Indian banking - opportunities, challenges and the road ahead

Abstract

Introduction The Indian banking sector is going through a phase of transformation and moving towards an agile framework with increased competition and focus on mass banking rather than class banking. Competition has increased in the sector with Private Sector Banks gaining size, NBFCs planning to convert into banks, foreign banks setting up shops and awakening of Public Sector Banks. This sector is witnessing intense competition along with rising interest rates which are impacting the bottomline of banks. Debt investments have become less attractive, while creating a sustainable source of fee income has become a viable and lucrative option. With a strong credit offtake, healthy asset quality, relatively immune treasury book to rising interest rates, and diversification of revenue stream prospects for this sector are excellent. Moreover, governments focus on phased implementation of international best practices will help Indian banks to meet the increased competition from foreign players and prepare for the post FY09 era, wherein foreign banks will be allowed to takeover private sector banks. The credit growth has outpaced the deposit growth in the economy. As the economy will continue to grow at a robust rate in the next two years, the Credit-Deposit ratio will continue to show an uptrend buoyed by the more purchasing power and lifestyle changes of the Indian consumers. The banks are increasingly re-deploying funds from government securities to high yielding assets to increase profitability and save on interest rate risk. A trend has been witnessed over the last few quarters wherein deployment of funds towards advances has been highest by foreign banks followed by private sector banks. As at end FY05, foreign banks had a Credit-deposit ratio of 87.1% against 57% of PSU banks and 65% of Private sector banks. Foreign banks operating in India and Indian banks with overseas branches have to prepare themselves to meet the standards of the Basel II norms March 31, 2008, while other commercial banks have to meet the requirements by March 31, 2009. Basel-II islikely to impact the CAR due to the change in risk weightages on certain asset classes and introduction of market and operational risks. RBI has maintained its norms more stringent than required by Basel-II accord, wherein it requires CAR to be maintained at a minimum 9%, which is above the 8% level mentioned in the Basel-II accord. The fast pace of IT implementation in Indian banks will help in smooth migration to Basel II norms along with reduced costs and increased efficiencies. Currently, fees contribute only about 20% of income for Indian banks, versus 30-35% for their peers internationally. Banks have cited the immense potential in this segment and have gone aggressive in setting up businesses which will help them earn a larger share of non-interest income. As per a survey only 2% of bankable population has credit card in India, which again cites the immense potential this segment has, however private and foreign banks are more aggressive in this segment. A number of initiatives have been taken by banks to build a sustainable source of fee income like setting up of ATM networks, advisory & consultancy services for clients, loan syndication, foreign currency services, capital market services and remittance business. Retail business is acting as a key driver for generation of non-interest income for banks. Over the last three years, Scheduled Commercial Banks have seen a remarkable improvement in their asset quality with Gross NPAs decreasing by 520 bps to 5.2% and Net NPAs decreasing by 350 bps to 2%. Majority of the banks have started selling bad assets to ARCs to clean-up their bad assets and leave the problem of collection of dues to the experts. Many foreign banks are expanding their presence in India and preparing for the post 2009 era wherein foreign banks will be allowed to acquire Indian Private Sector Banks.Foreign banks are showing a growing preference for India, as most of them are impressed by the pace of reforms and expect high growth rates over the next few years. Their confidence is evident from the levels of investment and expansion plans for the country. HSBC and Standard Chartered Bank are leading the pack and investing large sums in India and expanding in all directions.PSU banks, which have historically controlled the largest chunk of Indian banking industry are slowly losing market share to their private and foreign counterparts. The share of private and foreign banks in total assets, which was less than 10% at the inception of reforms, has steadily risen to about 25% at end FY05. The rise in market share of the new private sector banks is particularly evident. Across bank groups, the rate of expansion of deposits was highest in respect of new private sector banks (21.1%), followed by PSU banks (15.6%), old private sector banks (10.8%) and foreign banks (7.9%). A recent trend which has been witnessed among the banking companies is to build a brand image for themselves which will distinguish them from their competitors. The average yearly spend on advertisements by PSU banks is Rs. 50 mn for FY05 which is much higher than last year’s Rs 20.5 mn. Individual banks are adopting different mediums/channels to boost their image. Many have hired brand ambassadors, changed their logo and run advertisement campaigns. The makeover and transformation of two of the largest Indian banks, State Bank of India and Bank of Baroda, have been quite visible. The focus of our study is the Public Sector Banks as they are the largest category of banks in India and are a force to reckon with.