The Indian banking industry is poised for a period of hectic activity given the nearing of the 2009 deadline when the second phase of the Road Map charted by the Reserve Bank of India (RBI) to allow greater access and operational freedom to foreign banks comes into force. But before that a major milestone in the journey of Indian banking industry towards greater efficiency would be the implementation of Basel II norms.

In order to comment on how domestic banks can leverage future opportunities in view of the above circumstances it is important to establish the present institutional environment and financial health of the Indian banking industry.

Effect of reforms on the Indian Banking sector

Banks being the mainstay of a country’s financial sector, it was necessary to overhaul this sector in light of the broad based economic reforms of 1991. The thrust of these reforms was to promote a diversified, efficient and competitive financial system, with the ultimate objective of improving the allocative efficiency of resources, through operational flexibility, improved financial viability and institutional strengthening (Reddy, 2006). The reforms have been instrumental in:
- Creating a conducive policy environment by lowering reserve requirements, gradual rationalization of administered interest rate structure and streamlining allocation of credit across sectors.
- Increasing efficiency in the system by fostering greater competition through liberalized yet clear and transparent guidelines for entry of private and foreign players.
- Broadening ownership base in domestic banks.
- Benchmarking against international best practices by instituting micro prudential measures and also strengthening regulation, supervision and transparency.
The positive impact of reforms in evident from a comparison of the Indian Banking sector with the Rest of the World.

 
Source: Indian Banking Sector Analysis 2006-2007, RNCOS

Spread of Banking

Indian banks have continued to grow in order to serve the ever increasing population through branch expansion and growth of credit and deposits. Credit portfolio has witnessed sharp growth riding on a buoyant economy while banks have been able to strike a balance between investments and loans and advances in recent years.

Progress of banking in India
 
Source: Mohan R (2006) Financial Sector Reforms and Monetary Policy

Competition and Efficiency

As evident from the decline in the share of public sector banks (PSBs) in total assets of commercial banks, competition has gradually increased. PSBs have in turn responded to these challenges as can be seen from their share in overall profits.

Group wise share of banks in select indicators
 
Source: Mohan R (2006) Financial Sector Reforms and Monetary Policy

Efficiency in the sector is robust as apparent from the decline in intermediation cost defined as operating expenses to total assets ratio.

Intermediation costs of scheduled commercial banks (1996-2005)
 
Source: Mohan R (2006) Financial Sector Reforms and Monetary Policy

However penetration is limited and structural inadequacies like a fragmented industry structure, restrictions on capital availability and deployment, restrictive labour laws, weak corporate governance and ineffective regulations beyond scheduled commercial banks (SCBs) have the potential to threaten the health of the industry (McKinsey & Co., 2005) .

Effect of foreign banks entry on domestic banks: Evidence from past

It is in this context that we assess the opportunities for growth an expansion of Indian banks and the challenges therein. Previous research and empirical evidence on the impacts of the entry of foreign banks on domestic banking sector in emerging market economies (EME) shows that in emerging markets, foreign banks are more profitable and more efficient than domestic banks (Demirg¨u¸c-Kunt and Huizinga (2000), Bonin, Hasan and Wachtel (2005), Martinez Peria and Mody (2004) as quoted by Claeys and Hainz, 2006). Classen, Demirg¨u¸c-Kunt and Huizinga (1998) used bank level accounting data from 80 countries in the 1988-1995 period and compared Net interest margins, overheads, taxes paid, and profitability of foreign banks and domestic banks to conclude that foreign banks achieve higher(lower) profits than domestic banks in developing (developed) countries.  Traditional literature also predicts that presence of foreign banks in domestic markets provide increased access to credit, especially for large and transparent firms (Mian (2006a), Giannetti and Ongena (2005), Clarke, Cull and Martinez Peria (2001) as quoted by Claeys S, Hainz C (2006)), leading to domestic firms being forced to lend to smaller and more opaque firms. (Dell’Ariccia and Marquez (2004) as quoted by Clays and Hainz, (2006)).

