After a difficult period immediately before the Covid-19 pandemic began, India’s banks are now moving forward in renewed health. Rekha Gupta Menon reports.
The Indian banking sector has emerged after two years of the Covid-19 pandemic in a remarkably healthy state, with high profits combined with improved asset quality and stable capital positions. This is in stark contrast to the five-year period before the pandemic, when the banking industry, especially state-backed public sector banks, struggled under a mountain of stressed assets that impacted both growth and profitability.
Of the 25 Indian banks included in The Banker’s Top 1000 World Banks 2022 ranking, only two relatively small banks showed losses in the financial year ending March 31, 2022, while the overall profitability of these 25 banks grew by 49% year-on-year. Asset quality has also improved across the board, with both public and private sector banks reporting a significant drop in non-performing assets (NPAs).
In its analysis of the Indian banking-sector in April this year, domestic ratings agency Crisil Ratings, a subsidiary of S&P Global, observed that India’s banking sector is structurally stronger today and well-positioned to fund faster credit growth. In a note, Crisil said: “First, capital buffers are healthier with all public-sector banks having a cushion of at least 100 basis points (bps) over the regulatory requirement, while private banks continue to be solid on this score.
“Second, profitability metrics are at a nine-year high. Third, asset quality pressures are waning with-sector-level gross NPAs likely declining 500bps from their 2018 peak, because of the improvement in the corporate book. All these factors, coupled with strong deposit growth, bode well.”
Crisil expects bank credit growth in India to hit a four-year high of 11–12% in the financial year 2022/23. The rating agency says that this growth will be driven primarily by an uptick in corporate credit. This had slowed down considerably in recent years, as capital expenditure was muted and banks were wary of lending to corporates because they accounted for most of the bad loans.
Corporate credit, which accounts for 40% of bank credit, is expected to double to 7% or 8% year-on-year on the back of enhanced government expenditure announced in the February 2022 Union Budget, says Crisil. The retail book, it says, will remain steady at 14–15% while bank credit to micro, small and medium-sized enterprises (MSMEs) could grow at 12–14% during this financial year.
Geopolitical concerns
There are, however, rising concerns about the prevailing geopolitical situation, namely the protracted Russia–Ukraine war and its impact on commodity prices, as well as global supply chain disruption and rising inflation.
In April this year, retail inflation in India surged to a high of 7.79% on an annual basis, following which the country’s central bank, Reserve Bank of India (RBI), sharply increased the benchmark interest rate twice, by 40bps and 50bps respectively, within a span of five weeks. There are expectations of further rate hikes in the coming months. The RBI has also moderated India’s gross domestic product (GDP) growth outlook for the current financial year from 7.8% to 7.2%.
Dipak Gupta, joint managing director at private sector lender Kotak Mahindra Bank, urges caution: “A few months back, we were very optimistic. The economy was coming back to normal after two years of below average growth and GDP growth predictions were in the 8– 9% range. However, one needs to take cognisance of the fact that inflation will create trouble for overall growth, and impact corporate profits.”
Mr Gupta warns that the entire cycle of corporate delinquencies that caused the bad loan problem in the past may restart, so banks need to tread carefully and be selective about the sectors they lend to.
Sanjiv Chadha, managing director and CEO at public sector lender Bank of Baroda, takes a more pragmatic stance. He states that the impact of inflation and interest rate hikes will be muted. “Interest rate levels were at historical lows because they were driven by the special circumstances of Covid. With Covid dissipating, we were anyways on the cusp of an interest rate normalisation cycle,” he says.
“Our internal customer survey has also revealed that since corporates did significant deleveraging during Covid, they are in a better position to absorb the interest rate hikes. For the past two years there has been a steady improvement in the corporate credit cycle, which we expect to continue.” Mr Chadha points out that MSME restructured loans are an area of concern and need to be watched carefully.
To help the MSME-sector cope with Covid-related stress, the Indian government launched schemes whereby banks could restructure their loans and extend additional loans. There are now concerns that these loans may soon turn sour, with rising interest rates further adding to the stress, explains Saswata Guha, senior director for financial institutions at Fitch Ratings. “MSMEs, we think, are the most vulnerable sector. We believe that the stress from this pool of Covid-impacted loans will manifest more meaningfully towards the end of this financial year, and into the next,” he states.
