While cataclysmic events began to unfold in the US financial services sector last September, with Lehman Brothers' demise and Bank of America's takeover of Merrill Lynch, the Indian banking industry also witnessed a crisis of public confidence.
A run began on the country's largest private sector bank and second biggest lender, ICICI Bank. There were concerns that its UK subsidiary had an $80m exposure to Lehman Brothers, leading to several hundred customers lining up to withdraw their cash from branches and ATMs in several Indian cities.
Top management tried to reassure customers that the bank was stable and, in a rare move, the Reserve Bank of India (RBI), the country's central bank, pitched in with a statement confirming there was enough liquidity at ICICI Bank and affirming that it had arranged to provide adequate cash to the bank to meet customers' demands.
Doomsday scenario
The situation finally settled down after a tense few days, but several naysayers predicted a doomsday for India. They expected the same scenario that had befallen the US and UK, where a run on a bank caused its near or total demise. They also feared the contagion would spread to other banks – but nothing like that happened.
Albeit a little battered at the edges, ICICI Bank is now back to normal. And most other Indian banks appear to be cruising along too, posting strong third-quarter results for 2008. HDFC Bank, one of the strongest in the private sector, reported net profit of Rs6.2bn ($121.5m) for the 2008 third quarter, a year-on-year growth of 44.8%. Similarly, Axis Bank, another leading private sector bank, reported a strong 63.2% year-on-year increase in net income. In the meantime, publicly owned State Bank of India, the largest bank in the country, showed a 35.5% year-on-year growth in net interest income, while another leading public sector bank, Punjab National Bank, reported an 85.8% year-on-year increase in net profits. State-owned banks account for nearly 75% of the industry's assets and private sector banks about 20%.
Some of India's 30-odd foreign banks have also announced stellar 2008 results. While HSBC Holdings announced a 68% drop in net profit, its Indian operation reported a 26% increase in pre-tax profit. And Standard Chartered's Indian business was one of the main contributors to its overall revenue, with its wholesale operation growing by 16% and its consumer banking arm by 13%.
The unexpectedly strong results can be largely attributed to Treasury gains made by banks in the third quarter due to a steep decline in bond yields. Nonetheless, compared to the level of distress evident in US and UK banking, the Indian system appears remarkably robust.
So why hasn't Indian banking suffered the calamitous meltdowns suffered by banks in the West?
Limited exposure
RBI governor, Duvvuri Subbarao, explained at a conference late last year: "The Indian banking system is not directly exposed to the subprime mortgage assets. It has very limited indirect exposure to the US mortgage market, or to the failed institutions or stressed assets."
"All the reasons for which you had financial destabilisation in other parts of the world have really been missing in India," adds Dr PJ Nayak, chairman and CEO of Axis Bank. "We didn't have toxic assets because credit default swaps weren't permitted in India. We are more 'boring bankers'. We believe that the borrower and lender need to know each other. That's the way we have always done banking – over the recent period that has actually protected us."
Chanda Kochhar, the new managing director and CEO at ICICI Bank, credits the regulator, banks and consumers for not being predisposed towards over-leveraging. It is the "Indian mindset" she says.
The Indian banking industry today is safe, sound and secure, states HDFC Bank managing director, Aditya Puri. "We have sufficient capital adequacy. There are no unexploded bombs in the system. We are sufficiently strong in terms of funding and leverage and banking credit has been growing at 24%."
Notably, the banking industry regulator, the RBI, having taken flak in the past for its conservative approach, is now showered with unmitigated praise from all quarters for "prudent" policies that experts say have helped shield the industry from the global financial crisis. "We need to credit the RBI for its policies, because of which we have a sound banking and financial system at a time when the rest of the world is under pressure," says Uday Kotak, executive vice-chairman and managing director at Kotak Mahindra Bank, one of the youngest banks in India.
Improving solvency
Reforms initiated by RBI 15 years ago have been a considerable help in improving the solvency of Indian banks. However, it is the long-standing mandate of statutory reserve requirements that is key. Banks in India need to maintain certain percentages of their deposits in liquid cash with the RBI (the cash reserve ratio [CRR]) and in government bonds (the statutory liquidity ratio [SLR]). Since September last year, the RBI has reduced CRR by 400 basis points to 5% and SLR by 100 basis points to 24%.
