Business Today

Indian banks: Not yet out of the woods

The Indian banking system did well to survive the carnage of the global meltdown that brought marquee institutions down to their knees. But there are challenges which, if not tackled, could derail India’s ambition of higher economic growth.

Print Edition: December 13, 2009

Wow! What a year we have been through. We witnessed a perfect storm—volatile oil prices, asset bubbles and overleveraged banks, in a very inter-connected world—all leading to unarguably the greatest global financial crisis witnessed in human history. One year later, central bank chiefs and well-known economists continue to sound cautious about declaring an end to the crisis. While massive doses of emergency liquidity pumped in by governments has resulted in a short-term avoidance of a catastrophe, it is also very evident that the collateral damage continues to mount—global recession leading to increasing defaults, deficit-ridden economies writing off taxpayers money to prop up “too-large-to-fail” banks— and the spreading contagion is yet to be contained.

One of the popular myths floating around is that Indian banking has kept its head well above the global meltdown that has felled or humbled larger marquee names around the world. And while it is true that we in India have not seen a collapse like that of Lehman Brothers or Merrill Lynch, or witnessed massive government-funded bailouts as in the case of Citibank or RBS (Royal Bank of Scotland), the reality is that we have seen a significant shift in the behaviour of large Indian banks, which, if not corrected, could result in a slowdown of India’s aggressive growth plans.

The near catastrophic events that hit the financial services industry initially in the US and almost immediately around the world has exposed critical systemic issues— not only in the US banking business, but also in India. While at a global level, these systemic issues are being tackled at the legislative and regulatory levels, in India, the solution to the systemic issues will require significant regulatory, industry and infrastructural interventions. This article attempts to dissect these systemic challenges, understand the underlying structural weaknesses/issues and suggest solutions for the future.

Much has been written by experts on the reasons for the global financial services meltdown and many others have attempted to analyse the short-term and long-term impact on the Indian economy, its banking system and its future regulatory models. A little over a year after the fall of Lehman Brothers, it is a good time to take a more objective review of the events that unfolded.

The US system collapse was triggered partly by bankers combining innovation and greed. And by the regulator turning a blind eye to off-balance sheet activities. The bubble created thus has not gone away and is more than likely to come back and haunt the regulators.

The impact of the collapsing portfolios of US banks triggered a massive need for dollars to shore up liquidity and risk capital in the US. This resulted in greenbacks being sucked out of India’s capital markets and the banking system, causing multiple systemic issues to arise.

Banks tried to quickly assess their liquidity reserves and capital position, in the event that they had an exposure to the failing global entities. This also meant a clampdown on additional credit outflow, until their positions were clear. Within a very short period of time, banks had nearly stopped disbursing credit.

Meanwhile, the Reserve Bank of India (RBI) responded proactively to the vacuum created by the outflow by buying available dollars in the market, thereby creating a rupee liquidity crunch. Wisely, and in an unprecedented manner, RBI made significant reductions in the repo and cash-reserve ratio (CRR) rates to enable banks to free up large amounts of reserves for lending.

However, banks, which were now in a panic mode, had to also rapidly assess how the global meltdown would impact India’s macroeconomic position, and more critically, impact their corporate credit portfolio. The added dangers to contend with were the anticipation of a widespread fallout in the high-growth export sectors, resulting in significant defaults, a domino effect on job losses, which, in turn, led to defaults in the retail portfolios.

Those banks that held promoter stakes as collateral were especially vulnerable— since either the revaluation would force them to seek additional stakes or potentially look at ways to restructure these large-ticket credits. Large corporates, especially those with large export dependencies, immediately went into a “wait-and-watch” mode—many put a hard stop to investments, capital expenditure and hiring. In any event, most companies coming off the peak growth periods of 2006-07 were flush with funds from internal accruals and required limited working capital. Thus, corporate credit growth dropped from 28 per cent in 2007 to 19 per cent in 2008 on the back of lower demand and rating downgrades (see Credit Growth has Slowed Down). Our analysis also shows that corporate credit was selectively available to “better segments” or quasi-sovereign areas like petro loans or construction.

The small and medium enterprises (SME) segment, which always had restricted access to funding, faced a virtual drought. Without satisfactory risk ratings, and short or over-leveraged on collateral, the SME sector was forced to cut down on production-led spending and/or resort to borrowing at significantly higher rates. SME sector funding remains frozen till date. A recent CII (Confederation of Indian Industry) Northern Region survey shows that over 34 per cent of respondents felt that there was a negative change in availability of credit and, combined with a substantial increase in receivables cycles, this has created major issues for SMEs.

