The Hindu Business Line : PSBs: Performing assets, now

TIMES have never been better for public sector banks (PSBs). For years, even their business model was in doubt. All that has changed now. They are minting profits and the return on their assets has improved too . Waking up to their strengths, the market is cheering the PSB. What has caused the change? Two summers of rapid growth in balance-sheet size and a substantial decline in interest rates have done more to these banks than what recapitalisation by the Central Government did years ago.

PSBs are healthier now than they have ever been in the past decade. Concerns such as bad loans and high intermediation costs, which made them seem unprofitable and uncompetitive, are now in the background . Indeed, in the next 12-24 months, their outlook will only be to lower costs, lower bad loans and enhance profits.

Large spreads

Spreads in the banking business, the barometer of profitability, continue to be high. Spreads refer to the difference between interest income and interest expenses as a proportion of the funds deployed.

For PSBs, the spreads are between 2.8 per cent and 3.5 per cent. Spreads in the region of 3 per cent are a luxury but most bankers are confident of maintaining them at least in the next 12 months.

Banks will be able to maintain such spreads because the incremental cost of funds have been declining. They are now mobilising funds at costs that range between 4 per cent and 5 per cent.

The cost of funds is so low that it offsets the twin burden for PSBs — investment in government securities and bad loans.

Investment in government securities (gilts) typically earn thin or, at times, even negative spreads for banks. PSBs invest a substantial proportion of the funds raised in gilts and such spreads hurt profitability. On the other hand, provisions for bad loans erode the large positive spreads from advances.

Now, with incremental cost of funds being quite low, spreads on investment in gilts are less biting. That strengthens the ability of banks to deal with bad loans by, for instance, increasing the provisioning for the same.

In fact, if the yields on investments and advances do not decline as much as the cost of funds, then spreads can even improve.

Or, if interest rates decline, then treasury profits will be even more substantial. Better profitability is a distinct prospect. Marry such profitability with large volumes and you get the sunny situation that PSBs find themselves in.

Larger volumes

The growth in money supply sets the tone for the extent of volume growth possible for the banking industry. Money supply growth has been in double digits for the whole of the last decade. For 2003-04, money supply growth is expected to be about 11 per cent.

The balance-sheet growth of PSBs is also expected to be in double-digits this year. The only exception could be State Bank of India. As SBI redeems Resurgent India Bonds, there will be a decline in the size of its balance-sheet, which will need to be compensated through fresh growth.

However, more important than balance-sheet growth is the growth in advances. This is because growth in the size of the gilts portfolio is unlikely to be that helpful owing to the relatively thinner spreads. Indeed, most banks are looking at double-digit advances growth this year. For example, SBI, the public sector behemoth, is looking at an advances growth of about 16 per cent, while Bank of Baroda, which recorded poor advances growth in 2002-03, is targeting a growth of about 22 per cent.

Flush with liquidity

In fact, most PSBs are targeting a growth of above 11 per cent (which is the estimated growth in money supply) in their advances portfolio. This would require them to reduce the proportion of funds invested in government securities in 2003-04 compared to 2002-03.

Normally, that can be a bit dicey. That might even to lead to pressure on interest rates or from the government to invest in gilts. However, the situation is different now. The liquidity situation will allow them to do so without affecting the government's borrowing programme or the interest rates.

In fact, most PSBs are flush with liquidity. Banks such as Bank of India and Bank of Baroda have surplus funds of about Rs 4,000 crore. Going by these numbers, SBI may well be sitting with surpluses of Rs 15,000-17,000 crore. And the banking system as a whole may well be having a surplus of about Rs 50,000 crore.

Now, these funds are being lent as short-term loans to corporates or invested in short-term instruments. The catch here is: Only if the demand for longer-term credit picks up can they be lent as advances.

Brightening credit picture

As of now, credit offtake from the industry has proved to be much less than the growth in deposits. Banks such as SBI, Union Bank of India, Bank of Baroda and Bank of India have been saying that credit growth in the first three months of 2003-04 has been flat.

The prospects, though, are relatively bright owing to the following factors:

A normal monsoon, pick up in industrial growth and good export growth augur well for credit growth in 2003-04. Sooner than later, this is expected to lead to a pick up in demand for term loans.

In the absence of demand from industry, PSBs have been focusing on retail credit, in which, they have traditionally had a much lower share.

Retail credit, however, is a highly profitable business owing to high margins and low delinquencies. Sensing an opportunity, the PSBs have been going the whole hog on lending to retail customers.

Retail loan growth has been between 35 per cent (Corporation Bank) and 70 per cent (Canara Bank) for most PSBs. Importantly, they have also entered such segments as car and truck financing which non-banking finance companies, private banks and foreign banks hitherto dominated.

For 2003-04, the strategy would involve more of the same. Over the years, retail loans, which ranged from 9 per cent for Bank of Baroda to about 20 per cent for Corporation Bank, could rise to as high as 50 per cent for most PSBs.

They are also likely to emerge as the growth engine for the project-starved, but healthy, PSBs.

Interest rate, the spoilsport

THE only threat to this sunny scenario comes from interest rate increases. However, these do not automatically lower profitability. What matters is when the rates rise and by how much.

A rate rise of less than a percentage point will not harm the unrealised profits on the treasury portfolio of the PSBs. In fact, many banks have indicated that the treasury portfolio will withstand a rate shock of more than 2.4 percentage points. Indeed, the threshold will come down over the next few months if the low interest regime continues.

The threshold could come down to zero per cent after some time. However, at that time, if interest rates do rise, then the yield on advances will improve. That is, banks will earn more from their advances. At the same time, their cost of funds will not rise immediately. So, for banks, there is a positive side to any increase in interest rates.

Importantly, if interest rate increases are accompanied by volume growth (because of increased economic activity) then the rate increases offer even lower threat to profitability. Only in a scenario of high inflation-low growth will interest rate increases have a negative impact on bank finances.

As of now, the outlook is quite sanguine. Even if interest rates do increase, it is not likely to be by much. It does appear that these good times will last for at least the next 12 months for the PSBs. If the bountiful foreign exchange reserves position persists, it might be extend even longer.

Article E-Mail :: Comment :: Syndication

Stories in this Section
Raipur Alloys and Steel — To be cast away

PSBs: Performing assets, now

NPA management: The key to enhanced yields

Low-cost deposits: The arbiter of fortunes

Bank stocks are risky

Car finance options — Drive off with a smart deal

More wheels in each segment

Sensex free-float: A stock taking

Software sector — Beyond near-term concerns

Asset disposal — Sabotaging the sale

HDFC Growth: Sell