An uncertain banking scenario: Financial Express: 30th December 2011

The current year has been quite a disappointment for the banking sector. This is not unusual as the fortunes of this sector are inexorably linked with that of the real sector. With industry down, GDP growth slowing down, interest rates rising and inflation peaking, banking performance has been affected in terms of net interest income and profits. The darker icing is the prospect of increasing NPAs on account of the downturn, which has also been highlighted by the RBI’s FSR. How would things look like in 2012?

The edifice for the banking sector in 2012 will be built by the state of the economy or rather the pace of recovery. Here there are varying views. There is a section that believes that the slowdown of FY12 will be exacerbated in FY13, but that may be overstating the impact. It may be assumed that there will be a recovery, albeit a gentle one, given that a lot has to happen to accelerate the process, which depends on the monetary stance of RBI. Today, investment is down as is leveraged-based consumption, which has to reverse soon. Investment takes time to take off because even if rates move down, expectations of the same will drive the pace of investment. If industry believes that a rate reversal has set in, then they would enter based on future expectations, which, in turn, will lead to lags in actual investment. This means that, to begin with, a cautious approach would be taken. The starting point hence will be RBI.

RBI will be the fulcrum for bank performance as its stance on interest rates will drive consumption and investment. Monetary policy is likely to hold the key to progress since the government, on its part, will tend to be more conservative with its budgetary policy. More likely, it will tread cautiously here and ensure that inflation is reined in before really releasing the pedal. This can happen earliest in the first quarter of FY13, and anything earlier will be a bonus.

The challenge for banks henceforth will be five-fold. First, they will have to endeavour to recreate their asset portfolios. Today, both the corporate and retail loan books have been afflicted by the economic environment and hence stepping up credit, especially on investment and retail loans, will be challenging as borrowers will wait for rates to come down further to seize the opportunity. And borrowers will be waiting for rates to decline further so as not to be caught in an interest trap. There will have to be some kind of a joint effort on the part of the auto and housing sectors to enthuse customers, while capital investment would tend to be cautious to begin with.

Second, banks have to work hard at raising capital to ensure that they have adequate capital to support the growth in their loan books. While banks are well capitalised at present (though the ratio has been falling in FY12), with growth in credit expected to be in the region of 20% per annum, the annual incremental capital requirement would be starting from R80,000 crore and move up to R100,000 crore in the next 5 years. Work evidently has to start from this year itself. Capital buffers are an extremely important component of the new macro-prudential regulatory framework that aims at improving both quality and quantity of capital. Now, capital is a competitive charge on the resources available for lending with a bank and hence stepping up counter-cyclical capital requirements and providing capital buffers will be a cost for the banking system. Capital enhancement is an inevitable prudential requirement and

prudent risk management has assumed considerable importance against the backdrop of the financial crisis.

Third, as liquidity is an issue under Basel 3, banks will have to necessarily look closely at building up systems to meet these norms going ahead. Fourth, risk management becomes important in the light of experiences of the financial crisis. Market risk has become more volatile both on interest rate and forex exposures while that on derivatives and other off-balance sheet items would require closer scrutiny. One cannot really be sure about the exchange rate as the euro crisis lingers. Interest rates, too, would be idiosyncratic depending on government borrowing, a pick up in the economy, bank credit and the RBI stance on the same.

Lastly, they would have to start looking closely at the quality of their assets in the light of the developments in the current year. The first two quarters of FY12 indicate an increase in the NPAs of the banking sector, which could probably be under pressure going ahead. Therefore, the task of banks is to make adequate provisioning and cover which will have a bearing on the profit levels. A rainbow in this scenario would be the treasury income as declining interest rates would mean gains for banks in the G-Sec market.

At the policy level, there are some changes that may be expected for the banks. Assuming that the governance issues are addressed and more time is spent on discussing reforms, these are exciting times for this sector. First, the issue of new banks will be addressed with permission being given to more banks to open shop. There have been constructive debates so far, and it may be expected that we can see this policy being implemented.

Second, the impasse on foreign banks and their route to operations through subsidiaries or branches should also be resolved this year. The resolution of these issues will provide a competitive thrust to the industry which will, in turn, make banks rework their business models. It must be remembered that the new bank concept will have a tilt towards inclusion, which will be major consideration for the others too.

A sub-sector that will become more important with reforms coming in would be MFIs. There is restructuring going on in some of the major MFIs that will help to channel funds in this direction. Given the political expediency for 2013, the government will be pushing hard at expanding inclusive lending, which will provide an impetus to this sector.

So, how would the soothsayer describe the prospects? It will be mildly positive but bordering more on caution as systems will be put in order as banks work

on reconstructing their business models under the umbrella of some interesting reforms. The liabilities side should be normal while asset creation takes the backseat, and the treasury vaults keep jingling all the way with volatility guiding these prospects.