India's banking sector: Cashing in on vibrant growth

By Dr. Uday Lal Pai
Exclusively for InvestorIdeas.com
posted July 04, 2006

Impressive performance, stable earnings outlook and undemanding valuations make India's public and private sector banks attractive pick in the banking space.

The ability to generate stable returns, the impressive business growth over the medium term and undemanding valuations strengthen the case for investment in select Bank shares. Most of the Indian Bank stocks continues to hold the potential to deliver returns commensurate with the risks involved.

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The banking sector witnessed strong growth in deposits and advances during the year 2004-05. As of March 2005, the number of commercial banks stood at 289. The aggregate deposits of scheduled commercial banks increased from US$ 331 billion in March 2004 to US$ 374 billion in March 2005. Credit of commercial banks in India saw an increase from US$ 185 billion in March 2004 to US$ 242 billion in March 2005. Investments of scheduled commercial banks (SCBs) also saw an increase from US$ 149 billion in March 2004 to US$ 162 billion in March 2005. India's retail-banking business is expected to grow 16% a year over the next four years.

Yes, Indian banking has come a long way, and is today relatively much stronger than its Asian counterparts in terms of performance indices and the product range.

Indian banks recorded impressive performance across several vital business parameters in financial year 2006. Its showing on advances and deposits has been strong. What is even more important is that the loan growth has been all-round, with all four key segments - agriculture, retail, SME and corporate - growing by about 35 per cent.

The credit boom seen over the last two-three years has helped banks increase their retail assets. Credit growth in the economy continued to be robust at 33%. The country's biggest bank, State Bank of India has indicated a full year loan growth of close to 35-40%. The sector has been able to sustain the credit growth momentum, which continues to be fuelled by retail and small enterprise financing.

Credit deposit ratio at 65.9% has consistently remained at a high level with incremental credit deposit ratio at 89%. Deposit growth at 16% has helped finance the credit boom along with lower incremental investments in government bonds. With credit growth continuing to grow strong, we expect many banks to tap the capital markets for more funds.

With short-term interest rates poised to move upwards, banks are scrambling to mobilize long-term deposits. This is prompting players in the banking industry to hike rates on term deposits, or better still, launch innovative deposit products.

However, with banks now having to provide for additional capital towards housing and real-estate lending, analysts believe growth in this segment is likely to slow down little bit. On the positive side, banks are increasingly turning to rural financing, which is expected to be the next frontier. Higher volumes in farm credit, in particular, are expected to help banks record healthy business growth.

In this backdrop, India's public sector and scheduled banks, with its long-held advantage in farm lending, is well-poised to cash in on the opportunity.

Indian banking systems for late beginners

Those who come late to study on India's banking sector, here are the details. The major participants of the Indian financial system are the commercial banks, the financial institutions (FIs), encompassing term-lending institutions, investment institutions, specialized financial institutions and the state-level development banks, Non-Bank Financial Companies (NBFCs) and other market intermediaries such as the stock brokers and money-lenders. The commercial banks and certain variants of NBFCs are among the oldest of the market participants. The FIs, on the other hand, are relatively new entities in the financial market place.

Banking Segment in India functions under the umbrella of Reserve Bank of India (RBI) - the regulatory, central bank. RBI has got wide ranging powers for supervision & control of banks. It also has licensing powers & the authority to conduct inspections. Indian banking segment broadly consists of Commercial Banks and Co-operative Banks

The commercial banking structure in India consists of Scheduled Commercial Banks and Unscheduled Banks. This sub sector can broadly be classified into:

The Indian banking system has a large geographic and functional coverage. Presently the total asset size of the Indian banking sector is US$ 270 billion while the total deposits amount to US$ 220 billion with a branch network exceeding 66,000 branches across the country. Revenues of the banking sector have grown at 6 per cent CAGR over the past few years to reach a size of US$ 15 billion.

Almost 80% of the business are still controlled by Public Sector Banks (PSBs). PSBs are still dominating the commercial banking system. Shares of the leading PSBs are already listed on the stock exchanges.

