Review of Indian Banking Sector and developments since liberalisation in 1994

It was great move in 1994 to introduce technology driven, termed as “new generation private sector banks” gifting banking licenses to Institutions (ICICI, HDFC, UTI and IDBI) and private entrepreneurs (IndusInd, Times, GTB, Bank of Punjab & more) to complement existing public sector and foreign banks for better customer reach and services as prelude to financial inclusion. So, it would not be an exaggeration to say that these private banks brought best-in-class technology to provide significant reduction in cost of transaction & time and upgraded customer service experience to customer delight. It also brought in seamless end to end automated front & back office systems & processes (across transaction entry to balance sheet accounting) to release HR bandwidth for customers & business for better productivity & efficiency of operating costs. Yours truly was fortunate to see both sides, moving from State Bank of India (1981-1994) to be in senior management team for set up of IndusInd Bank (1994-1999), moved into top management team for merger of TCFC for start-up Centurion Bank (1999-2002) and back to IndusInd Bank for crisis management & building scale of operations and re-rating of enterprise value (2003-2013). Unfortunately, the best & worst of banking sector happened during 2013-2019, kind of “inverted V-shaped” performance – valuation shot up swiftly, only to go down at faster pace! The best was triggered by the momentum in economic activity expanding capacity & output, and the worst was from greed for more, diluting the critical importance of risk, compliance, governance and more importantly, the banking prudence of acting in good faith and without negligence. This article is in no way like saying what couldn’t be said while in office. It’s think-aloud introspection from experience, highlighting the ugly part that pulled down the banking sector to where it is today! The intent of highlight of these is with hope that powers-that-be would work to clean-up the system to stop recurrence and ensure sustainable performance in gradual upward sloping curve – avoiding alphabets kind of performances! The study also includes the entrants in 2004 (YES Bank and Kotak Mahindra Bank).

Before 1994, banking sector was dominated by public sector banks led by SBI & its associates, while old generation private sector banks operating as regional banks with focus mostly on retail and MSME. Foreign Banks presence was to complement their foreign branches focusing on cross-border, off-balance sheet and Treasury products with mix of non-fund & non-Credit and contingent & settlement liability (involving replacement cost) products. To keep it short, public sector banks were active on financial intermediation (high on credit risk from higher on-balance sheet productivity) while foreign banks on financial services (low on credit risk and high on off-balance sheet) building lower cost-income ratio business model. Public Sector banks remained large (with high market share) but fragile on profitability (NPA woes and inefficient cost-income) while foreign banks were relatively small on balance sheet size but strong on profitability (over 100% loan-deposit ratio and high percentage of fee income on total income) and efficiency (lower cost-income ratio).

Private banks moved in as bridge to compete with PSU banks on financial intermediation and foreign banks on financial services, and pioneered the “super-market” concept – all financial products & services under one roof and introduction of (third-party) distribution services – what’s not manufactured is acquired for distribution. The agenda was to emerge as end to end financial services provider for holistic customer engagement with agenda not to let the customer go elsewhere and to get higher revenue from relationship (account profitability) through mix of net interest income and non-interest income (commission, exchange and fees). It’s perfect setting to achieve upgrade to establish best-in-class banking sector to be catalyst for economic growth post opening up further in 2004 (YES Bank and Kotak Bank) and 2014 (IDFC and Bandhan Bank) followed by launching of product & client focused Banks – Payments Bank and Small Finance Bank. What went wrong, then?

On one side, Public Sector banks got pushed to building top-line credit growth taking high risk wholesale exposures on sectors that they were not familiar with, while on the other side private sector banks got into chase of valuation & market cap! In that process, what got compromised (by both groups) is (credit & market) risk, compliance and governance, and those that got squeezed in between are the old generation private banks and foreign banks!

What went on wrong with Public Sector Banks? Main issue is the shorter tenor leadership at the top, not more than 3-5 years, and worse when the mindset of the institution is obey & execute, at all levels from top to bottom. So, when the top management at fag end of career ahead of retirement, none wish to disobey promoters instructions – serious governance issue. When there’s lapse on governance, risk & compliance can be no better with the process moving backwards from the risk decision to credit appraisals. Impact is obvious: (a) sharp increase in Gross NPA (b) profitability squeeze to maintain minimum Provision Coverage Ratio of 50-65% (c) reserves eaten away to provide for steady stream of NPAs (d) infusion of more money by promoter to stay clear of PCA, thereby increasing paid-up capital component of net worth (e) higher paid up capital and lower PAT leads to sub-optimal EPS and (f) when in low EPS & Book Value close to paid-up Capital, there’s no way of getting higher market cap from multiplier over EPS and book value. How to get out of this vicious cycle?

