Description
The document describes analyze the factors that will determine the future profitability of the banking sector.
Future of Banking Sector
VARUN GUPTA 2009A62
Future of Banking Sector 2009
Executive Summary
The banking sector is pivotal to any economy?s well being, essentially because it tends to lead investments by corporate in productive sectors. Given that domestic consumption and investments together account for close to 90 percent of GDP, we believe that both these engines would continue to engage policymakers? time and attention. Hence, if the economy were to grow at close to 6 percent or thereabouts, investments need to continue in a host of productive sectors. To fund these investments, corporate India will continue to depend heavily on banks. In this report, I have attempted to analyze in depth the factors that will determine the future profitability of the Banking sector: ? ? ? ? ? ? ? ? Improvement in economic outlook Credit Growth Deposit Growth Interest Rates Margins of the banks Asset Quality of the banks ( NPA Concern) Consolidation/ Mergers& Acquisition of Banks Regulatory Changes to boost growth & profitability
Despite the growth and asset-quality issues facing global financials, Indian banks are likely to sustain their structural growth trajectory, driven by an under-penetrated financial-services sector, a conducive economic environment and a supportive regulatory regime. An estimate of 17% credit CAGR over FY09-14. Over the next five years, bond-market development will lead to commoditisation of credit and margins will mainly be a function of retail liability franchise. The 10 year G?Sec yield is expected to remain in the range of 7?7.3% levels in FY10. A major portion of the bank?s investment book is hedged till 7.5% levels, therefore I don?t expect large MTM hits even if the yield touches 7.5% mark in the current fiscal. Earnings visibility of the sector has improved with superior outlook on credit, margins and asset quality of the banks. As the distribution network and technological infrastructure become basic requirements - which are insufficient to drive profit on their own - softer skills such as service standards and product innovation will be critical to enhance the franchise. Fee growth is likely to be healthy as a pickup in corporate activity further boosts retail-fee momentum. Industry consolidation is expected to continue, but big-scale M&A activity is unlikely. However, regulatory relaxation will help improve the industry?s overall profitability. The report elucidates facts & key structural aspects about the Indian Banking Sector, supplemented by latest statistical data and comprehensive analysis that will support the above. As
per the analysis Banks would be the key beneficiaries of the revival in the economic growth.
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Future of Banking Sector 2009
Table of Contents
Executive Summary................................................................................................................................. 2 Table of Contents .................................................................................................................................... 3 Overview to Indian Banking .................................................................................................................... 4 Sector Outlook ........................................................................................................................................ 5 1. 2. 3. 4. 5. 6. 7. 8. Improvement in the economic outlook of major economies ..................................................... 5 Credit growth .............................................................................................................................. 6 Deposit Growth ......................................................................................................................... 10 Interest rate Effect/Risk ............................................................................................................ 11 Margins are expected to improve ............................................................................................. 13 NPA concerns ............................................................................................................................ 14 Consolidation to increase, but M&A to remain subdued ......................................................... 16 Supportive regulatory regime to boost growth, profitability ................................................... 17
Bibliography .......................................................................................................................................... 20 Annexure ............................................................................................................................................... 21
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Future of Banking Sector 2009
Overview to Indian Banking
The Indian banking can be broadly categorized into nationalized banks, private banks and specialized banking institutions. The Reserve Bank of India acts a centralized body monitoring any discrepancies and shortcoming in the system. Since the nationalization of banks in 1969, the public sector banks have acquired a place of prominence. The need to become highly customer focused has forced the slow-moving public sector banks to adopt a fast track approach. The unleashing of products and services through the net has galvanized players at all levels of the banking and financial institutions market grid to look anew at their existing portfolio offering. Conservative banking practices allowed Indian banks to be insulated partially from the Asian currency crisis. Indian banks are now quoting al higher valuation when compared to banks in other Asian countries (viz. Hong Kong, Singapore, Philippines etc.) that have major problems linked to huge Non Performing Assets (NPAs) and payment defaults. Cooperative banks are nimble footed in approach and armed with efficient branch networks focus primarily on the „high revenue? niche retail segments. The Indian banking has finally worked up to the competitive dynamics of the „new? Indian market and is addressing the relevant issues to take on the multifarious challenges of globalization. Banks that employ IT solutions are perceived to be „futuristic? and proactive players capable of meeting the multifarious requirements of the large customers? base. Private Banks have been fast on the uptake and are reorienting their strategies using the internet as a medium The Internet has emerged as the new and challenging frontier of marketing with the conventional physical world tenets being just as applicable like in any other marketing medium. The Indian banking has come from a long way from being a sleepy business institution to a highly proactive and dynamic entity. This transformation has been largely brought about by the large dose of liberalization and economic reforms that allowed banks to explore new business opportunities rather than generating revenues from conventional streams (i.e. borrowing and lending). The banking in India is highly fragmented with 30 banking units contributing to almost 50% of deposits and 60% of advances. Indian nationalized banks (banks owned by the government) continue to be the major lenders in the economy due to their sheer size and penetrative networks which assures them high deposit mobilization. Industry estimates indicate that out of 274 commercial banks operating in India, 223 banks are in the public sector and 51 are in the private sector. The private sector bank grid also includes 24 foreign banks that have started their operations here.
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Future of Banking Sector 2009
Sector Outlook
1. Improvement in the economic outlook of major economies
More than a year after the US officially declared its economy to be in recession; the IMF has in its recent report on World Economic Outlook (WEO) noted that the world economy is stabilizing which is an outcome of unprecedented macroeconomic and financial support. IMF, in its WEO October update, has revised upwards the world GDP growth rate by 60 bps to 3.1% for CY2010 from its July 2009 estimates of 3.1% ? this stands out to be a huge revision in just 3 months. If the global GDP grows by 3.1% in CY2010, then world economy would be officially out of one of worst recessionary period it had seen after Great Depression of 1930s. Major economies like the US and UK, which were expected to register a near 0% growth rate 3 months ago, are now expected to record growth of 1.5% and 0.9% respectively – an upward revision of 70bps and 70bps respectively from the IMF?s previous forecast in July?09. In addition to this, major euro zone economies like Germany and France have reported a positive growth of 0.3% in Q2 (April?June quarter) of 2009. See Annexure: Table 1 However, the IMF also added that though downside risks to the outlook continue to exist, they have noticeably moderated. The pace of recovery is slow, and activity remains far below precrisis levels. The pickup is being led by a rebound in manufacturing and a turn in the inventory cycle, and there are some signs of gradually stabilizing retail sales, returning consumer confidence, and firmer. If such moderations prevail and eventually lead to a recovery, it can prove to be a major positive for International Trade. India?s external trade has continuously reported negative growth in the preceding ten months which has affected major employment sectors dependent on exports. See Annexure: Table 2
1.1 US economy shows diminishing rate of deterioration
Four major indicators that the National Bureau of Economic Research (NBER) in the US considers apart from the real GDP to officially declare or call?off recession – 1) the real income, 2) the employment scenario, 3) the industrial production, and 4) wholesale retail sales have been flagging a diminishing rate of deterioration. The overall confidence in the economy as seen in recent Consumer and Business Confidence surveys has also improved. The scenario suggested by the indices and statistics has been found to be consistent with a stabilization of output seen in the H2 of 2009. Hence it is expected that a gradual recovery would emerge in 2010. The scenario that is building up offers optimism, however overall recovery cannot be accurately timed as it is not expected to be uniform.
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Future of Banking Sector 2009
1.2 Domestic economy witnessing signs of strong resilience
The India economy stood reasonably shielded owing to the absence of the toxic subprime assets from the financial ledgers of its system. The predominant domestic demand driven economy also acted as a strong cushion against the global economic turmoil. The Indian economy though not the worst hit could not completely decouple from the effects of a recession in the industrial countries. A sustained sell?off in the equities and a subsequent pull?out of capital out of the country caused substantially tight conditions declining continuously from 8.6% in Q4FY08 to 5.8% in Q4FY09. See Annexure: Table 3 The Reserve Bank of India, taking note of the developments announced some sweeping changes to the policy regime. The LAF signal rates significantly cut by 400bps and the CRR was cut by 400bps at the beginning of mid?FY09. The government of India followed up by announcing a fiscal package each in December 2008 and January 2009 to stabilize a slowing economy and thereby further stimulate economic activity. After witnessing three quarters of declining industrial production, the policy measures announced in the form of monetary and fiscal stimulus bore the desired results and the economy appears to be on the road to a sustainable recovery. The latest data on Index of Industrial Production estimated that June growth at 7.8% is well ahead of mean street expectations of 3.7% and the highest estimate of 4.8%. Core segments of intermediate goods and capital goods have also registered robust growth. The mining and manufacturing indexes recorded the sharpest rise in over a decade. Consumer durables reflecting consumer spending on white goods also recorded a strong 15.3% Y?o?Y growth. See Annexure: Table 4 The RBI survey of economic forecasts pegging the country?s fiscal 2010 real GDP growth rate upwards of 6% despite a weak monsoon has been equally encouraging. I believe that the upgrades are suggestive of robust resilience in the domestic economy which is also being reflected by the data releases in the core sector. Cement dispatches, steel production, commercial vehicles, and non?commercial vehicle segment have also registered strong growth in the recent months.
