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Indian Banking Sector

Although India has always had the potential to be a great economic power, it is only recently that its true potential has emerged and it has become an increasingly attractive destination for global businesses and investments. The competitive landscape in the Indian consumer banking industry is changing as the advent of private sector banks and market-savvy foreign banks are putting pressure on the public sector banks to raise their game.

The players in the Indian banking sector can broadly be classified into three distinct groups, who although face common issues, are subject to specific issues pertaining to their sector. The three main segments are the public sector banks, private sector banks and foreign banks.

Public Sector Banks

It is evident from the table below that the public sector banks constitute the majority of the Indian banking system, be it by geographical reach or deposit and credit volumes. The public sector banks which, although in theory are independent, take strategic direction from their majority shareholders. They have historically been and continue to be, important mechanisms by which the government delivers policy promises and maintains confidence in the banking system.

Indian Banking System

Source: Reserve Bank of India

As a result of the design of government policies to extend credit to the rural population and the accidents of failed banks in the Indian system, the public sector banks have grown to establish a formidable network of branches. The largest of these is the State Bank of India (SBI), which is the largest bank in India as measured by the number of branches (over 9,000 branches and 15,000 branches including its affiliated banks) and asset base (Rs407, 815 crores or $88bn). The large branch networks that are owned by some of the public sector banks, and particularly SBI, have a significant advantage over the private and foreign banks, who, although they have well established operations in the metro cities need to establish better distribution capabilities in the semi urban and rural areas.

Despite owning these impressive networks, the lack of investment in technology leads to inefficiencies in processes and restricts the bank's ability to equal customer promises made by private sector and foreign banks. The need for more sophisticated technology has also become more relevant as the public sector banks start to tap foreign capital markets to raise funds to meet their expansion plans. The exposure to foreign markets will require them, among other things, to raise the bar with regard to customer service, efficiency and producing timely, auditable financial and non-financial information. Although the banks in this sector have embarked on modernising their technology infrastructure and streamlining their internal processes, this will absorb both time and resources.

The public sector banks have not traditionally been regarded as very customer-centric organisations but the advent of private sector banks and market-savvy foreign banks has changed the competitive landscape in the Indian consumer banking industry. Although the customer service levels of public sector banks are now growing to meet the complex needs of customers, some suggest that there is still a long way to go. Indian banks are regulated by the Reserve Bank of India (RBI), an autonomous organisation set up under a specific legislation of the parliament with limited government control, as per provisions of Banking Regulation Act. The RBI regulates all banking sector aspects, such as cash reserve ratio, statutory liquidity ratio and capital adequacy. No one can carry on the business of banking in India without a licence granted by the RBI and all banks have to adhere to a transparent reporting system of the RBI.

Private Sector Banks

The private sector banks in India have really established themselves over the last 10 years and with aggressive marketing and, focus on customer care, have begun to take the market share away from the public sector banks. Most notable amongst the private sector banks are ICICI and HDFC Bank, which have introduced a level of sophistication in the banking sector that has not been apparent in India before. Apart from adoption of relatively sophisticated technology, these banks have been quick to grasp the consumers' psyche of 'time is money'. Another advantage of large private banks in the country is that they are 'universal banks' which cross-sell a host of financial services and offer all solutions to customers' financial needs under one roof. Some of the smaller private sector banks have not yet employed the use of sophisticated customer relationship management systems.

Management of the banks in this sector is largely Indian, by people who understand the Indian market and the Indian consumer and are able to successfully compete with the larger public sector banks in the metro cities where they have appeal to the more urban customer. As they continue to grow and the urban markets become saturated, they, like the foreign banks, need to establish an operational network that will reach the wider population. Also, an emerging trend with the private banks is that they are seeking to establish a presence in global markets with the aim of attracting lucrative NRI business.

Foreign Banks

The third sector is the foreign banks of which there are 42 currently operating through more than 184 branches in India (see graph below). The larger foreign banks enjoy strong franchises, both in corporate banking as well as in retail savings products, among high net worth individuals. That said they have an increasing market share in retail lending including auto loans, credit cards and personal loans. Growing acceptance of foreign banks is partly as a result of the high 'aspirational value' attached by consumers to banking with a foreign brand. Robust systems, well-defined processes of their global network and an attractive market have enabled these banks to move from a 'dipping the toe' strategy to establishing and cementing their foothold in the Indian market.

