Indian Banking Sector 2010 : Opportunities and Challenges
The current economic situation provides a lot of opportunities as well as challenges to the existing banks. It is up to the banks to leverage the opportunities to meet the challenges to the best of their abilities.
The past year witnessed a lot of turmoil in the Indian banking industry owing to the global financial crisis. The Reserve Bank of India (RBI), Ministry of Finance and other regulatory authorities have made several notable efforts to improve regulation in the sector. Many big banks operating in the market have made use of the changed regulations (viz., change in CRR and interest rate) to provide better options to potential and new customers. Adoption of new practices to cater to the demanding economy situation has enabled the banks to meet the changing customer requirements. Compared to other regional banks, over the last few years, Indian banks have performed favorably on growth, asset quality and profitability. The banking index has grown at a compounded annual rate of over 51% from April 2001 compared to the market index for the same period, which registered a growth rate of 27%.
The crisis that hit the financial services industry initially in the US and almost immediately in the entire world has moved our focus towards critical systemic issues—not only in the US banking business but also in India. Globally, these systemic issues are being tackled at the legislative and regulatory levels; in India, the solution to the systemic issues will require significant inputs and regulatory, industry and infrastructural interventions. To ensure survival, banks tried to quickly assess their liquidity reserves and capital position to check if they had any exposure to the failing global entities. Additionally, this check also meant a clear pulling down of new/additional credit outflow, unless and until their positions were clear. Over a short span of time, the situation resulted in banks totally stopping the outflow of new credit.
According to Indian Banks Association Data, retail credit growth dropped drastically from 30% in 2007 to 10% in 2008, owing to increased pressure on existing loan portfolios and the fear of anticipated mass job losses which would result in high NPAs. Analysts and credit rating agencies in their reports showed marginal to moderate increases in NPLs in assets such as two-wheelers, commercial vehicles and unsecured loans. Growth in mortgages, which forms 50% of banks' retail portfolio, was also hit due to upward movement in interest rates, restriction on collection practices and soaring real estate prices.
Indian banks had to clean up their systems and practices to ensure stability in a recovering economy. Four challenges must be addressed before success can be achieved.
• The market is witnessing haphazard growth, driven by new products and services, which include credit cards, consumer finance and wealth management on the retail side, and fee-based income and investment banking on the wholesale banking side. Continuous growth in these new products and services requires new skills in sales and marketing, credit, operations and, above all, a potential customer base to provide these offerings.
• There will be no windfall treasury gains, which banks used to enjoy as a result of the decade-long secular decline in interest rates provided. This will expose the weaker banks and put them in trouble to a large extent.
• Growing interest in India will encourage foreign banks to set shop in India, thereby intensifying the competition for domestic and other existing players.
• As India is experiencing demographic shifts resulting from changes in age profile and household income, now consumers will demand improved institutional capabilities and enhanced service levels from banks.
As has been mentioned earlier, in India, regulators need to play a major role in revolutionalizing and bringing about changes in the economy. Of late, it has been realized that there is a need to create a market-driven banking sector, with ample stress on social development. This requires dedicated efforts by the regulators in six important areas, which are as follows:
• Focus strongly on `social development' by shifting from universal directed norms to an explicit incentive-driven system by introducing credit guarantees and market subsidies to encourage leading public sector, private and foreign players to leverage technology to innovate and profitably provide banking services to lower income and rural markets, thereby improving financial inclusion in the economy.
• Like the biggest financial markets of the world, create a super regulator rather than having separate regulators for each and every participant in the financial services industry.
• Focus on corporate governance and ensure that the same is improved by primarily focusing on board independence and accountability.
• Speed up the process of creation of world-class supporting infrastructure (e.g., payments, Asset Reconstruction Companies (ARCs), credit bureaus, and back-office utilities) to enable the banking sector focus on core activities.
• Undertake labor reforms, focusing on enhancing human capital, to help the public sector and old private banks compete with the newly established and much more efficient private banks and foreign banks entering the country.
Not only the regulators need to gear up, but even the banks need to pull up their socks and bring about some changes to support the reforms which the regulators aim to bring in:
• Public sector banks need to improve certain areas of their work performance, viz., sales and marketing, service operations, risk management and the overall organizational performance ethic. Last but not the least is to enhance the human capital, which will be the single biggest challenge and definitely the most time-consuming one also.
• What is true for public sector banks is also true for old private sector banks, as they have to also strengthen their basic skills. Additionally, they have to ensure their proactive participation in the Indian banking sector. This is of utmost importance to them, because the same will keep them up-to-date in this fiercely competitive market.
• New private banks can achieve an altogether new height in their growth in the Indian banking sector by continuing to engineer new and differentiated business models to profitably, efficiently and effectively service segments like the rural/low income and affluent/HNI segments, and by keeping an eye open for the acquisition of small banks to grow and reach the next level of performance in their service platforms. Attracting, developing and retaining management capacity would be another critical factor for achieving this and would be the biggest challenge that these banks will have to face.
• Foreign banks entering India will have to be innovative in their approaches to win the largest customer base and share of wallet and above all, to build a value-creating customer franchise in advance of regulations potentially opening up post 2009. At the same time, they need to be an active player in the game for potential acquisition opportunities, as and when they emerge, to ensure growth and establishment in India. They need to sustain and maintain a long-term value-creation mindset, which will not be an easy task by any means.
