As India’s public sector banks work to rid their balance sheets of legacy assets, could this be a chance for private sector banks to finally bulk up their market share? Stefania Palma investigates.

Indian banks are steeped in history. In the boardroom in State Bank of India’s (SBI's) Mumbai headquarters there is a photograph of the inaugural board of the Imperial Bank of India, the oldest lender in the country, set up in 1921 under British colonial rule and the precursor to SBI. But while public sector banks such as SBI retain unique historical value, today they also have some of the highest non-performing asset (NPA) ratios and lowest capitalisations in the industry.

The ministry of finance and the Reserve Bank of India (RBI), the country’s central bank, are rolling out policy reforms aimed at strengthening public sector banks. Even the lenders themselves are pushing for change. But transforming some of India’s oldest banks, which are deeply linked to the government, the economy and India’s population, will not happen quickly. So now is the time for India’s younger, more nimble private sector lenders to finally build up market share in a banking sector historically dominated by state lenders, say market participants. Private banks’ growth strategies will involve using technology and reaching out to unbanked customers in India’s rural areas.

Infrastructure boom and bust

India’s infrastructure crisis is the key factor behind the country's public banks’ ballooning NPAs. Poor supervision allowed corruption and poor accountability to dominate infrastructure projects after India liberalised its economy in 1991, say analysts. As a result, scores of infrastructure and mining projects have stalled in recent years and the banks have been the victims. 

“Large business houses… borrowed heavily during the boom years to invest in infrastructure and commodity-related businesses, such as steel. Corporate profits are low while debts are rising, forcing firms to cut investment to preserve cash flow,” says the Indian government’s economic survey for 2015-16. “The leverage levels are higher than the cash flows that were anticipated,” adds Chanda Kochhar, managing director and chief executive at ICICI Bank.

What is worse, it takes more than four years to wind up ailing companies in India due to fragmented and conflicting insolvency laws. This means bankruptcy cases last for years and company assets that could be used to repay obligations to banks lose value. But now, the government has proposed a law to create a single insolvency code that should prioritise unsecured lenders, including public sector banks, over the government when it comes to debt repayment. Finance minister Arun Jaitley says it is reasonably possible the bankruptcy law will be passed by the end of 2016. 

Public banks suffer

Public banks have suffered from these legal inefficiencies and high corporate debts the most. In 2015 they recorded the highest share of stressed advances (the combination of restructured standard advances and non-performing loans) in the industry, at 13.48%. Private banks’ ratio was only 4.63% by comparison. 

Setting aside money to deal with stressed assets is eroding profits even among India’s top public banks. SBI, the largest bank in the country, recorded a 62% year-on-year drop in net profits in the third quarter of 2015 for this reason. “We reasonably expect this to be a short-term drop. SBI has the capabilities to withstand such a drop,” says an SBI official. And of the bank’s NPAs, he adds: “We are taking strong and prudent decisions in line with [our] policy guidelines and we expect results soon.”

At the other end of the spectrum, Union Bank of India – which is in the bottom 10 Indian banks by Tier 1 capital, according to The Banker database – announced an even larger drop of 74% over the same period. What is more, raising capital for public banks remains tricky internally – due to poor asset quality – and externally: several lenders trade below book value, which makes it hard to access equity capital markets.

Standard & Poor’s argues that India’s public sector banks will not be able to meet Basel III capital requirements in 2019 without government assistance. Indeed, the government is set to infuse Rs250bn ($3.71bn) annually into public sector banks in fiscal years 2016 and 2017, and Rs100bn annually in fiscal years 2018 and 2019.

But Geeta Chugh, senior director, financial institutions, for south and south-east Asia at S&P, argues this still is not enough. “We estimate that Indian public sector banks need about Rs2300bn in capital by 2019, and the RBI’s recent directive to banks to clean up their balance sheets has [anticipated] that requirement,” she says.

