It is by now well recognised that India is one of the fastest growing economies in the world.
Evidence from across the world suggests that a sound and evolved banking system is required for sustained economic development. India has a better banking system in place vis a vis other developing countries, but there are several issues that need to be ironed out.
In this article, we try and look into the challenges that the banking sector in India faces.
Interest rate risk
Interest rate risk can be defined as exposure of bank's net interest income to adverse movements in interest rates. A bank's balance sheet consists mainly of rupee assets and liabilities. Any movement in domestic interest rate is the main source of interest rate risk.
Over the last few years the treasury departments of banks have been responsible for a substantial part of profits made by banks. Between July 1997 and Oct 2003, as interest rates fell, the yield on 10-year government bonds (a barometer for domestic interest rates) fell, from 13 per cent to 4.9 per cent. With yields falling the banks made huge profits on their bond portfolios.
Now as yields go up (with the rise in inflation, bond yields go up and bond prices fall as the debt market starts factoring a possible interest rate hike), the banks will have to set aside funds to mark to market their investment.
This will make it difficult to show huge profits from treasury operations. This concern becomes much stronger because a substantial percentage of bank deposits remain invested in government bonds.
Banking in the recent years had been reduced to a trading operation in government securities. Recent months have shown a rise in the bond yields has led to the profit from treasury operations falling. The latest quarterly reports of banks clearly show several banks making losses on their treasury operations. If the rise in yields continues the banks might end up posting huge losses on their trading books. Given these facts, banks will have to look at alternative sources of investment.
Interest rates and non-performing assets
The best indicator of the health of the banking industry in a country is its level of NPAs. Given this fact, Indian banks seem to be better placed than they were in the past. A few banks have even managed to reduce their net NPAs to less than one percent (before the merger of Global Trust Bank into Oriental Bank of Commerce, OBC was a zero NPA bank). But as the bond yields start to rise the chances are the net NPAs will also start to go up. This will happen because the banks have been making huge provisions against the money they made on their bond portfolios in a scenario where bond yields were falling.
Reduced NPAs generally gives the impression that banks have strengthened their credit appraisal processes over the years. This does not seem to be the case. With increasing bond yields, treasury income will come down and if the banks wish to make large provisions, the money will have to come from their interest income, and this in turn, shall bring down the profitability of banks.
Competition in retail banking
The entry of new generation private sector banks has changed the entire scenario. Earlier the household savings went into banks and the banks then lent out money to corporates. Now they need to sell banking. The retail segment, which was earlier ignored, is now the most important of the lot, with the banks jumping over one another to give out loans. The consumer has never been so lucky with so many banks offering so many products to choose from. With supply far exceeding demand it has been a race to the bottom, with the banks undercutting one another. A lot of foreign banks have already burnt their fingers in the retail game and have now decided to get out of a few retail segments completely.
The nimble footed new generation private sector banks have taken a lead on this front and the public sector banks are trying to play catch up.
The PSBs have been losing business to the private sector banks in this segment. PSBs need to figure out the means to generate profitable business from this segment in the days to come.
The urge to merge
In the recent past there has been a lot of talk about Indian Banks lacking in scale and size. The State Bank of India is the only bank from India to make it to the list of Top 100 banks, globally. Most of the PSBs are either looking to pick up a smaller bank or waiting to be picked up by a larger bank.
The central government also seems to be game about the issue and is seen to be encouraging PSBs to merge or acquire other banks. Global evidence seems to suggest that even though there is great enthusiasm when companies merge or get acquired, majority of the mergers/acquisitions do not really work.
So in the zeal to merge with or acquire another bank the PSBs should not let their common sense take a back seat. Before a merger is carried out cultural issues should be looked into. A bank based primarily out of North India might want to acquire a bank based primarily out of South India to increase its geographical presence but their cultures might be very different. So the integration process might become very difficult. Technological compatibility is another issue that needs to be looked into in details before any merger or acquisition is carried out.
The banks must not just merge because everybody around them is merging. As Keynes wrote, "Worldly wisdom teaches us that it's better for reputation to fail conventionally than succeed unconventionally". Banks should avoid falling into this trap.
Impact of BASEL-II norms
Banking is a commodity business. The margins on the products that banks offer to its customers are extremely thin vis a vis other businesses. As a result, for banks to earn an adequate return of equity and compete for capital along with other industries, they need to be highly leveraged.
The primary function of the bank's capital is to absorb any losses a bank suffers (which can be written off against bank's capital).
Norms set in the Swiss town of Basel determine the ground rules for the way banks around the world account for loans they give out. These rules were formulated by the Bank for International Settlements in 1988.
Essentially, these rules tell the banks how much capital the banks should have to cover up for the risk that their loans might go bad. The rules set in 1988 led the banks to differentiate among the customers it lent out money to. Different weightage was given to various forms of assets, with zero per centage weightings being given to cash, deposits with the central bank/govt etc, and 100 per cent weighting to claims on private sector, fixed assets, real estate etc.
The summation of these assets gave us the risk-weighted assets. Against these risk weighted assets the banks had to maintain a (Tier I + Tier II) capital of 9 per cent i.e. every Rs100 of risk assets had to be backed by Rs 9 of Tier I + Tier II capital. To put it simply the banks had to maintain a capital adequacy ratio of 9 per cent.
The problem with these rules is that they do not distinguish within a category i.e. all lending to private sector is assigned a 100 per cent risk weighting, be it a company with the best credit rating or company which is in the doldrums and has a very low credit rating.
This is not an efficient use of capital. The company with the best credit rating is more likely to repay the loan vis a vis the company with a low credit rating. So the bank should be setting aside a far lesser amount of capital against the risk of a company with the best credit rating defaulting vis a vis the company with a low credit rating. With the BASEL-II norms the bank can decide on the amount of capital to set aside depending on the credit rating of the company.
Credit risk is not the only type of risk that banks face. These days the operational risks that banks face are huge. The various risks that come under operational risk are competition risk, technology risk, casualty risk, crime risk etc. The original BASEL rules did not take into account the operational risks. As per the BASEL-II norms, banks will have to set aside 15 per cent of net income to protect themselves against operational risks.
So to be ready for the new BASEL rules the banks will have to set aside more capital because the new rules could lead to capital adequacy ratios of the banks falling. How the banks plan to go about meeting these requirements is something that remains to be seen. A few banks are planning initial public offerings to have enough capital on their books to meet these new norms.
In closing
Over the last few years, the falling interest rates, gave banks very little incentive to lend to projects, as the return did not compensate them for the risk involved. This led to the banks getting into the retail segment big time. It also led to a lot of banks playing it safe and putting in most of the deposits they collected into government bonds. Now with the bond party over and the bond yields starting to go up, the banks will have to concentrate on their core function of lending.
The banking sector in India needs to tackle these challenges successfully to keep growing and strengthen the Indian financial system.
Furthermore, the interference of the central government with the functioning of PSBs should stop. A fresh autonomy package for public sector banks is in offing. The package seeks to provide a high degree of freedom to PSBs on operational matters. This seems to be the right way to go for PSBs.
The growth of the banking sector will be one of the most important inputs that shall go into making sure that India progresses and becomes a global economic super power.
The author is Research Scholar, ICFAI University.
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