Claessens et al (1998) found that EME subsidiaries of foreign banks enjoy higher interest rate margins and profits than domestically owned banks. This is also true for the Indian Banking sector where there has been a consistent decline in the share of public sector banks in total assets of commercial banks (Mohan, 2006)

Therefore with more freedom to foreign banks one of the most critical challenges before domestic Indian banks would be to manage their profitability in an environment of decreasing spreads, while at the same time focus on improving productivity.

There are two major ways in which banks would look at addressing this issue. By adopting the Universal Banking Model and through consolidation while adopting technology for risk mitigation and reaching out and serving the customer better.

The Universal Banking Model

President A. P. J. Abdul Kalam, commenting on the advent of universal banking said, “The days of the development financial institutions (DFI) are over. The current fashion is the universal bank.” (The Hindu, 2004)

Worldwide experience suggests that the traditional divide between banks and DFIs is increasingly getting blurred. Commercial banks have stepped into investment banking, securities trading and mutual fund services along with providing term-financing. DFIs on the other hand have entered the domain of short term credit finance. Banks will increasingly adopt the model of universal banking to play a broader based role in development. However, there are several caveats. Under universal banking, potential systemic effect of a bank failure could be far greater (Suarez, 1997 as quoted by (Bhide, Prasad and Ghosh, 2001). The authors further argue that there is a  fundamental difference in the balance sheets of commercial banks and DFIs, while liabilities for banks consist mostly of short term deposits, those of DFIs consist of long term resources. But with the RBI’s removal of existing floors on CRR and SLR prescriptions through the RBI (amendment) Bill 2005 (The Hindu, 2006), more operational flexibility would accrue to the universal banks in terms of balancing relatively liquid assets and heavy borrowings.

Consolidation in the Banking sector

Learning from other economies

Based on literature for industrial economies Hawkins and Mihaljek (2000) identify broad motives for consolidation within the banking industry

a. Economies of scale: banks with similar operations have an incentive to merge thereby eliminating overlapping branches and freeing resources such as back office, administration, and marketing. Productivity gains from implementation of new technologies is also enhanced due to incurring of large initial investments compared to scale of operations.

b. Diversification of credit risk: this becomes more relevant for smaller banks concentrated in particular regions and serving niche markets. As banks merge and grow bigger they are in a  much better position to introduce complex financial instruments such as derivatives.

c. Cheaper cost of funds: since large banks are in a better position to manage risks they are viewed as safe. Their large size also bolsters the belief that government support would be more forthcoming in case of a crisis as governments implicitly cannot let big banks fail.

d. Economies of scope: As discussed above in the Universal Banking model, mergers among banks offering complementary services gives them synergies from offering a wider range of products.
Bank mergers can be a potentially important tool for improving the efficiency in the system in a highly fragmented environment in terms of size, number of branches, ownership structure, profitability and competitiveness (Mihaljek, 2005).

A review of literature suggests that bank mergers in Latin America, Central Europe and Hong Kong have been largely market driven. Central banks in these countries have played a neutral role vis-à-vis mergers and acquisitions while fulfilling its role of regulation. In many Asian countries, including Indonesia, Malaysia, Philippines and Thailand mergers and acquisitions have been promoted by authorities. Singapore on the other hand, adopted a facilitative approach, realizing that cross border competition and globalization of financial markets gave it the opportunity to become a financial hub. 

Consolidation in the Indian Banking sector

It remains to be seen whether consolidation in the Indian banking sector would  pick up post 2009. Finance Minister P. Chidambaram (2005), in his 2005-2006 budget speech identified “Competition, Consolidation and Convergence” as the key drivers of the banking sector in the future. However, Ram Mohan (2004) argues that no real logic exists for consolidation in the Indian context. The author argues that PSBs in India have so far been able to effectively counter the threat of decreasing spread in the face of competition from foreign banks. His findings indicate that lending rates have been declining but not as much as deposit rates resulting in a widening of spreads of PSBs.
Net Interest Income (Spread) to Total Assets
 
Source: Ram Mohan TT (2005). Bank Consolidation Issues and Evidence

On the issue of profitability also the author argues that wider spreads, lower NPAs and treasury profits have made the Indian Banking system the most profitable only after US.
Profitability of Banking System
 
Source: Ram Mohan TT (2005). Bank Consolidation Issues and Evidence

Next, on the issue of size and performance, the author argues that profitability and not size should be the rationale for mergers as real benefits accrue not from scale or scope but diversification on which aspect Indian PSBs fare well both geographically and by borrower characteristics. Also there is no established optimal size in the Indian context and needs to be ascertained through rigorous research.

