Fee-based income holds the key for Banking system

ImageIn the era of quantitative easing and significant market competition, maintaining profitability through interest-based income is becoming very tough for banks. In the last two decades, interest margins have come under tremendous pressure. In modern times, banks prefer non-interest income i.e. fee based income to drive profitability and return on capital.

The 2008 financial crisis was a big blow for banks, especially for those depending broadly on interest-based income. As the global economic recovery still looks fragile, banks are finding it hard to do loan- and mortgage-based business i.e. interest-based business. The ultra-low central bank interest rate regime was supposed to spur economic activity, as it (theoretically) supports more lending activity, but many banks are hesitant in lending due to potential bad loan losses and slow demand for loans. It would be worth to mention the ultra-low interest rate regime has also dampened savings account activities in banks.

Most of the fee-based incomes (advisory and management fees) are fairly risk-free, as these services don’t involve significant capital investment.

In recent times, banks have reported handsome revenues from fee-based income; thanks to the spur in M&A activities and private equity deals (mainly in US). Since we are living in a globalized society, there are no boundaries for banks and they can reach out to any corner of the world, thus making many potential M&A and private equity activities lucrative.

It would be pertinent to mention that fee-based driven income cushions banks against market competition. In coming days, implementation of new banking rules and regulations are going to take a paradigm shift (Dodd Frank rule, Basel III). This might curb the freedom of leverage banks take on their reserves and provisions, which in turn will leave banks with limited capital or liquidity to do the traditional business of loans and advances –further constraining interest-based income.

Fee-based income is more volatile than interest-based income, but a range of services like wealth management, transaction banking, treasury, and investment banking are covered under fee-based income. The wide spectrum of fee-based service provides room for banks to shuffle service strategies.

In the prevailing economic situation, banks would look for more fee-based income, but they won’t be able to ignore interest-based income completely. They have to build up modus operandi for various possible economic situations. For example, they will have to understand, what would be good for business if the Fed will increase the short-term interest rate or possible ‘tapering’ in coming months? How to benefit from the global corporate houses’ quest for M&A?

The Missing Sense: Indian Economy

“Expect the unexpected”. I must say today’s monetary policy decision by RBI (worth to mention the US Fed as well few days back)has made it clear to the market.

When everyone at financial street were expecting for a repo cut and more ease in the liquidity the RBI Governor kept the ‘inflation mandate’ intact.

The main reasons for RBI to increase rate (further tightening of liquidity) was primarily based on the CPI data and possible ‘Fed tapering’ in coming months which might drag the economy further.

Meanwhile, RBI Governor made it clear, he can’t ignore the inflationary pressure on the behest of so called liquidity ease; which banks are demanding from past few months.

In its mid-quarter policy, the RBI gave respite to short term borrowing by decreasing the Marginal Standing Facility (MSF) rate to 9.5 percent from 10.25 percent. Although it increased the repo rate by 25 basis points (0.25%) to 7.5 percent.

On the side note, most of the banks channelise short term funds through MSF, when the common way of borrowing dries up in the market. So, reduction in the MSF would bring down Certificate of Deposit (CD) rate in the market i.e. short term borrowing rates will gradually come down to sub 9.5 percent level. MSF rate was increased in July to curb the rupee depreciation.

With all the concerns on liquidity and growth I would like to bring some missing links which many of market pundits are ignoring. So, here are few missing sense which we need to check:

1. Our first quarter GDP ticked at 4.4 percent versus 5.4 percent year on year; lowest in four years.

2. One of the main components of Service Sector – Trade, hotel, transport and communication which comprises of small shops, restaurants and rickshaw-wala grew just at 3.9 percent (having 25 percent of weightage in the service sector). The slow pace of growth in the ‘trade, hotel, transport and communication‘ means there is slow employment growth for low income and low skill people.

3. Mining contacted by 2.8 percent in first quarter so were the manufacturing sector and capital formation by 1.2 percent, indicating the investment and consumption cycle are weak.

4. The Gross Fixed Capital Formation (GFCF) which accounts property, plant and equipment and excludes land purchase and depreciation was at 32.6 percent of GDP. The GFCF is a gauge used to check how good the economy is in utilising its capital. Previously estimated figures suggest the GDP should be around the level of 6.5 to 7 percent if the GFCF is 30 percent of the GDP but in the present scenario its is way behind that observed level. 

The bottom-line remains the same for our economy – we are failing to utilise our capital. If we can channelise our investment capital the economy will definitely shape up in a proper direction letting the RBI concentrate on the inflation check .  

D-Day: RBI strikes back

ImageToday, the Reserve Bank of India (RBI) will auction short term Cash Management Bills (CMBs) in the market. This step by RBI is seen as a dire desire to contain the liquidity and Indian Rupee in the market.

Under this scheme, every Monday the RBI will auction an amount of Rs. 22,000 crore of CMBs, wherein,  it will be selling Rs11,000 crore each in two CMBs maturing for 35 and 34 days on Monday and Tuesday, respectively. Although, the CMBs will carry characteristics of Treasury bills but the major difference lies in flexible maturity date. Unlike Treasury bills which carry fixed maturity date like 30 days, 91 days, 182 days, the CMBs will have flexible maturity dates between seven days and one year based on RBI’s view on prevailing market situation. RBI did sell CMBs On 25th July, 2013 which was for 28 and 56 days.