The roadmap for the banking sector unveiled by the RBI on budget day reconciles the often-conflicting positions of the several players - the foreign banks, the domestic private banks and other stakeholders. Finance Minister, P. Chidambaram said that relevant legislative measures will be introduced to give the Reserve Bank of India flexibility in prescribing the statutory pre-emptions for CRR (cash reserve ratio) and SLR (statutory liquidity ratio). These will help the central bank manage monetary policy better. Banks will be allowed to issue preference capital that can under certain circumstances qualify as regulatory capital under the Basel II accord. The RBI will also be enabled to supervise the consolidated balance sheets of banks and their subsidiaries in line with best international practices. Inevitably legislative changes such as these will take time.

Performance getting better and better

Indian banks have done quite well, especially in terms of efficiency and non-performing loans. But there is still a long way to go before they can catch up with their peers in the US, the UK, Germany or China.

According to figures given by Dr Rakesh Mohan ,the RBI Deputy Governor in regard to the efficiency and productivity indicators of the Indian banking system, some commendable achievements can be seen. An impressive figure is that of non-performing loans to total advances, which has declined from 24.8 per cent in 1994 to 3.5 per cent in 2005 in respect of public sector banks. For foreign banks, the ratio is significantly lower (2.8 per cent) and in new private banks (3.6 per cent), both for 2004. The corresponding figures for China in 2004 stood at 15.6 per cent, Indonesia at 13.4 per cent, South Korea at 1.7 per cent, the US at 0.8 per cent, the UK at 2.2 per cent and Japan at 2.9 per cent.

The cost-income ratio of Indian banks also shows similar picture of improvement over the years. The cost to income ratio of public sector banks declined from 58.4 per cent in 1992 to 45 per cent in 2004. For all scheduled commercial banks taken together, the decline was from

55.3 per cent to 45.1 per cent. Foreign banks, however, showed an increase in the ratio from 30.9 per cent to 42.8 per cent. The productivity indicators of Indian banks show a similar pattern over the reform period. All these are, no doubt, impressive advances. But the gnawing question remains whether they will survive increasing regulatory rigour!

A comparison with banks in major Asian countries, however, gives a slightly less flattering picture. Intermediation costs (operating expenses as percentage of assets shows a range from 1.01 in China to 2.19 in India in 2004, Indonesia at 2.94, the Philippines at 3 are worse than India. While India's figures have declined from 2.77 in 1996 to the current level of 2.19, China had a head-start with a low figure of 1.23 in 1996, showing a lower level of operating expenses in general.

A comparison of the interest rates in the US, the UK, Australia and Canada with India's has shown that the country has recorded the third largest hike in the last 12 months (June 2005-June 2006). Next only to the US and Canada, this clearly shows interest rate movements in India are increasingly driven by global rates. Interest rates in India have gone up by 75 basis points, while the US Fed rate has moved up by 200 (from 3% to 5%) basis points and Canadian rates have increased by 150 (from 2.5% to 4%) basis points.

Most of the commercial banks have substantially reduced their non-performing assets (NPAs) ranging between 29 per cent and 65 per cent, as they registered a handsome growth in their retail advances in the fourth quarter of fiscal 2005-06. Riding on the above 8 per cent growth of economy, the NPAs of the scheduled commercial banks went down by 44 per cent on an aggregate.

ICICI Bank and Oriental Bank of Commerce (OBC) have emerged as the top performing banks in terms of cleaning their bad assets and bringing down non-performing assets, taking advantage of healthy GDP growth and impressive topline and bottomline performance by borrowers. According to Assocham Eco Pulse study, ICICI Bank was able to cut its NPA by 65.02 per cent while OBC reduced its NPAs by 61.54 per cent as on March 31, 2006 as compared on March 31,2005.

One of the significant reasons for a substantial decline in NPAs in the banking system is the low level of default in the retail sector as compared to other sectors. The retail sector has also made a noticeable contribution in getting more business, as a major thrust to non-food credit growth has, in the recent years, emanated from sectors, particularly housing and retail loans. As a result of strong economic fundamentals, the aspirations of middle class people have grown on account of rise in income levels, as they have exhibited strong growth in their spending.

