Indian banks may have to face a sharp reduction in core profitability this year, as a surging demand for credit will increase the cost of raising funds, a study conducted by rating agency Crisil says. It predicts that the net profitability margin (NPM) of banks may decline by up to 20 basis points to 1.4 per cent in 2007-08.

The core profitability of banks has fluctuated over the years. From 2000-01 to 2004-05, banks saw an increase in margins, with steady interest spreads, reducing operating expenses, and stable, though low fee-based income.

NPMs touched a peak of 1.83 per cent in 2004-05. In 2005-06, the trend of improving profitability margins began to reverse, though it recovered lost ground in 2006-07. Another decline in profitability appears "highly likely" in 2007-08 the study said.

Monetary measures of the Reserve Bank of India (RBI) over the last few years, including a 175-basis-point hike in repo rates and an increase of 2 per cent in cash reserve ratio (CRR) have increased the overall cost of resources for banks.

The cost of deposits has risen by around 60 basis points in 2006-07, and excess statutory liquidity ratio (SLR) - now at around 3 per cent - is no longer adequate to fund credit growth.

The SLR norms dictate that banks have to compulsorily park a part of their deposits in government securities. The minimum level is now at 25 per cent of the net demand and time liabilities, while the average SLR ratio of the system is around 28 per cent.

The study recommends that a softer interest rate regime, by the RBI slashing repo rates or cutting the mandated SLR investments limit, could provide banks with a much-needed breather, and help improve their core profitability levels.

The study also warns that banks'' asset quality might also be impacted amid strong credit growth. It said asset quality had improved consistently over the past seven years, with a steady decline in non-performing assets (NPAs), both in absolute terms and as a percentage of total advances. Banks have also been diversifying their advances portfolios in favour of the higher-yielding retail and housing segments.

also see : General reports on Banks & Financial Institutions
Other reports on Crisil