A year-and-a-half ago, at the 58th annual general meeting of the Indian Banks Association (IBA) at Mumbai's NCPA centre, several of the blue-chip public sector bank chairmen sat in the front row, listening to Finance Minister P. Chidambaram. Nothing unusual, except that there was an air of expectancy around the fm's speech. Earlier in his opening remarks, IBA Chairman (and, then, State Bank of India Chairman as well) A.K. Purwar had made a daring suggestion to the fm to give banks greater autonomy in deciding pay packets of senior management. Now, India's public sector banking brass wanted to know how their political boss would react to the suggestion.

Chidambaram, dressed in trademark veshti and white shirt, addressed the issue in his inimitable style, weighing each and every word that he uttered. "I am constrained to point out," Chidambaram said, as the bank chairmen began squirming in their seats, "that some of the banks have projected a deposit growth in 2005-06, which is lower than that of 2004-05." As the banking brass began wiping sweat off their faces, Chidambaram continued, "If the rate of growth of the economy in 2005-06 is maintained at 7 per cent, then it is difficult to understand how business projections by public sector banks, especially deposits and advances, can evidence deceleration in growth. How can the perceptions of the bankers be so different from that of the rest of the economy?" he questioned. Predictably, there was pin-drop silence in the hall as the fm wrapped up his speech.

If business performance has to be the measure for determining remuneration of bank bosses, then the state-owned banks have even less of a case today. As Chidambaram evidently knew back then, the PSU banks have been facing a problem. Their deposits haven't grown fast enough to keep pace with the surge in credit that has happened due to economic expansion and boom in consumption. For instance, for the third year in a row, bank deposits have grown by just 15 per cent while credit has been growing at twice the pace. A classic example: The Delhi-based Oriental Bank of Commerce, whose credit disbursals have grown at 33 per cent, but deposits at just 5 per cent.

"We are extremely careful in doling out credit. We don't (lend) beyond a limit that we can't manage" V.P. Shetty CMD/ IDBI Bank	"These are issues that have macro-economic implications, so one has to move carefully" M.V. Nair CMD/ Union Bank of India

With the result, what the banks had been doing was to dip into their own safe deposits, or statutory liquidity ratio (SLR) that the Reserve Bank of India requires them to maintain for safety. As a result, the SLR-held in the form of government securities-at these banks has dropped from 41.50 per cent in March 2003 to 29.8 per cent in October 2006.

Should industry and other borrowers worry? To some extent, yes. Slashing SLR further from the current mandatory level of 25 per cent doesn't look like a real possibility, simply because it will end up squeezing the credit to the government of India. Says M.V. Nair, Chairman and Managing Director, Union Bank of India: "These are issues that have macro-economic implications, so one has to move very carefully." Adds V.P. Shetty, CMD of the development-institution-turned-bank, IDBI Bank: "We are extremely careful in doling out credit. We don't (lend) beyond a limit that we cannot manage."

If the banks don't raise deposit in pace with lending, they won't have any money (in a manner of speaking) to lend to more profitable customers such as corporates and retail consumers. On the other hand, if the banks do raise their deposit rates to attract customers, they will have to necessarily hike their lending rates as well, in order to protect their spreads. And higher interest rates is the last thing the government or the Reserve Bank of India (RBI) would like in an economy that's clipping at 8 per cent a year. Reason: Inevitably, prices will go up and consumers will cut back on their spending, putting the brakes on an economy that's rolling. Admits Prakash Mallya, Chairman and Managing Director of Bangalore-based Vijaya Bank: "It's a Catch 22 situation for us."

The Way Out

Remember that earlier we had said that cutting SLR further wasn't really an option. However, if it came to the crunch, RBI Governor Y.V. Reddy may be forced to make a concession and drop the limit to 20 per cent. Bankers point out that developed countries such as the US only require 10 per cent of the deposits to be kept in reserves. "There is definitely a case for SLR reduction," says P.L. Gairola, CMD, Dena Bank. No one knows for sure if Reddy will actually tinker with SLR, which has remained untouched since 1997. It's more likely that he will want the PSU banks to become more efficient and, hence, competitive.