FY05 saw a shift in the revenue stream for the banking entities from non-banking to core banking activities. The rise in interest rates caused banks to book MTM (mark to market) losses for their investment portfolios, and treasury operations no longer remained profitable. At the same time, pick up in incremental credit growth (29% YoY) led to banks increase their credit deposit ratio to 58%. While the retail loans (comprising approximately 30% of total industry advances) grew at an average of 40% YoY, the growth in corporate loan book also showed signs of revival. Infrastructure loans (comprising 17% of total industry loans) grew by 22% YoY. Deposit mobilization, however, took place at a slower pace due to rise in cost of funds.

Retail Boom

How far is the retail boom sustainable? Retail market to grow at a CAGR of 8% till 2007. Corporate lending to rise on back of planned fresh capacities, to improve credit off take.

Retail lending (especially mortgage financing) formed a significant portion of the portfolio for most banks and the entities customized their products to cater to the diverse demands. With better penetration in the semi urban and rural areas the banks garnered a higher proportion of low cost deposits thereby economizing on the cost of funds.

The Indian players are bullish on the Retail business and this is not totally unfounded. There are two main reasons behind this. Firstly, it is now undeniable that the face of the Indian consumer is changing. This is reflected in a change in the urban household income pattern. The direct fallout of such a change will be the consumption patterns and hence the banking habits of Indians, which will now be skewed towards Retail products. At the same time, India compares pretty poorly with the other economies of the world that are now becoming comparable in terms of spending patterns with the opening up of our economy. For instance, while the total outstanding Retail loans in Taiwan is around 41% of GDP, the figure in India stands at less than 5%. The comparison with the West is even more staggering. Another comparison that is natural when comparing Retail sectors is the use of credit cards. Here also, the potential lies in the fact that of all the consumer expenditure in India in 2001, less than 1% was through plastic, the corresponding US figure standing at 18%.

With a jump in the Indian economy from a manufacturing sector, that never really took off, to a nascent service sector, Banking as a whole is undergoing a change. A larger option for the consumer is getting translated into a larger demand for financial products and customization of services is fast becoming the norm than a competitive advantage. With the Retail banking sector expected to grow at a rate of 30% players are focusing more and more on the Retail and are waking up to the potential of this sector of banking.

The policy makers are too moving in tune with changing times. Bank customers will soon know what services to expect from their branches and whom to approach in case of any grievance. The Code of Bank's Commitment to Customers, released by Dr. Y.V. Reddy, RBI Governor, provides protection to individual customers and explains how banks are expected to deal with customers in their day-to-day operations.

However, Of a total of 191,963,935 households in the country, only 68,230,642 households (35.5%) avail of banking services, according to the Census data. Of the 35 states and union territories covered, only eight reported that banking services were available to more than half its households.

Consolidation Moves

With as many as 27 Public sector banks, 31 Private banks and 29 Foreign banks anybody can say that there are just too many players in the industry. The Indian banking sector is headed for consolidation. The presence of many regional players will see few banks emerging as global competitors.

RBI's roadmap for the penetration of foreign banks and the acquisition of stake by the foreign entities in Indian private banks seems to be a step towards facilitating entry of foreign banks into India. The twin-phased roadmap also seems to be towards fulfilling the key objectives of competition, consolidation and convergence in the sector.

Prime Minister Manmohan Singh has asked public sector banks to explore the possibilities of consolidation to take on their bigger rivals -- foreign banks in India -- and increase their presence in overseas market.

"They (PSU banks) need to seriously examine possibilities for consolidation of PSU banks to give them both depth and reach. They must also devise effective global strategies for improving their international presence," Singh said. Pointing out that increased presence of foreign banks over time will pose further competitive challenges to domestic banks and also to the regulator, he said domestic banks are smaller in size relative to their international competitors, which are now very large indeed.

"If these large banks have emerged as a result of real economies of scale and scope, our own banking system will have to respond in kind both domestically and abroad," the Prime Minister said.

