The global financial crisis contagion sprouted out into serious risk aversion the world over, leading to a severe liquidity crunch transcending all the surmountable boundaries.

While the involvement of India's banking system in the sub-prime crisis, which has led to the current global crisis, has been negligible and hence it remained relatively unscathed, it is now facing its own set of problems locally. Among the most recent ones was the extremely tight liquidity conditions.

While the government and the RBI have announced measures that have alleviated the pressures for the time being, the Indian banking system continues to be surrounded by a host of issues which include high cost of funds, slowing business growth and concerns pertaining to asset quality. To know more on how these are impacting the sector, read on.

Liquidity woes: Partly resolved

Recently, liquidity taps resembled the ones in the Thar Desert and the banking system was made to fight a lone battle to tide over this liquidity crunch. Advance tax payouts in September, dollar selling by RBI (to prevent steep depreciation of the rupee) in the forex market (due to selling by FIIs and demand from oil companies among others) led to a short-term liquidity squeeze.

Consequent to the global events, Indian banks were also finding it difficult to raise funds from abroad, and had to rely on the domestic borrowing to pump that money for their overseas operations. The borrowing by banks from the RBI too, was also on the rise, and not enough. Consequently, the domestic liquidity tightened and manifested in call money rates soaring to as high as 23 per cent.

The severity of the problem is visible from the fact that the country's finance minister and the RBI governor had to repeatedly step in to cool the nerves, with soothing words, immediate measures to ease the problems and forward-looking initiatives.

The good part is that the measures (CRR cut, etc) have solved the problems, at least for the near-term, as over Rs 100,000 crore (Rs 1 trillion) worth of funds have been infused into the system. Additionally, the first tranche of farm loan waiver disbursements, repayment of fertiliser loans to banks along with central government employee's arrears is likely to give a boost to the sagging liquidity conditions going forward. Any increase in government spending as most of the expenditure will also ease liquidity concerns.

Inflation & interest rates seen easing

The RBI had adopted a hawkish approach and maintained a tight monetary policy stance in view of the high inflation, on the back of food articles, metal and oil prices moving northwards during the year.

The sharp rise of inflation by nearly three times during the last 12-15 months, had seen the RBI use tools like CRR (interest-free cash deposits that banks have to place with the RBI) and repo rate (at which the RBI lends to banks) in order to keep a tight leash on the general interest rate environment.

In recent weeks, inflation has been inching lower, albeit marginally, from its high of 12.82 per cent to 11.44 per cent currently, following the softening of global commodity prices.

But, despite the fall in commodity prices, the weakening rupee has negated part of the gains from lower prices for the imported goods. Thus, inflation is expected to remain firm until end-December 2008, to some extent due to a lower base in 2007.

Says Madan Sabnavis, chief economist at NCDEX, "Inflation would hopefully be contained at just around the 10 per cent mark by the end of the year. The decline in prices globally of metals in particular and crude oil would both have a soothing effect on inflation during the year. The critical factor would be agricultural commodity prices. Going by the government's first advance estimate, production may be sub-optimal, in which case there could be pressure on prices unless the Kharif crop is better."

He adds, "Interest rates would tend to ease during the second half of the year since the RBI would be focusing on growth now that inflation has been contained. In order to enable this, the RBI would be further easing the CRR as well the rates to provide a fillip to industry. Overall, the CRR is already down to 6.5 per cent and interest rates ie repo rate, may come down to 7-8 per cent till March -- probably in 2 or 3 tranches."

Credit off-take: Off highs

While credit growth at close to 25 per cent in the first half of FY09 looks healthy, it is due to the higher demand from the oil, fertiliser and infrastructure sectors. Some of the demand is also from the Indian corporate sector.

For India Inc, it was used to raising cheaper loans from abroad, but those rates have increased in line with the tight liquidity conditions, while the ECB route is not as easy as before.

The rupee's depreciation is also making things worse. The recent meltdown on the bourses has meant that raising money from the equity route is also largely closed. As a result, banks are witnessing credit demand from bigger corporates.

However, even as the fears of higher inflation are subsiding, higher interest rates have led to a slowdown in the industrial activity. Higher rates and bottlenecks in raising funds are also leading to projects being postponed in the course of time.

