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Banking: Lender beware! - Views on News from Equitymaster
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Banking: Lender beware!
Feb 27, 2006

Evaluation of the banking scenario in fiscal 2006 presents a mixed picture of growth optimism coupled with inherent handicaps. Record incremental credit offtake (albeit on a lower base) helped banks shrug off their 'lazy banking' image. Nevertheless, liquidity constraints and higher interest rates (both pressurising margins) cloud the possibility of the trend continuing further. Monetary developments during FY06 were characterised by:

  1. Rapid growth in bank credit

  2. Reduction in SLR investments by banks to meet rising non-food credit demand

  3. The RBI's strict vigilance on credit quality and NPA provisioning

  4. Severe liquidity crunch emanating from lower deposit growth and RBI's introduction of 'hybrid' capital options

  5. Higher international commodity and crude oil prices influencing inflation and interest rates

Price stability despite a rapid increase in money supply during the current fiscal testified the investment-driven nature of the credit growth and the inflation stability expectations based on confidence in the appropriate stance of monetary and fiscal policies.

The regulator's mandate: Continuing the process of financial reforms for induction of best practices, the Reserve Bank of India (RBI) emphasised on transparency, diversification of ownership and strong corporate governance practices to mitigate the prospects of systemic risks in the banking sector. This was, especially, in the light of preparation towards implementation of the Basel II framework, which is to be operationalised by banks and financial institutions by March 2007. Subsequent to the roadmap for entry of foreign banks and restriction of foreign holding to 74% in private banks, the RBI also laid down policies in FY06 to ensure healthy growth in the sector. This included:

  1. Guidelines for raising innovative capital

  2. Guidelines liberalising dividend payment by 'healthy' banks

  3. Guidelines for mergers between banks and NBFCs

  4. Guidelines on sale or purchase of NPAs

Monetary policy changed stance: After several months of maintaining status quo, the RBI finally changed its stance with respect to monetary measures and adopted a 'restrictive' stance for tightening the excess liquidity in the system. This was by way of three consecutive rises in the repo and reverse repo rates by 25 basis points each time, very much parallel to the Fed's 'measured' approach.

Rates over the months...
Rates over the months...
(%, p.a.) Jan-05 Mar-05 Jan-06
Bank rate 6.00 6.00 6.00
CRR 5.00 5.00 5.00
SLR 25.00 25.00 25.00
BPLR 10.25-10.75 10.25-10.75 10.25-10.75
Call money rates (low/high) 3.85/5.60 2.25/5.25 4.50/7.95
CPs by companies 5.20-7.25 5.1-6.30 6.65-8.50
Deposit rate (> I year) 5.25-6.25 5.25-6.25 5.25-6.25
Repo rate 6.00 6.00 6.50
Reverse repo rate 4.75 4.75 5.50

Credit offtake so far so good: The robust GDP growth of 8.1% during 1HFY06 has been reflected in a steady growth of 17.5% YoY in net domestic credit growth during the same period. While retail continued to be the mainstay of banks' credit borrowers, industrial and the services sectors (credit growth 17% YoY) contributed to only 13% of the increase in net credit disbursals, thereby indicating latent demand. Mortgage and infrastructure lending constituted a majority of the banks' retail portfolios despite increase in the risk weightage for the same. The steady expansion in credit contributed as much as 16% to the overall increase in money supply, which at 16% YoY was not only higher than the growth witnessed last year (14% YoY) but higher than the RBI-projected 14.5% for FY06.

Going forward, however, lower deposit mobilisation and liquidity constraints (including shortage of excess SLR securities) pose challenges to the sector's incremental credit growth, which has already assumed a higher base. Also, given that the short term lending rates in the country are witnessing an upward trend, in line with other developed and developing nations (see chart), the possibility of further hardening of interest rates cannot be ruled out.

NPAs Recovering ground: Asset quality of banks registered significant improvement simultaneously with the increase in the quantum of credit to the commercial sector. A significant improvement in recovery of NPAs combined with writes-offs on the back of treasury profits reduced the gross NPAs to advances ratio to 5.2% in FY05 from 7.2% in FY04. Resolution of the 'Dabhol' case was also a significant contributor to this. Guidelines for sale of poor assets to ARCIL and intra-bank sale of NPAs relieved several banks of their high delinquencies.

Tackling the issue of 'pricing of assets' while catering to credit demand across sectors will continue to pose challenges for the banking sector. Tightening of monetary measures may further aggravate the problems unless sops are provided to ease deposit mobilisation. While higher credit growth may be the fallout of extended franchise, excessive credit growth without adequate safeguards could lead to some erosion in credit quality. So far banks have been able to finance the credit boom efficiently with an average CAR of 12.8% considerably higher than the 9% RBI stipulation. But come March 2007, banks are required to conform to Basel II norms, and this will require additional capitalisation.

Thus, in view of the rapid growth of bank credit, there may be a need for not only further capitalisation of banks but also for developing strict management techniques for the prudent appraisal of credit demand so as to avoid repeating past mistakes.

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