BRIC Spotlight

Banking Sector in India: Counting on Credit Growth

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April 2011
In 2008, when the global banking industry was being shaken by the tremors of the unfolding financial crisis, only one bank in India felt the aftershocks, and this, only because one of its overseas subsidiaries had made an opportunistic bet on debt issued by the failed investment bank Lehman Brothers. While the market valuations of all the leading banks in India slipped as equity prices tumbled, their businesses were not affected and their balance sheets remained healthy. Most domestic commentators continue to hold up this episode as

Fast Facts
Indias banking industry has evolved over a long period of more than two centuries. Despite the recent growth of private banks, the sector is dominated by government-controlled banks that hold nearly three-fourths of total bank assets. Indias banking industry is considered to be very stable with healthy balance sheets and low exposure to risky assets. The global financial crisis did not affect the Indian banks significantly. Nearly 40% of the population does not have a bank account and only 15% have borrowed from banks. Even after sustained growth since the nineties, the share of consumer credit remains very low in total bank loans. The banking sector in India has a relatively high proportion of women CEOs. The chief executives of leading domestic lenders ICICI Bank and Axis Bank, besides the country heads of HSBC, JP Morgan, UBS, and RBS are all women. Until recently, two among the Reserve Bank of Indias four deputy governors were also women.

evidence of the inherent strengths of the Indian banking industry and have lauded the Reserve Bank of India (RBI), the countrys central bank and banking regulator, for sticking with its conservative approach. When regulators around the world were loosening their grasp over the banking and financial services industry, RBI steadfastly held on to the strings that prevented banks in India from making risky investments and following highly aggressive business practices. Though some of the countrys younger banks have fast growing asset management and insurance businesses, the industrys bread and butter is still industrial lending. Asset Backed Securities and Collateralized Mortgage Obligations are still unheard of in the country, while Indian lenders warmed up to the idea of teaser rate mortgages only after the global financial crisis. So far, they do not appear to be any worse for it. The Indian banking industry is also well capitalized and capital ratios are above the global average. The average tier-1 capital adequacy ratio of the Indian banking industry is above 10%, when compared to the Basel III norm of 8.5% including the contingency buffer. The average total capital of banks in India stood at 14.5% as of March 31, 2010, compared to the Basel III requirement of 10.5%.

Leading Indian Banks by Assets and Market Capitalization Bank State Bank of India ICICI Bank Punjab National Bank Bank of Baroda Bank of India Canara Bank IDBI Bank HDFC Bank Union Bank of India Axis Bank Majority Shareholding Government Private Government Government Government Government Government Private Government Private Asset Size (in $ Billions) 314 81 66 62 61 59 52 49 43 40 Market Capitalization (in $ Billions) 36.6 25.6 7.6 7.3 5.1 5.5 2.9 22.2 3.7 11.6 Stock Listing Mumbai, London Mumbai, New York Mumbai Mumbai Mumbai Mumbai Mumbai Mumbai Mumbai

Mumbai, London Market capitalization data based on full capitalization as on March 18, 2011 Bank Assets as on March 31, 2010; Source: Indian Banks Association

