Banks on a roll now, but may see slowdown going forward

The banking system’s NPAs had been rising over the years and reached a peak level of Rs 10 trillion in 2018 with the NPA ratio at almost 12 percent.

Banks seem to be on a roll, if the half yearly results are anything to go by. Net profits of 14 banks who came out with their half yearly results (about 80 percent of the banking system) grew by almost 50 percent over the previous half year. Credit growth averaged 22 percent and asset quality continued to improve, with the overall NPA ratio declining by nearly 160 bp. While economic fundamentals are undoubtedly looking up, super profits may need explaining because lending is generally considered a low value- added business with small premia. Their return on assets (RoA) is small, averaging only about 1.1 percent in 2022-23. With thin margins such as these, credit volumes usually need to be high to generate profits. But for banks there is another element, which is risk, which has proved more crucial for profitability. The play of these factors is seen in the data below, which covers the past year as well the current half year.

Operating Margins

We find that operating margins (operating profits to total assets) were steady through all periods, averaging around two percent, which is typical for banks, since interest rate changes impact both income and expenditure. The RoA (net profit to total assets) was also reasonably stable except during 2016-20 when they slumped to 0.04 percent, before recovering to 0.87 percent during 2021-23. The drop was caused by higher risk, captured by the ratio of provisions to total assets which had shot up due to the high level of NPAs. The banking system’s NPAs had been rising over the years and reached a peak level of Rs 10 trillion in 2018 with the NPA ratio at almost 12 percent. The provision to assets ratio effectively reveals how much of the operating spread is used up for provisioning. Though the ratio has always been high (averaging 1.1 percent), it shot up to 1.9 percent during 2016-20 which caused RoA to plunge to 0.04 percent. The provision ratio declined from 2021 when the absolute levels of NPAs began to reduce.

But they were still high as a proportion of operating spread, which is why RoA continued to be low even when credit and operating spreads were increasing during 2021-23. Some of these numbers improved significantly during the current half year, which explains the huge jump in net profits. For one, operating spread remained high at 2022-23 levels as transmission of policy rate hikes continued. Also, the fall in provision spread was more pronounced, which fell to 0.74 percent, leading to net profit growth of almost 50 percent and RoA to increase to 1.29 percent. To be sure, the numbers are based on the results of only 14 banks, but they cover almost 80 percent of the banking system in terms of assets. Another caveat would be the impact of the HDFC bank merger in the period, which distorted quite a few statistics.

The Big Banks

The big banks also registered good numbers, though HDFC’s seemed clouded by the effects of the huge merger. A summary of HDFC bank’s half-year performance could be that while its balance sheet grew by 53 percent, net profits went up by 41 percent. Its spreads (net interest income, operating profit) grew more moderately, as it had taken on a massive level of liabilities (deposits and borrowings). Interest expenses grew by 96 percent and its average cost of funds went up from 3.9 percent to 5.5 percent from presumably higher cost liabilities. A huge increase in NPAs (70 percent) was another fallout, though surprisingly, NPA provisions declined by 10 percent. ICICI Bank’s numbers were also impressive, with credit growing at 18 percent and net interest income by 30 percent.  A large reduction in provisioning (33 percent) helped net profits grow by 38 percent. But its average cost of funds also rose sharply from 3.5 percent to 4.8 percent. SBI’s growth story was a little different. Credit growth was modest (13 percent) as was net interest income growth (18 percent). But net profits increased by 60 percent with the growth coming from a massive increase in non-interest income (104 percent) and a 65 percent drop in NPA provisioning. The NPA ratio also dropped significantly by nearly 100 bp.

Slower Credit Growth

For the current financial year, credit growth seems to have slowed, in contrast to the strong growth on a half-yearly basis. As per RBI data, excluding the HDFC merger impact, bank credit grew by only 6.5 percent between April 2023 and September 2023, with personal loans growing by only 7.1 percent.  The tepid growth in retail credit is surprising, considering it has been the main growth engine. Perhaps the continued transmission of lending rates is making credit costlier. The RBI’s concerns on retail, particularly on unsecured lending, may also have weighed in on banks.

Asset quality is likely to keep improving with write-offs continuing. The reduced levels of risk could now let banks focus again on growth and margins, as the effects of lower provisioning wear off. Which is why the slowing credit in the first half is a concern. Another issue is the tapering of CASA deposits, whose traditionally high share has often helped buffer interest rate increases and protect margins.  Their growth was only six percent during 2022-23 and continuing to be so which could strain margins. Thus, even with risk subsiding, the pressure on margins and volumes could ultimately tell on profitability.

SA Raghu is a columnist who writes on economics, banking and finance. Views are personal, and do not represent the stance of this publication.