How demonetization will impact Indian banks…

The first week since demonetization was dramatic to say the least. The rush to surrender old notes and the limited release of new money created a huge monetary imbalance in the system. Obviously, it will take some time for the system to self-adjust and for normalcy to be restored. But during this period, there has been a phenomenal increase in the deposits with the banking system. According to early estimates, the first 3 days resulted in total deposits in the banking system going up by nearly Rs.350,000 crore of which over Rs.50,000 crore was received by SBI alone. On the day after the demonetization announcement, we did see a sharp rise in banking stocks. The question, therefore, is whether there is a fit case for re-rating banks. There are 3 ways in which banks will benefit from the demonetization drive.

The surge in deposits will continue.…

Banks are likely to see a sharp rise in deposits in the coming weeks. With withdrawals restricted and likely to continue to face limits, the banks will find themselves in a sweet spot. Banks will be in a situation where the net growth in deposits will be really rapid. Now why is this important? The largely cash economy was restricting the growth of deposits with banks. Most of these deposits over the next 45 days will come in the form of current and savings account (CASA) deposits, which means they will be low cost funds and will bring down the average cost of funds for banks. This will have 3 very important implications. Firstly, it will allow banks to expand their lending books as deposits growth was the key constraint. Secondly, this will have a salutary effect on cost of funds. As we have seen earlier, most of this money will come in the form of CASA deposits and hence the cost of overall deposits in the banking system will come down. Lastly, as the loan book expands the NPAs as a percentage of the outstanding assets will come down sharply. This will ensure that rate cuts are more seamlessly transmitted to the end customer.

It will bring down the yields on bond holdings…

The surge in deposits will ensure that the banking system is flush with liquidity. We have already seen how the surge in liquidity in the money market due to the RBI’s reverse repo operations have brought down the yields at the short end of the yield curve. The fall in yields at the shorter end of the yield curve will get more acute. As rate cuts are more seamlessly passed on to the end user, the RBI will have the incentive to cut rates further and that will bring the yields at the long end of the curve also down. The net effect will be that the overall yield curve will actually shift downward. Now, why is this important? Firstly, the fall in yields will result in appreciation in bond prices. Banks will directly benefit from this move as they are already holding bonds above the 21.5% prescribed SLR limit. Secondly, as yields come down, the RBI will be in a position to bring down the SLR further. With lower yields on bonds, banks will have no incentive to hold on to excess government bonds in their SLR portfolio. That will mean greater off-take of loans; of course hoping that the credit demand also picks up by then. That will almost be like hitting two birds with one stone.

Banks will see an improvement in their operating margins…

Currently, Indian banks (especially the PSU banks) are suffering from low OPMs due to weak net interest margins (NIM) and high level of NPAs. The current surge in deposits and fall in yields will combine to change that scenario. Banks will find themselves in a situation where the sharp increase in CASA deposits will reduce their average and incremental cost of funds substantially. That will be combined with a pick-up in credit as investing in SLR securities will become unviable with lower yields. Interest rates on the loan portfolio will not fall at the same rate as the cost of deposits having a salutary impact on the NIMs. With a surge in deposits, the average cost per client will also come down sharply and that will have its positive impact on the operating expenses of the bank. This, of course, will also have a positive impact on the valuations of Indian banks making a fit case for re-rating.

So, in a nutshell, this demonetization may have come as a boon for Indian banks. On the one hand, they may see a surge in new account openings and on the other hand they are already seeing a surge in deposits. The bigger takeaway for banks will be the improvement in their operating margins. This could be the big moment for the Indian banking system.

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