Mr Guha observes that despite challenges of job losses during Covid, the retail sector proved to be quite resilient. “If you look at the broad break up of retail loans in India, more than 70% are secured with 50% being mortgage loans and the majority to first time home buyers. This probably explains why the retail loans performed relatively much better during Covid.”
With the corporate credit market being very muted in recent years, it is retail lending that drives bank credit growth. Moreover, it is private sector banks that are leading the charge. Recent RBI data showed that private sector banks achieved a double-digit year-on-year credit growth in 2021/22, increasing from 9.1% in March 2021 to 15.1% in March 2022. Public sector banks also improved their credit growth, but stayed in single digits, growing from 3.6% a year ago to 7.8% in March 2022.
Growth and consolidation
Private sector banks driving credit growth points towards a larger trend in Indian banking, that of private banks established after the mid-1990s growing faster than their long-entrenched government-owned counterparts. While public sector banks continue to have the majority market share in both advances and deposits, private sector banks have steadily gained on them.
RBI data shows that between 2010 and 2021, the share of public sector banks in total lending dropped from around 78% to 58%, while the share of private sector banks nearly doubled from around 18% to 36%. In the same period, the share of deposits for public sector banks dropped from 78% to 64%, while private sector banks’ share grew from around 17% to 31%. This trend is expected to continue as public sector banks continue to face issues of weak governance and low capital. On the other hand, the nimbler private sector lenders have efficiently managed their operations, albeit with occasional hiccups, while maintaining a strong customer and technology focus from inception.
In an effort to reform public sector banks, the Indian government initiated three successive rounds of consolidations in recent years, consolidating 13 banks into five banks. This helped bring down the number of public sector banks from 27 in 2017 to 12 in 2020. “The consolidation helped improve banks’ capital base, which has helped them in navigating the various risks that are inherent in the system,” says Dinesh Khara, chairman of the country’s largest lender, government-owned State Bank of India (SBI). In 2017, SBI absorbed five of its associate banks along with its own subsidiary, Bharatiya Mahila Bank.
Mr Guha agrees that a lot of operational efficiencies have been addressed through these consolidations. “To meet the financing needs of a growing economy like India, you need a few large financial institutions rather than multiple small ones, and these consolidations help address that. However, several structural issues remain unaddressed. Consolidation has not necessarily improved the pricing power of these banks.”
He adds that there could be one more round of consolidation among public sector banks. The privatisation plans that the Indian government had announced last year for two as yet unnamed public sector banks is important as it will be a true litmus test of private investor appetite in state banks despite the structural issues.
As such, Indian banking is set to witness a fresh round of consolidation, this time from private sector players.
In April 2022, HDFC Bank, the country’s largest private sector bank, announced plans to merge with its parent company, Housing Development Finance Corporation (HDFC Ltd), the country’s largest housing finance company. While there has long been market speculation regarding this merger, it is only now that the regulatory, market and operational dynamics converged to create the right environment, says Kaizad Bharucha, executive director at HDFC Bank. As of the end of March 2022, HDFC Ltd had total assets worth Rs6.23tn ($79.85bn) and HDFC Bank had total assets worth Rs20.68tn. Following the merger, HDFC Bank will continue to be the second-largest bank in the country after SBI, and will be nearly twice the size of the country’s second-largest private sector bank, ICICI Bank.
Meanwhile, India’s third-largest private sector bank, Axis Bank, pulled a coup of sorts when it announced that it was acquiring Citi’s coveted India retail business, leaving many active contenders behind. The entire transaction is valued at around $1.6bn, with Axis acquiring Citi’s loans, credit cards, wealth management and retail banking operations. The US banking giant had announced last year that it was exiting retail operations in 13 markets, including India. “This acquisition gives us access to a high-quality franchise that Citi built over 120 years, which would have taken Axis a very long time to develop organically,” says Amitabh Chaudhry, managing director and chief executive officer at Axis Bank.
Fitch Ratings observed that these proposed amalgamations could encourage banks towards more mergers and acquisitions (M&A): “Large non-bank financial institutions (NBFIs) could be acquisition targets, given their higher-margin products, large pools of priority-sector customers and loans, and potential cross-selling opportunities.”
Both HDFC Bank and Axis Bank are awaiting regulatory approval for their M&A transactions, after which the entire integration process could take up to 18 months.
