KEY HIGHLIGHTS

Indian Overseas Bank (IOB) reported a moderate growth of

8.4% YoY in Net Interest Income (NII) which was in line with
our expectation due to fall in margins and spike in cost of funds.
The bank’s net profit grew 25% YoY to Rs3.08bn due to strong
performance in non interest income and lower provisioning
attributed to improving asset quality as well as write back of
provisions.
NIM under pressure
Surge in interest expense by 64% to Rs14.2bn, mobilization of high
cost deposit in the first half of current fiscal, moderation in NII growth
and shrinking CASA brought down the margin by 60 bps to 3.11%.
Moderate growth in core business
Advances and deposits witnessed subdued incremental growth of 14%
and 14.6% in the current fiscal. Hence, C-D ratio has also declined to
69% from 75%.
Net profit growth
Despite slower growth in income, net profit increased by 25% YoY to
Rs 3.1bn mainly due to write back of provisions and decline in overall
provisioning requirements. Improvement in asset quality also resulted
in lower provisioning.
VALUATION AND RECOMMENDATION
IOB has higher bulk deposit due to which it has taken a sharp hit on the
margins. Deposit growth outpaced credit offtake in Q2FY08 and which
has remained stagnant in the quarter un der review. We believe margins
would continue to remain under pressure until high cost deposits mature.
We value the stock at a sustainable RoE of 22.74% (CoE-14%;
g-7%), fair Adj. PBV multiple of 2.25. With these assumptions, we arrive
at FY09 price target of Rs215, which represents 34% upside from the
CMP. Hence, we maintain our ‘BUY’ recommendation on the stock .

PERFORMANCE OVERVIEW
Modest NII Growth
Indian Overseas Bank (IOB) reported a subdued incremental growth in advances and
deposits of 14% and 14.6% to Rs546bn and Rs788bn respectively. The Bank witnessed
sluggish NII expansion of 8.4% to Rs6.55bn on account of surge in interest expense by
63.5% to Rs14.19bn and slower growth in advances. Accretion of high cost deposits in
the first half of the current fiscal has resulted in high interest expense. CASA ratio has
fallen by 420 bps to 30.8% which has resulted in the cost of funds of IOB inching
upwards
by 134bps YoY to 6.7% in Q3FY08.
Pressure on NIM to continue
NIM for the current quarter has dipped by 61bps YoY and 29bps QoQ to 3.11% due to
spike in cost of funds and declining credit - deposit ratio. Majority of the advance
portfolio
of IOB were given at a fixed rate due to which this part of portfolio could not be
repriced
upwards. The bank maintains that by improving share of low cost deposits and
increasing
NII, it will be able to improve the margins.
High Non-Interest income growth
Non-interest income surged 63% to Rs2.2bn led by higher growth in core non-interest
income. Excluding treasury gains/losses the expansion has been even higher at 1.5
times
YoY. IOB has strong franchise network in South India and it has tie ups with several
mutual funds and insurance firms to distribute their products. Thus, we maintain that
non
interest income will continue to remain robust for the Bank.
Write back of provisioning, lower provisioning requirements on account of improving
asset quality has resulted in provisions declining by 44% to Rs367mn. During Q3FY08,
the bank had write back of investment provisions of Rs300mn. Gross and Net NPA’s
have
declined by 67 and 12 bps YoY to 1.87% and 0.36% respectively.
INVESTMENT ARGUMENT
We expect IOB to achieve a moderate CAGR in credit of 20% between FY08 - FY10. NIM
is expected to remain under pressure until the high cost bulk deposits mature and the
Bank is able to replace them with low cost deposits. Also, healthy growth in advances
would support the margins. We estimate NIM to remain ~3% by FY10.
CASA ratio of the Bank has drastically fallen from last year and we estimate marginal
improvement in the same to hover ~34-35% in the next 3 fiscal. CASA remains key
focus
of the bank as an effort to maintain their margin at current levels.
Rising delinquencies has also been a major cause of concern in FY07. We expect the
delinquencies to show an upward trend due to rising interest rates and the high credit
growth of ~35% YoY during the last 2 fiscal. The delinquencies as a percentage of
previous year end advances have risen from 1.89% in FY06 to 2.04% during FY07. We
have factored in delinquencies at 2.08% - 2.20% during the next three fiscal, which is
going to keep LLP high ~ 0.24 of average assets in FY09. Any worsening of loan
slippages
over and above these levels would lead to further deterioration in RoA & hence, RoE.
OUTLOOK
Under the current set of assumptions, we expect the bank to achieve net profit CAGR
of 12.5% during FY08-10. We project a decline in RoA to 1.23% in FY09 due to pressure
on the margins and high LLP. This would lead to RoE contracting from 29.1% in FY07 to
24.75% by FY09. IOB was the only bank among Indian frontline banks to consistently
deliver RoE of over 28% for the past 5 fiscals. However, the same has been declining
due to earnings slowdown going forward due to the higher profit base of previous years
and shrinking margins and therefore we expect pressure on operations to continue. IOB
carries large proportion on investments in the AFS category. Liquidation of investments
in the AFS category, given that interest rates would fall going forward, would provide
an upside to our estimates.
VALUATION
IOB has higher bulk deposit due to which it has taken a sharp hit on the margins.
Deposit growth outpaced credit offtake in Q2FY08 and currently growth in business has
become stagnant for the bank. We believe margins would continue to remain under
pressure untill high cost deposits mature and get replaced by low cost deposits.
We value the stock at a sustainable RoE of 22.74% (CoE-14%; g-7%), fair Adj. PBV
multiple of 2.25. With these assumptions, we arrive at FY09 price target of Rs215
which represents 24% upside from the CMP. Hence, we maintain our ‘BUY’
recommendation on the stock .
REVISED INTEREST RATES

At IOB, our objective is to give you the best, which includes the best interest rates. The
rates of interest are calculated using various parameters depending on the account,
scheme or facility used. Find out more about our interest rates from the table below.