But, what went wrong with new generation private sector banks? While public sector banks got pushed from the top, most private banks (except couple) the top management got worked up on growth & bottom-line to get the best multiplier over EPS! So, most got glued to (a) top-line growth at 20-25% double of market average, come what may (b) while ensuring NII growth of 20-25%, non-interest income need to grow significantly over 25% by whatever means (c) credit cost need to be maintained not above 0.5% on NII of 3-4% by any means (d) aggressive targets on distribution products as cross-sell for higher fee income from non-credit business without use of capital & risk weight, which led to mis-selling and many more, all went well till the burst of bubble – (a) excellent RoA on high productivity (b) great cost-income from super efficiency for higher PAT (c) build-up of high reserves making paid-up capital minuscule leading to high EPS (d) high market cap from multiple times over book value (e) marginal dilution of equity to acquire high zero cost share premium for inorganic growth in book value…all super, but issues emerged from sustainability & continuity from higher base effect against no commensurate growth in opportunities. But, “come what may” and “by any means” surfaced leading to compromises on risk & compliance against low governance standards of management dominant boards. This led to acquiring high risk, high yield and high fees risk exposures to achieve set growth parameters. Unfortunately, this game couldn’t last for long putting these banks behind by 5-10 years, back to the starting point of 2013 making it painful for promoters & investors!

During this phase, foreign banks got either passive or into exit mode, while the worst emerged for old generation private sector banks that were unable to compete with public or private sector banks on productivity or efficiency. But the need to survive pushed them to partner with banks on large exposures, but turned disastrous in the absence of net worth bandwidth to absorb many large value NPAs. All combined, banking sector lost its strength and started looking upto regulator for SOS help. YES Bank got resolved in a unique way, but some more are in pipeline. When the economy was needing the support of banking sector in the post-Covid era, most banks are grasping for breath while some strong ones are conservative to take on high risk exposures even at better margin from TLTRO kind of liquidity support.

What’s the take-away?

While there are very many issues, let us focus on 2 critical issues that exist at the top, which if resolved would set right other issues.

1. There is need to establish board level responsibility (over the performance of management) and accountability (on the lapses and related losses thereof). The Board composition with mix of representation from non-Independent Directors (representing promoters), Executive Directors and Independent Directors (both chosen by promoters) need to have the necessary competency for the job and high on integrity at right compensation. There’s no dearth for talent when just retired top management officials are in plenty in the market. Another issue to be resolved is promoter (major shareholder) double-hatting as head of management, seen as conflict of interest?

2. Most failures arise from failures on risk management and non adherence to compliance standards. It’s more of execution failure despite having proper policies, systems, procedures and processes. When the responsibility of business performance and Risk & Compliance is vested with same individual, compromise on risk & compliance is bound to occur to meet stiff business targets, when the Board is weak on governance.

RBI plays a very critical role in establishing the above major “make or break” critical issues, when having the authority to appoint the board of directors or take over the board if not functioning to its satisfaction. The department of banking supervision is responsible for ensuring risk & compliance, being proactive and not reactive. While RBI could do better with private banks, there’s feeling of limitations on oversight over public sector banks. Business performance is important, but more important is effectiveness of risk & compliance to ensure continuity of business and sustainability of performance.

What are immediate requirements to get Banking Sector back on feet?

Top priority is to strengthen the balance sheet of PSU banks – recapitalisation to bring GNPA to below 5% and at PCR of not below 65% for NNPA around 3% (average NIM). It would involve huge amount when the agenda is to reduce the number of PSU banks from 12 to 5 and post Covid-19 GNPA would spike into double-digit against decline in profits from GDP contraction. When recapitalisation from Budget is tough, need to look at alternate options. The concept of “Bad Bank” – initial equity from the Government (minimum 25%) and debt from RBI (for an equivalent amount) and raising balance 75% equity and debt from domestic & foreign investors. At this point, there’s no clarity on the quantum required for one-shot resolution and whether the initial 25% of equity is within exchequer’s capacity. Good to keep it one shot as piece-meal never works!

When the exchequer struggle to recapitalise PSU Banks, private banks would need to fend for themselves in whatever manner desirable through dilution or merger with capital rich banks. RBI would need to facilitate this. There could be few old generation private banks will get left out, which would need reconstruction through bail-in or YES Bank model, making it an affiliate of either public or private sector bank.

Next is leadership continuity at the top management at least for 10 years for PSU Banks with increase in retirement age to 65 years for top management positions, and maximum 15 years for private sector banks with maximum age limit as 65 years. When MD is key member of the board, powerful than the non-executive Chairman, there shouldn’t be Business performance responsibility, which should be assigned to an Executive Director as Chief Business Officer. Given the importance of Support vertical comprising of Operations, IT and HR, an ED level position as Chief Operating Officer reporting to MD will be desirable. Reporting structure of control functions is critical to enforce efficiency of risk & compliance, not reporting to MD, instead to the Chairman of respective Board Committees – Chief Risk Officer to the Risk Committee, Chief of Inspection & Audit to the Audit Committee and Chief Compliance Officer reporting to the Chairman. While all these exist in the rule book, execution is flawed, all reporting lines flowing into one-man, the MD & CEO and high risk if this position is occupied by the promoter/major shareholder. To sum up, need to ensure (a) promoter being hands off from management (b) Board to assume responsibility & ownership of risk & compliance and governance functions (c) No direct responsibility of Control functions to MD, while taking direct charge of business and support functions.