However, Arundhati Bhattacharya, the chairman of SBI, says neither SBI nor its five associate banks – State Bank of Mysore, State Bank of Patiala, State Bank of Hyderabad, State Bank of Bikaner and Jaipur and State Bank of Travancore – will struggle to meet Basel III requirements in 2019. SBI is planning to raise capital from the public markets through selling non-core assets and by listing its subsidiaries throughout the course of 2016. SBI will not consider raising capital in the private markets because pricing is unfavourable. “We don’t want to sell ourselves too cheaply,” says Ms Bhattacharya. The bank’s core Tier 1 capital adequacy ratio was 9.13% in 2015.

Policy solutions

In light of public sector banks’ struggle, India’s government and the RBI are rolling out measures to help these lenders reform. Raghuram Rajan, the governor of the RBI, suggests that public banks should improve governance, strengthen their management and increase the power of the boards. Then, they should clean up their balance sheets from legacy assets and, lastly, the government should recapitalise public banks in need. “But of course the idea is to delink these banks from government [capital] infusions,” he adds. 

Consolidation is a further option. Mr Rajan says: “There would be value gained if the right kinds of mergers take place.” But in spite of market participants’ support, consolidation still has not materialised in scale because it remains politically sensitive in India.

SBI’s Ms Bhattacharya also favours consolidation and thinks India should work towards having only four or five major banks. “The government shares this view and it will push for consolidation, but it should have made this very explicit from the start rather than waiting for banks to find their own partners. Banks are not going to do this on their own,” she says. SBI has consolidation plans, but it will acquire its own five associate banks before considering other players. “If we start, we should start with those,” says Ms Bhattacharya.

Privatising banks, which in India is as politically sensitive as consolidating them, is also on the table. IDBI Bank – the ninth largest bank in the country by Tier 1 capital, according to The Banker Database – could be the first to go private. “The government will take [the process of transformation] forward and also consider the option of reducing its stake [in IDBI] to below 50%,” announced Mr Jaitley in the 2016 budget. 

Asset quality of scheduled commercial banks

RBI reforms 

The RBI has also been key to transforming public sector banks. It rolled out strategic debt restructuring measures that urge banks to convert non-performing loans to equity shares in 18 months’ time. However, some market participants find this deadline too close. “Eighteen months is pretty tight to turn this kind of deal around,” says Shikha Sharma, managing director and chief executive at Axis Bank.

The RBI is also making all banks share data on corporate customers with overdue payments before their assets become non-performing to avoid other lenders taking on these same customers.

The government’s 2015-16 economic survey even suggests the RBI, which boasts an equity share of about 32%, could redeploy capital itself to help ailing public sector banks. According to a Bank for International Settlements sample, the RBI’s equity share is only second to Norway’s central bank worldwide. “If the RBI were to move even to the median of the sample (16%), this would free up a substantial amount of capital to be deployed for recapitalising the public sector banks,” says the government survey. 

“There is nothing on the table at this moment on this matter,” says an RBI official, however. Some analysts argue the RBI’s and the government’s balance sheets should in any case be deemed as one. Whether the government or the RBI deploys capital, it is always the central bank that generates the additional money supply. And it is always the RBI that will absorb the extra money back to keep inflation in check. 

Hiring flexibility

Giving more management and hiring flexibility to public sector banks is also crucial to help them reform, according to some market participants. “As a public sector bank you have to wait for things to happen,” says Ms Bhattacharya.

Hiring is one of the problems. Public lenders’ board members are appointed by the government. And lenders are not able to recruit junior talent freely. Public sector banks are restricted to hiring from campus recruitment drives, which means they attract an enormous number of applications and talent that is often not specialised enough. “This talent often needs a lot of polishing,” says Ms Bhattacharya. 

Ideally, state banks would rather hire from India’s prestigious Indian Institutes of Technology and Indian Institutes of Management, which attract India’s top students and specialise in areas of study conducive to careers in banking. “We need to be able to recruit talent from the right places,” says Ms Bhattacharya. 

