Banking: the key lies in quality of earnings

ISSUE

Lazy banking no more

SHUBHADA RAO
Banking economist

The three-year declining interest rate regime helped Indian banks significantly to improve profitability as well as cleanse their impaired assets, giving them healthier balance sheets.

The surge in domestic liquidity, benign inflation and moderate growth in credit off take during this period nudged the interest rates downwards.

The yields on 10-year government securities declined from 10.27 per cent in financial year 2000-01 to 5.14 per cent in financial year 2004. Robust growth in banks' profits was thus primarily driven by treasury gains prompting many banks to indulge in 'lazy banking'.

This conducive environment for banks however, underwent significant change since the beginning of fiscal 2005. Inflation, which had begun firming up during the last quarter of financial year 2004 has shown no signs of easing yet.

With the global prices of crude and metals showing no signs of stabilizing, inflationary expectations have been reigning high in the financial markets. Furthermore, the global interest rate cycle has been moving up in a measured manner.

Inflationary pressures have consolidated further with rising investment cycle in the domestic economy. Credit offtake has been significantly higher in the current financial year so far.

Cost-push and demand-pull factors are both in play currently. Reflecting these developments, the yields on 10-year government securities have moved up from around 5.11 per cent in April 2004 to around 6.6 per cent in early October 2004.

What implications do these developments have on bank profitability during the current year? Softening yields have exerted significant pressure on banks' major source of income "" treasury.

In addition, lower interest rates and competitive pressures have also resulted in lower spreads on their credit portfolio. As a result, bank profitability has come under strain and a few banks have even put a profit warning for 2004-05. A quick (conservative) estimate shows that banks' profits may dip between 12-14 per cent for the current year. Unrealised treasury gains will not take too long to be wiped out if interest rates move up rapidly.

Going forward, especially during the second half of this year, global factors will play a dominant role in determining the direction of domestic inflation and thereby the interest rates. The recent fiscal and monetary measures undertaken to dampen inflationary pressures have yet to bear fruit.

However, if the global crude and commodity prices do not soften in near term, then it will prompt the Reserve Bank of India (RBI) to signal a measured hike in the interest rates in the forthcoming mid-year review of monetary and credit policy.

Under such an uncertain scenario, the quality of banks' earnings has assumed great significance.

Banks, which have increased their credit portfolio both retail and corporate, anticipating depleting treasury incomes, will be able to better withstand any further rise in yields of government securities, and its adverse impact on treasury incomes. Further, banks which have been able to supplement their shrinking fund-based incomes through fee-based incomes will also be able to improve their profitability.

The consolidation process in the Indian banking sector through mergers and acquisitions thus needs to be driven primarily by balance sheet synergies rather than geographical complementarities to ensure sustainability of higher profits.

An imminent upward interest rate cycle will ensure that bankers can no longer afford to indulge in 'lazy banking'!

Conventional growth beckons

INDRANIL PAN
Chief economist
Kotak Mahindra Bank

The operating paradigm for the Indian banking sector has been witnessing change in the past few months. Over the last few years, bank balance sheets have got increasingly linked to the interest rate environment.

With foreign exchange reserves climbing up sharply and the Reserve Bank of India (RBI) having to buy dollars to prevent an appreciation in the rupee, liquidity generated in the banking system was huge.

Consequently, the deposit growth of the banking sector was large and with traditional credit demand not so strong, banks were saddled with surplus funds.

This liquidity found its way into the bond market, leading to phenomenal rises in bond prices, especially at the longer end of the curve. Over the last few years, non-interest income, rather than interest income, was the bigger contributor to bank profits.

And the biggest contributor to non-interest income was bond market trading profit. However, the one-way street in the bond market was not destined to last for ever, especially with the global interest rate cycle poised for a turn.

The change in sentiment in the bond segment came about from end-April 2004, a culmination of various factors including signals from US that it is on the verge of reversing interest rates.

From around 5.05 per cent in April 2004, the 10-year benchmark yield has now risen to around 6.50 per cent.

The interest rate outlook has increasingly become cloudy, given the sharp rise in the headline WPI inflation, the firmness in the international crude oil prices and apprehensions that RBI will reverse its interest rate stance in the coming monetary policy statement on October 26.

The RBI has already signalled 'quantitative' tightening through the market stabilisation scheme and the cash reserve ratio hike. These measures have significantly lowered the liquidity surplus.

Fund inflows into the banking system (via foreign portfolio inflows, mainly) are also lower (in May, June and July the RBI sold a cumulative of Rs 8,500 crore worth of dollars to prevent a sharp depreciation in the rupee).
And it is showing in the lower deposit accretion of scheduled commercial banks. In the current financial year till September 17, aggregate deposits increased by Rs 81,237 crore compared with Rs 94,804 crore in the same period last year.

On the other hand, credit off-take looks to be significantly stronger than in the previous year. In the slack season itself (first half of the current fiscal), non-food credit (till September 17, 2004) has increased by Rs 76,237 crore (partly explained by a rise in the drawdown of limits by oil companies) compared with Rs 18,277 crore in the same period last year.

In an environment of decreasing systemic liquidity, banks might have had to sell government securities to accommodate higher credit flows, thereby leading to lower investment in gilts in this fiscal compared with the last.

With an agenda of inflation control, it is unlikely that the RBI will allow liquidity to return to very high levels again. Consequently, government bond yields will remain on the weaker side and volatile, dependant on news flows.

And, in such a scenario, we are likely to see banks returning to their traditional area of credit growth for generation of profits.

(The views in this article are personal)