2. Credit growth
Sectoral credit to grow at a healthy rate of 19?20% on Y?o?Y basis in FY2010 based on the premise that GDP sustains a growth rate of 6% in the current fiscal, thereby taking the loan growth to a real GDP multiplier of 2.7x (average multiplier of last 3 years). A recent study by CRISIL that has exhaustively compiled planned capex across various industry segments, debt funding required for such capex, and expected repayments during the year also points to credit growth of 20% Y?o?Y growth in FY10. A major chunk of this is expected to crystallize in the late 3QFY09. Other parameters which suggest healthy credit growth are briefed below: 1) Global and domestic economy showing signs of stabilization – restoring corporate confidence– In the Q1FY10 monetary policy review, RBI has highlighted that the knock on effects of the global financial crisis seem to be receding with global economy showing incipient signs of stabilization coupled with the revival of the industrial activity in a number of emerging
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Future of Banking Sector 2009
economies. In our view, this would restore the corporate confidence which would be crucial for the revival of credit demand in the economy. 2) Strong investment pipeline of companies – We expect credit demand to pick up both in term and working capital loans segments. CMIE data shows that the Corporates have made investments into capacities of more than 5 trillion which will translate into the credit growth of 18% (on current outstanding credit of SCBs) from the industrial segment alone whose share in the total outstanding bank credit is at 37.7%. These investments would however translate into staggered growth in the credit outlay of the banks. In addition to this, we expect demand for the working capital loans to again momentum with an upward movement in the commodity cycle. Our interaction with the bankers? has brought to knowledge that there are considerable amount of sanctions suggesting a potential real demand which could materialize into higher credit growth in the coming quarters. 3) With the reduction in the lending rates, viability and internal rate of return (IRR) of the projects has improved appreciably over the last 6 months and this could create a strong credit demand. (SBI BPLR has come down by 200 bps to 11.75% from peak of 13.75% in August). Banks? higher lending rates was one of major cause which had resulted in subdued credit growth in the second half of the last fiscal bringing down the full year growth to 18% levels v/s 22.8% growth seen in FY08. See Annexure: Table 5
2.1 Expect demand revival to be led by corporate loans, select retail to show growth
The demand for the agriculture loans is seasonal and steady; it is known to accelerate during the crop seasons. Given the norms of priority sector lending, PSBs have maintained a corresponding a high agriculture portfolio with heavy lending to the farm sector. It is expected that the demand to sustain. Agriculture apart, it is expected that the initial demand for credit to come from the corporate segment. Corporate are now in a rush to get capex proposals approved and achieve financial closure. Hence, it is believed that the pick-up in the credit cycle should be led by revived demand from the corporate segment. Pick up in retail, particularly the residential mortgages and auto loans might be driven by temporary favourable price elasticity in this segment as banks have announced special rates for specific periods. However, a sustained pick up for retail credit will take some time and shall be dependent on other important variables like economic outlook and stability in the job market, clarity on asset prices etc. Initial growth should again be led by SME segment which typically is the first to be hit in the event of a downturn and takes longer to recover in the event of an upturn. Thus demand is seen to persist in the SME segment while the large corporate should generate healthier demand for demand loans. See Annexure: Table 6 & Table 7
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Future of Banking Sector 2009
2.2 Challenges
Key challenges for banks are intensifying competition in lending activity from non-banking sources like insurance companies, mutual funds, overseas investors and external commercial borrowing (ECB); and mobilisation of long term resources for project and infrastructure financing. It is expected that corporate loans to drive credit growth; share of retail credit is unlikely to rise, as banks remain averse towards high-risk, unsecured retail loans. Project financing will drive corporate credit demand (including infrastructure projects), as companies build up new capacities and government increases infrastructure spending. Demand for working capital is also likely to rise as most industries have reached peak efficiency levels and their working-capital demands will reflect volume pickup. Challenge 1 - Deposit mobilisation Over the past decade, Indian banks have expanded their loan book ahead of their retail-depositgrowth rates. This was due to their ability to sell down excess government-securities (G-Sec) holding and the rising proportion of borrowings. With minimal excess statutory-liquidity-ratio (SLR) holding, drying-up of flow from non-banking sources (due to rising capex and higher alternative investment options), it is expected that the banking credit growth over the next five years to be a function of retail deposit inflow in the banking system. See Annexure: Table 8 In the past five years, banking-sector deposits have seen a healthy CAGR of 20%, driven by a host of factors: acceleration in nominal GDP growth; rising savings rate; increasing proportion of bank deposits in total financial savings; and inflow of non-retail deposits. With most of these factors being close to their peak levels, I don?t foresee deposit growth running ahead of its long term average multiple (to GDP) and hence are building in a moderation in deposit growth to 16% per annum over FY09-14. The key for banks to boost their deposit growth will be to increase presence in semi-urban and rural areas to improve banking penetration. See Annexure: Table 9 Challenge 2 - Rising competition in the lending space Credit growth for Indian banks over the next five years will not be as smooth as it has been over the past decades. Recent trends suggest new competition in the lending space from insurance companies, mutual funds and even foreign companies participating in the debt market. The entry of these new players forces Indian banks to restrict their balance-sheet growth to the extent that they are able to mobilise retail deposits. See Annexure: Table 10 Banks will also find it difficult to provide long-term financing due to their shorter maturity profile. On the other hand, insurance companies have an ever-growing demand for long-term investments, due to their fast-growing corpuses, which are also long-term in nature. Other nonbanking sources such as external commercial borrowings (ECB), insurance companies, mutual funds have also reported an increase in appetite for corporate debt over the past few years. It is estimated that insurance companies will have an appetite for about Rs3.1tn of corporate bonds/debentures (9% of incremental bank credit) over FY09-14. Demand from mutual funds will be another Rs2.6tn, at least over FY09-14. Ease of foreign-ownership norms for investments in debt will also boost foreign participation in long-term financing, threatening Indian banks.
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Future of Banking Sector 2009
These sources collectively could invest/lend Rs7-8tn to the corporate sector, ie, almost 24% of incremental banking credit over FY09-14 (34% of incremental corporate credit). Hence, even though we expect credit-demand growth to be about 20% per annum; we have built in a 17% bank-credit CAGR, factoring in the rising share of non-banking players. See Annexure: Table 11 Challenge 3 - Requirement for long-term resources Indian banks have historically focused on financing working-capital loans, while development financial institutions (DFI), such as Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI) and ICICI, funded long-term project loans. With the death of the DFIs in early 2000, over the past few years banks have been funding even long term project loans, but with limitations due to the shorter maturity profile of their liabilities (only 15% of deposits have maturity of over five years). With long-term project financing making up more than 60% of incremental credit demand, it is the key for banks to mobilise long-term liabilities, especially given the rising competition from insurance companies and foreign investors. Recent regulatory incentives, such as tax benefits on long-term deposits, have boosted flow of long-term deposits for banks. Given the government?s focus on infrastructure, it might offer some more sops to banks (in the form of tax-free bonds, etc) to improve flow of long-term retail deposits. See Annexure: Table 12
Challenge 4 - Capital constraints are bank-specific With ROE improving to 17% and the switch to Basel II, resulting in release of Tier I capital, Indian banks are adequately capitalised to support a 17% loan CAGR over the next five years. However, in some specific cases, banks targeting aggressive loan growth may look to raise capital. See Annexure: Table 13
2.3 Traditional lending to be commoditised
Over the next five years, banks? inability to fund long-term projects, rising demand for corporate debt paper from non-banking sources (discussed in the earlier section) and Basel II norms will facilitate the development of an active corporate-bond market in India. This will lead to commoditisation of corporate credit to some extent. With credit getting commoditised, liability franchise will become the key margin driver, while risk-evaluation skill set will be increasingly important for banks that are active in syndication. Even though India has been considering a bond market for quite some time, we believe the catalysts are now in place. A key hindrance to the development was a lack of a wider investor base, with banks being the only investor for corporate debt. However, rising assets under management (AUM) of insurance companies and relaxation of foreign-ownership norms in corporate debt have boosted demand for corporate debt, and could be the much-awaited catalysts for the development of bond markets. A wider base of rated corporate debt is a prerequisite for greater participation of non-banks in corporate funding. Implementation of Basel II norms is driving banks to encourage their customers to get “rated” as it allows banks to utilise their capital efficiently, improving ROEs. Banks pass on some benefits to customers by cutting rates.
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Future of Banking Sector 2009
3. Deposit Growth
Systemic deposits to comfortably achieve growth of 19.5 percent in FY10E and 19 percent in FY11E, assuming that the economy will continue to generate a GDS in excess of 35 percent and a nominal GDP growth of 11 percent. Based on the assumption that the share of the banks deposits in the incremental savings will fall to levels seen in FY06, it is still expected for reasonable healthy growth in deposits. Bank term deposits are preferred instruments of house hold financial savings in India as indicated by GDS. Corporate savings have also significantly invested in bank term deposits apart from the liquid mutual funds. Hence, it is believed that the share of the bank deposits in the incremental GDS may not drop to alarming lows. The 3Qfy09 saw aggressive growth in the systemic bank deposits, but certain key competitive features of bank deposits have undergone notable change in the last two quarters, mainly: 1. The interest rates offered on bank deposits across various tenors have declined 300-400 bps in the last two quarters. 2. Rates now offered on one year maturity deposits are 150-200bps lower than the post office small saving scheme rate of 8 percent. 3. Revival of investor interest in equity markets and equity linked saving schemes is being anticipated.
3.1 Focus to remain on retail and low cost deposits
Banks aggressively mobilized deposits from retail depositors during Fy09 while they tried to reduce their dependence on institutional or bulk deposits. Though the definition of wholesale deposits varies with every bank, in general parlance, it is typically understood as a large ticket deposit (>Rs 10 million) carrying a specially quoted interest rate that is distinct and usually higher from the published card rate of bank. The massive fall in rates of bulk deposits has led to significant cost re-pricing benefits. However, given the extreme volatility observed in the rates of wholesale deposits between cycles of high economic growth and economic slowdown, banks are wary; they are instead focusing on expanding their retail client base and acquiring retail and low cost deposits. This practice is drawn from the generally anticipated scenario of the beginning of economic revival a couple of quarters ahead which can lead to gradual firming up of interest rates again making bulk deposits costlier than retail deposits. See Annexure: Table 14
3.2 Penetration levels suggest healthy potential
Despite the aggressive growth in most financial segments over the past decade, the Indian financial sector offers structural growth opportunities given the under-penetration of most financial products/services and an expanding target market. Even though Indian banking credit has enjoyed a 27% CAGR (23% in US-dollar terms) over 2003-08, credit penetration remains well below regional benchmarks, suggesting healthy growth potential for the next five years. Even large banks such as SBI, ICICI and BoB have been able to expand their loan book at about a 30% CAGR over FY04-09 and may continue to gain market share.