Some companies are already reportedly cutting production and have announced plans to postpone expansion plans, all of which are clearly an indication of slowing economic growth. Banks, too, on their part are showing cautiousness in lending due to tight liquidity conditions, and perhaps the threat pertaining to deteriorating economic conditions.

Lastly, for banks with international exposure (they had witnessed strong growth in international business), analysts expect this business to slow down substantially, if not shrink. While the capital adequacy ratio for most banks is fine and the move to increase it to 12 per cent is aimed at instilling in customers, inability of banks to raise capital (given the depressed capital market conditions) could curtail growth plans of such banks.

Profitability: Under pressure

The cheaper CASA deposits are not coming easily as the depositors are showing an inclination for term deposits, with the hike in deposit rates; evident from the lower CASA ratio for many banks in Q1FY09. Any substantial conversion of CASA to term deposits will increase the cost of funds for the banks, going forward, thus the pressure on net interest margins.

The RBI's surprise U-turn with the reduction of CRR by 250 basis points in a matter of two weeks will negate any liquidity deficit that is present in the system. The freeing of CRR may, at best, provide some cushion to margins, as these funds can now be deployed for lending (or parked in bonds that yield close to 8 per cent annually).

Says a recent release by Crisil, 'The profitability of Indian banks is expected to remain under pressure due to increased cost of borrowing, declining interest spreads, and lower fee income due to slowdown in retail lending. Profit levels are also likely to be impacted by mark-to-market provisions on investment portfolios and considerably lower profit on sale of investments, as compared with previous years.'

To sum up, expect margins for banks to remain under pressure for some more time.

Asset quality: Needs monitoring

In a high interest rate and slowing economic growth scenario, asset quality of banks will come under rigorous scrutiny. The retail non-performing assets are likely to be in the uptrend, even though banks have recently pared exposure towards retail assets to improve their asset quality.

The NPAs could also arise from small and medium enterprises segment from the last quarter of FY09. In that light, the provisions for bad loans will continue to remain high for the banking sector and will dampen the overall profitability.

For now, the comforting factor is that the NPA levels are far from historic levels. Rajesh Mokashi, executive director, CARE Ratings, says, "The overall asset quality of 44 Indian banks studied by CARE has shown an improving trend with median Gross NPAs reducing from 2.54 % as on March 31, 2007, to 1.83 % as on March 31, 2008. The first quarter FY09 median Gross NPA numbers for 32 banks studied by CARE have marginally increased to 1.93%, however they are substantially lower than the corresponding period in the previous year."

Although Indian banks are well capitalised and regulated, and are seen in a better position to endure any probable increases of NPA, the situation needs monitoring as the trend could change and NPA levels may move up substantially, should there be a worsening of domestic economic conditions.

The recent events including postponing of expansion plans by some companies (steel, cement, etc), the retrenchments or delay in recruitments (BPOs, IT, airlines, etc) and the reported inability to repay loans taken (especially by real estate companies) only indicate that the near- to medium-term is going to be tough. In the long run, the threat on account of a potential change in attitude of agri-customers (given the loan waiver) also needs to be watched.

Outlook

Banking stocks have been underperforming the indices from the last one year, as the markets were of the view that inflation induced high interest rates will result in credit slowdown and asset deterioration.

However, the recent moderation of inflation and CRR cuts has kept the banking stocks in the limelight. In fact, the low FII holding in the public sector banks have helped the PSBs escape (partially) the recent wrath of stock markets.

All this, along with the government's announcement to pay interest on farm loan waiver, has also led to their outperformance (since July) against the broader indices.

As banking is talked as a proxy to the Indian growth story, the signals from the general economy will have an effect on the banking sector as well. In the near-term, higher provisions for NPAs and impact on other income (from overseas business, capital market related activities, slower growth in retail loans, lower profit on sale of investments, etc) are also likely to affect the profitability of the banks.

In this light, banks focussing on quality asset growth and higher CASA among others should be relatively better off. Meanwhile, any surprise moves by the regulator or government to boost economic growth rates (or reduce interest costs by lowering the repo rate), which is anybody's guess as of now, could rub off positively.

To conclude, while the situation has not turned for the worse, there are concerns over profitability, growth and asset quality. Meanwhile, analysts recommend being selective while picking banking stock and that too on declines and with a long-term perspective.