PORTER’S FIVE FORCES

ANALYSIS OF INDIAN
BANKING INDUSTRY
There are numerous competitors in the banking industry, including banks, investment
banks, credit unions, thrifts, advisory firms, and credit card issuers, among others, all of
them competing in each of the industry's numerous respective segments and niches.
However, the banking industry is intrinsically concentrated to a few large players; the
strict capital regulation to secure the stability of the financial system, along with the
nature of this business itself, mean that asset concentration is reinforcing growth
through economies of scale.

The banking industry serves a wide range of customer types: from mass-market
individual consumers to high net- worth individuals; and from small, local businesses to
major corporates. Due to the large number of buyers, the gain or loss of an individual
customer is not significant, thereby reducing buyer power. This is, however, not the
case with large companies, some of whom generate a large amount of revenue and
profit for banks. Overall, the indispensability of banking services for all types of buyers
limits their bargaining power.

Players operating within this industry need a reliable and secure ICT infrastructure in
place. The providers of these products and services tend to be large, with the ability
to assess the complex ICT needs of major banks and offer appropriate solutions, which
strengthens supplier power. Furthermore, network operators which can process card
and ATM transactions are large and few, having great power over the industry players
with which they form partnerships.

Regulation in the banking industry is costly, working as a high barrier for new entrants.
Banking institutions must adhere to strict regulation in all aspects of their operations,
such as meeting capital adequacy ratios and maintaining morality and transparency
in terms of their practices, which entail high costs of compliance. Moreover, non-
regulatory barriers, such as brand recognition and the extensive branch networks of
large incumbents, through which they accumulate a disproportionate share of assets,
further prevent new entrants. Small scale entry is only possible by operating exclusively
through digital channels, thanks to the proliferation of online banking services, but
significant investment is still necessary to challenge incumbents.
Substitutes include loaning from family, friends or loan sharks, bearing limited capacity
and extremely high interests, respectively. The benefits of investment alternatives are
difficult to gauge since they offer varied returns and risks. Other substitutes include
non-financial corporations that take revenue away from industry players, with the
rising popularity of e-wallets and other depository alternatives, such as
cryptocurrencies, adding to the substitute threat.

I. Buyer Power
The banking industry serves a wide range of customer types: from mass-market
individual consumers to high net- worth individuals; and from small, local businesses to
major corporates. Due to the large number of buyers, the gain or loss of an individual
customer is not significant, thereby reducing buyer power. This is, however, not the
case with large companies, some of whom generate a large amount of revenue and
profit for banks. The effect of gaining or losing one or more of these ‘key clients’ would
be significant.

The economic crisis of 2008-2009 has led to an erosion of customers' trust in banks as
safe places to deposit savings, while the low interest rate environment that still prevails
after the end of that crisis has reduced the appeal of these core banking products for
consumers. Nonetheless, banking services are still indispensable for transactions, and
their rate of dispensability is dependent on the financial inclusion of individuals within
a country. On the other hand, 2019 negative and close to zero rates have made
individual consumers reluctant to deposit savings as it is more expensive, decreasing
their savings in the long-run. However, it increases lending and borrowing for
consumers and big corporations as it is cheaper to lend money from banks when you
are dealing with negative rates. When a consumer makes a deposit under negative
rates, he or she pays the bank to save their money; however, when a consumer or a
company borrows money from the bank under negative rates, then the bank pays
those individuals to borrow money from them.

In India, a bank account is essential to receive salaries and government transfers, but
other transactions such as paying bills via standing orders and direct debits are not
usually carried out by account transfers. Moreover, the country has not achieved
financial inclusion for its total population. There were 1.89 deposit accounts per adult,
but only a minority of people possesses a bank account according to the IMF
Financial Access Survey. However, Banking services have been made even less
dispensable by progress towards a cashless society. In 2017 there were 12 card
transactions per capita in India, according to the Bank for International Settlements
(BIS). Credit (wire) transfers and direct debits amounted to 4.57 and 0.35 transactions
per capita, respectively, according to the same source, but have increased rapidly
in recent years. Overall, India is characterized by moderate financial institution depth,
with domestic credit from banks to the private sector equivalent to 49.5% of the
country’s GDP in 2016.

