India recently concluded its 16th general election, the largest in the world, and the mood among both the business community and the general public is positive and hopeful. The election saw the spectacular victory of the erstwhile opposition party, the Bharatiya Janata Party, led by Narendra Modi, who was later sworn in as the country’s prime minister.
The triumph of a single political party is remarkable in a country that has witnessed nearly three decades of coalition governments, which have struggled to balance regional partners and their discordant interests. It was without doubt a vote for change from the 10-year Indian National Congress-led United Progressive Alliance rule, which in its latter years was characterised by sub-5% economic growth rates, high inflation, weak domestic demand, slowing industrial production and policy paralysis.
Weak leadership and a series of corruption scandals irredeemably eroded public confidence in the government in recent years. In this climate, Mr Modi’s high-intensity campaign, focusing on development and the mantra of ‘less government, more governance’, resonated with the young and old alike.
“The elections have delivered a clear mandate for governance and growth, which should be leveraged for decisive action that will rebuild confidence in the economy,” says Chanda Kochhar, managing director and CEO of ICICI Bank, the largest private sector bank in the country.
Rana Kapoor, managing director and CEO of Yes Bank, the country’s fourth largest private lender, says: “The new government will have to take decisive steps to bridge the trust deficiency by focusing on creating a stable policy environment and effective governance.” The banking industry is a critical component in driving the growth of the Indian economy, adds Mr Kapoor, who says that the government needs to take robust measures to rejuvenate this sector.
Banking the masses
India’s Rs81000bn ($1379bn) banking sector, which was among the few that withstood the onslaught of the 2007 global financial crisis and its aftermath, faces several challenges. For starters, more than half of the country’s adult population remains excluded from the formal banking network.
India has adopted a bank-led model for financial inclusion, unlike in other emerging countries where telecommunications providers have been allowed to lead the way. The country's banking industry regulator and central bank, the Reserve Bank of India (RBI), has over the years worked on several initiatives to ensure financial inclusion in the country, from instructing banks to open branches in rural areas to encouraging mobile banking.
Under the RBI’s 2010 to 2013 financial inclusion plan, banking outlets in Indian villages increased to nearly 268,000 in 2013, from 67,694 in March 2010. Furthermore, about 7400 rural branches were opened during the three-year period, compared with a reduction of about 1300 in the past two decades. This progress is encouraging, but with India’s vast size and population, the scale of the task ahead remains immense.
In April 2014, after months of deliberation, RBI gave in-principle banking licences to two new players – infrastructure financier IDF and micro lender Bandhan Financial Services. The last time that new private banks were allowed into the system was in 2004, when Kotak Mahindra Bank and Yes Bank were given banking licences. Others, including ICICI Bank and HDFC Bank, were given licences about a decade before that.
These new private sector banks – there are seven of them today – along with 26 public sector banks, in which the government owns a majority stake, 13 old private sector banks and about 40 foreign banks, form the bulk of the Indian banking industry. Shinjini Kumar, executive director in charge of banking and capital markets at professional services firm PricewaterhouseCoopers, says that to expand the Indian banking industry in terms of products and services, as well as increase banking penetration, new players need to be allowed into the banking system more frequently, “India needs more new banks, we need to ease the licencing regime and base it on market conditions,” she says.
Incidentally, RBI has announced that it will soon be coming out with a framework for providing on-tap differentiated banking licences where banks will be allowed to offer products in select categories, meaning there could be specific institutions, such as payment banks, wholesale banks and retail banks.
Asset quality questions
While financial inclusion is an ongoing exercise, the overriding challenge that India’s banking industry faces today is that of poor asset quality or non-performing assets (NPAs).
NPAs have ballooned in the past few years. According to RBI’s estimates, the gross NPAs of domestic banks jumped from 2.3% of total lending in March 2011 to 3.6% a year later, and to 4.2% by the end of September 2013. About Rs2000bn in loans is now classified as NPAs and at least Rs4000bn is being restructured. Together, these stressed assets (gross NPAs plus restructured loans) account for about 10% of the total loans of Indian banks.
NPA growth can be attributed to the recent slowdown of the Indian economy, high interest rates and high leverage of corporates in the distressed sectors. Ratings agency Standard & Poor's (S&P) states that the infrastructure, textiles, and metals and mining sectors accounted for the largest share of banks' stressed assets at the end of September 2013. Loans to these sectors formed about one-quarter of total bank credit, but contributed half of the stressed loans. Bank loans to the infrastructure sector (comprising power, telecoms, roads and other infrastructure) have rapidly increased over the past decade, with the sector's share growing from 8% in 2006 to 15% in 2013.
