Lending blues

The latest Reserve Bank of India data show a sharp rise in non-food credit offtake, which is good news for the banking sector.

With interest rates bottoming out, a pick-up in credit is essential if banks are to post good results, now that the windfall gains from the sale of securities are no longer available.

Earnings growth has slowed down sharply for many banks in the third quarter of the year, because while income from capital gains has fallen, that has not been offset by a corresponding rise in interest income.

Indeed, net interest income has risen in most instances, thanks to the fall in deposit rates, but that has not been enough to compensate for the decline in "other income". It is critical, therefore, for banks to increase lending.

There are, however, powerful headwinds that banks will have to battle through. One of them is the recent relaxation in the norms for external commercial borrowings (ECB), which has given a free hand to corporates to borrow abroad.

Smaller companies were already doing so, since ECBs up to $50 million were freely allowed. But now the larger corporates will follow suit, and that could mean substantial lost business for many banks.

Add to that the lowering of the rate of interest on loans to the Food Corporation of India, and quite a few public sector banks will feel the heat.

Add to that the fact that banks have been at the receiving end of the Finance Minister's liberal interest reduction schemes for agriculture and the small scale industry, and pressure is being applied to ensure that targets for mandated lendings are met.

To be sure, the government will presumably bear the interest subsidy, but it is possible that the subsidy will be merely for the difference between the administered interest rate and the prime lending rate, which is not really fair, since such loans will under market conditions be priced much higher than the prime rate.

Moreover, although there is no question that the economy is picking up steam, corporates have plenty of cash with which to fund their expansion programmes.

What's more, now that ECBs have been relaxed, companies can not only fund these programmes through overseas loans, they may even use them to pay back their loans to domestic banks.

Does all this mean that banks are in for difficult times? Not really. The Indian banking system remains one of the soundest in Asia "" non-performing assets as a percentage of gross domestic product is the lowest in the region.

Banks have used the windfall capital gains well in cleaning up their balance sheets, and it is to be hoped that lower NPA provisions going forward will mean higher earnings.

Indian banks have a great competitive advantage in their low-cost information technology infrastructure, and new sources of income have been found through selling products such as mutual funds and insurance policies.

In retail lending, banks have merely scratched the surface so far. But while the long-term potential of the industry remains very good, it is to be hoped that the demise of windfall gains and the easing of ECB norms will force banks to start lending to the second rung of corporates.

That is already happening, with several banks expanding their Small and Medium Enterprise (SME) departments.