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Indian Banks Part 1: The System In Perspective

SECTOR ANALYSIS: 18 DEC 2011, 7:49 PM ET

India's economic development and financial sector liberalization have led to a transformation of the Indian banking sector over the past two decades Asset quality and profitability have improved significantly and the system has become more commercially oriented Indian banks were not much impacted by the financial crisis, helped by their relative isolation and some counter-cyclical measures implemented by the Reserve Bank of India in the mid-2000s, but asset quality deterioration led to some proactive loan restructuring Over the past year Indian banks have encountered more headwinds as high inflation led to tightening monetary policy, putting pressure on borrowers, especially in weaker sectors. Funding and liquidity are relatively strong features of the Indian banking system as the Loans/Deposits ratio is under 80% and the banks are required to hold large amounts of Indian government bonds. Their access to offshore funding is constrained by India's just investment grade sovereign rating. Capital is also adequate in aggregate but some banks, including large Public Sector banks, are in need of core capital.

In this comment we review recent trends in the Indian banking sector, taking a look at the performance and soundness of the banking sector as well as regulatory developments in the context of the broader economic environment. In doing so we draw on the work done by India's central bank, the Reserve Bank of India (RBI), whose "Perspectives on Indian Banking" provides very useful data and commentary. Structure of the Banking System The bulk of India's banking system is made up of the "Scheduled Commercial Banks" (SCBs) which includes both the Public Sector banks (PSBs), in which the government must retain a stake of more than 51% and the Private Sector banks. The latter include the "Old Private sector" banks that have been around for decades and the "New Private sector banks that came into existence in the past twenty years during India's financial reforms. The latter include newly established banks such as Yes Bank, Axis bank and existing institutions that were converted into commercial banks, such as the former development institution ICICI and specialized lenders such as HDFC. India retains leglisation specific to the Public Sector banks and to the State Banks and the RBI suggests a review to bring legislation up to date with real developments and to remove inconsistencies.

As the table shows, the SCBs at 31 March 2011 had total assets of IDR71,835, or about US$1.3 trillion. The bulk of these (74%) were held by the Public sector banks which are dominated by State Bank of India and its associated State Banks. The Private sector banks accounted for 19% and the foreign banks for 7%. Some key features of the Indian banking sector stand out from these data. One of the most notable is the high proportion of government securities held as investments. This stems from the Statutory Liquidity Ratio ("SLR") under which banks are required to keep holdings of high quality liquid assets, notably Indian government bonds at 24% of their deposits in India. It is not entirely clear whether this is best viewed as a prudential measure or a device to ensure a ready supply of funds to cover the central government's perennial fiscal deficits. In addition to this, the CRR or Cash Reserve Ratio requires them to keep 6% of their deposits in cash with the RBI. The consequences of this requirement are that 6% of assets are held as cash and balances with the RBI, 27% are held in investment securities, 60% in the form of loans, resulting in a modest sector Loan/Deposit ratio of 77%. On the other side of the balance sheet, deposits make up 78% of SCB's total funding, consisting of demand deposits (9%), savings deposits (19%) and time deposits (50%). The Public sector banks have the strongest deposit funding which accounts for 83% of their total funding sources; for the Private banks this drops to 72% and for the foreign banks is much lower at 49% as they are more reliant on borrowings and their own capital. Interest rates in India have been deregulated over the past 20 years but one significant control remained until October 2011 that on Savings deposits. The lifting of this control should lead to more competition between banks and higher funding costs. But since most of such deposits are held by a handful of the largest Public and private banks the effects may be limited. The RBI is keen to make deposits more attractive to savers so as to mobilize more funds for investment. The RBI is aware that liberalization will put some pressure on banks' NIMs and it encourages Indian banks to further improve their operating efficiency, which has moved closer to global best practice over the past 15 years. RBI notes that the NIM for Indian banks is higher than that in some other emerging market banking systems even though the banks are subject to requirements to direct specified proportions of their lending to the government's "Priority Sectors" see below.

