With yet another year of high economic growth, the Indian economy continues on a sustained upwards trajectory. The GDP growth has averaged 8 per cent over the past four years, determined by three key macroeconomic factors:
The expected impetus to the infrastructure segment is likely to further broadbase the economic growth in the years to come. The development of the debt market and the role of financial intermediaries in routing national savings to fund the massive requirements of the infrastructure segment will play a critical role in sustaining the growth momentum.
The underlying structural, demographic and economic changes have put India on the global map as one of the fastest growing economies.
The relatively slower pace of growth in the developed world and increasing de-coupling of the emerging economies is expected to alter the world economic order in less than two decades.
The sustained economic growth provides banks with significant business opportunities for rapid growth driven by clear strategic choices.
While some banks have aggressively focussed on pure growth to create size and mass, others have focussed on the quality of growth. These widely divergent strategic approaches are likely to establish leadership positions for the future.
|Subprime crisis: Lessons for India|
Years of easy liquidity and a low interest rate regime fuelled an economic boom across the globe, driven largely by credit expansion and a significant rise in asset prices. However, the problem of plenty began to surface in the US mortgage economy, with disastrous consequences. Mortgage prices in the US dropped 40 per cent in less than a year.
The slowdown in the US mortgage sector is now spreading to the rest of the world. Economists predict that the US economy could shed two percentage points of growth in 2008, even as the Federal Reserve endeavours to contain the crisis and prevent a full-scale recession. The worst hit has been the banking sector, which has seen its collaterised structured obligations melt with the rapidly falling mortgage prices. Several large global financial institutions have written off billions of dollars in order to clean up their balance sheets, and sacked those who did not see it coming.
The European Central Bank and Bank of Japan are struggling to prevent the contagion effect of the US mortgage segment from reaching their shores. But, it is too early to pass judgment on whether they have succeeded. We have already seen significant write-offs from some large banks in that part of the world and there is probably more to come. The spread of this contagion to other developed economies may not only affect the global banking system, but could also have an impact on global economic growth.
Indian banks have been relatively unaffected by the crisis. The Reserve Bank of India (RBI) has acted swiftly in stemming speculative advances to the real estate sector to control spiralling real estate prices. The steady hikes in the interest rates, CRR (increased from 5.5 per cent in January 2007 to 7.5 per cent in November 2007) and risk weights for provisioning have so far been effective. However, most indicators, including US economic trends, policy outlook, and stock market volatility, indicate that the storm may not have passed yet. The lessons from the subprime crisis highlight the need for banks to be cautious against expansionary forces and bring back the focus on fundamentals that include:
While growth brings great opportunities, it also creates significant new challenges for the Indian banking system—challenges that, we believe, have the potential to fundamentally change the structure of the indian financial services industry, particularly banking.
This article discusses three key impact areas— the capital management challenge, managing the convergence of financial services and finally, mastering the challenge of liabilities.
Management of capital
Banks are guzzlers of capital. In many ways, for banks, capital is not just a source of funds, but an enabler for growth. A study of the advances growth visà-vis the capital adequacy reflects a requirement for larger infusions of capital at shorter time frequencies in order to sustain the growth momentum (See The Growth Matrix).
The Indian Banks Association estimates that the collective capital requirement of public sector banks alone is likely to be around Rs 1.5 lakh crore over the next two years. The total capital requirement for the banking system, thus, may well be over Rs 2 lakh crore. This high requirement for capital is driven by:
The capital requirement figures are staggering compared to the capital these banks have raised in the past. Given the requirements, there is also the likelihood of banks overcrowding the capital markets with public offers.
This overcrowding is likely to impact the resource raising capacity, in particular, of the weak banks. This, we believe, is likely to be the single-most critical driver for consolidation in the banking system. In many ways, the year ahead may well be the year of forced mergers for the banking system.
The weaker banks, in order to attract capital and sustain growth, may have to undertake rapid restructuring across their operating models, asset portfolios, technology architectures, as well as development of human resource competencies.
As the market for hybrid instruments is not well developed, equity instruments will be the preferred route for the banking system to raise capital. Indian banks may have to take a cue from their Chinese counterparts—who have raised $37 billion (Rs 1.48 lakh crore) of capital over the past two years (the Industrial and Commercial Bank of China raised $19 billion, or Rs 76,000 crore, in October 2006 through a single issue)— to actively tap the global markets to raise resources.
The success of Indian banks in raising capital from the global markets is expected to be driven by the larger Indian growth story and may potentially require a structural change in the shareholding pattern.
Convergence in financial services
The expected deregulation in the financial services landscape after 2009, the high valuations in the capital markets, and high growth rates in retail financing and product distribution have attracted a number of players, both global and domestic. The new entrants are taking the non-banking finance company route to create financial services plays.
With redefined business models, these players are likely to shape the future of financial services and banking. With segmented customer models, wide distribution reach, lean operating structures, and a targeted set of product propositions— funded by capital raised through private equity— the new players are targeting new pockets of profitable and affluent customers. Traditional Indian banks are being severely challenged in attracting and retaining profitable customers, in the face of this onslaught (See The New Models).
Banks that are unable to reorient themselves and attract and retain profitable customers are likely to see their returns (RoA) under pressure, despite the growth in business. A study of the growth in advances versus RoA reveals that while most banks have shown growth over the last two-to-three years, this has not necessarily translated into improved returns for stakeholders (See How They Fared).
Banks that are able to realign their business and operating models in terms of distribution reach, competitive and value-added product offerings and differentiated customer services are likely to be successful in protecting their turfs and in retaining and attracting profitable customers.
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To meet the challenge emerging from the convergence in the financial services sector, banks will have to:
Management of liabilities
Management of liabilities is a critical driver for growth. Banks that are able to attract low-cost deposits and maintain overall lower cost of borrowings will have the flexibility to define their asset books and, thereby, attract new customers. A study of the gains or losses in market share of low-cost borrowings reveals that the private banks are gaining incremental market share at the expense of public sector banks (See The Big Picture).
The ability to attract low-cost deposits and maintain market share will no longer be determined by size or reach in terms of number of branches. The ability to attract low-cost deposits, in future, will be increasingly determined by the ability to offer value-added services such as:
Asset quality and impact of the SARFESI Act
Non-performing assets (NPAs) are a double-edged sword that affects income recognition, while the provisioning on the NPAs impacts the profitability and earnings of banks. The study reflects critical trends with regard to improvements in NPAs (See Quality of Assets).
Traditionally, a large chunk of NPAs in the banking system have been with regard to corporate exposures. Public sector banks, in particular, were saddled with bad corporate exposures. The last three years have seen a significant improvement in the NPAs of PSU banks, with gross NPAs as a proportion of total advances show a declining trend. Significant improvement in NPAs and recoveries can be attributed to:
Some of the smaller banks, particularly those classified as “weak banks”, have also benefited significantly from the environmental changes. The improved position of the NPAs has been one of the key reasons for the turnaround of these banks.
However, the aggressive growth in retail assets and, specifically, non-collateralised assets like credit cards and personal loans over the last two-to-three years is likely to present a new challenge to the banking system. The first signs of recovery weakness in retail exposures are clearly on the horizon. Given the challenges in the retail recovery framework, the banking system will have to look beyond. Strengthening the loan origination framework and ensuring generation of healthy credit will be critical for a healthy retail portfolio. The banking system critically needs systemic initiatives with regards to:
We believe that each of the trends highlighted above will individually, and in tandem, shape the future and rewrite the rules of the Indian banking landscape. Banks that are able to innovate to keep up with emerging market trends are likely to be more successful and will establish longterm leadership positions. The fun is about to start.