With the RBI hiking policy rates by an unexpected 50 basis points (bps), banks, already reeling under higher costs and slipping asset quality, may receive a further jolt.

After the RBI's mid-quarter policy rate hike of 25 basis points in June 2011, the markets took the view that rates were close to their peak. However, the central bank has quickly gone back to a hawkish stance this quarter by hiking policy rates by a hefty 50 bps, to rein in inflation which remains unabated. The market, which was expecting a 25 bps hike or no hike, was visibly disappointed with the BSE Bankex falling by 2.5 per cent. The BSE Bankex was up close to 10 per cent over the last one month on expectation that the RBI may go slow in hiking rates. Other debt market indicators also reacted, with the 10-year government bond price falling marginally.

This hike would not only mean a higher cost of funds for banks, given the effectiveness of the monetary transmission over the last one year, but also indicates that the rate hikes are far from over. The policy rate hike is likely to lead to higher lending rates. While banks may go slow on deposit rate hikes given the healthier deposit inflows, with credit offtake slowing in recent times, the borrowings from the repo window suggest otherwise. Banks have been borrowing around Rs 46,000 crore from the repo window over the last one month, suggesting tight liquidity. If liquidity continues to be in a deficit mode, banks may raise deposits rates to support any rise in credit offtake in the second half of the year. The gap between deposit and credit growth came down from 9 percentage points in December 2010 to 1.5 percentage points in July 2011.

NPA ratio

YES Bank was the first to react to the policy rate hike by increasing the base rate by 50 bps and other banks are expected to follow suit. The hike in lending rates also poses the risk of a rise in non-performing asset ratio. RBI's recent Financial Stability Report noted that in a ‘base line' (normal) scenario the gross NPA ratio in the banking system would go up to 2.94 per cent from 2.31 per cent, even without a rate hike. However, if the GDP rate falls, interest rates rise and inflation persists, the NPA ratio may be far higher than estimated.

While credit offtake may be dented by rate hikes and asset quality may slip further, banks may also have to provide for higher treasury losses (real and notional) given that bond prices have reacted. After the policy pronouncement, the one-year overnight indexed swap, which gives market expectation of repo hikes, went up by more than 50 bps, factoring in another 25 bps of policy rate hikes.

Related Topics