Domestic and NRO Savings Bank Deposits : 3.50% p.a. (effective from 1.3.2003)
NRE Savings Bank Deposits : 3.50% (w.e.f. 18.11.2005)
Domestic & NRO Term Deposits
Interest rates and Effective Annualised Return for various term deposit maturities
With nine-month ROE (not annualised) at 23.15%, we expect Indian Overseas
Bank to beat our estimated ROE of
27.8% for the full year FY08. PAT grew a healthy 24.5% to Rs 308.1 crore from
Rs 246.8 crore in the corresponding
quarter the previous year on account of a reversal in investment depreciation
(change in method of amortization)
resulting in overall provision coming down by 40% y-o-y for the quarter.

2.) history and schemes adopted by bank and the projects undertaken so far.which will
be given by garima

3.) Annual Policy Statement for the Year 2008-09

-Highlights (29th April 2008)

Bank Rate, Reverse Repo Rate and Repo Rate kept unchanged.

High priority to price stability, well-anchored inflation expectations and orderly

conditions in financial markets while sustaining the growth momentum.

Swift response on a continuous basis to evolving adverse international and domestic

developments through both conventional and unconventional measures.

Emphasis on credit quality and credit delivery while pursuing financial inclusion.

Scheduled banks required to maintain CRR of 8.25 per cent with effect from the
fortnight beginning May 24, 2008.

GDP growth projection for 2008-09 in the range of 8.0- 8.5 per cent.

Inflation to be brought down to around 5.5 per cent in 2008-09 with a preference for
bringing it close to 5.0 per cent as soon as possible. Going forward, the resolve is to
condition policy and perceptions for inflation in the range of 4.0-4.5 per cent so that
an inflation rate of around 3.0 per cent becomes a medium-term objective.

M3 expansion to be moderated in the range of 16.5-17.0 per cent during 2008-09.

Deposits projected to increase by around 17.0 per cent or Rs.5,50,000 crore during
2008-09.

Adjusted non-food credit projected to increase by around 20.0 per cent during 2008-
09.

Active demand management of liquidity through appropriate use of the CRR

stipulations and open market operations (OMO) including the MSS and the LAF.
Introduction of STRIPS in Government securities by the end of 2008-09.

A clearing and settlement arrangement for OTC rupee derivatives proposed.

Domestic crude oil refining companies would be permitted to hedge their commodity
price risk on overseas exchanges/markets on domestic purchase of crude oil and sale
of petroleum products based on underlying contract.

Currency futures to be introduced in eligible exchanges in consultation with the SEBI;

broad framework to be finalised by May 2008.

Indian companies to be allowed to invest overseas in energy and natural resources

sectors.

Reserve Bank can be approached for capitalisation of export proceeds beyond the
prescribed period of realisation.

Loans granted to RRBs for on-lending to agriculture and allied activities to be

classified as indirect finance to agriculture.

The shortfall in lending to weaker sections would be taken into account for
contribution to RIDF with effect from April 2009.

RRBs allowed to sell loan assets to other banks in excess of their prescribed priority
sector exposure.

The Reserve Bank to disseminate details of various charges levied by banks.

Asset classification norms for credit to infrastructure projects relaxed.

The prudential guidelines for specific off-balance sheet exposures of banks to be

reviewed.

Reserve Bank to carry out supervisory review of banks' exposure to the commodity
sector.

The limit of bank loans to individuals for housing having lower risk weight of 50 per
cent enhanced from Rs. 20 lakh to Rs. 30 lakh.

Consolidated supervision of financial conglomerates proposed.

Working Group to be set up for a supervisory framework for SPVs/Trusts.

Inter-departmental Group to review the existing regulatory and supervisory framework

for overseas operations of Indian banks.

All transactions of Rs. one crore and above made mandatory to be routed through the
electronic payment mechanism.

Dispense with the extant eligibility norms for opening on-site ATMs for well-managed
and financially sound UCBs.

Regulations in respect of capital adequacy, liquidity and disclosure norms for

systemically important NBFCs to be reviewed. Details

Macroeconomic and Monetary Developments in 2007-08

-Announced on the 28th April 2008
The Reserve Bank of India on 28th April 2008 released the document “Macroeconomic
and Monetary Developments in 2007-08” to serve as a backdrop to the Annual Policy
Statement for 2008-09 being announced on April 29, 2008.

The highlights of macroeconomic and monetary developments during 2007-08 are:

1. Price Situation

Headline inflation firmed up in major economies, mostly during the second half
of 2007-08, reflecting the combined impact of higher food and fuel prices as
well as strong demand conditions, especially in emerging markets. The
monetary policy responses during the year, however, were mixed in view of
heightened concerns about the implications of credit crunch arising out of the
US sub-prime crisis on financial stability and economic growth in the latter part
of the year.

Global commodity prices firmed up during 2007-08 led by sharp increases in

food and crude oil prices. Metal prices, which had witnessed some moderation
during June-December 2007, rose again during January-March 2008.
Agricultural raw materials prices, however, remained largely range bound
during 2007-08. International crude oil prices, represented by the West Texas
Intermediate (WTI) rose to a historical peak of US $ 119.2 a barrel level on April
22, 2008. Food prices firmed up especially during the second half of 2007-08,
led by wheat, rice, and oilseeds/edible oils, reflecting surging demand (both
consumption demand and demand for non-food uses such as bio-fuels
production) and low stocks of major crops.

