Typically, a role reversal takes place between banks and their borrowers near the end of every fiscal. In the last fortnight of the year, banks turn borrowers and borrowers banks! It may sound like a riddle but the process is fairly uncomplicated. First, banks disburse hefty loans to some borrowers to inflate their loan books. Second, the money comes back to banks in the form of deposits. This time, it serves the purpose of inflating their deposit portfolios. Often, what borrowers pay for their loans is less than what they earn on deposits. In other words, they play a nice arbitrage game, using banks’ money.
Why do the banks do this? To show higher deposits and higher loans. This practice is rampant in some public sector banks where both the credit and deposit divisions have year-end targets to achieve and they work in silos and don’t necessarily coordinate with each other.
A bank chairman told me last week the age-old practice is less visible this year as banks are increasingly becoming conscious of the cost of money and most are aggressively getting rid of high-cost deposits to protect their net interest margin, or NIM—the difference between what they pay for deposits and earn on loans.
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Rising interest rates are the biggest headache for the banking system in the new fiscal that starts this week. The Reserve Bank of India (RBI) has already raised its policy rate by a quarter of a percentage point and many expect it to increase it by at least another one-and-a-quarter percentage points next fiscal. Banks get hurt when interest rates rise as the value of their bond portfolio is eroded. Under the law, banks in India are required to invest 25% of their deposits in government bonds, but in the absence of loan growth in the past one year, many of them have invested much more than the limit in government bonds. When bond yields rise, their prices fall but banks are required to value them at their current price and not the price of acquisition. This means they need to make good the gap between the cost of acquisition and the prevailing price of bonds. This affects the profitability of banks. The yield on the 10-year government bond has risen from 7.01% to 7.86% this year and bond dealers say it could cross 8.5% next year. Public sector banks will be more affected than private banks as they hold more bonds and the maturity profile of their bond portfolios is longer.
The other major concern in the next fiscal is the quality of assets. Many borrowers found it difficult to service loans in 2009 as economic growth slowed and people lost jobs when an unprecedented credit crisis hit the system after the collapse of the US investment bank Lehman Brothers Holdings Inc. RBI allowed banks to restructure such loans and offer borrowers longer time to repay debt. If the loans turn bad again, banks will be required to set aside money for such loans. An RBI estimate suggests that if all restructured loans turn bad, banks’ non-performing assets, or NPAs, will rise by 3 percentage points. There would not be any systemic stress but some banks will be hurt more than others.
Three other critical issues will impact banks’ performance next fiscal, and all of them are on account of regulatory changes by RBI. One of them is higher provisions for NPAs that banks will be required to make from September. RBI wants banks to set aside funds to cover at least 70% of their NPAs. Currently, the provisioning requirements for NPAs range between 10% and 100%, depending on the age of the stressed assets and the security or collateral available against them. The objective behind the insistence on higher provisions is to enhance the stability of the financial system.
Five large banks, including the country’s largest lender, State Bank of India, and the second largest, ICICI Bank Ltd, have less than 70% coverage ratio. All of them will have to set aside more money to achieve the higher coverage ratio, and this will dent their profits. Banks will also need to calculate their cost of funds and formulate their base rates by July, from when no loans can be given below the base rate. Currently, around 70% of bank loans are given below banks’ prime lending rate, which the base rate will replace. Loans to exporters, farmers and small entrepreneurs have also been delinked from the prime rate. Banks will be free to price all loans, but if under competitive pressure some banks decide on a base rate lower than what their cost of funds justifies, their NIM will be under pressure.
Banks’ NIM will also be under pressure as they will have to pay more on savings deposits from April. Historically, banks have had to pay interest on the minimum balance kept in a savings account between the 10th and the last day of a month, but from next fiscal, banks will have to calculate interest on savings accounts daily. The impact on banks’ balance sheets will be enormous when RBI frees the savings bank interest rate, which can happen in 2011. Once this is done, the industry will witness the fiercest rate war ever and that can claim a few victims. Investors in bank stocks will watch out for this. For the record, in the current fiscal, the Bankex, the Bombay Stock Exchange’s banking index, has risen 137% vis-à-vis a rise of 82% in the benchmark index Sensex. Good times may not last for ever.
I am taking a fortnight off and will resume this column on 12 April. Have a wonderful fiscal 2011.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to firstname.lastname@example.org