Bank credit has grown at a rapid pace of over 33 per cent for the first nine months of the current financial year. Interest levels have moved up only smoothly during the year, allowing banks to unwind their extra investment portfolio to fund credit growth. While this year the net interest margins would not compensate for the profits banks made in the past few years on the investments, next year is likely to be more challenging for banks.
The most imminent challenge that banks have to face is one of resources. In the current year, deposits have so far grown at little over 16 per cent, while credit assets have grown over 33 per cent. Banks have largely financed the stupendous asset growth by liquidating their investments. By now most banks have reached the prescribed statutory limits of SLR investment holdings, which will require them to bolster fresh resources to fuel growth. Interest rates have been hardening slowly.
The last credit policy has also signalled a tighter interest rate regime. While continued inflows of funds from foreign sources will supply liquidity, the massive credit offtake currently being witnessed is likely to continue to push interest rates higher.
Also, the vulnerability to volatility induced by changes in foreign inflows has heightened and is likely to play a more significant role in the determination of local interest rates and exchange rates. In other words, from banks' perspective, apart from raising additional resources, banks may have to contend with higher interest rates on their deposits.
In the past, banks have tended to reduce the average tenure of deposits to contain the cost of deposit, in the face of rising interest rates. That would be the third risk associated with liabilities for banks in future.
Given the higher volatility in interest rates than before, banks need to be a lot less sanguine in running a huge asset-liability mismatch that they have historically run in the past between their deposit tenures and asset maturities. This should then make the deposits more expensive. Given the competitive environment for the lending market as well, the net interest margins for banks will come under squeeze.
To mitigate that, banks will pursue volume growth to protect their return on assets. They are likely to be particularly challenged this year, as the regulation for securitisation has been tightened. This would mean that growth would have to come from organic, capital-backed, deposit-funded operations and not much help from the capital-efficient securitisation route adopted by banks in the past year.
While the liabilities side challenges might be a new paradigm, banks have been traditionally exposed to asset-side concerns. Some banks have taken the initial steps to tighten their lending practices. But by and large, much of the credit expansion currently witnessed appears to be along the same paradigm as in the past. It should not therefore be surprising if the incremental assets that banks are currently adding display historic levels of delinquencies in the next few years.
While retail assets, which are the bulk of the addition, as a class belong to a lower-risk category, they also can display higher delinquencies if banks do not adopt prudential origination and monitoring policies and processes. While the present balance sheets display healthy asset quality, there is a case to make forward-looking provisions.
Under these circumstances, the risks arising from the credit quality of the incremental portfolio that banks are now accumulating would have to be closely monitored. A fast pace of growth and a competitive lending market are likely to increase the incidents of credit risk in the banking system.
In addition, there is a greater likelihood of the credit risk remaining bottled up within the banking system as the avenue of securitising and selling assets has become less attractive after the fresh guidelines require heightened capital charge and stricter profit recognition norms.
In the past, the securitisation market allowed banks to sell their credit portfolio to mutual funds, provident funds, and increasingly the insurance industry and potentially the retail bond investors.
In other words, the future few years are likely to see banks competing more strenuously for deposit, credit, ALM maintenance, capital adequacy and provisions for asset delinquencies, while maintaining profitability. What should banks be doing to counter this trend?
Of course, fee-based activities have been identified by most banks as an area to work on. The service-oriented economy of the country supports it. Banks should augment longer-tenure resources. The recent Budget announcement of 80cc benefit to the 5-year deposit programme is a step in the right direction.
Hybrid bonds are another great instrument that will bolster both capital and resources. Despite their stringency, the new guideline announced by the RBI on securitisation sanctifies this avenue. Despite muted capital adequacy benefit under the present guidelines, securitisation will allow tremendous flexibility for banks to adjust ALM mismatches and thwart interest rate risk.
Banks will do well to embrace these guidelines and become important players on both sides of the market. If and when the RBI readjusts capital adequacy norms relating to these transactions, those benefits could be counted as bonus.
Interest rate swap is another important instrument that banks must evaluate to use. Although there is some ambiguity about the legal status and the limited access available to this instrument only through the OTC market, it is a potent product for hedging interest rate risks.
Similarly, the ability to arbitrage interest rates between the domestic and the overseas markets is an important avenue for banks to diversify both resource mobilisation and the cost of resources. Again, the currency futures markets are in a very nascent stage and the policy regarding their usage a bit unclear.
However, this will be an important instrument which banks cannot do without in a market economy that is internationally linked as our markets are. Sooner or later, these markets will become widely traded and therefore accessible to banks, and it will be prudent for banks to be prepared to make use of them in a timely fashion.
From a regulatory regime point of view, it is important to review the ALM practices in the system. It will also be useful to lay down policy that allows banks to access legitimate interest rate and currency hedge mechanisms following prudential norms. This will allow banks to access the wider resource base globally to fuel what looks like an insatiable investment cycle in the making.
Some parity in regulatory stance between marked-to-market norms between assets and investments might also be desirable, because interest rate risk does affect both sides of the bank balance sheet's asset side. The current paradigm makes banks prefer the investment mode in a falling interest rate scenario and assets in a rising interest rate scenario.
These large swings between assets and investments come with increased transaction cost, operational risks, illiquidity cycles and staff disorientation within the banking system.
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