Timely warning

BS OPINION

The central bank is referring, of course, to banks in India abdicating their traditional role as providers of credit to industry, preferring instead to pour their funds into gilts.

The RBI points out that this is "narrow banking", and while this kind of banking may have helped banks avoid non-performing assets and post massive gains by selling their securities portfolio in an environment of falling interest rates, in the long-term, the performance of the banking system will "hinge on their ability to fund industrial and other enterprises".

The central bank refers to the rising competition among banks and the consequent pressure on spreads, the disintermediation by blue chips and the new opportunities available to depositors, and advises public sector banks in no uncertain terms that their future profitability would "depend on their ability to generate greater non-interest income and control operating expenses."

That's a signal that the era of fatter bank bottomlines based on capital gains is coming to an end. It is, in fact, a profit warning by the central bank.

The RBI points to the high cost of credit and says that the rigidity in lending rates stems from the overhang of non-performing assets, on the one hand, and the low productivity of Indian banks on the other.

It says that "harnessing technology to improve productivity so as to produce highly competitive types of banking and generating greater non-interest income by diversifying into non-fund based activities will be important features of the Indian banking of tomorrow".

The Reserve Bank of India's warning is certainly justified. Almost a third of the operating profits of scheduled commercial banks in FY 2003 was out of trading profits.

While that trend has persisted in the first two quarters of the current fiscal, thanks to declining bond yields, there are indications that non-food credit is rising and yields hardening.

Going forward, therefore, profits on sale of investments will not be available. Thankfully, banks have used their windfall profits wisely by cleaning up their balance sheets, which means that banks need not make huge provisions.

But while lower provisioning requirements will to some extent make up for the lack of capital gains, banks have no alternative to increasing credit.

In other words, a stable interest rate environment will mean that bankers will once again be forced to lend.

Additionally, the fact that many blue chips are flush with cash will mean that banks will necessarily have to fund the second rung of corporates, for which traditional banking credit appraisal skills are indispensable.

In sum, while the falling interest rate environment of the last few years has helped banks, Indian banking will see a return to a more traditional mode of making money. The pick-up in the economy will also lower lending risks, helping bankers.

The report also points to the risks in co-operative banking, and to the still unresolved issue of multiple supervision. It makes a passing reference to the disadvantages of public ownership of banks.

In short, in these days of stock market euphoria about the re-rating of the Indian banking system, the RBI report provides a timely warning of the challenges ahead.