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Who is left out of the party?

November 05, 2003

Providence could not have given Y Venugopal Reddy, Governor of the Reserve Bank of India, a better headstart.

Few RBI governors have had a more pleasurable task than his, of simultaneously hiking the projection for the growth rate and lowering the projection for inflation. Hence he and his colleagues have done what is most sensible: put the Monetary Policy on autopilot for six months.

His cup of good fortune seems to run over, just as that of Alan Greenspan did through the Clinton years right up to the point the technology bubble burst in 2000.

In these good times, it is necessary to ask what lies at the root of the continuing improvement in the health of banks -- something that has contributed greatly to the Reserve Bank of India's comfort level.

The most significant component of profits during falling interest rates is treasury profits, more specifically those earned from the sale of old high coupon government securities.

The most recent shot of this was the government buying back its old high cost paper and giving banks a bonus.

This is a win-win situation for both the banks and the government. It is fine so far as it goes, particularly when the windfall gain has been used, as in the case of State Bank of India, to make additional provisions and sharply bring down the NPA level. But, this may not last.

The Credit Policy has chosen not to coax interest rates down further and during a period of steady interest rates, banks' ability to profit out of the sale of governments securities will sharply diminish. Where will profits then come from?

To answer this, let us take a look at the other component of bank profits -- handsome net interest income. The device is as simple as it is effective. When interest rates fall, the first to do so are those that poor savers get. Then come the interest rates for borrowers.

Not only do these not fall by as much as those for savers, smaller businesses have a hard time getting any kind of benefit out of falling interest rates. The most undramatic part of banks' results has been the growth in advances, as opposed to personal loans.

The good news here is that the RBI sees a recent pick up in credit offtake.

With a broad-based economic recovery on the way, hopefully advances will grow at a faster rate than in the recent past and the RBI has promised to ensure that there is enough liquidity to make available the required credit.

It is only when banks register a healthy growth in interest income, as opposed to net interest income, that they will be seen to be on a sustainable and healthy growth path.

A steady stream of fee-based income is another stabilising element in banks' profits but it is only the more efficient banks, both private and public sector, which can be expected to have a fee-based income of any consequence.

In the search for a banking system which will serve the needs of broad-based growth, attention has inevitably turned to rural credit.

Dr Reddy has candidly admitted that so many institutional innovations have been tried, from bank nationalisation to supporting the cooperative credit movement, but the credit needs of the rural Indian go unmet by the organised sector.

He has been bold enough to rhetorically declare that he would happily allow the panchayats to lend if they could handle the job.

Rural lending, along with support to micro credit organisations, offers a key growth opportunity to banks which have lost their prime corporate customers through the process of disintermediation.

Other than rural borrowers, smaller businesses also make up a key segment which has largely been left out of the party.

Rates of interest have gone down for large companies and those seeking personal loans but not for the smaller businesses.

Hence, RBI's ongoing effort to have a single prime lending rate calculated in a transparent and scientific way so that it is easy to see if a borrower is getting the short end of the stick after taking into account the markups needed for risk and tenure.

Banks need to lend profitably to small businesses and the rural sector holds the key to both successful monetary management and continued economic growth.

But relatedly, and even more fundamentally, banking costs and margins have to go down for the economy to keep progressing down the road towards greater competitiveness.

When the entire manufacturing sector is reaping the benefits of reduced costs and reorganising for greater efficiency, financial intermediation cannot remain a high cost island.

There is much more to serious cost cutting than going in for a couple of rounds of VRS, with amortisation costs comfortably spread over several years.

Extensive adoption of IT is also a must but will not deliver by itself the full results. Banks have to change the way they work, redo their processes, so that the gains from IT can be utilised to the full and staffing levels can be brought down much more.

Being a service operation where wages are a key element in costs, there is no reason why Indian banking should not be the least costly in the world.

There is also no reason why quality levels in banking should not aspire to the same high levels as software services. This will come only if business survival depends on it.

And this is where the regulator comes in. The RBI has so far carefully constructed market conditions which allow banks to make handsome profits that can be ploughed back into provisioning to take care of past sins.

Banks have also made marginal improvements in the way they run. The combined impact of these on banks' bottomlines is the bull run in bank shares.

The future of monetary management and also bank valuations will depend on how much banks are forced to look at neglected market segments with clear commercial eyes.

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