Kotak Mahindra Bank's standalone net profit rose 29% to INR 42.12 billion in the July-September quarter, as bad loans and provisions fell, but a surge of foreign-currency deposits pulled its net interest margin down to 4.31% from 4.53% three months earlier.

The result, released Oct. 24, matters beyond Mumbai. Kotak raised about INR 553 billion in foreign currency non-resident, or FCNR(B), deposits during the quarter, foreign-currency savings that Indian banks take from non-resident customers; its Oct. 6 business update put the haul at $5.78 billion. That inflow made Kotak's balance sheet look much bigger and its profitability ratios look weaker at the same time, and it shows how India's lenders are scrambling for funding as loans outpace deposits across the system.

Consolidated profit, which includes the brokerage, asset management and insurance arms, rose 26% to INR 56.45 billion, the bank said. That compares with INR 54.80 billion in the June quarter.

Kotak Mahindra Bank's margin takes the FCNR hit

Net interest income, the gap between what the bank earns on loans and pays on deposits, rose 16% from a year earlier to INR 84.59 billion and 7% from the June quarter. The margin did not keep pace. It slipped to 4.31% from 4.53% in the June quarter and 4.54% a year earlier, and the bank put the decline mainly down to the FCNR(B) money.

Cost of funds rose to 4.52% from 4.46% in the previous quarter, though it was still below the 4.70% of a year ago.

Management told reporters the foreign-currency deposits were used to repay costly inter-bank participation certificate borrowings and to pay for a loan portfolio bought from group company Kotak Mahindra Investments, according to UNI India. The rest of the cash was parked until it could be lent to customers. Idle liquidity earns little, which is one reason the margin fell.

In a provisional business update on Oct. 6, Kotak said the FCNR(B) deposits were raised under the Reserve Bank of India's swap facility, and that its international branches had lent about $1.68 billion (INR 161.1 billion) against them, according to the Free Press Journal.

Balance sheet swells as bad loans fall

On the headline numbers, the balance sheet grew fast. Net advances rose 25% from a year earlier to INR 5.77 trillion and deposits climbed 23% to INR 6.51 trillion. Excluding the FCNR(B) effect and the portfolio acquired from Kotak Mahindra Investments, loan growth was 19%, and deposit growth without the foreign-currency money was 13%, the bank said.

The mix of deposits got more expensive. The share of low-cost current and savings accounts, known as CASA, fell to 38.2% from 42.3% a year earlier. Excluding FCNR(B) deposits it was 41.8%. The credit-to-deposit ratio edged up to 88.6% from 87.5%.

Fee and service income rose 21% to INR 29.26 billion, while operating expenses rose 14% to INR 52.71 billion. Operating profit grew 21% to INR 63.82 billion, according to PSU Connect.

Returns remain modest for a lender of Kotak's standing. Standalone return on assets was 1.92% and return on equity 11.65%, weighed down by a very large capital cushion. The bank's capital adequacy ratio stood at 21.9%, with common equity tier-1 capital at 21.4%.

The cleaner loan book did most of the work on profit. Provisions fell 15% from a year earlier to INR 8.03 billion, although they rose from INR 6.68 billion in the June quarter. Annualized credit cost dropped to 0.35% from 0.79% a year earlier and 0.46% in the previous quarter.

New bad loans, or slippages, fell 24% to INR 12.30 billion. The gross nonperforming asset ratio improved to 1.04% from 1.39% a year earlier, and net bad loans fell to 0.24% from 0.32%. Provision coverage rose to 78% from 77%.

Among subsidiaries, Kotak Securities earned INR 3.48 billion in the quarter, the asset management and trustee business INR 2.87 billion and Kotak Mahindra Prime INR 2.51 billion.

What investors made of it

The stock rose more than 2% on Monday, Oct. 26, the first trading session after the results, touching INR 440 during the day, according to NewsBytes. Shares had already traded about 3.5% higher on the morning of Oct. 6 after the provisional update showed the deposit surge.

HDFC Securities kept a buy rating and set a target price of INR 480, valuing the group as a sum of its parts, Business Today reported. The brokerage said the quarter was in line with its forecasts, with stronger volume growth and asset quality partly offsetting the margin squeeze. It flagged "sub-optimal capital deployment" and a return on equity of about 12% as concerns.

That is the test for the coming quarters. Kotak is sitting on capital well above regulatory minimums and a pile of foreign-currency liquidity it has yet to lend out. How quickly that cash moves into customer loans will decide whether the margin recovers from 4.31% in the December quarter.