The balancing act between growth and profitability does not come easy to most businesses. Those that manage to do so for a temporary period often get copied by peers and competitors. In the bargain, the fragmented market leaves little room for supernormal profits. This holds very true for the financial sector where any hint of callous growth can take a toll on profitability. At times there are players lending at very thin margins. This helps them grab market share from the larger players. But their own profitability takes a dip as margins fail to accommodate rising operational costs. In addition if the quality of assets proves dismal, there are additional losses to be written off. Hence the banking regulators keep a watchful eye on the capital base. The capital adequacy ratio (CAR) has come to be a yardstick for both growth and cushion against losses.
To further differentiate bank's capital from shareholders from that borrowed from long term lenders, it is bifurcated into Tier I and Tier II capital. Each economy has rules in place for its banks to sustain Tier I capital above a certain limit. Cases of banks with Tier I capital as low as 2% or 3% seeking bailouts have taught regulators how to be firm on this count. Hence banks in Europe and the US have had to raise capital and dilute near term returns for shareholders so as to strengthen their balance sheets. It is further estimated that banks in Europe and US will need Euro 1.1 trillion and US$ 850 bn respectively to keep themselves healthy over the next decade.
In India there are banks currently that can be called 'over-capitalised'. These hold Tier 1 capital well above the RBI stipulated 8%. Given the slower pace of growth in their asset books these entities have seen their capital shrink at a slower pace. But there are concerns whether holding too much capital is against the interests of their shareholders.
Important to note that however safe Indian banks may be, they were not isolated when it came to holding high capital base at the end of March 2011. In fact even banks in the US and Greece held Tier I capital close to 8% at the end of this period. Also there were hardly any nations in the US or Europe with Tier I capital less than 6%.
Thus even if shareholders in some Indian banks may be disappointed to see the current return ratios lower than expected, they need to look at the big picture. Equity dilution in PSUs for government funding or lower growth rate in some private sector banks need not be a signal for poor returns. In fact these may just be cases of the entities getting stronger or taking a conservative approach to growth. It would be best to not force them to sacrifice safety for profits. For only if they remain safe, will they deliver the long term returns.