The profitability of Indian banks is under increasing pressure due to subdued growth in interest income, sharp slowdown in deposit growth, and an increase in credit costs led by a rise in non-performing assets (NPAs).

Credit growth has been far ahead of deposit growth over the last three years, and this trend has continued in the first-half of 2013-14 as well. Between 2009-10 and 2012-13, banking credit grew at a compounded annual growth rate (CAGR) of 19 per cent, with deposit growth lagging behind at 16 per cent. The slowdown in economic growth and entrenched inflation have adversely impacted savings with household savings rate (as percentage of gross domestic product (GDP)) declining to an estimated 22 per cent in 2012-13 from 25.2 per cent in 2009-10. More worryingly, the proportion of financial savings (of which bank fixed deposits form 56 per cent) has declined. High inflation has severely impacted inflation-adjusted returns from financial instruments such as deposits, leading retail investors to turn towards physical savings avenues.

Deposit growth

For banks, this worrisome decline in deposit growth has severely impacted their liquidity, which is reflected in the sharp rise in borrowings from RBI’s liquidity adjustment facility (LAF) window. Average daily borrowings increased to Rs.74,000 crore during 2013-14 (till October 11, 2013), which is more than double the Rs.35,000 crore borrowed in 2010-11. Borrowings have been especially high in recent months, due to the liquidity draining measures announced by the RBI to shore up the rupee. These measures led to a spike in short-term money market rates, pushing corporates to resort to bank borrowings for funding their working capital requirements. Although some of those measures have been gradually withdrawn, the situation still remains strained for many banks, especially as there are no signs of deposit growth picking up ahead of the busy season. The systemic credit-deposit ratio as of September 2013 was at an all-time high of 78.3 per cent, clearly pointing towards the need to attract deposits.

Many banks are responding to the situation by hiking deposit rates, especially on shorter-term deposits, by 50-100 basis points even though credit pricing is also under pressure. The fall in CASA (current account savings account) deposit base — 33 per cent as of June 2013 compared to 34.1 per cent as of March 2013 — is not helping matters.

Due to rising cost of funds, we expect net interest margins (NIMs) of banks to decline by 20-25 basis points in 2013-14. The drop in NIMs is expected to be far more sharper in the case of public sector banks (PSBs), given the higher proportion of non-interest earning weak assets and lower increase seen in their lending rates.

Due to weak economic conditions, the asset quality of the banking system is expected to deteriorate sharply. We expect gross NPAs to increase to 4.4 per cent by March 2014, from 3.3 per cent a year ago, propelled by weak demand and liquidity constraints being faced by corporates.

We also expect to witness a sharp increase in slippages from restructured assets. Despite restructuring, the inherent weakness in restructured assets will be accentuated by the fragile economic environment. Consequently, we expect over 30 per cent of restructured assets (excluding state power utilities, which are likely to receive sovereign support from the Central and State governments) to slip into NPAs in the next two years. (By contrast, during the two-year period, following the global financial crisis of 2008, only 15 per cent of restructured assets turned NPAs.) Therefore, the total weak assets in the banking system (gross NPAs plus likely slippages of restructured assets) will shoot up to 5.7 per cent by the end of this fiscal from 4.3 per cent a year ago.

Weakening asset quality as well as increased provisioning on restructured assets (announced in May 2013) will significantly increase the credit costs for banks. On account of increased provisioning on restructured assets alone, Crisil Research anticipates that banks will have to make additional provisions to the tune of Rs.13,000 crore between April 2013 and March 2016. Again, PSBs will bear the brunt of the increase in provisioning.

In the wake of slow accretion to deposits, rising delinquencies, stricter provisioning norms and implementation of Basel-III norms, Indian banks’, particularly PSBs, will need significant capital infusion over the next five years.

To sum up, the banking sector will face tough times for the next 12 months, with upward pressure on cost of funds and lower profitability. To protect the downside in profitability, banks’ will have to focus on garnering retail deposits and minimising slippages from restructured assets by closely monitoring them. In the long-term as well, with capital requirements all set to shoot up with the stage-wise implementation of Basel-III, providing adequate returns to equity shareholders by judiciously deploying capital would become a critical differentiator across banks.

The author is Director, Crisil Research, a division of Crisil

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