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Oiling the economic engine... - Views on News from Equitymaster

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Oiling the economic engine...

Apr 15, 2000

The Indian banking sector has never had it so good. The Reserve Bank of India (RBI) decided to make it even better when on the 1st of April it announced a 1 percent cut in cash reserve ratio (CRR) and the bank rate (BR). The RBI also cut the savings rate by 0.5 percent to 4 percent.

What is it that makes the banking sector look so vibrant?
The core business of credit is growing at a brisk pace, in line with the growth in the economy (the gross domestic product grew 5.8 percent in the third quarter). According to the RBI, total bank credit grew by 14.9 percent in financial year 2000 as compared to just 9.1 percent in the previous year. As industrial investment activity picks up, demand for credit would get a further boost, thus benefiting banks as funds utilisation improves.

Also, a part of the debts that were earlier considered doubtful stand a chance of recovery in view of the improving economic climate. This will benefit banks in terms of an improvement in the quality of assets.

Next come the value added services. With businesses looking at streamlining their cash operations to maximise returns, they are increasingly turning to banks to provide cash management services. Other services pertaining to foreign exchange too have recorded significant growth in view of the increasing globalisation of the Indian economy. Banks have also ventured into product financing, treasury services, portfolio management and depository services among others to tap the latent demand in the market. Such services fit well into the overall framework of a financial organisation and as such do not imply a diversification of business. These ventures will help banks to improve their profitability apart from boosting their client bases (an asset that can be leveraged upon to launch new products).

Then there is 'technology'. The advent of the computer and subsequently networking has enabled banks to improve their efficiency and profitability in a number of ways. For example in controlling bad debts through credit appraisal, where the prospective client's track record can be cross-checked instantaneously; in better management of resources by enabling banks to forecast their cash flows in a more accurate manner; in providing more value added services without incurring much incremental costs. To quote some numbers, the cost of a banking transaction (inter bank transfer) over the Internet is just one cent as compared to over a US$ 1.27 if done by a bank teller.

The RBI's decision to lower the BR, CRR and the savings rate too will augur well for the banking sector. The lower costs of borrowing will spur the demand for credit. The Rs 72 bn that have been freed by the RBI by its decision to reduce the CRR will benefit the banks - CRR deposits earn 4 percent as against market rates of 10 - 12 percent. The decision to lower the savings rate will result in cost savings of upto Rs 8 bn. These measures will improve credit volumes (as lower interest rates will make borrowing attractive) and also add to the bottomline of the banking sector (to the extent the decline in costs is not passed onto the customers). Also, lower interest rates will imply large book profits especially for banks that have large holdings of government paper.

And that's not all. The government has recently permitted participation of banks in the insurance sector. Their retail reach has placed them optimally to capitalise on this opportunity. Given that in India the per capita insurance premia is just 1 percent of the average in advanced countries, the potential is apparent.

Domestic banks seem to be well placed to capitalise on opportunities that are being thrown up by liberalisation and globalisation of the Indian economy. However, their tendency to pile up loans of dubious quality often makes them subject to intense scrutiny - especially in times economic slowdowns. And this is one factor that will continue to weigh heavily against a number of them.

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