Thus, banking in India involves the cooperation and participation of many stakeholders for the desired changes to be made in the existing system. Last year, during the economic slowdown, when the banking system globally went for a toss, the Indian banking industry emerged as a strong performer owing to the coordinated efforts of policy makers and the banks in bringing these policies to action for the best of the economy.
The Indian banking industry gathered the strength to sustain during such times through its huge deposit base, which is consistently on a growth path, central bank's proactive measures to steadily improve banks' balance sheet strength, and a demand in the economy for physical asset creation. These factors enabled the Indian banking sector to become stronger on the capitalization front and also ensure lower level NPAs and better spreads in the past one-and-a-half decade.
The strength provided through timely measures has helped the industry and the economy in many ways. Last year, the economy witnessed perhaps the biggest and positive impact of higher credit growth in infrastructure- related companies—power, telecom and others. However, it was partially compensated by the reduction in other funding sources such as private equity and foreign institutional investors.
The alarm will start ringing if the regulator decides to continue with the stimulus package for long. With dried-up liquidity and no borrowers (given the low credit growth), the banking system will continue to invest excessively in government securities, leading to fiscal deficit eventually.
However, an increase in domestic liquidity has had a cascading effect on the asset price inflation. According to a report by Tata Securities, the YTD growth in deposits is 9%, while the credit growth is only 5.4%, resulting in the banks' looking for other investment opportunities. The high liquidity with banks forced them to invest in the liquid funds of mutual funds, which in turn invested in commercial papers of corporates at a lower coupon— corporates would have otherwise borrowed at a higher cost from the banks for their working capital requirements.
The second half of the year, which is typically the time for maximum activity in the economy, usually witnesses a higher demand for bank credit, compared to the first six months of the financial year. The three broad segments of bank credit are: Capex and Infrastructure Credit; Working Capital Loans; and Consumer Loans.
It is expected that growth would be highest in the case of infrastructure credit and consumer loans. Additionally, it is also expected that the demand for working capital loans is likely to be low, as commodity prices (crude oil and metals) continue to be low, and thus companies will have to work with low working capital requirements on a yearly basis.
Infrastructure is expected to catalyze credit growth in the Indian economy. According to the allocations made by the authorities concerned, the planned outlay on infrastructure under the 11th Five Year Plan under the projected investment in infrastructure should be around Rs 4,500 bn per annum for the next three years. According to a report from Tata Securities, infrastructure as a percentage of total bank credit exists at 10.2% currently, and it is projected to grow at more than 40% y-o-y in the next three years.
Consumer demand has been very resilient. There has also been a rise in the purchasing power in smaller cities and rural areas, along with job stability in large cities and Pay Commission benefits. Research by Tata Securities suggests that secured retail loans in the mortgage and vehicle financing segments are seeing good demand and will drive the overall bank credit growth. The research also states that in the absence of a pickup in corporate working capital loans, banks are eager to grow the secured consumer loans portfolio. It is expected that a price correction in the real estate market and gentle interest rates are factors which will promote growth in loan portfolios.
The downturn which the economy witnessed has discouraged the banks from having any exposure to unsecured consumer credit, and a revival in this segment is not expected to happen soon. According to a research report from Tata Securities, retail loans showed a CAGR of 22% during FY05-FY09. Within the retail segment, housing loans grew by 20% CAGR during the same period and consisted ~10% of the total bank credit. Thus, the banks, which had a big challenge on the unsecured loan front, had at the same time a bigger opportunity in the mortgage-backed security portfolio.
Abundant liquidity in the banking system during FY10 has been ensured through secular growth in deposits, low credit demand and prudent borrowing schedule issued by the government to maintain a balanced growth. According to a research report, despite the huge borrowings of Rs 4,510 bn by the government in FY10, the money held in reverse repo by banks remained considerably high. This will provide an opportunity to the banks to utilize the money in the most efficient and effective way to the benefit of both the customers and the economy as a whole, comprising various stakeholders.
Having talked about comfortable liquidity and the much-wanted stability in the banking system, one can expect that bond yields will remain in a higher range and would not fall significantly. Other reasons which are likely to support this fact includes:
• Lower than expected government borrowings
• Reduced global risk premium
• Higher credit growth
This brings another opportunity for the
banks to earn higher income.
Besides the favorable condition for liquidity and high bond yield, it is expected that the Net Interest Margin (NIM) will not expand much. The banks need to have higher incremental CD ratio, improvement in spreads and stable yield on investments to improve NIMs. Banks are expected to have a low cost of deposits owing to a stable interest rate scenario and ample liquidity in the system. 
Another important area which requires critical attention is fee income. In the past few years, fee income has been the major contributor of revenue for private sector banks. Private sector banks have leveraged those areas to achieve the above, which public sector banks have not been able to, viz., transaction- related services and third party products sales, among others, to increase this non-fund based income.
Thus, we can very well say that the current situation has provided a lot of opportunities and challenges to the existing banks. Now, it is up to the banks as to how well they leverage the opportunities to meet the challenges to the best of their capacities.
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