In India, headline inflation based on the wholesale price index (WPI) softened
from 6.4 per cent at the beginning of the fiscal year to a low of 3.1 per cent on
October 13, 2007 before increasing again to 7.4 per cent by March 29, 2008,
mainly reflecting hardening of prices of primary articles, fuel group and some
manufactured products items.
 Primary articles inflation, y-o-y, eased from 12.2 per cent at the beginning of
April 2007 to an intra-year low of 3.7 per cent by end-December 2007 but
increased to 8.9 per cent on March 29, 2008 mainly led by fruits and
vegetables, oilseeds, raw cotton and iron ore. Fuel group inflation, after
remaining negative during June-November 2007, turned positive from mid-
November 2007 to reach 6.7 per cent on March 29, 2008 reflecting increases in
the prices of some petroleum products such as naphtha, furnace oil, aviation
turbine fuel (ATF) and bitumen as well the upward revision in the domestic
prices of petrol and diesel in February 2008. Manufactured products inflation,
y-o-y, eased from 6.4 per cent at the beginning of the year to 3.5 per cent by
November 24, 2007 but increased to 7.1 per cent by March 29, 2008, mainly
reflecting the continued rise in the prices of edible oils/oil cakes, basic heavy
inorganic chemicals, and basic metals and alloys.

Inflation based on year-on-year variation in consumer price indices (CPIs) eased

up to January 2008, mainly reflecting the deceleration in food price inflation.
Subsequently, there has been some increase in CPI inflation measures mainly
due to food and fuel prices. Various measures of consumer price inflation were
placed in the range of 5.5-7.9 per cent during February/March 2008 as
compared with 6.7-9.5 per cent in March 2007.

As per the latest available information on WPI, headline inflation eased

marginally to 7.3 per cent during the week ended April 12, 2008 from 7.4 per
cent at end-March 2008.

2. Financial Markets

Global financial markets remained volatile during 2007-08 as the crises about
the US sub-prime mortgage market and other credit markets exposures
deepened and spilled over to markets for other assets.

The Indian financial markets remained largely orderly during 2007-08, barring
the equity market which witnessed bouts of volatility, especially beginning the
 second week of January 2008 in tandem with trends in major international
equity markets. Over the year, however, the equity market registered gains.

Brief spells of volatility were observed in the money market on account of

changes in capital flows and cash balances of the Central Government with the
Reserve Bank.

After the withdrawal of the ceiling of Rs. 3,000 crore on reverse repo
acceptances under the LAF on August 6, 2007, interest rates in the overnight
money markets moved in the reverse repo and repo corridor and remained
within the corridor during the remaining part of the year. Interest rates in the
collateralised segment of the overnight money market remained below the call
rate during the year.

In the foreign exchange market, the Indian rupee generally exhibited two-way
movements against major currencies.

The 10-year yield in the Government securities market softened during the
most part of the year.

3. The External Economy

India’s balance of payments position remained comfortable during 2007-08

(April-December). The merchandise trade deficit, on balance of payments
basis, widened to US $ 66.5 billion in April-December 2007 from US $ 50.3
billion in April-December 2006. Net surplus under invisibles (services, transfers
and income taken together) was higher at US $ 50.5 billion in April-December
2007 as compared with US $ 36.3 billion in April-December 2006.

Despite sharp rise in merchandise trade deficit, the net invisible surplus,
mainly emanating from the rise in remittances from the overseas Indians and
software services exports, contained the current account deficit at US $ 16.0
billion during April-December 2007 (US $14.0 billion in April-December 2006).
 The current account deficit was more than financed by capital flows which
remained large during 2007-08.

Net inflows by foreign institutional investors (FIIs) aggregated US $ 20.3 billion

during 2007-08 (US $ 3.2 billion during 2006-07). Inflows under foreign direct
investment (FDI) were US $ 25.5 billion during 2007-08 (April-February) as
compared to US $ 19.6 billion during 2006-07 (April-February). During 2007-08
(April-December), inflows (net) under external commercial borrowings (ECBs)
amounted to US $ 16.3 billion (US $ 9.8 billion during April-December 2006).
Non-Resident Indian deposits registered a net inflow of US $ 106 million during
2007-08 (April-February) as compared with net inflows of US $ 3.9 billion during
the corresponding period of the previous year.

According to the data released by the Directorate General of Commercial

Intelligence and Statistics (DGCI&S), during 2007-08 (April-February),
merchandise exports recorded a growth of 22.8 per cent as compared with 23.2
per cent growth posted during 2006-07 (April-February). Growth in imports at
30.1 per cent was higher than 25.2 per cent recorded a year ago. Non-oil
imports recorded a substantial increase of 31.8 per cent (22.6 per cent a year
ago), while oil imports showed a deceleration in growth (26.4 per cent as
against 31.2 per cent in April-February 2007). Merchandise trade deficit during
April-February 2008 widened to US $ 72.5 billion from US $ 49.4 billion, a year
ago.

Foreign exchange reserves increased by US $ 110.5 billion during 2007-08 to US

$ 309.7 billion as on March 31, 2008. As on April 18, 2008, India’s foreign
exchange reserves were US $ 313.5 billion.

Public sector banks losing 1% mkt share a yr: Moody's::::

NEW DELHI: Public sector banks in the country are losing around one per cent market
share per annum on an average for over 15 years to the private sector, says credit
rating agency Moody's.
The banking sector in the country has been witnessing a fierce growth in competition
since the last decade and the worst hit have been public sector banks (PSBs), which
have constantly failed to keep up the pace with their private counterparts, and to
some extent foreign banks as well, the rating agency's banking system outlook stated.

"We estimate that PSBs have been losing on average roughly one per cent market share
a year over a 15-year period," Moody's said.

