Banks likely to make huge gains on bonds as RBI cuts rates.

When interest rates fall, bank stocks rise. The Bank Nifty index rose 4 per cent in the month before the Reserve Bank of India's (RBI's) meeting on January 29 where it cut the rate at which it lends to banks by 25 basis points or bps. Let's look at the complex relationship between banks and interest rates and see which banks will gain the most from the turning interest rate cycle.

In India, banks have to hold at least 23 per cent demand and time liabilities in gold or government or other approved securities. Time liabilities have a fixed period while demand liabilities, for instance savings account balances, are payable on demand. The ratio, called the Statutory Liquidity Ratio, or SLR, is decided by the RBI.

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A cut in the repo rate lowers banks' borrowing costs. This makes them cut both lending and fixed deposit rates. Falling rates across the debt markets increase the demand for instruments that pay higher interest. At this stage, prices of bonds which banks had bought when interest rates were high rise, as there is a scramble among investors to lap up these higher-yielding securities.

Hence, the value of government securities that banks have bought for the SLR requirement rises. This increases profits as banks record the market value of these securities in their books. Under this process, called marking to market, organisations record profits/losses in their books on a daily basis without actually booking any profit or loss. So, more SLR bonds the bank holds, the higher its mark-to-market profit.

The other reasons bank profits rise when interest rates fall are pick-up in growth as companies borrow at lower rates as well as improvement in liquidity. Market analysts, however, say that profits from rise in the value of bonds do not come from banks' core operations and are, therefore, unstable. "Profits from government securities or other investments are considered unhealthy," says Clyton Fernandes, banking analyst, Anand Rathi Securities.

However, any profit is good for investors . Keeping in mind business growth and treasury profits, we analyse banks that have clocked the entire 2012-13 profit in the first nine months of this financial year. With their business on track and growing, a look at their SLR holdings will reveal if there are some extra profits that these banks may make if the RBI starts cutting interest rates.

Source : Business Today.

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