It is party time for retail investors. With rapid increase in interest rates on term deposits, investors are laughing all the way to banks to park their money. In the last three months, banks have frequently raised interest rates in a mad rush to raise funds. Since September this year, interest rates on bank fixed deposits have gone up from around 6.50 per cent to around 9 per cent (senior citizens get 0.50 per cent more) in most leading banks - a rise of 250 basis points.
While the investors are rejoicing, banks are not. They are forced to offer high interests to lure away investors from other banks and to overcome a severe liquidity crunch in the banking system. With the country’s economic activities reviving, credit growth has picked up faster but deposit growth failed to keep pace. Banks now fear that if the deposit rates keep growing unchecked, the entire sector will see a drop in net interest margins and in profits in the next financial year of 2011-12.
Asset liability mismatch
According to the Reserve Bank of India, the credit growth in the banking sector between April-November 2010 was 23 per cent while deposits grew by only 15 per cent during this period. Data for some large banks are pointers: largest bank State Bank of India saw credit grow by 20 per cent but deposits grew by only 11 per cent. In the case of Corporation Bank, the figures were 33 per cent and 20 per cent, respectively.
There are several reasons for the liquidity crunch. In the middle of 2010, around Rs 1,06,000 crore was collected by the government by auctioning spectrum for 3G mobile telephony and BWA (broadband wireless access). Through disinvestment of PSU shares, it got another Rs 60,000 crore. While money went out of the system, the governments - central and state, are not spending enough in the planned schemes.
State Bank of Mysore Chairman Dilip Mavinkurve pointed out two other reasons for funds crunch: large FII outflow from the stock and bond markets and drying up of the CD market. FIIs (foreign institutional investors), who had invested heavily in the Indian stocks and bonds till around September 2010, started taking cash out mainly on the concern of weakening rupee and scams affecting Indian stock markets.
Banks also raise short term money by issuing CDs (certificate of deposits) to bridge the asset-liability mismatch. Sensing a great opportunity, short term lenders like cash rich corporates, have also jacked up the rates. “CD rates are very high as they have reached close to deposits rates of 9 per cent,” said Mavinkurve.
Advance tax paid by corporate India is yet another reason. SMC Global Securities Limited Strategist & Head of Research Jagannadham Thunuguntla pointed out, “There has been large outflow of liquidity due to the advance tax payments made by the corporates in December. The result has been that the banks have been borrowing huge amounts from the RBI over the past few weeks.”
A large part of the funds in a bank comes from current accounts and savings accounts (CASA) where the banks pay only 3.5 per cent interest or nothing. The share of CASA in total fund for some large PSU banks varies between 30 and 40 per cent. But with the deposit rates going up, account holders now are transferring money from savings to FDs leading to the depletion of low cost fund for banks. Investors are also moving deposits from one bank to another to reap benefits of higher interest rates. Banks having lower CASA ratio depend more on bulk deposit from corporte and mutual funds, hence, they these banks’ interest margins will be impacted more than those who have higher CASA ratio.
While the cost of funds is going up, lending rates cannot be raised beyond a limit. Since July last year banks are fixing lending rates on the basis of ‘Base Rate’ while the earlier borrowers are under the earlier system of Prime Lending Rates (PLR). As cost of deposits is always factored-in in the base rate, most banks have already raised their base rates to around 8.5 to 9 per cent. They have also raised the PLR, with which 70 per cent of the bank loans are linked, to around 12 to 13 per cent. The PLR of private sector banks are generally 100 to 150 bps more than PSU banks.
The lending rates may go up again by around 25 to 50 bps, if the RBI decides to raise policy rates. But the question is, can or will the borrowers accept higher interest rates every time the banks deposit rates go up? Resistance is already building up. In a recent representation to the Finance Minister, industry associations like Ficci, CII and Assocham pointed out that the Indian companies already pay one of the highest interest rates in the world and if the cost of funds goes up further, many will be forced to shut down or curtail production.
The latest data on index of industrial production shows that the growth rate in industrial activity had slowed down to just 2.7 per cent in November 2010 and analysts blame high cost of fund as one of the reasons. Recently, Ficci President Rajan Mittal said, “Let the interest rates not be hardened up because industry is in the investment mode.”
Bankers also understand that they cannot keep raising lending rates jeopardising the industrial growth. In a recent representation to the RBI, bank CEOs requested the central bank to cut the statutory CRR (cash reserve ratio) and the SLR (statutory liquidity ratio), besides asking for retention of key policy rates unchanged. Talking to Deccan Herald, Indian Banks Association (IBA) Chief Executive K Ramakrishnan said, “RBI should take measures to ease the liquidity in the banking system. Current situation is far from being comfortable.”
CRR is the fund banks have to park with the central bank and SLR is the quantum of prudential reserves that banks keep in the form of government securities, bonds etc. SBM’s Mavinkurve, making the same plea, pointed out that if the RBI reduces the CRR by 1 percentage point, it will bring Rs 70,000 crore liquidity in the system. Rising interest rates are also eating away bank’s income and profits from treasury operations. When interest rates rise, value of government securities, held by banks as a part of treasury activity, drop in the bond market leading to loss in market value. The reverse happens when interest rates go down. Thunuguntla said, “Banks’ net interest margins may take a beating but more due to losses on the treasury portfolios of banks rather than just due to increased cost of deposits.”
Analysts and stock brokers too think that banks’ profits will be under pressure. Fearing drop in profits investors are selling bank stocks leading to major erosion in their values. Reflecting the market apprehension the Bombay Stock Exchanges’ 14 share banking index Bankex, for example, has dropped 20 per cent in the last 70 days. Share price of country’s largest bank SBI has dropped by Rs 1,010 or 29 per cent to Rs 2,490 from Rs 3,500 two months ago. During the same period, ICICI Bank lost 263 points or 21 per cent and the new generation Yes Bank lost 128 points or 33 per cent. Commenting on bank stocks taking a beating, Mavinkurve said that investors seem to have overreacted and he does not expect much of an impact on banks profits in the December and the March quarter. “If the interest rates continue to rule high and liquidity remains tight, we may see a reduction in bank profits in the next financial year,” he warned.
Banks are aware that external factors will put pressure on profit margins and that is why they are looking internally to cut cost and improve efficiencies. SBM, for example, has plans in place to attract more people to open savings and current accounts with them. This will help the bank maintain CASA ratio at 32 per cent and in turn provide low cost of fund. The Bank has also decided that it will not chase borrowers beyond a particular yield rate. Mavinkurve said, “We would rather sacrifice some growth in business rather than compromising on yields.”
The new age private banks, on the other hand, have become quite aggressive in diversifying their revenue streams in the form of Fee-based income, said Thunuguntla. After a couple of years of lull, banks have also become aggressive in the retail loan markets like home, auto, education and personal loans where higher cost of fund can be passed on easily to the consumers. Bankers also expect that the liquidity may soon improve as the central and state governments will start spending in February and March.
Trying times will separate more efficient banks from the laggards. Investors in bank stocks should be very selective and look for winners in terms of lower cost of fund, larger share of fee-based income (as opposed to fund-based income), lower employee cost, superior loan portfolio and low non-performing assets.