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A Budget for banks?
February 26, 2003 10:14 IST
Whichever way one looks at, banks are likely to be benefited the most from this budget
Current industry status
The Indian Banking industry has been undergoing rapid changes reflecting a number of underlying changes. Liberalisation and deregulation witnessed in the Indian markets in the 1990s have resulted in a spurt in banking activity in India. Significant advances in communication have enabled banks to expand their reach, both in terms of geography covered as well as new products introduced. With increased competition in wholesale banking due to the entry of foreign banks and new private sector banks, the sector has witnessed a squeeze in margins. This has led to banks increasing their focus on retail banking so as to obtain access to low cost funds and to expand into relatively untapped, potential growth areas. Banks and financial institutions are thus continuously exploring new avenues for increasing their footprint and safeguarding their margins.
Competition from multinational banks and entry of new private sector banks has rewritten the rules of the retail lending business in India. Slow growth in corporate lending, pressure on corporate spreads due to competition and concerns over asset quality have induced public sector banks to follow the private sector banks in placing emphasis on growth through expansion of retail portfolio.
The Indian retail lending market is relatively unexplored with the per-capita usage of retail product offerings such as housing finance, credit cards, auto loans, consumer finance, etc. lower as compared to Asian peers. Also the relative size of the Indian market, backed by factors such as a growing population of bankable households, low penetration rate for retail finance products and the increased propensity of the urban populace to take credit, offers scope for expansion.
In retail financing most of the players are trying to enter or consolidate their housing finance segment, as housing loans market is perhaps the least risky segment in the financial sector. Housing finance companies (HFCs) generally target the retail borrower where the nature of the loan ensures that defaults are few and far between. The relatively small size of a housing loan also ensures the risk is well spread out. Moreover pursuance to the government's policy to provide shelter to a large number of people and concessions provided in the Finance Act to boost housing and housing finance activities indicates great future potential for this segment. Interest paid on capital borrowed for the acquisition or construction of property is entitled to a deduction. A couple of years ago, the maximum amount eligible for deduction was Rs 15,000 and then got doubled to Rs 30,000. Later, the amount got further enhanced to Rs 75,000 and is now Rs 1,50,000.
The growth of banking industry is closely interlinked with the growth in the economy. Slowdown in economy in the past few years meant lower credit offtake. With lower demand for credit, banks had no option but to invest in low yielding Government securities (G-sec). However with the recent recovery in economy the credit offtake is likey to pick-up and pick-up in credit offtake means deploying funds to the commercial sector and earning a higher return than G-sec. Recovery in the select sectors, like steel, textile and capital goods which have high credit consumption, has lead to pick-up in credit offtake. This clearly means a good topline growth for the banks.
Moreover falling interest rates have led to appreciation in value of G-sec and given chance to banks to book huge treasury profits. Last year many banks booked handsome profits on appreciation in their value of investments. In the current year also the same trend continued, thus helping banks to continue to make good treasury profits. This year even the interest spreads are expanding as banks are aggressively reducing their borrowing costs and benefits of past deposits getting renewed at lower rates are materialising
Apart from above the major problem faced by the banks in India was the rising Non Performing Assets (NPAs). While fresh NPAs kept adding every year to the pile of old NPAs, recoveries was very difficult and time consuming. Besides the genuine business failures, extent of willful defaults and diversion of funds was rampant. With the enactment of The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 (The Securitisation Act), banks have been empowered to attach assets of the defaulters without intervention of lengthy and time consuming court procedures.
This has suddenly turned the tables in favour of banks. Till recently, debt recovery was one of the most hopeless jobs in India due to archaic laws, which were totally tilted towards borrowers. Banks were in fact at the mercy of borrowers' willingness to pay. Thus in spite of the fact that most borrowing is against security, the value of which is often higher than the loan, banks still could not do much except cajole and tempt borrowers to pay up. Huge NPAs were burdening the entire banking sector. Not only large portion of banks' profits were going towards providing for these NPAs, they also reduced their capital adequacy reducing their capacity to expand business. Due to the fear of increasing NPAs, their willingness to lend and expand business was also adversely affected. It is expected that over the next couple of years, banks will be able to significantly clean up their NPA mess due to the Securitisation Act.
Further the government is considering a proposal to begin a second round of the Voluntary Retirement Scheme (VRS) for banks. The manpower for each bank will be determined by customer profile, network of branches and the level of computerisation. In the first phase, around 100000 people had opted for the VRS scheme offered by various banks. This had reduced the manpower of banks by 12-15% and helped banks to improve their productivity and profitability significantly.
Most recently the trend observed in the banking industry is the sharing of ATMs by banks. Sharing of ATM network will minimise geographical overlap of ATMs and provide better coverage to customers. At the same time, the sharing helps the banks to develop economies of scale and minimise the cost of servicing customers.
Advancements in technology have helped aggregation of information as well as effective dissemination of financial activity, apart from rationalisation of cost structures. Banks are increasingly adopting technology as a platform for their product offerings so as to differentiate themselves from competition. Technology has revolutionalized the delivery chain for financial products and services with ATMs, Home banking and Telephone banking taking the place of banking at bank branches.