However, that there is scope for further consolidation is supported empirically (Prasad and Ghosh, 2005). The researchers examined the degree of competition in the Indian banking industry for the period 1996-2004, divided into two sub-periods 1996-1999 and 2000-2004. They found that the competitive nature of Indian banking system is not significantly different from other countries and that recent consolidation has led to more competition in the sector. The weekly magazine Businessworld identifies India as the last frontier in the wave of banking FDI that has swept the globe over the past 15 years. Cross border acquisitions in EME shot up from $55 billion in 1996-2000 to $67.5 billion between 2001-2005 (Businessworld, 2006).

The three biggest foreign banks in India namely, Citibank, HSBC and Standard Chartered are looking at playing bigger roles in consumer banking in their portfolios while also aiming to expand in rural markets. Standard Chartered has already applied for permission to open branches in under banked areas, Citibank has applied for rural banking and HSBC is trying to lend to microfinance institutions. Presently the means to achieve this growth are organic due to lack of freedom in choosing targets, but this would change post 2009 when these banks enter the acquisition mode. (Businessworld, 2006).

For the domestic banks too, inorganic growth would be one of the ways to compete with the larger banks and they should be encouraged to do so. Banks also need to increase their product portfolio and geographic reach.. This would specially be true for the weak private sector banks with a limited capital base which have been unable to limit their NPAs and diversify their portfolios. As far as the PSBs are concerned, the gains, if at all, that can be attained from mergers and acquisitions are limited by the fact that bank staff, that forms a big chunk of the cost savings that can be attained by reduction is very difficult to lay off. Not being able to prune staff also means that the potential of working culture conflicts looms large thereby putting a question mark on the efficiency gains attainable.

Challenges before Indian Banks

There are several aspects on which banks would have to focus in order to remain competitive and build efficiencies.

Management of NPAs: Credit risk forms one of the most critical elements of risk in India. In 2004-05 annual growth in bank credit exceeded 30% while total deposits grew by only 15.4%. 
 
Source: www.imf.org
Growth in total credits and deposits in India

An IMF report on India highlights the following with respect to credit growth:

a) Credit off-take in India is riding on a developing economy suggesting “financial deepening”

b) Credit growth has been broad based with rural sector credit growing by 25%

c) Share of industry in the total loan portfolio has declined whereas consumer credit is growing rapidly (IMF, 2006)

Fast credit growth can trigger distress through deterioration of loan quality given the greater volume of credit applications. However for Indian banks’ gross NPAs as a percentage of gross advances stood at 5.2%, lower than the 7.2% figure last year15. But this should be looked in conjunction with credit off-take which suggests that a growing share of credit is relatively new whereas deterioration in asset quality typically occurs after 1-2 years when a bad loan is classified as such.

Source Reserve Bank of India
Movement of CRAR and NPAs of Scheduled Commercial Banks

However, a series of stress tests, conducted under three scenarios, namely (i) an increase in provisioning to the levels consistent with international best practices; (ii) an increase in NPLs by 25 percent; and (iii) an increase in NPLs due to a portion of the “new” loans becoming nonperforming indicates that the Indian banking sector as a whole is resilient to tightening of provision requirements and deterioration of credit. (IMF, 2006)

Derivatives: In the off balance sheet (OBS) exposures of banks, derivative exposures have grown significantly. Out of the total derivatives in March 2006, foreign exchange contracts had a share of 43% while interest rate contracts had a share of 54%. (Gopinath, 2006)

Cardenas, Graf and O’Dogherty argue that global financial firms are increasingly concentrating their business and managerial decision levels in fewer places while measuring their exposures on a global basis, booking certain types of positions, like derivatives in “hubs” to take advantage of economies of scale and friendlier regulatory environments, as well as to exert greater control.

