On the face of it, bankers have the best of both worlds. They make money when interest rates fall and they make money when they rise. When interest rates fall, the value of bonds they hold rises, though they earn less on the fresh loans they make as these are naturally at lower interest rates.
Conversely, when interest rates rise, banks lose out on the value of the bonds they hold but make more money on the loans they advance.
That's the theory. In the real world, things don't necessarily happen that way, and the best evidence of this is what has happened to Indian banks in 2004-05.
After a gap of eight years, the yield on the benchmark 10-year government paper -- a barometer of interest rates -- rose by 150 basis points (one basis point is one hundredth of a percentage point) last year.
Thirty-three commercial banks, a majority of them are listed on bourses, collectively posted a 6.2 per cent drop in their net profit in the year.
The same set of banks had posted a phenomenal 85.5 per cent growth in their net profit in 2001-02 when the benchmark 10-year paper yield dropped by close to 300 basis points -- from 10.32 per cent to 7.47 per cent.
The last time the banking posted a drop in net profit was in 2000-01 -- by 8.4 per cent. In 2003-04, the growth in net profit was 32.7 per cent, and 57.6 per cent in 2002-03.
Except for Oriental Bank of Commerce and Punjab & Sind Bank, the performance of the entire nationalised banking industry, State Bank of India and its seven associate banks, and eight major private sector banks including ICICI Bank, HDFC Bank, UTI Bank has been taken into account for this study.
Collectively, this set of 33 banks has shown a 233 per cent growth in their net profit over a five-year horizon -- between 1999-2000 and 2004-05 -- from Rs 5,288 crore (Rs 52.88 billion) to Rs 17,630 crore (Rs 176.3 billion).
Twenty of the 33 banks recorded a decline in their net profit and one of them (Ing Vysya) posted a net loss last year. In contrast, in 2003-04, only one bank posted net loss (Centurion) and another (Ing Vysya), a decline in net profit.
Similarly, in 2002-03 as well as 2001-02, only a few banks -- Dena Bank and Indian Bank in public sector and Centurion in private sector -- did not perform well.
In 2000-01, when the net profit of the industry dropped by 8.4 per cent, 12 banks had recorded a decline in net profit and two of them losses.
The most affected banks in 2004-05 were the Bank of India, Dena Bank, Jammu & Kashmir Bank, State Bank of Saurashtra, Bank of Maharashtra, Bank of Rajasthan, Central Bank and South Indian Bank.
All these banks have posted over a 40 per cent drop in net profits. On the positive side, Punjab National Bank, Indian Overseas Bank, HDFC Bank, ICICI Bank and UTI Bank have all posted over 20 per cent growth in net profit.
The State Bank of India came close to posting $1 billion net profit, the highest ever by any Indian financial intermediary, posting nearly a 17 per cent growth.
Now, take a look at the operating profit of these banks. Collectively, the operating profit of these 33 banks has dropped by 0.6 per cent {from Rs 43,035 crore (Rs 430.35 billion) in 2003-04 to Rs 42,796 crore (Rs 427.96 billion) last year}.
This did not happen in 2000-01 when there was decline in their net profit. Despite eight banks recording a drop in their operating profit in 2000-01, the overall operating profit went up by 7.6 per cent -- from Rs 13,556 crore (Rs 135.56 billion) in 1999-2000 to Rs 14,580 crore (Rs 145.80 billion) in 2000-01.
Last year, as many as 18 banks posted a drop in their operating profit and the quantum of drop is over 25 per cent for eight banks. J&K Bank, Bank of Rajasthan and Ing Vysya Bank have posted very sharp drops in their operating profit -- between 43 per cent and 62 per cent.
HDFC Bank, ICICI Bank and Allahabad Bank have posted over a 20 per cent growth in operating profit while State Bank's growth has been 15 per cent.
Between 1999-2000 and 2004-05, these banks' operating profit grew by 216 per cent -- from Rs 13,556 crore (Rs 135.56 billion) to Rs 42,796 crore (Rs 427.96 billion).
In a rising interest rate scenario, the two key performance parameters are interest income and "other income". As the bond prices drop (the prices and the yield or interest rates on bonds move in opposite directions), banks' trading profit goes down and it affects "other income", which is a combination of bond trading income as well as fee-based income.
A higher interest income -- triggered by rising interest rates and credit offtake -- can offset this. However, that has not been the case as yet.
The average interest income of these 33 banks last year has gone up by 7.8 per cent while "other income" dropped by 14.9 per cent. In absolute terms, interest income is far higher than "other income" but the trend is an indication that the banks have not been able to cash in on the rising rates the way they did when the rates dropped in the past.
The only bank that shows a drop in interest income in 2004-05 is Dena Bank (-0.6 per cent). HDFC Bank, Syndicate Bank and UTI Bank have recorded over a 20 per cent rise in interest income while Allahabad Bank's interest income rose by 19.4 per cent.
Among the big banks, State Bank of India's interest income rose by 6.5 per cent, Canara and Punjab National Bank's by over 8 per cent, ICICI Bank's 5.8 per cent, and that of Bank of India and Bank of Baroda by over 4 per cent.
Over a five-year horizon, these banks' interest income rose by 62.6 per cent -- from Rs 80,834 crore (Rs 808.34 billion) in 1999-2000 to Rs 1,31,412 crore (Rs 1314.12 billion) in 2004-05.
Twenty-eight of the 33 banks studied have shown a drop in their "other income". While the average decline is 14.9 per cent, as many as 16 banks have shown a drop of over 20 per cent in "other income".
The sharpest drops in "other income" have been registered by J&K Bank (72 per cent), followed by Ing Vysya (66 per cent) and Bank of Rajasthan (64 per cent).
Both HDFC Bank and ICICI Bank are exceptions. HDFC Bank's "other income" during the year grew by 35.7 per cent (on a very low base) and that of ICICI Bank by 11.5 per cent.
State Bank of India, which has the largest bond portfolio in the banking system and the biggest "other income" kitty {Rs 7,120 crore (Rs 71.20 billion)}, has shown a 6.5 per cent decline in this segment.
Over the past five years, the growth in "other income" of these banks is, however, far higher than their interest income growth. Their "other income" grew by 129 per cent during this period, from Rs 12,040 crore (Rs 120.4 billion) in 2000 to Rs 27,526 crore (Rs 275.26 billion) in 2005.
Taking advantage of the rise in income from bond trading, these banks have also made huge provisions to clean their balance sheets.
The collective provisioning of these 33 banks jumped from Rs 8,268 crore (Rs 82.68 billion) in 2000 to Rs 25,164 crore (Rs 251.64 billion) -- a growth of 204 per cent. Little surprise then that only one bank had non-performing assets of more than 5 per cent in 2005-05 -- Dena Bank.
The rest of the pack has NPAs of less than 3 per cent and at least five of them have NPAs of less than 1 per cent. Five years ago, 25 of these banks had NPA levels of more than 5 per cent and four of them even had NPA levels of over 10 per cent.
With low NPA levels, the banks can now aggressively expand their loan portfolios and this will more than compensate for the losses in treasury income. There is of course one rider.
All bad loans are created in good times when the economy is on a roll.