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See Annexure: Table 15 The credit growth has encompassed all sectors. However, retail credit growth has been a primary driver, having delivered a 51% CAGR with share of retail credit in total bank credit rising from 10% in FY04 to 22% in FY09. Not only has industrial credit seen a healthy 27% CAGR, incremental lending has been much diversified compared to in the mid- and late-1990s. See Annexure: Table 16
3.3 Target market still expanding
While existing penetration levels are low, the “bankable population” is expanding at a healthy pace led by economic growth momentum, especially in rural India, and favourable demographics. The structural opportunity for banks is evident from the fact that more than 30% of Indians are below 15 years of age and over the next five to 10 years will enter in the “bankable population” category. The younger generation is far more open to consumer loans, financial products like insurance, mutual funds, wealth management, etc, and thereby offers a much bigger revenue pie for financial-service providers. See Annexure: Table 17
4. Interest rate Effect/Risk
Interest rates are expected to remain in the range of 7?7.3% levels in FY10; they are likely to inch upwards by 50?100 bps from the fiscal year FY10 end in line with improvements in the business cycle, reversal of expansionary monetary policy, and rise in inflation. During the same period, surplus banking liquidity (under RBI LAF window) is expected to diminish largely on account higher credit growth. Fundamentally, interest rates undergo a marginal fall in the recessionary period, they rise steadily with the recovery and finally, increase at the end of the growth period to brake the possible inflationary dynamics. Below are explained few of the important factors that would influence the interest rates going ahead: 1. Improvement in business cycle – signals higher interest rate regime Fluctuations in the economy, often referred to as a business cycle, correspond to changes in the business conditions. When the real GDP zooms business registers good returns, profits of the firms expand and hence demand for investment is also high during such phases. Hence, this entire phase signifies higher demand for money leading to a higher interest rate scenario. Over the last 10 months, global recessionary pressures led to sharp fall in the domestic demand for investment resulting in decline in the interest rates of the economy (during the same period rates were also influenced by central bank?s intervention). Going ahead, we expect increase in the domestic output would lead to revival in the investment demand which could cause the interest rates to rise in FY11. See annexure: Table 18
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2. Expansion of monetary policy most likely to reverse in the beginning of March 2010 Going ahead, the central bank?s policy objective would be to stimulate economic growth and at the same time curb the inflationary pressures, unlike earlier where for the last 11 months growth accorded high priority over inflation management. Tightening of monetary policy to begin from March 2010, because an earlier reversal of economic policy would hurt the economic growth. RBI may intervene if the inflation pressures increases the 6-6.5 percent mark; chances of inflation crossing that mark is bleak. RBI?s survey of professional forecasters estimate the median value of WPI inflation to be 5.4 percent for the year ending march 2010, which is close to the RBI estimate of 5 percent. Beginning March 2010, the inflation going to be triggered by 1) Increase in commodity price 2) Rising food grain prices due to the delayed rains 3) Current surplus liquidity which holds the potential to create inflationary pressures. See Annexure: Table 19 3. Higher borrowing programme not likely to impact money supply For the fiscal year 2010, the central and state government net borrowing program is estimated to be Rs 3980 billion and Rs 1400 billion respectively summing to Rs 5380 billion. The central government has already completed 37 percent of its planned borrowings while the remaining 63 percent is programmed for the rest of the year. As per the analysis the market can absorb a fresh supply of securities without materially impacting the money supply. Net shortfall in the liquidity due to the central?s government borrowings borrowing stands at Rs 350-518 billion only. The shortfall will turn into surplus if the banks increase their SLR above 29 percent levels. See annexure: Table 20 4. Higher capital inflows would call for tighter monetary regime The monetary policy framework in India also targets monetary aggregates, chiefly the broad money or M3. The M3 components between FY06?FY09 were heavily influenced by strong flows of external capital in the form of portfolio investments, corporate borrowings, and bank deposits. This period also saw the interest rate cycle coming full circle with the tightening that commenced in early FY06 finally leading to an extremely accommodative monetary policy towards the end of FY09. The policy rates and CRR requirement which was raised to the highest in the period was brought down below the level prevailing at the beginning of the cycle. The FY09 was also the period when India witnessed a net outflow of USD 20bn compared to a cumulative inflow of USD 144bn FY06 through FY08. Given the extremely accommodative stance of the policy at present, additions to domestic liquidity can prove to be inflationary and may therefore need sterilization. Hence we believe the policy actions of previous cycle will repeat with a gradual tightening bias as an expanding liquidity begins pushing the M3 faster. Though RBI has currently targeted the M3 to grow at 18% Y?o?Y, the current growth stands at 20% Y?o?Y.
4.1 Banks not to suffer large MTM hits in FY10 even if the G-Sec yields touches 7.5%
10 year benchmark yield would remain in the range of 7?7.3% levels while it would start moving upwards from end Mar?10 onwards. Banks won?t suffer from large MTM hits on their AFS book in the current fiscal even if the yields touches 7.5% mark as most of the them are hedged till the
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said rate. However, in next fiscal, with the rise in the interest rates, banks would have to take higher MTM hits couple with higher provisioning levels on their investment book. However, higher credit growth, margin expansion would compensate for the losses on investment book in FY11, while keeping the profitability growth of the banks unabated. In the scenario, private sector banks would enjoy distinct advantage over the PSU counterparts as former carry lower duration of investments which results in lower losses on their AFS book. PSU banks have shown sharp volatility in their earnings due to unpredictable losses or MTM hits on their investment book which is an outcome of high duration of their investments. Contrary to this, private sector banks have lower duration of their investments which is more representative of the current yields and hence lesser variance to their investment book yields resulting in lower losses. Lower duration on investments also causes banks to provide lesser for investment depreciation provisions. See Annexure: Table 21
5. Margins are expected to improve
Q1FY10 margins of the banks were at cyclical low levels as assets have re?priced at faster pace than liabilities with the interest rate cycle coming down. However, margins across the sector are likely to improve from the current levels as the total impact of re?pricing of liabilities is yet to reflect in the margins (along with re?pricing of high cost bulk deposits). The uptick in the credit demand will further give pricing power to banks capping the fall in their advances yields. Our view of improvement in the margins is supported by the followings arguments – 1) Pricing power of the banks will be back in the reckon with the improvement in the credit demand – Since Oct?08, banks have gone for aggressive lending rates cuts i.e. PSU banks have reduced their PLR by 200 bps, private banks by 100 bps and foreign banks by 50 bps which was largely driven by decline in the investment demand and also due to regulatory forbearance to bring banks? PLRs down. Fundamentally, lending rates behave as a function of demand and supply of the credit (and availability of liquidity in the market) i.e. lending rates harden if the demand for credit exceeds its supply and vice-versa. Going ahead, in our view, with the improvement in the credit demand, banks will gain the pricing power resulting in lending rates of the banks to improve or at least stabilize at current levels. In addition to this, over the last 8 months, reduction in the deposits rates have been sharper than the lending rates, which is expected to provide some cushion to the margins of the banks. 2) Expansion of the low cost deposits could support margins – Due to the recessionary pressures felt in the economy during 2HFY2009, the current account balances of the corporate with the banks had fallen considerably. They fell to negatives in the case of few banks wherein current account holders had turned net borrowers, than depositors. This has resulted in fall in the CASA ratio of the banks. With the improved economic scenario, we expect banks to show absolute growth in the current deposits, although, maintaining the CASA ratio for banks would be a challenge. 3) Cost benefits on re?pricing of bulk deposits – Banks, which have a greater share of bulk deposits on their balance sheet, have been prone to very volatile margins recently. During 1HFY2009, banks had accumulated a huge chunk of high cost bulk deposits at the rate > 9% anticipating a liquidity crunch in the economy. The rate has
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affected their margins adversely over the last 2 quarters. On an average, nearly 20?40% of bank?s term deposits comprise of bulk deposits, this ratio is as high as 90% for the wholesale funded banks like Yes Bank. With the interest rates on the bulk deposits crashing down by more than 600 bps (i.e. from peak of 12.9% in Oct?08 to 6.6% currently) over the last 11 months, banks would receive considerable cost re?pricing benefits when these deposits would mature in Q2 and Q3 of FY2010. However, its impact on the margins would depend on the quantum of the redemption of these bulk deposits i.e. higher the redemption amount higher the improvement in the margins. 4) Improvement in the C/D ratio – C/D ratios usually improve in the boom cycles while it declines in the bust cycles. Over the last 9 months, banks have recorded a decline in their CD ratios i.e. they have posted stronger deposit growth, while on the other hand, equivalent credit off-take has not picked up which has eventually pressurized margins. In our view, this scenario is likely to reverse, with the revival in the credit demand, C/D ratio of the banks will improve ultimately resulting in fall in the I/D ratio – which would further cushion the banks? margins.
6. NPA concerns
Over the last one year, with the economy entering the slower growth phase there have been looming concerns on the astoundingly high NPAs levels of banks, which had led to abrupt sector downgrades. In our view, economic growth would overturn to a recovery phase in the current fiscal which would lessen the NPA concerns to a large extent ? Faster the economic recovery, shorter would be NPA cycle. Post the fiscal stimulus packages, many of sectors have rejuvenated which has been reflected in their Q1FY10 strong profitability numbers. Cement dispatches, steel production, commercial vehicles, non?commercial vehicles volumes have all shown strong growth in the recent months. We believe all these factors are early indicators of improvement in the business cycle of the economy.
6.1 Stimulus packages have eased pressures in high-stress sectors
Over the past nine months, the Indian government has announced multiple measures, aiming to accelerate demand in sectors like real estate, steel, autos, and extend support to labour-intensive, export-oriented sectors like gems and jewellery and textiles. The impact has been fairly prompt and visible, with industries such as autos, cement and real estate already showing a pickup in activity, partly driven by the pent-up demand itself. See Annexure: Table 22 The Reserve Bank of India?s restructuring guidelines also facilitated the revival in these sectors, as it encouraged banks to take a slightly longer term view in financing the stressed sectors that were facing a temporary liquidity crunch. See Annexure: Table 23
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6.2 Stressed assets are 6.3% of loans, much lower than estimates
Sales pickup in these sectors also eased debt-servicing pressure, which was reflected in lowerthan-expected 4QFY09 NPLs. Most banks reported flat to marginal increase, despite what were arguably the toughest two quarters for corporate India in recent history. While the lower NPLs were also a result of „regulatory flexibility? given to banks with respect to „restructuring of loans?; even gross stressed assets (NPL plus restructured loans) for the sector, at 6.3% of loans, were much lower than concerns of double-digit NPLs. We are building in gross NPLs increasing to above 2.5x FY09 levels over the next two years, ie, from an estimated Rs689bn as on March 2009 to Rs1.7tn by March 2011. Gross NPLs as a share of advances will rise from 2.5% in FY09 to 4.4% by FY11. See Annexure: Table 24
6.3 Loan-loss charges to rise, but will be manageable
It is expected for Indian banks? asset quality to deteriorate, but the resultant increase in loan-loss charges should be manageable. Based on the current estimate of increase in gross NPLs, it is forecasted the loan-loss provision will rise from 88bps in FY09 to 130bps in FY11. But as highlighted earlier, actual provisioning could be lower if economic growth momentum remains stable or improves. See Annexure: Table 25
6.4 Restructured assets
Our analysis shows that top 14 banks of the country have restructured Rs633.9 billion worth of assets so far i.e. Rs380.3 billion restructured till Q4FY09 and Rs253.6 billion in Q1FY10. The Q1FY10 performance of the assets which were restructured in Q4FY09 was encouraging as an insignificant amount of assets restructured under the special RBI dispensation slipped during the Q1FY10. Any further development of stress may be delayed if the RBI extends the scheme to restructure assets. In addition to this, the bank management?s have sounded optimistic on slippage risks subsiding and are expecting the asset quality to stabilize and improve from the current levels. RBI came up with a revised set of guidelines (more logical), thereby: (1) Tweaking the provisioning calculation methods on restructuring of advances (2) Allowing (again) floating provisions for calculation of net NPA. Key highlights Restructuring guidelines Latest guidelines differ from the earlier guidelines with respect to: (1) calculation of interest cash flows pre-restructuring and, thus, (2) avoidance of quarterly MTM on loans post restructuring. Under earlier guidelines, interest cash flows pre-restructuring was calculated as per current BPLR
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+ term risk premium + credit risk premium. This, under the current guidelines, will be calculated as per the original rate in the loan agreement. Impact: This would lead to: 1) lower interest cash flows, as interest rates have risen over the past few years (current BPLR> original loan rate) and (2) avoidance of MTM, since original loan rate remains constant, unlike BPLR that keeps on getting revised. This will help improve profitability of the banks in the near term with lower provisioning requirements. As explained in the illustrations below, the new guidelines are likely to lead to a sharp reduction in the provisioning requirement, thus minimizing the impact. Guideline on accounting floating provision deferred for FY09: In our recent report, „RBI guidelines-increased net NPA; no economic impact?, dated March 26, 2009, we had discussed the move made by RBI to restrict banks from utilizing their floating provisions for netting off against existing gross NPA to arrive at net NPA. RBI has deferred the implementation of this move for FY09: As explained before, the timing and nature of these guidelines was puzzling as it penalized banks that were conservative in their accounting policies. Impact: The current move will ensure that banks like Federal Bank, Punjab National Bank, and Union Bank of India, reporting no substantial (ceteris paribus) change from the previous quarter for FY09, would see changes coming in FY10. Discussion on buffer creation: RBI also mentioned the need to build buffers to be drawn to counter pro-cyclicality of gross NPA. A detailed guideline is expected in the near future in consultation with international bodies. Overall, the revised guidelines are positive for banks and are expected to boost their near-term profitability due to lower provisions. However, they do pose the risk of moral hazard. Higher provisioning on restructured assets would have restricted unwarranted/unviable restructuring, giving a clearer picture of the asset quality; with lower provisioning, the disincentive to restructure has reduced.
