Banks will continue to face the challenge of flat treasury income

Treasury income — that is to say, income earned by banks on their investment of surplus funds in government bonds — for 2013 will likely face the same pressures as experienced in 2012. Why? Bond yields are expected to remain high, the rupee is expected  to move in a range and the RBI is keen on curbing volatility, as indicated by its recent measures both on trading limits and client activity.

There seem to be fewer opportunities to make trading profits on investments. Having said that, we will see movements in interest rate swaps and other money market instruments, making it open to an opportunistic trading environment. Client margins will continue to experience shrinkage which will, to some extent, be compensated by increased client activity.  Hence, ability to capture larger share of clients’ wallet will be an important determinant of success.

On the trading side, the magnitude and timing of the rate cut during the fiscal 2013 will be an influencing factor on treasury income. There has been a heightened level of volatility both in bonds and interest rate swaps and has given many opportunities albeit with no firm trend.

The RBI has left the market disappointed with its stance of remaining stern on any monetary easing to tame inflation, which along with external factors like the euro zone, sluggish demand  and high crude prices, has led to a significant slowdown in the economy. The fiscal deficit is a cause for concern and the government borrowing programme to fund the gap is at an all-time high.

Having said that, it is necessary to state that the RBI’s clear statements point to a possible shift in stance towards an easing, subject to headline inflation showing a clear downtrend. The RBI will also look for signs of government’s capability to implement quantifiable measures to achieve fiscal prudence. It will study evolving dynamics in global commodity prices.

The expectations on the quantum of reduction stands reduced from 150 basis points to 75 basis points. This, coupled with demand-supply mismatch, and less likelihood of open market operations (OMOs), will keep mid and longer end of the yield curve at an elevated level, resulting in thin trading gains and large ‘mark to market’ provisioning in first half of the fiscal.

Forwards will closely track the shorter end of the domestic rate curve. On the foreign exchange front, the rupee will indeed continue to see a volatile trend. We witnessed a 25% move from July to December 2011 and then a partial retracement of 8%.  Induced volatility on account of FII flows, NRI flows, oil price movement and a current account deficit make no inference for a clear trend, resulting in short-term bouts of exaggerated movements. This thereby creates good opportunities to generate trading income throughout the year. But it is limited by the control on net overnight open position limits.

The second half of the fiscal looks more promising for trading gains; the expected OMO support to the tune of Rs1.2 -1.5 trillion from the RBI is a firm indication pointing towards likelihood of achievement of budgeted Rs3,000 crore disinvestment target and Rs5,820 crore of spectrum sale target will drive  the longer end of the yield curve southwards.

On the client side, as discussed above, the macro factors such as the euro zone crisis, oil price movements, sluggish economic growth (both global and domestic), domestic inflation, fiscal deficit have led to higher borrowing costs and increased level of volatility in earnings due to rupee movements. In order to curtail the volatility, the RBI came out with stricter guidelines for cancellations and rebooking of merchant forward contracts. This has led to a substantial slowdown in client foreign exchange activity.

However, given the impact of this increased volatility on corporate earnings, coupled with a rapidly increasing cross-border activity from both trade and capital financing perspectives, corporates are pro-actively looking at framing robust risk management policies to protect their cost of financing. With this in mind, cross currency products — plain-vanilla forex, currency swaps, forex options and interest rate swaps — will continue to be the key revenue drivers.

A close second would be activities centred around raising of domestic capital. The rise in duty on gold imports from 2% to 4% in the budget will impact bullion turnover in FY13 as gold imports are expected to be reduced by 25% of last year’s turnover. Cross-selling is going to be key, leading to a potential that exists with banks that have a universal banking model. Wholesale clients will continue to migrate towards banks that offer the full suite of products that meet their diverse needs.  This would mean that banks not only need to have the entire suite of treasury products but also need to be able to offer assorted wholesale banking products, for a successful treasury model.

The typical trading P&L share is not over 30% for most banks; however, its importance should not be underestimated.  Hence, over and above the client business, it will be imperative for treasuries to capture the alpha associated with warehousing and managing risk effectively and utilising their capital, aggregate gaplLimit,  net open positions and risk limits in the most judicious manner.

The writer is head of the Global Markets Group at IndusInd Bank. Views are personal.