Summary of rating action 

* Taken over from erstwhile Capital First Limited and Capital First Home Finance Limited; **Non-convertible debentures (NCDs) of erstwhile IDFC

Limited reassigned to erstwhile IDFC Bank Limited (now IDFC First Bank Limited – IDFC First) following the transfer of business with effect from October

1, 2015

^ Rs. 480 crore outstanding, balance yet to be placed

Rationale

The rating downgrade considers IDFC First Bank Limited’s weak earnings profile, given the elevated cost-to-income ratio because of the ongoing branch expansion, which has been pressurising the operating profitability, and an increase in credit provisions on account of unanticipated fresh stressed exposures identified by the bank in Q4 FY2019.

The bank’s earnings profile remains weak, given its dependence on wholesale deposits. Despite the strong growth in current account and savings accounts (CASA) deposits, its share in overall liabilities remains low resulting in higher cost of interest-bearing liabilities compared to other banks. Going forward, the ongoing branch expansion drive (600-700) branches to be added over the next few years) will aid franchise expansion while the ability to maintain the traction in CASA deposits will drive the improvement in the earnings profile in the medium to long term.

Moreover, in its recently declared earnings for Q4 FY2019, IDFC First reported an increase in stressed exposures (including non-performing advances (NPAs)), primarily due to the deterioration in the credit profile of three large exposures. Even though these accounts remain standard exposures, the bank has made a voluntary provision of Rs. 420 crore on these exposures, which increased its loss in Q4 FY2019. The ability to resolve some of these exposures will be a driver of the associated credit costs and profitability in FY2020. Accordingly, in the near term, despite Capital First Limited’s (CFL) higher-yielding portfolio, ICRA estimates that IDFC First’s return on assets (RoA) may remain muted in FY2020 due to the ongoing investments in the expansion of the retail franchise and possible credit provisions on stressed exposures. In a weak case scenario, ICRA estimates credit costs of up to 06-0.9% of ATA compared to operating profitability of 0.7-0.9% of ATA for FY2020, translating into a muted RoA of 0.2-0.3%.

The ratings continue to be supported by the bank’s capitalisation. Despite ICRA’s expectations of moderate profitability,the capital requirement for growth shall not be a constraint in the near to medium term. Further, the share of retail assets has improved with the merger and the management has guided towards increased focus on improving the granularity of the loan book while gradually scaling down the wholesale book, which is likely to temper the pace of capital consumption.

The ratings continue to be supported by the bank’s capitalisation. Despite ICRA’s expectations of moderate profitability, the capital requirement for growth shall not be a constraint in the near to medium term. Further, the share of retail assets has improved with the merger and the management has guided towards increased focus on improving the granularity of the loan book while gradually scaling down the wholesale book, which is likely to temper the pace of capital consumption.

Outlook: Stable

In ICRA’s opinion, the capitalisation is expected to remain comfortable even though the overall earnings may remain weak in the near to medium term. The outlook may be revised to Positive if the bank is able to significantly improve its retail franchise in assets and liabilities, thereby leading to better granularity, while lowering the cost of funds and improving the earnings over the next few years. However, the outlook may be revised to Negative if the bank’s earnings profile remains weak, thereby significantly weakening its capital position, or if it reports a further increase in the quantum of stressed assets. This will remain a key rating sensitivity.

Key rating drivers

Credit strengths

Capitalisation profile remains strong despite weak internal capital generation in FY2019; current capital to support credit growth during next few years – The capitalisation of the merged entity remained strong with Tier I capital of 16.14% as on December 31, 2018. This was mainly driven by the strong Tier I capitalisation of erstwhile IDFC Bank (IDFCBK). However, the Tier I moderated to 15.27% as on March 31, 2019 because of losses in Q4 FY2019, an increase in the risk weighted assets (RWAs) due to priority sector lending (PSL) pool buyouts, an increased asset base and higher stressed assets. Nevertheless, the bank’s capitalisation remains strong and will be sufficient to support growth for the next 2-3 years. Moreover, it remains focused towards expanding its retail loan book, while gradually scaling down its infrastructure and wholesale book, which is likely to keep capital consumption at relatively lower levels.

