Can lower interest rates improve banks' asset quality?

While the private sector banks are well capitalised and poised for growth when demand for credit revives, analysts believe some of the asset quality stress may abate for the PSU banks on lower interest rates.

The Reserve Bank of India on Tuesday indicated interest rates could be cut next year, if inflation continued to moderate and fiscal developments were encouraging.

Lower interest rates are good not just for corporate India also for banks, especially state-owned ones.

The BSE Bankex has risen nine per cent in the past month in anticipation of a rate cut on Tuesday.

Lower interest rates could mean lower asset stress for public sector banks.

While the private sector banks are well capitalised and poised for growth when demand for credit revives, analysts believe some of the asset quality stress may abate for the state-owned banks on lower interest rates.

Asset quality stress has ballooned recently, as growth slowed and interest rates continued to rise.

According to Morgan Stanley, a rate cut will go a long way in pushing up operating profit margins of corporate India.

It says rising interest rates have accounted for two-thirds of 500 points margin decline since 2008, so a decline in interest rates would go a long way in improving the balance sheets of stressed companies.

Foreign brokerage firm Jefferies believes corporate leverage has plateaued with the number of corporates whose net debt to Ebitda ratio is more than five has come off in FY14. Combined with lower interest rates, the brokerage believes the impairment profile for banks will undergo a cyclical improvement.

However, Dhananjay Sinha, head (institutional equities) at Emkay Global, believes lower interest rates result in higher treasury gains, but would not bring down cost of funds substantially.

Sinha says a cyclical instrument like rate cut cannot address a structural issue like asset quality.

Also, in a deflationary environment, companies’ ability to repay debt would weaken further.

Once the rate cycle turns, state-owned banks, which have a substantial portfolio of securities held under the available for sale category, will need to sell them, else they will have to book a loss on these securities.

Jefferies says of the 12 state-owned banks in its sample, those with a higher proportion of AFS assets and carrying a higher duration AFS book should gain materially from the falling rates.

Indian Overseas Bank, IDBI Bank and Canara Bank would benefit the most, it says.

Kotak Institutional Equities likes State Bank of India, as it expects the macroeconomic recovery to result in strong revenue growth and reduction in credit costs.

Also, SBI’s cost control initiatives will result in strong earnings growth and its return ratios are likely to see gradual improvement.