ride to continue
Current valuations of Indian banks are attractive on both absolute basis and when compared with other
countries. Indian banks still trade at a huge discount to their global peers and we expect this gap in valuations
to narrow as banks grow in size (both organically and inorganically) and move to more sustainable sources
of earnings. Union Bank, Syndicate Bank and PNB are our top picks among state owned banks and we
like ICICI Bank and Centurion Bank of Punjab the most among the private sector banks.