What has changed for banks post demonetisation

Demonetisation has only added to the plethora of challenges that banks are already up against. Near-term pain aside, a meaningful recovery is unlikely in the 2018 fiscal.

Banking sector in a flux

If the aam aadmi has been rattled by the cash-crunch post the Centre’s demonetisation move, banks that have been on the firing line, are up against a host of new challenges. After three long years of slowdown, the banking sector had been pinning its hopes on recovery of sorts. With balance sheet repair underway, post the RBI’s asset quality review, banks were just about prepping the pitch for the next leg of lending.

But the joker in the pack---demonetisation—has once again roiled the picture. In the second half of this fiscal, gains from a sharp fall in cost of funds and strong treasury income, will be offset by the marked slowdown in credit growth, steep lending rate cuts, risk of higher delinquencies and surge in costs.

But short term disruption aside, structural recovery in the sector is now under a cloud. While it is still early days to gauge the full impact of demonetisation, new loan growth---key to the revival of the sector—will take a knock, pushing recovery down several quarters. We remain cautious and recommend investors to be selective while stock-picking.

Here are four trends and their likely impact on banks’ performance in the 2018 fiscal.

Surge in deposits

Demonetisation has indisputably aided banks on one front—high accretion of deposits. The withdrawal of legal tender character of old Rs 500/1000 notes from November 9, and subsequent caps on drawing out money from banks and ATMs, have left banks flush with deposits over the past two months.

Sample this. Between October 28, 2016 and December 23 2016, banks’ deposits have shot up from around Rs 107 lakh crore to 112.6 lakh crore---an increase of about Rs 5.5 lakh crore in two months. This is nearly twice the amount of deposits that flowed into banks between April and October 2016.

But how much of this increased liquidity will stay on in the banking system, once currency flow normalises and various caps on withdrawal are lifted?

Few bankers are of the opinion that the current level of 40-50 per cent retention of deposits, can go down to 20-30 per cent over the course of the year. This means that even if we assume that about two-third of the deposits coming into the system are withdrawn finally, the growth in deposits at the end of FY17 and FY18 fiscal will be notable and higher than the 9-10 per cent growth seen in 2015-16.

Way forward

Fall in cost of funds:

Over the past two months, with bank deposits swelling, deposit rates have fallen by a substantial 50-75 basis points across banks and tenures. While such a steep fall is unlikely again, banks retaining a portion of the deposits (in the form of CASA and term deposits), will continue to trim deposit rates. This should lead to reduction in banks’ cost of funds through the next fiscal (2018). The uptick in deposits will be commensurate with the market share of banks. PSU Banks that command a lion’s share (over 70 per cent) of the deposits, will be the biggest gainers of the rise in deposits, leading to lower cost of funds.

Good appetite for government bonds:

After the sharp rise in funds post demonetisation, banks began lending such surplus to the RBI under the reverse repo option. PSU Banks, in particular, aggressively deployed excess funds in government bonds too. The fall in bond yields is likely to add 15-20 per cent kicker to banks’ earnings in FY17.

As withdrawal caps are lifted, and banks are able to gauge liquidity scenario better, parking huge sums under the reverse repo window will likely halt. Banks instead will look to deploy these funds for a longer term. Given the slackness in credit growth, particularly in PSU Banks, a large portion of excess funds will continue to find its way into the government bond market. This should bump up banks’ treasury income in FY18 and aid earnings to some extent. But after the sharp rally in bonds last year, treasury gains will likely moderate in FY18.

In the month of November, PSU Banks have been net buyers in government securities to the tune of about Rs 25,900 crore. Private Banks too bought (net) around 20,000 crore in November. In the month of December, the buying spree continued for PSU Banks, who made net purchases of a whopping Rs 61,000 crore, even as private banks turned net sellers.

Slackness in lending

Banks flush with liquidity, in a falling interest rate scenario, is a perfect recipe for boosting lending. But tepid borrowing appetite by highly-leveraged corporates and banks’ reluctance to lend, has failed to spur loan growth, even after a substantial fall in lending rates over the past year. Even before demonetisation, credit growth had slipped to 8 per cent levels in the beginning of November. According to the RBI’s latest figures (as on December 23), credit growth has fallen to a meagre 5.1 per cent, down from 10-odd per cent levels last year. The growth had already fallen to 5 per cent levels in November, as credit to industry (corporate) shrunk by 3 per cent.

Credit growth has been closely linked to the pace of economic growth, growing at 2.5 to 3 times the real GDP growth in the past. The multiple at which bank credit has grown in relation to real GDP has however shrunk over the last two to three years. This is partly explained by the Centre’s move to a new series of GDP two years back and weak credit offtake in public sector banks. In 2014-15 and 2015-16, bank credit has grown at 1.2 to 1.4 times real GDP growth (new series) and about one time nominal GDP growth.

Way forward

No big recovery:

The Central Statistics Office, recently put out its advance estimate for GDP growth for 2016-17, which has been questioned by many economists. The CSO’s 7.1 per cent growth in real GDP in 2016-17, has been pegged down by most economists to 6.8 per cent levels. With the cash-crunch in the economy expected to normalise by the second half of 2018 fiscal, many economists estimate a 7.6-odd per cent growth in real GDP for 2017-18.

If we apply a 1.2-1.4 times multiple to this, bank credit can, at best, grow by 10-11 per cent in 2017-18. Also, while bank credit grows at a certain multiple to real GDP growth, the nominal GDP, matters too, as it in turn decides the credit requirement of a corporate.