7. Consolidation to increase, but M&A to remain subdued
We expect consolidation in the Indian banking sector to crystallise further over the next five years, driven by market-share shifts rather than big-scale M&A activity. We expect the top-five banks to gain market share, at the expense of smaller private and PSU banks. The smaller banks will lose market share at a rising pace, as they lag the large banks on most critical parameters, right from the basic technological infrastructure to the more sophisticated, softer skill set. We expect the market share of Tier II PSU banks to fall to 33% in total deposits and to 31% in Casa deposits over the next five years, which will further deteriorate their operating metrics, setting the platform for a pickup in M&A activity. The expectations of big-scale consolidation within the sector have been belied, be it within PSU banks or large private banks acquiring smaller privatesector banks. Over the past four decades, few M&As have happened from a commercial standpoint, and most acquisitions have been forced upon PSU banks, aiming to bail out troubled banks. Looking back at the past five years, there was a brief period when RBI?s issuance of new branch licences slowed, resulting in some commercial M&A activity as private banks acquired smaller banks to ramp up their distribution networks. However, once RBI became liberal again in the
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issuance of fresh licenses, the inclination of private banks to acquire smaller banks died down. Within state-owned banks, SBI amalgamated one of its banking subs with itself, but couldn?t carry the process further due to labour/political issues. Although we believe M&A activity will pick up, we do not envisage any big-scale ones such as merger of two large PSU banks, acquisition of Indian banks by foreign players or even a private bank acquiring a public-sector banks. Foreign-ownership guidelines are unlikely to be relaxed substantially; private banks have been lobbying to restrain the opening-up of the Indian financialservices sector to foreign players, given that Indian banks are not getting permissions to operate in developed economies. The M&A activity is likely to be split into private banks acquiring few small, and not well-run, private and cooperative banks to strengthen their distribution networks, and large PSU banks acquiring smaller PSU banks, beginning with the merger of associate banks of SBI with the parent. Key catalysts for M&A activity include rising demand for big-ticket project financing, which increases need of bigger balance sheets, inability of smaller private-sector banks and Tier II PSU banks to compete with the large banks due to their fast-depleting liability franchise, and a supportive regulatory regime. See Annexure: Table 26
8. Supportive regulatory regime to boost growth, profitability
A tightly regulated environment and a conservative regulator have always led to sub-optimal operating metrics for Indian banks. As the regulator continues to adopt global banking practices, easing some regulatory requirements, Indian banks are likely to see an improvement in their growth trajectory, and more importantly, profitability. Even after the number of regulatory reforms over the past 15 years, the Indian banking sector remains the most tightly regulated one in the region and also globally. The tight regulatory regime has helped Indian banks to withstand the Asian financial crisis and, more recently, the subprime turmoil relatively unhurt. However, it has also led to a sub-optimal profitability metrics for Indian banks for a long period of time, at times hindering the growth of the market?s financial system per se. Key regulations governing Indian banks & likely changes 1) Political stability at the centre to be a long-term value driver: Outcome of the current general elections is a big positive for the domestic economy. The investor communities, both domestic and overseas, have given thumbs up to the pro-reformist government at the centre. Political risk has long been a hindrance to overall valuations in the Indian market which seems to be on the downside and will be a long-term value driver for our equity markets. However, the government needs to actually deliver on long pending financial sector reforms and other infrastructure projects to further attract capital flows. 2) Significant positive for bank stocks: With Left parties not having a say at the centre, the chances of long pending banking and financial services sector reforms being implemented
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have increased significantly. This is a medium-to-long term positive development for the sector which in all probabilities will lead to a rerating of the banking stocks. 3) Removal of 10% voting cap: Long awaited reform, but RBI regulations don?t allow >10% ownership in banking stocks. Hence, full benefit will only be realized when RBI realigns the same. 4) Consolidation in the banking sector – especially among PSU Banks: Government will definitely give it a push but opposition from unions remains a hindrance. However, with Left parties out of the coalition, unions will have significantly less head room to bargain. Bank?s top management will have to take the initiative which will be facilitated by the government. 5) Hike in FII holding in PSU banks: Significant value driver will help PSU banks to raise capital at better valuations in the medium term. 6) Reduction in GOI shareholding in PSU banks below 51%: We observe GOI will not do all changes at one stroke but prioritise the same based on the need of the hour. Hence, reduction in GOI shareholding will not remain on the top of the list despite high fiscal deficit for FY10. Again top level ministers have commented that GOI holding in PSU banks is unlikely to fall below 51%. 7) Cap on use of Third party ATM: Yielding the bankers demand RBI has now modified the existing system where the use of the ATMs was bank neutral for the customers. The new development would now allow customers to withdraw cash from other bank?s ATMs for no more than five times per month at no cost. Also in such cases the upper limit of RS 10000 is fixed by RBI as demanded by IBA. The earlier move had hit the bank?s balance sheet as cost of withdrawals, the inter change fees as high as Rs 20 per transaction, was not passed to the customers. A customer usually keeps Rs 25000 balance in their respective accounts. The bank earns Rs 1250 per annum in such cases. If the customer accesses five another ATMs per month for free withdrawals, the bank would lose at Rs 1200 per annum. This would increase the profits of banks. 8) RBI relaxed the norms for the banks to get an approval to open an offsite ATM anywhere in the country. The banks now merely inform the regulator when a new offsite ATM is opened as no prior permission is required. This would help in faster penetration of the banking facilities. 9) RBI has kicked off a review of branch licensing norms. Opening branches may be made easier for Indian Banks. The present policy requires banks to put in an annual request for opening new branches and only after RBI authorisation can the new outlets be opened. It would result in quicker development of banking facilities. 10) Frauds on the rise: There has been a sharp increase in the number of frauds and amounts involved that are reported by banks to the RBI. The RBI report notes that apart from traditional areas, frauds are happening in new areas – including housing loans, credit cards, internet banking & outsourcing business. The number of large value frauds of amount over Rs 1 crore has also gone up sharply. The last fiscal saw about 212 cases involving an amount of Rs 1404 crore compared o about 177 cases involving Rs 659 crore in 2007-08. Security is a growing concern for the banking sector.
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11) Technology development has helped banking sector to reach the remotest of place without having a branch in that area or asking the customer to come to the branch for banking. With internet banking a great success, the next concept is Mobile Banking. Mobile banking removes the condition of having a PC and internet. The mobile usage & customer base is increasing with every day. This provides the bank an excellent opportunity to leverage this network to provide banking facilities. RBI has come up with the norms for the mobile banking. Security concerns need to be taken care in this case. As the customer base would increase, so do the deposits & credit growth. For a consolidated list see Annexure: Table 27
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Bibliography
1. RBI website - www.rbi.org.in/ 2. CSO website -http://mospi.nic.in/mospi_iip.htm/ 3. IMF website - www.imf.org/ 4. Business Today (December 13 issue) , 5. The journal of Banking Studies founded by Prof. G.S Lall, October& November 2009 issue 6. CMIE - Money & Banking data ( November 2009) By Economic Intelligence Service 7. Bank Quest – the Journal of Indian Institute of Banking & Finance 8. Bloomberg website & database - www.bloomberg.com/ 9. Banking Sector – Systematix Institutional Research 10. Banking Sector – Ambit Capital 11. Banking Sector Preview – Anagram 12. Banking – Edelweisis 13. Banking Sector NPA concern – Antique
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Annexure
Table 1: Overview of the world economic outlook projections
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Table 2: Export & Imports of India (2009)
(Rs. Crores)
DEPARTMENT OF COMMERCE ECONOMIC DIVISION
EXPORTS & IMPORTS : (PROVISIONAL) OCTOBER EXPORTS (including re-exports) 2008-2009 2009-2010 %Growth 2009-2010/2008-2009 IMPORTS 2008-2009 2009-2010 %Growth 2009-2010/2008-2009 TRADE BALANCE 2008-2009 2009-2010 -57114 -41120 -383278 -276700 125868 102759 -18.4 916483 716535 -21.8 68754 61639 -10.3 533205 439835 -17.5 APRIL-OCTOBER
*Figures for 2008-09 are the latest revised whereas figures for 2009-10 are provisional.
Source: Department of commerce, India
Table3: Growth rates of various GDP components and its share in the total
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Table 4: India IIP index
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Table 5: Distribution of Gross Bank Credit
Table 6: Distribution of total Bank credit of SCB’s
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Table 7: Loan Growth
Table 8: Investment in Government securities
Table 9: Sector Credit & Deposit
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Table 10: Outstanding Credit
Table 11: Funds raised by Indian Corporations
Table 12: Loans
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Table 13: Sector profitability
Table 14.1: Mobilisation of Mutual funds, small savings & deposits over the years
Source: RBI
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Table 14.2: Percentage share of deposits, mutual funds, small savings in gross domestic savings
Source: RBI Table 15: Credit Growth
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Table 16: Percentage Loans Across sectors & by various institutions
Table 17: Target Population
Table 18: Higher investment demand leading to higher credit growth
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Table 19: Chart reflects that RBI has been extremely successful in influencing the direction of yields
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M3 growth (percent) and 10 year G-sec yield (percent)
Table 20: Schedule of central bank’s borrowing programme
Source: RBI
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Table 21: Shape of yield curves now, 3 months and 6 months back
Table 22: Stimulus measures taken by government
Table 23: Sector sales report
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Table 24: Sector gross NPLs
Table 25: Provisioning for Banks
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Table 26: Consolidation of banks in past
Table 27: Key Regulations & likely changes
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doc_676358854.docx
The document describes analyze the factors that will determine the future profitability of the banking sector.
