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Banking sector: Growth converging with prices?

Mar 10, 2006

India embarked on the trajectory of economic reforms in the wake of a serious balance of payment (BoP) crisis in 1991, with banks being the mainstay of financial intermediation. The objective of the banking sector reforms was to promote a diversified, efficient and competitive financial system with the ultimate objective of institutional strengthening. As the banking system became liberalised and financial markets developed concurrently, the conduct of monetary policy was also tailored taking into account the realities of the changing environment. Tracing the sector's growth justifies the convergence of the same to the valuations awarded to the sector. Countering competition
Beginning from 1992, Indian banks were gradually exposed to the rigours of domestic and international competition. Newly opened banks from the private sector and entry and expansion of several foreign banks resulted in greater competition in both deposit and credit markets. Consequent to these developments, there was a consistent decline in the share of public sector banks in total assets of commercial banks. Notwithstanding such transformation, the public sector banks still remain the mainstay, accounting for nearly three-fourths of the sector's assets and income. It is also important to note that public sector banks have responded to the new challenges of competition, as reflected in the increase in the share of these banks in the overall profit of the banking sector. From the position of net loss in the mid-1990s, in recent years, the share of public sector banks in the profit of the commercial banking system has become broadly commensurate with their share in assets, indicating a broad convergence of profitability across various bank groups. This suggests that, with operational flexibility, public sector banks are competing relatively effectively with private sector and foreign banks.

Rising contribution
The contribution of banking and insurance to the aggregated service sector revenues tripled from 4.6% in FY71 - FY75 to 12.3% in FY00 - FY04. Also, the contribution of the same to the country's GDP increased nearly four folds from 1.8% of GDP in FY71 - FY75 to 6.7% of GDP in FY00 - FY04 (source: RBI). These observations are particularly relevant from the standpoint of the role of banks in the intermediation process. Juxtaposed with the financial sector reforms, this suggests that the enhanced freedom of banks since the liberalisation process has provided them with the flexibility in resource mobilisation and deployment, which has manifested itself in the uptrend in these ratios.

Fine-tuning operations
Banks and the concerned regulatory body (Reserve Bank of India (RBI)) have had to fine-tune their regulatory stance in consonance with the changing market and institutional dynamics so as to balance growth with stability. For instance, with the gradual tightening of prudential norms (shift from 180 days to 90 days regime), the ratio of average NPAs to total advances, which was at a high of 15.7% in FY97, declined to 5.2% in FY05. Prudent loan loss provisioning, securitisation of assets and improved recovery management (through the CDR route) aided the cleansing of the sector's assets. Thanks to this, India today has NPA levels close to that seen in the developed markets.

Also, the capital adequacy of the sector recorded a marked improvement reaching 12.8% in FY05 (well above the stipulated level of 9%) and the sector shows adequate preparedness to comply with the Basel II norms in FY07.

Market rewards
It is thus interesting to note that with the evolution of the sector, stock markets have also come to reward them with better valuations. While the gap amongst the two widened between the 1980's to early 1990's, the subsequent improvement in the sector's fundamentals narrowed down the same. The ratio of the sector's market capitalisation to total assets has improved from 21% in FY70 to 72% in FY05 (Source: RBI).

Nonetheless, without undermining the sector's well-deserved value appreciation, we would like to highlight the caveat to investors - that 'sour mangoes' continue to exist in the basket. Investments in the sector therefore need to be guided with a thorough analysis of key parameters. Also, in well-priced markets (like the current ones), growth visibility and commensurate valuations cannot be ignored even in the case of sector behemoths.

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