Dip in interest margins, rising bad loans lower banks' profitability in FY12

Fortunes of the banking system are linked to the performance of the real economy. Growth of the Indian economy slowed significantly from 8.4 per cent in 2010-11 to only 6.9 per cent in 2011-12. This was because of a host of factors, including the hike in policy rates 13 times.

How has the growth slowdown affected banks in India? We consider the performance of nationalised banks (NBs) which account for around three-fourths of the assets of the banking system in India.

Business Growth

We first look at how the banking business has grown in 2011-12. If we consider the year-end numbers, deposits and advances of the banking system grew 17.4 per cent and 19.3 per cent, respectively, in 2011-12 compared with 15.9 per cent and 21.5 per cent in fiscal 2010-11.

However, as on March 23, 2012, the last reporting Friday for the banks, the growth in deposits and advances were only 13.4 per cent and 17 per cent respectively. The sharp rise in deposits and advances in the last week of March 2012 reflects window dressing by banks.

If we consider the March 23 figure, which is devoid of window dressing, both deposit and credit growth have slowed down. However, the deceleration has been much more acute on the resource mobilisation front.

This is partly reflected in the higher money market rates and the rise in average daily borrowings of banks from the repo window, especially in the last five months of 2011-12.

For NBs as a group, business growth has decelerated appreciably from 22.3 per cent in 2010-11 to 16.3 per cent in 2011-12. The deceleration is seen both in resource mobilisation and credit disbursement. While deposit growth has shrunk from 21 per cent in 2010-11 to 15 per cent in 2011-12, credit growth has slowed from 25.2 per cent in 2010-11 to 18.1 per cent in 2011-12.

The subdued growth of deposits has multiple implications for banks. It raises the cost of funds in their bid to boost deposits by offering higher rates. This affects the interest margin. In an environment where credit growth is robust, banks can pass on the higher cost to borrowers. However, when economic activity is restrained, it limits the ability of banks to pass on the higher cost of funds to borrowers and can result in shrinking of interest margins.

In fact, NIMs of NBs fell by 58 basis points in 2011-12 over the levels seen in 2010-11.

This implies that nationalised banks have not been able to pass on completely the increase in cost of deposits to the lenders. The lowering of growth has kept demand for loans subdued, which has prevented the banks to pass it on to the borrowers fully.

Seen from a different perspective, net interest income (NII) has increased by only 10 per cent in 2011-12 compared to 48 per cent in 2010-11.

The subdued growth in NII is due to much higher growth in interest expenses at 46 per cent in 2011-12 compared to 33 per cent growth in interest income. The growth in interest income and interest expenses were 23 per cent and 12.6 per cent, respectively, in 2010-11.

NPA

Higher interest rates affect the loan servicing capacities of some categories of corporate and retail borrowers, and is ultimately reflected in deteriorating loan quality.

One of the major worries is the sharp rise in NPAs in 2011-12. Gross NPAs in absolute terms increased by 56 per cent in 2011-12 compared to only 21.6 per cent in 2010-11.

Gross NPAs as percentage of assets increased from 1.92 per cent in 2010-11 to 2.5 per cent in 2011-12. Net NPAs have also increased by 83 per cent in 2011-12 and the net NPA percentage has gone up from 1 per cent in 2010-11 to 1.4 per cent in 2011-12.

The drop in net NPAs in 2011-12 implies that the provision-coverage ratio for nationalised banks would have deteriorated in 2011-12

RoA

The dip in NIM coupled with an increase in NPAs has eroded profitability of the nationalised banks in 2011-12.

We find the RoA for NBs has declined by 14 bps in 2011-12 compared with the levels in 2010-11. Growth in net profits has been much lower at 3.5 per cent compared to 23.2 per cent in 2010-11.

Cost-to-income ratio

Unlike in 2010-11, when the growth in employee expenses was to the tune of 40 per cent because of the implementation of second pension option for bank employees, it has been only 1 per cent in 2011-12.

This has helped the banks to post some improvement in their operating efficiency measured through the cost-to-income ratio. This ratio has improved slightly from 46 per cent in 2010-11 to 44.3 per cent in 2011-12.

Performance of banks is not only conditioned by the larger macroeconomic environment but also by specific policies and regulations for the banking sector.

In 2011-12, apart from a challenging macroeconomic environment, a number of changes in the policy and regulatory domain affected banks' performance.

Some of them include the deregulation of savings bank rates on October 25, 2011, and regulatory mandate to migrate to the system tracking of NPAs of the entire loan book by September 2011.

The cleaning-up exercise on the NPA front in an elevated interest rate regime coincided with the slowdown in the economy. This has led to a triple whammy for the nationalised banks, resulting in their lacklustre performance in 2011-12.

(The author teaches Economics and is Associate Dean, Xavier Institute of Management. The views are personal.)