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Budget 2006-07: Banking Having witnessed historic growth rates in terms of credit offtake, the banking sector saw itself getting transformed from treasury income reliant to core income (NII) reliant in the previous year. The revived credit offtake (both from the food and non-food segments) and technological reforms paved the way for a change in the dynamics of the sector itself. However, liquidity constraints and capital shortage (for compliance with Basel II accord) posed encumbrances to the sector's margin and asset growth respectively. Consolidation and investments through the FDI route continue to remain in the sector's 'wish lists'.  Budget Measures Banks to increase disbursements to farmers to Rs 1,750 bn by FY07 (with addition of 5 m farmers) and open a separate window for self-help groups (SHGs). Additional 0.4 m SHGs to be credit-linked by FY07 in association with NABARD. Farmers to be extended short-term credit at interest rate of 7% p.a. with an upper limit of Rs 0.3 m on the principal amount. Net capital support to banking sector (by way of issuance of special non-tradable government securities), standing at Rs 228 bn at the end of 9mFY06, to be restructured by their conversion to tradable SLRs. Fixed deposits with tenures of not less than 5 years to be included under Section 80 C for tax exemptions. Loans to food processing sector to be included in the priority-sector lending basket. Bill on insurance sector to be introduced in FY07. ATM operations and collection services provided by banks in public issues to be brought under the service tax net. Banking Cash Transaction Tax to continue for some more time until the AIR system is able to capture all significant financial transactions.  Budget Impact Inclusion of long term FDs under tax saving instruments may facilitate the mobilisation of deposits for banks that are constrained for low cost funds to meet the incremental credit demand. This will prove to be especially beneficial to banks like SBI [Get Quote] that have a large and well-diversified franchise. Conversion of the non-traded securities to traded GSecs will facilitate banks to offload the excess SLRs and access additional liquid resources for catering to the increasing credit needs of the economy. Mandation on banks (especially PSU ones) to hike their agricultural lending may resurface the problem of NPAs for these banks. Also, the interest rate of 7% to be offered to farmers will be approximately 350 basis points sub-PLR, thus pressurising margins for banks. Imposition of service tax on ATM operations may discourage usage, thus increasing operational costs for banks. Also, this may dissuade banks from entering into ATM sharing networks. However, banks are likely to pass on the same to the customers. Imposition of service tax on collection services provided for public issues - to dampen fee income for banks.  Sector Outlook The budget has offered 'sweetened pills' to the banking sector. While on the one hand, inclusion of long term FDs under tax exemptions and conversion of non-tradable GSecs into tradable SLRs provides greater liquidity to the sector (sweeteners), on the other hand, forced lending to agricultural sector coupled with compromised margins (NIMs) could dampen profits. Also, given that the tax exemptions are offered only on high cost (long term) FDs, the measure is not expected to significantly pare cost of deposits for banks. Discouraging the use of ATMs may add to the sector's already growing cost to income ratio. Service tax on fee income (for collection services) may further marginalise the other income component. Amendments to the Banking Regulation Act are yet to be 'tabled' and the reforms expected therein will be subject to their subsequent approval. Enhanced lending to agriculture and priority sectors will require banks (especially PSU banks) to exercise more caution on the NPA front. While we expected the structural factors such as credit growth and quality improvements to continue, cyclical ones such as margins pressures and liquidity constraints remain possible deterrents.  Industry Wish List Mr. K.L. Soumitraraj (PPR Department, SBI) In the light of the fact that banks are likely to face capital crunch on account of Basel II, banks may be permitted to float new capital options like preference shares. Necessary amendment to Banking Regulations Act 1949 requires to be made in this respect. In case of capital options like Innovative Perpetual Debt / Hybrid Debt recently permitted by the RBI, clarification may be given as regards to the tax deductibility for the interest paid on these instruments. Banks should also be permitted to raise short term Tier III subordinated bonds to cover the capital charge for market risk, which will help them in capital planning over a short to medium term. Ms. Jayashree Menon (Indian Banks Association) Sec 23 (D): Security receipts of Asset Reconstruction Companies (ARCs) should be treated as units of mutual funds and ARCs should get all the benefits available to mutual funds on their units. Sec 196: Aligning the TDS norms for ARCs to that of mutual funds. Sec 35 (D): Allowing the preliminary deduction allowed to corporate bodies (for capital issue related expenses and for setting up new projects) to banks, for raising capital through Tier I, II and innovative capital routes. Sec 36 (1) (VIIA) and sec 43 (D): Allowing banks deduction on provision made for all grades of assets (as per RBI norms) and not only on bad and doubtful debts as is currently allowed by the IT department. This is in wake of the fact that the RBI has raised the provisioning requirement on standard assets from the erstwhile 0.25% to 0.4% (of asset value). CII and FICCI Encourage consolidation, allow private banks the benefit of carry forward and set off of accumulated losses Exempt banks' long-term funds from SLR and CRR Allow deduction for initial contribution of capital by banks in asset reconstruction companies (ARCs) and exempt ARCs from tax Reactivate project financing by strengthening development financial institutions so that long-term funds are available for 10-15 year duration to the corporate sector at a lower 5-6% interest rate  Budget over the years Budget 2003-04 