Smart banking, or safe banking?

Lending is risky business but yet commands only a small premium as it is considered a low-value added activity. Thus, when bad loans become large, lending spreads can turn negative, which has been the case with our banks.

There could be two ways of viewing the financial results of our banks for FY2017: one would be to acknowledge that banks are diversifying their business and not relying on lending (like those in developed economies); the other view could be that banks made a flight to safety and benefited from not taking risks. The financial results of the top ten banks (by assets) appear impressive —combined profits rose by 79 per cent, in spite of NPAs increasing by 17 per cent.

But if we probe further, we will find that this was made possible by two components, non-operating income and non-lending income. This raises interesting prospects about the future of the banking business.

First, the lending business — all ten banks had healthy net interest spreads (30 per cent of interest income, on average) to begin with, but the double whammy effect of NPAs viz. the loss of income and increased provisioning, brought them down to a negative 7 per cent. It was non-operating income that finally helped them post positive numbers. Non-operational income is largely fees, commissions from transactions and many types of one-off gains from trading or sale of investments.

If we exclude non-operating income, individual bank results change dramatically — only three banks would make profits, and that lower by 60-90 per cent. Only three of the ten would have sufficient spread to even make provisions. Such was the significance of non-operating income to the bottom line that when the RBI changed the rules on foreign exchange gains translation last year, it caused a buzz as it impacted bottom lines.

The issue is not about non-operational income, but in its becoming the mainstay of profitability. The larger question is really about the role that banks play in our economy. This will be clearer when we consider the other aspect of their performance.

The second aspect of the flight to safety was the increased reliance on investment and non-lending income. This narrow banking was more pronounced in public sector banks who chose to invest much of their resources in Government securities or in building up cash balances.

Of course, large cash balances this year were partly an unintended effect of demonetisation, but the extra income from cash was significant — so much so, that if we exclude it, three banks would make losses and the profits of majors such as ICICI Bank and the SBI would be considerably smaller.

In countries such as the US, nearly half of banks’ income come from non-banking activities, primarily because of dis-intermediation. Bank assets form less than 30 per cent of their financial system. This dis-intermediation happened over years and forced banks to look for profits outside banking, while markets did the job of banks; but we have a predominantly bank-led financial system- deposits are still the largest component of domestic savings and bank borrowings are the major source of debt.

So, if banks are shying away from lending, it is a concern. It was not that lending activity froze; overall loans grew by 12 per cent, mainly by private banks who grew at 17 per cent.

But the growth was almost entirely in retail. Retail portfolio now forms about a third of total portfolio for most banks. SBI’s current exposure to home and auto loans is now larger than its infrastructure exposure. Further, the retail exposure is highly skewed, almost wholly made up of home and vehicle loans, making it riskier.

Private bank NPAs are already on the rise — HDFC bank’s gross NPAs rose by 34 per cent during the year, about 15 per cent of which were from consumer loans, a fact that could easily be missed under its modest overall NPA ratio. But the key issue is this: if the Government’s objectives from the clean-up exercise were getting private investment going, banks seem comfortable financing the consumption engine. The neglect of corporate and infrastructure lending has to do with issues that go beyond impaired balance sheets: the availability of long term funding sources, capabilities and sector risks are only a few of them.

To be fair to banks, their business model is somewhat pre-determined due to the overarching regulatory framework — cash reserves, statutory investments, directed lending, capital risk weights, all have a bearing upon asset selection and returns.

Raghuram Rajan termed it a grand bargain, where “banks get the benefits of low cost insured deposits and liquidity support in return for maintaining reserves with RBI, subscribing to Government bonds and lending to the priority sector”.

This model may have served us well in the past, but has left us with a legacy of a massive public sector and huge bad loans. If nothing else were to change, risk avoidance would simply lead to the continued financing of Government borrowings or private consumption (an option capital-starved, risk-averse public sector banks may consider).

Or, the quest for profits could lead market-driven private banks into non-banking businesses. Either way, the question that pops up is about the role that banks should be playing in the economy.

The writer is an independent consultant