The market share of PSBs in terms of total assets was 75.6 per cent in 2003, which
reduced to 70.5 per cent in 2007. However, private banks, which had a share of 17.5
per cent in terms of total assets, stood at 21.5 per cent in 2007.

ICICI, HDFC and Axis bank are leading the competition from private sector banks by
providing quality and profitable business, though foreign banks, due to their small
size, are not that big a threat to the PSBs, Moody's said.

Despite facing a constraint of limited branches, private sector and foreign banks are
giving a tough competition to PSBs by ensuring quality banking and distinctive product
offerings, including hedging instruments, to the more sophisticated clients, it stated.

Their flexible nature and high-end infrastructure adds muscle to their competitive
nature in terms of services, compared to the PSBs, the report added. MORE PTI SHS
IND PKS

The report highlighted problems faced by PSBs in modernising themselves and

improving infrastructure.

"Computerisation of a huge number of PSB branches, networking and carrying out vital
business process re-engineering are the main issues that need to be tackled," the
report said.

As per the RBI data, although 86 per cent of PSBs are fully computerised, only 44 per
cent are actually functioning under core banking solution platform.
The "inefficient labour force and an outdated human resource infrastructure" in PSBs is
a major hindrance in beating the competition from private lenders.

The report said the profitability of Indian banks is on a rise, but PSBs were marginally
less profitable compared to private and foreign banks.

However, the report said, PSBs enjoyed a robust franchise, which ensured relatively
cheap and stable source of funding and comfortable liquidity profile.

RBI’S CREDIT POLICY FOR 2008-09

Growth, stability on even keel

S.VENKITARAMANAN

The Credit Policy has not rocked the boat. It has preserved the broad emphasis of the
central bank on growth with stability and is friendly to the economy, markets and
infrastructure. It is to be hoped that the RBI

Governor’s objective of containing inflation will

be realised, says S.VENKITARAMANAN.

The RBI Governor, Dr Y. V. Reddy, has been true to his word and unveiled a package of
relatively benign measures to fight the inflationary threat. Together with the
Government’s fiscal actions, the RBI’s monetary policy aims at containing the
inflationary expectations.

Governor Reddy has not raised the bank rate nor the repo rate, but has resorted to
tightening liquidity, through an increase in the CRR to 8.25 per cent, with effect from
the fortnight beginning May 24, 2008. Analysts calculate that this will mean an
increased abstraction of Rs 9,000 crore, in addition to Rs 18,000 crore withdrawn by
the RBI a few weeks back.

There is an expectation that this contraction in liquidity with the banks will reflect
itself over time in a hit on the profit and loss statements of the banks and thus lead to
a rise in interest rates charged by them. But this takes time to come into effect and
the RBI is apparently hoping that the abstraction of Rs 9,000 crore in extra liquidity
from the banks will help to control inflationary expectations.

It is, however, doubtful whether these aims will be realised in time. More importantly,
the Central Government is taking actions on the fiscal side, such as reduction in duties
and increasing availability of supplies. These will have a more immediate effect on
inflationary expectations than the monetary policy changes announced by the
Governor.

The Governor’s policy actions have, however, an important role to play in deciding the
behaviour of market participants. They will take into account the continuing stance of
the RBI in favour of sacrificing a little bit of growth to meet the goal of inflationary
management.

Opinions are divided as to whether inflation in India, which is essentially determined

by supply-side factors, such as the rise in crude oil price and food prices on a global
scale, can be influenced by monetary measures. But I think the Governor has chosen
an anti-inflationary stance as a better policy.

In spite of the contraction in liquidity, the Governor expects credit growth to be

reasonable, although not at the same level as last year. Correspondingly, the rate of
growth of GDP is also expected to be moderated to 8-8.5 per cent.

The most important message from the Governor’s policy statement is his
determination to come up with measures, if necessary, as may be called for by the
international and domestic developments and not to be deterred by the timing of the
Credit Policy statement. This is line with central bank practices around the globe.

On exchange rate policy, the Governor has nothing new to add. He reiterates his
earlier stance that has guided the exchange rate policy in recent years. This is
governed by broad principles of careful monitoring and management of exchange rates
with flexibility without a target of a pre-announced rate on a bank, coupled with the
ability to intervene if and when necessary.
Intervening when necessary is a “catch-all” term. Whether the competitiveness of
Indian exporters is taken into consideration is a matter that can be debated. The
overall approach, which the Governor has described, may need some change.

Inflation strategy

The expectation of the Governor that the inflation rate will be brought down to
around 5 per cent in the medium term and 3-4 per cent in the longer term seems to be
optimistic, considering the pressures of global prices on the domestic economy.
However, these are desirable goals.

The question remains, however, that the trade-off with growth engendered by such
single-minded concentration on inflation will not affect the poverty alleviation goal of
the Government. I am sure the Governor will find appropriate responses to these
challenges.

All in all, the latest Credit Policy has not rocked the boat. It has preserved the broad
emphasis of the central bank on growth with stability. While there are suggestions that
credit growth should be restricted, there are also measures, such as those on housing,
announced by the Governor, which will induce a desirable expansion in credit.

The Credit Policy is, on the whole, friendly to the economy, markets and
infrastructure. It is to be hoped that the Governor’s objective of containing inflation
will be realised, aided and abetted by the improved prospects on the food production
front and actions taken by North Block.