A bank's reputation is also vulnerable to corruption scandals and misconduct

practices. Issues impacting consumer confidence persist. Banks across the world have
seen regulatory action and punishments for perceived infringements of regulations,
such as money laundering or tax evasion facilitation. The amount paid in fines by
institutions across the globe in recent years runs into the billions. In February 2018, a big
bank corruption scandal caused major upset to Indian consumers. Executives of one
of India’s largest banks, Punjab National Bank (PNB), were involved in bribery by an
Indian jewellery billionaire, Nirav Modi, for defrauding $1.8bn. This is scandal is
indicative of the corruption problems in the Indian banking system. Reportedly, over
2012-2017, Indian banks faced nearly 23,000 cases of fraud, with total losses estimated
at $10.8bn.

The minimal product differentiation in the banking industry enhances switching

among consumers who seek high returns. Customer service, reputation and security
against fraud may influence customer loyalty. However, there is little differentiation
between the core services for a given customer type, for example, extending credit,
deposit facilities, and the withdrawal of funds to mass-market individual consumers; or
asset management and private banking for high net-worth individuals and businesses.

Switching costs depend upon the product and customer type. For individual
consumers, early exit from a mortgage usually incurs a fee, while the cost of switching
credit cards and bank accounts is minimal. For business customers with more complex
banking needs, the switching process may be more complicated and have a
potential impact on their business operations. As a result, this reduces the buyer power
of corporate clients.

Overall, buyer power is assessed as moderate in the banking industry.

II. Supplier Power

The banking industry serves a wide range of customer types: from mass-market
individual consumers to high net- worth individuals; and from small, local businesses to
major corporates. Due to the large number of buyers, the gain or loss of an individual
customer is not significant, thereby reducing buyer power. This is, however, not the
case with large companies, some of whom generate a large amount of revenue and
profit for banks. The effect of gaining or losing one or more of these ‘key clients’ would
be significant.
The economic crisis of 2008-2009 has led to an erosion of customers' trust in banks as
safe places to deposit savings, while the low interest rate environment that still prevails
after the end of that crisis has reduced the appeal of these core banking products for
consumers. Nonetheless, banking services are still indispensable for transactions, and
their rate of dispensability is dependent on the financial inclusion of individuals within
a country. On the other hand, 2019 negative and close to zero rates have made
individual consumers reluctant to deposit savings as it is more expensive, decreasing
their savings in the long-run. However, it increases lending and borrowing for
consumers and big corporations as it is cheaper to lend money from banks when you
are dealing with negative rates. When a consumer makes a deposit under negative
rates, he or she pays the bank to save their money; however, when a consumer or a
company borrows money from the bank under negative rates, then the bank pays
those individuals to borrow money from them.

In India, a bank account is essential to receive salaries and government transfers, but
other transactions such as paying bills via standing orders and direct debits are not
usually carried out by account transfers. Moreover, the country has not achieved
financial inclusion for its total population. There were 1.89 deposit accounts per adult,
but only a minority of people possesses a bank account according to the IMF
Financial Access Survey. However, Banking services have been made even less
dispensable by progress towards a cashless society. In 2017 there were 12 card
transactions per capita in India, according to the Bank for International Settlements
(BIS). Credit (wire) transfers and direct debits amounted to 4.57 and 0.35 transactions
per capita, respectively, according to the same source, but have increased rapidly
in recent years. Overall, India is characterized by moderate financial institution depth,
with domestic credit from banks to the private sector equivalent to 49.5% of the
country’s GDP in 2016.

