With the economy on the upswing post-recession, Indian banks are riding high due to increase in demand for loans and decrease in bad loans. This is expected to show up in the first quarterly results.

The country’s leading lenders, State Bank of India, ICICI Bank and HDFC Bank are witnessing a steady climb in demand for loan over the past few months. Another positive phenomenon seen is the drop in the number of loan defaulters, resulting in improvement in the quality of assets. With the economy predicted to grow beyond the government forecast of 8.5% in the current fiscal, there is a definite surge in confidence level all around.

The intermittent rate hikes by the Reserve Bank of India to combat the spiraling inflation has largely left this feel-good atmosphere untouched. The imminent RBI policy review scheduled for July 27 may also see another marginal rate hike, without any impact on the loan demand.

One of the reasons attributed to this is the presence of ample liquidity in the system. The rate hikes are too small to have any effect on the system. Moreover, the amazing growth of the economy is opening up lucrative avenues for the banking sector. The first quarter also witnessed the unbelievable competition among telecom providers in securing the 3G spectrum and their subsequent clamber to cough up adequate money to pay the spectrum fees to the government.

The superb performance of the manufacturing sector in the last few months has led to a substantial reduction in bad loans and defaulters. The first quarter of the current fiscal saw a drop of 30 basis points in the 10-year benchmark bond yield, which is beneficial from bank’s perspective.

The annual bank credit stands now at 21.7%, which is a tremendous improvement from 9.7% last October.

The banking sector’s benchmark, prime lending rate (PLR), had been in the center of controversy for long, which prompted RBI to constitute a panel to look into the issue in detail. According to the panel’s recommendation, the PLR system is being abandoned and a new system based on base rate is being introduced. One of the advantages of base rate system is that it will make lending process more transparent.

O P Bhatt, Chairman, SBI, India’s largest bank said, “The base rate will be transparent. Credit will henceforth revolve around the base rate as it will be the reference rate over which all loans will be priced and it will succeed in monetary transmission.”

One of the perennial complaints against PLR system was that many private sector banks were not passing on the reduction in policy rates to customers, but lose no time when the policy rates are hiked. This equals nullifying the monetary policy. The banks are also accused of favoring their corporate customers at the cost of individual customers and smaller companies, with the latter forced to bear the financial consequences. Many banks are lending lower than even funding cost to their most valuable clients.

A base rate system can solve the existing maladies plaguing the banking sector at present. The base rate is the rate below which a bank cannot lend even to their most favored customers. This is determined after analyzing a bank’s funding cost and operating cost.

With the base rate system coming into effect today, Indian banks will be forced to stop lending below 7%. The base rate for different banks will be in the range of 7%-8.75%, depending on each bank’s funding cost.

The Indian Banking sector is expected to witness credit growth in the range of 20% to 22% in the financial year 2010-11. This was disclosed by Ms. Rupa Kudva, MD &CEO, Crisil India in Mumbai on Thursday. She was speaking at the seminar ‘The New Normal: The Changing Face of the Financial Markets’.

Ms. Kuduva stated that the growth would be mostly driven by demand from infrastructure, automobile and telecom sectors. However, to fuel this high demand, banks will have to aim for a near-impossible compounded growth rate of 25% in deposits. This situation may ultimately compel banks to borrow funds from the market at a higher cost.

Regarding the recent spurt in influx of foreign investments in Indian market, she said that capital controls is a possibility if the abundance of money becomes a threat to financial stability. “India may have to control the amount of foreign money flowing into its economy if the surplus cash threatens to destabilize the financial sector. In the corporate bond market, foreign investments have reached $10 billion, which is an all-time high,” she said.

Ms. Kuduva stated that Indian banks were never involved in over-leveraging and complex financial products. Instead, they will become ‘more sophisticated, issuing complex products and became more transparent’, which means that they will not be mimicking the global trends. Despite this, there will be improvement in its integration with global markets, driven by the need for funds .

The recent spat among regulators over ULIPs has thrown up solutions such as appointing a super regulator. Ms. Kudva, though did not reply directly, said that it is ideal for each market to have a single regulator rather than a super regulator to regulate regulators.

Usha Thorat, RBI Deputy governor had expressed the central bank’s concern over the scaling down of loan interest rates by Indian banks for limited period to lure borrowers.  She said while addressing a banking conference, “Teaser rates do cause a concern. Banks should ensure that income of borrowers is adequate to service the loan when recovery picks up and interest rates return to normal levels.”

To entice customers, many banks like SBI, Axis Bank, ICICI Bank and HDFC Bank had earlier started offering home and auto loans at low fixed rates in the range of 8% – 8.5% for the first two years. After this period, the interest would be charged at a floating rate.

The matter of concern is the ability of borrowers to stick to loan repayment schedule when the floating interest rate goes up after the initial period. “I hope banks are ensuring that borrowers are aware of the implications of such rates and the appraisal takes into account the repaying capacity of borrowers when rates become normal,” she said.

However, the bankers defended their decision to go in for low fixed loan rates to woo customers, though for a limited period. SBI Chairman OP Bhatt said that these special rates have helped immensely in reviving the housing loan demand.

“We had done it when the credit offtake was almost nil. Hence, we were compelled to park our money with RBI at 3.25% interest rate. So, what is wrong if we are getting 8% interest rate on home loan,” Bhatt demanded. He added that this scheme has not placed any pressure on bank’s margin and there was no governmental coercion to implement lower rates.