What RBI could do to calm prices

India's central bank is expected to tighten monetary policy soon, although governor
Y.V. Reddy has indicated a tightening will be a carefully considered step, calming
concerns of swift and aggressive action.
Annual inflation rate unexpectedly jumped to 11.05% early this month from 8.75% late
May, due mostly to a rise in government-set fuel prices at the start of June.
The rate has doubled since February largely on costlier oil, metals and food.
Following are some of the instruments available to the Reserve Bank of India (RBI) and
possible scenarios.
Instruments -
Repo rate: The short-term rate at which the RBI lends cash to banks. The rate was last
raised on 11 June by 25 basis points to 8.0%. This was the first increase since March
2007.
Reverse repo rate: The short-term rate at which the central bank absorbs cash from
the market. It has remained steady since July 2006 when it was raised to 6.0%.
Cash reserve ratio (CRR): The CRR is the percentage of banks' deposits which they
must keep with the central bank. It was last raised by 25 basis points to 8.25% on 24
May.
Bank rate: Banks use this to price long-term loans to firms and individuals. It has been
steady at 6.0% percent since 2003.
Possible scenarios
• Raise repo rate and CRR: A slim majority of the 13 economists polled by Reuters
after an increase in the RBI's key lending rate on 11 June expected the repo rate to
rise by 25 basis points again in 2008. But some economists have since said more might
be needed and some expect the CRR to rise as well.
If RBI Governor Y.V. Reddy raises the repo
rate and CRR, banks' resources would
become more expensive, and ergo, so
would lending rates. While this may
temper inflation and reduce demand in
teh economy, it could also drastically
growth, hurt consumer sentiment and
dent investments.
Money market conditions are tight at the moment so the RBI could announce a CRR
increase at a future date.
Advantages: Using the two instruments together would be a potent combination as it
would raise the cost of funds for banks and in turn lending rates. It may temper
inflation expectations and reduce demand in the economy — a way to try to dampen
potential second-round effects from the recent fuel prices hike.
Disadvantages: It may drastically slow growth in months ahead, hurt consumer
sentiment and dent investment. This could reduce government revenues and push up
its borrowing costs when funds are needed for the next pay round for government
employees and to compensate banks for a farm loan waiver.
• Raise repo rate, leave all other rates unchanged:
Advantages: Strong signal to banks to raise lending rates to curb demand pressures in
the economy.
Disadvantages: Unlikely to work effectively if cash conditions improve as this can
lower money market rates. More government spending is expected and banks are likely
to be compensated by the government for waiving farmers' loans soon.
• Raise CRR, leave other rates unchanged:
Cash conditions are tight in the money markets at the moment with advance tax
payments last week and bond sales, making a CRR hike more tricky unless the RBI
announces it for a date in the future.
Advantages: Could help reduce cash in circulation in the system, with M3 money
supply well above the RBI's comfort level. Restricting liquidity was the central bank's
most favoured option in the past year, until the June 11 rate hike, and the CRR has
risen by 275 basis points since the beginning of 2007.
Disadvantages: May reduce demand for government bonds and hurt banks'
profitability.
• Raise repo and reverse repo rates, others unchanged:
Advantages: Overnight cash rates usually hover between these two rates. An increase
in reverse repo would prompt banks to raise deposit rates, pushing up lending rates in
turn.
Disadvantages: Pushing up money market rates will increase borrowing costs for
companies, which in turn could impact investment and dent growth. Higher reverse
repo rate could reduce the central bank's income and in turn lower government
revenues.
• Raise reverse repo rate, leave others unchanged:
Similar effect to option 4. Only difference is that by leaving the repo steady, it might
be read as less aggressive. Effectiveness of measure depends on day-to-day market
liquidity.
• Intervention to push up rupee, leave all rates steady:
The rupee is holding just above 43.00 per dollar, a level it has only crossed once,
briefly in late May, since last year. Traders suspect the central bank has sold dollars
and bought rupees to stop it weakening beyond this level and importing inflation.
Advantage: The rupee has depreciated about 8% in 2008 after a 12% rise in 2007.
Selling dollars to push it up could reduce the price of imported commodities,
particularly crude oil, which is India's largest import.
Disadvantage: Hard to push against the market with a widening trade gap and foreign
investor selling. Furthermore exports might suffer and software industry, already
bearing brunt of the U.S. economic uncertainty, could be hurt.
Background:
— Annual wholesale price inflation has held above 5.5%, the RBI's target for the fiscal
year end, for 17 consecutive weeks.
— GDP has expanded at an average 8.8% over the past five fiscal years. The RBI
estimates growth at 8.0-8.5% in the 2008-09 fiscal year that began in April.
— The monsoon is forecast to be near normal this year. Farming contributes less than a
fifth to GDP but good farm output pushes up rural incomes and triggers all-round
demand.
— The government plans to issue Rs960 billion ($22 billon) of bonds in April-September,
and a gross total of Rs1.45 trillion in 2008-09.
— M3 money supply growth was at annual 21.4% in the two weeks to 6 June, above the
RBI's 2008-09 forecast of 16.5-17%.
— Bank loans rose 25.9% year-on-year in the two weeks to 6 June.
— Foreigners have sold a net $6.1 billion worth of shares so far this year. In 2007, they
bought a record net $17.4 billion.