A bank's reputation is also vulnerable to corruption scandals and misconduct

practices. Issues impacting consumer confidence persist. Banks across the world have
seen regulatory action and punishments for perceived infringements of regulations,
such as money laundering or tax evasion facilitation. The amount paid in fines by
institutions across the globe in recent years runs into the billions. In February 2018, a big
bank corruption scandal caused major upset to Indian consumers. Executives of one
of India’s largest banks, Punjab National Bank (PNB), were involved in bribery by an
Indian jewellery billionaire, Nirav Modi, for defrauding $1.8bn. This is scandal is
indicative of the corruption problems in the Indian banking system. Reportedly, over
2012-2017, Indian banks faced nearly 23,000 cases of fraud, with total losses estimated
at $10.8bn.

The minimal product differentiation in the banking industry enhances switching

among consumers who seek high returns. Customer service, reputation and security
against fraud may influence customer loyalty. However, there is little differentiation
between the core services for a given customer type, for example, extending credit,
deposit facilities, and the withdrawal of funds to mass-market individual consumers; or
asset management and private banking for high net-worth individuals and businesses.

Switching costs depend upon the product and customer type. For individual
consumers, early exit from a mortgage usually incurs a fee, while the cost of switching
credit cards and bank accounts is minimal. For business customers with more complex
banking needs, the switching process may be more complicated and have a
potential impact on their business operations. As a result, this reduces the buyer power
of corporate clients.

Overall, buyer power is assessed as moderate in the banking industry.

III. Threat of New Entrants

Regulatory barriers regarding the vast amount of capital required for a banking firm,
and the burden of a strict operation-framework, are high enough to deter new
entrants. Moreover, non-regulatory barriers such as the brand recognition and
extensive branch networks of large incumbents, through which they accumulate a
disproportionate share of assets, further prevent new entrants.

Entering this industry as an entirely new start-up company would require substantial
funds to comply with the capital requirements needed to obtain a banking license.
Moreover, the amount of investment in infrastructure, particularly in distribution
networks (e.g. setting up a branch network) and IT systems, as well as the marketing
expenditure for brand-building to compete on the same scale with large incumbents,
is significant, even for established international banking firms entering a country’s
industry. Reputation is a key factor in this industry, with a player’s reputation
concerning security and customer service holding particular importance. Thus, huge
investments are required in information systems to improve security, along with
expenses for marketing and customer service initiatives.

Smaller-scale entry may be possible through digital channels (digital banks), thanks to
the proliferation of online banking services. However, such a new player would still be
competing with similar services offered by larger players with strong brands. These
incumbents have a first-mover advantage based on their established position in terms
of industry assets and distribution channels. In this regard, brand loyalty and switching
costs favor customer retention. On the other hand, the operating model of large
incumbents, which is based on significant investments into fixed assets, entails high
fixed costs. Under these terms, that operating model might be challenged by
standalone banks, with legacy banks being less flexible in terms of adopting digital
innovation (FinTech) as they would have to abandon to some extent their current
operating model of physical distribution channels, which is one of their competitive
edges. The distribution channel of the Indian banking industry is 14.72 branches per
100,000 adults, according to the IMF 2017 Financial Access Survey. Moreover, these
figures have been increasing slightly in recent years – as the industry has expanded in
line with increasing financial inclusion - indicating that physical distribution channels
are still essential.

FinTech is going to play a crucial role in the development of online distribution

channels in the banking industry, with many large banking firms investing in these
solutions. HDFC and the State Bank of India have already invested in FinTech,
developing online banking platforms and artificial intelligence solutions. What is more,
the demonetization imposed in India over the last few years has increased financial
inclusion through FinTech. At the end of 2016, the Indian government withdrew high-
value bank notes from circulation to increase financial inclusion in the country’s formal
banking sector. However, a cash shortage and the limited expansion of bank
branches and ATMs through the country have enhanced the use of online payments.

