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Banks: Saved from the blushes?

Dec 7, 2007

While banking behemoths in the developed economies have faced a lot of flak after the subprime malady, their Indian counterparts have, so far at least, escaped from the blushes. While that does not assure absence of future surprises on the delinquency front, what can be gauged from the historical facts available about the global banking industry, is that the risk-reward trade off for the Indian players is even.Risks
Susceptible to the high growth-high risk trap: Indian private sector banks, particularly the new generation ones, have made rapid progress in terms of increasing their income and asset base since the mid-1990s. In terms of branch expansion, the compounded growth rate of private sector banks over the period FY02 to FY07 was almost three times that of all scheduled commercial banks and more than four times that of public sector banks.

However, there is catch to this. Most of the incremental lending during this period has been towards retail assets, thanks to the then prevailing lower interest rate scenario. Also, the desire to make a thicker margin was tempting enough for banks to increase their exposure to high risk assets such as credit cards and personal loans besides mortgage and vehicle loans with a very high loan to value ratio. However, interest rates being cyclical in nature, have played their part in reducing the loan servicing ability of the retail borrowers (due to higher EMI to monthly income ratio). Thus Indians banks continue to be susceptible to ample surprises on the retail delinquency front.

Low provisioning: Indians banks, having tasted the brunt of BIFR cases in the late 1990s, realised the need to provide for possible delinquencies. However, the new private sector banks were then the new kids on the block and do retain much of this memory. Also, their public sector counterparts seem to have erased their's. As a result, while most developed and developing economies maintained provisioning levels nearly equal to the vale of substandard assets, the Indian banks have been content with providing for only half of it (see table). This is despite the fact that this has not really helped them outperform on the return ratios.

Indian banking industry vis-a-vis global peers
(%)CARGross NPAProvisions to NPAReturn on Assets
Developed economies
US13.0 13.0 1.4 0.8 123.7 137.2 1.3 1.3
UK13.1 12.9 2.6 0.9 75.0 -0.4 0.5
Japan9.4 13.1 7.4 2.5 -30.3 (0.7)0.4
Developing economies
India 12.0 12.4 10.4 3.5 - 58.9 0.8 0.9
China -- 26.0 7.5 --- 0.9
Brazil 16.6 18.9 4.5 4.1 155.9 152.8 2.1 2.5
Russia 19.1 14.9 5.6 2.6 112.5 159.3 2.6 3.2
Source: Global Financial Stability Report 2007, IMF

Write offs - No more: The lower interest rate scenario in the early part of this decade also opened up the window of treasury gains for Indian banks. This helped them get rid of the legacy substandard assets that they had accumulated in the books and report lower NPAs. In fact, the net NPA to advance ratio dropped from 8% to 1% in the last decade. However, times have changed and NPA write offs have become unfeasible in the books due to absence of treasury gains. At such times, any rise in delinquency levels will leave banks with no option but to report higher slippages.

Resistance to credit: Indians are known to be risk averse by nature. This has kept the credit to GDP levels in the country relatively low (at 61% in FY07) as compared to its counterparts in the developed as well as developing world. Having said that, what has benefited banks is the fact that the ratio of population in the country that is 'over-leveraged' is miniscule and the banks can therefore comfortably tap the latent demand for credit.

Low penetration: The lack of credit penetration and the geographic concentration of bank credit is evident from the fact that 5 states having the highest proportion of per capita credit enjoy 55% of the total credit disbursals in the country. A large population in the rural areas still depends on the unorganised sources of credit such as moneylenders. This makes it easier for Indian banks to diversify their exposure by tapping the rural and semi-urban population that have a low credit penetration.

Improving efficiency: Efficiency gains are reflected in containment of the operating expenditure as a proportion of total assets. This has been achieved despite large expenditures incurred by Indian banks in installation and upgradation of information technology and, in the case of public sector banks, large expenditures under voluntary retirement scheme (VRS) of nearly 12% of their total staff strength. This has helped the banks streamline their operations and clock bottomline growth in the range of 27% to 36% in the last fiscal while deposits and advances have grown in the range of 32% to 51% and 39% to 71%, respectively.

Strict governance: Improvement in the credit appraisal process, upturn of the business cycle, new initiatives for resolution of NPAs (including promulgation of the Securitisation Act), and greater provisioning for NPAs under the revised Reserve Bank of India (RBI) guidelines, have to an extent, contributed to the reduction in unforeseen slippages.

As investors, you need to keep your eyes open not just to what is evident in the banks' balance sheets currently but also what is likely to appear in it in the medium to longer term. An evaluation of this kind can keep you well informed about the possible downsides.

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