Future of Banking Sector
VARUN GUPTA 2009A62
Future of Banking Sector 2009
Executive Summary
The banking sector is pivotal to any economy?s well being, essentially because it tends to lead investments by corporate in productive sectors. Given that domestic consumption and investments together account for close to 90 percent of GDP, we believe that both these engines would continue to engage policymakers? time and attention. Hence, if the economy were to grow at close to 6 percent or thereabouts, investments need to continue in a host of productive sectors. To fund these investments, corporate India will continue to depend heavily on banks. In this report, I have attempted to analyze in depth the factors that will determine the future profitability of the Banking sector: ? ? ? ? ? ? ? ? Improvement in economic outlook Credit Growth Deposit Growth Interest Rates Margins of the banks Asset Quality of the banks ( NPA Concern) Consolidation/ Mergers& Acquisition of Banks Regulatory Changes to boost growth & profitability
Despite the growth and asset-quality issues facing global financials, Indian banks are likely to sustain their structural growth trajectory, driven by an under-penetrated financial-services sector, a conducive economic environment and a supportive regulatory regime. An estimate of 17% credit CAGR over FY09-14. Over the next five years, bond-market development will lead to commoditisation of credit and margins will mainly be a function of retail liability franchise. The 10 year G?Sec yield is expected to remain in the range of 7?7.3% levels in FY10. A major portion of the bank?s investment book is hedged till 7.5% levels, therefore I don?t expect large MTM hits even if the yield touches 7.5% mark in the current fiscal. Earnings visibility of the sector has improved with superior outlook on credit, margins and asset quality of the banks. As the distribution network and technological infrastructure become basic requirements - which are insufficient to drive profit on their own - softer skills such as service standards and product innovation will be critical to enhance the franchise. Fee growth is likely to be healthy as a pickup in corporate activity further boosts retail-fee momentum. Industry consolidation is expected to continue, but big-scale M&A activity is unlikely. However, regulatory relaxation will help improve the industry?s overall profitability. The report elucidates facts & key structural aspects about the Indian Banking Sector, supplemented by latest statistical data and comprehensive analysis that will support the above. As
per the analysis Banks would be the key beneficiaries of the revival in the economic growth.
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Table of Contents
Executive Summary................................................................................................................................. 2 Table of Contents .................................................................................................................................... 3 Overview to Indian Banking .................................................................................................................... 4 Sector Outlook ........................................................................................................................................ 5 1. 2. 3. 4. 5. 6. 7. 8. Improvement in the economic outlook of major economies ..................................................... 5 Credit growth .............................................................................................................................. 6 Deposit Growth ......................................................................................................................... 10 Interest rate Effect/Risk ............................................................................................................ 11 Margins are expected to improve ............................................................................................. 13 NPA concerns ............................................................................................................................ 14 Consolidation to increase, but M&A to remain subdued ......................................................... 16 Supportive regulatory regime to boost growth, profitability ................................................... 17
Bibliography .......................................................................................................................................... 20 Annexure ............................................................................................................................................... 21
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Overview to Indian Banking
The Indian banking can be broadly categorized into nationalized banks, private banks and specialized banking institutions. The Reserve Bank of India acts a centralized body monitoring any discrepancies and shortcoming in the system. Since the nationalization of banks in 1969, the public sector banks have acquired a place of prominence. The need to become highly customer focused has forced the slow-moving public sector banks to adopt a fast track approach. The unleashing of products and services through the net has galvanized players at all levels of the banking and financial institutions market grid to look anew at their existing portfolio offering. Conservative banking practices allowed Indian banks to be insulated partially from the Asian currency crisis. Indian banks are now quoting al higher valuation when compared to banks in other Asian countries (viz. Hong Kong, Singapore, Philippines etc.) that have major problems linked to huge Non Performing Assets (NPAs) and payment defaults. Cooperative banks are nimble footed in approach and armed with efficient branch networks focus primarily on the „high revenue? niche retail segments. The Indian banking has finally worked up to the competitive dynamics of the „new? Indian market and is addressing the relevant issues to take on the multifarious challenges of globalization. Banks that employ IT solutions are perceived to be „futuristic? and proactive players capable of meeting the multifarious requirements of the large customers? base. Private Banks have been fast on the uptake and are reorienting their strategies using the internet as a medium The Internet has emerged as the new and challenging frontier of marketing with the conventional physical world tenets being just as applicable like in any other marketing medium. The Indian banking has come from a long way from being a sleepy business institution to a highly proactive and dynamic entity. This transformation has been largely brought about by the large dose of liberalization and economic reforms that allowed banks to explore new business opportunities rather than generating revenues from conventional streams (i.e. borrowing and lending). The banking in India is highly fragmented with 30 banking units contributing to almost 50% of deposits and 60% of advances. Indian nationalized banks (banks owned by the government) continue to be the major lenders in the economy due to their sheer size and penetrative networks which assures them high deposit mobilization. Industry estimates indicate that out of 274 commercial banks operating in India, 223 banks are in the public sector and 51 are in the private sector. The private sector bank grid also includes 24 foreign banks that have started their operations here.
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Sector Outlook
1. Improvement in the economic outlook of major economies
More than a year after the US officially declared its economy to be in recession; the IMF has in its recent report on World Economic Outlook (WEO) noted that the world economy is stabilizing which is an outcome of unprecedented macroeconomic and financial support. IMF, in its WEO October update, has revised upwards the world GDP growth rate by 60 bps to 3.1% for CY2010 from its July 2009 estimates of 3.1% ? this stands out to be a huge revision in just 3 months. If the global GDP grows by 3.1% in CY2010, then world economy would be officially out of one of worst recessionary period it had seen after Great Depression of 1930s. Major economies like the US and UK, which were expected to register a near 0% growth rate 3 months ago, are now expected to record growth of 1.5% and 0.9% respectively – an upward revision of 70bps and 70bps respectively from the IMF?s previous forecast in July?09. In addition to this, major euro zone economies like Germany and France have reported a positive growth of 0.3% in Q2 (April?June quarter) of 2009. See Annexure: Table 1 However, the IMF also added that though downside risks to the outlook continue to exist, they have noticeably moderated. The pace of recovery is slow, and activity remains far below precrisis levels. The pickup is being led by a rebound in manufacturing and a turn in the inventory cycle, and there are some signs of gradually stabilizing retail sales, returning consumer confidence, and firmer. If such moderations prevail and eventually lead to a recovery, it can prove to be a major positive for International Trade. India?s external trade has continuously reported negative growth in the preceding ten months which has affected major employment sectors dependent on exports. See Annexure: Table 2
1.1 US economy shows diminishing rate of deterioration
Four major indicators that the National Bureau of Economic Research (NBER) in the US considers apart from the real GDP to officially declare or call?off recession – 1) the real income, 2) the employment scenario, 3) the industrial production, and 4) wholesale retail sales have been flagging a diminishing rate of deterioration. The overall confidence in the economy as seen in recent Consumer and Business Confidence surveys has also improved. The scenario suggested by the indices and statistics has been found to be consistent with a stabilization of output seen in the H2 of 2009. Hence it is expected that a gradual recovery would emerge in 2010. The scenario that is building up offers optimism, however overall recovery cannot be accurately timed as it is not expected to be uniform.
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1.2 Domestic economy witnessing signs of strong resilience
The India economy stood reasonably shielded owing to the absence of the toxic subprime assets from the financial ledgers of its system. The predominant domestic demand driven economy also acted as a strong cushion against the global economic turmoil. The Indian economy though not the worst hit could not completely decouple from the effects of a recession in the industrial countries. A sustained sell?off in the equities and a subsequent pull?out of capital out of the country caused substantially tight conditions declining continuously from 8.6% in Q4FY08 to 5.8% in Q4FY09. See Annexure: Table 3 The Reserve Bank of India, taking note of the developments announced some sweeping changes to the policy regime. The LAF signal rates significantly cut by 400bps and the CRR was cut by 400bps at the beginning of mid?FY09. The government of India followed up by announcing a fiscal package each in December 2008 and January 2009 to stabilize a slowing economy and thereby further stimulate economic activity. After witnessing three quarters of declining industrial production, the policy measures announced in the form of monetary and fiscal stimulus bore the desired results and the economy appears to be on the road to a sustainable recovery. The latest data on Index of Industrial Production estimated that June growth at 7.8% is well ahead of mean street expectations of 3.7% and the highest estimate of 4.8%. Core segments of intermediate goods and capital goods have also registered robust growth. The mining and manufacturing indexes recorded the sharpest rise in over a decade. Consumer durables reflecting consumer spending on white goods also recorded a strong 15.3% Y?o?Y growth. See Annexure: Table 4 The RBI survey of economic forecasts pegging the country?s fiscal 2010 real GDP growth rate upwards of 6% despite a weak monsoon has been equally encouraging. I believe that the upgrades are suggestive of robust resilience in the domestic economy which is also being reflected by the data releases in the core sector. Cement dispatches, steel production, commercial vehicles, and non?commercial vehicle segment have also registered strong growth in the recent months.
