Bank profitability set to fall

Higher salaries, declining spreads and lower fee incomes will ensure this.

Macroeconomic headwinds in 2006-07 and 2007-08 have resulted in substantial fluctuations in banks' profitability. Rising interest rates in 2006-07 and the first half of 2008-09 raised banks' overall cost of borrowings; as yields on advances and investments did not keep pace, banks' profitability suffered.

Moreover, the RBI's use of reserve ratios, statutory liquidity ratio and cash reserve ratio as monetary policy tools affected banks' profitability: No interest is paid on CRR balances, and the interest yield on SLR securities is far lower than the yields on advances.

By the time the RBI relaxed reserve requirements in October 2008, reducing CRR and SLR to 5 per cent and 24 per cent respectively -- from 9 per cent and 25 per cent -- the effect on banks' profitability was already apparent.

For these reasons, after 2004-05, when banks' net profitability margin peaked at 1.63 per cent, their core profitability has been on a declining trend; by 2007-08, it had reached 1.40 per cent.

CRISIL believes that banks' core profitability remained under stress in 2008-09, with the system NPM estimated to have reduced to 1.26 per cent; a further drop to 1.19 per cent is projected for 2009-10.

Rising Cost Of Deposits For Banks

The hardening of interest rates, acting in combination with a steady increase in CRR between 2004-05 and 2007-08 resulted in an across-the-board increase in banks' overall cost of resources.

Further, strong credit growth, and a shift in the deposit-mix towards expensive term-deposits, added to the pressure on banks' CoB. The Indian banking system experienced credit growth averaging 28 per cent annually between 2002-03 and 2006-07.

To fund credit growth, banks started vying for big-ticket term-deposits. In addition, the tenure of term deposits started shrinking. Because interest rates were increasing, banks were forced to re-price deposits at renewal. Pricing pressure and a paucity of retail deposits compelled banks to offer higher interest rates on retail term-deposits.

The double impact of business-led upward pressure on cost of deposits, and tighter monetary policies, saw banks' cost of deposits rise to 6.1 per cent in 2007-08, from 5.1 per cent in 2006-07. CRISIL estimates that the cost of deposits has further increased by about 50 basis points (bps; 100 bps equals 1 percentage point) in 2008-09, to around 6.6 per cent.

Yields Fail to Play Catch-Up

RBI's liquidity-tightening measures, especially the increase in CRR, left no option for banks but to increase prime lending rates. Between 2005-06 and 2007-08, banks increased their PLRs by 150 to 200 bps, causing yields on advances to increase to 8.56 per cent in 2007-08 from 7.92 per cent in 2006-07.

Although yields did increase to some extent, they did not keep pace with the sharp increase in CoB. Banks also suffered because of the negative carry on SLR portfolios, as term-deposit rates rose faster than yields on incremental SLR portfolios (yield on 10-year government securities moved in the range of 7.48-8.32 per cent during 2007-08).

The combined effect of increasing CoB, negative carry on SLR portfolios, and zero interest on CRR, was to severely constrain banks' spreads. The system average interest spread declined by 32 bps, to 2.31 per cent in 2007-08, from 2.63 per cent in 2006-07.

CRISIL estimates that the yield on advances has increased by 63 bps in 2008-09, driven by higher yields on corporate and retail advances, but overall interest yields are estimated to have increased by only 49 bps, because of the braking effect of SLR and CRR. CRISIL estimates that interest spreads declined to 2.22 per cent in 2008-09.

Fee-Income Growth to Moderate

Since 2003-04, banks have reported strong growth in fee revenues, a trend primarily led by private banks' focus on retail credit, distribution of third-party products such as insurance and mutual funds, and provision of wealth management services.

After 2004-05, public sector banks also focused increasingly on fee-income generation as the contribution from treasury operations declined.

Sustained growth in retail credit (where banks charge up-front processing fees), and buoyant capital markets, enabled the banking sector to increase the proportion of fee-based income (as a percentage of average funds deployed) to 1.14 per cent in 2007-08, from 1 per cent in 2005-06. CRISIL expects the contribution of fee-based income to banks' total income to reduce to around 1.09 per cent in 2008-09, and further to 1.05 per cent in 2009-10, on account of the slowdown in retail credit growth, and weaker distribution income because of sluggish capital market conditions.

Opex Unlikely to Reduce

Most public sector banks have sought to rein in their operating expenditure (Opex) by investing substantially in the implementation of core banking solutions which will allow banks to reduce their operating expenses over the medium-term - because of greater operational integration and real-time processing of transactions.

However, public sector banks' operating expenses may increase over the next 18 months, on account of wage revisions due from November 2007.

Core profitability to decline

Equities: Between 2005-06 and 2007-08, banks recorded a significant growth in profits on sale of investments on account of buoyant equity markets. However, equity prices have declined sharply since January 2008.

CRISIL believes that equity prices will remain subdued over the near- to medium-term, and that banks are unlikely to book the levels of POSI that they enjoyed between 2005-06 and 2007-08.

Debt: In the past, banks also booked huge gains on their large bond portfolios when yields were falling. However, banks had to provide for mark-to-market losses in 2007-08 and the first quarter of 2008-09 as yields increased.

A sharp fall in yields on government securities during the third quarter of 2008-09, after the repo rate cuts by RBI, helped Indian banks register a high level of income from POSI on debt.

CRISIL, however, believes that these treasury gains were driven by short-term swings in interest rates, which were the result of several macro-economic and demand-supply factors.

The subsequent increase in the interest rates during the fourth quarter of 2008-09 could negate the benefit of treasury gains booked in the previous quarter, and significantly affect profits for 2008-09.

The economic slowdown, declining spreads, and lower fee-income, are expected to result in weakening profitability for Indian banks over the next two years. CRISIL expects the system average NPM to reduce to 1.19 per cent in 2009-10, from 1.40 per cent in 2007-08.

Banks' profits will also be affected by lower POSI, and higher provisioning costs.

The author is manager, financial sector ratings, at CRISIL