Morgan Stanley said it is time to get selective on Indian banks, as margins and asset quality are set to normalize in the next few years and drive divergence in profitability based on the franchise strength.

The brokerage said it is shifting further away from state-owned enterprise (SoE) banks/mid-sized private banks toward large private banks. As profitability normalizes, ICICI Bank, Kotak Mahindra Bank and Axis Bank are better placed to manage profitability around normalized levels, along with sustained market share gains, it added.

“We expect these banks to see valuations move higher relative to SoE banks and mid-sized private banks over the next few years,” Morgan Stanley said in an investor note.

Furthermore, the brokerage said it sees a big trade-off between growth and profitability at state-run banks, as most banks have utilized excess liquidity, with liquidity coverage ratio (LCR) now close to that of private banks. Loan growth will likely have to match retail deposit run-rate, which is 40%-50% lower at public sector banks than large private banks, it noted.

“SBI (State Bank of India) is our preferred pick among SoE banks and should see valuation premium stay/move higher than peers,” Morgan Stanley said.

The brokerage also said that mid-sized private banks are structurally more challenged in this cycle, given highly competitive intensity. “That said, they should incrementally benefit when the rate cycle turns. Further, their credit costs are already elevated and hence, could see relatively lower pressure,” it noted.

Morgan Stanley, which sees mid-sized private banks’ risk reward as better than state-run banks once the rate cycle turns, said AU Small Finance Bank and IndusInd Bank are its preferred picks, and it expects to see a material valuation premium relative to peers.

The brokerage downgraded Federal Bank to Underweight from Overweight and reiterated Underweight call on RBL Bank. It also adjusted the target prices and estimates.

India Watch List For Friday - September 1