With inflation heading lower, the gap between real GDP and nominal GDP shrank in 2015-16. But in the last Budget, GDP deflator (ratio of nominal to real GDP) — another measure of inflation —was assumed to go up in 2016-17 by 3.2 per cent, on the back of base effect. The CSO while revising the growth in real GDP down, has upped the growth in nominal GDP to 11.9 per cent as against 11 per cent earlier. If we assume a 7.6 per cent growth in real GDP for FY18 and a similar growth in deflator then the nominal GDP growth of 11-11.5 per cent will again mean a 11-12 per cent growth in bank credit (at one time multiple).

Pockets of growth

Even within the modest 10-11 per cent credit growth in 2017-18, the growth will be concentrated in pockets. In the last three years, PSBs have grown at a far slower pace, because of their huge exposure to the corporate segment — 40-50 per cent of lending is to large corporates. Credit growth of PSBs plummeted to 4 per cent in 2015-16 from 7 per cent in 2014-15. In contrast, private sector banks were able to clock a robust 26 per cent year-on-year rise in lending in 2015-16. This disparity is likely to continue and the growth in 2017-18 too will be driven by private banks, as corporate lending will continue to remain weak.

The spate of lending rate cuts recently is likely to trigger growth in retail loans---home loan, personal and auto loans, and credit cards. Unlike in 2008-09, when in the wake of the global financial crisis the RBI adopted an aggressive monetary easing and PSBs sprinted ahead, growing their corporate loans aggressively, the focus this time around will be on retail loans.

The only trigger for loan growth besides consumption driving retail loan growth will be government spending in FY18.

Margin pressure

With deposit rates trending lower, banks, no doubt, have gained from lower cost of funds. But moving to the new marginal cost of funds based lending rate (MCLR) structure has forced banks’ hands to pass on the benefit to new borrowers at a faster pace. Effective January most banks have slashed their MCLR by a sharp 75-90 basis points. The price war, will put pressure on yields on advances and hence margins, thus offsetting gains of lower cost of funds.

Way forward

Retail vs corporate

The pressure on margins can be felt more by retail-oriented banks, because transmission of rate cuts will happen faster there and new growth will be at lower lending rates. On the corporate side too there will some reduction in rates, but less dramatic. Also growth in corporate loans will only pick up with a lag, despite rate cuts. The general risk appetite for corporate lending is low for banks and hence the pressure on growth and pricing will be low.

Overall margins will remain stable to marginally negative for FY18.

Other costs

The biggest setback in terms of costs for banks due to demonetisation has been on account of recalibration of ATMs and logistics costs involved in transporting currency, in a short period of time. Also, post demonetisation, between November 9 and December 30, banks had to waive off ATM charges for all transactions (irrespective of the number) and merchant discount rate for debit card transactions etc. These will have short term impact on costs.

However over the long run, the sector as a whole will benefit from increased use of digital modes of transactions, which will improve operational efficiency.

Asset quality woes yet to bottom out

Before we gaze into the crystal ball and predict how asset quality will pan out in FY18, let us look back at the performance of banks until the September 2016 quarter. Four quarters after the RBI’s asset quality review (in the December 2015 quarter), the NPA problem still loomed as a key risk to banks’ earnings. Despite the massive clean-up, between March and September 2016, gross NPAs went up from 7.8 per cent to 9.1 per cent of total advances.

Factors that were likely to weigh on the performance of banks (up until demonetisation), were large slippages into NPAs from the watch list that certain banks such as SBI, ICICI Bank and Axis Bank had created (of stressed accounts). Also while the pace of quarterly slippages had moderated (from a whopping Rs 1-1.5 lakh crore in the second half of FY16 to Rs 50,000-odd crore in the first half of this fiscal), provisioning requirement was unlikely to fall substantially due to higher provisions doe older NPAs.

Way forward

Mixed bag

Post demonetisation, there are fresh set of risks to banks’ asset quality-- supply chain disruption for large corporates, possible increase in delinquencies in the SME and LAP portfolio (loan against property) due to cash crunch in the short-term and general slowdown in the economy. But there are also other factors that are likely to balance out some of these risks.

For one, the biggest benefit from demonetisation has been the accelerated fall in lending rates, which should help improve the debt servicing ability of corporates thus easing up asset quality pressure.

Two, large corporates have been deleveraging---paying off debt, by selling off assets. Asset sales can accelerate, with steep fall in borrowing costs for the acquiring company.

Three, the RBI has relaxed NPA recognition norms by 60 days, for payments due between 1 November and 31 December on loans up to Rs 1 crore. This should keep asset quality steady for the SME segment. The RBI has also offered similar dispensation to famers, for prompt repayment incentive of 3 per cent on crop loans.

Risks from retail

Up until now, stalled projects and stress in core sectors have spelt doom for banks with large corporate exposure. But with banks aggressively growing their retail business, risk from the huge unsecured portfolio, looms large.

The credit card business that peaked at about Rs 30,000 crore in 2008 and almost halved by 2011, has been growing steadily by over 20 per cent annually in the last two years--now a Rs 46000 crore business. Personal loans too have been growing at a fast clip, ending the 2016 fiscal with a 25 per cent increase, and 17 per cent growth as of November. Vehicle loans, while secured, are nonetheless riskier than housing loans, as they are offered against a depreciating asset. These loans, too, have grown by 21 per cent as of November.

Some private banks, having built a strong retail focus over the years, have mitigated risks by extensively using data analytics and automation to assess the credit behaviour of customers. But PSU Banks, have been late adapters to the usage of credit bureaus, and unless back end processes of underwriting customers are streamlined, adhoc focus on retail can spew problems.

In the ensuing quarters, asset quality of retail portfolio will need a keen watch.

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