Retail credit growth dropped dramatically, partly driven by increased stress on existing portfolios, partly by the fear of anticipated mass job losses and mostly by the fact that this portfolio moved swiftly into the domain of non-banking finance companies (NBFCs). Reports from analysts and credit rating agencies showed marginal to moderate increases in nonperforming liabilities (NPLs) in assets such as two-wheelers, commercial vehicles and unsecured loans. Growth in mortgages, which constitutes half of Indian banks’ retail portfolio, was also hit, courtesy an escalation in interest rates, a restriction on collection practices and mounting real estate prices.

Perhaps the biggest and only positive impact was seen in the higher credit growth in infrastructurerelated companies like power and telecom. This partially offset the reduction in other funding sources such as private equity and by foreign institutional investors.

A major danger could appear given RBI’s policy to continue with the fiscal stimulus in the near term. Flush with liquidity, with no borrowers (given low credit growth), the banking system will continue to invest excessively in government securities, causing the fiscal deficit to balloon. As is already forecast by RBI, the rate of inflation will increase and if this is accompanied with a rating downgrade, a resultant sharp and sudden interest rate rise is likely to catch banks by surprise. This would likely result in significant markto-market losses on the portfolio of banks, coupled with increasing borrowing costs for corporates—further slowing credit—perhaps to a freezing point.

Our conclusion: Indian banks are neither decoupled from the global financial system nor have they emerged untainted from this grim episode. The fact that growth of investments in government securities and other instruments far outstripped growth in credit—on the back of liquidity released by lowering repo and CRR rates—should be viewed as a serious systemic concern.

Preventing the post-traumatic stress syndrome
Let’s assume that there is a semblance of stability by the summer of 2010. What happens then? Will global banks go back to their pre-meltdown models? And will Indian banks move away from their extremely conservative positions?

In the West, legislative and regulatory attention is evenly focussed between tightening control on off-balance sheet activities (a new version of the Glass-Steagall Act is likely) and regulations on behavioural issues such as Wall Street compensation. It is also highly likely that some of the largest institutions will be forcibly broken up—partly to be able to pay back the emergency funding, but more specifically to restrain their activities. That emerging regulatory reporting and risk frameworks from the G20 and the Basel committees will assume draconian proportions is almost a given.

In Indian banking, however, where compensation is tightly regulated and off-balance sheet activities are not undertaken under the commercial banking licence, the challenges are more fundamental and systemic. One year after the economic crisis is a reasonable timeframe to assess the lessons learnt and discuss some key mitigating steps. After all, if the Indian economy has to get onto a higher growth trajectory over the longer term, the banking system has to be in a position to provide access to credit across a range of industrial sectors. Here’s what banks need to do.

To start with, Indian banks need to diversify their portfolios significantly—not only within the corporate book, but also in the SME and retail sectors. Given that Indian banks are primarily providing credit to large and medium-sized corporates and focussing on the mortgage portfolio, large NBFCs must position themselves to fund SME and retail (except mortgage) customers. The flexible operating models of the NBFCs and their proximity to their customer segments enables them to operate at a faster pace, and build competencies at much lower costs. However, banks and NBFCs must pay increasing attention to their credit assessment processes, credit scoring models, risk assessment structures, analytical tools and underlying technology.

To enable this model to proliferate, systemic changes are being enabled, such as RBI’s decision to allow the setting up of credit information companies. The muchanticipated Unique Identification project will also help on this front. And then there’s RBI’s anticipated changes to make recovery guidelines less onerous and increase use of electronic payment systems to reduce operational costs. RBI also needs to license a larger number of asset reconstruction companies, narrowing them down to gain a sector-specific and geographic focus.

Banks, for their part, must increasingly use the effective securitisation law and accepted restructuring methods to alleviate asset quality pressures. They should also start work on managing the looming threat of interest rate risks. This can be done either through changes in their investment policy or hedges through recently introduced -derivative instruments or through smarter ways of directing credit to good borrowers.

This brings us to the final speculative position: If the global recovery is just a shadow, does India have the strength to sustain itself through increasing domestic demand for a longer period of time? The answer, perhaps, lies in the fact that with a robust banking system that has managed to ride over the crisis and is sitting on piles of deployable capital, we may be able to ride out a tougher storm better than most others. In any event—short-term recovery or long-term—the banking system will have to play the lynchpin role in sustaining the growth story for India.

The views and opinions expressed herein are those of the author(s) and do not necessarily represent the views and opinions of KPMG’s network of firms. Abizer Diwanji, Ravi Trivedy, Manoj Kumar Vijai, Naresh Makhijani, Akeel Master, G.N. Sampath, Ritesh Goyal, Janaki Krishnamurthy, Forum Mehta, Urvi Sompat, Gaurav Sheth, Kunal Jain, Ruchika Anand, Divya Arora, Sneha Rohekar, Tarini Fernandes & Fiola Colaco worked on this article and the Best Banks study.

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