The timing of the government’s cash clean-up drive may have been bad for many but couldn’t have been better for the bad loan battered banking sector. The drive to flush out cash hoarded by Indians and channel it into banks has given public sector lenders an opportunity to turn their losses into profits. But will they be able to milk this opportunity?
Investors think so as is reflected in the smart rise in most bank shares ever since the currency withdrawal took effect. Twenty-two of the 39 listed banks saw their stock gain even though the broader market has declined.
Let us look at the immediate benefits for banks that will help them turn profitable in the third quarter. The first benefit is from the incoming deposits in the low-cost current and savings accounts. Official estimates indicate that banks have garnered close to Rs3 trillion worth of deposits in just over four days after the currency withdrawal took effect. These deposits can either be loaned out to companies and individuals or invested in government securities and money market instruments. Lenders can earn 2-4% margin by parking this inflow into money markets and bonds. If banks succeed in lending this money out, their core income would get a boost too. But loan disbursement is a function of aggregate demand in the economy and this has been hit hard. Benefits through this route would be hard to come by.
The second benefit is the positive rub-off of liquidity onto bond yields. Government bond yields have dropped by nearly 40 basis points over the last one week. Yields move inversely to bond prices. This would beef up treasury income and give a boost to non-interest income, currently the only driver of profits for banks. Investment bank CLSA’s analyst Aashish Agarwal believes that 20-25% of banks’ profit during the third quarter could be generated from this currency withdrawal event, according to a Mint article.
But to argue that demonetization would be the driver of profits would be wrong. Public sector lenders would show profits in the third quarter simply because of a base effect since collectively they made a whopping loss of Rs10,723 crore in the December quarter last year.
A real threat to banks’ profitability is again the bad loan problem. Toxic assets have not gone anywhere and the economy has not increased its speed. In fact, the clean-up of cash from the economy could lead to a dirtier loan book, especially of micro, small and medium enterprises (MSMEs). Small businesses rely heavily on cash for payments from counterparties and currency withdrawal would hit their fund flow. The MSME loan book is already showing weakness in many banks and this would make it worse. The loan-against-property portfolio is another emerging bugbear for banks. Any shock to real estate prices is bound to create ripples in collateral of bank loans.
Every clean-up drive ends up piling dirt at one corner. As Indians put their cash pile into banks, the dirty corner would be the loan book.