The Indian banking industry should hopefully see one or two cases of "true consolidation" before the end of the year, the Union Finance Minister, P. Chidambaram, said. "Weaker banks may have no option but to merge with banks having better capital. The Government maintains that the initiative should come from the banks themselves," the minister said. Consolidation can help save costs and effect optimal deployment of capital. Banks will also have to explore different avenues for raising capital to meet norms under Basel-II. These norms come into force in India from March 31, 2007 onwards. Banks would require low-cost capital under Tier-I and Tier-II. "The task is cut out for banks and they will have to speed up their efforts of raising capital," Chidambaram said.

Future belongs to technology

Cheaper delivery points like Internet and tele banking to improve their shares. ATM banking costs 80% while Internet and telebanking costs only 15% compared to normal banking transactions. Apart from streamlining their processes through technology initiatives such as ATMs, telephone banking, online banking and web based products, banks also resorted to cross selling of financial products such as credit cards, mutual funds and insurance policies to augment their fee based income.

The Prime Minister Manmohan Singh said in a speech: "If there is one aspect in which we can confidentially assert that India is ahead of China, it is in the robustness and soundness of our banking system." Indian banks have been rated higher than Chinese banks by international rating agency Standard & Poor's. With the credibility of the Indian banking system on a high, a number of Indian banks are now leveraging it to expand overseas.

To meet the challenges of going global, the Indian banking sector is implementing internationally followed prudential accounting norms for classification of assets, income recognition and loan loss provisioning. The scope of disclosure and transparency has also been raised in accordance with international practices. India has complied with almost all the Core Principles of Effective Banking Supervision of the Basel Committee. Some Indian banks are also presenting their accounts as per the U.S. GAAP. The roadmap for adoption of Basel II is under formulation.

The use of technology has placed Indian banks at par with their global peers. It has also changed the way banking is done in India. 'Anywhere banking' and 'Anytime banking' have become a reality. The financial sector now operates in a more competitive environment than before and intermediates relatively large volume of international financial flows.

Munish Mittal, V-P, HDFC Bank says: " Technology, unquestionably has played a key role in the evolution of a competitive banking sector. Technology has created speed, brought about accuracy and efficiency of operations, and thus driven down transaction costs. So the banker now has more time to effectively service the customer. We have moved away from an era when a visit to a bank had to be scheduled with careful advance planning, to an age where "any how, any time, any where, any type banking" is the mantra. Private sector banking companies themselves owe their success to the use of innovative technology."

Beyond the transition from manual systems to automated core banking, ATM, phone, internet and mobile banking enablement, some of the pioneering private and foreign banks have moved on to set up a highly technology enabled CRM strategy to acknowledge the customer's patronage, reward loyalty and offer very robust relationship-based service offering and price competitiveness, while ensuring there are defined service levels and a great deal of standardization.

Take the case of ATM alone. This machine has single-handedly enabled large metro, urban and semi-urban society with a choice to bank at their convenience.

And, ATM just does not offer a cash withdrawal or deposit facility; one can pay insurance premium or any utility bill, do a funds transfer between amongst the same customers-linked accounts, recharge one's prepaid mobile phone or simply obtain a mini-statement; passbooks are passé.

Bank Stocks and Investments

India is the second-largest new-growth market for private banking in terms of the number of wealthy households. Boston Consulting Group projects that growth in Asian offshore private banking will be fueled by those two countries for at least another five years. India's wealthy families have an estimated $560 billion in assets, and China's wealthiest have more than $700 billion. Investors seeking to expose their portfolio to these families can consider Asia's biggest private banks, which, according to the Financial Times, include Citigroup, HSBC, and UBS. With household wealth growing at slower levels elsewhere in the world, the rising riches on the subcontinent represent an opportunity that the big global players simply can't ignore.

Indian banks will face greater competition as foreign banks progressively increase their activities in India, post April 2009, said T. S. Bhattacharya, acting Chairman, State Bank of India. As per the Reserve Bank of India's roadmap, foreign banks may be permitted up to 75 per cent investment in a private Indian bank. This implies that Indian banks will face greater competition and squeeze on margins. The emphasis is there on product innovation, Bhattacharya said.