"It makes a lot of sense for PSU banks to take the securitisation route to free up capital" Rajesh Mokashi Executive Director/ Care Ratings

Currently, the cost of operations of PSU banks is a little more than 1 per cent of the total working capital funds. According to seasoned banker K. Cherian Varghese, former chairman of Corporation Bank and Union Bank of India, a 0.75 per cent savings in cost of operations would result in a 25 basis points savings for the bank. This could act as a cushion if the banks have to resort to other sources of capital such as bonds (where the cost of funds is between 7 and 7.5 per cent), foreign currency loans (7 per cent), and G-secs (7.5 per cent), as against the prime lending rate (PLR) of 11-12 per cent. Yet, nothing beats deposits in terms of costs, since they cost less than 5 per cent. "We are focussing on a lot of cross-selling and a non-branch model to acquire new customers," says B. Sambamurthy, CMD, Corporation Bank.

Others such as the Union Bank of India are coming up with more attractive deposit products-like the one that doubles money in eight-and-a-half years. Often, the deposit schemes are being launched in the face of competition from other aggressive institutions. "We are pitted against postal deposits and equity-oriented instruments," says Mallya. Worryingly for the banks, there has been a shift in the nature of deposits to short-term bulk deposits by corporates from retail deposits, which have traditionally been the core of all deposits. That, in turn, has resulted in shortening of deposit maturity. "Undoubtedly, we need stable retail deposits to fund the higher credit growth," says Gairola. That the banks are scrambling for money is also evident in the overnight call money market, where rates have shot up to 20 per cent (week ended December 31, 2006)-the highest in nine years.

Some Other Options

Given that a lot of PSU banks either already have branches abroad or are opening them, raising deposits abroad is an option too, but a limited one. Additionally, banks have the option to borrow in foreign currency, but the "high forward premia in the market has been discouraging bankers from utilising this option," says Sambamurthy. The forward premia (over libor, or London Interbank Offered Rate) are ruling at 3 per cent, which leaves hardly any margin for the borrowing banks. (Banks hedge their currency risks by fixing the exchange rate for repayment by paying a premium.) That means, even if banks borrow from abroad, they must find investment avenues that return higher than normal lendings. As one can imagine, that's not the easiest of things to do in a competitive market.

Yet another option for these banks could be securitisation of their retail portfolios, which will allow them to bundle all their retail loans (cars, home, credit card etc.) and sell as a single marketable security. Private sector banks such as ICICI Bank and HDFC Bank are already quite active in the securitisation market. "It makes a lot of sense for PSU banks to take the securitisation route to free up capital," says Rajesh Mokashi, Executive Director, Care Ratings. However, a critical mass in terms of portfolio size will be needed for securitisation.

If nothing works out, the banks may have to resort to raising capital either via equity or debt, or a mix of both. But equity is expensive and debt is usually costlier than deposits, besides which banks, globally, never raise capital for the purpose of lending, which is what the PSU banks in India will end up doing should they choose this route.

There's good reason for the global practice. Raising capital has a direct impact on the return on capital, which is an indicator of efficient use of capital. Private sector banks such as ICICI Bank, HDFC Bank and UTI Bank have an roc of 18-20 per cent, while PSU giants such as SBI and the Bank of Baroda have an roc ranging between 13 and 19 per cent. Any reduction in roc will further bring down the P-Es of public sector banks, which anyway don't get the same multiples as private banks. And as their owner, the government will be the biggest loser when their market value drops. Says Mokashi. "Raising capital is no solution."

There's hope yet. A recent study by rating agency CRISIL reveals that the PSU banks' share in the country's incremental savings has remained remarkably stable (and not declined) over the past five years. With some smart marketing-and not to mention better internal efficiencies-if the banks are able to attract more depositors at no great additional cost, then their woes may end. If not, they'll have to go knocking on the doors of the central bank for relief.