Prevailing tax rates and provisions
The fiscal policies are the domain of the government, while the monetary policy is the domain of Reserve Bank of India (RBI). It has taken various measures to adjust the money supply in the economy in accordance with the internal and external business environment prevailing.
- Bank rate reduced to 6.25%
- Cash Reserve Ratio (CRR) reduced to 4.75%
- Capital Adequacy Ratio is equal to the ratio of TIER-I and TIER-II Capital to the Aggregate of Risk Weighted Assets (RWA). However, TIER-II capital cannot be more than 50% of TIER-I capital. Currently the banks have to meet the CAR requirement of 9%. It is proposed to hike the CAR to 12% by 2004 based on the Basle Committee recommendations. Thus it is expected that the CAR requirement may be hiked in the current budget. Housing finance companies have to maintain the CAR of 12%.
- The foreign bank can hold by to 49% in a private sector bank, while for public sector the same is at 20%.
- No shareholders can exercise voting rights on poll in excess of 10% of the total voting rights of all the shareholders for private banks and State Bank of India, while for other PSU banks the same is just 1%.
- The RBI has stipulated certain ceiling relating to advances and interest rates which banks have to adhere to which carrying out their lending operations. Some of them are as follows:
- Exposure to a single borrower should not exceed 15 % of advances.
- Exposure to a business group should not exceed 40 %
- Exposure to stock market should not exceed 5 % of total advances as at the end of previous year.
- 5% of profits earned through investments to be set aside as ‘Investment Fluctuation Reserve' for a period of five years beginning financial year 2001-02.
- Foreign banks can either operate as branches of their parent banks or to set up subsidiaries.
- According to RBI guidelines unsecured portion of NPAs has to be fully provided for in 18 months, and the secured portion has to be provisioned over five and a half years. Further they are been advised to gradually move to international best practice of 90 days for classifying troubled assets from the current 180 days
- Banks are allowed to deduct upto 7.5% of their total income against provisions made by them for bad and doubtful debts
- Setting up of Asset Reconstruction Companies (ARCs) for providing Banks and FIs to tackle the problem of NPAs and develop market for securitised debt. However no ARC has commenced operations as yet.
- Most important long-term measure in containing the growth of NPAs is radically altering the bankruptcy and recovery laws and procedures. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 on Banking Sector Reforms has been passed by Parliament recently to strengthen creditor rights through foreclosure and enforcement of securities by banks and financial institutions
- Interest payable on housing loans for self-occupied houses even where such houses are acquired or constructed after 31st March 2003 allowed for deduction. The maximum amount eligible for deduction from income tax currently is Rs 1,50,000.
- National Housing Bank (NHB) commenced securitisation of housing loans and easier foreclosure of mortgages. It will also launch a Mortgage Credit Guarantee Scheme.
- Exemption of dividend tax completely - neither the bank nor the recipient to be taxed.
- Higher tax break for provisioning of bad loans. Banks & Financial Institutions (FIs) are suffering from NPAs as such it is retrospective, which has its assessment problems. So long as provisioning of NPAs is according to RBI norms within the stipulated time frame, or on an accelerated basis the amount provisioned should be treated as deductible for tax purposes.
- Increase in FDI cap of 20% in PSU banks and exclusion of ADR/GDR holding from FII limit, as more and more foreign banks have evinced interest to picking up stakes in Indian banks. Also the Government intends to reduce its holding to 33% in banks.
- Removal of 10% voting right restriction for private banks.
- Abolition of 5% service tax.
- Reforms in co-operative banking systems.
- To allow to issuance of infrastructure bonds for long-term funding.
- Permission to Banks to raise Tier II capital overseas.
- Announcement of second round of VRS for banks.
- Sops for Corporate Debt Restructuring (CDR) in Steel, Textiles and Chemicals etc. to reduce NPAs.
- Increase in exposure limits to capital markets from 5% of incremental deposits to 8-10% to improve credit flow to capital of markets.
- Kelkar committee has recommended drastic reduction in tax exemption for interest payable on housing loans from Rs 1,50,000 to Rs 50,000. This should be implemented gradually over a period of time.
Companies to watch
Top picks in this sector are State Bank of India, Punjab National Bank, Canara Bank, Corporation Bank, Bank of Baroda & ICICI Bank.
The banking sector is poised to grow in line with growth in economy. Their balance sheets are getting cleaned up faster than earlier. Also interest rates are likely to remain soft thus helping banks to reduce cost of funds and earn higher treasury gains, recent fall in their prices notwithstanding. Any reduction in corporate tax rates or surchargs will also benefit banks as they are largest tax payers. Abolition of tax on dividend will also make banks more attractive as banks in general offer higher dividend yields. Further move towards simplified FDI norms will improve the valuations of PSU banks. We expect a bullish trend in bank stocks to continue, as valuations remain attractive.
Run-up to the Budget 2003