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Banks: Interest rate concerns - Views on News from Equitymaster
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  • Nov 18, 2003

    Banks: Interest rate concerns

    The RBI has come out with its latest report on Trends and Progress of banking in India for 2002-03. While most of the central bank's statistics indicate improving fundamentals of the Indian banking system, there is one aspect that the Reserve Bank Of India (RBI) is concerned about. This is the strong dependence, currently, of Indian banks, especially public sector banks, on trading income (profit from sale of investments). The RBI has highlighted that the large policy-induced changes in the interest rate environment have brought forth the issue of interest rate sensitivity of banks' balance sheet.

    This means that the bottomline of most banks in the country is to a large extent dependent on the kind of trading profits they make. And trading profits are largely dependent on the interest rate scenario prevailing in the country. This means that as of now there is a direct linkage between the interest rates and bank bottomline. The RBI in order to ensure that banks are adequately protected from any contingency arising from a rising interest rate environment had advocated the need of an Investment Fluctuation Reserve (IFR) to be set up by each bank.

    Just to highlight the extent of the dependence, according to the RBI, old private sector banks depended heavily on securities trading which contributed over 50% of their operating profits both in 2001-02 and 2002-03. Even the largest bank in the country, State Bank Of India (SBI), is not insulated from this risk, as trading profits contributed nearly 25% of its operating profits. While this was lower compared to the system average of 33%, it shows the high dependence on trading profits.

    Banks have made provisions for the IFR, but the RBI's prescribed extent is of 5% of investments in the next five years. Of all the bank groups new private sector banks were seen lagging behind their other peers in terms of provisioning for IFR. By FY03 the provisioning done by new private sector banks was only 1.1% of their investments compared to 2.1% for old private sector banks and 1.9% for foreign banks. Even public sectors banks had an IFR, which was 1.8% of their investments. We must understand that old private sector and public sector banks are more susceptible to interest rate risk (due to a relatively older portfolio of G-Secs) and hence the rush to make higher provisioning for IFR.

    By this article we are trying to highlight the fact that while banks have been able to post strong bottomline growth in the last three years, investors need to understand that it has been to an extent due to large gains from trading. While interest rates are soft as of now, any upward movement in the same is likely to adversely impact these trading profits and hence we may not see bottomline growth as seen in the last 2-3 years. The IFR is a cushion for this type of contingency. It is time to tone down one's expectations (regarding bottomline growth) and keep a close watch on the movement of interest rates in the future, as this will to an extent determine the profitability of a large number of banks in the country.



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