The recently released financial stability report of the Reserve Bank of India (RBI) contains an analysis of the return on equity (RoE) of the banking sector.
Despite the boom and the bust since 2005, RoE of the banking sector hasn’t changed much. It was 12.7% in 2005-06, went up to 13.2% the following year and then fell to 12.5% before recovering to 13.1% in 2008-09.
The return on assets (RoA) have hovered between 0.9% and 1%. RBI tries to find out the drivers of RoA by breaking it up into two components—the profit margin or net profit/total income and asset utilization or total income/assets. RBI says that in 2008-09, it is better asset utilization that has enabled banks to keep up RoA despite a slight dip in margins.
The RoE is then broken down into two components, RoA, or net profit/assets and the equity multiplier, or total assets/total shareholders’ equity. The equity multiplier is a measure of financial leverage and is also known as the financial leverage ratio or the leverage ratio.
RBI points out: “The RoE of the banking system has remained relatively low, mainly on account of a declining equity multiplier. In the face of the reasonable growth in bank assets, a declining equity multiplier is a source of regulatory comfort as it implies that a larger portion of banks’ earnings are retained and transferred to loss absorbing common equity.”
In other words, bank leverage has gone down, which is a source of comfort to the central bank.
RBI says profits could be hurt because of the need for banks to make provisions for at least 70% of their non-performing assets.
It is also planning to go in for counter-cyclical provisioning along the lines of Spain’s “dynamic provisioning.” This essentially means that banks will have to build up provisions during good times as a buffer, which will be allowed to be used during the down leg of the business cycle.
And if margins come under pressure due to extra provisions and declining asset quality, RBI says, “It would be a challenge to the banking sector to maintain its existing RoA level, particularly in a growing balance sheet scenario.”
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