Indian Banks' Profit Escalator

The rate cut means lenders can offer cheaper credit, and do so at a decent margin.

India's monetary policy czar, Raghuram Rajan, has finally built his country's banks a profit escalator that's taking them up rather than down.

Subdued Business

Deposits at India's banks are growing at a weaker pace than loans

Source: RBI, Bloomberg

Lenders can now borrow short-term money more cheaply, advance longer-term funds at a higher premium, and use the additional profit to provide for past lending mistakes. Large industrial groups are still looking to cut leverage, but new borrowers, such as online retailers and a yoga guru's rapidly expanding consumer goods empire, could help financial institutions find fresh business. So long as the escalator doesn't stall, banks stuffed with zombie loans might be able to ride it to the land of the living.

For now, it looks like the moving staircase is speeding up.

Today's widely expected quarter-percentage-point reduction in the central bank's policy rate takes the benchmark for Indian borrowing costs to its lowest in five years. Despite tight liquidity, rate cuts have had a fairly strong effect on the money market, with three-month treasury bills yielding nearly 1.5 percentage points less than they did before Reserve Bank of India Governor Rajan began pruning rates in January last year.

By comparison, 10-year government bond yields have fallen very little. The yield curve has shifted down, but equally importantly, it's sloped up. The downward shift means banks can acquire new customers by offering cheaper credit at all maturities; the steepening implies they can do so at a decent margin. That's a sweet spot for lenders who haven't had much good news over the last several years. Shares of as many as 28 of them -- including State Bank of India and Bank of Baroda, the country's largest and third-largest lenders by assets respectively -- trade for less than their book value.

Pathway to Profit

Indian banks can use rising yield spreads to boost earnings

Source: FIMMDA, Bloomberg

It will take billions of dollars of fresh capital for India's banks to get healthy again. For lenders to be able to generate some of that from their own earnings, credit demand needs to pick up; it's unclear if a nascent revival in loans will endure in the absence of matching deposit growth. Besides, the 15 large Indian companies with the highest risk of default, according to a Bloomberg metric, paid five times more interest on their debt last year than in 2011.  They certainly can't take on more loans.

But there are bright spots. Growing e-commerce inventories need financing, and a new law that gives superior consumer protection to home buyers may lead to stronger mortgage demand. According to the Economic Times, Patanjali, yogi Baba Ramdev's herbal soap-to-rose sherbet business, is in the market for bank loans. With some help from Rajan's profit escalator, the nation's banks might just be able to come up for fresh air.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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