The softening of yields due to surplus liquidity could help Indian banks in registering INR 382 billion of potential treasury gains for FY17, says India Ratings and Research (Ind-Ra). The INR 382 billion worth of potential treasury gains are significantly large, considering the banking sector reported an INR 236 billion profit for FY16 (public sector banks (PSBs) reported INR 177 billion in loss). The development comes at a time when the banking sector is facing challenging conditions. The profitability levels of Indian banks remain weak owing to continued pressure on asset quality and weak loan expansion. It would be imperative for banks starved for capital to strengthen their capital adequacy ratios.

Meanwhile, even better placed banks can use this likely opportunity to improve their provision coverage ratios, which recently witnessed a downtrend. However, large profit booking, followed by a spike in yields, could have a double whammy effect on the profitability levels of banks in subsequent years.

Treasury Gains to Partially Ease Capital Requirement for PSBs: Treasury gains in FY17 would enable PSBs to contribute towards reducing their capital requirements, in accordance with the Basel III requirement. Domestic additional Tier 1 (AT1) issuances worth INR154 billion have been made so far in FY17, with increased participation from mutual funds. Ind-Ra believes the softening of yields could prove to be an additional impetus in the development of AT1 markets.

Demonetisation to Drive Yields Lower: A surge in deposits, due to demonetisation, will increase demand for government and high-rated corporate bonds, and is likely to put downward pressure on yields under the current tepid credit demand scenario. Banks are poised to benefit from the softening of yields, considering they are the largest holders of government bonds (about INR29 trillion as on 11 November 2016).

UDAY Bonds to Add to Treasury Gains: In addition to statutory liquidity requirement (SLR) bonds, banks hold bonds issued by states under Ujwal Discom Assurance Yojana (UDAY). UDAY bonds have been converted to bonds from standard restructured loans given to state distribution companies (discoms). In FY16, the value of loans converted to state government bonds under UDAY was about INR0.75 trillion. Ind-Ra estimates the value of loans converted to state government bonds at end-September 2016 at about INR1 trillion, a significant proportion of which continues to be a part of banks’ investment portfolio. Under UDAY, discom bonds with different maturity periods, ranging from 4-15 years, were issued. The yields at the time of the issuance were in the range of 8.10%-8.75%. At present, UDAY bonds are trading at close to 7.25%. This could result in a potential gain of 100bp-150bp.

Mid-Sized PSBs Likely to Register Larger Treasury Gains: Some mid-sized PSBs would continue to report stressed profitability figures for FY17 on account of rising credit costs due to the ageing impact of a large proportion of assets classified non-performing in FY16. Treasury gains would provide some relief to the overall profitability levels of PSBs. Some mid-sized PSBs witnessed an increase in their investment portfolios in recent quarters on account of challenges with regard to the deployment of incremental deposits. The compression of yields has proved to be a boon for them. A weak profitability forecast, along with challenging capital conditions, would result in mid-sized PSBs registering high treasury gains to protect themselves from potential capital erosion.

Daily Average LCR Reporting to Increase SLR Holdings of Banks:
Ind-Ra expects an increase in the structural volatility in the liquidity coverage ratios (LCRs) of banks, given the proposed switch from monthly to daily average LCR calculations by January 2018.

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