Early this century, the Reserve Bank of India (RBI) deputy governor Rajesh Mohan coined a term “lazy banking” to describe the state of affairs in the Indian banking industry.
That was before the bull run started on the bourses and the economic growth picked up its pace. As corporations and individual borrowers were not coming forward to lift loans, banks were saddled with huge amounts of money. So, they decided to park their funds in government securities. It served two purposes. First, they got reasonable returns on their funds as bond prices were rising at that time and the yield coming down. Second, government bonds are risk-free assets and banks will never be required to make provisions for such exposures.
After a gap of a few years, Indian banks seem to be going back to their lazy banking days. Consider these facts: the Indian banking industry’s investment in bonds has risen by 21.3% between April and mid-January this fiscal year. In absolute terms, their bond portfolio has risen by Rs1.68 trillion. In the comparable period last fiscal year, their exposure to bonds rose by 5.5%, or Rs39,516 crore. Year-on-year, that is between mid-February 2007 and now, their bond portfolio has risen by Rs2.01 trillion, or 26.6%, against Rs41,589 crore, or 5.8%, growth between mid-February 2006 and mid-January 2007.
What has suddenly rekindled banks’ lost love for bonds? The phenomenal rise in banks’ deposits and fall in bank credit. Bank deposit, up to 18 January, has gone up by Rs4.22 trillion, or 16.2%, against Rs2.82 trillion, or 13.4%, last year. Year-on-year, it is up by Rs6.39 trillion, or 26.7%, against Rs4.45 trillion, or 22.9%, in the past year. But there is a distinct slowdown in their credit growth. Bank credit since the beginning of the year has gone up Rs2.37 trillion, or 12.3%, against Rs2.61 trillion, or 17.4%, in the comparable period last year, and the year-on-year credit growth is 22.5%, or Rs3.97 trillion, against 29.9%, or Rs4.06 trillion. With credit not growing, banks are saddled with excess liquidity and so they have started parking their deposits in government securities because money, the main raw material of banking business, has a holding cost and it should not be kept idle.
Under the law, Indian banks are required to invest 25% of their deposit liabilities in government securities. During their lazy banking days, banks’ investment in government securities rose to as much as around 40% of their deposits. But when credit started picking up, their investment in government bonds started going down as banks were liquidating their bond portfolios to disburse more and more loans. Now we have started seeing a reverse trend. Their investment in government bonds has risen from about 28% of total deposits in March 2007 to 29.1% now.
This makes it clear that after a 30% credit growth for three years in a row, banks have started looking for “safe” investments as they apprehend that aggressive lending may create stressed assets. RBI initiated the move by tightening its monetary policy through a series of rate hikes and rise in cash reserve ration, the percentage of deposits commercial banks are required to keep with the banking regulator. It also brought down the yearly target for credit to around 25%. But the actual credit growth is even lower than this target as banks are losing their appetite for risk.
But strangely, their appetite for deposits is not diminished and therein lies the problem. Since they do not want to bring down the growth in deposits, they continue to pay high rates on their deposits and, because of this, they cannot bring down their lending rates. Typically, banks are paying anywhere between 7.5% and 8.5% for one-year retail deposits and even more for corporate deposits. They are earning 7.5% on government bonds and 6% at RBI’s reverse repo window that daily absorbs excess liquidity from the financial system. This means they are just cutting losses by parking money in government bonds and the RBI window.
Before they forget the art of lending, bankers should start disbursing loans to medium and small industrial units and traders who are starved of credit and willing to pay for it. Even at 12-13%, returns on such loans are any day more than what the banks are earning from investing in government bonds. The other alternative before them is to pare their deposit rates as they do not need so much of money if they are not willing to lend.
At his last meeting with public sector bankers, finance minister P. Chidambaram had asked them to bring down their cost of lending by cutting their deposit rates. Last week, RBI governor Yaga Venugopal Reddy, too, said this in a different way. According to him, there have been “little or no adverse effects on banks’ net interest margins and profitability.”
Indeed, Indian banks enjoy the maximum cushion of net interest margin, or NIM, as they are always quick in cutting deposit rates but slow in paring the lending rates when the policy rates go down.
NIM is arrived at dividing a bank’s net interest income by its average interest-earning assets. While the NIM of Indian banks—between 3% and 4%—is double that of global banks, their return on assets, a very important profitability indicator, is comparable with their global peers. This is because operating expenses and credit cost that includes provision for bad assets and write-offs eat away a substantial part of NIM. Banks can bring down their operating cost by being more efficient. And they can become efficient only when they stop lazy banking.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mubai bureau chief of Mint. Please email comments to firstname.lastname@example.org