The proportion of long-term loans in bank portfolios has increased with the growth in lending to the infrastructure and housing sectors, but banks have at the same time increasingly borrowed short-term, mainly to manage margins. Given the hardening of interest rates, this strategy is a risky one, as it has contributed to increasing asset-liability maturity (ALM) mismatches. Consequently, to counter ALM mismatches and to encourage lending to the infrastructure sector, the Reserve Bank of India (RBI) in June 2004 permitted banks to raise long-term bonds with a maturity of five years and above; these bonds could only be used to fund outstanding infrastructure loans with a residual maturity greater than five years.

However, most banks did not effectively leverage this opportunity: to maintain profitability, they continued to rely on short-term borrowing. Given the rising interest rate scenario, CRISIL believes that banks will need to revisit this strategy. In the notification enabling the issue of infrastructure bonds, CRISIL sees a Rs.200 billion opportunity for Indian banks to leverage the hitherto unutilised long-term bond opportunity. Making use of this opportunity can help banks reduce the risk of large ALM mismatches, and broaden their resource base.

The increasing use of short-term deposits for long-term funding
The share of industry advances in gross bank credit, though declining in recent times, has continued to be prominent; as on March 31, 2005 it stood at 37.7 per cent of total credit. Within this, the share of infrastructure advances has steadily increased: as a percentage of banks' credit to industry, infrastructure advances have grown to 15.5 per cent as on March 31, 2005, from a meagre 2 per cent as on March 31, 1998. This is one of the reasons for the share of long-term loans in the total loans and advances profile increasing significantly to 45 per cent as on March 31, 2005 (please refer chart 1), from less than 25 per cent as on March 31, 1998. Over the same period, the share of short-term deposits, grew to 39.4 per cent of total deposits, from 27.7 per cent (please refer chart 2). Effectively, this meant that banks were funding more of their long-term advances through short-term deposits, thereby widening the ALM gap.

Chart 1: Tenure of outstanding loans and advances of Scheduled Commercial Banks (SCBs)

Source:RBI

Chart 2: Maturity pattern of terms deposits of SCBs

Source:RBI

RBI steps in
With a view to reduce ALM mismatches arising from the increased share of long tenor infrastructure advances, RBI circulated a notification in June 2004 permitting banks to raise long-term bonds for funding outstanding infrastructure loans that had a residual maturity of more than five years. These bonds would have a maturity of five years and above. The permitted sectors of deployment of such funds included power, telecommunication, roads, and ports. However, at that time, most banks chose not to take advantage of this opportunity, as they preferred to concentrate on short-term deposits, which involved a lower interest rate and therefore resulted in better margins.

A missed opportunity given the rising interest rate scenario
Since the end of 2004, interest rates have shown a rising trend. In June 2004, the yield on the 10-year Government Security (G-Sec) was at 5.85 per cent after the lowest yield of 4.95 per cent observed in October 2003. Further, during June 2004, the yield for 5 year AA+ rated bonds was 6.5 per cent; the yield has touched 8.4 per cent in April 2006 . Had banks issued long-term bonds in 2004, they would have been able to lock in long-term funds at relatively low rates; to that extent, they would have been shielded today from the pressures of rising interest rates.

Pressure on liquidity
Due to the dependence on short-term borrowings, the ALM of the banking system is skewed with a negative gap up to the 1-3 year bucket, as seen in Table 1. Additionally, the liquidity gap in the one-year bucket has increased considerably to (-)26.7 per cent as at March 31, 2005 from (-)21.5 per cent as at March 31 2002. These figures underline the perils of relying extensively on short-term funding.

Table 1: Maturity profile of select assets and liabilities of SCBs (as on March 31, 2005)
(Figures in Rs. Billion)

Source:RBI

Increasing interest rate mismatches
The focus on short-term borrowing has led to increasing the interest rate risk on banks' balance sheets. An analysis of the Interest Rate Sensitivity (IRS) statement of select CRISIL-rated banks reveals that the duration gap has widened from 0.83 years as on March 31, 2004 to 0.97 years as on March 31, 2005. When translated into the long-term impact on capital, this amounts to a 24.7 per cent drop in value in case of a 200 bps interest rate shock. The recent draft RBI guidelines suggest that in line with Basel II recommendations, banks should move to the duration gap approach which measures the long-term impact of interest rate risk, as against the traditional Net Interest Income (NII) approach. Some CRISIL-rated banks have been actively managing their duration gap in tune with interest rate movement, by employing techniques such as floating rate advances and interest rate swaps, and have thus reduced their duration gaps as at March 31, 2006 from the previous year.

• Permitting repos in corporate bonds,
  
• De-linking the issue of bonds from infrastructure exposure,
  
• Enhancing the scope of investment by PFs and insurance companies with ratings forming the basis rather than the issuer category, and
  
• A separate foreign institutional investors (FII) investment limit within the overall country cap for debt,