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Profitability in Banks: A Study

According to a Credit Rating and Information Services of India (Crisil) study, Lower operating expenses including rationalisation of employee costs have improved the profitability of banks, contrary to the popular perception that only trading profits helped the banking sector shore up their bottomlines. The reduction in operating expenses was achieved through large-scale voluntary retirement schemes implemented by public sector banks. Since this reduction in operating expenses seems sustainable, it promises a brighter future for the banking sector.

Although the non-interest income of banks did increase by 0.3% during this period, it was more than offset by a 0.21% increase in provisions and an identical decline in spreads. Compared to the relatively volatile treasury income, the reduction in operating expenses imparts a greater level of comfort in terms of the banking sector's ability to sustain its profitability in the future.

The banking sector’s overall profitability as measured by the return on average assets (RoAA) has improved to 0.84 per cent in 2001-02 from 0.53 per cent in 2000-01. An analysis of the incremental change in the various profitability components shows that:

* In 2001-02, the sector’s non-interest income rose by 32 basis points (bps) over the previous year, primarily due to an increase in treasury profits. On the other hand, the net interest income or interest spread declined by 21 bps in the same period. This was in line with the declining interest rate regime and increasing competition in the sector. At the same time, provision and contingency charges rose by 21 bps. Together, the two more than offset the incremental contribution from the non-interest income.

* Operating expenses, however, declined significantly by 41 bps in 2001-02 over 2000-01 and this enabled the banking sector to report an overall increase in profitability by 31 bps. The reduction in operating expenses can be attributed to the large-scale voluntary retirement schemes (VRS) being implemented across all public sector banks as well as other cost-cutting measures.

A closer analysis of the different banking groups (public sector banks, old private sector banks, new private sector banks and foreign banks) also shows that the reduction in operating expenses was only experienced by the public sector and foreign banks.

For private sector banks, the profitability improvement was mainly because of the increase in treasury income and not due to any material reduction in operating expenses. But since public sector and foreign banks account for over 80 per cent of the total assets of all scheduled commercial banks, a reduction in their core operating expenses contributes significantly in improving the profitability of the entire Indian banking sector.

Crisil believes that the banking sector is now reaping the benefits of rationalising its employee costs and undertaking other cost-reduction initiatives, which is a welcome sign in terms of the banks’ financial performance. Crisil, however, pointed out that banks’ ability to repeat and sustain such efforts would be critical in maintaining their profitability, given the increasing pressure on interest spreads and rising provisioning levels.

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