Southern Delight
Indian Overseas Bank (IOB) remains in ‘sweet spot’ with its superior return ratios,
consistently high net interest margins, better operating efficiency and higher
leverage.
Despite a moderate growth in bottomline, recoveries from bad loans will improve
asset quality and bottomline as well. Going ahead, with the government’s holding at
61%, IOB would be an active candidate in the consolidation process in the PSU
banking space. We have valued IOB at a 10% discount to fair value to factor in its
geographical concentration. At the CMP, the stock trades at 5.9x and 1.3x FY2009E
EPS of Rs21.5 and ABV of Rs97, respectivley. We initiate coverage on IOB with a
Buy recommendation and 12-month Target Price of Rs150.
Well-managed Assets and Liabilities to drive Earnings: IOB’s business
growth is likely to remain moderate with Advances and Deposits to grow at a
CAGR of 20% and 18% respectively, over FY2007-09E. In view of the high interest
rate regime, CASA is expected to remain muted at 34%. With its prudent
asset-liability management, we expect NIMs to stabilise at 3.6% .
Significantly de-risked Investment book: IOB has significantly de-risked its
investment portfolio with 84% of its investments in HTM category. This is expected
to reduce pressure on Bank’s earnings due to the mark-to-market (MTM) provision.
Although, duration on AFS investments is relatively higher at 4.08 years.
Strong Operating peformance, superior Return Ratios driving valuations:
IOB’s operating efficiency has been superior on account of strong business
growth. Opex/Average Assets ratio has been superior at 1.96% compared to
industry average of 2%. We estimate this ratio to further improve to 1.86% in
FY2009E. IOB has superior return ratios due to strong operating performance
and prudent asset-liability management. We estimate IOB to clock RoA Aof
1.1% and RoANW of 22% in FY2009E, which would fetch it premium valuations.
Recoveries to improve Asset quality and boost Bottomline: IOB’s Net NPAs
have improved from 6.32% in FY2002 to 0.55% in FY2007. Over FY2006 and
FY2007, IOB recovered Rs246cr and Rs444cr, respectively. IOB is targeting
Rs320cr recoveries in FY2008E while we have factored in 50%of targeted recovery.
This would help improve the Bank’s asset quality and boost profitability.
Background
Indian Overseas Bank (IOB) is a mid-sized public sector bank with a dominant presence
in
South India, which accounts for 45% of the Bank's branch network. IOB is gearing to
effectively
leverage its domestic presence with 1,781branches, 113 extension counters and 382
ATMs.
The Bank also has a international presence with seven branches and extension
counters.
IOB was established in 1937 with the twin objective of specialising in the foreign
exchange
business and overseas banking, while it got Nationalised in 1969. The Bank made its
maiden
issue in FY2001 to raise Rs110cr and made a Follow on public offering (FPO) in FY2003.
The
Bank's IPO came at par with a face value of Rs10 while the FPO was made at Rs24 per
share.
IOB had a balance sheet size of Rs82,257cr in FY2007 and total business turnover of
Rs1,15,800cr. IOB is structurally well placed with superior NIMs, high operating
efficiency,
strong balance sheet and is effectively leveraging on its capital to maintain return
ratios in
excess of 20%, one of the highest in the Indian PSU banking space.
Centralised Banking Solution (CBS)
IOB has developed its centralised banking solution (CBS) in house, which has been
implemented at 709 branches and four regional centres. This covers 40% of the Bank’s
branch
network and 70% of its total business. Going ahead, the Bank targets to cover over
1,000
branches under CBS covering 90% of its business.
Merger with Bharat Overseas Bank
In September 2006, IOB acquired the balance 70% stake in its 30% joint venture, Bharat
Overseas Bank (BhOB), for a total consideration of Rs170cr at a valuation of Rs242cr or
1.2x
BhOB's FY2006 Book Value. The merger process was completed by March 2007. With
the
merger of BhOB, IOB's balance sheet stood augmented by around 6% along with an
addition of
103 branches, six extension counters, one overseas branch in Bangkok and 23 ATMs.
International Business
Presently, IOB has an international presence in eight countries with seven full-fledged
branches
and two representative offices. IOB has a presence in Bangkok, Hong Kong, Singapore,
Seoul,
Colombo, China, Malaysia and New Zealand. During FY2007, the Bank's international
business
comprised only 4.5% of its total business volumes. IOB is further contemplating
expanding its
overseas presence for which it has applied to the RBI for a representative office
license at
Vietnam.
Investment Argument
Well-managed Assets and Liabilities to drive Earnings
Over FY2002-07, IOB witnessed significant growth in business, which was mainly
supported by
liquidating excess SLR from its investment book and strong focus on CASA deposits. The
Bank's credit-to-deposit ratio improved from 47.8% in FY2002 to 68.5% in FY2007. In
FY2005
and FY2006, incremental credit-to-deposit ratio stood at over 150%. We expect IOB to
maintain
its credit-to-deposit ratio at around 70% during FY2007-2009E with incremental credit-
todeposit
ratio at 75%. The Bank has well managed assets and liabilities, where majority of the
deposit growth is funded through CASA Deposits and stable retail long-term deposits.
Hence,
re-pricing of the Bank's deposits has been slower. At the end of FY2007, around 24% of
Deposits and 47% of Advances had a duration of less than a year. Hence, re-pricing of
Deposits
is slower while re-pricing of Advances is faster. Such an asset-liability mix is favourable
especially in a high interest rate regime. We expect this to benefit IOB and help it
maintain
stable net interest margins (NIMs) going ahead.IOB's total business in FY2007 grew by
36%
yoy to Rs1,15,800cr (Rs85,286cr). This strong growth in the Bank's business came on
the back
of 35% yoy growth in Advances and 36% yoy growth in Deposits. The merger of BhoB
also
augmented the Bank's business growth.

