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As the inflation data for May and June 2021 breaches the Reserve Bank of India’s (RBI) target corridor, it could exert pressure on the long-term yield curve, says India Ratings and Research (Ind-Ra).

Ind-Ra’s analysis shows that this could have a significant impact on the profitability of the Indian banking system. A 100bp upward shift in the yield curve could impact the pre-provisioning operating profit (PPOP) of public sector banks (PSBs) by 8.0% and that of private banks by 3.2%; while for the overall banking system, the impact could be 5.8%.

The 100bp movement in the yield curve would impact the common equity tier 1 of PSBs by 28bp and that of private banks by 13bp; while for the overall banking system, the impact could be 22bp yoy.

This has been taken on a post-tax basis, without considering the banks’ ability to reclassify their trading book and a likely partial offset from lower pension costs.

Upward Trend in Interest Rates Could Amplify Volatility in Operational Profitability: On analysing the past interest rate cycles, Ind-Ra has observed there have been three cycles of a yield curve expansion FY05 onwards, showing a strong inverse correlation between treasury income and interest rate movement.

The sensitivity seen for PSBs was much higher than that for private banks. During the first cycle, treasury income contribution to PPOP reduced to 3.4% in FY07 from 21.3% in FY05, while it reduced to 3.2% in FY12 from 15.3% in FY10 in the second cycle and to 5.6% in FY19 from 22.5% in FY18 during the third cycle.

Also, the sensitivity was similar for private banks; however, the volatility in PPOP and PAT was limited due to a lower share of trading book than that for PSBs till FY14 and stronger operating profit buffers. Nonetheless, private banks were also impacted in the FY18-FY19 cycle during which the treasury income fell to 3.3% from 9.7% of PPOP and to 9.3% from 25.8% of PAT.

The expansion in treasury contribution to PPOP and PAT was visible post September 2018, where the yield curve peaked and PSBs’ treasury contribution to PPOP increased to 16.0% in FY21 from 5.6% in FY19.

Even at PAT level, PSBs’ losses were minimised in FY19 and FY20 with gains from treasury income. Furthermore, even with improvement in operating profit buffers in FY21, 98.5% of PAT came from treasury gains. Similarly, private banks’ treasury contribution to PPOP and PAT increased significantly to 12.5% from 3.3% and to 31.3% from 9.3%, respectively, during FY19-FY21.

Muted Credit Growth and Regulatory Dispensation Lead to Larger Investment Books: With the credit offtake remaining muted since FY17, banks have been maintaining a balance between holding higher statutory liquidity ratio (SLR) and carrying interest rate risk, also taking on risk by giving out loans in a falling interest rate environment.

Post the first covid wave, the RBI has further extended the dispensation of allowing banks to hold more than 25% of their total investments under the held for trading investment category, subject to them holding up to 22% in the form of SLR securities.

While the limit for holding SLR securities had already been increased to 22% from 19.5% earlier, the RBI in its February Monetary Policy Committee meet has further extended the window for these holdings till March 2023 and a phased wind down thereafter by December 2023.

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