"We have very sound regulation. Some exceptional measures have been adopted in the past to insulate the banking system from shocks," says Rana Kapoor, managing director and CEO of Yes Bank, which commenced operations in 2004. In particular, Mr Kapoor points towards counter cyclical measures adopted by the RBI about 18 to 24 months ago. These increased provisioning in the system by almost 2% and stepped up capital adequacy to nearly 150% in sensitive sectors such as unsecured consumer loans, capital markets and real estate. This was a very timely strategy, he says, because it built a cushion in the system on the back of strong earnings, which has stood banks in good stead in the current economic climate. Another extremely important step, in the present context, notes Mr Kapoor, was the RBI disallowing securitisation and credit derivatives in the Indian market "much to the disappointment of banks at that time".
While the Indian banking sector might have escaped the full force of the financial crisis suffered by its European counterparts, it has not emerged totally unscathed. The financial crisis has entered India through other channels.
In the wake of the global slowdown, foreign institutional investors (FIIs) withdrew nearly $13bn last year and, for the first time in 11 years, there was a net outflow of FII money from India. As credit lines and credit channels overseas dried up, some of the credit demand previously met by overseas financing is shifting to the domestic credit sector, putting pressure on domestic resources. The BSE Sensex (Bombay Stock Exchange Sensitivity Index) has dramatically slumped from its peak of 21,000 in January 2008 to sub-8500 levels at the beginning of March 2009. Reduced global demand has badly impacted exports, which fell in the last quarter for the first time in seven years. On the domestic front, the auto and manufacturing sectors have witnessed a slowdown. The Indian economy, which grew at an average 9% in the past four years, is now expected to grow at about 5%.
Dr Nayak says: "In the US and Europe, the direction of distress originated in the financial sector and then moved on to the real economy. Here, the direction of causality has been the reverse. Other than currency and equity markets, which had a first order impact in India because of pain in financial markets overseas, the adverse impact has actually come via the real sector. Exports are slowing down, and the Index of Industrial Production has also shown negative growth.
"However, it is my intuition that banks which have been relatively prudent in the way they expanded assets during the upswing of the business cycle will suffer much less pain during the downswing – and in that sense you will see a differentiation driven by asset quality among Indian banks by the time the downturn ends. Every business cycle downswing is transformational for market structure and I expect a significant market structure change in Indian banking as the present cycle plays out."
The results of a study of the top 25 banks by the Associated Chambers of Commerce and Industry of India (Assocham), released in January, highlighted the growing problem of non-performing assets (NPAs) in the Indian banking industry. According to the study, net NPAs in the third quarter of 2008 showed an average year-on-year increase of 34.5%. Assocham's secretary-general, DS Rawat, said: "In divergence to the turmoil in the global banking institutions, the Indian banking sector stands tall with stupendous growth in profits. However, the rise in NPAs may remain a key challenge." Ashwin Parekh, partner and national leader – global financial services, at Ernst & Young agrees. "Recovery management of NPAs is a key challenges facing banks in the coming months," he says.
Restructuring package
The central bank recently announced a restructuring package to ease the NPA situation. Mr Puri, whose bank, HDFC Bank, registered the highest growth in net NPAs in the Assocham study, contends that the NPA issue is well under control. He says: "The average NPA is 2.08% gross, net is 1%.
General reserves are 1% and capital adequacy is at 12%. So, definitely, this is not an alarming situation. When the economy slows down, there will be some increase in NPAs. It always happens. Even if the NPAs double from their current level, it wouldn't even dent one year's profit of the banking system, let alone hitting reserves, contingency or equity."
In the retail sector, NPAs comprise the small-ticket personal loans business dominated by banks and non-banking financial companies. These were dogging the Indian banking sector even before the current financial crisis began. "It was India's own version of the subprime crisis, albeit at a much smaller level," says Mr Nayak, whose Axis Bank chose to stay away from this market. This business includes unsecured personal loans and two-wheeler loans where ticket costs sometimes went as low as $200. Several players such as GE Money, Citifinancial (the consumer finance arm of Citibank in India), Standard Chartered and ICICI Bank got badly burnt by the high levels of delinquencies in this business and many have exited the arena. Problems include high transaction costs, the absence of a fully functional credit bureau, and the lack of a strong and quick legal redress mechanism in cases of default. "Collection issues are the main reason behind the high NPAs," says Mr Kochhar.