“These policies mean, for example, that a long position on a fix-rate-10-year-bond denominated in pesos booked in a Mexican subsidiary, might be hedged with a derivative position booked in a Cayman Island branch. Thus, losses incurred by one subsidiary will be offset by gains on the other. While this policy might be optimal from a parent bank perspective, local subsidiaries are left to experience wide fluctuations in their profit-loss statements. Furthermore there are no obligations, neither guarantees, that the parent will use gains in one entity to cover losses in another.” (CárdenasJ,  Graf J. B,  O’Dogherty P, 2003, p.16)

The RBI is sensitive to this issue and has commented, “The risks arising on account of OBS activities of banks are sought to be controlled through a combination of both banks’ internal control policies and risk mitigation mechanism imposed by the regulator. The board approved internal control policies covering various aspects of management of risks rising both on- and off-balance sheet exposures is the first line of defense. Holding of minimum defined regulatory capital for all OBS  exposures, collection of periodic supervisory data and adequate disclosures in bank balance sheet are some of the major regulatory  initiatives undertaken to control and monitor OBS exposures of the banking system.” (RBI, 2005)

Basel II norms: The RBI is of the opinion that given the increased cross border activity and sophistication in the system, it had become important to mitigate operational as well as market risk. Under Basel II banks’ capital requirements would be more closely aligned with the underlying risks in their balance sheets. Beginning March 31, 2007 banks would adopt Standardized Approach for credit risk and the Basic Indicator Approach for operational risk. However several challenges can be identified in this regard:

i. Low level of rating penetration and ratings being issued only to issuers.

ii. Non availability and costs associated with building up and maintaining requisite database relevant to ratings

iii. Scope for supervisor to prescribe higher than the minimum capital level for interest rate risk

iv. To institute proper supervisory policies to address challenges posed by the presence of financial conglomerates.

Capital Requirement: With the implementation and acceptance of Basel II norms banks would be able to capture operational risks better and therefore may need additional capital.  This may make them turn increasingly to the flourishing capital market. The RBI is therefore trying to facilitate this process by proposing amendment to the Banking Regulation Act, 1949.

Other growth challenges

a) Higher sustainable growth is creating greater demand for financial savings opportunities while in rural areas there is increasing demand for product opportunities. The banking sector therefore has to increase penetration to reach out to a wider customer base. There are only about 10-12 ATMs in India per million population, as compared with over 50 in China and 500 in Korea. (McKinsey & Co., 2005 as quoted by Mohan R, 2006)
 

Source: Reserve Bank of India
ATMs in India: Group wise share (March 2005)

As it can be observed from Table 8, the costs of electronic transactions are the lowest Banks therefore would not only have to invest in infrastructure but leverage information technology to find more innovative ways to reach to the customer through new delivery mechanisms, economizing on transaction costs and providing better access to the under served. Electronic transactions also serve in improving the efficiency of the system since they are faster in comparison with paper based transactions.
 

Source: The banking industry in the emerging market economies:
competition, consolidation and systemic stability - an overview (Hawkins J and Mihaljek D, 2000)

b) Another critical challenge would be to hire and retain talent in the face of stiff competition from private players on compensation. Banks will also have to invest in new skill development and training.

c) Ever increasing challenge to providing the best value to the customer in terms of service levels and transparency. Banks will have to find ways to optimize each customer relationship as they compete with global players with deep pockets and deep customer insights.

Conclusion

The emerging scenario in the Indian banking industry promises to alter forever the banking landscape in this country. It would be a testing time for the resilience of those who decide to compete and there seems to be no  single strategy by which Indian banks can win. No real rationale for consolidation exits in the industry as of now but there is strong evidence from emerging economies that in the event of shrinking profitability consolidation can be used as a tool to thwart competition.

Indian banks therefore will not only have to build on existing capabilities but also add new capabilities. This would pose a more serious managerial challenge given the dynamic environment in which banks will be forced to continuously learn and reorient themselves, be it in adopting new technologies for risk management, building innovative service mechanisms of delivery and customer care or making mergers an effective tool to gain advantage over rivals.  But at the same time the aim would be to move towards universal banking solutions by expanding product portfolios through partnerships, broadening capital base, productivity and efficiency with an emphasis on satisfying the diverse needs of the customer.

References

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Contributed by Vipul Singh ( This email address is being protected from spam bots, you need Javascript enabled to view it ), IIM Ahmedabad.

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