The Reserve Bank of India (RBI) orchestrated thirteen consecutive rate hikes over the past 18 months, in its attempt to curb high inflation. It has been one of the most aggressive central banks on this front in the whole of Asia. These multiple rounds of policy action have been the quickest pace of monetary tightening India has ever seen. Believe it or not, but these rate hikes have actually benefitted some banks. Higher policy rates caused banks to correspondingly hike their base rates. This in turn led to higher yields on loans. Banks that could control their borrowing costs saw an increase in their net interest margins (NIMs), a key measure of a bank's profitability.
But now, the RBI is putting these higher margins into question. Indian banks earn much higher NIMs than their global peers. Banks in Europe fare especially poorly on this account. The range of Indian bank's margins was in the range of 2.5-3.1%, while some developed countries' banks struggle to even maintain NIMs at around 1.5-2%. This year banks in India have seen their margins improve on account of re-pricing assets at higher rates. Thus, most of the improvement has come from passing on higher rates to customers. This is despite the fact that most banks have not yet passed on the past two rate hikes, cumulatively 0.5%, to their customers.
Irrespective of this, higher rates have hit the industry hard. The costs of capital have gone up sharply for businesses in India. The financial results for the second quarter of 2011-12 (2QFY12) have been poor on account of ballooning interest costs. In order to fulfill its dual interests of safeguarding the economy as well as regulating banks, the RBI believes that banks' profits should come down. It believes that if banks want to maintain or increase their profits, it should come from other income, and not by simply increasing the costs of funds. As the banking system evolves, NIMs are expected to moderate. Margins get squeezed and banks are expected to look towards other sources of fee-based income.
The RBI may be right that banks should not profit from just maintaining a wide spread between the cost of borrowing and the cost of lending. But, maintaining spreads at low levels may force some banks to opt for other means to jack up their profits. Trading in complex instruments such as exotic derivatives, collateralised obligations, etc may lead to short term gains. But, they can also cause the collapse of age old institutions like Lehman Brothers and Merrill Lynch. However, we believe that the RBI is a prudent regulator and Indian banks are generally risk averse and do not have much exposure to such assets. The rising levels of NPAs, slowing credit growth and tight liquidity are bigger concerns at the moment.