However, it can also be argued that the cautious regulatory controls have stifled the growth of the banking industry in India. This is the sector with the most entry barriers as the RBI has not issued new banking licenses for well over a decade. Foreign shareholdings in domestic banks are restricted and foreign banks have to wait years to get permission to start banking operations or expand their network. Except for a few cases where the large banks were encouraged by the RBI to acquire failing banks, the industry has not seen any meaningful consolidation. As a result, while India continues to move up the ranks of the largest economies in the world, most Indian banks are significantly smaller than their global counterparts. They are no match to even banks in other emerging economies like China, and only one bank from India is ranked among the global top-100 in terms of asset size. Also the cost of financial intermediation is relatively high in India and banks enjoy wide net interest margins. Access to banking services is poor across vast areas of the countrys rural hinterlands and as a result, more than 40% of the population does not have bank accounts and only about 15% have received some form of bank credit. The World Economic Forum currently ranks India 37th out of 55 countries in financial development, behind other large emerging economies like China, South Africa, and Brazil. An industry built over more than two centuries The origins of the banking industry in India go as far back as the 18th century but many of the early banks promoted by groups of businessmen to finance their trading activities did not survive long. Joint-stock banks made their entry during the second half of the 19th century and a few of them, including Allahabad Bank and Punjab National Bank, have survived to this day. So have several of the banks promoted by the small kingdoms during the first half of the 20th century, which later came under the control of the Indian government. Foreign banks, including The Chartered Bank, which came to the country in 1858, and HSBC, which followed in 1867, were attracted to the increasing trade between India and Britain in the 19th century. The early 19th century also saw the emergence of three large banks, Bank of Bengal, Bank of Bombay, and the Bank of Madras, named after the three major cities that were the regional administrative bases of the English East India Company, which ruled most of the country during that period. Collectively called the presidency banks, they dominated the industry as bankers to the government, and also functioned as the countrys central bank. The Imperial Bank of India was established during the first half of the 20th century by the merger of the presidency banks, and gave up its role as the central bank only after the Reserve Bank of India was formed by the British government in 1935. It was subsequently renamed the State Bank of India after India became free from British rule in 1947. Interestingly, one of the earliest banking industry crises in India was triggered by the American Civil War. As cotton supplies to Britain from the U.S. fell sharply after the war started in 1861, demand for raw cotton exports from India surged. To exploit this opportunity better, some cotton
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Government-Controlled Banks Dominate Controlled

Percentage Share of Total Assets

Foreign Banks 7%

GovtControlled Banks 74%

At the time of Indias independence, almost all major banks except the State Bank of India were privately owned. They remained so for the next two decades until 1969, when the federal government took until control of more than a dozen of the largest banks in the country. More than nine nine-tenths of the banking industry came under government control after the forced acquisition of private banks continued in 1980. The industry remained closed to private promoters until the early nineties, ndustry when the government decided to issue new banking licenses as part of economic liberalization. Though the entry and growth of new private banks over the last two decades has transformed the transforme Indian banking industry, the government-controlled banks still dominate. Together they government controlled command nearly three-fourths of the total banking industry assets and an even bigger share of fourths the branch network. However, the new private banks have been far ahe of the government-controlled banks in ahead controlled utilizing technology to integrat their network and offer more efficient services. They have also integrate been more aggressive in exploiting the business opportunities in the financial services space. Some of the largest private banks in India are now also among the top players in insurance and asset management. Their strong presence in the fast growing financial services sector has helped the leading private banks attract far higher equity market valuations, despite their relatively small balance sheet size. Banking regulation remains cautious As in most countries, the central bank is entrusted with the role of banking regulator in India and the Reserve Bank of India is widely acknowledged as an efficient, but cautious regulator. The government still drives the broader policy framework for the industry, including setting the limits for foreign investments in the sector. While the Indian government has opened up most sectors of the economy to foreign investors over the last two decades, it has been more guarded about banking and financial services. , Accordingly, the aggregate foreign investment limit in domestic private banks increased from 49% to 74% only in 2004, but it remains at a low 20% in banks where the government is the
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Private Sector Banks 19%

traders set up banks to finance their export trade. However, as the war ended in 1865 and exports from the U.S. resumed, demand for Indian cotton also reverted to the earlier levels. Traders who had large inventories and the banks that financed them went bankrupt.

