Banks' interest spreads to recover in FY07: Crisil

Interest spreads of banks are likely to recover in FY07, according to research by ratings agency Crisil.

According to the agency's comprehensive review of the Indian banking system, interest spreads are expected to increase by 11 basis points to 2.89% in FY07 with the aversion to raising lending rates seen in FY06, now gone. One basis point is one-hundredth of a percent.Crisil said the increase in interest spreads will be driven by a 50 basis
points likely rise in banks' yield on advances in FY07 against just 20 basis points in FY06. This would be a result of banks being able to pass on the increasein the cost of funds to their customers in FY07, by re-pricing a significant portion of their loan books during the year.

In FY06, stiff competition had prevented most banks from passing on the entire increase in the cost of funds to customers. Only a portion of advances got re-priced, translating into a 20 basis points increase in yield
on advances in FY06.

Crisil said the overall yield on carry business (advances plus investments) of banks is likely to increase by 36 basis points to 7.98% in FY07 from 7.62% in FY06, as the increase in yields on advances would more than offset the declining trend in the yield on investments.

This increase in the overall yield would be contrary to a 2 basis points fall in FY06, which was because of a 45 basis points decline in the yield on banks' investments.

Crisil said it believes that the sharp dip in core profitability levels across the banking sector during FY06 was a temporary deviation from the upward trend seen in core profitability levels since FY02 and that it would be reversed in FY07.

The intrest spreads - the difference between the interest yield on carry business and the cost of funds - for the banking sector had declined by 23 basis points to 2.78% in FY06 from 3.01% a year earlier.

The downward trend in operating expenses in the banking sector is also expected to continue during FY07, as more branches get automated, software-driven systems. But the decline in operating expenses is expected to be marginal in 2006-07 as the roll-out of automation would happen
gradually.

Moreover, the quantum of fee-based income would also continue to increase. Fee based income in the banking system has increased from 1.13% of average funds deployed in FY03 to 1.27% in FY06.