The high level of regulation in the banking industry creates high operating costs which
are unattractive to new entrants. Regulatory bodies should make sure that players in
this economically vital industry apply moral and transparent practices that are
stimulating for the economy. For this reason, capital adequacy ratios dictated by
Basel Accords are restrictive in terms of a bank's operations. Banks are periodically
subjected to stress tests which involve high costs, in order to limit the possibilities of a
systemic risk. In addition, anti-money laundering rules increase bureaucracy and fixed
costs. The breach of regulation can be costly for players within the industry. For
instance, in July 2016, the Indian regulator fined 13 banks $400m for violating the
country's Foreign Exchange Management Act (FEMA) regulation and KYC (Know Your
Client) norms. Most recently, in October 2017, the regulator fined IDFC Bank INR6 crore
($0.92m) and Yes Bank INR2 crore ($0.3m) for deficiencies in regulatory compliance;
the former for breaching regulation relating to loans and advances and the latter for
not reporting security incidents.

Regulation is enforced by the Reserve Bank of India. The Indian banking industry
complies with capital regulatory standards dictated by Basel III. A cash reserve ratio
(CRR) of 4% on a daily-basis is also dictated by the Reserve Bank of India. The Basel III
legislation (a global regulatory standard on bank capital adequacy and liquidity
agreed by the members of the Basel Committee on Banking Supervision) increased
the mandatory Tier 1 capital ratio (equity capital to risk-weighted assets) of banks from
4% to 6%, effective from January 2015, with the minimum common equity capital ratio
set at 4.5%. The capital requirements of Basel III were further tightened in 2018. The
capital conservation buffer introduced in the Basel III standards (an additional capital
buffer built-up outside periods of stress to be used as a cushion against losses) is set at
1.875% of risk-weighted assets - increased from 1.25% in 2017 – effective from 2018,
and it will be further raised to 2.5% effective from 2019. This brings the overall common
equity Tier I capital ratio requirements to 6.375%. Moreover, the minimum liquidity
coverage ratio (the ratio of highly liquid assets to be held by banks in the total of net
cash outflows over 30 days) has also increased to 90% in 2018, from 80% previously in
2017, and is set to reach 100%, effective from 2019. This makes operating in the industry
more capital intensive, and in turn, more difficult, thus reducing the likelihood of new
entrants.

What is more, the introduction of the Insolvency and Bankruptcy Code (IBC) in 2016
addressed non-serviceable debt accumulated by firms, and repayments to banks
through the insolvency of these firms, as this framework identifies, standardizes and
speeds-up the corporate insolvency resolution process.

Ultimately, the likelihood of new entrants to this industry is assessed as moderate

overall.

IV. Threat of Substitutes

Although gifts and loans from family or friends can serve as a substitute for loans from
banks and credit cards, capital available from this stream is likely to be very limited.
Other substitutes include lending through loan sharks or payday lenders. However,
these are not as stringently regulated as banks and do not have a good reputation
among consumers.

The available alternatives to banks only serve as substitutes for certain banking
operations and products, as banking activities cannot be substituted as a whole. For
instance, mortgage lending for buying a house might be threatened by the
alternative option of rented accommodation; assessing the true cost of this substitute
is difficult, as while monthly rent may be lower than mortgage repayments for
comparable properties, a homeowner ends up with an asset, the ultimate value of
which may be much greater than the cost of the mortgage. Moreover, usual banking
activities such as international money transfers and electronic transactions can be
substituted by non-financial institutions, namely PayPal and other online payment
service providers (e-wallets), as well as non-banking financial service providers such
as MoneyGram and Western Union. The value of e-money payments in India stood at
INR1tn ($15.3bn) according to the Bank for International Settlements in 2017,
demonstrating a rapidly increasing trend. The popularity of online payment
companies such as Paytm (also funded by Alibaba) increased, particularly with low-
income consumers in rural areas.

There are also multiple investment alternatives such as stocks or other financial
products that serve as substitutes for savings and investment banking products. These
alternatives, however, cannot be easily assessed as the more attractive options with
greater return-potential are usually associated with higher risks.
Overall, there is a weak threat from substitutes.