Advances book to grow at 20% CAGR

The Bank’s growth strategy hinges on the high-yield segments of Infrastructure, SME,
Agriculture and Retail lending. Over FY2002-07, IOB's Advances book grew at a CAGR of 25%
to Rs47,060cr. The growth in Advances is taken care of by the excess SLR in the investment
book and core deposits. The share of Retail Advances to Total Advances stood at 23% at
Rs10,880cr in FY2007. IOB management expects to further increase the share of Retail
Advances to 26% over FY2009E. The key focus areas to improve the share of retail loans would
be education loans, personal and trade finance segment. We expect IOB's Advance portfolio to
grow at a CAGR of 20% over FY2007-09E.
Deposits to grow at 18.1% CAGR
Over FY2002-07, IOB's Deposits grew at a CAGR of 17% to Rs68,704cr. The share of low-cost
current and saving accounts deposits or CASA improved from 30% in FY2002 to 35% in FY2007.
However, during FY2007, IOB's CASA ratio actually slipped by a significant 506bp to 35%
(41%). This was mainly on account of a shift from current and savings account deposits to term
deposits. Considering the high interest rate scenario, we expect the Bank to maintain CASA
ratio at around 34%. Over FY2007-09E, we expect IOB's deposits to grow at a CAGR of 18.1%
to Rs95,813cr.
At the end of FY2007, to fund the high growth in Advances, IOB added certain short-term bulk
deposits, which account for around 18% of total deposits carrying an interest rate of 9.5%.
Faster maturity of these high-cost deposits will help the Bank in keeping a check on the cost of
funds. On the other hand, with the recent reduction in the cost of funds, IOB has been able to
reduce its reliance on bulk deposits and increase its focus on low-cost retail deposits. This
helped it contain the cost of funds. Besides, the Bank also has access to low-cost NRI
deposits, which account for around 9% of its deposits. All these factors are expected to help
the Bank maintain its cost of funds at around 5.5% levels.

Significantly de-risked Investment book albeit at high duration

For FY2007, IOB’s investment in HTM category comprised 74% (45%) of total investments, as it
transferred investments worth Rs4,510cr to the HTM category. However, duration of the AFS
portfolio remained high at 5.1 years. During Q1FY2008, IOB further transferred investments
worth Rs2,000cr from AFS to the HTM category thereby transferring 84% of its investments to
the HTM category and holding 25% of NDTL. With this, duration of the AFS portfolio declined to
4.1years. However, it still remains on the higher side compared to industry average of around two
years. Going ahead, with every 25bp increase in 10-year G-Secs, IOB will have to take a hit of
Rs44cr. Overall, the Bank’s portfolio duration also remains high at five years. Nevertheless, with
84% of the IOB’s investment portfolio is in HTM category, the risk on its investment portfolio in a
rising interest rate scenario has reduced considerably.
Margin pressure to continue but to remain the best in PSU banking space
IOB has around 42% exposure in the high-yield Advances segment due to which the yield on
Advances was comparatively higher than other PSU banks at 9.5% during FY2007 (10.5% at the
end of Q1FY2008). IOB has increased its PLR by 125bp in the last seven months to 13.3%.
During FY2007, yield on Advances improved by 77bp whereas, yield on investments declined by
88bp. Cost of deposits and overall cost of funds increased by 24bp and 41bp respectively, as the
CASA ratio declined by 506bp and intake of bulk deposits increased to take care of Advances
growth. In the past, IOB’s NIMs were around 3.9% levels, which was one of the best in the PSU
banking space. However, during FY2007, the Bank’s NIMs contracted by 15bp mainly due to a
fall in yield on investments as long securities had gone off the Balance Sheet. Going ahead, we
believe that despite efforts to contain the cost of funds and improvement in yield on Advances,
the Bank’s NIMs would remain under pressure mainly due to the dwindling yield on Investments.
We expect IOB’s margins to decline marginally to around 3.6% over FY2007-09E, although it
continues to be one of the best among the PSU banks.

Robust non-interest income backed by strong recoveries and treasury gains

IOB has initiated various measures to increase the share of fee-based income in its total
income. As a result, IOB's core fee-based income to total income increased from 18% in
FY2002 to 21% in FY2007. Non-interest income contribution to total income were off their highs
of 36% in FY2002 to 13% in FY2007 due largely to the hit on amortisation in its investment
portfolio and reduced treasury gains following hardening of interest rates since 2004.
IOB has now started focusing on the Retail segment apart from the traditional fee income
generating sources from corporates. IOB has entered into tie-ups with nine asset management
companies for the distribution of their mutual fund products, has tied-up with LIC for distribution
of its life insurance products and United India for its general insurance products. IOB has also
started selling gold coins to its customers. Due to its dominance in South India and its
overseas branches, the Bank is leveraging on its NRI customers to increase its fee-based
income by way of remittances. IOB has also entered into MoUs in a five way tie-up with Allahabad
Bank, Dabur India, Karnataka Bank and Sampo Japan for its non-life insurance foray. IOB holds
19% in the venture. Recently, the Bank also started a syndication desk to arrange loans for
corporates and derivative products for its corporate customers.

