Getting a handle on inflation continues to elude Reserve Bank of India (RBI). This has forced it to act hawkish in the current annual policy meeting.

By hiking repo rate by 50 bps, it has signalled the end of baby steps and opened the possibility of further such tightening if inflation continues to persist at current levels. As a result, BSE Bankex, which lost 5 per cent over the last four trading sessions, lost another 3.1 per cent on Tuesday.

Rise in cost of borrowing due to repo rate hike and changes in savings deposit rate, higher provisions to be set aside for NPAs have all been viewed negatively.

Additionally, standard asset provisioning for restructured assets and expectation of moderation in credit growth due to slowdown in the economy are expected to take a toll on banks. Longer-term impact may be the investment book taking a hit in terms of mark-to-market losses.

Higher cost of funds

The rise in repo rate of 50 bps may have an immediate effect on the interest rates due to persistent liquidity deficit in the system. Banks had borrowed an average of Rs 40,000 crore from the repo window since April 25, 2011.

While short-term rates are not expected to rise sharply, any further rate hikes makes a good case for increased deposit rates for banks. The one-year Overnight Indexed Swap rate which gives a forward looking perspective of the market on policy rates, has gone up by 20 bps to 8.1 on Tuesday. This implies expectation of another 75 bps hike in the repo rate by the market going forward.

The RBI, from next week, is introducing the Marginal Standing Facility rate which is pegged to the repo rate (repo plus 100 basis points). This window will allow banks to borrow up to 1 per cent of their deposits without any collateral. With the reverse repo rate pegged to the repo rate, the corridor for movement of call money rates is widened to 200 bps.

In addition to the policy rate hikes, the cost of borrowing will go up due to the hike in savings bank deposits rate to 4 per cent from 3.5 per cent in March 2011 and 2.7 per cent in March 2010.

As of March 2010, the savings bank deposits comprised 23.30 per cent of the total bank deposits. Assuming that the ratio is maintained at this level, a hike of 50 bps in savings rate would increase the overall cost of funds by 12 bps.

For banks which are already facing pressure from rising borrowing costs, this impact would be hard to digest. However, this 4 per cent rate is a temporary measure till such time that the banks' savings bank rate is deregulated.

Old deposit accounts will start getting re-priced at very high rates and impact the margins of the banks severely. However, some respite is expected as the lending rates will be hiked. The RBI expects the average yield on advances of banks to improve by 70 bps to 10.3 per cent for the year-ended March 2012.

Provisioning

Another negative impact for banks is the increased provisioning requirement. The RBI last week gave reprieve for banks in terms of maintaining provision coverage of 70 per cent. However, it has now announced a rise in provisions for sub-standard assets, doubtful assets and restructured assets.

Taking into account March 2010 data for doubtful assets, sub-standard assets and restructured assets (3.03 per cent of the standard advances) the provisioning impact would be in excess of Rs 5,600 crore for the banking system as a whole.

Since then, a lot more accounts slipped and got restructured and the amount to be set aside may go up. However, given that most banks have 70 per cent provision coverage as of March 2011, the excess provision between September 2010 and March 2011 can be utilised towards these provisions.

BL Research Bureau

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