An important element of Reserve Bank of India?s (RBI) first quarter review of the Annual Statement on Monetary Policy was the aggression with which the central bank decided to attack inflation. The steep 50 basis points hike in the repo rate and the 25 basis point increase in cash reserve ratio, taken together, underscore the fact that RBI will continue to relentlessly pursue its anti-inflationary agenda.

For banks, however, there is another aspect which merits special mention: RBI governor Yaga Venugopal Reddy, in his post-policy review presser, made it amply clear that banks would need to take the profitability pangs in their stride. Reddy, rather aggressively, said, ?whatever pain and non-profitability fears there might have been, the outcome was not consistent? with the complaints. ?Every time medicine is given, and people have considered it to be bitter, in the end they have turned out to be healthy,? the governor said.

Coming just days after some of the largest banks in the country reported bad knocks in profitability for the first quarter of the current fiscal, this statement of the governor can only be a sign of things to come. The rest of the fiscal will continue to be difficult for them.

The country?s largest private sector lender ICICI Bank, for instance, reported a 6% drop in net profits, as it took a big knock of Rs 594 crore on the treasury side, denting the bottomline. The bank?s chief financial officer Chanda Kochhar feels the past quarter was one of the toughest seen recently, where interest rate movements caused havoc in the money markets. One-year G-Secs moved up 130 bps or so, overnight index swaps (OIS) by around 230 bps and the equity markets slumped 24%. All this meant severe strain on bank treasuries.

Now, with the latest double-whammy from RBI, things have just turned that much more serious for banks. Consider some basic calculations. Roughly, at the new level of 9%, the amount of CRR banks will have to keep with RBI works out to Rs 2,70,000 crore. If one assumes a 10% yield, that means Rs 27,000 crore is the amount banks could have earned in a year, if this money was available with them. Post-tax, the impact on their bottomlines, for the system as a whole, works out to anywhere around Rs 18,000 crore for the year.

This, obviously, isn?t all. Net interest margins will be further squeezed. Bond valuations will continue to be a major problem for the banks, as no one is ruling out more rate hikes before the year is out. In fact, RBI itself has said ?there is headroom available? with it in terms of the flexibility in the deployment of instruments at its command. In simple terms, it means more rate hikes will happen as the central bank seeks to bring inflation down to its targeted rate of close to 7% by March 2009.

RBI has clamped down on aggressive balance sheet expansion by banks, and with the rate hikes which banks undertake, some element of delinquencies on home and personal loans will creep in. But there will also be a limit to which banks will be able to hike rates. With derivatives products being sold earlier by banks also gone, thanks to the problems they got into, that?s one less source of fee-based income. Many banks are still betting on the existing investment pipeline of projects to see them through, but with corporate margins and bottomlines too getting squeezed severely, it?s not a very happy picture. Cost overruns for projects are a possibility. Retail lending is already down, and is seen growing at 5-10% this year.

All this means all of FY09?not just the first quarter?will be an intensely challenging year for banks.

To stave off some of this impact, banks will need to understand that the days of depending on treasury incomes and the usual channels are over as the market gets tougher. As banks compete for liquidity, current and savings account banking will have to drive its strategy. Reach will have to be expanded, the deposit franchise enhanced and newer customers tapped. This, as microfinance institutions have shown, is possible and profitable, if a strategy to penetrate deeper through the network is rolled out.

sourav.majumdar@expressindia.com