major shareholder. The limit covers all investments by foreigners, including portfolio investments. In addition, the RBI has other restrictions that are aimed at ensuring wider distribution of bank shareholding. Investments exceeding 5% of a banks equity capital by a foreign investor require RBI approval, and a single foreign investor cannot hold more than 10%. These restrictions have also been progressively applied to the domestic shareholders of the smaller private banks, but some of the larger and healthier banks have been given specific exemptions. Further, no bank can hold more than 5% of the shares of another bank, except when a bank on the verge of failure is acquired. The limits on foreign investment do not apply to foreign banks starting a subsidiary or branch network, wholly-owned by the promoting bank. Like regulators in some other countries, in granting new banking licenses, the RBI often favors applicants from countries that have favorable policies for Indian banks seeking to open overseas branches or expand existing ones. As a result, it may take several years for a new foreign aspirant to get a license. More than a dozen applications from foreign banks for banking licenses now await RBI approval, including well-known names like Goldman Sachs. The RBI has also been careful when allowing new branches for existing foreign banks, but the number of branches approved has always exceeded Indias WTO commitment of a dozen new branches a year. Whats more, the RBI also has policies to direct bank credit to sectors that are deemed socially or economically important by the government. Accordingly, all domestic banks are required to lend at least 40% of their total net credit outstanding to exporters, farmers, small businessmen, and low-income borrowers. For foreign banks, the requirement is lower at 32% of net credit. Limited deposit insurance is available to customers of all banks, including foreign banks. Though it influences the credit policies of the banking industry through specific lending requirements, the Indian government generally has less sway over banks when compared to select other emerging economies like China. By and large, banks in India do not boost or curtail credit flows at the governments bidding. Though the government occasionally encourages the banks to increase credit availability, as it did during the global financial crisis, even the government-controlled banks are not forced to comply. This apparent autonomy, though limited in many ways, has allowed most Indian banks to follow prudent credit standards and prevent excessive bad loan losses. However, there have also been cases of banks being pushed to the verge of failure by corruption and political manipulation. Some of the leading banks have also occasionally disagreed with regulatory policies and guidance, though the senior officers of all government-controlled banks are appointed by the government with the consent of the RBI. For instance, the State Bank of India recently refused to
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withdraw its teaser rate mortgages from the market though the RBI repeatedly expressed its RBI dislike for such loans. Industry structure evolving at a measured pace The business composition of banks in India has seen significant changes over the last two decades, but the rate of change has been more measured. Lending to industrial borrowers, including construction, constituted well over half of total bank credit during the mid mid-nineties. This ratio has now come down to 44% in 2010 and most of the decline has been absorbed by consumer loans, which doubled in share to nearly 20% during the same period. Among industrial e borrowers, the banks have the most credit exposure to utilities. This reflects the number of power generation projects that have commenced construction in recent years.
Industrial Lending is the Biggest Segment
Percentage Share of Loan Assets

Most Credit Exposure to Utilities

Percentage among Industrial Borrowers

Farm Sector and Others 13%

Industry 44%

Steel 19%

Textiles 18% Chemicals 13% Energy 11% Road Constructi on 11%

Personal Lending 19%

Services 24%

Utilities 28%

Though the growth in consumer credit has been most evident in urban areas, in recent years semi-urban and even rural areas are seeing excellent growth in this segment. Home mortgages urban account for more than half of all consumer loans, as housing demand and h home prices have increased substantially since the nineties. Also, rising consumer aspirations are driving increased rising credit demand for purchasing Mortgages Form Bulk of Personal Lending automobiles and durables. However, Indian consumers are more cautious Other Loans Home 29% when it comes to credit card debt debt, Mortgages 52% which has a share of only 3% of all Credit Card consumer loans. Interestingly, total Outstanding 3% credit card outstanding has declined in recent years, though aggregate Personal consumer spending has continued to Loans 16% grow.

Government-Controlled Banks: As mentioned earlier, despite the rapid growth of the private banks, the government-controlled banks continue to hold the dominant share in industry assets and branch network. Except for some of the largest banks which have branches in most areas of the country, most of them have their business concentrated in a state or region. As they have been around for a while and their brands are well-recognized, these banks are often among the popular choices for both depositors and borrowers. The financial backing from the government adds to their allure to depositors, and the government has consistently bailed out the failing banks it controls, through capital infusions. Over the last couple of years, helped by a $3 billion World Bank loan, the government has provided additional capital to several of the smaller banks. At the same time, the government has steadfastly held on to its policy of retaining majority shareholding in all banks under its control. This may restrict the capital raising options for some of the banks, as the government shareholding is already close to the threshold. For instance, at the State Bank of India, which may require the most capital as it is the largest, the government holding is already down to 59%. Hence, the government may have to deploy additional capital if it wants to retain majority holding of 51% or above. Without the support of institutions like the World Bank, fiscal constraints may prevent the government from providing sufficient capital to retain its majority shareholding. The government-controlled banks also have pension liabilities, which are not fully recognized on their balance sheets. These liabilities arose from a settlement with older employees who wanted to revert to a defined benefit program, which some of them had opted out several years back in favor of a defined contribution plan. The aggregate liabilities for all banks are currently estimated to be below $3 billion and banks are expected to recognize their additional liabilities over a period of several years. New bank employees are not offered defined benefit pension plans and hence these liabilities are not expected to accumulate in the future.

