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Banks: Reality check

May 9, 2003

The banking sector in the country continues with its transition. A falling interest rate scenario has helped Indian banks in two ways. First, banks have been able to improve their Net Interest Margins (NIM) significantly. Secondly, they have also been able to book profits on their G-Sec portfolios. This was what happened, from here on as the fall in interest rates abate, banks are likely to face the second stage of the transition, i.e. falling NIMs. The reason why banks have been able to improve upon their NIMs is due to the fact that banks re-price their liabilities faster than their assets. What this means is that with falling interest rates banks lower their deposit rates faster than their lending rates. This leads to better interest spreads and consequently better NIM. But from here on since interest rates are not expected to fall drastically as seen before banks will not be in a position to significantly reduce their deposit rates like before.

Also banks are likely to face increasing pressure on the yields front. Since lending rates are also falling, the interest spread that bank make will also fall from here on. Another crucial factor to look into is the fact that yields of banks from their G-Sec portfolios are likely to fall much faster from here on. There are two reasons for the same. First, falling interest rates mean that new G-Secs issued in the markets will have lower yields. Hence incremental investments of banks will yield lower returns. Second, banks have aggressively sold off their G-Secs in order to take advantage of falling interest rates. Hence, fall in returns from G-Sec portfolios of banks will be much faster from here on.

RBI's pointers towards lowering of interest rates seem to have been heard. Banks like BOB, SBI and OBC have already reduced their lending rates. Other banks in order to remain competitive may have no choice but to cut their own lending rates. Moreover, the Indian retail segment, which has been fueling credit growth in the country, has become more demanding and hence banks are under increasing pressure to structure the price of their products in line with customers needs. For example, a person who has a home loan is right now in a very good position to negotiate the pricing of the loan due to the competition in this segment. This means further pressure on yields on the banks' lending portfolio.

Banks have enjoyed the benefits of falling interest rates in the past but increasingly benefits of this scenario are likely to diminish. There are no immediate hopes of a strong revival in credit offtake for capacity expansion in India Inc. Thus banks are faced with a prospect of falling yields and consequently falling NIMs. From here on, banks with a reasonably large presence and who have the ability to garner low cost deposits will be the entities that would be able to maintain or atleast limit the fall in their NIMs. As the pressure on banks increases only the ones with a strong focus for the long term and integrity will be successful.

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