India's Banks Gear Up for the Global Market

Better Capital Allocation

Indian banks have improved capital allocation dramatically during the past four years, and this is evident in the decline of their gross non-performing assets (NPAs) as a proportion of total loans -- from 9% in 2003 to about 3%, the report finds. Indian banks could achieve that with a lot of help from a booming economy, but they deserve credit also for making better lending choices, McKinsey says.

For instance, Indian banks reduced their exposure to industries where they were losing money, such as paper, steel, textiles, hotels and tourism, from 56% in 2003 to 22% in 2007. They achieved this by increasing their exposure to borrowers that brought positive returns, including paints, cement, automobiles and pharmaceuticals, from 44% to 78% in the last four years, the report says.

The intermediation cost -- or the spread between the average deposit rate and the lending rate -- at Indian banks is high at 5.1%, compared with that in the U.S. (2.9%), Singapore (2.4%) and China (3.4%), according to McKinsey. A significant reason for this is that Indian regulators require banks to maintain 25% of their deposits in what is called a "statutory liquidity ratio," or SLR, which in effect allows government-sponsored programs to access those funds at below-market interest rates.

India's central bank also requires banks to earmark 40% of their advances for so-called "priority sectors " such as agriculture and small business, where the returns are patchy and banks encounter bad debts .

"Those reserve requirements are hangovers from the past for India," says Wharton finance professor Franklin Allen, who closely tracks the Indian financial services industry. "They have to be dismantled."

"There is a huge amount of pre-emption of funds that goes on in India," says Chakrabarti. "There is a case to dismantle the SLR. If you take away 40% to 50% of the banks' funds, they are forced to increase their lending rates on the remainder, and they find their prime corporate customers prefer to raise their money in the overseas markets (called "external commercial borrowings," or ECBs, in Indian official parlance).

Chakrabarti says recent studies show that the top 50 Indian companies have raised about 30% of their fund requirements through ECBs; losing that market share adds further pressure on Indian banks to increase their interest rates on other, second-tier customers. "That becomes a vicious cycle," he says, "and a high interest rate regime certainly hurts overall output."

Incumbents vs. Attackers

The McKinsey surveys also revealed fundamental shifts occurring in the composition of Indian banks, with newly emergent private banks -- McKinsey calls them "attackers" -- rapidly stacking up gains over the older, incumbent banks, with improved customer service, better risk management and leveraging of IT skills to expand their global reach. Consequently, in the last seven years, these attackers have increased their market share of Indian banking assets from 12% to 26%, their share of aggregate profits from 21% to 32% and their share of market capitalization from 37% to 49%, the report says.

Investors rewarded that performance handsomely, lifting the banks' price-earnings multiples from an average of three in 2000 to 27 by 2007; by contrast, the incumbents were able to grow their stock multiples from one to seven in that period.

McKinsey finds that India's incumbent and attacker banks boasted roughly similar after-tax returns on equity in the latest financial year (2007), with 14% and 15%, respectively. But a closer look reveals that in retail banking -- the biggest profit driver -- the incumbents averaged a 33% return on equity , while the attackers achieved only 16%. "Incumbents continue to profit from large deposit bases, thanks to their legacy distribution networks and franchises," the report says. On the rest of their businesses, the attackers fared better in 2007 with a 15% return on equity, while the incumbents managed only 9%, McKinsey adds.

"The attacker banks use innovative distribution channels," says Sengupta. "They use non-branch, feet-on-the-street sales force channels much more aggressively than we have seen in banking in most parts of the world."