M.V. Nair, chairman of Union Bank; Devendra Verma, a bond dealer with a private bank; Vinit Kumar, a software engineer and a prospective home buyer; and Atul Shirsat, a retired state government employee—all of them would look back at 2006-07 differently.
Nair would look at the bank’s accounts for the year with a finetooth comb to gauge the impact of the central bank’s monetary tightening measures spread over the year. Verma will not get a hefty bonus this year as he has not made enough money trading bonds. Kumar, on his part, had to postpone his plan for buying a flat as he cannot afford the high home-loan rates.
The only person in this group who is smiling is Shirsat. He is now earning 9.5% on his savings kept with a public sector bank, against the 6% he earned at the beginning of the year.
With Friday’s measures, the Reserve Bank of India (RBI) has raised its short-term rate by one percentage point to 7.75% in four stages this year. It also raised banks’ cash reserve ratio, which determines how much money banks need to keep with RBI, by 1.25 percentage points to 6.5%, taking out about Rs45,000 crore from the banking system.
Commercial banks, on their part, have raised their prime lending rate by an average two percentage points while retail loans, particularly consumer loans, mortgages and auto loans, have risen by between three and four percentage points.
With RBI raising rates at frequent intervals, banks had little choice but to pass on the interest burden. At the same time, to support their loan growth, banks also hiked their deposit rates to attract customers—a move that has benefited the saving community.
A deposit with a term of more than three years, which fetched returns of 6.25% to 7% till a year ago, now gives anything between 9.25% and 10%.
But the rise in loan and deposit rates was much sharper than that in bond yields. Bond prices and yield move in opposite directions. In a rising interest rate scenario, bond prices crash and bond yields rise. With the prices going down, banks are required to make provisions to offset the depreciation in their bond portfolios, affecting profitability.
At present, banks are required to invest a minimum of 25% of their deposits in government securities, or “gilts”. To meet this stipulated liquidity requirement, banks invest in gilts across maturities, ranging from two to 30 years, besides short-term treasury bills.
Over the last few years, banks have invested in shorter maturity paper ranging from three to five years, expecting that their investment portfolio would not depreciate.
The rising interest rate scenario changed all that. While yields on the benchmark 10-year paper swayed between 7.6 % and 8.14% in 2006-07, the rise of bond yields in shorter maturity papers ranging between three and five years has been much sharper— 6.75% to 7.49%.
“This meant that those banks who had thought they had made a smart move by buying short-term paper faced a larger depreciation on their bond portfolio,” said C.E.S. Azariah, chief executive officer, Fixed Income Money Market and Derivatives Association of India.
However, most banks over the past fiscal year moved their SLR investments from the “available for sale” category to the “held to maturity” category. A bank’s bond portfolio consists of three categories of gilts: held to maturity, available for sale and held for trading. Bonds in the held-to-maturity segment do not face depreciation, and hence banks are not reqired to make provisions for their declining prices.
But banks’ investment portfolios are seen to take a hit on account of the depreciation of corporate bonds.
“The negative impact of the valuation on corporate bonds will be much more since the spread between the 10-year benchmark bond and a triple-A rated corporate bond of similar maturity has gone up from 70-80 basis points last year to 150 basis points this year. Most banks have built up considerable portfolios of corporate bonds, which will be hit to that extent,” says Ashish Parthasarthy, head, trading, HDFC Bank. One basis point is one hundredth of a percentage point. Still, banks will make profits as their interest income has risen substantially with the rise in loan growth. However, this story may not continue next financial year, beginning next week, with the central bank likely to further tighten the monetary policy.