Foreign banks
The foreign banking segment in India is witnessing an interesting divergence. On one hand, global banks such as Citi, Deutsche and Barclays have scaled down their operations, while on the other, Singapore’s DBS Bank is actively growing its Indian presence. Unlike most foreign banks that operate through branches, DBS is one of only two foreign banks to establish a wholly owned subsidiary in India. The other is the State Bank of Mauritius.
Following the subsidiary route allowed DBS to acquire troubled private lender, Lakshmi Vilas Bank and gain a footprint of around 600 branches — the largest for a foreign bank in India. Surojit Shome, CEO at DBS Bank India, explains that most of the banks moving out of the Indian market are primarily motivated by capital considerations, and the need to focus on home markets or markets that are more mature where return on capital is closer to group and investor requirements. In contrast, he says, DBS’s strategy has always been that of a pan-Asian bank with deep presence in six core markets including India.
Commenting on the evolving competitive landscape in the Indian banking sector, Mr Chadha of Bank of Baroda says that a vibrant private sector is the most important stimulus for all banks to raise standards. “Today, foreign banks find it tough to compete with private sector banks because of their high quality. That means even for public sector banks we have to really up our game every year to be competitive. I think there is a case for more competition rather than less.”
Competition in the banking sector is coming from three sides, he says: banks, NBFIs and fintechs, which are privately owned non-bank companies.
Digital expansion
In the past five years, fintechs have transformed the Indian digital payments space, making digital the fastest growing mode of retail payments in the country. A recent digital payments report by consulting firm Boston Consulting Group (BCG) stated that two out of five payment transactions in India are conducted digitally. BCG estimates that the digital payments market in India is worth $3tn and will triple to $10tn by 2026.
This explosive growth is aided by several enabling factors, such as a supportive regulatory environment and appropriate technological innovation. The United Payments Interface (UPI), for example, allows funds to be transferred instantaneously using personal information such as phone numbers and digital identification systems. There are more than 6000 fintech start-ups in the country and tech giants such as Google, Amazon and Facebook have also entered the fray. Google Pay already enjoys a more than 30% share of UPI transactions.
What distinguishes fintechs is their agility, as well as tech and market savviness. Most banks have partnered with them to gain access to new technology and markets. Increasingly, with very thin margins in the payments domain, many fintechs are also venturing into other financial services, such as lending. Even though many banks have upped their own digital strategies, there are rising concerns about fintechs posing a potential threat to traditional banks.
Mr Chaudhry of Axis Bank says that traditional banking institutions need to rethink the way they do business. “The past few years have been marked by shifting sands in the banking landscape. We are already seeing customer demands being shaped by the offerings of new-age players, with their unique acquisition paradigms and capabilities to build breadth and depth in engaging with customers. So customer retention is a big challenge in the wake of competition from big tech and fintech players,” he explains.
Since most banks are typically saddled with legacy systems that make it difficult to easily offer innovative services, Mr Chaudhry advises that they upgrade their tech architecture. “Data can be stored in a legacy platform, but the bank should be available to build services on top that allows the bank to operate like a fintech in terms of experience and products.”
Axis Bank has taken a three-pronged approach to dealing with fintechs, says Mr Chaudhry. Along with upgrading its technology architecture, it is partnering with fintechs in areas where it is not active and taking a strategic stake in fintechs that offer interesting technology or value propositions.
Mr Chadha of Bank of Baroda views fintechs as collaborators especially for financial inclusion. “Fintechs are indispensable to construct the bank of the future,” he notes. “Our core competence is that we are a regulated institution and we can manage risk. But in terms of last-mile connectivity with our customers, we need partners.”
Mr Khara of SBI adds: “My sense is that the banking system is highly regulated across the world. So, as a regulated entity, perhaps it will be the partnership model which will probably work better, as compared to fintechs competing with banks.”
Mr Gupta of Kotak Mahindra Bank, which has partnered with several fintechs for various services, believes big tech players present a bigger threat to banks. He says: “They have the technology, money power and the customer base. Fintechs may have the technology and money power, but do not have the necessary customer base. We are vying for the same customers as the big techs.”
However, banks enjoy a superior ability to offer a wider basket of financial products, he says. Another crucial advantage for banks, Mr Gupta says, is that they are relatively trusted entities with which customers prefer to establish a financial relationship. “In an increasingly crowded and competitive market place, the trust piece remains a significant advantage for banks. “We have a small window wherein we need to get our product, digital and technological capabilities in place before the tech players catch up,” he says.