Top 10 Indian banks by Tier 1 capital and NPL ratios

SBIs reform package

SBI – the largest bank in India – hopes to counter issues of stressed assets and decreasing profits by investing in technology and by diversifying its lending portfolio away from India’s infrastructure and commodity sectors. 

In terms of technology, SBI is looking to upgrade its internal processes, launch new digital products and no longer rely on labour-heavy, costly bricks-and-mortar branches. Investing in technology is key to target India’s young population, says Ms Bhattacharya (the country’s median age is 26). The bank plans to reach out to this customer base through collaborations with technology companies, which tend to be more tech-savvy than India’s public sector banks. “[This type of technological development] is not something that will be achieved internally,” says Ms Bhattacharya. Meanwhile, SBI has opened more than 250 ‘sbiIntouch’ branches, where banking services are carried out digitally, to appeal to tech-savvy customers. 

SBI is also diversifying its portfolio by lending to new sectors such as defence, logistics and urbanisation. This decision comes at a time when India might step up its military presence in the region now that “Asia-Pacific has seen the greatest arms build-up ever in the past few decades”, according to Shivshankar Menon, a former national security adviser of India. The increased military presence is mostly due to the escalating dispute between China and Japan over the Diaoyu/Senkaku islands in the South China Sea.

As Indian arms production starts growing, this could become a financing opportunity for local banks. “India used to largely import arms. Now, for the first time the government is keen to develop local arms manufacturing. Joint ventures will bring in a lot of capital, but the sector will be also financed through banks,” says Ms Bhattacharya.

SBI is also keen to finance urbanisation. “Urban infrastructure in India has been pretty poor. Urban local bodies’ book-keeping and governance standards leave a lot to be desired. Even today there are many local bodies that have single-entry booking,” says Ms Bhattacharya. SBI is set to help local bodies get their accounts in order so that they can qualify as potential SBI borrowers.

SBI expands overseas

SBI is also ramping up overseas business to improve risk management and diversify away from a troubled domestic market. At the moment, international operations account for 17% of SBI’s balance sheet and 22% of its profits. 

In Asia, SBI opened a Seoul branch to service corporate clients. It also set up a representative office in Myanmar — a market many banks shy away from as it only opened up to foreign lenders in 2015. 

In the UK, where SBI has operated for 95 years, the lender is waiting for final regulatory approval to become a subsidiary. This will allow SBI to start a retail business in the UK as soon as January 2017. Meanwhile, SBI opened two new branches in the London areas of Hounslow and Ilford in early 2016. 

In the southern hemisphere, SBI is looking to do a joint venture or buy a stake in a local bank in east Africa since this region has the strongest commercial links with India and some of the continent’s strongest economies, says Ms Bhattacharya.

Private banks step in

As public sector banks roll out reforms to strengthen their asset bases and capital ratios, pundits argue they will be forced to cut back on market share. Rajiv Lall, managing director and chief executive of the Mumbai-based Infrastructure Development Finance Company, argues that public banks’ market share will fall from 75% to 50% in the next five years.

India’s privately owned lenders could fill this void, say market participants. These banks were established in the 1990s and 2000s to revive India’s banking sector. But private banks’ market share still only sits at 25%. Indeed, private lender HDFC Bank only managed to reach a market share of just 5% since it launched 20 years ago. “Even if you have a great brand, you need to get customers to move. Customers in India are particularly sticky,” says Paresh Sukthankar, deputy managing director at HDFC Bank. Most Indians still bank with public sector lenders due to their strong history and trust factors. Some of these banks are almost 100 years old. 

Pundits argue private banks’ market share is limited also because they have targeted similar clients as those of public banks – urban, middle-class individuals or large corporates.

Bringing the unbanked in

But private banks are now starting to see value in servicing the unbanked of India, who totalled 233 million in October 2015, according to PricewaterhouseCoopers. Today, about 55% of HDFC Bank’s branches are in semi-urban and rural India. Almost 7000 HDFC employees (8% of the bank’s total staff) roll out services such as customer acquisition, forming self-help groups, lending, financial literacy and capacity building training in poorer Indian regions. The bank’s objective is to get 10 million families above the poverty line. It is now half way there.

