Call it lazy banking or lack of opportunities, but India’s banks have parked a larger portion of their deposits in government bonds than they lent to borrowers in the past two years.
A copious amount of liquidity and relaxations allowed by the regulator ensured that lenders didn’t lose money and even made big gains out of their investments.
That era of easy earnings is now coming to an end as bond yields have begun climbing sharply with expectations of them rising higher in the coming months. Even as lenders begin to offer more of their deposits as loans, their bond portfolio will make them sweat for returns.
In fact, analysts believe that when banks mark their investments to market prices, they would stare at losses this financial year.
“Trading profits are trending down and there could be a mark-to-market hit as well. So on a net basis, the number could be negative,” said Anil Gupta, vice president at rating company ICRA Ltd.
Rising yields
Banks held nearly a third of their deposits in government bonds as of March-end, Reserve Bank of India (RBI) data shows.
Since April, the benchmark 10-year government bond yield has risen by 50 basis points to trade around 7.35 percent currently. One basis point is one-hundredth of a percentage point.
Bond investors expect the 10-year yield to rise to 8 percent by the end of this year as an unfriendly inflation forces rate hikes by RBI. “We pencil in the 10-year yield in a range of 7.25-8 percent for the rest of FY2023E,” analysts at Kotak Mahindra Bank wrote in a recent note.
When bond yields move up, their prices go down, resulting in losses in the bondholder’s portfolio. Bond investors mark their investments to current market prices frequently to get a handle on their gains or losses from trading.
The impact of rising bond yields is already visible in banks’ trading incomes. Banks made Rs 28,000 crore of trading gains during the first nine months of FY22, less than 60 percent of the gains made in the corresponding period in FY21, Gupta said. Trading profits had been falling every quarter during the year.
Segregated portfolio
For banks, the segregation of their bond portfolio ensures that losses are limited. Banks hold their bonds in three categories, i.e. held-to-maturity (HTM), held-for-trading (HFT) and available-for-sale (AFS) categories. While bonds are marked to market prices, those held in HTM need not be, which limits the notional loss incurred by the bank.
This elbow room applies to 19.5 percent of bond holdings, which was increased to 22 percent last year by RBI as a relief measure. The caveat was that only new bond purchases would be allowed in this enhanced HTM portfolio. This relaxation is effective until March 2023.
These regulatory relaxations, along with buoyant bond markets, ensured that trading profits surged in FY21. Banks raked up Rs 50,000 crore worth of trading profits in just nine months of FY21, 25 percent more than the trading profit in the entire FY20, according to ICRA.
As such, banks are allowed to shift bonds from the other two categories into HTM once a year as a measure to limit mark-to-market hits.
In FY23, the opportunities to make money off trading would be stymied by a hawkish monetary policy. Bond yields have risen across markets globally, which puts further pressure on domestic government paper.
Does this mean that banks would take a hit on their net profit? There is a fair chance that the pressure on profitability would arise from banks’ investment portfolio rather than their loan book. Note that in FY21, trading profits contributed almost entirely to the core operating profit of banks.
That said, trading gains or losses tend to be outsized when monetary policy and inflation trends turn. Some deft portfolio management could limit these. The fact remains that the boost to earnings from the trading desk is over.
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