Higher market risk may hit bank profitability, says Fitch

According to the international rating agency, Fitch Ratings, the recent interest rate volatility, which has resulted in a decline in the trading profits of most Indian banks, may further affect their profits and earnings in the future, though without impairing their capital position.

In a study titled Market Risk for Indian Banks: Profits Under Pressure but Capital Should Stay Intact, Fitch notes that as a result of the rise in Indian rupee interest rates, the mark-to-market (MTM) provisions have substantially eroded the unrealised gains on the banks' government securities (G-sec) portfolio.
With the possibility of interest rates rising further in the future, Fitch cautions the unrealised gains may turn into losses. Perhaps, with this risk in mind, the Reserve Bank of India (RBI) has permitted banks to hold a larger proportion of securities under the held-to-maturity (HTM) category that need not be marked to market. As a result, banks will be protected from an accounting perspective, from future increases in interest rates on a large majority of their G-sec investments.

While the increase in interest rates has highlighted the inherent market risk that exists in the balance sheet of Indian banks, Fitch is of the view that interest rates are likely to rise gradually, rather than in sudden violent surges. This may affect the banks' profits, but their capital base should largely stay intact. In fact, higher earnings from the bank's lending activities, together with RBI's permission to hold a larger portion of securities under MTM, may even substantially absorb or offset such MTM losses.

Nevertheless, the incidence of market risk has again brought attention to the relatively low level of capitalisation of most Indian banks, which Fitch has commented upon in the past. In view of the increased regulatory capital allocation for market risk in future, Indian banks' capital base would appear even less satisfactory, although most banks are exploring various options to boost their capital position.

The focus on market risk has also drawn attention to the quality of earnings of Indian banks, even as they seek to replace their depleted trading profits with lending-related and non-interest income. This is likely to emerge as an important tool for differentiating between banks in an increasingly competitive environment. Banks will also need to more actively manage their investment portfolio through better risk measurement and monitoring systems. At some stage of the cycle, the rising interest rates should reflect in higher net interest margins. Until then, profits of most Indian banks are expected to be under pressure.