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Banking: Back to the basics

Jul 2, 2009

Historically, banks have played the role of intermediaries between the savers and the investors. However, in the last few decades, the importance and nature of financial intermediation has undergone a dramatic transformation the world over. While on the positive, this has led to better functioning of financial markets, the negative aspect has been characterized by bubbles, the latest one bursting in early 2008. However India, on the back of the RBI's prudent monitoring, has largely come out unscathed of the banking crisis that has engulfed the entire developed world. The Economic Survey has highlighted this aspect very well. As it has indicated that while practitioners of monetary policy in India, as in other countries of the world, have faced an extraordinary economic situation in the recent past, we have remained largely untouched by the fear psychosis that has come to define modern day banking in the west.

Despite this though, the Indian banking sector led by the RBI also faces some challenges, mainly:

  1. The need to strike an optimal balance between preserving financial stability;

  2. Maintaining price stability;

  3. Anchoring inflationary expectations; and at the same time

  4. Sustaining the growth momentum.

The survey highlights the fact how the RBI, during the first half of FY09, endeavoured to control monetary expansion through increases in its benchmark interest rates - the cash reserve ratio and repo rate. And then, during the second half, how it (the RBI) facilitated monetary expansion through cutting these rates again.

With respect to the banking sector in particular, the survey has highlighted that the continued boom in the economic activity that had led to significant expansion of credit by commercial banks for three years in a row, moderated during 2008-09. Though bank credit to the commercial sector witnessed strong growth in the first half of the year, it decelerated particularly in the second half. For the full year, bank credit to the commercial sector grew by around 17%, as compared to a growth of 21% in 2007-08.

During the year, the banking sector also recorded a moderation in credit growth, which slowed down to almost 17%, from a level of 22% in the previous year.

While loans to agriculture & allied activities grew by 23% during 2008-09 (20% during the previous year), credit to industry (comprising of large, medium and small scale sector) grew at almost 22% (down from around 24% during the previous year). Within the industry group, the deceleration was noticeable in credit to food processing, textiles, auto and auto ancillaries, and transport equipment segments. Personal loans recorded a growth of just around 11% (as compared to 12% growth recorded in 2007-08).

Bank credit to productive sectors of the economy has a critical role in sustaining the growth process. The last few quarters have been testing times for Indian commercial banks as they operated in a situation of very tight liquidity and steep borrowing costs. The RBI's measures of rate cuts (through CRR and repo rates) and special liquidity windows solved the problem of short term liquidity since the second half of 2008-09. Also, with the upward re-pricing of loans, most banks have been able to report stable net interest margins (NIMs) during the year.

Further, the incremental credit growth remained in excess the RBI's targets until 9mFY09 as banks deployed the funds derived from high cost term deposits. However, in recent months, the economic slump has had a negative impact on credit growth. With little upside in margins, banks are expected to rely heavily on their fee income generating abilities in addition to their operating leverage. Also, most banks envisage higher slippage rates and provisioning costs in the next fiscal, which may eat into their profits. Having said that, the Indian banking sector continues to remain very healthy as compared to its global counterparts in terms of systemic risks and safety of depositors' money.

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