Foreign BanksSource: Fitch Ratings

Whereas the state and private banks are largely locally incorporated banks, it is important to note that most of the foreign banks operate as branches of the parent bank which, due to regulatory considerations, puts a constraint on the number of branches they can open. In the retail space, if foreign banks are to participate in the growth of the Indian banking sector on a footing equal to their Indian counterparts, they would need to establish a wider distribution network than is currently allowed under the foreign branch structure. Although the central bank is meeting and exceeding its WTO commitments with regard to allowing the branches of foreign banks to be set up, foreign banks would need to wait for some time before they have flexibility on their distribution network.

This presents an interesting conundrum for the foreign banks that recognise the need to establish a distribution network but is limited due to their current structure and by the government's ceiling on foreign ownership of private banks.

An alternative that foreign banks are increasingly pursuing is the creation of non-banking financial companies (NBFC). Although there are various restrictions on resource mobilisation and certain restrictions on foreclosure rights otherwise available to banks, NBFCs are subject to relatively less stringent regulatory requirements than banking subsidiaries. For example NBFCs are not required to comply with certain prudential measures such as the statutory liquidity and cash reserve ratios or provide, at RBI's behest, priority sector lending (NBFCs are, however subject to almost identical capital adequacy requirements as banks).

Although many internationally active banks have an 'India strategy', in order to succeed, it is imperative that foreign banks understand the culture within each state they wish to operate in. This alone is a significant challenge that should not be underestimated.

Foreign Ownership

Ownership and governance of banks (private banks and foreign banks as discussed previously) is high on RBI's agenda. The RBI is committed to strengthening the domestic banking sector before allowing further room for foreign investment and the recent announcement limiting foreign banks from owning controllership rights of more than 5 per cent in private sector banks is evidence of this. This presents the foreign banks with a significant challenge in the race for customer acquisition. In the meantime however, consolidation among public sector banks, which will seek to merge themselves based on operational, geographical and asset synergies, is widely believed to be imminent.

Credit Growth and Basel

The RBI has issued guidelines recently for the adoption of elements of the Basel II framework (the Standardised Approach for credit risk and Basic Indicator Approach for operational risk) with effect from 31 March 2007.

Following the sharp credit growth and in order to comply with Basel II norms, it is widely believed that Indian banks will need significant capital infusion over the coming few years. A recent study conducted by a leading credit rating company in India reveals that if Basel II norms were applied to Indian banks' portfolio (as at March 2004), capital adequacy would have been 160 basis points (bp) lower than reported. This 160bp decline is a function of a 70bp gain on credit risk and a loss of 120bp on market risk and 120bp operational risk. This reinforces the view that although Indian banks have begun integrating effective credit risk management systems into their operations, adequate progress needs to be made for the assessment and monitoring of market and operational risk.

One obvious area for these banks to consider when looking at their market/operational risk framework is derivative trading which is a relatively new area for Indian banks (particularly in the more structured products) and is set to grow further. It is widely accepted that as the volume of transactions increases, they need to upgrade their current internal control environment and their middle and back offices.

Transparency and disclosure standards are also important constituents of a sound corporate governance mechanism. Although transparency and accounting standards in India have been enhanced to align in many ways with international best practices, there are still many gaps in the areas of risk management strategies and practices, risk parameters, risk concentrations, performance measures and components of capital structure. Hence, the disclosure standards need to be further broad-based along with improvements in the capability of market players to analyse the information objectively. This will help in their efforts to comply with Pillar III requirements of Basel II.

Apart from the challenge of managing capital adequacy by establishing/enhancing operational and market risk management frameworks, Indian banks will need to establish capital raising programmes.

Securitisation

Securitisation and loan sales have made a slow beginning in India. With higher growth rates now being witnessed in loan assets as compared with deposits, securitisation will be a key area for banks to maintain adequate short-term liquidity in order to capitalise on the expected growth. Lack of legal clarity and high transaction costs (stamp duties) are acting as impediments to the securitisation market. Although recently passed legislation does address these issues, continued commitment from the regulators is required to develop these markets.

Bankruptcy laws in India have traditionally favoured borrowers, which has in the past resulted in a large amount of assets becoming distressed, since the powers of lenders were limited. Recent legislation empowers banks to take action against defaulters without resorting to the painfully slow traditional recovery methods like those accessed through the Debt Recovery Tribunals. However, this legislation needs to be further refined and may take some time before it is practically implemented and the benefits realised.

Conclusion

There is no doubt that India presents a huge opportunity for the banking sector but, as outlined above, there are various hurdles that need to be overcome before the true potential can be realised.

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