Since half of SBI's [Get Quote] loans were made in the last 3 years, a sharp hike in NPLs is a possibility.

State Bank of India Chairman OP Bhatt is a man in a hurry. Although he has five years at the helm of India's biggest bank by assets, Bhatt wants to capture as much as he can and as quickly as possible.

Last November, he said he wanted SBI's balance sheet to grow from $150 billion (Rs 600,000 crore), at the time, to $250 billion (Rs 10,00,000 crore), in the next couple of years. By the end of the March 2008, SBI had already hit a balance sheet size of Rs 720,000 crore (Rs 7,200 billion), which meant it had clocked a brisk 28 per cent growth in FY08.

But, in the meanwhile the environment too has deteriorated. So much so that the central bank too doesn't really want credit, for the banking industry, growing beyond 20 per cent in FY09. By trying to force the pace, SBI may just end up compromising profitability.

In a year when retail loans didn't find too many takers, SBI's asset book stands out, growing as it did well above the industry average, though by the end of the year, even SBI had some trouble finding customers.

Between April-December 2007, SBI's assets grew 26 per cent versus 22 per cent for the banking industry. Whether it was auto loans (up 30 per cent) or advances to SMEs (up 26 per cent) or even personal loans (up 19 per cent), the bank was determined not to be outdone.

Even in the home loans space, its run rate was far higher than that of the industry, though the pace tapered off to about 19 per cent compared with 20 per cent-plus a year back. ICICI Bank's [Get Quote] retail loan growth in FY08 was 3 per cent net of sell-downs.

Interestingly, Lehman Brothers estimates that more than half of SBI's current outstanding loans were made in the last three years. The growth may have come at a cost.

NPAs are up and net interest margins are down -- from 3.2 per cent in FY07 to 2.8 per cent in FY08. Profits look healthy but may not actually be so. Q4 profits of Rs 1,883 crore (Rs 18.83 billion) included Rs 900 crore (Rs 9 billion) of IT refunds and pension writebacks -- take this into account, and profit before tax actually fell 27 per cent. With the bank having reduced the prime lending rate earlier in February 2008, it couldn't charge its customers what it should have, though the cost of money stayed high.

Also, yields on investments fell though the bank didn't really pay customers less for their deposits. Looking ahead, profitability will be hard to come by -- even if SBI has a some cushioning because it mopped up money recently through a rights issue -- because the full impact of the PLR cuts will be felt now and in the coming quarters.

Besides, the increase in the cash reserve ratio -- an amount that banks keep aside but on which they earn very little -- will mean pressure on the net interest margin. That's why SBI needs to pick and choose its borrowers, using its size to its advantage.

In fact, given that money will be in less abundance than it has so far, SBI should have tremendous pricing power and can use this clout with big borrowers, agreeing to lend only if there is an upside in the form of fees.

Typically loan origination is more difficult in a liquid market, when money is cheap -- ICICI Bank possibly demonstrated exceptional origination skills by generating loans at a time when money was abundant and becoming cheaper.

But in a market when money is not easy to access, SBI stands a good chance of accessing quality clients. Even if earns a lower rate on the loan, this is a time when it can more than make up from the fees.

In fact, lending to larger companies may be a better bet at a time when industrial growth is slowing down, than giving money to an SME at a higher yield. Loans to SMEs, which now account for about a fifth of SBI's portfolio, are already posing some problems for the management which has attributed stress in the loan portfolio to farm, SME, mid-corporate and retail loans.

The March quarter numbers showed a marked deterioration in asset quality: gross non-performing loans (NPLs) were up 28 per cent y-o-y with fresh slippages in retail and mid-corporate spaces going up to Rs 400 crore (Rs 4 billion). Obviously, things have taken a turn for the worse in the recent past because sequentially, NPLs were up 21 per cent.  

For all the growth, SBI ended FY08 with a portfolio that has more bad loans: gross NPLs were up at 3.04 per cent from 2.92 in the previous year, while net NPLs rose to 1.78 per cent from 1.56 per cent.

Since a good part of the retail and SME portfolio has been created over the past year or so -- the increase in total advances during the year was 23 per cent but the SME piece grew faster at 26 per cent -- the portfolio is relatively new and could throw up a few more nasty surprises.

Given the credit losses suffered in the SME portfolio, SBI may want to go slow on this segment.

The bank is also obviously concerned with the state of its farm loan portfolio: RBI data indicates that historically, SBI has underperformed the sector on farm loans with higher NPLs (agricultural NPLs account for about a fifth of its total NPLs).

Even if banks are reimbursed in cash, the Rs 60,000 crore (Rs 600 billion) farm loan write-off (for PSU banks together) will mean a hit of Rs 1,500-2,000 crore (Rs 15 to Rs 20 billion) for SBI, according to the management. SBI recently attempted to hold back and become stricter with loans for farm equipment but wasn't allowed to do so.

As it is, the bank's loan loss coverage ratio at 42 per cent is the lowest in several quarters and it may need to set aside more money as provisions in the current year. That would imply an increase in the cost of credit. That, in turn, could hurt margins.

Even otherwise, the cost of money could increase with banks competing harder for deposits, whether wholesale or retail. SBI, however, with its extensive network of 10,000-plus branches, giving it tremendous reach, should have a clear edge.

A study by Deutsch Securities, however, shows that in the recent past SBI has not always cut deposit rates in line with a cut in the PLR; moreover, it has, on occasion, not raised deposit rates in line with increases in the PLR, a surprising fact given SBI's strong franchise.

The study notes that SBI is probably not as well-protected from margin pressures as is the common perception. Data studied over a period shows how SBI has cut deposit rates less than ICICI Bank or HDFC Bank [Get Quote], in the one-two years bucket.

Of late, however, the bank has been able to arrest the fall in the market share of deposits: Bhatt says the bank has actually gained market share. That's why it's hard to understand why SBI needs to add 3,000 branches -- it has added 1,000 in FY08 and plans to add 2,000 this year.

If it moderates the loan target, SBI should be in a far more comfortable position on deposits than competitors. Otherwise, it could just end up paying more and crimping its margins in the process; in FY08, deposits cost the bank 80 basis points more than they did in the previous year, while the proportion of cheaper current and savings accounts  stayed flat at 43 per cent.

The cost of setting up and running 3,000 more branches, at a time when other costs such as wages are going to increase, seems unjustified.

SBI could probably use the money to upgrade technology further and build its brand to connect with the younger generation,which is going to be the largest demographic segment. That should fetch it more customers at its existing branches, giving it more bang for the buck.