Leading brokerage firm Sharekhan stated in a recent report that there were "tough challenges" ahead for the Indian banking industry. Banks, it said, would be hurt by moderating advances growth as slowing economic activity catches up with credit demand. The treasury gains enjoyed by banks in the third quarter, said the brokerage firm, would probably no longer be available since bond yields are not expected to decline much further.
Further reforms
Credit growth in the Indian economy has indeed slowed down considerably. According to data released by the RBI, credit growth between October 10, 2008, and February 13, 2009, was only $7.6bn, compared with $37.8bn during the corresponding period of the previous fiscal year. Banks need to increase their lending, says Abizer Diwanji, head of financial services at KPMG India. "Banks' fee-based income has dried up in the current economic environment and they need to focus on growing their interest income which is only possible if credit off-take occurs," he says.
In a bid to encourage banks to lend more, the RBI introduced a series of rate cuts from mid-September last year, but these have not had the desired impact. While the state-owned banks have responded to some extent by reducing their lending rates, private sector banks have not. The problem lies with high deposit rates, says Mr Diwanji. "There is enough liquidity in the system, but unless the RBI cuts deposit rates, private banks will not be able to lower interest rates since they have a high cost of funds. Reduction in rates would increase asset demand and hence make loans more viable at lower rates."
The current economic scenario is a wonderful opportunity for the regulator to introduce further financial sector reforms, states Mr Kapoor. The last major set of banking reforms were introduced in the early to mid-1990s. These included steps such as interest rate deregulation, the introduction of competition in the hitherto state-controlled banking sector through the launch of new private sector banks, and a dramatic reduction of CRR and SLR rates.
Mr Kapoor suggests that the CRR and SLR rates need looking at again: "In India we block almost 29% of our deposits into CRR and SLR. On SLR, banks have a negative U-turn, while on CRR the return is zero. This sequestered capital is a big loss of productive growth capital in the system." With another 40% of capital being directed into priority sector lending, Mr Kapoor adds, only 31% of the banking sector's funds are actually available to meet the country's core funding requirements. "There isn't enough funding from the Indian banking system, which is why we are so dependent on foreign capital. The banking system needs to be able to make more funds available for bona fide commercial purposes. There needs to be some serious rationalisation of CRR and SLR norms. This is one very big reform that we are keenly awaiting and now is the time to implement it."
Opinions differ on this subject. While some experts support Mr Kapoor's views, others argue that the current CRR and SLR levels provide the requisite cushion in the system, pointing out that their role in protecting the banking system has been borne out by recent events. Mr Puri says: "We need to look at CRR and SLR levels again and decide whether the current levels provide safety or not. There are two views to it – that it provides tremendous safety to the banking system and that it pre-empts liquidity for the government."
Mr Puri adds: "We have a situation where credit demands may exceed what the banking sector can provide. That is something where the development of a long-term debt market comes into play. We need an appropriate set of equity investors, credit derivatives and currency derivatives. These are important to create a deep bond market." While the regulator has been steadily working in this regard, Mr Puri believes that in the current global financial situation, the pace needs to quicken.
An oft-repeated criticism of Indian banks in the past has been lack of size, with consolidation mooted as a possible remedy. According to The Banker's 2008 rankings, there is only one Indian bank, the State Bank of India, in the list of top 25 Asian banks. It is also the only Indian bank among the top 100 banks globally. By contrast, Asia's other giant, China, has eight banks among the top 25 Asian banks, and the top three Chinese banks – ICBC, Bank of China and China Construction Bank – are among the top 15 in the world.
Biggest casualty
Size has been the biggest casualty of the financial crisis, says Mr Kochhar of ICICI Bank. "If the Indian economy had continued to grow at the phenomenal rate it was growing, there would have been commensurate growth in the banking sector as well. There would also have been a huge opportunity for consolidation, but that is no longer the case. Apart from some consolidation among public sector banks, most banks will grow organically." Ranked 150th globally, ICICI Bank has, in the past, grown extremely aggressively, both through organic and inorganic means.
Mr Puri of HDFC Bank, ranked 219th globally, counters this. "Size beyond a point is a fallacy as proved by RBS and Citibank. Every bank that is big is down the tube," he says. Chinese banks might be big, adds Mr Puri, but the Indian banking system is much better. "We are better positioned, better provisioned and better capitalised. We have better systems and better risk management procedures."
He agrees with Mr Kochhar that the Indian banking industry will not witness much consolidation in the coming months; instead the focus among banks will be to consolidate existing positions and build robust risk management systems.
In the current economic scenario, that certainly seems to be the best option.
