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Banks: Crystal gazing...

Oct 26, 2006

Reckon this. The cumulative assets of top 5 Indian banks equal the assets of 5th largest bank in China. The top 5 Indian banks command 45% of total banking sector assets compared to global standards of 70% to 75% of total assets. The country's largest bank, SBI, features at the 80th position amongst the top banks in the world. The fact that banking has got commoditised is part attributable to the lower bargaining power of players, thanks to the fragmented nature of the Indian banking industry. At a time when buoyancy in credit disbursals, higher fee income, lower delinquencies and possibility of treasury gains (in the event of interest rates turning southwards) continue to enthuse investors, we diagnose some factors that will have a telling impact on the prospects of the industry in the long-term.

Financial inclusion: Although the depth of banking services has increased (with the rise in per capita income of urban households), the breadth has not widened - substantiated by the increasing population per rural branch. This is despite the fact that per capita income growth in rural areas is similar to per capita urban income growth and value of non-cereal based production (which is more credit intensive) is now more than cereal based production. According to RBI deputy governor Dr. Rakesh Mohan, accelerated growth of the banking sector could be achieved only by 'financial inclusion' of first time savers, non-banked population and funding new entrepreneurs.

Basel II implementation: The central bank has time and again reiterated its gradualist stance in implementing Basel II in India, deferring it beyond the March 2007 deadline. Also, the Reserve Bank of India (RBI) is yet to outline the timeframe for implementation of internal rating based approach (for credit risk) and advanced measurement approach (for operational risk), which is likely to release capital requirements to banks with strong risk management systems. The implementation of each of these will meaningfully impact the capital adequacies of the strong and weaker players in the sector.

Higher risk weights: The RBI, in the past, has been proactive in assigning higher risk weights to residential mortgage, real estate loans and personal loans as compared to those required by Basel II - taking into account the risks perceived due to an unprecedented credit growth. For example, for residential mortgages and personal loans, the RBI guidelines require a risk weight of 75% and 125% as compared to a 35% and 75% respectively, as per Basel II. It remains to be seen whether this measure proves to be a cushion for asset delinquencies when the credit cycle turns. The same concerns have been cited by global rating agencies given the past experiences in various other countries (namely Japan, Taiwan and Korea), which have observed very high delinquencies on cyclical downturn after retail and real estate credit booms.

External ratings: Currently only 10% of the banks' corporate borrowers are rated by external rating agencies. As the un-rated borrowers attract a risk weight of 100%, it leads to incorrect pricing of risks and higher cost of credit to banks. A shift to external rating system may not only influence banks to make their operations more transparent, but also align the sector with its global peers.

Consolidation - Fence-sitting to continue: At the outset, it is widely acknowledged that the weak and fragmented nature of the Indian banking sector leads to duplication of banking network, capital inefficiency and reduced ability to withstand the onslaught of foreign banks post 2009. However, very little has been done when it comes to consolidation, sparing a few attempts at infrastructure and manpower sharing. Unless the public sector banks themselves discard their rigidity towards mergers and adopt a more realistic approach for their survival, the regulators' roadmap for consolidation will continue to remain on paper.

Albeit the fact that we have witnessed an unprecedented rally in credit offtake in the country, India's low credit to GDP (around 60%) and mortgage to GDP ratios (6%) lead us to believe that we have barely scratched the surface. This is when we benchmark the broader statistics of the sector to the global standards. Nevertheless, the above structural factors will determine the extent to which the domestic banking sector can align itself with its global peers and justify the acceleration in credit appetite.

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