With the economic growth picking up pace and the investment cycle on the way to recovery, the banking sector has witnessed a transformation in its vital role of intermediating between the demand and supply of funds.

The revived credit offtake (both from the food and non food segments) and structural reforms have paved the way for a change in the dynamics of the sector itself. Besides gearing up for the compliance with Basel-II accord, the sector is also looking forward to consolidation and investments on the FDI front.

Budget Measures Farm credit target for FY08 set at Rs 2,250 bn with an addition of 5 m new farmers to the banking system and provision of Rs 17 bn for 2% interest subvention for short-term crop loans To augment resources for refinancing rural credit cooperatives, NABARD to issue Government guaranteed rural bonds to the extent of Rs 50 bn SARFAESI Act to be extended to loans advanced by Regional Rural Banks (RRBs). RRBs to be permitted to accept NRE/FCNR deposits and those that have a negative net worth to be recapitalised Cooperative banks to be allowed deduction in respect of provision for bad and doubtful debts under section 36(1)(viia). Also, amalgamation and de-merger of banking companies is tax neutral. This benefit to be extended to cooperative banks Cash withdrawals by Central and State Governments to be excluded from the scope of Banking Cash Transactions Tax (BCTT). Exemption limit for individuals and HUFs to be raised from Rs 25,000 to Rs 50,000 The government has proposed to acquire RBI's equity holding in State Bank of India (59% currently). It has provided a sum of Rs.400 bn for this purpose, but the transaction will be deficit neutral to the government. Also, the fund of Rs 7.5 bn created for awarding 0.1 m (of Rs 6,000 each per year) will be placed with the SBI, and the yield from the fund will be used for awarding the scholarships. Increase in dividend distribution tax from 12.5% to 15%. 1% higher education cess to charged. The dividend distribution tax on dividends paid by money market mutual funds and liquid mutual funds increased to 25 % for all investors.  Budget Impact Provision of funds for interest subvention for subsidised farm credit and allocation of funds to NABARD (by way of issue of tax saving bonds) to prove beneficial for banks in meeting their priority sector agriculture credit requirement. Extension of SARFAESI to RRBs will help reduce NPAs for such banks and the permission to garner NRI /FCNR deposits will augment resources for the banks. Deduction in respect of bank merger and provision for bad debt will improve the health of cooperative banks and facilitate consolidation in the sector. Exclusion of State and Central government withdrawals and individual withdrawals below Rs 50,000 from the scope of Banking Cash Transactions Tax will reduce the administration costs of banks on the same (given the massive volumes).  Sector Outlook The budget had very little to offer for scheduled commercial banks, with the exception to the fact that it reduced the burden on banks for financing subsidised farm credit. No measures were taken for improving liquidity in the banking system by way of exempting taxes on 3-year fixed deposits, taking note of the high inflation in the economy persisting currently. Enhanced lending to agriculture and priority sectors will require banks (especially PSU banks) to exercise more caution on the NPAs 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.  Company Impact While the Rs 7.5 bn scholarship fund will provide additional liquidity to SBI to that extent, the transfer of promoter stake to the government also opens up the public issue route (divestment of government stake upto 51%) for SBI, for augment its capital base. The interest subvention for subsidised farm loans to be beneficial to private sector banks that were earlier excluded from this benefit.  Industry Wish List Indian Banks Association Bank deposits should be brought under section 80 L for income tax deductions. Tax deducted at source (TDS) on savings accounts should be removed for making the same more attractive. The ceiling of Rs 15,000 for TDS on interest earned on bank fixed deposits should be raised. 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 the 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). Simplification of service tax and fringe benefit tax norms. CII and FICCI Allow banks to raise capital by issue of preference shares Perpetual non-cumulative preference shares to be included in Tier-I capital and redeemable cumulative preference shares to be included in Tier-II capital Provide banks additional source for augmenting their capital base ahead of implementation of Basel II. Relaxation in the lock-in period for bank savings to qualify for tax benefits from five years to three years. Increase the FII/ FDI limit in PSU banks from 20% to 49%. Allow another round of VRS in PSU banks and more powers to attract suitable talent  Budget over the years Budget 2004-05 Budget 2005-06 Budget 2006-07 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) 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 statutory liquidity ratio (SLR). 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. ATM operations and collection services provided by banks in public issues to be brought under the service tax net. Banking Cash Transaction Tax (BCTT) to continue for some more time until the AIR system is able to capture all significant financial transactions.
Key Positives Guidelines on bank mergers: The RBI's guideline on bank mergers cleared the ambiguity persisting regarding the route that banks need to follow for their inorganic growth. While '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, dissenting shareholders would get the value as per the valuation computed by the RBI. Liberalisation of ECB norms: The government also liberalised the external commercial borrowing (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 managements 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 the 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.		Key Negatives No interest on CRR: The staggered four-staged rise in the CRR from 5% to 6% is already bearing a telling impact on the banking sector's liquidity scenario. Besides together locking in liquidity to the tune of approximately Rs 25 bn from being deployed in productive revenue-generating resources (advances and investments), the removal of interest payable by the RBI on CRR maintained by banks above 3.5% of net demand and time liabilities, made it completely non-remunerative for the latter. 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 25 basis points rise in the repo rate. A corresponding rise in deposit rates, not commensurate with rise in yields, may pressurise the margins (NIMs) for the sector. 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, the investment 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%. 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. 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.

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