RBI study finds lazy banking rewards public sector banks but not private lenders

“The analysis finds a favourable impact of investment in government securities (G-Secs) on the profitability of PSBs, indicating better risk-adjusted returns on G-Sec investments relative to lending operations amidst an increase in their non-performing assets. On the other hand, for private sector banks, G-Sec investments are not found to result in higher profitability in line with the conventional wisdom of higher returns from lending relative to G-Sec investments,” the RBI study said.

India’s banks are, by nature, captive investors of government bonds, as by regulation they are required to invest 18 percent of their deposits in government paper. This ratio was as high as 38 percent in the early 1900s and was progressively brought down as the economy’s needs for banking finance increased.

Nevertheless, PSBs have bought more than the regulatory minimum. Private sector banks, on the other hand, have stuck to the regulatory requirement and big lenders have held bonds only slightly above the minimum.

The key reason that a similar investment strategy has a diverse outcome for PSBs and private sector banks could be due to their approach in pricing credit risk. Past bad loan cycles have shown that private sector banks have demonstrated a more robust credit risk pricing ability compared with their public sector counterparts. Indeed, in the bad loan pile-up during FY16-FY19, PSBs had a lion’s share of the overall stressed loan pile. Private sector banks showed relatively resilient loan portfolios, partly due to reliance on retail loans and adequate risk pricing. The need to reduce credit risk by incrementally investing more deposits in low-risk government bonds than lending to riskier private sector does not arise as much for private sector banks as does for PSBs.

The RBI study does not examine the credit risk pricing of banks, though.

The study examines the relationship between banks’ credit and investments and the reasons for the changes in both. The study concludes that depending on the conditions in the economy, an increase in government bond purchases by banks could crowd out private investment. At the same time, an increase in government bond purchases by banks also indicate a portfolio rebalancing during episodes of rise in stress within their loan books. “The empirical analysis, thus, suggests the presence of both portfolio rebalancing and crowding-out channels at play and policies aimed at strengthening the asset quality and capital position of the banks can lead to an enhanced flow of bank credit to the productive sectors,” the study said.

While the positive effect of reduction in credit risk on balance sheet and thereby increase in profitability has been found, holding a large bond portfolio can bite otherwise. The negative fallout of a large bond portfolio is mark-to-market losses. In the current interest rate cycle, this has emerged as a key risk to banks’ earnings.