V. Degree of Rivalry
There are a number of competitors within the banking industry. Players must compete
with other banks, thrifts, credit unions, investment banking firms, investment advisory
firms, brokerage firms, investment companies, mortgage banking companies, credit
card issuers and mutual fund companies in numerous respective segments and niches
of the industry. However, the banking industry is also intrinsically concentrated to a
few large players; strict capital regulations for securing the stability of the financial
system, along with the nature of the business as asset concentration reinforces growth
through economies of scale, lead to a heavily concentrated industry.

Nevertheless, the limited capacity of differentiating services and products within the
banking industry preserves competition. Product differentiation may exist only in the
form of fees, interest rates on loans and deposits, lending limits, notice periods for
withdrawals, and customer convenience, along with the general quality and range
of product and service offerings. Most banks offer a diverse range of products,
including: retail banking (home, small business, insurance), card services, investment
banking, asset management, cash management, and e-commerce products.

There are only a few banking firms that focus on a particular segment or niche market
of clients.

Both product and geographical diversification ease rivalry, as companies are less
reliant on a specific market, while that diversification may also serve as a competitive
advantage in terms of robustness against market shocks.

Players can differ in the method of delivering their products: retail branches, online
banking, and telephone banking are all available distribution channels for players.
High fixed costs regarding the development of physical distribution channels, as well
as expenditure for advertising and brand-building, limit the growth potential of smaller
players, favoring concentration. It should be noted though that the proliferation of
online banking services has changed this as it offers less costly growth potential. This
has given room to smaller players such as online banks to expand, inducing
competition.

Efficiency is the key aspect of competition in this industry as banking operations are
based on the maximum utilization of capital. All banking firms borrow capital at similar
cost, yielding the margin between borrowing and lending operations, and achieving
return from investment-trading activities in the financial market. Accordingly,
improved efficiency creates greater competition capacity; banking institutions that
increasingly accumulate capital are able to further increase their share of assets in
the industry (economies of scale), offering competitive lending/savings interest rates.
Conversely, a high cost-to-income ratio, poor capital adequacy, and bad-quality
assets (high portion of non-performing loans) are impediments for the growth of
banking operations.

Rivalry and profitability in the banking industry is also dictated by the macroeconomic
environment. The term structure of interest rates, depicted by the yield curve, which
reflects the relationship between the (expected) level of interest rates (of similar bonds
and other financial instruments) and the time until maturity, is an important measure
for the future profitability of banks. For example, an existing term structure of interest
rates depicted by an upward- sloping yield curve, which indicates that the level of
short-term interest rates is lower than that of long-term interest rates, is a positive sign
for banks’ profitability, since that profitability is based on borrowing in the short-term
(mainly through deposits) and lending on the long-term (through long-term loans and
debt securities). In contrast, an inverse relationship that leads to an inverted yield
curve signals a negative outlook for banks’ profitability, along with expectations of an
economic recession, as short-term interest rates that are higher than the long-term
rates indicates an unprosperous scenario for banking operations.

Moreover, a negative macroeconomic environment can evaporate the assets of

banking institutions, reducing deposits and the value of investments/securities held by
them, hence impairing their capital adequacy. As a result, in times of economic
downturn, banking firms with poor capital adequacy may face sustainability issues. In
this case, the consolidation of the banking system is inevitable as past experience has
proven. Following the 2008/09 global economic crisis, the banking industry has
become more concentrated, as a result of acquisitions, mergers, and bankruptcies.
Overall, 1,745 credit institutions (21 public sector banks, 21 private banks, 56 regional
banks and 1,551 urban non-cooperative) banks were operating in the Indian industry
as of the end of 2017, with that number slightly decreasing in recent years, as the
relaxed monetary policy and increasing regulatory capital requirements have
encouraged consolidation in order to achieve economies of scale.

Increased rivalry in the banking industry may lead to financial instability. This was
proven in the crisis of 2008 when banks invested too much in high-risk financial
products and extended subprime lending to improve their position. On the other
hand, rising levels of concentration in the industry can lead to moral hazard problems,
creating players that are too big to fail.

