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Banking: Treasury misnomers...

Apr 27, 2007

A spurt in interest rates over the past year raised concerns over Indian banks' balance sheets. These banks took a substantial hit on their investment portfolios on account of the marked-to-market (MTM) provisioning of investments in the available-for-sale (AFS) category. Most banks transferred long-dated G-Secs to the held-to-maturity (HTM) category by taking big one-time provisioning hits over the last two years. This helped to insulate their income statements to an extent.Banks have also been gradually reducing the tenor (duration) of their investments to de-risk their investment portfolios against interest rate volatility. Those that still hold a large proportion of their investments in the AFS category have taken hits in 4QFY07, though lower than that in 4QFY06. In 4QFY07, the rise in shorter-end paper (2-year) has been steep compared with longer-tenor paper (10-year G-Sec). PSU banks that have a relatively high proportion of their books in AFS as compared to their private sector counterparts are expected to bear the maximum brunt of treasury provisioning. We would however suggest investors to do away with certain misnomers with regard to the banking entities' treasury portfolios.

Firm G-Sec yields to aggravate losses
While the G-Sec yields have remained high until March 2007 (demand for funds remains strong in March every year), we expect the rates to moderate from FY08. For FY08, the government has budgeted net market borrowings of Rs 1,096 bn, a marginal jump of 2% YoY. This reflects the comfortable deficit management by the government without resorting to excess borrowings. Thus, the overall supply of G-Secs during the next year could be contained.

Due to surplus investments in SLR (statutory liquidity ratio) securities and strong credit growth, Indian banks have not been buying bonds over the last two years. Instead, they have been using the incremental deposits and excess SLR investments to fund their credit growth. We believe that from FY08 onwards, banks will turn net buyers of G-Secs, as the current strong credit demand has exhausted their surplus holdings of government securities for the first time in recent economic history. Also, it would limit the RBI's ability to inject liquidity through open market operations by purchasing bonds from banks having surplus SLR. We believe that the requirement of minimum SLR will result in banks having to buy bonds, resulting in softer yields in FY08. Resultantly, the possibility of banks booking treasury losses due to higher G-Sec yields remains capped.

Treasury hedge
HTM (%)
AFS (yrs)2323
Investment deposit ratio
FY0658.3 47.9 52.1 41.5
FY07E38.3 32.0 33.1 30.3

Inflation to trigger higher SLR...
We do not expect the Reserve Bank of India (RBI) to take any step in the direction of reducing banks' SLR in the near-term, as it battles inflation. Immediate lowering of the SLR ratio would mean fuelling strong credit growth as well as inflation.

The improving fiscal situation reflected in reducing deficits coupled with higher allocation from insurance companies and mutual funds towards government securities, however, implies sufficient availability of funds in the government securities market. We believe that there is, in fact, a case for the government to lower the SLR requirement (currently 25%) for banks in the medium term. The recent ordinance passed in the Union Cabinet allowing the RBI to reduce the floor in SLR substantiates this view.

This would be extremely positive for banks, as any reduction in SLR requirement would translate into higher margins - since the yield on loans is nearly 300 basis points (3%) higher than the yield on G-Secs. This would, in turn, have a positive effect on banks' return on assets and return on equity besides favouring their valuations. Additionally, lower SLR would also imply that sensitivity of banks' financials to interest rate moves would reduce. On the same note, earnings volatility could reduce, which would act as another sweetener.

Yield differential(%)
Incremental yield on loans11
Incremental yield on G Secs8
Difference in yields3
Increase in Interest income with…(%)
3% reduction in SLR9
5% reduction in SLR15

Our analysis of the banking sector's treasury portfolio points out towards muted risk on this ground. However, the same does not in any way de-risk the sector from other perils of rising delinquency and depression in net interest margins with the rise in cost of funds. Investments in the sector, hereon, have to therefore factor in astute estimations of the possible downsides to the banks' valuations due to each of these risks.

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