Capitalisation profile remains strong despite weak internal capital generation in FY2019; current capital to support credit growth during next few years – The capitalisation of the merged entity remained strong with Tier I capital of 16.14% as on December 31, 2018. This was mainly driven by the strong Tier I capitalisation of erstwhile IDFC Bank (IDFCBK). However, the Tier I moderated to 15.27% as on March 31, 2019 because of losses in Q4 FY2019, an increase in the risk weighted assets (RWAs) due to priority sector lending (PSL) pool buyouts, an increased asset base and higher stressed assets. Nevertheless, the bank’s capitalisation remains strong and will be sufficient to support growth for the next 2-3 years. Moreover, it remains focused towards expanding its retail loan book, while gradually scaling down its infrastructure and wholesale book, which is likely to keep capital consumption at relatively lower levels.

Shift in focus towards granular loan book, going forward – Following the merger with CFL, the share of wholesale funded assets to total funded assets of the bank (advances + credit substitutes) reduced to 54% as on December 31,2018 from ~75% as on March 31, 2018. The share of the wholesale book moderated further in Q4 FY2019 to 49% as on March 31, 2019. While the merger with CFL helped dilute the significantly high share of the bank’s wholesale book, the bank remains focused on growing the retail book while gradually scaling down the wholesale segments.

Post-merger, the overall funded assets grew by 5% sequentially to Rs. 1,10,401 crore as on March 31, 2019 from Rs.1,04,660 crore as on December 31, 2018. While the retail segment grew by 13% sequentially to Rs. 40,812 crore from Rs.36,236 crore, the wholesale book de-grew during this period by 6% to Rs. 53,649 crore from Rs. 56,809 crore. Even though the wholesale book continues to dominate the loan book, its share is likely to continue to reduce over the medium term.

As per IDFC First’s stated strategy, the share of retail advances will increase, thereby improving the granularity of the loan book, while the growth in corporate advances is expected to remain low, going forward. According to the guidance given by the management, the share of the retail loan book is expected to increase to 70% over the medium to long term (from 37% as on March 31, 2019).

Credit challenges

Profitability expected to remain weak; internal capital generation to remain weak in medium term – With reliance on wholesale deposits in the medium term and high-cost debentures, which are scheduled for maturity during FY2020- FY2021, the cost of interest-bearing liabilities is likely to remain high compared to peers over the medium term. Further,the ongoing expansion of the retail banking operations will continue to keep profitability subdued in the near term. It is expected to yield results over the medium term in the form of low-cost CASA mobilisation and will be a key driver of profitability and the cost-to-income ratio. The management has given guidance that the share of CASA to total deposits will increase to 30% over the next five years, supported by the addition of 600-700 branches during this period. IDFC First’s yields and profit margins are also impacted by its reliance on portfolio buyouts for meeting PSL requirements and the bank is expected to be largely self-sufficient for organically sourced PSL assets in FY2020, aiding its profitability. The yield as well as profit margins are positively supported by the increasing share of the higher-yielding retail loan portfolio. Moreover, the merged entity stands to benefit, to a reasonable extent, from the replacement of high cost funds, which even if replaced by wholesale funding at merged entity, will be cheaper than the funding cost of the erstwhile CFL.

