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Banks: Back to the future!

Jul 15, 2005

As the Bankex touches news highs in consecutive trading sessions, it becomes pertinent to scrutinize and conclude whether the fundamentals support such valuations. The government's liberal stand on banking reforms and the economic buoyancy has also in more ways than one supported the 'optimism' towards the sector. In the following article, we take stock of what aspects are expected to drive the sector's future growth.The positives...


Credit growth to sustain: The renewed growth in incremental credit offtake that has been witnessed since the latter half of FY05 is expected to continue in FY06. The same can be justified on the following grounds:

  • Low credit penetration: Despite the credit growth being at all time high levels, the penetration of the same remains very low in India as compared to other developing nations of the world. Besides, the loan to GDP ratio in India being fairly low at 37%, retail loans (consumer credit) as a percentage of GDP in India at 7% is abysmally lower as compared to an average of 45% for other Asian countries (Source: RBI and World Bank).

  • Strengthening of the capex cycle: A buoyant economy and need for capacity expansions coupled with lower interest rates is driving the corporate demand for credit. The differentiating factor here is that the demand is now emanating from the mid-corporate and SME segments alike and not restricted to the large corporates. Besides, on our meetings with the bankers we were also able to comprehend that while the smaller corporates have been borrowing for their capex needs, the AAA-rated ones are fulfilling the same through internal accruals. However, going forward the banks expect capex credit demand to emanate from this segment also (albeit at lower yields).

  • Infrastructure investments: Besides corporates, the government's thrust on infrastructure investment is expected to be another trigger for credit demand. The current rate of infrastructure investment in India at 3.5% of GDP is well below the target rate of 8.0% proposed by the Expert Group on Commercialisation of Infrastructure Projects (Source: ADB). Also, the share of private players is expected to rise from 20% to 40% in the next 5 years, thus propelling the incremental credit demand.

Treasury portfolio well hedged: Thanks to the Reserve Bank of India (RBI)'s intervention, most banks have been able to shift a major part of their investment portfolio to the held to maturity (HTM) category from the (available for sale) category. This was in the wake of safeguarding their portfolios against the depreciation in values due to a rising interest rate regime. Also, banks that have not transferred a substantial proportion to the HTM category, have hedged themselves by provisioning for a rise in bond yields. Given this, the possibility of treasury losses impacting bottomline has reduced.

Better asset quality: Most banks have not only adopted stricter vigilance on asset quality to arrest the incremental delinquencies, but have also made adequate provisioning for the same. The improvement in asset quality has thus not just improved their valuations (with less erosion from book value), but has also reduced their liability for future provisioning.

Benign policy initiatives: The RBI's policy initiatives by way of opening up of the sector to foreign players and facilitating the consolidation of the sector are expected to augur well for the domestic players in the longer term, as they will become more competitive and capitalise on the economies of scale.

The negatives...
Low scope for Tier I growth: In case of PSU banks, the scope for increment to Tier I capital is limited given the fact that most banks in this sector have reached the minimum government holding limit beyond which government's stake cannot be divested. Due to this, these banks can now only resort to Tier II borrowings that will call for higher cost and lower margins. Additional capital requirement is also pertinent for the private sector entities to meet the Basel II capital adequacy norms.

Margin pressures-dampening effect: Although the projections for credit volumes remain robust, the spread on the same is likely to diminish due to rising interest rates. Inflationary pressures, rise in global interest rates (like Fed rates) and higher need for deposit mobilisation will only add to the interest costs of the banking entities. Passing on of the same to the consumers will however not be instantaneously possible. This may cause their net interest margins to shrink and have a dampening effect on their topline.

To conclude...
Although the temporary hiccups in the sector's margins are well anticipated, we remain positive on the sector's long-term prospects. Economic growth targets and need for financial maturity also call for higher investment and government focus on the sector. While the efficient and stronger entities are well poised to benefit from the sector's prospects, the future of the other entities will remain in terms of 'survival of the fittest'.

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