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Rising unemployment and hard-hit sectors such as tourism and hospitality are pulling down the economy. The financial system, dominated by the banking sector, has not been in a healthy state in the last few years. The regional banks, due to weak macros, saw stress formation spiking to 4.5% during FY21.

But despite being under pressure, regional banks have made the most out of a challenging situation by substantially strengthening their balance sheets, Investec Securities noted in a report.

Improved capitalisation

Their advances growth had been reducing, which protected them during the Covid year. Further, banks undertook a higher share of secured (GL) and government-guaranteed (ECLGS) lending (8-15% of advances as of Mar’20), which de-risked their balance sheet, also improving capital efficiency by 60-270bps (CET1). The capitalisation of these banks now stands comparable to larger peers.

Interest rate cycle

To rejuvenate the economy, RBI slashed policy rates sharply to spur demand, the deposit rates were reduced across the banking sector to cushion net interest margins. Regional banks with relatively stronger liability franchises like Federal Bank, City Union Bank and Karur Vysya Bank were able to bring down their cost of funds almost in line with the likes of HDFC Bank, ICICI Bank and Kotak Mahindra Bank without compromising deposit growth.

Top picks

Most regional banks continue to trade at a significant discount to their historical averages due to the shrinking of growth premiums. Regional banks have historically outperformed the sector, and Investec expects growth to normalise as the economic revival gathers steam.

City Union Bank | Target price: Rs 210 | Upside: 26%

City Union Bank is a conservative regional bank and has consistently delivered strong returns along with healthy growth. The current pandemic saw the highest stress addition among peer banks for City Union Bank but the bank still delivered Return on Assets (RoA)/Returns on Equity (RoE) of 1.1%/10% during FY21, the highest among peers. City Union Bank’s SME customers rebounded sharply after the economy opened up. While the second wave will keep profitability subdued in FY22, we expect improvement in performance for the bank FY23e onwards. Build 26% Profit after Tax (PAT) compounded annual growth rate (CAGR) the bank, expecting the bank to deliver RoA/RoE of 1.5%/14% by FY23e.

Federal Bank | Target price: Rs 125 | Upside: 45%

Slippages during the year was the lowest among peers, even better than most large private banks. De-risking of the corporate book has yielded results for the bank with corporate slippages benign at 1.3%/1% during FY20/FY21. However, with the disruption caused by the 2nd wave, the journey towards 1% RoA will likely get pushed further. NIMs remain the key driver for RoA improvement beyond 1%. PAT estimates downward by 4%/6% for FY22/23e factoring the impact of second-wave and expect the bank to deliver a PAT CAGR of 18% over FY21-23 and RoA/RoE of 1.0%/12% in FY23e.

DCB Bank | Target price: Rs 185 | Upside: 79%

DCB Bank has seen a substantial improvement to its balance sheet strength with improved liabilities, increased exposure to lower risk assets and an improvement in operating leverage. DCB Bank improved the share of granular deposits to 67% as of Mar’21 from 47% as of Mar’19. Further, the bank managed to improve capital efficiency, bringing down Risk-Weighted Assets (RWA)/assets to 58.5% as of Mar’21 (from 62% as of Mar’19) thereby improving its capital adequacy ratio. With these changes, DCB is well placed to deliver 1.2% RoA by FY23e.

(Disclaimer: The recommendations in this story are by the respective research and brokerage firm. Money9 does not bear any responsibility. Please consult your investment advisor before investing)