The persistent fear among investors regarding bank stocks is slowly but surely becoming a reality and this has impacted investor sentiment towards the banking sector stocks.

While everyone knew that banks would be hit hard by a rising interest rate scenario, no one knew as to what would be the extent to which banks would be hit by the same.

These fears have been compounded due to the fact that public sector banks, which are bound by regulatory requirements to maintain G-Sec investment portfolios, have in the last 2-3 years increased their exposure to this segment due to lack of other investment avenues (read: lack of adequate credit offtake).

In the last two-three years, bank have been able to book supernormal profits on their G-Sec portfolios. This has helped them to provide strongly for their impaired assets, thus improving their asset quality significantly.

Banks were also able to show strong rise in their net profits for these years mainly due to the profits from their G-Sec portfolios. However now, with inflationary pressures and likelihood of the beginning of an investment cycle, we may witness a hardening of interest rates and this may erode bank's G-Sec profits as severely as they came about in the first place.

What this mean is that as the banks saw supernormal gains in their G-Sec portfolios, they may see supernormal losses in a rising interest rate scenario on the same G-Sec portfolio.

According to the Indian Banks' Association, Government Securities (G-Sec) holding of Indian banks stands at around 35%-40% of aggregate deposits (summation of demand deposits and time deposits), as compared to only 4.6% in banks of the United States, a negligible 0.3% in banks of the United Kingdom and around 6.9% in banks of the Euro zone.

However, one needs to keep in mind the fact that Indian banks have to hold a minimum of 25% of their deposits in the form of G-Secs. This requirement is called the SLR.

The table below indicates the duration of the G-Sec portfolios of the banking sector. The sector has been classified on the basis of foreign banks, private sector banks and public sector banks. The table indicates that the duration is the highest for the public sector banks and this means that they have a high sensitivity to any change in interest rates.

Consequently, they are likely to witness higher erosion in the value of G-Sec portfolio compared to foreign and private sector banks if the interest rates rise. While the data is for FY02, and since then banks may have reduced their durations, it can be taken as a broad indicator.

The IBA has indicated that an interest rate shock (where rates rise significantly in a short span) would erode more than 25% of the net worth of foreign banks.

Among private sector banks, this proportion was around 54%, and among nationalized banks, it was as high as 89%. These figures indicate the susceptibility of various segments of the banking sector to adverse changes in interest rates.

The Reserve Bank of India has already instituted a mechanism in place to protect banks against any adverse shocks due to interest rate changes. The Investment Fluctuation Reserve is such a mechanism that mandates banks to keep a reserve that will protect them against an interest rate shock in the future.

The limit for this reserve has been kept at 5% of the investment portfolio. While most banks have already created these reserves, they are still some time away before the statutory limit is reached.

Apart from this measure, there are other instruments that could help banks mitigate interest rate risk in the future. Interest rate swaps and interest rate futures are such instruments that are essentially derivative products which can help the sector hedge its G-Sec portfolio against interest rate shocks.

Floating rate G-Secs are another instrument that can be used to mitigate the risk. However, the proportion of floating rate G-Secs to total G-Sec portfolio only stands at 3% currently.

A conscious increase in the same by the RBI may go a long way in insulating the banking sector from the interest rate risk.

As far as the impact is concerned, banks have already seen a very large fall in their other incomes in 1QFY05. The profit from sale of G-Sec investments always used to reflect in the other income for banks, and due to rapidly falling profits from G-Sec portfolios, other income has been hit badly.

While a rapid rise in interest rates would be very adverse for the sector, a measured rise may be well handled (which seems more likely at the current juncture). Investors need to focus on banks, which have lower dependence on profit from sale of G-Sec investments as far as their other income is concerned.

Since other income forms a large part of profit before tax for the sector, this aspect is of importance. Performance in the core business of lending will be a key determinant of valuations from here on.

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