2. Credit growth
Sectoral credit to grow at a healthy rate of 19?20% on Y?o?Y basis in FY2010 based on the premise that GDP sustains a growth rate of 6% in the current fiscal, thereby taking the loan growth to a real GDP multiplier of 2.7x (average multiplier of last 3 years). A recent study by CRISIL that has exhaustively compiled planned capex across various industry segments, debt funding required for such capex, and expected repayments during the year also points to credit growth of 20% Y?o?Y growth in FY10. A major chunk of this is expected to crystallize in the late 3QFY09. Other parameters which suggest healthy credit growth are briefed below: 1) Global and domestic economy showing signs of stabilization – restoring corporate confidence– In the Q1FY10 monetary policy review, RBI has highlighted that the knock on effects of the global financial crisis seem to be receding with global economy showing incipient signs of stabilization coupled with the revival of the industrial activity in a number of emerging
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economies. In our view, this would restore the corporate confidence which would be crucial for the revival of credit demand in the economy. 2) Strong investment pipeline of companies – We expect credit demand to pick up both in term and working capital loans segments. CMIE data shows that the Corporates have made investments into capacities of more than 5 trillion which will translate into the credit growth of 18% (on current outstanding credit of SCBs) from the industrial segment alone whose share in the total outstanding bank credit is at 37.7%. These investments would however translate into staggered growth in the credit outlay of the banks. In addition to this, we expect demand for the working capital loans to again momentum with an upward movement in the commodity cycle. Our interaction with the bankers? has brought to knowledge that there are considerable amount of sanctions suggesting a potential real demand which could materialize into higher credit growth in the coming quarters. 3) With the reduction in the lending rates, viability and internal rate of return (IRR) of the projects has improved appreciably over the last 6 months and this could create a strong credit demand. (SBI BPLR has come down by 200 bps to 11.75% from peak of 13.75% in August). Banks? higher lending rates was one of major cause which had resulted in subdued credit growth in the second half of the last fiscal bringing down the full year growth to 18% levels v/s 22.8% growth seen in FY08. See Annexure: Table 5
2.1 Expect demand revival to be led by corporate loans, select retail to show growth
The demand for the agriculture loans is seasonal and steady; it is known to accelerate during the crop seasons. Given the norms of priority sector lending, PSBs have maintained a corresponding a high agriculture portfolio with heavy lending to the farm sector. It is expected that the demand to sustain. Agriculture apart, it is expected that the initial demand for credit to come from the corporate segment. Corporate are now in a rush to get capex proposals approved and achieve financial closure. Hence, it is believed that the pick-up in the credit cycle should be led by revived demand from the corporate segment. Pick up in retail, particularly the residential mortgages and auto loans might be driven by temporary favourable price elasticity in this segment as banks have announced special rates for specific periods. However, a sustained pick up for retail credit will take some time and shall be dependent on other important variables like economic outlook and stability in the job market, clarity on asset prices etc. Initial growth should again be led by SME segment which typically is the first to be hit in the event of a downturn and takes longer to recover in the event of an upturn. Thus demand is seen to persist in the SME segment while the large corporate should generate healthier demand for demand loans. See Annexure: Table 6 & Table 7
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2.2 Challenges
Key challenges for banks are intensifying competition in lending activity from non-banking sources like insurance companies, mutual funds, overseas investors and external commercial borrowing (ECB); and mobilisation of long term resources for project and infrastructure financing. It is expected that corporate loans to drive credit growth; share of retail credit is unlikely to rise, as banks remain averse towards high-risk, unsecured retail loans. Project financing will drive corporate credit demand (including infrastructure projects), as companies build up new capacities and government increases infrastructure spending. Demand for working capital is also likely to rise as most industries have reached peak efficiency levels and their working-capital demands will reflect volume pickup. Challenge 1 - Deposit mobilisation Over the past decade, Indian banks have expanded their loan book ahead of their retail-depositgrowth rates. This was due to their ability to sell down excess government-securities (G-Sec) holding and the rising proportion of borrowings. With minimal excess statutory-liquidity-ratio (SLR) holding, drying-up of flow from non-banking sources (due to rising capex and higher alternative investment options), it is expected that the banking credit growth over the next five years to be a function of retail deposit inflow in the banking system. See Annexure: Table 8 In the past five years, banking-sector deposits have seen a healthy CAGR of 20%, driven by a host of factors: acceleration in nominal GDP growth; rising savings rate; increasing proportion of bank deposits in total financial savings; and inflow of non-retail deposits. With most of these factors being close to their peak levels, I don?t foresee deposit growth running ahead of its long term average multiple (to GDP) and hence are building in a moderation in deposit growth to 16% per annum over FY09-14. The key for banks to boost their deposit growth will be to increase presence in semi-urban and rural areas to improve banking penetration. See Annexure: Table 9 Challenge 2 - Rising competition in the lending space Credit growth for Indian banks over the next five years will not be as smooth as it has been over the past decades. Recent trends suggest new competition in the lending space from insurance companies, mutual funds and even foreign companies participating in the debt market. The entry of these new players forces Indian banks to restrict their balance-sheet growth to the extent that they are able to mobilise retail deposits. See Annexure: Table 10 Banks will also find it difficult to provide long-term financing due to their shorter maturity profile. On the other hand, insurance companies have an ever-growing demand for long-term investments, due to their fast-growing corpuses, which are also long-term in nature. Other nonbanking sources such as external commercial borrowings (ECB), insurance companies, mutual funds have also reported an increase in appetite for corporate debt over the past few years. It is estimated that insurance companies will have an appetite for about Rs3.1tn of corporate bonds/debentures (9% of incremental bank credit) over FY09-14. Demand from mutual funds will be another Rs2.6tn, at least over FY09-14. Ease of foreign-ownership norms for investments in debt will also boost foreign participation in long-term financing, threatening Indian banks.
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These sources collectively could invest/lend Rs7-8tn to the corporate sector, ie, almost 24% of incremental banking credit over FY09-14 (34% of incremental corporate credit). Hence, even though we expect credit-demand growth to be about 20% per annum; we have built in a 17% bank-credit CAGR, factoring in the rising share of non-banking players. See Annexure: Table 11 Challenge 3 - Requirement for long-term resources Indian banks have historically focused on financing working-capital loans, while development financial institutions (DFI), such as Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI) and ICICI, funded long-term project loans. With the death of the DFIs in early 2000, over the past few years banks have been funding even long term project loans, but with limitations due to the shorter maturity profile of their liabilities (only 15% of deposits have maturity of over five years). With long-term project financing making up more than 60% of incremental credit demand, it is the key for banks to mobilise long-term liabilities, especially given the rising competition from insurance companies and foreign investors. Recent regulatory incentives, such as tax benefits on long-term deposits, have boosted flow of long-term deposits for banks. Given the government?s focus on infrastructure, it might offer some more sops to banks (in the form of tax-free bonds, etc) to improve flow of long-term retail deposits. See Annexure: Table 12
Challenge 4 - Capital constraints are bank-specific With ROE improving to 17% and the switch to Basel II, resulting in release of Tier I capital, Indian banks are adequately capitalised to support a 17% loan CAGR over the next five years. However, in some specific cases, banks targeting aggressive loan growth may look to raise capital. See Annexure: Table 13
2.3 Traditional lending to be commoditised
Over the next five years, banks? inability to fund long-term projects, rising demand for corporate debt paper from non-banking sources (discussed in the earlier section) and Basel II norms will facilitate the development of an active corporate-bond market in India. This will lead to commoditisation of corporate credit to some extent. With credit getting commoditised, liability franchise will become the key margin driver, while risk-evaluation skill set will be increasingly important for banks that are active in syndication. Even though India has been considering a bond market for quite some time, we believe the catalysts are now in place. A key hindrance to the development was a lack of a wider investor base, with banks being the only investor for corporate debt. However, rising assets under management (AUM) of insurance companies and relaxation of foreign-ownership norms in corporate debt have boosted demand for corporate debt, and could be the much-awaited catalysts for the development of bond markets. A wider base of rated corporate debt is a prerequisite for greater participation of non-banks in corporate funding. Implementation of Basel II norms is driving banks to encourage their customers to get “rated” as it allows banks to utilise their capital efficiently, improving ROEs. Banks pass on some benefits to customers by cutting rates.
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3. Deposit Growth
Systemic deposits to comfortably achieve growth of 19.5 percent in FY10E and 19 percent in FY11E, assuming that the economy will continue to generate a GDS in excess of 35 percent and a nominal GDP growth of 11 percent. Based on the assumption that the share of the banks deposits in the incremental savings will fall to levels seen in FY06, it is still expected for reasonable healthy growth in deposits. Bank term deposits are preferred instruments of house hold financial savings in India as indicated by GDS. Corporate savings have also significantly invested in bank term deposits apart from the liquid mutual funds. Hence, it is believed that the share of the bank deposits in the incremental GDS may not drop to alarming lows. The 3Qfy09 saw aggressive growth in the systemic bank deposits, but certain key competitive features of bank deposits have undergone notable change in the last two quarters, mainly: 1. The interest rates offered on bank deposits across various tenors have declined 300-400 bps in the last two quarters. 2. Rates now offered on one year maturity deposits are 150-200bps lower than the post office small saving scheme rate of 8 percent. 3. Revival of investor interest in equity markets and equity linked saving schemes is being anticipated.
3.1 Focus to remain on retail and low cost deposits
Banks aggressively mobilized deposits from retail depositors during Fy09 while they tried to reduce their dependence on institutional or bulk deposits. Though the definition of wholesale deposits varies with every bank, in general parlance, it is typically understood as a large ticket deposit (>Rs 10 million) carrying a specially quoted interest rate that is distinct and usually higher from the published card rate of bank. The massive fall in rates of bulk deposits has led to significant cost re-pricing benefits. However, given the extreme volatility observed in the rates of wholesale deposits between cycles of high economic growth and economic slowdown, banks are wary; they are instead focusing on expanding their retail client base and acquiring retail and low cost deposits. This practice is drawn from the generally anticipated scenario of the beginning of economic revival a couple of quarters ahead which can lead to gradual firming up of interest rates again making bulk deposits costlier than retail deposits. See Annexure: Table 14
3.2 Penetration levels suggest healthy potential
Despite the aggressive growth in most financial segments over the past decade, the Indian financial sector offers structural growth opportunities given the under-penetration of most financial products/services and an expanding target market. Even though Indian banking credit has enjoyed a 27% CAGR (23% in US-dollar terms) over 2003-08, credit penetration remains well below regional benchmarks, suggesting healthy growth potential for the next five years. Even large banks such as SBI, ICICI and BoB have been able to expand their loan book at about a 30% CAGR over FY04-09 and may continue to gain market share.
