There could be a significant impact on the profitability of the Indian banking system as the inflation data for May and June 2021 breached the Reserve Bank of India’s (RBI) target corridor, in turn exerting pressure on the long-term yield curve, according to India Ratings and Research (Ind-Ra).
Retail inflation remained above the monetary policy committee’s upper threshold of 6 per cent for the second successive month in June at 6.26 per cent against 6.30 per cent in May.
A 100 basis points (bps) upward shift in the yield curve could impact the pre-provisioning operating profit (PPOP) of public sector banks (PSBs) by 8 per cent and that of private banks by 3.2 per cent, Ankit Jain, Senior Analyst, Ind-Ra, said in a note.
The impact on the overall banking system, could be 5.8 per cent. One basis point is equal to one-hundredth of a percentage point.
Ind-Ra assessed that the 100 bps movement in the yield curve would impact the common equity tier 1 of PSBs by 28 bps and that of private banks by 13 bps; while for the overall banking system, the impact could be 22 bps year-on-year (yoy).
The note said this has been taken on a post-tax basis, without considering the banks’ ability to reclassify their trading book and a likely partial offset from lower pension costs.
Three cycles of yield curve expansion
On analysing the past interest rate cycles, Ind-Ra has observed there have been three cycles of a yield curve expansion FY05 onwards, showing a strong inverse correlation between treasury income and interest rate movement.
Furthermore, the sensitivity seen for PSBs was much higher than that for private banks.
Ind-Ra said during the first cycle, treasury income contribution to PPOP reduced to 3.4 per cent in FY07 from 21.3 per cent in FY05, while it reduced to 3.2 per cent in FY12 from 15.3 per cent in FY10 in the second cycle and to 5.6 per cent in FY19 from 22.5 per cent in FY18 during the third cycle.
Also, the sensitivity was similar for private banks; however, the volatility in PPOP and PAT (profit after tax) was limited due to a lower share of trading book than that for PSBs till FY14 and stronger operating profit buffers.
Nonetheless, private banks were also impacted in the FY18-FY19 cycle during which the treasury income fell to 3.3 per cent from 9.7 per cent of PPOP and to 9.3 per cent from 25.8 per cent of PAT.
Muted credit offtake
With the credit offtake remaining muted since FY17, banks have been maintaining a balance between holding higher statutory liquidity ratio (SLR) and carrying interest rate risk, also taking on risk by giving out loans in a falling interest rate environment, the note said.
Post the first covid wave, the RBI further extended the dispensation of allowing banks to hold more than 25 per cent of their total investments under the held for trading investment category, subject to them holding up to 22 per cent in the form of SLR (statutory liquidity ratio) securities, it added.
While the limit for holding SLR securities had already been increased to 22 per cent from 19.5 per cent earlier, the RBI in its February Monetary Policy Committee meet has further extended the window for these holdings till March 2023 and a phased wind down thereafter by December 2023.
