State-Owned Banks Squatting On Gilts Bomb

Public sector banks, which have piled-up investments and have routed almost all their incremental deposits in this financial year into government securities or gilts, are sitting on a time bomb.

Though gilts are the safest instrument when there is a slump in credit offtake, the finance ministry feels the banks would be hit hard in the next couple of years.

"The spread between the banks' cost of funds and yields on gilts has narrowed down considerably and is disappearing fast," said a senior official.

The official said, "The attitude of banks to play safe will spell trouble for them in the next 2-3 years. Their bottomline would be under pressure." He pointed out that the weighted average cost of government borrowings had already dropped to 10.91 per cent this year compared to 10.97 per cent in 2000-01.

According to sources in the ministry, the banks have hardly cut their deposit rates though they have been forced to reduce their lending rates following successive bank rate cuts. This means the cost of funds of the banks continue to remain high. The Reserve Bank of India Report on Trends In Banking also pointed out that while the average cost of funds of the banking industry was about 7 per cent, the overhead cost (establishment and fixed costs) would take the total cost to between 9 per cent and 9.5 per cent.

As on November 2 this year, banks' total investment in gilts was a whopping Rs 3,85,324 crore. It accounted for about 36.6 per cent of their aggregate deposits. This is significantly higher than the mandatory 25 per cent statutory liquidity requirement (SLR) for banks. In the first eight months of this fiscal, banks have rushed and invested almost Rs 45,300 crore into gilts.

"Banks have not reduced their deposit rates. The spread between their cost of funds and lending rates which is already narrow is under greater strain due to falling yields on gilts," said Arun Kaul, managing director, PNB Gilts, a leading primary dealer.

He also said that banks faced another risk of depreciation in gilt prices as and when interest rates hardened. "If there is any pick up in demand, the interest rates would go up, forcing a depreciation in gilt prices," Kaul said. The banks would thus face a double whammy on their books of accounts when interest rates firm up with the market price of their G-sec holdings taking a hit and lower interest earnings on outstanding paper.