Profitability expected to remain weak; internal capital generation to remain weak in medium term – With reliance on wholesale deposits in the medium term and high-cost debentures, which are scheduled for maturity during FY2020- FY2021, the cost of interest-bearing liabilities is likely to remain high compared to peers over the medium term. Further,the ongoing expansion of the retail banking operations will continue to keep profitability subdued in the near term. It is expected to yield results over the medium term in the form of low-cost CASA mobilisation and will be a key driver of profitability and the cost-to-income ratio. The management has given guidance that the share of CASA to total deposits will increase to 30% over the next five years, supported by the addition of 600-700 branches during this period. IDFC First’s yields and profit margins are also impacted by its reliance on portfolio buyouts for meeting PSL requirements and the bank is expected to be largely self-sufficient for organically sourced PSL assets in FY2020, aiding its profitability. The yield as well as profit margins are positively supported by the increasing share of the higher-yielding retail loan portfolio. Moreover, the merged entity stands to benefit, to a reasonable extent, from the replacement of high cost funds, which even if replaced by wholesale funding at merged entity, will be cheaper than the funding cost of the erstwhile CFL.

Asset quality challenges arise in Q4 FY2019; credit costs estimated to remain at elevated levels in relation to operating profits during FY2020 – The net stressed book (including net NPAs, net security receipts and other stressed book) of erstwhile IDFCBK stood at ~Rs. 2,094 crore, which was ~2.8% of its advances (including credit substitutes) as on September 30, 2018. The bank had a provision cover of ~57 % on these stressed assets as on September 20, 2018.

However, in Q4 FY2019, the net stressed assets increased sharply to Rs. 3,929 crore (excluding stressed investments) or 3.56% of net advances. This increase was due to a Rs. 465 crore increase in GNPAs in Q4 FY2019 (partly due to the alignment of NBFC NPA norms with banks as well as slippages in the bank’s wholesale book) as well as Rs. 1,326 crore of exposures classified as stressed by the bank. The bank also reported a stressed investment of Rs. 1,461 crore as on March 31, 2019. A sharp increase in the pool of stressed assets lowered the bank’s provision coverage on stressed assets to 46% as on March 31, 2019. While the bank has provided for a part of the stressed assets and the investment of Rs. 2,787 crore identified in Q4 FY2019 with credit provisions of Rs. 419 crore, the ability to resolve these exposures will be a key driver of credit provisions in FY2020. IDFC First reported gross NPA (GNPA) and net NPAs (NNPA) of Rs. 2,136 crore (2.45%) and Rs. 1,107 crore (1.28%), resulting in a provision cover of 48% as on March 31, 2019.

Reliance on wholesale funding to continue, leading to higher cost of funds than industry average – IDFC First’s liability profile remains skewed towards the fixed rate debentures that were inherited from the erstwhile IDFC Limited. These debentures stood at ~Rs. 26,000 crore (20% of its borrowings and deposits), as on March 31, 2019, at an average cost of 9.1%. Further, given its limited retail franchise, the bank is highly dependent on wholesale deposits (including certificates of deposits – CDs) which stood at ~ Rs. 53,000 crore (37% of its borrowings and deposits). This led to a higher cost of interest-bearing funds compared to peers (8.33% for IDFC First in H2 FY2019 compared to the banking sector average of 5.4% for 9M FY2019), thereby impacting its competitive ability to expand its loan portfolio while maintaining profitability. Although the CASA deposit base improved to ~6.5% of the borrowings and deposits of the merged entity as on March 31, 2019 from 5.4% for IDFCBK as on March 31, 2018 and 4.9% as on December 31, 2018, the retail liabilities remain low.

Liquidity position

The bank’s daily average liquidity coverage ratio (LCR) of 120% in Q4 FY2019 and 123% in Q3 FY2019 were higher compared to the pre-merger levels of LCR of 108% in Q2 FY2019 and 112% of Q1 FY2019. The bank’s LCR metrics remain comfortably above the Reserve Bank of India’s (RBI) requirement of 100% as on January 1, 2019. The asset liability mismatches, as per the structural liquidity statement as on March 29, 2019, stood at a negative cumulative mismatch of 10.03% (as a percentage of total outflows) in the 1-year bucket. In addition to government securities, the marginal standing facility of the RBI and cash balances with the RBI can be used to meet any liquidity requirements in case of temporary liquidity pressure.