The monetary policy, which is determinant of money supply in the industry, in theory
has a neutral role on banks’ competition and financial stability. However, there is
evidence that a prolonged relaxed monetary policy might lead to higher bank risks
and impaired profitability in the face of competition. This is because there is a de facto
limited capacity of banks to reduce interest rate expenditure (deposit rates) in the
case of a relaxed monetary policy, as deposits would become unattractive for
consumers at zero or negative interest rates (savings account charges).

Subsequently, the profitability of banks is impaired due to suppressed net interest

income driven by the need to maintain customers’ deposits, and thus banking
operations may become risky in the search of profits from trading income or high-risk
lending.

On the other hand, it should be noted that limited bank competition can impair the
monetary policy transmission mechanism. The effect of monetary policy adjustments
might not be fully-transmitted through the lending and saving interest rates offered by
(large) banks, as the latter might exploit their market power to increase their margin.

Moreover, monetary policy transmission effects can also be asymmetric due to limited
competition; lending rates can be more rigid to relaxed monetary policy adjustments
than in the case of monetary policy tightening. As a result, the competition in the
banking industry has substantial impact on the economy, as it shapes the
fundamental input of funding costs for all firms.

Overall, there are two main views on the measures-indicators of banking competition.
Firstly, the share of assets of leading firms in the industry defines the structure of the
industry and can be indicative of the conduct of these firms. Secondly, the interest
rate spread – the difference between lending and deposit rates – is a useful proxy of
firms’ conduct to identify the level of competition. In a perfect-competition
environment this spread is equal to zero. In this regard, the lower the net interest
margin of banking firms, the more competitive the industry is.

The big four banking firms (in terms of assets) in India are State Bank of India, HDFC
Bank, ICICI and Punjab National Bank. The Indian banking industry is highly
fragmented. Nevertheless, stated-owned banks, particularly the State Bank of India,
Punjab National Bank, and Canara Bank, exercise power. Private banks such as ICICI,
HDFC, Axis Bank and Yes Bank are constantly gaining ground over state banks,
inducing competition. Competition from foreign banks is limited due to their limited
presence, but new foreign entrants have been increasing in recent years. Overall,
there are 328 branches across India, most of which are operated by Standard
Chartered Bank which has 100 branches in 43 cities across the country.

State banks are used as instruments from the government for the development of the
national economy, such as financing infrastructure priorities. In this way, some state
banks are subject to bad debt accumulation. Private banks such as Axis banks and
foreign branches differentiate from public banks by addressing high-end consumers,
also being more diverse on asset management and consumer credit segments.

Consolidation has occurred in recent years as the industry is highly fragmented to be

sustainable, while the piles of bad debt accumulated have worsen this situation. In
2017, the State Bank of India merged with five associate banks (State Bank of Bikaner
& Jaipur, State Bank of Mysore, State Bank of Travancore, State Bank of Patiala, and
State Bank of Hyderabad), creating an even bigger player with an estimated asset-
value of $550bn, 500 million customers, and a network of nearly 23,000 branches.
Through this consolidation, it is expected to offer cost savings of $200m.

Concentration, and subsequent consolidation, will increase as long as the profitability

of banks is suppressed, with bigger and more profitable lenders gaining market shares
against smaller players that lack profitability and capital.

A capital injection of $14bn into public lenders other than India Bank, which
accumulated the largest amount of bad debt, by March 2018 and another $19.1bn
by March 2019, will improve the capital adequacy of these lenders. IDBI Bank, which
is the lender with the highest non-performing loan ratio, will receive the biggest share
of this state-aid (INR106.1bn). State Bank of India will receive 88bn rupees, while
Punjab National Bank will get INR54.73bn.

Finally, it should be noted that the quality of credit issued will be a challenge for the
industry; in rural areas credit is mainly spent in consumption purposes, while high
interest rates apply to these short-term loans. Moreover, household debt in urban
areas is higher in terms of income, and in some cases, it also serves consumption
purposes such as medical treatment. This will have a negative impact on growth if
credit policies are not tightened, and intense competition means of indiscriminate
lending is not going to serve that purpose.

Ultimately, the degree of rivalry is assessed as moderate.