On 8 January, Sensex, the benchmark index of the Bombay Stock Exchange, closed at its lifetime high of 20,873.33. Since then, it has lost more than 26%. During the same time, Bankex, the banking industry index, has fallen even sharper — some 35%. Bankex represents 18 of the 40 listed banks. About 75% of the listed banks have lost much more than the Bankex. For instance, the price of Kotak Mahindra Bank Ltd has come down by close to 54% since 8 January—from Rs1,325 a share to Rs613. Among public sector banks, Kolkata-based Uco Bank has lost more than 54%.
In the pack of private banks, both ICICI Bank Ltd and Yes Bank Ltd have lost more than 42% each and Axis Bank Ltd some 33%. HDFC Bank Ltd has relatively been less affected, losing close to 25%. Among large public sector banks, Industrial Development Bank of India Ltd has lost more than 48% and Canara Bank some 44%. State Bank of India has lost about 31%, while Punjab National Bank has lost 28%.
Investors are punishing the sector for various reasons. With the wholesale price-based inflation rate shooting to a three-year high of 7%, an impending tightening of liquidity is on the horizon — either through a raise in commercial banks’ cash reserve kept with the Reserve Bank of India (RBI) or a hike in policy rates, or even both.
Theoretically, banks can have the best of both worlds. When the interest rates go up, they earn more on their loan assets and when the rates decline, the income from bond trading rises. Prices and yield of bonds move in opposite directions. This means, when the bond yield goes down, their prices soar and banks make more money trading bonds than selling loans. However, in reality, banks’ income rise in a low interest rate regime is more than when the rates harden and liquidity tightens. This is because when the rates rise, companies’ ability to access bank loans gets affected and weak firms start defaulting, leading to more non-performing assets and forcing banks to provide for the stressed loans. Banks also need to provide for their bond portfolio whose value depreciates when the rates rise and prices fall.
Apart from these factors, banks’ exposure to credit default swaps abroad and their derivatives portfolio in India are a cause of concern. A few private banks have aggressively sold exotic options to their corporate clients to hedge currency risks. With the value of the dollar depreciating against some of the global currencies, these deals have turned sour and firms that have bought them have started losing money. The amount of loss for some of the small and medium firms could be more than their net worth. This means they may default in honouring their commitment for such derivatives deals. If that happens, banks will be in trouble. This is because under the law, Indian banks cannot have a naked exposure to cross-currency derivatives. All cross-currency options and swaps of their customers are hedged back-to-back with the same tenure and amount with foreign banks. So, if a company defaults, banks will have to pay up to settle the contracts with the counter-parties. More than half a dozen companies have already dragged some of the banks to court, challenging the validity of their options and swaps contracts, and at least one bank has slapped a case against a firm for not paying up its dues to clear the derivatives deal.
Though risk management consultants, law firms fighting such cases and banking analysts have been saying the losses of firms can run into thousands of crores, RBI does not seem to be perturbed. The central bank feels that the rules for the derivatives deals are firmly in place and that it should not interfere in the bilateral contracts between a bank and a firm. In other words, there is no systemic crisis.
This means investors in bank stocks may flee but the depositors need not worry about their money kept with Indian banks as they are safe. Indeed, not a single Indian bank has been allowed to fail in recent history but that does not necessarily mean that risk for the depositors in every Indian bank is the same. This is because the business profiles and the appetite for risk vary from bank to bank. And, if that’s the case, the premium that the banks pay to the Deposit Insurance and Credit Guarantee Corporation (DICGC) for buying insurance for deposits should not be uniform.
Under the law, up to Rs1 lakh deposit is guaranteed by DICGC against a bank’s failure. Till 2004, banks were paying 5 paise for every Rs100 of deposits as a premium for the cover. This has been raised to 10 paise in two stages uniformly for all banks despite recommendations by various committees for risk-based pricing. The concept of insuring deposits was first mooted in 1948 after the banking crises in Bengal but it came into force in 1962. In fiscal 2007, 83 commercial banks, 96 regional rural banks, four local area banks and 2,209 cooperative banks were registered with DICGC. Since its inception, the corporation has paid Rs296.63 crore to protect the depositors of 27 commercial banks. Its payment towards 176 cooperative banks till last year has been Rs2,298.50 crore! This shows the risk is not the same across banks. So, why should all banks pay the same premium for the insurance cover? Banks may not fail but the higher risk takers must pay higher premium for deposit insurance.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to email@example.com