Foreign Banks are Ahead in Most Profitability and Return Ratios Cost of Funds % Government-controlled Banks Private Banks Foreign Banks 5.3 4.8 2.8 Net Interest Margin % 3.8 5.1 7.2 Return on Total Assets % 1.0 1.3 1.3 Total Capital Adequacy % 13.3 17.5 17.3

Data as on March 31, 2010; Source: Reserve Bank of India

Private Banks: Apart from the new banks that started in the nineties, this group also includes the older private banks, which escaped nationalization in 1969 and 1980. In performance parameters and business style, these subgroups are distinct from each other. The new private banks have aggressive business strategies and generate a relatively higher percentage of their total income from fee-based services. They have also utilized technology better and some of them have extensive financial services businesses. The older private banks, on the other hand, are more comparable to the government-controlled banks, but they are much smaller in size. The largest private banks have enjoyed higher equity market valuations because of their presence in financial services, besides the perception that they are better placed to exploit the future opportunities in the banking sector. Unlike the government-controlled banks, the private banks have no restrictions on raising additional capital, other than the governments foreign investment limits. They also have leaner organizations and a younger workforce, factors that are considered a distinct competitive advantage.

Foreign Banks also have more Fee Income, but have Higher Employee Costs and Bad Loans Other Income % of Total Income Government-controlled Banks Private Banks Foreign Banks 13.6 19.6 27.4 Employee Costs as % of Total Cost 14.8 12.8 23.5 Bad Loans % of Net Assets 1.1 1.0 1.8 Number of Branches 61,301 10,387 310

Data as on March 31, 2010; Source: Reserve Bank of India

Foreign Banks: Though foreign banks have a long history in India, they have remained only a small part of the banking industry. Among them, they had only 310 branches as of last year and almost all of them are concentrated in major cities. Most foreign banks focus on business banking in India, servicing the domestic operations of their global clients. But the aggressive overseas expansion by some of the large Indian businesses has opened up more opportunities for these lenders in recent years. Foreign banks derive more than a quarter of their total revenues from fee-based services, a far higher ratio than the domestic banks. Only a handful of the foreign banks have made serious efforts to expand their retail business. All foreign banks in India now operate as fully-owned branches of their parents, though the RBI has encouraged them to open domestic subsidiaries. The foreign banks have not opted for the subsidiary model as there is some skepticism about the future policy requirements. The Committee on Financial Sector Assessment, appointed by the RBI, recently opined that the 74%
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foreign investment limit should be made applicable to subsidiaries of foreign banks as well. If imposed, this limit, which currently applies to only domestic private banks, will force foreign banks to seek domestic equity partners in their subsidiaries. The committee, however, favors listing the foreign bank subsidiaries on the domestic stock exchanges. Interestingly, depository receipts of Standard Chartered, which is one of the largest and oldest foreign banks in India, are listed on the domestic exchanges.

