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Banks: Buyer beware!

Jun 23, 2006

The legendry investor Warren Buffet in an interview to 'Fortune' once quipped, "In economics, interest rates act as gravity behaves in the physical world". The rate hike triggered liquidity drought has put on hold the banking sector's claims of sustenance of a robust credit cycle. The shift from the falling interest rate scenario (FY01 to FY04) to a rising one (FY05 onwards) is expected to have telling impacts on the banking sector. While the former gave the players in the sector the comfort of lower cost of funds, windfall treasury gains and ability to write-off/settle NPAs, the latter will not be as benign. Here, we look at some of the early signs of the same. Credit - rate shy: While most banks started hiking their lending rates since 2HFY06 (post IMD redemptions), for players across the sector, it became pertinent to do so once the rise in funding costs became unsustainable. The funding pressure was accentuated in the sub-PLR loan portfolio, which needed an immediate rate revision, leading to most banks raising their PLR rates too. The mortgage loan portfolio witnessed rate hikes to the tune of 200 to 300 basis points as the risk weights on real estate loans were pushed up to 150%. With this, the incremental credit offtake showed a clear sign of deceleration and credit offtake declined by 1% YoY in the first two months of FY07. The decline in credit offtake was also evident from the falling credit to deposit (CD) ratios. The nominal CD ratio is currently at 69.9%. While on the face of it, this ratio may appear comfortable, it must be noted that the incremental CD ratio has sharply dipped. The Reserve Bank of India (RBI's) latest weekly statistical bulletin shows the incremental CD ratio at 43%, which is a three-year low. The same was over 125% in FY05!

The liquidity meltdown…
(Rs bn) As on 15/6/06 Growth/(Decline)
FY06 FY07
Food credit 391 46 (16)
Non food credit 14,541 360 (123)
Total credit 14,931 406 (140)
Demand deposits 3,314 55 (332)
Term deposits 18,048 731 604
Total deposits 21,363 787 272
Credit / deposit 69.9%
Source :RBI Weekly Statistical Supplement

Deposits - hard to come by: The liquidity dry up in the banking system coupled with the RBI's T-Bill auctions has left banks hard-pressed for deposits, more so for low-cost deposits. However, despite the revision in interest rates, the banking sector has witnessed a fall in demand deposits in the current fiscal so far. The term deposits have been better off due to the relative attractiveness of the same due to fiscal benefits.

Margins - lag effect: As can be seen in the adjacent chart, the net interest margins of banks have a clear correlation to movement in interest rates. While in a falling interest rate scenario, banks defer the passing on the rate benefit to customers (leading to sustenance of higher NIMs), in a rising rate scenario the same deferral happens in case pricing the assets higher (leading to early contraction in margins). The NIMs of banks across the sector have witnessed around 20-30 basis point contraction over the last fiscal.

Treasury - at mercy of Bond Street: The banks' treasury portfolio, which saw windfall gains during the falling interest rates scenario, bore the brunt of losses as the rates headed upwards. This was on both counts, provision for shift of investments to the HTM basket as well as booking of mark to market (MTM) losses in the AFS basket. Given this, with the 10-year G-Sec yield now hovering at 7.9%, it will be the banks that have majority of the investments in the HTM portfolio and sufficient floating provisions to meet the rising interest rate risks, which will stand hedged against treasury losses.

Delinquencies - learning from the past: In the previous upturn in interest rate cycle, the adverse impact on banks was the phenomenal rise in delinquency rates (going upto 14% in some cases). This time, however, banks seem to have learnt lessons from the past. Although the possibility of higher NPAs surfacing in the retail credit portfolio cannot be ruled out, banks have better appraisal procedures and provisioning measures in place to keep the same under check.

Investment in banking stocks...
While the above caveats should not be construed by investors as a guidance that investment in this sector is a no-no, what we intend to do is make you aware about the changes in the sector's dynamics. It is pertinent that the investment decision in a company in any particular sector is undertaken by considering the fundamentals of the sector. As certain players in the sector may enjoy a competitive edge (for e.g.: banks with above average NIMs, lower NPAs and sufficient floating provisions), investors would be better off keeping their portfolio de-risked by limiting themselves to these.

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