• DECEMBER 22, 2001

Finance: Emerging trends

The Indian financial sector is at the crossroads. On the one hand, financial institutions are getting ready to become universal banks, on the other, low quality of assets is becoming a matter of concern. Although, the finance sector offers immense growth opportunities, escalating non performing assets is denting its future prospects.

Asset concerns
Net NPAs as a % of loan portfolio14.2%5.2%20.0%
Capital adequacy ratio15.8%14.6%6.2%
ROE 7.5%6.5% *-16.7%
* After providing for accelerated provision of Rs 8 bn
** Numbers as on March 2001

The domestic financial sector has been historically governed by conventional regulations. Till the mid nineties, banks, financial institutions (FIs) and non-banking financial companies (NBFCs) operated comfortably within the artificial boundaries created by regulations. The business profiles of all the three categories were nearly similar with only exception that leading banks like SBI were also participating in project finance consortiums. The NBFCs flourished with limited competition from other entities like banks, which enjoyed lower cost of funds.

However, these boundaries have started narrowing in the past few years. FIs are now offering working capital and short term financing which was the traditional domain of the banking system. FIs gained significant share from state run bank, which were lagging behind due to their high operating cost and poor customer relations. FIs not only captured this segment but also diversified into retail lending which was the traditional domain of NBFCs. Gradually FIs have extended their services offerings to all financial areas. They have now become a one-stop shop for all financial needs of a customer.

Within the scope of the financial sector entities as defined today, a bank is the best-suited model for the future and it is globally accepted. The advantage of low cost funds and access to retail customers is the key driver of this competitive advantage. The incumbent banks (specially PSU) have however, not fully exploited the model due to their archaic business practices, weak technology and high cost structures, which nullify the funding cost advantages significantly. Private banking groups on the other hand, have taken a step towards it and ICICI group became the first such group to propose for a universal banking model. To survive in the internationally competitive environment it has become imperative for FIs to convert into banks to extract the full synergies of the business.

Typically, the Indian consumer has at least 5-6 banking relationships for his financial needs. A majority of the customers bank with state-owned banks for their deposit products, take an insurance policy from a state-owned insurance company, borrow for their homes from a specialized mortgage finance company and fund their car purchases with loans from NBFCs. This trend is however changing with the leading players in the financial sector spreading their wings in related businesses. HDFC and ICICI today offer a range of financial services including commercial banking, insurance, broking, personal finance, housing, asset management and investment banking. Financial groups are best positioned to emerge winners in the changed business paradigm of the banking system. Their extensive distribution reach and the slow progress of the competing banks on technology are likely to support these entities in strengthening their market position.

Retail asset franchises also assist in customer retention. A bank, which provides the entire product suite of liability, asset and wealth management products, is more likely to retain its customers. Foreign banks like Citigroup and HSBC have been following this strategy globally and have successfully built their franchise over the past decade. The new private banks are attempting to replicate the model by rapidly diversifying their product range to encompass the entire range of retail products. The ICICI group is a classic example of an entity that has transformed its image from a development financial institution to a full-fledged retail-banking group. No doubt, the competition for garnering a sizable share in retail market is intensifying but from the consumer perspective itís a win-win situation.

The newly formed universal banks will however pose a considerable threat to the state owned banks, even if the regulators do not allow the phasing out of the SLR (statutory liquid ratio) requirements. These banks would also challenge PSU banks dominance in the corporate banking business. Armed with a higher capital base, lower funding costs and a competitive cost structure, they would be able to snatch away market share in both fee and fund based businesses. ICICI is expected to become the second largest financial entity with a capital base of Rs 1 trillion after its proposed merger with ICICI Bank. Although SBIís capital base is three times higher than ICICI, in less than five years, ICICI could take the first position due to its aggressiveness.

It is said that all that shines is not gold. Similarly creation of a universal bank brings costs with it. There are certain banking regulations, which FIs would be required to follow. They will have to maintain a CRR (cash reserve ratio) of 5.5%, SLR of 25% and priority sector lending of 40%. This is likely to reduce their average yield on money lent, as interest on CRR balance is much lower than interest from lending to corporates (6.5% on the funds parked above 3%, i.e. 6.5% on 2.5% of funds). They will also not get any tax rebates on project lending and will have to reduce the number of subsidiaries which are not in consonance with the activities specified for banking subsidiaries.

Also, the recent financial crisis at IFCI has forced the regulators to go slow on extending approval for the universal banking model. The problem of bad quality loans is surrounding the entire sector. If ICICI has been successful in combating the problem of NPA, it is primarily because of the greater degree of freedom it enjoys as a fully private institution. If IDBI and IFCI were to be given similar degree of freedom, they could come out from these troubles.

Adopting a universal banking model is not likely to help FIs to arrest the persisting problem of bad quality of loans. Growth prospects for FIs are not very encouraging in the current year. Indian corporates are facing difficult times and are already saddled with unutilized capacities. In such circumstances fresh investments are unlikely to be taken up by them. This could not only affect loan disbursement growth of FIs but could also lead to a further rise in NPAs.

FIs: Eyeing for growth
(Rs bn)April-Aug '00April-Aug '01ChangeApril-Aug '00April-Aug '01Change

The Enron bankruptcy has brought asset quality issues to the fore again. Domestic FIs have together lent about Rs 40 bn to the Dabhol Power Company (DPC), a 65% subsidiary of Enron. If the matter remains pending towards the year-end, domestic lenders are likely to take a hit on fee based income and they will have to classify DPC loans as NPAs. These issues have resulted in domestic FIs trading at a substantial discount in the stock markets compared to their global peers. A re-rating in their valuations depends on their ability to improve the asset quality before becoming a universal bank.

Comparative performance
Projections for year endedDec-01Mar-02Mar-02
P/E (x) 17.1 4.12.5
Price / Book Value (x) 3.4 0.40.1
Price / sales (x) 2.3 0.30.1
Dividend yield1.0%12.5%16.7%
Income to assets13.1%12.1%10.3%
NPA / total assets (x)1.7%5.2%14.8%

Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA, Canada or the European Union countries, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

Equitymaster Agora Research Private Limited (Research Analyst)
103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407