Holding its own against the uncertain economic climate impacting many countries around the world, the Indian economy is powering ahead. After clocking an average growth of 9% a year in the five financial years to 2007/08, India's gross domestic product (GDP) rate slipped below 6% at the height of the financial crisis. Since this dip, normal service has been resumed. The country's central statistical bureau states that the GDP growth rate for the financial year 2009/10 was 7.4%. Furthermore, the Indian government has indicated that it expects the country's economy to grow at 8.5% in the current fiscal year, with the medium-term target being to achieve 10% economic growth annually.
Banking benefits
India's banking sector has naturally benefitted from this economic recovery. Industry margins are expected to be higher this year and credit growth has picked up. Credit growth for Indian banks, more than 25% in fiscal 2007, moderated to a 13-year low of about 10% towards the end of 2009. However, aided by the banking regulator's monetary policies and broader positive economic conditions, credit growth has increased to 16.5%. This trend is expected to continue. While the institutional research team at stockbroking firm HDFC Securities estimates that credit growth will be at 18% between financial years 2009 and 2012, many other analysts expect the growth to expand beyond 22%.
"The Indian banking industry is very stable when compared to banking sectors in other countries," says Joydeep Sengupta, a director at consultancy McKinsey. However, he adds that there is a vast divergence in the performance of banks, both public and private. This is not surprising considering the varied players of differing sizes that comprise the banking sector. There are 80 or so scheduled commercial banks in India, which include 27 state-backed public sector banks, 22 private sector banks and 32 foreign banks, with a combined network of about 65,000 branches. Apart from these commercial banks, there are urban co-operative banks and regional rural banks as well.
HDFC Bank, one of the strongest private sector banks in India, has experienced a 13.8% increase in net revenues and a 31.3% increase in net profits over the previous year. In The Banker's Top 1000 ranking for 2010, it has moved up by one place to become the third largest bank in the country with total Tier 1 capital of $4.5bn. Axis Bank, another leading private bank and the seventh largest bank in India, also reported a strong operating performance with a 31.5% year-on-year growth in net profits. Leading public sector bank Bank of Baroda was another to turn in a strong performance, of 37.3% net profit growth and a 24% growth in total business. Baroda has moved up three positions in The Banker's rankings to become the fourth largest bank in the country and taken the mantle of the second largest public sector bank in the country from Punjab National Bank.
The Overseas Bank, a public sector lender, is among the banks that have not performed quite so well in the past fiscal year. It reported a decrease in asset quality and operating performance, with overall net profit declining by 46%. Private sector bank Bank of Rajasthan (BoR) is another that announced weak results in the financial year 2009/10. Its total operating income declined by 1.19% and it reported a net loss of about $22m, compared with a net profit of $26m in 2008/09.
Chanda Kochhar, CEO of ICICI
Merger activity
Meanwhile, BoR is in the process of merging with ICICI Bank, India's second largest lender and the largest private sector bank. The worst impacted Indian bank in the financial crisis, ICICI has had a rough ride during the past two years largely due to a reduction in customer confidence following the financial crisis. High levels of non-performing assets as a result of the aggressive retail-driven growth strategy it pursued in the pre-crisis boom years were also a factor.
Over the past year, ICICI has focused on improving the quality of its assets and strengthening its mix of loans and deposits. "We have consciously tried to reduce large wholesale deposits and increased low-cost deposits. We have also brought down unsecured advances and increased other loans such as mortgages, car loans, infrastructure project loans and trade finance," says Chanda Kochhar, CEO of ICICI. The bank has also changed its focus from being product-centric to customer-centric, she says.
Commenting on the merger with BoR, Ms Kochhar says the deal is the right strategic fit. ICICI is offering the smaller bank's controlling shareholders 25 shares in ICICI for 118 shares in BoR. While several industry analysts opine that the deal is very expensive for ICICI, Ms Kochhar is confident that the merger will add considerable value. She says: "Our philosophy is to operate on a customer-centric bank model which is possible through focusing on branches. With this merger we get 463 new branches, and a 25% growth in our branch network."
The benefits of the merger to ICICI are expected to be primarily funding related, as it will be able to leverage BoR's network of 463 branches and its low-cost deposit base, according to ratings agency Fitch. The agency expects that any adverse impact from BoR's asset quality problems and weak capital position on ICICI's financial profile will likely be limited given BoR's relatively small size, representing less than 5% of ICICI's assets.
Apart from being able to enhance its network in the north and west of the country, where BoR has a strong presence, the merger will also give ICICI a critical time-to-market advantage, says Ms Kochhar. "It takes one year to set up 500 branches and three years to get deposit levels up to what BoR's branches already enjoy. We will now only need to focus on increasing the level of business from the branches, so there is a huge opportunity for us." In addition, she adds, ICICI is no stranger to mergers, having already successfully managed two in the past, with Bank of Madura and Sangli Bank.
Stalled Consolidation
The ICICI-BoR deal is the first consolidation since 2008 in India's crowded banking sector where, according to some estimates, the top five banks account for about 50% of market share. In 2008, HDFC Bank merged with another private sector player, Centurion Bank of Punjab. In the same year, state-owned State Bank of India, the country's largest lender, merged with State Bank of Saurashtra, one of its seven associate banks.
C Jayaram, executive director of Kotak Mahindra Bank, says old private sector banks are the most obvious candidates for consolidation. "Most of these banks are small, promoters do not have deep pockets and expansion for them is not easy." The next on the list for consolidation, he says, are the weak public sector banks. He adds, however, that historically there has been union opposition against such moves. As a consequence, although the Indian government has over the years repeatedly urged the banking community, especially public sector banks, towards consolidation to strengthen the banking sector and make it more competitive, progress has been exceedingly slow.