ICICI Bank is also expanding in the unbanked areas of the country, especially since they are fuelling a 25% year-on-year growth in ICICI’s consumer lending, which now accounts for almost half the bank’s book. “Corporate and small and medium-sized enterprise assets are growing at a much lower rate. We are re-allocating capital towards mortgage, car and commercial vehicle loans instead,” says Ms Kochhar. And low-income individuals account for about half of ICICI’s growing consumer base. ICICI now has operations in more than 15,000 Indian villages.

Retail banking is also at the crux of Axis Bank’s expansion into India’s semi-urban and rural areas. The lender has focused on the retail market both on the asset and liability side in the past six years to reduce the concentration of risk on the corporate sector, says Ms Sharma. Axis Bank’s most popular services in India’s unbanked areas are government subsidy transfers, remittances between urban and rural areas, group lending for micro loans and a new, 30-year home loan product for first-time, low-income home buyers.

Tech investment 

But private banks’ foray into unbanked areas will not be immediately profitable. Since micro loans have small ticket sizes and short tenors, the financial inclusion business becomes profitable only once it reaches scale. “Like any other new initiative it will take time for it to recover costs and become profitable. We are in the investment phase,” says Ms Kochhar. “It might not meet our return on equity threshold but the business will end up paying for itself,” adds Mr Sukthankar.

Technology will be key to minimising costs in the financial inclusion business since it helps aggregate customer data, roll out products through mobile phones and minimise the number of staff and bricks-and-mortar branches, say local bankers.

But technology is not only limited to improving the financial inclusion business. Investing in digital banking services will also help private sector banks build market share in urban areas.

HDFC Bank is focused on improving customer experience to differentiate itself from other lenders and make the relationship with its clients stickier, says Mr Sukthankar. This includes minimising turn-around time for loan disbursements – now as quick as 10 seconds for pre-approved HDFC loans – or making it easier to buy financial products online. HDFC Bank is also developing peer-to-peer transfers, an electronic wallet application and an e-commerce platform. Some of these services, however, are still rolled out through ATMs. “India is still mostly a cash-based economy. Even if you give a client a debit card, they tend to use it to take cash out and then spend it. The ATM is still an important channel,” says Mr Sukthankar.

For ICICI, capturing India’s growing internet usage on mobile phones is crucial. The bank relaunched its mobile application, which now offers more than 100 ICICI products, and its digital wallet has been downloaded by about 3 million individuals. ICICI has also used technology to improve internal processes. “This is one of the reasons why our cost-to-income ratio of 37% is one of the best in the industry,” says Ms Kochhar. 

Healthy base

Sustaining private banks’ investments in technology and in the financial inclusion business will be supported by their strong asset bases and capitalisations relative to public sector lenders. Although NPA ratios for private sector banks have increased somewhat at the end of 2015 due to commodity price drops and a low-growth, high-inflation, low-rates environment in India, they still are the healthiest in the industry. HDFC and Axis Bank boast some of the lowest NPA ratios in the sector, at 0.9% and 1.43%, respectively, as of 2015.

Meanwhile, ICICI is the private Indian bank with the highest NPA ratio at 3.78%. But Ms Kochhar is not worried. “About 44% of the bank’s assets are in the retail sector, which is doing very well. In the corporate sector, the assets that have been built are of high quality. Once India’s growth comes back, they will generate the cash flow that was anticipated,” she says. 

Overall, despite public sector banks’ poor asset quality and capital ratios, market participants are confident the government will not allow public sector banks to fold – their deposit bases are too large and links to India’s economy too deep. But public banks’ reliance on free capital from the state is not sustainable. While public sector banks go through unprecedented reform to reduce dependence on the state, privately owned lenders finally have the opportunity to build market share that does justice to their efforts and that could revive India’s banking sector.

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