Budget 2004-05 Budget 2005-06 The FDI limit in private sector banks has been raised to 74% from the existing 49%. The SBI will have to lend at lower rates to the agricultural sector as well as SSIs. SBI will now offer loans in the range 2% above its Prime Lending Rate (PLR) or 2% below its PLR. Tax exemption on interest on housing loans maintained at Rs 150,000 per year. The government has agreed to buy back older government borrowing with high interest rates from banks. Reduction in the interest rates on all small savings schemes by 1%. The government proposed to double credit to the agriculture sector in the next three years. Significant emphasis on making credit available towards infrastructure development. Inter-institutional group comprising select banks and financial institutions incorporated to ensure speedy conclusion of loan agreements for infrastructure projects. Nearly Rs 400 bn will be kept aside by this consortium for infrastructure support. Task force to be set up to explore reforms in the cooperative banking sector. Securitisation Act to be amended. FDI in the insurance sector to be hiked from 26% to 49%. Autonomy to RBI to implement reforms in banking sector. Amendment of the Banking Regulation Act. Allow banking companies to issue preference shares to boost their Tier-I capital. Introduce provisions to enable the consolidated supervision of banks and their subsidiaries by RBI. Increase bank lending to agricultural sector by 30% and PSU banks to increase number of agricultural borrowers by 5 m. Remove the lower and upper bounds to the statutory liquidity ratio (SLR) and removal of the limits on the cash reserve ratio (CRR) to provide flexibility to RBI to prescribe prudential norms 0.1% banking transaction tax to be imposed on cash withdrawals above Rs 10,000 on a single day. Enable RBI to lend or borrow securities by way of repo, reverse repo or otherwise. Removal of benefits available to depositors (Section 80-L) Key Positives Guidelines on bank mergers: The RBI's guideline on bank mergers cleared the persisting ambiguity regarding the route that banks need to follow for their inorganic growth. 'Voluntary' merger between two banks requisite approval by two-thirds of the total board members and disclosure of the valuation details, financials and share price movements. The dissenting shareholders would get the value as per the valuation computed by the RBI. Liberalisation of ECB norms: The government also liberalised ECB norms to permit financial sector entities engaged in infrastructure funding to raise ECBs. This enabled banks and financial institutions, which were earlier not permitted to raise such funds, explore this route for raising cheaper funds in the overseas markets. Restriction of voting rights: In another move to narrow down the impact of foreign entities on management of domestic banks, the government in its new norms for ADR/GDR issues has specified that the voting rights of ADR/GDR holders will be restricted to 10% (which is as per RBI norms). Credit classification: To accelerate the initiatives for credit efficiency of banking entities post Basel II (FY07 onwards), the RBI has suggested that banks will need to classify loans above Rs 50 m as 'non-retail exposure' and exercise credit rating on the same through their internal rating mechanism. Ceiling on dividends: The RBI has raised the ceiling on the dividends that commercial banks are permitted to pay to 40% of a bank's net profits, from the earlier 33.3%. The caveat, however, is that banks can now pay dividends if their NPAs are less than 7% of their total advances and they have had a capital adequacy ratio (CAR) of at least 9% for three consecutive years. As not meeting any of the said guidelines makes a bank ineligible for dividend payment, it ensure that bank sustain a healthy asset book in the longer term. Hybrid capital: In an attempt to relieve banks of their capital crunch, the RBI has allowed them to raise perpetual bonds and other hybrid capital securities to shore up their capital. If the new instruments find takers, it would help PSU banks, left with little headroom for raising equity. Significantly, FII and NRI investment limits in these securities have been fixed at 49%, compared to 20% foreign equity holding allowed in PSU banks. Final guidelines on securitisation: The apex bank having issued the draft guidelines on securitisation in April 2005 is expected to issue the final mandate on the same by the end of February 2006. The move is aimed at ensuring that standard assets securitised constitute a true sale and an arm's length is maintained between the originating bank and the special purpose vehicle (SPV) to which the assets are transferred. This will lead to increased transparency in securitisation of assets.    Key Negatives Increase in risk weightage: The National Housing Bank (NHB) has further tightened norms for housing finance companies (HFC) in the wake of the risk foreseen due to high asset prices. The NHB has increased the risk weightage for loans to the commercial real estate sector from 100% to 125%. Also, investments in mortgage-backed-securities (MBS) will attract risk weightage of 125%. The decision comes close on the heels of the NHB increasing the risk weightage on home loans from 50% to 75%. This will lead to contraction in CAR. Refusal to dilute stake in PSU banks: The government has refused to dilute its stake in PSU banks below 51% thus choking the headroom available to these banks for raining equity capital. Higher provision for standard assets: The RBI has increased the provisioning requirement on standard assets from 0.25% to 0.4%, thus increasing the provisioning liability for banks. Interest rate dampener: The interest rate movement in the short term is likely to be with an upward bias as is evident from the RBI's dual 25 basis points rise in repo and reverse repo rates. A corresponding rise in deposit rates, not commensurate with rise in yields, may pressurise the margins (NIMs) for the sector. Impediments in sectoral reforms: Opposition from Left and resultant cautious approach from the North Block in terms of approving merger of PSU banks may hamper their growth prospects in the medium term. Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.