A. Interest earned

Advances: Corporate demand to drive growth

Retail
In the last five years, the key growth driver on the retail side has been housing loans (growing at over 25% per annum). From a very negligible contribution before five years, total retail advances as a percentage of bank advances for the industry is estimated at around 20% levels in FY04. This goes to show the magnitude of growth during the period.

Given the current retail credit penetration level (estimated at 2% in case of housing loans), we continue to be optimistic about the growth rate of credit on the retail side. Despite thinner margins, retail credit will continue to occupy a substantial portion of the banks' credit portfolio, thanks to the volume growth, on the back of extensive reach. New schemes (better availability) and superior marketing of the same (better awareness) will aid the volume growth. However, we believe that the rate of growth is likely to slowdown in 2005 and beyond. While factors that drive retail credit viz. availability of loans, awareness and real income will increase in 2005 (see graph), interest rates will increase (as it has in the last six months), which will be a dampener.

Corporate
Given the fact that gross fixed assets of the manufacturing sector grew only by 2% CAGR in the last five years as compared to a sales growth of 17% in the same period, existing capacities are being fully utilised. With industrial growth expected at more than 6% in 2005, the capex of corporates will increase (to fund expansion). But the caveat here is that, bank credit is no longer the 'most preferred' avenue for raising funds. It now faces tough competition from the capital markets (domestic and international), which is likely to witness a rush of equity and debt issues. All said, banks are expected to focus on their corporate customers for their 'non-food credit' segment, to support their net interest margins. We are positive on this side.

Investments - Lesser allocation in 2005
Once bitten, twice shy, the banks are unlikely to overexpose themselves to interest rate risks in investments. With non-food credit picking up, they are expected to deploy majority of their funds in advances rather than investments (a reversal of the trend). Conducive government regulations with regard to enabling consolidation may see banks opting for inorganic growth (domestic and overseas). Thus interest income from investments is likely to be pruned in the coming quarters.

Given this backdrop of higher corporate credit growth and lower investment income, interest income of banks is expected to grow at a faster rate in 2005.

B. Interest expended

Margins - To come under pressure
The margins that the banks will be anticipating, given the optimism about credit offtake, may not after all materialize, thanks to pressures on the 'interest expended' front. Better investment avenues (offering higher payoffs like equities) will succeed in luring investors away from bank deposits, unless the banking entities offer higher yields. Also, the necessity to augment their Tier II capital (to meet CAR requirements) will see banks go in for additional borrowings. This again will amplify their interest expenditure budgets. A proactive measure on RBI's behalf to maintain price stability (slowing down economic growth by hiking interest rates) could reduce funds available with banks for lending, which then will influence the cost of lending.

To conclude...
In 2005, we expect net interest income to come under pressure (interest earned � interest expended), as the latter could shoot up at a faster pace than the former. Of course, the impact could vary bank to bank. The optimism with respect to the sector's future performance needs to be toned down to that extent.

The caveats:

• In the backdrop of a rising interest rate along with a fall in the treasury gains, there would be competition amongst banks for the expansion of loan book along with deposit mobilization. This drive would invite a huge credit risk for all the banking entities.
  
  

• The banks' ability to advance credit will be limited to the extent permitted by their CAR (capital adequacy ratio is increasing), which again may pose a major hindrance to most banks, given the need to comply with Basel II norms. This will in turn results in banks tapping the primary market to raise capital. While this will enable banks to fund their expansion plans, there will also be equity dilution (i.e. more number of outstanding shares). Whether all banks have the risk management system and ability to grow ahead of the market remains to be seen.
  
  

• Consolidation could gain pace in 2005. Whether the drive will lend the requisite synergies to the combined entity is another matter of concern.
  
  

• Lastly and more importantly, we believe that the net non-performing assets to advances ratio have bottomed out for the banking sector as a whole. The benefit of higher treasury profits that was supporting the banking sectors move to clean up their balance sheet has exhausted. If investors expect all banks to have low NPA ratios in the future, they are in for some surprise. Economy goes through cycles and the same will influence banking sector. Though the pressure of high NPAs is not likely to be witnessed in 2005, this risk exist beyond that.