The Hindu Business Line : Thinning spreads, bulging NPAs

CAN old private banks grow? Or, have they been growing at all these past years? If the question is with reference to their size, then the answer is yes on both counts. Their deposit growth rate has been better than that of public sector banks in 1997-2002. There is no reason why this trend should not continue.

The obvious next question is whether these funds can be profitably deployed. The outlook for old private banks on this count is entirely predicated on their ability to contain non-performing assets (NPAs) and the drop in spreads; indeed, this is a challenge for almost all banks. However, the question is more relevant for old private banks because of their business model.

Spread compression

Most banks, including old private ones, are likely to benefit from the "re-pricing" of their high-cost fixed deposits that will be maturing. In addition, fresh inflows will be contracted at a lower rate. Some degree of success in attracting savings and current account deposits can also help lowerthe cost of funds. Banks in Kerala will benefit from re-pricing maturing non-resident deposits at substantially lower rates. In effect, these banks are aiming at a reduction in their cost of funds by around 75 basis points, in the year ahead.

This certainly is an encouraging development. But that is only one half of the story. The other half — return on advances — is also witnessing sharp declines in spreads. If a major proportion of the funds can be invested only in sub-prime rates offered by triple-A-rated companies and government securities, then spreads are set to decline from the current levels.

Only if retail lending and lending to the lower-rated business segment account for substantial proportion can these banks hope to contain the compression in spreads. However, while enhancing retail lending beyond a point may not be advisable, opportunities for lending to the lower-rated businesses appear low.

Importantly, the lending rate on all types of advances is set to decline for these banks. The extent of premium charged for relationship banking may need to be reduced to ensure that the customer does not gravitate owing to competition. Moreover, the premium rate at which loans are made may itself deter demand for loans, from both the retail segment and smaller and mid-size businesses.

Overall, spread compression is certain. The extent of decline is not. It will depend on the extent of success achieved in attracting savings deposits, making inroads in cash management services (this will increase demand deposits) and the composition of the portfolio of advances.

Old private banks that manage this equation better will be in a relatively stronger position to tackle the problem of NPAs. Old private banks say they are focussed on controlling generation of fresh NPAs as well as improving the quality of existing assets.

If they succeed, the boost to profitability will be significant.

Profit growth

While most old private banks appear set to grow in size, profitability growth beyond the next few quarters seems a difficult proposition.

In the next few quarters, treasury operations would continue to contribute. Most of these banks are still sitting on sizeable unrealised profits. These profits will not be unduly affected even if interest rates rise, provided the rise is limited to within a percentage point. Importantly, the prospect for a rise in interest rate also appears limited.

Overall, profit growth in the next few quarters will be sustained. Beyond that period, the effect of compression in spreads will begin to have an impact on profit growth. In fact, there is the possibility that profits may even decline. Improvement in the economic situation will help. And if advances to the midsize and small businesses look up following an improved economic environment, then the spread compression can be managed better. However, if deposits keep flowing at a high rate and the economic scene is such that they can deploy it only in government securities, then spread compression will be rapid.

Realignment of interests in such a scenario may be inevitable. Allowing foreign banks to pick up stake in the venture, merging with other regional banks and being acquired by larger Indian banks may dot the landscape then. However, if the economy revives, then such a scenario may yet be years away.

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