Improving operating efficiencies

Skilled staff has been a crucial factor in IOB's success story. Beefed up with a skilled set of
employees, the Bank has been able to develop its in-house technology platform, which has
resulted in substantial cost savings. Going ahead, IOB has guided for rationalisation of
employees with the number of employees reducing by 400 every year.
In FY2007, IOB had one of the best operating ratios with its cost to income ratio at 47%
compared to 58.9% in FY2002. IOB's operating cost to average assets ratio at 1.96% was also
below the industry average of over 2%. Over FY2002-07, the Bank's balance sheet has
increased in size from Rs35,441cr to Rs82,257cr growing at a CAGR of 18.3%. Operating
expenses also grew at a CAGR of 9.4% during the same period. Over FY2007-09E, we expect
the employee cost to grow by 17.8% mainly due to the provision for employee benefits as per
AS-15. Accordingly, IOB expects to account for Rs180cr annually over the next five years
towards AS 15. Overall the Bank's operating costs are expected to grow at a CAGR of 17.4%
over FY2007-09E. By FY2009E, operating expenses, as a percentage of average assets, is
expected to be 1.86%.
Aggressive recoveries to improve Asset quality substantially
Considering the rapid CAGR growth of 25% in IOB's Advance book over FY2002-07, the Bank's
asset quality has remained steady. Aggressive recoveries and a prudent provisioning policy
have helped the Bank improve its asset quality. By FY2007, the Bank’s Gross NPA ratio
improved to 2.34% (Rs1,120cr) from 11.4% (Rs1,819cr) in FY2002. Net NPAs also improved
significantly from 6.32% (Rs958cr) in FY2002 to 0.55% (Rs258cr) in FY2007. Over
FY2002-07, the Bank’s provision coverage also improved from 47% to 77%. The Bank has
resorted to a combination of one-time settlements/out-of-court settlements, recoveries through
Lok Adalats and adhering to the Securitisation Act for tackling sticky assets. This hasresulted
in significant improvement in recoveries from bad accounts. On the back of improved asset
quality and higher focus on recoveries from bad loans, we believe that the provision for bad
loans in proportion to Advances, would remain low going forward.
Since the Bank has undertaken technical write-off of bad accounts, the recoveries flowing in
from the same would add to its bottomline. During FY2006 and FY2007, the Bank recovered
Rs350cr and Rs444cr respectively, from written-off bad loan accounts. Strong recoveries from
written off and bad accounts will remain the key trigger for the Bank’s earning growth. For
FY2008, IOB management is targeting recovery of around Rs320cr from such bad accounts
(other than Upgradation). We have factored in 50% of the projected target of recoveries. Going
ahead, we expect Gross NPAs and Net NPAs of the Bank to be 2.54% and 0.62% in FY2008E
respectively, considering that slippages would increase to 2.15% in FY2008E (following
exposure in relatively riskier assets), while the provision coverage will remain at around 75%.
Going ahead, lower provision on bad loans would boost the Bank’s return ratios.

Outstanding Return Ratios despite aggressive write-off of bad loans

Steady core operating income and strong balance sheet growth helped IOB maintain its RoAA.
Higher RoAA has also been supported by recoveries and treasury gains. However, going ahead
we do not expect contribution from these segments to continue to be high but, the Bank’s core
operating performance is expected to remain strong. Over FY2003-07, IOB constantly delivered
good return ratios. RoAA was constantly above 1% and due to the higher leverage on balance
sheet, the Bank’s RoNW remained between 28-32% in the mentioned period. IOB was among
the first banks to raise Perpetual bonds. On the back of addition of Tier I Perpetual bonds, the
Bank could leverage its Balance Sheet by about 20x. Over FY2002-07, IOB’s core Operating
profit and Net profit grew at a CAGR of 38% and 34% respectively, whereas the Balance Sheet
size grew by 18%. In FY2007, IOB reported RoA of 1.42% and RoNW of 28%. For FY2008E
and FY2009E, we expect IOB to report RoAA of 1.14% and with an effective leverage of around
20x and RoNW is expected to be 23% and 22%, respectively. Going forward, we have factored
in 50% of the targeted recoveries from written off accounts. Hence, higher recoveries for FY2008
from these accounts would be a positive trigger for the stock.
Capital Adequacy Ratio (CAR) remains comfortable
IOB is well placed on the capital adequacy ratio (CAR) front. For FY2007, the Bank reported
CAR of 13.27% of which Tier I comprised 8.2%. In FY2007, the Bank had raised innovative
perpetual debt instruments (IPDI) of Rs280cr totaling Rs480cr. Upper Tier II subordinated bonds
of Rs1,000cr while bonds worth Rs257.8cr were redeemed during FY2007. At the end of FY2007,
IOB held bonds worth Rs2,683cr. Post implementing Basel II, management expects CAR would
stand at 12%. IOB has to comply with Basel II guidelines by FY2008 due to its overseas branch
network. We do not expect the Bank to dilute its equity in the near term.
Source: Company

Capital Adequacy Ratio (CAR) remains comfortable

IOB is well placed on the capital adequacy ratio (CAR) front. For FY2007, the Bank reported
CAR of 13.27% of which Tier I comprised 8.2%. In FY2007, the Bank had raised innovative
perpetual debt instruments (IPDI) of Rs280cr totaling Rs480cr. Upper Tier II subordinated bonds
of Rs1,000cr while bonds worth Rs257.8cr were redeemed during FY2007. At the end of FY2007,
IOB held bonds worth Rs2,683cr. Post implementing Basel II, management expects CAR would
stand at 12%. IOB has to comply with Basel II guidelines by FY2008 due to its overseas branch
network. We do not expect the Bank to dilute its equity in the near term.

Valuation
We prefer IOB for its consistent performance over the years despite progressive write off of
sticky assets. The Bank will continue to be in ‘sweet spot’ with its superior return ratios,
consistently high net interest margins, better operating efficiency and higher leverage. Going
ahead too, we expect IOB to deliver robust performance with RoNW estimated at 23% over
FY2008 and FY2009E. For the purpose of our valuation, we have given equal weight to the
Residual Income and Gordon Growth Methodology. Based on this, we have arrived at a fair price
of Rs167. Nonetheless, we have attached a 10% discount to our Target Price due to IOB's
geographical concentration. Post its public issue in FY2001 and FY2003, the government’s
holding in IOB stood at 61%. On account of this, we expect IOB to be an active participant in
the consolidation process. We initiate coverage on the Bank with a Buy
recommendation and Target Price of Rs150. At the CMP, the stock trades at 5.9x and 1.3x
FY2009E EPS of Rs21.5 and ABV of Rs96.6, respectively. At the Target Price of Rs150, IOB
would trade at a P/E of 7.0x and P/ABV of 1.6x EPS and ABV of Rs21.5 and Rs96.6,
respectively. Based on our Target Price, the stock offers a potential upside of 20.7% including
a dividend yield of 2.8% over a period of 12 months.