Arun Tiwari, the chairman and managing director of state-backed Union Bank of India (UBI), explains the reasons behind the growth of stressed assets in the industry: “With falling external demand in the wake of the global financial crisis, and domestic factors such as high inflation, which warranted interest rate hikes, and the policy logjams, many projects witnessed delays [to their] operations, which meant earnings deferral for the borrowers. Since infrastructure loans are of long gestations while the banks’ resource profile has a short-term make-up, there is an asset-liability perspective appended with it. As the growth slowdown hit other sectors of the economy, banks started piling up bad assets on their loan book.”
UBI reported gross NPAs at 4.08% of total loans in the fourth quarter of the fiscal year 2014, significantly higher than the 2.98% figure for the same period the previous year. The bank posted a net profit of Rs5789.6m for the first quarter of 2014, down 26.7% from Rs7893.8m in the corresponding quarter in 2013.
In the bad books
The gross NPA ratio – gross NPAs as a percentage of total advances – helps identify the quality of a bank’s assets. The gross NPA ratio for state-owned public sector banks in India is, on average, about 4%, nearly double that of private sector banks. In fact, public sector banks, which account for nearly three-quarters of the Indian banking industry’s assets, accounted for about 85% of gross non-performing assets in 2013, a 10 percentage point increase from 2003. In the same period, the share of private sector banks' gross NPAs decreased from 14% to 8%.
Punjab National Bank, the second largest state-run bank in the country, reported an increase in gross NPAs to 5.25% in the fourth quarter of the fiscal year 2014, from 4.27% in the same period the previous year. The bank said that its net profit dropped 28.7% to Rs8060m in the fourth quarter of the fiscal year 2013 because of higher provisions made for bad debts.
Similarly, state-owned Bank of India’s 26% fall in profit in the fourth quarter of fiscal year 2014 is attributed to deteriorating asset quality and high staff costs. Gross NPAs at the bank stood at 3.15% compared with 2.99% a year ago and 2.81% in the previous quarter. At another state-run lender, UCO Bank, which reported a five-fold increase in profits for the quarter to March 2014, gross NPAs were at 4.32%.
In comparison, at private lenders such as HDFC Bank, Axis Bank and Kotak Mahindra, gross NPAs have remained at 1% to 2%. The largest private sector bank, ICICI Bank, has the highest NPA levels. The bank reported a gross NPA ratio of 3.03% for the quarter ending March 2014, the lowest in more than three years as it managed to recover about Rs4bn of assets and write-off assets worth Rs7bn.
Fixing the problem
Over the past few months, the regulator has been working with the industry to develop a framework to help banks assess accounts that are unviable, identify stressed assets early on and take corrective actions accordingly. The RBI has also been exhorting banks to improve internal processes. This is because industry experts maintain that some of the key reasons behind the spiralling growth of NPAs lie within banks themselves – sub-optimal credit management processes, inefficient governance structures and inadequate implementation, as well as usage of information systems.
In February 2014, Archana Bhargava, the then chairman and managing director of UBI, resigned only 10 months into the job and one year before her term was due to end. It is widely believed that her resignation was linked to difficulties relating to NPAs.
NPAs at UBI had remained under-reported for a long time, because of the practice of manually determining asset quality and other accounting issues. Ms Bhargava’s insistence on close scrutiny of the books led to the bank seeing a dramatic increase in gross NPAs to more than 10%, the highest in the industry, and a net loss of Rs16.83bn for the nine months to December 31, 2013, compared with a net profit of Rs36.1bn a year earlier. Ms Bhargava’s initiatives in cleaning up the bank’s books did not go down very well among the stakeholders and led to her sudden exit.
Speaking at an industry event on NPAs in May this year, R Gandhi, the deputy governor of the RBI, said that while macroeconomic factors are responsible for the decline in the banking sector’s asset quality, it was shortcomings in the credit appraisal, disbursal and recovery mechanism of the banks that was responsible for their high levels of NPAs.
“Lack of robust verification and screening of application, absence of supervision following credit disbursal and shortfalls in the recovery mechanism have led to the deterioration of asset quality of these banks,” he pointed out.
The first quarter of 2014 has seen a slight improvement in the NPA situation at a few banks. At India’s largest commercial bank, State Bank of India, the gross NPA ratio for the quarter was 4.95%, a dip from 5.73% in the previous quarter. Similarly, the country’s second largest public sector lender, Bank of Baroda, reported gross NPAs of 2.94% of its loan book, a drop from 3.32% in the previous quarter.
“NPAs have bottomed out. We should see a gradual improvement going forward,” says Ranjan Dhawan, executive director of Bank of Baroda. He adds that the country’s gross domestic product growth will assist the NPA situation, saying: “A number of projects that contributed to stressed assets were financially viable, but were stalled because of lack of adequate clearances. The new government is serious about taking steps to solve these issues.”
