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The naked truth about Indian banks

September 02, 2004

Between July 1997 and October 2003, the yield on the most traded 10-year government security - a barometer for domestic interest rates - crashed by over eight percentage points (from 13 to 4.9 per cent).

The banking community watched this with glee, chased government securities with fat money bags and made huge profits on bond portfolios.

That was the first act in the Indian banking sector's turnaround drama. What we are witnessing now is the second act. Rates have started firming up. Since the beginning of 2004-05, the yield on 10-year gilts has increased by around 1.25 percentage points. Bankers are no longer smiling.

Instead, they are rushing to Mint Road, headquarters of the Reserve Bank of India, for a rescue package to ward off the impact of the rising yields on their balance sheets. If the rise in yields is not arrested, some of them may end up posting losses in their investment portfolios and bottom-line.

This is only one aspect of the unfolding banking drama. The other and more serious issue is that the reversal in interest rate movement will expose the vulnerability of a sector that was touted as strong and resilient.

Perhaps the best indicator of the banking industry's health is the levels of non-performing assets. On that basis, Indian banks seem to be quite healthy now.

At least one bank -- Oriental Bank of Commerce -- is a zero-NPA bank, while five other listed banks (Andhra Bank, HDFC Bank, IDBI Bank, Kotak Mahindra Bank and Vijaya Bank) have less than 1 per cent net NPA as on March 31.

But with the rise in interest rates, banks' net NPA numbers will go up. This is because Indian banks have been able to reduce the net NPAs by making huge provisions with the money made on their bond portfolios.

Once treasury profits drop, they will lack the wherewithal to tackle NPAs. At least two banks, HDFC Bank and Corporation Bank, have posted treasury losses in the first quarter of 2004-2005.

Simply put, the naked truth about Indian banking is that net NPAs dropped substantially over the last few years not on account of any dramatic improvement in the quality of assets or better credit appraisal and monitoring but huge provisioning.

So banks will face a double whammy. First, in absence of treasury income, their profitability will be hit. Then, they will be unable to make large provisions to bring down their net NPAs.

If they want to continue to make large provisions for NPAs, their profitability will be squeezed even more since the money will have to come from their interest income.

It is simple arithmetic. Thirty-five listed banks made Rs 15,452.18 crore (Rs 154.521 billion) profit from sale of investments in 2003-04. Out of this, Rs 14,482.47 crore (Rs 144.824 billion) was used for NPA provisioning. Why did they need to make such a high level of provisioning? Well, these 35 listed banks added Rs 19,239.42 crore (Rs 192.394 billion) fresh NPAs during the year!

The accretion of fresh NPAs ('slippages' in banking terminology) has been increasing. In the previous fiscal (2002-03), slippages were Rs 16,660.52 crore (Rs 166.605 billion). During that year, these banks made a provision of Rs 10,430.32 crore (Rs 104.303 billion). This matched the income from sale of investment (Rs 10,287.23 crore -- Rs 102.872 billion).

Let's take a look at the balance sheet of some of the big banks. The State Bank of India added Rs 4,688.57 crore (Rs 46.885 billion) to its sticky assets in 2002-03. The pile was raised by Rs 5,721.34 crore (Rs 57.213 billion) last year. Despite that, the bank's net NPA dropped from 4.50 per cent to 3.48 per cent.

This is because provisioning increased from Rs 2,958.68 crore (Rs 29.586 billion) to Rs 3,824.68 crore (Rs 38.246 billion). Most of this money came from its treasury profits - Rs 1,694.59 crore (Rs 16.945 billion) in 2002-03 and Rs 3,073.45 crore (Rs 30.734 billion) last year.

Similarly, Canara Bank's fresh NPA accretion jumped from Rs 1,227.65 crore (Rs 12.276 billion) in 2002-03 to Rs 1,890 crore (Rs 18.90 billion) in 2003-04. Despite that, its net NPA dropped from 3.59 per cent to 2.89 per cent.

This was possible because NPA provisioning zoomed from Rs 476.15 crore (Rs 4.761 billion) to Rs 1,238.63 crore (Rs 12.386 billion). Again, the funds mostly flowed from treasury profits -- Rs 640.09 crore (Rs 6.40 billion) in 2002-03 and Rs 1,206.67 crore (Rs 12.06 billion) in 2003-04.

This is the case with most of the listed banks (Click here to the see table). No wonder that they do not want interest rates to rise.

A 2003 January study on interest rate risk in the Indian banking system by two well-known economists says when interest rates go up, banks' bond portfolios suffer. A bond that has a duration of 10 years suffers a loss of roughly 1 per cent when the 10-year rate goes up by one percentage point.

A Business Standard Research Bureau study in mid-August shows that commercial banks, which are sitting on gilts worth Rs 7,00,000 crore (Rs 7,000 billion), have seen the value of their holdings depreciate by Rs 50,824 crore (Rs 508.24 billion) as the market value of actively traded gilts has dropped by 8.06 per cent since March 31 this year.

Of the 106 government securities valued at Rs 7,04,902 crore (Rs 7,049.02 billion), 61 securities valued at Rs 5,07,099 crore (Rs 5,070.99 billion) are actively traded in the bond market. The average price of 80 per cent of government bonds was Rs 124.50 at the end of March. It dropped to Rs 112.85 in mid August.

Since then, the situation has improved and the banks have cut their notional losses as the yield on 10-year paper which touched 6.64 per cent on August 11 dropped to 6.15 per cent. When the yield or interest rate on bonds goes up, the entire bond portfolio suffers as bond prices - which move in the opposite direction - go down.

It is not possible to assess the impact of rising rates on individual banks as the composition of their bond portfolios is not known. For instance, a bank with a bond portfolio of average maturity of two years will be less hurt compared with a bank with a bond portfolio of longer maturity.

This will lead us to the third act of the drama. Today, if you ask any banker how he plans to tackle rising rates, he would probably say that the absence of treasury income would be more than compensated by recovery of bad assets.

This may be optimistic; banks have been on the recovery trail for quite sometime. The rate of recovery of bad loans is unlikely to reach a level high enough to offset the loss of treasury income so quickly.

Banks need to return to their bread and butter business - giving loans - with a vengeance. Otherwise, not only will their profitability be hit but too many chinks in their armour will be exposed. It's time that easy banking gave way to busy banking.

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