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See Annexure: Table 15 The credit growth has encompassed all sectors. However, retail credit growth has been a primary driver, having delivered a 51% CAGR with share of retail credit in total bank credit rising from 10% in FY04 to 22% in FY09. Not only has industrial credit seen a healthy 27% CAGR, incremental lending has been much diversified compared to in the mid- and late-1990s. See Annexure: Table 16
3.3 Target market still expanding
While existing penetration levels are low, the “bankable population” is expanding at a healthy pace led by economic growth momentum, especially in rural India, and favourable demographics. The structural opportunity for banks is evident from the fact that more than 30% of Indians are below 15 years of age and over the next five to 10 years will enter in the “bankable population” category. The younger generation is far more open to consumer loans, financial products like insurance, mutual funds, wealth management, etc, and thereby offers a much bigger revenue pie for financial-service providers. See Annexure: Table 17
4. Interest rate Effect/Risk
Interest rates are expected to remain in the range of 7?7.3% levels in FY10; they are likely to inch upwards by 50?100 bps from the fiscal year FY10 end in line with improvements in the business cycle, reversal of expansionary monetary policy, and rise in inflation. During the same period, surplus banking liquidity (under RBI LAF window) is expected to diminish largely on account higher credit growth. Fundamentally, interest rates undergo a marginal fall in the recessionary period, they rise steadily with the recovery and finally, increase at the end of the growth period to brake the possible inflationary dynamics. Below are explained few of the important factors that would influence the interest rates going ahead: 1. Improvement in business cycle – signals higher interest rate regime Fluctuations in the economy, often referred to as a business cycle, correspond to changes in the business conditions. When the real GDP zooms business registers good returns, profits of the firms expand and hence demand for investment is also high during such phases. Hence, this entire phase signifies higher demand for money leading to a higher interest rate scenario. Over the last 10 months, global recessionary pressures led to sharp fall in the domestic demand for investment resulting in decline in the interest rates of the economy (during the same period rates were also influenced by central bank?s intervention). Going ahead, we expect increase in the domestic output would lead to revival in the investment demand which could cause the interest rates to rise in FY11. See annexure: Table 18
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2. Expansion of monetary policy most likely to reverse in the beginning of March 2010 Going ahead, the central bank?s policy objective would be to stimulate economic growth and at the same time curb the inflationary pressures, unlike earlier where for the last 11 months growth accorded high priority over inflation management. Tightening of monetary policy to begin from March 2010, because an earlier reversal of economic policy would hurt the economic growth. RBI may intervene if the inflation pressures increases the 6-6.5 percent mark; chances of inflation crossing that mark is bleak. RBI?s survey of professional forecasters estimate the median value of WPI inflation to be 5.4 percent for the year ending march 2010, which is close to the RBI estimate of 5 percent. Beginning March 2010, the inflation going to be triggered by 1) Increase in commodity price 2) Rising food grain prices due to the delayed rains 3) Current surplus liquidity which holds the potential to create inflationary pressures. See Annexure: Table 19 3. Higher borrowing programme not likely to impact money supply For the fiscal year 2010, the central and state government net borrowing program is estimated to be Rs 3980 billion and Rs 1400 billion respectively summing to Rs 5380 billion. The central government has already completed 37 percent of its planned borrowings while the remaining 63 percent is programmed for the rest of the year. As per the analysis the market can absorb a fresh supply of securities without materially impacting the money supply. Net shortfall in the liquidity due to the central?s government borrowings borrowing stands at Rs 350-518 billion only. The shortfall will turn into surplus if the banks increase their SLR above 29 percent levels. See annexure: Table 20 4. Higher capital inflows would call for tighter monetary regime The monetary policy framework in India also targets monetary aggregates, chiefly the broad money or M3. The M3 components between FY06?FY09 were heavily influenced by strong flows of external capital in the form of portfolio investments, corporate borrowings, and bank deposits. This period also saw the interest rate cycle coming full circle with the tightening that commenced in early FY06 finally leading to an extremely accommodative monetary policy towards the end of FY09. The policy rates and CRR requirement which was raised to the highest in the period was brought down below the level prevailing at the beginning of the cycle. The FY09 was also the period when India witnessed a net outflow of USD 20bn compared to a cumulative inflow of USD 144bn FY06 through FY08. Given the extremely accommodative stance of the policy at present, additions to domestic liquidity can prove to be inflationary and may therefore need sterilization. Hence we believe the policy actions of previous cycle will repeat with a gradual tightening bias as an expanding liquidity begins pushing the M3 faster. Though RBI has currently targeted the M3 to grow at 18% Y?o?Y, the current growth stands at 20% Y?o?Y.
4.1 Banks not to suffer large MTM hits in FY10 even if the G-Sec yields touches 7.5%
10 year benchmark yield would remain in the range of 7?7.3% levels while it would start moving upwards from end Mar?10 onwards. Banks won?t suffer from large MTM hits on their AFS book in the current fiscal even if the yields touches 7.5% mark as most of the them are hedged till the
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said rate. However, in next fiscal, with the rise in the interest rates, banks would have to take higher MTM hits couple with higher provisioning levels on their investment book. However, higher credit growth, margin expansion would compensate for the losses on investment book in FY11, while keeping the profitability growth of the banks unabated. In the scenario, private sector banks would enjoy distinct advantage over the PSU counterparts as former carry lower duration of investments which results in lower losses on their AFS book. PSU banks have shown sharp volatility in their earnings due to unpredictable losses or MTM hits on their investment book which is an outcome of high duration of their investments. Contrary to this, private sector banks have lower duration of their investments which is more representative of the current yields and hence lesser variance to their investment book yields resulting in lower losses. Lower duration on investments also causes banks to provide lesser for investment depreciation provisions. See Annexure: Table 21
5. Margins are expected to improve
Q1FY10 margins of the banks were at cyclical low levels as assets have re?priced at faster pace than liabilities with the interest rate cycle coming down. However, margins across the sector are likely to improve from the current levels as the total impact of re?pricing of liabilities is yet to reflect in the margins (along with re?pricing of high cost bulk deposits). The uptick in the credit demand will further give pricing power to banks capping the fall in their advances yields. Our view of improvement in the margins is supported by the followings arguments – 1) Pricing power of the banks will be back in the reckon with the improvement in the credit demand – Since Oct?08, banks have gone for aggressive lending rates cuts i.e. PSU banks have reduced their PLR by 200 bps, private banks by 100 bps and foreign banks by 50 bps which was largely driven by decline in the investment demand and also due to regulatory forbearance to bring banks? PLRs down. Fundamentally, lending rates behave as a function of demand and supply of the credit (and availability of liquidity in the market) i.e. lending rates harden if the demand for credit exceeds its supply and vice-versa. Going ahead, in our view, with the improvement in the credit demand, banks will gain the pricing power resulting in lending rates of the banks to improve or at least stabilize at current levels. In addition to this, over the last 8 months, reduction in the deposits rates have been sharper than the lending rates, which is expected to provide some cushion to the margins of the banks. 2) Expansion of the low cost deposits could support margins – Due to the recessionary pressures felt in the economy during 2HFY2009, the current account balances of the corporate with the banks had fallen considerably. They fell to negatives in the case of few banks wherein current account holders had turned net borrowers, than depositors. This has resulted in fall in the CASA ratio of the banks. With the improved economic scenario, we expect banks to show absolute growth in the current deposits, although, maintaining the CASA ratio for banks would be a challenge. 3) Cost benefits on re?pricing of bulk deposits – Banks, which have a greater share of bulk deposits on their balance sheet, have been prone to very volatile margins recently. During 1HFY2009, banks had accumulated a huge chunk of high cost bulk deposits at the rate > 9% anticipating a liquidity crunch in the economy. The rate has
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affected their margins adversely over the last 2 quarters. On an average, nearly 20?40% of bank?s term deposits comprise of bulk deposits, this ratio is as high as 90% for the wholesale funded banks like Yes Bank. With the interest rates on the bulk deposits crashing down by more than 600 bps (i.e. from peak of 12.9% in Oct?08 to 6.6% currently) over the last 11 months, banks would receive considerable cost re?pricing benefits when these deposits would mature in Q2 and Q3 of FY2010. However, its impact on the margins would depend on the quantum of the redemption of these bulk deposits i.e. higher the redemption amount higher the improvement in the margins. 4) Improvement in the C/D ratio – C/D ratios usually improve in the boom cycles while it declines in the bust cycles. Over the last 9 months, banks have recorded a decline in their CD ratios i.e. they have posted stronger deposit growth, while on the other hand, equivalent credit off-take has not picked up which has eventually pressurized margins. In our view, this scenario is likely to reverse, with the revival in the credit demand, C/D ratio of the banks will improve ultimately resulting in fall in the I/D ratio – which would further cushion the banks? margins.
6. NPA concerns
Over the last one year, with the economy entering the slower growth phase there have been looming concerns on the astoundingly high NPAs levels of banks, which had led to abrupt sector downgrades. In our view, economic growth would overturn to a recovery phase in the current fiscal which would lessen the NPA concerns to a large extent ? Faster the economic recovery, shorter would be NPA cycle. Post the fiscal stimulus packages, many of sectors have rejuvenated which has been reflected in their Q1FY10 strong profitability numbers. Cement dispatches, steel production, commercial vehicles, non?commercial vehicles volumes have all shown strong growth in the recent months. We believe all these factors are early indicators of improvement in the business cycle of the economy.
6.1 Stimulus packages have eased pressures in high-stress sectors
Over the past nine months, the Indian government has announced multiple measures, aiming to accelerate demand in sectors like real estate, steel, autos, and extend support to labour-intensive, export-oriented sectors like gems and jewellery and textiles. The impact has been fairly prompt and visible, with industries such as autos, cement and real estate already showing a pickup in activity, partly driven by the pent-up demand itself. See Annexure: Table 22 The Reserve Bank of India?s restructuring guidelines also facilitated the revival in these sectors, as it encouraged banks to take a slightly longer term view in financing the stressed sectors that were facing a temporary liquidity crunch. See Annexure: Table 23
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6.2 Stressed assets are 6.3% of loans, much lower than estimates
Sales pickup in these sectors also eased debt-servicing pressure, which was reflected in lowerthan-expected 4QFY09 NPLs. Most banks reported flat to marginal increase, despite what were arguably the toughest two quarters for corporate India in recent history. While the lower NPLs were also a result of „regulatory flexibility? given to banks with respect to „restructuring of loans?; even gross stressed assets (NPL plus restructured loans) for the sector, at 6.3% of loans, were much lower than concerns of double-digit NPLs. We are building in gross NPLs increasing to above 2.5x FY09 levels over the next two years, ie, from an estimated Rs689bn as on March 2009 to Rs1.7tn by March 2011. Gross NPLs as a share of advances will rise from 2.5% in FY09 to 4.4% by FY11. See Annexure: Table 24
6.3 Loan-loss charges to rise, but will be manageable
It is expected for Indian banks? asset quality to deteriorate, but the resultant increase in loan-loss charges should be manageable. Based on the current estimate of increase in gross NPLs, it is forecasted the loan-loss provision will rise from 88bps in FY09 to 130bps in FY11. But as highlighted earlier, actual provisioning could be lower if economic growth momentum remains stable or improves. See Annexure: Table 25
6.4 Restructured assets
Our analysis shows that top 14 banks of the country have restructured Rs633.9 billion worth of assets so far i.e. Rs380.3 billion restructured till Q4FY09 and Rs253.6 billion in Q1FY10. The Q1FY10 performance of the assets which were restructured in Q4FY09 was encouraging as an insignificant amount of assets restructured under the special RBI dispensation slipped during the Q1FY10. Any further development of stress may be delayed if the RBI extends the scheme to restructure assets. In addition to this, the bank management?s have sounded optimistic on slippage risks subsiding and are expecting the asset quality to stabilize and improve from the current levels. RBI came up with a revised set of guidelines (more logical), thereby: (1) Tweaking the provisioning calculation methods on restructuring of advances (2) Allowing (again) floating provisions for calculation of net NPA. Key highlights Restructuring guidelines Latest guidelines differ from the earlier guidelines with respect to: (1) calculation of interest cash flows pre-restructuring and, thus, (2) avoidance of quarterly MTM on loans post restructuring. Under earlier guidelines, interest cash flows pre-restructuring was calculated as per current BPLR
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+ term risk premium + credit risk premium. This, under the current guidelines, will be calculated as per the original rate in the loan agreement. Impact: This would lead to: 1) lower interest cash flows, as interest rates have risen over the past few years (current BPLR> original loan rate) and (2) avoidance of MTM, since original loan rate remains constant, unlike BPLR that keeps on getting revised. This will help improve profitability of the banks in the near term with lower provisioning requirements. As explained in the illustrations below, the new guidelines are likely to lead to a sharp reduction in the provisioning requirement, thus minimizing the impact. Guideline on accounting floating provision deferred for FY09: In our recent report, „RBI guidelines-increased net NPA; no economic impact?, dated March 26, 2009, we had discussed the move made by RBI to restrict banks from utilizing their floating provisions for netting off against existing gross NPA to arrive at net NPA. RBI has deferred the implementation of this move for FY09: As explained before, the timing and nature of these guidelines was puzzling as it penalized banks that were conservative in their accounting policies. Impact: The current move will ensure that banks like Federal Bank, Punjab National Bank, and Union Bank of India, reporting no substantial (ceteris paribus) change from the previous quarter for FY09, would see changes coming in FY10. Discussion on buffer creation: RBI also mentioned the need to build buffers to be drawn to counter pro-cyclicality of gross NPA. A detailed guideline is expected in the near future in consultation with international bodies. Overall, the revised guidelines are positive for banks and are expected to boost their near-term profitability due to lower provisions. However, they do pose the risk of moral hazard. Higher provisioning on restructured assets would have restricted unwarranted/unviable restructuring, giving a clearer picture of the asset quality; with lower provisioning, the disincentive to restructure has reduced.