Ms Kochhar of ICICI Bank is confident that NPA levels at the bank will not increase any further. “We believe that the pace of addition to non-performing loans [NPLs] and restructured loans has peaked and we should see a lower formation of NPLs and restructured loans in the fiscal year 2015,” she says.
Basel target
Since asset quality issues continue to impact the Indian banking sector and economic growth is yet to pick up, the RBI recently extended the deadline for the country's banks to meet capital requirements under the Basel III norms by one year, to March 31, 2019. Basel III regulations kicked in on April 1, 2013, and the internationally agreed deadline for implementation is January 1, 2019. In a notification, the RBI said: “Of late, industry-wide concerns have been expressed about the potential stresses on the asset quality and consequential impact on the performance and profitability of the banks. This may necessitate some lead time for banks to raise capital within the internationally agreed timeline for full implementation of the Basel III capital regulations.”
Under Basel III norms, which are supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage, banks need to have a core capital ratio of 8% and a total capital adequacy ratio of 11.5%, compared with 9% now. In 2012, the then RBI governor D Subbarao estimated that the banking sector would need about Rs5000bn of capital to meet Basel III requirements, of which equity capital would be Rs1750bn.
As capital requirements increase under Basel III, banks will have to progressively mobilise additional capital. Mr Dhawan says that raising capital will be a big challenge for public sector banks. “Using hybrid instruments for raising Tier 1 capital is uncharted territory for us,” he says.
UBI's Mr Tiwari agrees, saying: “Capital maintenance under Basel III has emerged as the foremost challenge for state-owned banks.”
Ratings agency Standard & Poor's (S&P) states that private sector banks are better placed than public sector banks in terms of meeting Basel III capital requirements, because of better capitalisation, healthier asset quality and stronger profitability. Public sector banks, suggests S&P, will have to rely on a combination of government capital infusion, additional Tier 1 hybrid instruments and equity markets to support their capitalisation.
S&P also notes that public sector banks' reliance on capital infusion from the government is likely to remain very high. “The government has infused about Rs586bn of equity into these banks in the fiscal years 2011 to 2014, and we expect such support to continue. However, the government's capacity to keep providing sufficient and timely capital is a risk. Simultaneous equity issuances by many banks as well as negative sentiment on emerging markets could pose challenges for raising capital,” the agency says.
The January 2014 equity raising exercise of State Bank of India, for instance, was not very encouraging. It drew a tepid response from foreign investors and had to be finally aided by the government-owned Life Insurance Corporation of India, which picked up one-third of the Rs80.32bn issue.
Pace of progress
There is no doubt that today, while public sector banks hold the bulk of the Indian banking industry’s assets, they also lag behind their private sector peers on a variety of parameters, such as operational efficiency, profitability and asset quality. The entry of new private banks in the mid-1990s had spurred public sector banks in transforming themselves, however they have not kept pace with industry requirements.
With the government holding more than 51% stakes in these banks, critics would say that often policy objectives take precedence over commercial considerations, and the boards are also politically influenced, as a result of which corporate governance suffers. Furthermore, having to adhere to a set compensation structure, these banks are not able to attract and retain the best and brightest talent in the industry, who tend to gravitate towards the private sector and foreign banks instead. Another cause for concern is that due to a decade-long hiring freeze in the 1990s, and resistance to lateral hires, public sector banks are expected to face a leadership vacuum in the next few years when a majority of their senior leaders retire.
Recently, an RBI-appointed committee headed by Dr P J Nayak, the former chairman and CEO of Axis Bank, prepared a report that suggested radical structural changes at public sector banks. The report recommended that the government continue to maintain a major share in the lenders, but keep it at less than 50%, thus providing banks with greater operational independence and ability to professionalise their boards. The report has, unsurprisingly, created a furore in the industry, and among banking trade unions in particular. However, several banking industry experts, including RBI governor Dr Raghuram Rajan, have endorsed the recommendations as being necessary to improve the competitiveness of public sector banks in the country.
Speaking at the annual day lecture at the Competition Commission of India in May this year, Mr Rajan said that privatisation was not required to improve the functioning of most public sector banks, rather that their governance, management and operational and compensation flexibility needed to be changed.
Calling out for a healthy public sector banking system, Mr Rajan said: “If public sector banks become competitive, and especially if they do so by distancing themselves from the influence of the government without sacrificing their ‘public’ character, they will be able to raise money much more easily from the markets. Indeed, the better performers will be able to raise more, unlike the current situation where the not-so-good performers have a greater call on the public purse.”
State-owned public sector banks account for nearly three-quarters of the assets of the Indian banking industry. Improving their performance will no doubt dramatically transform the sector. If the Nayak committee recommendations are implemented, it would certainly prove to be a game-changer. The report is currently being reviewed by the newly formed Finance Ministry. However, it remains to be seen whether the government stays true to its promise of bringing about financial sector reforms and is able to implement these radical but much-needed recommendations.
