Banking in hot waters

A consequence of the Reserve Bank of India’s (RBI) announcements on Monday, to shore up rupee value, is the adverse impact it will have on the finances of the banking industry. These measures aimed at squeezing the liquidity available in the system, led to yields on government bonds soaring by over 50 basis points in just one day and triggering even sharper increases in other money market rates. Banks have, thus, been dealt a double whammy of now facing the prospect of not only erosion in treasury profits but also experiencing further pressure on interest margins.

While private sector banks, who rely significantly on wholesale funding sources such as certificates of deposits, may be the first to feel the pinch, those in the public sector will be no less affected. Recent quarters have seen them burdened by mounting bad loan provisions and a growing list of companies queuing up to restructure debts. So long as the RBI was easing its monetary policy stance, howsoever slowly, banks could pin their hopes on an eventual decline in lending rates to help these distressed borrowers de-leverage. Such hopes are now dashed, with RBI signalling its preference to keep interest rates high as long as the pressure on the rupee lasts. The resultant liquidity squeeze and spike in short term rates will be a particularly unkind cut to already stressed sectors such as small and medium industries, textiles, infrastructure, realty and capital goods.

But the second major effect on banks will be the treasury losses they will now have to take on their investment portfolios due to rising bond yields. Securities offering fixed coupon rates below the current yields will have to necessarily be marked down to match the market expectations on returns. This is in direct contrast to the hefty gains banks registered in a scenario of declining yields until recently. Indeed, such gains partially made up for flagging profits in their core lending business. Public sector banks, especially, had resorted to parking an increasing portion of their gilt investments in the available-for-sale (AFS) category, with a view to marking them up (mark-to-market) from the cost at which they were carried earlier and credit the difference as incremental profits. Some of them held, as of last fiscal, up to half of their statutory investments in government bonds in the AFS category, as against ‘held-to-maturity’ (where portfolio gains are not recognised), category as on end-March. True, banks may have had no means of foreseeing this bolt from the blue when a bet on treasury gains seemed reasonable till recently. What this episode highlights is that the bond market, in today’s fluid scenario, offers no more certainty than that for ‘risky’ equities. It reinforces the need for banks to set prudential internal limits on their treasury activities, in terms of the extent of their bond portfolios exposed to yield and price swings. For now, signals from the US Fed, rather than the needs of domestic banks or their borrowers, is what is going to influence RBI policy.

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