Economic Background The main challenge for India's policy makers over the past two years has been to tackle inflationary pressures that built up after the financial crisis which did not, in fact, do much damage to India but led the RBI to adopt an expansionary monetary policy. In the financial year ending March 2011 the RBI raised its policy rate (the repo rate) eight times (375bp) and a further five times (175 bp) in FY2011-12 for a total of 525bp of tightening between October 2009 and October 2011. Inflation is still running at close to and loan interest rates are in high single digits.The IMF forecasts India's economy to grow in the 7% range in 2011 and 2012 but there is considerable uncertainty as to how far growth will slow, concerns that are exacerbated by the ongoing policy paralyisis. Performance of SCBs Against this background, the performance of banks has faced some headwinds and pressure on borrowers has led to some asset quality deterioration. Even so, the SCB's still managed to achieve (per RBI) a net ROA of 1.1% and a ROE of 15% in the year to 31 March 2011. This enabled the RBI to conclude that "the performance of Indian banks remained robust during 2010-11". Within this, the ROA of the public sector banks was 0.96%, the Private banks 1.28% and the foreign banks 1.74%. But the Public sector banks achieve higher a higher ROE at 17% vs 14% for the Private banks and 10% for the foreign banks thanks to their higher leverage. One reason for the NIM improvement in FYE2011 was the introduction in July 2010 of a new "Base rate system" which may have helped curb rate competition in corporate lending as banks were prohibited from lending below their Base rate. Considering that so much of their assets are allocated to cash and government bonds the Indian bank's NIM is better than might be expected though it trails that in some other emerging market economies in Asia (e.g, Indonesia) and Latin America. Costs have increased rapidly in part due to additional cost burdens in both FYE2010 and FYE2011 relating to pension and other staff-related benefits. Changes to these led to large costs that some banks recognized immediately while others are taking advantage of the RBI's permission to amortise the costs over a five year period. Not surprisingly this is a bigger issue for the Public sector banks with their large, long-serving staff and less so for the new Private banks. To cover the costs SBI took a charge directly against equity reserves. Helped by their reasonably strong revenues, cost/income ratios for the SCBs as a whole are not high around 45%. Policymakers in India are currently very focused on "Inclusive growth" which for the banks means making banking services available to the still very large number of people living in India's smaller towns and villages which currently have no access to banking services. Naturally, one reason why such services are not available is the low level of incomes and savings in such areas. The policymakers recognize this and are encouraging banks to develop low cost products, services and delivery channels including the use of agents to act on their behalf. RBI allows banks to open new branches freely in smaller cities but requires them to open 1 new rural branch or point of representation for every new branch opened in large towns and cities. Provisions for loan and other losses have absorbed more than 50% of pre-provision operating profit in the past two years. The high level of charges reflects some increase in NPAs after the

crisis as well as the after-effects of India's consumer credit boom which left many banks with heavy bad loans. In 2010 RBI required banks to set up specific provisions to cover (together with write-offs) 70% of NPAs. Some banks such as SBI were below this level and have been raising reserves to reach the target. Even so, the underlying profitability of Indian banks has been strong enough to enable them to absorb the costs and still report reasonably good levels of net profitability. In some respects this high level of profitability is surprising given the prevalence of government owned banks. In our view a key underlying factor is the strong demand for credit stemming from India's growth and the previously low level of financial sector development, with a low ratio of bank credit to GDP. Such strong demand has enabled banks to make sufficiently wide spreads that enable them to achieve a reasonably good return after credit losses. Lending distribution The distribution of the "Gross Bank Credit" in India per the RBI is shown in the accompanying chart. As can be seen, lending to agriculture and industry, including infrastructure, accounts for a majority of the bank's lending and lending to individuals for just under 20% of which half is housing loans. Auto loans and education loans make up most of the rest. Unsecured consumer loans and credit card lending is small and domestic and foreign lenders have pulled back from this sector after suffering heavy losses in the mid-2000s. Policymakers have for decades tried to encourage the banks to lend more to designated "priority" sectors. Banks are in fact required to extend 40% of their lending (32% for the foreign banks) to the priority sectors, which includes farmers and the broader agricultural sector, to which 18% of credits should be extended. Priority sectors also include Micro and Small Enterprises (credit up to to IDR2.5 mln about US$50,000), education loans and housing loans also under IDR2.5 mln. Some banks, especially the private banks, have sought to fulfill the requirement with least risk by making "indirect loans" e.g. to micro-finance lenders and by lending to agribusinesses and larger SMEs, while the PSBs, especially State Bank of India, with its very large network, have lent more directly to farmers and very small businesses. At the same time, regulators are keen to discourage banks from excessive lending to higher risk sectors and the RBI requires banks to monitor and disclose their exposure to certain "Sensitive Sectors", notably (Commercial) Real Estate, Capital Markets and Commodities. Asset Quality It is not only India's politicians that have been interventionist in steering the banking system towards providing more credit to those sections of society that would normally find it hard to get access to bank credit. The RBI has also taken a proactive approach towards bank regulation and in the run-up to the Global Financial Crisis it made adjustments to Risk Weights and loan loss reserve requirements to discourage lending to certain sectors it feared were overheating, notably commercial real estate and some areas of retail lending, on which banks

