Theoretically, bankers can always have the best of both worlds. In a declining interest-rate scenario, they make money with both hands on their bond portfolio as the prices of bonds rise when their yields decline. Conversely, when the interest rates rise, bankers make money on their credit portfolio as they lend at a higher rate.
However, bankers are not the sole professionals on earth who can have their cake and eat it too. Even their corporate borrowers enjoy the best of both worlds. When interest rates fall, they raise money cheap by bargaining hard and playing one bank against another. Similarly, when the rates rise, they make money earning a very high rate for their deposits, once again, by playing one bank again another.
But there is a crucial difference between a bank and its borrower, a corporation. Commercial banks make money by using their own money (taken in the form of deposits) to invest in bonds or loan assets, but corporations do not necessarily need to have their own funds to make money.
Does it sound like a puzzle? Then consider these facts: Two very large public sector undertakings early this month parked about Rs1,000 crore each with two large public sector banks for 45 days at an interest rate of 10.5%. A few days before putting this money with these two banks as deposits, these two firms had used their unutilized working capital limit for the year by drawing Rs1,000 crore each from their banks. Incidentally, they raised the money from banks at 9%.
Essentially, they took money from banks and parked the same resources with the banking system at a higher rate—thereby making a cool, risk-free 1.5% spread. In banking parlance, it is called credit arbitraging. Without employing any capital and carrying any risk, smart treasury managers of corporations are making money. And mind you, they are doing it transparently by following the auction route.
How does that work? Well, while raising money, they ask banks for quotations of rates and choose the player who offers them the best rate. Similarly, while parking the same money as deposits, once again they ask for quotations in sealed envelopes and the money goes to the vault of the bank which offers the maximum interest rate. It is not necessary that the same set of banks that gives them credit takes the money back in the form of deposits. Corporations normally deal with a consortium of banks. Indeed, there could be instances when the same bank is offering credit and taking it back in the form of deposits but, even then, there is nothing wrong in it as money is fungible and hence there is no foolproof method to prove that the same money is recycled. Moreover, different divisions of a corporation and a bank are dealing with these transactions. So, theoretically, it is always possible that the general manager in charge of the resources in a bank does not know that the money he is accepting today as a bulk deposit at a hefty rate was disbursed by his colleague in the credit division a day before to the same firm.
Normally, the corporate borrowers have sanctioned working capital limit based on the assessment of their funds requirements taking into account the actual production, inventories, sales cycles and so on.
Corporations often do not need lift the credit as they do not need them by virtue of better inventory management but as the financial year draws to a close, they rush to utilize their credit limit and invest them in deposits for making a few extra bucks. Also, this way they can also escape the “commitment charge” that banks levy on the unutilized working capital limit.
That’s the story of smart treasury-savvy corporations. But why do banks encourage such a practice? They do this as their focus is still on “total business” and not profitability alone. By adding deposits and advances, one gets the portfolio of the total business of a bank. The year-end ritual of allowing corporations to use their unutilized credit limit and bringing the same money back in the form of deposits help banks build total business and their balance sheets. There is always a rush to increase deposits and advances by the end of the financial year. Once the mission is accomplished, the level of deposits and advances dip immediately.
Earlier, when the financial system followed the January-to-December financial year, bank deposits used to swell on 31 December and disappear a day later. This was done by using inter-bank money. The concept of short-term deposit was unheard of in the 1970s and the 1980s, but short-term money was available in the form of inter-bank deposits. These were not regulated by the Reserve Bank of India. So banks could mutually decide the interest rate on these deposits maturing at times in 48 hours.
Apart from expanding their balance sheets, the year-end play with advances and deposits, popularly known as “window-dressing”, has other benefits too. For instance, by inflating their advance portfolio, banks can bring down their gross non-performing assets (NPAs) in percentage terms. This is simple arithmetic. A Rs50 crore NPA on an advance base of Rs1,000 crore translates into 5% NPA. But when the advance portfolio goes up to Rs1,200 crore at the end of the year, the NPA level automatically drops to 4.16%—even though no bad assets are recovered.
The focus on total business also reveals the psyche of the Indian banking system—the top line is more important than the bottom line. Most of the banks are listed, but for them, growth in deposits and advances are still more relevant than other crucial financial parameters such as return on assets, returning on equity, return on capital and earning per share.
(Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org)