From 3 March, commercial banks will be able to lend Rs69 for every Rs100 worth of deposits they mop up. This is because they are required to invest Rs25 out of every Rs100 deposit in government bonds and keep another Rs6 with the Reserve Bank of India (RBI) as reserve on which they do not get any interest.
Banks will find it difficult to digest this as, for the last two years, some of them are actually using their entire deposit portfolio and even more to meet the insatiable credit demand of consumers. This has been possible because they had over-invested in government bonds.
So, they have been releasing money by selling off their bond holdings and using it to create loan assets. At this point of time, the banking industry as a whole is channelling Rs74 for every Rs100 worth of deposits into their credit portfolio. This means they are aggressively using their capital and reserves to meet the credit demand.
It is no wonder that RBI governor Yaga Venugopal Reddy is unhappy with the situation. Between October 2004 and now, he has raised the short-term policy rates by one and a half percentage points.
Besides, he has also raised the capital and provision requirements in some of the segments where credit growth has been too much, such as real estates, mortgages and consumer loans.
After all these measures failed, he has started impounding banks’ resources so that they are left with less money to lend.
This opens a new chapter in India’s monetary policy. The central bank is grappling with high credit demand, fuelling inflationary pressures and high capital flow. In such a scenario, draining capital is a more effective way to raise the cost of money than tinkering with interest rates.
Over the last four years, between February 2003 and now, India’s foreign currency assets have gone up by more than $100 billion (Rs4.4 lakh crore), from about $71 billion to $178 billion. This has created over Rs5 lakh crore rupee-liquidity in the system, roughly a little more than one-fifth of total bank deposits.
Tightening of liquidity will hinder growth. Listed Indian corporations have a capital expenditure plan of more than Rs9 lakh crore over the next four years. Besides, the infrastructure sector needs another Rs14 lakh crore. This essentially means that the total demand for resources in 2011 will be more than one and a half times the outstanding loan assets of the entire Indian banking system, and marginally less than its deposit liabilities.
Unless a vibrant corporate bond market is developed, overseas borrowings alone will not be able to take care of such a huge credit demand.
Banks, on their part, have a bigger challenge in hand now—maintaining their profitability. As the bond yields rise, they will have to book depreciation losses in their investment books. While medium- and long-term bond yields have not risen much, at the shorter end, there has been a sharp rise. Those banks that are holding long-term securities are relatively safe from the depreciation shock.
Overall, banks will also be able to maintain their net interest margin as they are hiking their lending rates along with deposit rates. The benefit of the lending rate hike is instant on their books as loans across the board get re-priced while higher deposit rates cover only new deposits and old deposits on renewal. Besides, about 35% of the deposit kitty consists of zero-interest current accounts and savings accounts on which 3.5% interest is paid.
Effectively, banks’ cost on savings accounts is even less—around 3%—as the interest is paid on the minimum balance kept between the 10th and the last day of a month. Overall, on 35% of deposit liability, banks are paying less than 2.5% interest.
On the other hand, they are earning higher interest rates on all loans, except for small crop loans of up to Rs3 lakh, which will be about 5% of their total credit portfolio. Banks are required to keep aside 18% of their total credit for agriculture loans—big and small. They earn 7% interest on small loans and another 2% subsidy from the government on such loans.
So, rising interest rates will not dent their profitability. Public-sector banks, which account for three-fourths of the total banking system, enjoy between 3% and 4% net interest margin—double that of global banks.
Their counterparts in the private sector have 2-3% margin and foreign banks less than 2%. Net interest margin is arrived at after dividing a bank’s net interest income by its average interest-earning assets.
Banks have traditionally been able to maintain the net interest margin as they are fast in raising lending rates and cutting deposit rates and slow in raising deposit rates and lowering lending rates.
Banks will find it difficult when rising interest rates start denting the quality of assets and corporations start defaulting on loan repayments.
The average net non-performing assets as a percentage of total bank loans is around 2%. With the rise in interest rates, it can go up and impact banks’ profitability as they will stop earning interest on such assets and, on top of that, will be required to make loan loss provisions. However, this will not happen now.
With the economy growing at more than 9% and inflation more than 6%, theoretically corporations can absorb as much as 15% interest cost on loans. Retail consumers will find it tough, but that’s another story.
(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)