did in fact get somewhat burnt after an overly enthusiastic push into unsecured consumer lending in the mid-2000s. The RBI appears to be pleased with the way it "deviated from the Greenspan orthodoxy" in the mid-2000s to "safeguard the banking system from the fall-out of asset price bubbles and busts". The RBI is apparently interested in the approach previously used by the Spanish bank regulator of 'counter-cyclical provisioning" i.e. forcing banks to build up loan loss reserves during good times, but implementation is proving challenging. Indian banks have not yet introduced IFRS and loan loss provisioning is one area that may require some adjustment. The asset quality of Indian banks has improved dramatically over the past 15 years as banks have strengthened their risk management capability at the same time as political intervention has diminished and regulation sharpened, all against a background of strong economic growth and in ealier years a strong push by regulators to encourage banks to resolve outstanding NPAs through collections or write-offs. The RBI cites the drop in gross NPAs from 15.7% in March 1997 to 2.2% in March 2011. The latter figure actually represents an increase from under 2% in March 2008. Are these numbers reliable? Can we have confidence in the asset quality numbers reported by Indian banks? Several years ago the answer would have been a clear negative. But the situation has improved in recent years and as we have noted, RBI is in some respects a conservative regulator. However, it is also aware of the banking sector's social development role and in the aftermath of the recent financial crisis it did allow Indian banks to assist borrowers by proactively restructuring loans, most of which were then reported as normal or "Standard" assets. The reported NPA figure is therefore understated, though some of the restructured loans have suffered "slippage" and have now fallen into the NPA category. Still, to its credit, RBI does clearly disclose what the banks have done and shows the amounts of restructured loans. If all these are assumed to be NPAs then the combined total of NPAs would rise to 5.01% and end-March 31 2011, a decline from 5.46% a year earlier. The total incidence of new NPAs that emerged during the year was 2.0% of outstanding loans (at the start of the year) in FYE2011 vs 2.2% in FYE2010, 2.1% in FYE2009 and 1.8% in FYE2008. State Bank of India had the highest incidence of new NPAs in FYE2011 with a slippage rate of 2.7% due to problems in its lending to small businesses and farmers. In 2010 the RBI required banks to maintain specific provisions at over 70% of NPAs, which includes some adjustment for write-offs and so does not always equate to simple calculation of provisions/NPAs. It is notable that the Private and Foreign banks are above the 70% level but the Public sector banks are not, mainly because SBI was still short and has just reached the required level in September 2011. For restructured loans banks set up provisions to take account of the lower NPV of loans whose interest rate has been reduced and/or the maturities extended. The banks also set up reserves for their performing, or Standard, assets at varying levels depending on asset class but for most loans at 0.4%, having been pushed as high as 2% for some loans as part of the RBI's countercyclical measures.

Funding Indian banks are mainly funded by deposits and, as noted above, the system's Loan/Deposit ratio of 77% is relatively low, mainly due to the SLR that requires them to hold so many government bonds. Assuming these SLR bonds are counted as liquid assets, the Indian banks should not face much difficulty meeting Basel 3's liquidity requirements. For most banks their preponderance of deposit funding should also help them comply with the Net Stable Funding Requirement. The banks issue bonds in the domestic market, especially the former development banks such as IDBI and ICICI, but since converting to commercial banks these banks have been focused on building up their deposit base to attract more stable and lower cost funding. The large Indian banks also raise wholesale funds outside India to finance their overseas lending, which is mainly India-related, and have raised hybrid capital instruments to meet regulatory capital requirements. Their offshore wholesale borrowings introduce an element of vulnerability for the Indian banks as the Indian sovereign is perceived as relatively weak, with low BBB sovereign ratings, though the main constraint on the rating is India's poor domestic fiscal position rather than its external debts. Capital The Indian banking sector's capital adequacy is reasonably strong overall, though there are significant variations. As the table shows, the total risk weighted capital ratio of the system was 13% at 31 March 2011, within which the Tier 1 ratio was 9.2%. RBI reports that at that date only three banks had a Tier 1 ratio below informal 8% which is the guideline for Indian banks. RBI also reports that Basel 3 should have only a limited impact, citing an estimate that in June 2010 the total CAR of the Indian banks would be 11.7% vs the 10.5% minimum. Nevertheless, capital remains an issue for some banks with weaker Tier 1 ratios that include some reliance on hybrids that will need to be replaced with common equity. This is clearly difficult at present as equity markets are not conducive to large scale capital raisings. Equity issues are more challenging to implement for the Public sector banks as the government must keep its stake above 51% and so may need to participate to avoid dilution. The government has indicated that it will provide capital to ensure the Public sector banks keep their Tier 1 ratios above 8%, but as ever in India, acting swiftly and coming up with promised cash is always a challenge for India's government. The government is looking at moving to the financial holding company model for listed banks which may also give the government more flexibility in raising capital for the Public sector banks.

Major Players Among Indian Banks SBI is three times the size of the next largest bank and dominates the system with a market share of 18% by these measures, though SBI cites its loans and deposits share as being 16%. As can be seen, only three of the top ten banks are private, as the PSBs continue to dominate the system. Although previously "nationalized" these banks have been partially privatized and are listed and operate as (largely) commercial banks.

Foreign Banks Major Players Among the foreign banks, Standard Chartered leads with around 25% of lending by the foreign banks. It is followed by Citi and HSBC and the three together account for 60% of lending by foreign banks.

David Marshall Published in: European Morning Comment [December 19]

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