Opening up the foreign direct investment FDI route connotes several issues. Infusing foreign capital has been thought of as a way to resurrect weak banks in the private sector. One new generation bank, the Centurion Bank was rescued by the infusion of foreign direct investment. Greater clarity on the FDI issue will obviously benefit foreign banks such as the HSBC that has been unable to pick up an additional stake in the UTI Bank. In short, mergers and acquisitions within the banking sector may become more common if foreign direct investment is allowed more easily.

Beyond this foreign banks are expected to bring in superior technology and a range of financial products not readily available in India. However, the professed skills of foreign banks in these two areas may be exaggerated. Despite having a long association with India - in a few cases over 150 years - foreign banks have not made any impact. Their branch network is less than 0.5 per cent of the total bank network with 5 per cent of total deposits and less than 7 per cent of total assets. A common complaint has been that they were not allowed to grow in India.

The existing guidelines prescribe a 74 per cent limit for all types of foreign investment and at least 26 per cent for resident Indian capital. Foreign banks have been allowed to open branches or establish wholly owned subsidiaries or subsidiaries, which have investment up to 74 per cent in private banks.

For small cap investors, private sector banks are expected to continue their sector out performance through higher operating income growth and lower interest rate sensitivity. Amongst the PSU banks, we prefer banks with lower sensitivity to interest rate volatility and higher reliance on credit off-take to drive performance. Our top picks amongst the PSU banks are SBI, PNB and UBI, while we prefer ICICI Bank and UTI bank amongst the private banks.

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Public sector banks have either the Government of India or Reserve Bank of India as the majority shareholder. This segment comprises of:
* State Bank of India (SBI)and its subsidiaries
* other nationalized banks.
The State Bank of India has been, over the years, the flagship of Indian banking. State Bank of India is the largest bank in India in terms of profits, assets, deposits, branches and employees. With a network of over 9,000 branches in India and 51 foreign offices in 32 countries, the Bank commands about one-fifth of the total deposits and loans in all scheduled commercial banks in the country.

State Bank of India has the following seven Associate Banks (ABs) with controlling interest ranging from 75% to 100%.
State Bank of Bikaner and Jaipur (SBBJ)
State Bank of Hyderabad (SBH)
State Bank of Indore (SBIr)
State Bank of Mysore (SBM)
State Bank of Patiala (SBP)
State Bank of Saurashtra (SBS)
State Bank of Travancore (SBT)

Nationalised Banks
* Allahabad Bank
* Andhra Bank
* Bank of Baroda
* Bank of India
* Bank of Maharashtra
* Canara Bank
* Central Bank of India
* Corporation Bank
* Dena Bank
* Indian Bank
* Indian Overseas Bank
* Oriental Bank of Commerce (OBC)
* Punjab and Sind Bank
* Punjab National Bank (PNB)
* Syndicate Bank
* UCO Bank
* Union Bank of India
* United Bank of India (UBI)
* Vijaya Bank

Old Private Sector Banks
* Bank of Rajasthan
* Dhanalakshmi Bank
* Federal Bank
* ING Vysya Bank
* Jammu and Kashmir Bank
* Karnataka Bank
* Karur Vysya Bank
* Ratnakar Bank
* SBI Commercial and International Bank
* South Indian Bank
* United Western Bank

New Private Sector Banks
* Bank of Punjab (merged with Centurion Bank)
* Centurion Bank
* Development Credit Bank
* HDFC Bank
* ICICI Bank
* IndusInd Bank
* Kotak Mahindra Bank
* UTI Bank
* Yes Bank

Foreign Banks
* ABN-AMRO Bank
* Abu Dhabi Commercial Bank Ltd.
* American Express Bank Ltd
* BNP Paribas
* Citibank
* DBS Bank Ltd
* Deutsche Bank
* HSBC Ltd
* Standard Chartered Bank

Disclaimer
Dr. Uday Lal Pai is an independent columnist for this web site. Dr. Uday Lal Pai  may hold long or short positions in any of the stocks mentioned in this article and those positions can change at any moment. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp, InvestorIdeas is not affiliated or compensated by the companies mentioned in this article. Dr. Uday Lal Pai  is a freelance writer. Nothing in the articles should be construed as an offer or solicitation or recommendation to buy or sell any specific products or securities. Past performance does not guarantee future results.

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