Rising spread to put banks on profit path

Interest spreads of banks are likely to recover in FY07 as a bigger part of the rise in cost of funds is seen being passed on to borrowers than was the case in FY06.

In a comprehensive review of the Indian banking system, ratings agency Crisil said interest spreads were expected to increase by 11 basis points to 2.89 per cent in FY07 with the aversion to raise lending rates seen in FY06 no more there. One basis point is one hundredth of one per cent.

Crisil said the increase in interest spreads would be driven by a likely 50 basis points 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 increase in cost of funds to their customers in this financial year, 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 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 per cent in the current financial year from 7.62 per cent in FY06, as the increase in yields on advances would more than offset the declining trend in the yield on investments.

This increase in 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 since 2001-02 and that it would be reversed in 2006-07.

Interest 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 per cent in FY06 from 3.01 per cent a year earlier.

The downward trend in operating expenses in the banking sector is expected to continue during FY07, as more branches get automated.

But the decline in operating expenses is expected to be marginal in FY07 as the roll-out of automation will happen gradually.

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