Largest Foreign Banks in India Asset Size and Branches Assets in $ Billions Citibank Standard Chartered HSBC Deutsche Bank RBS Barclays 21 20 20 6 5 5 Number of Employees 4,613 7,903 6,685 1,498 2,716 1,083 Number of Branches 43 95 50 13 31 7

Data as on March 31, 2010; Source: Reserve Bank of India

Consolidation moves stifled by employee and political opposition Over the past several years, the Indian government and the RBI have tried to encourage some of the government-controlled banks to gain size through mergers. Though the bank managements have favored the idea, the bank employee unions and some political parties have vehemently opposed it. While the resistance is mostly because of their economic ideologies, regional factors have also played a part. Several of these banks have a strong presence in select states and the respective state governments view the banks as important institutions, which are crucial for the regional economy. Naturally, the state governments are wary of mergers, which may dilute the regional focus of the banks. These political and regional undercurrents have also prevented the consolidation within the State Bank Group. The State Bank of India has several regional subsidiaries, which were promoted by the former kingdoms, but were subsequently taken over by the federal government. Though all of them are under the State Bank umbrella, each of these subsidiaries is very closely identified with their respective states or regions. The group has been trying for the last several years to merge all the subsidiaries with the parent, but progress has been very slow. Five more subsidiaries, of which three are listed on the domestic exchanges, await consolidation.
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Consumer credit to drive future growth in banking Like in most other emerging economies, the share of consumer credit remains very low in India, despite the recent growth. Average income levels are still very low and subsistence spending takes away most of the personal Ratio of Household Debt to GDP Still Very Low in India incomes of the lower income 101 114 UK groups. This leaves very little 96 78 US earnings surplus available for debt servicing and reduces their 67 96 Japan creditworthiness, and banks will be 96 China 12 hesitant to lend to them. Hence, the 42 India 10 marketing efforts by banks to Russia 10 40 promote consumer finance products onsumer Household Business Brazil 13 30 and services are now mostly lim limited to cities and towns where there is a 50 100 150 200 250 larger concentration of higher income customers. However, as average income levels are expected to rise further, the number of potential bank customers with sufficient earnings surplus will also grow Though the growth of income levels is grow. rowth likely to be measured and the potential loan size will remain small, the aggregate market size for consumer credit will become larger because of the large population size. This market will be made more attractive by Indias demographic advantage of a relatively young population, who demographic are likely to see faster income growth. Besides, younger customers are generally considered to be more receptive towards new financial products and services. Even in business banking, India may continue to offer attractive growth opportunities. The ratio continue of total business credit to GDP in India is less than half the level in China. While this gap mostly reflects the substantially larger industrial sector in China, it also indicates the potential credit requirement if Indian industry sustains its growth. Bond markets remain grossly underdeveloped in India, while exchange risks reduce the attractiveness of international bond markets to domestic borrowers. Hence, it is likely that most of the increased industrial credit requirements will have industrial to be financed by banks. However, it is also widely accepted that the Indian banking industry may find it difficult to achieve its potential without further regulatory initiatives. It is evident that without increased . competition, financial intermediation costs will remain high and banking services will not spread widely across the vast rural areas of the country. Also, to improve efficiency and compete better, it is believed that domestic banks in India need to build scale through consolidation. As past scale reports and policy statements by the Indian government and the RBI have made repeated references to these issues, it is hoped that entry barriers will come down in the banking sector
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and restrictive policies will be diluted. It is expected that the shareholding and investment norms diluted. will be further liberalized, while new banking licenses will be made available to both domestic players and foreign banks.
140%

Banks have Outperformed the Broader Market since 2009

100% 60% 20% -20% -60% Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09

S&P CNX Nifty 50 Index Bank Nifty Index

Jun-10 Dec-10

The government and the RBI have already announced a new policy framework to issue new banking licenses to domestic applicants. While the RBI is expected to maintain its preference for wider shareholding distribution in banks, corporations with good reputation and track record that reputation have large public shareholdings, may also be allowed to promote new banks. Confirming the shareholdings attractiveness of the Indian banking sector, it has been reported that nearly a dozen applicants, sector, including some of the most prominent business groups, are eager to acquire licenses. The banking sector is one of the most crucial sectors in any economy, and plays an instrumental role in promoting economic growth. In India, the sector is even more important as the expansion of banking services to rural areas may also play a significant role in reducing poverty and ces ensuring sustainable income levels. If favorable regulatory support is ensured, India will likely have a mature banking industry with sufficient scale and reach to support its fast growing economy.

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