Banking sector stability & strength has been turned from bad to worse from pre to post Covid-19 phase with set up of credit risk aversion. This scenario when FY21 GDP contraction outlook of around 10% is destructive on the economy. All attention is on the Finance Ministry for resolution while RBI is expected to ensure that regulatory supervision is above par and proactive to identify issues for resolution before it gets too late for repair. Recurrence of bank failures for same reasons is not acceptable, which means that powers that be haven’t learnt from past mistakes or unable to repair for whatever reasons leading to wasteful expenditure of taxpayers monies. What remains on the table is hope and not great confidence!

Moses Harding

Is HTM limit increase to 22% for SLR securities good for the system?

RBI impounds NDTL from banks as statutory obligation, currently at 18% for SLR and 3% on CRR, with special dispensation of holding SLR securities upto 19.5% in HTM category. While option to hold entire SLR book in HTM insulating from mark to market risk is not prudent practice (for determining book value), pushing Banks to buy more with option to park in HTM defies logic of financial intermediation. Now, post Covid-19 when market borrowing by the Government has shot up to over ₹12 Trillion to fund widening fiscal deficit, RBI hikes HTM limit for SLR securities to 22% with caveat that it applies for purchases of bonds issued on or after 1st September 2020.

RBI agenda of late is 2-fold – first, to ensure that Government’s borrowing schedule goes without market disruption at lowest cost possible and second, to ensure that credit flow to non-state borrowers is smooth at affordable rates. There’s debate on the priority of RBI, whether the Government or private borrowers, which will keep it aside for now. Having said this, RBI tried its best to direct credit flows to non-state borrowers (through provision of extremely lower cost liquidity providing better margin to cover credit cost) but couldn’t meet with success if seen from the quantum of reverse flow into Reverse Repo counter. Given the risk-aversion below AAA/AA borrowers, RBI has now chosen to divert the excess liquidity to the Government, thus helped to arrest run away spike on longer (5-15 years) tenor Gilt yields. It makes sense when new 10Y Gilt fell from issue coupon of 5.77% and 2nd issue devolved at 5.96% with spike to 6.20% – all within a month of issue in August, which is one of the worst disruption in the market. It’s an achievement of sort for RBI to establish stability at 5.90-5.95% when momentum was strong into 6.25-6.50%. It’s good to give the benefit of achievement to RBI and avoid getting deep into logic and conflict between intent & action.

What about Banks? Foremost, 10Y yield push back from 6.20-6.25% to 5.85-5.95% is big relief on AFS/HFT portfolios from huge mark to market loss that would have hit them hard on P&L of Q2/FY21. Secondly, does it makes sense for Banks to acquire longer tenor bonds at sub 6% yield when average cost of NDTL is around 6% for most banks at much shorter weighted average duration. This means that without spread benefit, Banks open up ALM risk when probability of hardening interest rate is high. So, it could end up as negative-sum game for Banks to buy Gilts to be issued since 1st September at 5.85-6%. Is RBI presuming that credit pick up is not going to happen in the medium term to push banks into this position? Does it provide comfort beyond OMOs ensuring that liquidity overhang position is there to stay to keep replacement cost remain sub 6%? If replacement cost between outgoing & incoming cost goes high, then would be big regret for Banks for obliging to RBI & the Government for buying against backstop market risk dispensation!

What’s the utility & usefulness of HTM category? Is it used for the purpose of intent to park matched maturity assets for liabilities. For example, if there is fixed rate term deposit of 10 years, Banks can buy 18% of the deposit in HTM category to achieve matched maturity ALM. When deposits are not marked to market, it makes sense to avoid m2m on statutory obligation and good for spread preservation through the life span of the deposit. The catch here is that while depositors have the flexibility for premature closure without penalty, the same dispensation is not available if the underlying (cover) SLR is at loss. So, bottom-line is that HTM category ends up as parking lot for “out of the money” securities (at lower YTM to market) when there’s option to take out “in the money” securities once in a year or for participation in the OMO to book profits categorised as “profit on sale of investments” and most call as trading profit from Treasury without mention of NII sacrifice for residual period. While it’s not fair to release financial results without disclosure of m2m position of HTM book, it’s not the time to deal with this now, but good to flag this as an agenda for investors, depositors and other stakeholders on the liability side of the balance sheet.

RBI Governor is “walking the talk” decisively ensuring that Government is not put to any kind of discomfort when the going gets tough, and of course to ensure orderly market conditions to ensure price stability to extent possible. It’s another subject on What Next whether 10Y could be made sustainable at 5.85-6%.

Moses Harding