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Banks: Ringing in reforms

Mar 4, 2005

The budget speech, delivered by the FM, seemed to be articulated to bring in reforms that will sweep across India's financial sectors in the coming months. The reason being, India would continue to 'shine' (read achieve targeted 6.9% GDP growth), if and only if, the financial backbone is strong enough to disburse credit to agriculture and India Inc. Not faltering on his balancing act, the finance minister also exhibited his far-sightedness in dispensing the following 'orders' to the country's banking entities:Bow down to RBIThe apex bank has been given the prime authority to control the regulations in the sector in more ways than one.

  • Decide CRR and SLR: The decision to vary the SLR and CRR requirements (two of the most important tools of monetary policy) will now rest on RBI's shoulders. Reserve Bank of India (RBI) could now use this authority to channelise the 'liquidity overhang' towards more productive usage.

  • Encourage money market transactions: Allowing RBI to lend and borrow securities by way of repo and reverse repo will not only improve liquidity for banks but also bring in more activity to the now stagnant money market.

  • Supervise banks and their subsidiaries: The provisions to enable the consolidated supervision of banks and their subsidiaries by RBI are expected to bring in more transparency in the functioning of the entities and make them answerable to the apex body.

  • Lay road map for entry of foreign banks: RBI has already laid down the roadmap for the penetration of foreign banks and the acquisition of stake by the foreign entities in Indian private banks. The same will heighten competition for the private sector entities and allow the weaker private banks to access foreign equity.

Raise more capital
Allowing banks to raise preference capital is a step towards helping them to gear up for compliance with Basel II. Although, there is no clarity on the issue of whether this will be classified as Tier I or Tier II. As per banking regulations, capital raised for a period of twelve years is to be classified under Tier I. Thus, it is unlikely that the preference shares so raised will be classified under Tier I. Whatever be the case, the additional capital infusion will definitely help the banks in meeting the Basel requirements.

Lend more…but carefully
The thrust on infrastructure lending through the 'infrastructure financing SPV' will seek higher exposure from the banking entities. Although the said financial aid is applicable to 'eligible and appraised projects', banks will need to ensure that the quality of their asset books does not deteriorate.

Trading in mortgage backed securities and tax sops on home loans will continue to add to the sector's mortgage financing portfolio, which at present is witnessing one of the highest growth rates. A higher allocation to Indira Awas Yojana (rural housing scheme) from Rs 25 bn to 27.5 bn will also augur well for the sector's priority sector credit commitments.

PSU Banks - continue agri funding
The PSU banks, however, continue to be meted out a step motherly treatment with a higher burden of priority sector lending. Not only will they have to increase their exposure to agricultural sector by 30% but will also need to increase the number of agri borrowers by 5 m. While these targets are definitely not desirable from the point of view of the banking entities, they will increase their dependence on NABARD and SIDBI (substitute routes for agri lending), which will offer lower interest rates depending on the level of shortfall (of direct agri lending).

Discourage cash transactions
The 0.1% banking transaction tax on withdrawals above Rs 10,000 will discourage cash transactions and bring in more fund transfers under the purview of the banking sector. An attempt to curb money laundering, this measure is also a step towards higher 'monetisation' of the economy. However, the new tax will bring in administrative nightmares for the banking entities, as most cash withdrawals are today via ATMs which allow withdrawals upto Rs 15,000 on a single day (may vary bank-to-bank).

Our view
The banking sector will continue to remain an important vehicle for driving in economic reforms and maintain the buoyancy in the country's economic growth. Be it by way of lending more autonomy to PSU banks, autonomy to RBI or encouraging more investments (upto Rs 1 lac) for availing tax benefits, each of these measures are expected to bring in sea changes in the sector's outlook and performance in the coming months.

Nevertheless, not all reforms will be beneficial to the sector. The following is our assessment of the key reforms:


  • Better liquidity through CRR and SLR flexibility

  • Hike in corporate credit due to infrastructure investment thrust

  • Mortgage financing fillip

  • More capital through preference shares

  • Lower corporate taxes benefit as depreciation 'loss' is nominal for this sector

  • Access to foreign equity through foreign banks


  • NPA risk to resurface

  • Priority sector lending amplified

  • Administrative blues (bank transaction tax)

  • Deposit crunch due to elimination of tax sops on bank deposit interest (Sec 80 L)

  • Competition for private banks from foreign counterparts

Summing it up, we believe that the sector continues to remain an attractive investment avenue. The opening up of the sector along with regulatory norms in place puts it in the in the reckoning. However, it's the PSUs that stand to be the larger beneficiaries of the reforms while the private sector entities will need to keep themselves well heeled to counter competition.

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