Aditya Puri, CEO of HDFC Bank, is not hopeful about consolidation picking up in the near future. Public sector banks account for more than 70% of India's banking industry, which is where the maximum opposition to consolidation emanates from. "Seventy per cent of the banking sector does not want to consolidate, so how can we proceed on this front?" he asks. "Private sector banks are small in size and merging with them does not provide the kind of reach and depth that is needed." HDFC Bank, he says, is not looking at any further mergers and acquisitions activity. "We have just completed our acquisition of Centurion Bank and need to now assimilate the synergies between the two organisations."
Against a backdrop of stalled consolidation, the Indian government has also indicated that it will allow new players to enter the banking sector to boost banking penetration in the country. In his annual budget speech in February this year, Pranab Mukherjee, India's finance minister, said that the Reserve Bank of India (RBI) is considering new bank licences to promoters in the private sector and also non-banking financial companies, providing they meet RBI's eligibility criteria.
The banking industry regulator has in the past been very frugal in allocating banking licences and this announcement has understandably led to considerable excitement among several business houses keen to enter the banking sector. The last time that new private players were allowed into the Indian banking market was in 2002, when YES Bank and Kotak Mahindra Bank were launched. Before that, six licences were granted in the early 1990s, which led to the formation of banks such as ICICI, HDFC and Axis (formerly UTI Bank). "In the past 15 to 20 years, the banking sector has been opened up on two occasions. Nearly eight years have passed since the last time so in that context, there is definitely a case for new players to be allowed into the banking sector," says Mr Jayaram of Kotak Mahindra.
Neeraj Swaroop, CEO of Standard Chartered Bank in India
New players
But YES Bank CEO Rana Kapoor argues, perhaps not surprisingly, that new players might find it difficult to operate in the current environment. "The big towns and cities are already well serviced by existing players and are over-branched in many instances. It is the rural markets that are under-penetrated. To service the needs of this sector, we need to build greater efficiencies through consolidation and use of technological solutions. Existing players that have already built a momentum are best placed to create acceleration in rural markets."
Mr Sengupta of McKinsey disagrees, however, and says there is still room for banking services in urban markets. "At the pace at which urbanisation is taking place, there will soon be mega-cities in the country. There is huge opportunity for new players that can capture market share by innovating and offering better business models."
ICICI's Ms Kochhar says that new players will be needed in the banking sector as it will be grow at a very high rate. "If the Indian economy grows at 10%, the banking sector needs to grow at 20%. In such a high-growth scenario, there will be space for new players," she says. Looking ahead, she adds, most of the challenges that the banking sector faces are those that are associated with a high-growth industry, be it capital sufficiency, risk management or personnel requirements.
Leadership, says Mr Sengupta, is one of the key challenges for the banking sector in the near term. This gap is most visible among public sector banks, although private sector banks are suffering as well, he adds. "The number of leaders is not commensurate with the business growth. We estimate that the public sector will soon face a shortfall of between 8000 and 12,000 managers at the senior level. There is also a huge skill gap in the industry. Current training systems are not adequate," he says.
As the Indian banking sector grows, the skill sets required have to change accordingly, concurs Mr Kapoor of YES Bank. While earlier knowledge of vanilla banking might have been sufficient, sectoral expertise needs to be developed, he says. In a similar vein, another challenge for the banking sector, he adds, is keeping pace with Indian corporates and their global requirements. "Banks need to create an offshore product suite to meet the needs of Indian corporate and multinational corporations. Currently, most capital-raising larger ticket deals are being managed by foreign banks."
Cross-border advantage
Foreign banks certainly have an edge over their domestic counterparts when it comes to cross-border business, especially in mergers and acquisitions. Despite being limited in their retail operations due to RBI's restrictions on Indian branch licences, banking the country's corporates represents a huge opportunity for foreign banks, says Neeraj Swaroop, CEO of Standard Chartered Bank in India.
As an example he says, Standard Chartered, which recently concluded the first ever Indian Depositary Receipt (IDR) issue, has been present in most major cross-border corporate deals involving Indian companies, from the acquisition of the Anglo-Dutch steelmaker Corus by India's Tata Steel to the recently concluded Bharti Zain transaction, where India's telecom leader Bharti Airtel acquired the African operations of Kuwait's Zain.
Indian banks don't have the scale and franchise that foreign banks can offer, says Mr Swaroop. "As Indian corporates globalise, their needs are very international. However, these needs aren't adequately met by Indian banks, which mostly operate single branches in other countries or through a correspondent banking network."
Indian banks are aware of the huge opportunities the cross-border business has to offer, but they do not seem to be in a hurry to capture this space. Instead, their main focus is on the rapidly growing domestic market. On the global front, they are sticking to a mandate of meeting the needs of the vast Indian diaspora, especially in the remittance business, as well as offering corporate banking services to Indian companies extending their operations out of the country. ICICI too, which a few years back appeared to be in a hurry to grow not only domestically but globally as well, appears to have tempered its global ambitions for the moment.
"At this stage of their evolution, this is the right strategy for Indian banks. Most international banks took the same path in the early stages of their globalisation efforts," says Mr Sengupta. With the Indian economy growing at such a rapid pace, however, he is confident that in 10 years, Indian banks will feature among the top 20 banks globally.
