RBI warns banks on rate hike fallout

RESERVE BANK OF INDIA'S REPORT ON CURRENCY AND FINANCE 2003-04

Banks' investments in government securities well above the stipulated 25%.

Banks' profitability could be hit with an upturn in the interest rate cycle as their investments in government securities still remain well above the stipulated 25 per cent, warned the Reserve Bank of India's (RBI) report on Currency and Finance (2003-04), released today.

The report asked banks to undertake appropriate risk assessments and trade-offs while allocating resources between credit to commercial sector and investments in government securities.

It hoped that the enactment of the Fiscal Responsibility and Budget Management Act, 2003 with its envisaged reduction in fiscal deficits will help reduce banks' investments in government securities. This, in turn, is expected to enhance flow of credit to the private sector.

The large holdings of government securities by banks in the face of comfortable liquidity had yielded some benefits. The large trading profits emanating from the rally in government securities enabled them to boost their profits and make higher provisions.

Also, excessive lending in a lacklustre industrial climate might have caused "adverse selection" of borrowers. The significant increase in non-food credit by banks in 2004-05 so far is a heartening development, the report noted.

Banks have been urged to improve their credit assessment capabilities so that they can distinguish adequately between and good and bad credit as regards credit to the small-scale industry (SSIs).

The report said if interest rates charged to SSIs are much higher than normal good credit risk to large sized industries, there is an implicit adverse selection in the credit appraisal process. Increased flow of credit to the SSI sector at reasonable costs is imperative and also small scale must not be equated with high risk.

The report said the acceleration in credit delivery to agricultural sector can be sustained in the medium term, only if rural cooperative structure and regional rural banks (RRBs) get fiscal support from state and central governments for their revival and reorganisation.

"The changes warranted in cooperatives as well as RRBs involve deep commitment of state-governments and have significant bearing on political economy. In view of overhang problems of bad loans and erosion of deposits in both cooperatives and RRBs, restructuring and recapitalisation by the government has become important."

With the waning of development finance institutions, the issue of meeting long-term funding needs of corporates has attracted attention. The ability of commercial banks to meet the long-term fund requirements is hampered by the relatively shorter maturity of their deposits.

The limited flexibility available to banks is further compounded by large volumes of investments in government securities, usually of long tenors.

The long term funding requirements throw up imperatives of developing an active corporate bond market. Although several pre-conditions for the a successful corporate debt market are now in place, other requirements such as enhanced public disclosure and effective bankruptcy laws are still awaited.