Treasury gain party over for banks

As rate easing cycle comes to halt, so does the high surge that banks witnessed in their income

The Reserve Bank of India (RBI)’s rather hawkish stance while announcing the sixth bi-monthly monetary policy review has surprised investors in the equity and bond markets. In fact, yields on the 10-year government security (G-sec) surged 31 basis points to 6.74 per cent on Wednesday (highest single-day surge in nearly 40 months) and another 10 bps on Thursday. 

RBI’s neutral stance indicates the rate-easing cycle is largely done with. This means that as against a sharp drop of over 100 bps in G-sec yields over the past year, bond yields are likely to remain a lot more stable, with an upward bias. This is bad news for banks, as lower yields had boosted the treasury incomes of most banks in the past few quarters. Amid falling net interest income, higher provisioning for bad and doubtful loans, as well as weak profit margins, treasury income was among the few supports to bank earnings.

Firming up of bond yields means that a large part of the jump in treasury income is behind. Bond yields and prices are inversely correlated – so, if yields fall, bond prices rise and vice versa.

Suresh Ganapathy, banking analyst, Macquarie Capital, says: “Last year was exceptionally good for banks in terms of treasury profits, with bond yields heading south. Given RBI’s neutral stance this trend is unlikely to continue from here on.”

Aalok Shah, banking analyst at Centrum Broking, says: "In Q3 (December quarter), most banks had reasonably decent operating profits, primarily because of treasury gains. Their NII (net interest income) growth was weak and even fell for some. One thing is for sure, that banks’ operating profits will be weak and they will have to work really hard to do business." 

In fact, he believes, banks could post treasury losses in the ongoing quarter. "Most banks have increased their investment book and that portfolio will see a mark-to-market (recalculating of assets at current values) loss. Yield is unlikely to move to 6.5 per cent anytime soon. Sequentially as well, yields have moved up."

For non-banking financial service companies (NBFCs) as well, higher yields will push up their cost of funds. Given the weak demand environment, they might not be able to pass this on to customers. 

Some squeeze in their spreads is, hence, possible. Banks, though, will have an edge over money market instruments in lending to NBFCs.

In this, investors should note that the pressure on banks’ earnings will intensify. Particularly for large corporate banks in both the private and public sectors. Additionally, the stalemate in credit demand, particularly from the corporate segment, does not seem to be ending and could continue to weigh on loan growth. Given the slowing of economic growth, resolution of the huge pile of bad loans in banks’ books is also likely to be a very slow process. 

In this backdrop, most experts believe the worst is not over for banking stocks. While quality names with good operating profit and return ratios could hold on to their current valuations, stocks of most public sector banks (PSBs) could come under pressure.

The recent rally in PSB stocks appears unsustainable. "On a price to book value basis, PSBs appear to be attractively valued. But, when you adjust the book for NPAs (non-performing assets) known to all, they would be at 0.9 to 1 times, for a return on equity of less than 10 per cent, which is not exciting. We like select private banks such as ICICI Bank and DCB,” adds Shah.