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The central bank has told public sector banks, that in future, their profitability would depend on their ability to generate greater non-interest income and control operating expenses.

Mumbai , Nov. 17

THE Reserve Bank of India has cautioned banks against the looming threat of an "interest rate risk", as they hold sovereign paper well above the 25 per cent statutory requirement.

Banks are exposed to re-pricing risk, arising from timing differences in the maturity and re-pricing of bank's assets and liabilities and yield curve risk, arising from changes in the slope and shape of the yield curve, the central bank has observed in its Report on the Trends and Progress of Banking in India, 2002-03.

"Bank balance sheets are getting linked to the interest rate environment, to the extent that bank stock valuations are being driven by expectations of trading profits. A new linkage is being forged between the debt and equity markets," RBI has said.

In its report, the central bank has emphasised the need to recognise the potential interest rate risks and put in place appropriate risk management systems, provisioning and building up of reserves in line with the best international practices. To safeguard banks against such eventualities, RBI had advised them to build up an investment fluctuation reserve (IFR) since March-end 2002, as a proportion of their traded securities portfolio, to serve as a cushion against adverse interest rate movements.

Yet, a preliminary internal exercise by the RBI to calculate the impact of interest rate changes on the net interest income of banks, carried out with reference to asset liability profiles as on March 31, 2003, reveals that the banking system as a whole is likely to have a positive impact of 4.9 per cent on interest income, in the event of a rise in interest rates by 200 basis points. In the event of a fall in interest rates by 200 basis points, new and old private banks would have a positive impact on net interest income. Foreign banks would have the least impact on net interest income in a rising or falling interest rate regime.

Pointing out a major structural rigidity relating to the cost of credit, the apex bank has said, that despite RBI adopting a soft interest rate stance and the declining trend of interest rates in the money markets along with the downward movement of yields in the government securities markets, the pass through to the credit markets is still not very strong.

Highlighting the primary business of banking to be the creation of credit, RBI has said, that while the kind of narrow banking banks have been engaging in, in the recent past, could be appropriate at times of easy liquidity, the macroeconomic performance of the banking system in the long-term would hinge on their ability to fund industrial and other enterprises.

Underlining the need for more transparency and disclosures in the banking system, the apex bank has said they are becoming increasingly complex organisations and investors are finding it harder to understand the quality of financial performance and risk exposures of banks.

The traditional set of information as contained in bank balance sheet often fails to convey information to readers of financial statements that can enable them to ascertain the quality of earnings, according to RBI.

Transparency challenges are met where market participants not only provide information, but also place the information in a context that makes it meaningful to accurately reflect risks. The quest for transparency therefore has to be continuous and persistent, the central bank has suggested in its report.

In defence of banks who have been heavily deploying credit into the housing sector, RBI has said, "It must be recognised that lending to potential home owners in the Indian case is fundamentally different from the speculation in the property prices by banks in many countries. The housing sector provides a relatively safe destination for bank credit on account of lower than average rates of default. Besides, there is an overall cap on the bank lending to sensitive sectors including real estate."

The demand for housing in India is strong as is the case with most economies which are now industrialising and urbanising rapidly.

Besides, construction has significant forward and backward linkages with a number of other industries, according to RBI.

The central bank has told public sector banks, that in future, their profitability would depend on their ability to generate greater non-interest income and control operating expenses. Since retail customers are fast becoming more demanding in the competitive environment, banks have to offer value-added services.

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