Will it strike and contain Indian Rupee?

Since the measure is for short term liquidity the CMBs will attract many institutional investors and fund houses as the bill maturing before 60 days will not be evaluated based on the prevailing market price thus fund houses will be free from any kind of accrued profits/losses in case of rise or fall in these CMBs.

Second point, this measure will keep the Indian Banks form speculating the Indian Rupee in the currency market as sell of CMBs will keep the short term liquidity at an elevated level thus there will be no leeway for banks to speculate Indian Rupee.

As the fall of Indian Rupee can be attributed to many economic factors but there is no doubt the speculative market is prudent enough to create further damage to the Indian Rupee in the currency market. Hopefully, this move will try to contain Indian currency in coming months.

Inverted Yield Curve: The Curious Case of Benjamin Button

The concept of ‘Inverted Yield Curve’ can be easily related to the ‘The Curious Case of Benjamin Button‘-  Hollywood’s fantasy drama movie.
In an ideal economic condition, a normal yield curve depicts low yield for short term papers (bills) with respect to the longer dated bonds (10-yr Treasury notes, 30-yr bonds).
But when the yields of short terms bills are higher than long dated bonds then it gives you an inverted yield curve. For those who are not aware of the movie, it was about a man who ages in reverse i.e. older to younger.  So, an inverted yield curve is a very unusual case similar to Mr. Benjamin Button.
Image  Image

Going by the terms, concepts and theory of economics; generally, an investor expects low return from short term investment whereas high return from long term investment. But when the investor believes that short term investments are risky and long term investment are secure even though they offer less return- this gives the yield curve a whole new look – an inverted yield curve.

The mechanism behind inverted yield curve
Imagine, the investors expect rates cut by Fed in coming months as the economic conditions are not favourable ( a perfect case would be recession period ). Since the short term bills closely follow Fed rates, investors will dump those bills on the anticipation that these bills will follow the Fed rates soon. In return they will flock themselves with longer dated treasuries, creating demand for it, which will shoot up the prices and bring down yield for those treasuries in the market. As everyone is running behind longer dated bonds, there will be few buyer for short term bills who will eventually demand for high coupon rates or yield, resulting, change in the dynamics of treasury yield curve see the graph below.

Although it is very pertinent to notice that an inverse yield curve can be used to forecast the recession. Many economists and market pundits will agree that a change in a yield curve always sends signal that the economy might see some hiccups in coming times. In the U.S., the treasuries yield curve got inverted before the recession of  2008, 2000, 1991 and 1981. The inverted yield curve had got many curious moments in past. In July 2006 the debt market witnessed inverted yield curve which remained  inverted for almost a year – till June 2007.
In the behest of cooling off the housing bubble the Fed increased its rate to 5.75 percent in 2006. After realizing the situation, in September 2007 it started cutting down rates consecutively ten times to near zero percent in 2008; the year which embarked official recession in the U.S. economy. One irony is ‘The Curious case of Benjamin Button’ got released in the same year – 2008.

I ask Rupee: Are you ‘Tumblr’ or ‘Tumbling’?

The headline seems funny, right? But it is a grave concern for the Indian economy.
Tumblr was worth so, Yahoo! bought it. But do you think rupee is worth in the current market situation? The Indian rupee is no more blockbuster currency among Asian currencies as it has fallen miserably this year.


If we see the quantum of fall this month itself, it fell more than 10 percent. To  evaluate how rupee has performed, read the article from moneycontrol.com; Rupee to see worst quarter in 10 years.

Now if we come to the basics, rupee’s downward spiral can be attributed majorly to the current account deficit, sudden policy change by major central banks, read: U.S. Fed and Bank of Japan (BoJ) and the Indian economic bottlenecks. To understand more about economic bottlenecks please check one well written article by Mr. Swaminathan Aiyar; Why RBI’s fears about India’s growing current account deficit are misplaced.

In the present market scenario everybody expects more exports from the country and more internal consumption driven system. To do so banking entirely on Reserve Bank of India to cut the interest rate so that we can boost the competition and make money easily available in the economy is not justified. When your currency has depreciated to a level where foreign investors are dumping bonds and getting rid of the Indian stock market, plus overall investment to the country is low, an interest rate cut is definitely not a wise step. Thus, RBI is not in position to cut the interest rate even though the headline inflation has eased a bit.

Situation has become tricky for the Indian economy which has lost many opportunities in past few years. Its failure to implement GST, lack of clear cut investment policy, tax regime for corporates and FIIs/FDIs are few major points to be noted here.  Now, the Indian economic system has to wait and get played by other influential central banks else accept the new level of its currency value against the dollar for the coming months- expecting it will get subsidise soon.

When India had chance to grab investment flow it failed to capitalize. So far, asian counterparts have done good enough to keep their currency level under control and they are still favoured as investment avenues when compared to India. I wish, the Indian currency could have shined just like Tumblr. Alas! rupee is tumbling indeed.