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Banks: Growth getting derailed?

Feb 10, 2006

An appraisal of the banking sector's performance reported for the quarter ended December 2006, while on one hand highlights historically high growth figures, on the other also raises qualms about the sector losing steam. Riding on the 'investment' and 'consumption' story for the corporate and retail credit segments respectively, the banking sector has surpassed credit growth estimations across product portfolios over the last couple of months. So much so that the apex bank itself seems apprehensive of the excess liquidity that has buoyed the incremental credit growth to unsustainable levels. Indians borrow more, more Indians borrow: While a loan to GDP ratio of 33% and consumer credit to GDP ratio of 6% (in FY05) may sound like a far cry from calling India an adequately banked economy, it is pertinent to note that both of these ratios have leapfrogged over the past three years (from 25% and 4% respectively). Although this may suggest evolution of the Indian banking and financial sector, a thorough scrutiny of the incremental credit demand poses delinquency concerns.

Indian households, which are known to be typically credit averse, with the advent of 'easy repayment' loans, have now started crossing their 'borrowing to annual income' limits. Thus, Indians are borrowing more than they should be ideally doing. While this may not be a cause of worry in a flourishing economy, any economic downturn or spurt in interest rates may lead to slippages in the banks' books. The same risks also apply to corporate credit that is witnessing higher growth rate due to more working capital and capex requirements. Mid-size and smaller corporates especially have endeared themselves to banks due to the higher yields offered by them. But complacency in the credit appraisal of these 'new' borrowers may lead to banks burning their hands once again.

Treasury's lost the 'Midas' touch: The treasury portfolio of banks that proved to be a gold mine during the falling interest rate scenario has now proven to be a bane in disguise, with interest rates being on an upturn. Most banks recorded a significant decline in their treasury income during 3QFY06, which was also a result of the high base effect of last year. Although banks have already transferred the surplus G-Secs in their SLR book to the held-to-maturity basket, depreciation of the existing available-for-sale basket will continue in the rising interest rate regime.

Costs weigh heavy: Operating costs for entities across the sector has escalated with expansion in franchise and addition to employee base. Even the relatively leaner private sector banks have not been spared. With the average cost to income ratio nearing 45%, net profit margins continue to remain depressed despite higher net interest income. With higher pressure on net interest margins (NIMs) being envisaged, inability to economise operating costs may lead to even the most efficient players in the banking sector compromising on their profitability in the medium term.

'Innovative' capital: Although the Reserve Bank of India (RBI) has lived up to its word of providing additional capital-raising headroom to banks by allowing access to innovative capital, the concern is that how many banks are in a position to or are willing to explore such 'innovations'. This is because the innovative instruments hold good only for those banks that have a high credit rating and good asset quality. Else, convincing investors about the security of their capital or garnering perpetual debts at feasible interest rates will prove to be a complex barrier for banks' capital expansion.

What to expect?
While our outlook for the banking sector per se remains positive from the medium to long-term perspective, our comfort factor rests with the larger and integrated players, having competencies to counter margin pressure and competition. Nonetheless, even some of the smaller players are promising candidates in terms of growth sustainability and operating efficiency. While cyclical factors like interest rates and liquidity may witness hiccups in the medium term, structural support like credit demand and good asset quality will provide a reasonable hedge. The only caveat for investors, therefore, is to beware of pricey stocks and invest with a long-term perspective.

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