7. Consolidation to increase, but M&A to remain subdued
We expect consolidation in the Indian banking sector to crystallise further over the next five years, driven by market-share shifts rather than big-scale M&A activity. We expect the top-five banks to gain market share, at the expense of smaller private and PSU banks. The smaller banks will lose market share at a rising pace, as they lag the large banks on most critical parameters, right from the basic technological infrastructure to the more sophisticated, softer skill set. We expect the market share of Tier II PSU banks to fall to 33% in total deposits and to 31% in Casa deposits over the next five years, which will further deteriorate their operating metrics, setting the platform for a pickup in M&A activity. The expectations of big-scale consolidation within the sector have been belied, be it within PSU banks or large private banks acquiring smaller privatesector banks. Over the past four decades, few M&As have happened from a commercial standpoint, and most acquisitions have been forced upon PSU banks, aiming to bail out troubled banks. Looking back at the past five years, there was a brief period when RBI?s issuance of new branch licences slowed, resulting in some commercial M&A activity as private banks acquired smaller banks to ramp up their distribution networks. However, once RBI became liberal again in the
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issuance of fresh licenses, the inclination of private banks to acquire smaller banks died down. Within state-owned banks, SBI amalgamated one of its banking subs with itself, but couldn?t carry the process further due to labour/political issues. Although we believe M&A activity will pick up, we do not envisage any big-scale ones such as merger of two large PSU banks, acquisition of Indian banks by foreign players or even a private bank acquiring a public-sector banks. Foreign-ownership guidelines are unlikely to be relaxed substantially; private banks have been lobbying to restrain the opening-up of the Indian financialservices sector to foreign players, given that Indian banks are not getting permissions to operate in developed economies. The M&A activity is likely to be split into private banks acquiring few small, and not well-run, private and cooperative banks to strengthen their distribution networks, and large PSU banks acquiring smaller PSU banks, beginning with the merger of associate banks of SBI with the parent. Key catalysts for M&A activity include rising demand for big-ticket project financing, which increases need of bigger balance sheets, inability of smaller private-sector banks and Tier II PSU banks to compete with the large banks due to their fast-depleting liability franchise, and a supportive regulatory regime. See Annexure: Table 26
8. Supportive regulatory regime to boost growth, profitability
A tightly regulated environment and a conservative regulator have always led to sub-optimal operating metrics for Indian banks. As the regulator continues to adopt global banking practices, easing some regulatory requirements, Indian banks are likely to see an improvement in their growth trajectory, and more importantly, profitability. Even after the number of regulatory reforms over the past 15 years, the Indian banking sector remains the most tightly regulated one in the region and also globally. The tight regulatory regime has helped Indian banks to withstand the Asian financial crisis and, more recently, the subprime turmoil relatively unhurt. However, it has also led to a sub-optimal profitability metrics for Indian banks for a long period of time, at times hindering the growth of the market?s financial system per se. Key regulations governing Indian banks & likely changes 1) Political stability at the centre to be a long-term value driver: Outcome of the current general elections is a big positive for the domestic economy. The investor communities, both domestic and overseas, have given thumbs up to the pro-reformist government at the centre. Political risk has long been a hindrance to overall valuations in the Indian market which seems to be on the downside and will be a long-term value driver for our equity markets. However, the government needs to actually deliver on long pending financial sector reforms and other infrastructure projects to further attract capital flows. 2) Significant positive for bank stocks: With Left parties not having a say at the centre, the chances of long pending banking and financial services sector reforms being implemented
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have increased significantly. This is a medium-to-long term positive development for the sector which in all probabilities will lead to a rerating of the banking stocks. 3) Removal of 10% voting cap: Long awaited reform, but RBI regulations don?t allow >10% ownership in banking stocks. Hence, full benefit will only be realized when RBI realigns the same. 4) Consolidation in the banking sector – especially among PSU Banks: Government will definitely give it a push but opposition from unions remains a hindrance. However, with Left parties out of the coalition, unions will have significantly less head room to bargain. Bank?s top management will have to take the initiative which will be facilitated by the government. 5) Hike in FII holding in PSU banks: Significant value driver will help PSU banks to raise capital at better valuations in the medium term. 6) Reduction in GOI shareholding in PSU banks below 51%: We observe GOI will not do all changes at one stroke but prioritise the same based on the need of the hour. Hence, reduction in GOI shareholding will not remain on the top of the list despite high fiscal deficit for FY10. Again top level ministers have commented that GOI holding in PSU banks is unlikely to fall below 51%. 7) Cap on use of Third party ATM: Yielding the bankers demand RBI has now modified the existing system where the use of the ATMs was bank neutral for the customers. The new development would now allow customers to withdraw cash from other bank?s ATMs for no more than five times per month at no cost. Also in such cases the upper limit of RS 10000 is fixed by RBI as demanded by IBA. The earlier move had hit the bank?s balance sheet as cost of withdrawals, the inter change fees as high as Rs 20 per transaction, was not passed to the customers. A customer usually keeps Rs 25000 balance in their respective accounts. The bank earns Rs 1250 per annum in such cases. If the customer accesses five another ATMs per month for free withdrawals, the bank would lose at Rs 1200 per annum. This would increase the profits of banks. 8) RBI relaxed the norms for the banks to get an approval to open an offsite ATM anywhere in the country. The banks now merely inform the regulator when a new offsite ATM is opened as no prior permission is required. This would help in faster penetration of the banking facilities. 9) RBI has kicked off a review of branch licensing norms. Opening branches may be made easier for Indian Banks. The present policy requires banks to put in an annual request for opening new branches and only after RBI authorisation can the new outlets be opened. It would result in quicker development of banking facilities. 10) Frauds on the rise: There has been a sharp increase in the number of frauds and amounts involved that are reported by banks to the RBI. The RBI report notes that apart from traditional areas, frauds are happening in new areas – including housing loans, credit cards, internet banking & outsourcing business. The number of large value frauds of amount over Rs 1 crore has also gone up sharply. The last fiscal saw about 212 cases involving an amount of Rs 1404 crore compared o about 177 cases involving Rs 659 crore in 2007-08. Security is a growing concern for the banking sector.
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11) Technology development has helped banking sector to reach the remotest of place without having a branch in that area or asking the customer to come to the branch for banking. With internet banking a great success, the next concept is Mobile Banking. Mobile banking removes the condition of having a PC and internet. The mobile usage & customer base is increasing with every day. This provides the bank an excellent opportunity to leverage this network to provide banking facilities. RBI has come up with the norms for the mobile banking. Security concerns need to be taken care in this case. As the customer base would increase, so do the deposits & credit growth. For a consolidated list see Annexure: Table 27
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Bibliography
1. RBI website - www.rbi.org.in/ 2. CSO website -http://mospi.nic.in/mospi_iip.htm/ 3. IMF website - www.imf.org/ 4. Business Today (December 13 issue) , 5. The journal of Banking Studies founded by Prof. G.S Lall, October& November 2009 issue 6. CMIE - Money & Banking data ( November 2009) By Economic Intelligence Service 7. Bank Quest – the Journal of Indian Institute of Banking & Finance 8. Bloomberg website & database - www.bloomberg.com/ 9. Banking Sector – Systematix Institutional Research 10. Banking Sector – Ambit Capital 11. Banking Sector Preview – Anagram 12. Banking – Edelweisis 13. Banking Sector NPA concern – Antique
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Annexure
Table 1: Overview of the world economic outlook projections
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Table 2: Export & Imports of India (2009)
(Rs. Crores)
DEPARTMENT OF COMMERCE ECONOMIC DIVISION
EXPORTS & IMPORTS : (PROVISIONAL) OCTOBER EXPORTS (including re-exports) 2008-2009 2009-2010 %Growth 2009-2010/2008-2009 IMPORTS 2008-2009 2009-2010 %Growth 2009-2010/2008-2009 TRADE BALANCE 2008-2009 2009-2010 -57114 -41120 -383278 -276700 125868 102759 -18.4 916483 716535 -21.8 68754 61639 -10.3 533205 439835 -17.5 APRIL-OCTOBER
*Figures for 2008-09 are the latest revised whereas figures for 2009-10 are provisional.
Source: Department of commerce, India
Table3: Growth rates of various GDP components and its share in the total
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Table 4: India IIP index
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Table 5: Distribution of Gross Bank Credit
Table 6: Distribution of total Bank credit of SCB’s
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Table 7: Loan Growth
Table 8: Investment in Government securities
Table 9: Sector Credit & Deposit
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Table 10: Outstanding Credit
Table 11: Funds raised by Indian Corporations
Table 12: Loans
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Table 13: Sector profitability
Table 14.1: Mobilisation of Mutual funds, small savings & deposits over the years
Source: RBI
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Table 14.2: Percentage share of deposits, mutual funds, small savings in gross domestic savings
Source: RBI Table 15: Credit Growth
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Table 16: Percentage Loans Across sectors & by various institutions
Table 17: Target Population
Table 18: Higher investment demand leading to higher credit growth
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Table 19: Chart reflects that RBI has been extremely successful in influencing the direction of yields
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M3 growth (percent) and 10 year G-sec yield (percent)
Table 20: Schedule of central bank’s borrowing programme
Source: RBI
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Table 21: Shape of yield curves now, 3 months and 6 months back
Table 22: Stimulus measures taken by government
Table 23: Sector sales report
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Table 24: Sector gross NPLs
Table 25: Provisioning for Banks
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Table 26: Consolidation of banks in past
Table 27: Key Regulations & likely changes
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