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India's banking industry these days finds itself on a treadmill where it has to keep pace with the country's rapid growth by servicing a customer base with global options.

A report by the consulting firm McKinsey & Co. finds that while Indian banks fare well by global standards on a few counts, including increasing shareholder value, they will have to do much more to stay competitive. India Knowledge@Wharton spoke with experts at Wharton, McKinsey and the Indian School of Business about how India's banks can deal with the challenges they face.

McKinsey, with support from the Indian Banks Association, tracked 14 leading Indian banks and their customers in five surveys. These covered their performance in personal financial services, retail banking, IT benchmarks, organizational performance and asset liability management. The institutions included seven public sector banks, four from the private sector and three foreign organizations.

India's banks have had "unprecedented opportunities" in the last four years of India's rapid growth, lifting their valuations , according to the McKinsey report. It is now time to look at how well they are positioned for continued growth, the report adds. Joydeep Sengupta, director at McKinsey and leader of the firm's financial services practice in India and Southeast Asia, who co-authored the report with McKinsey partner Renny Thomas, says their effort is the first of its kind to benchmark Indian banks' performance on a global scale.

How They Fare

India's banking industry fared better than its Asian peers on two out of five objectives that McKinsey identified. They scored high marks in increasing shareholder value and allocating capital efficiently, the report finds. They also compare favorably on a third parameter -- contributing to India's GDP ( gross domestic product ) -- on a global scale, the report adds.

Indian banks, however, don't look as good in fostering "financial inclusion"; banks in other countries do a better job of tapping household savings, the McKinsey report says. Also, they could do a better job of managing intermediation costs more efficiently, read as the spread between the interest rate on loans advanced and that paid for deposits.

Indian banks have a lot of ground to cover in participating in the country's GDP, says Rajesh Chakrabarti, professor of finance at the Indian School of Business in Hyderabad. "Bank credit accounts for about 40% of GDP in India, but it far exceeds the GDP in other Asian countries like Hong Kong, China, Taiwan, Singapore and Malaysia," he says.

Indian banks achieved the highest pretax returns on investment across Asia at 17.9% in 2006, compared with those in Malaysia (16.3%), China (15.1%) and Thailand (9.1%), the report says. That performance helped Indian banks post the highest returns to shareholders as measured by stock market banking indices , it adds.

Between January 2000 and October 2007, Indian banks delivered returns to shareholders of 36.76% (compounded annual growth rate ), compared with 24.03% for the entire Indian stock market. In the same period, Chinese banks achieved returns to shareholders of 17.57%, while British banks managed only 9.34%.

All those ranked better than the 7.16% by all shares on the FTSE (Financial Times Stock Exchange) index and 4.54% on the Dow Jones Industrial Average ( DJI), as tracked by the McKinsey report.

Chakrabarti says foreign banks operating in India have been the most profitable , and he attributes that to their ability to attract corporate current accounts, on which they pay zero interest; savings accounts pay interest rates of 3.5%, while longer-term deposits attract rates of up to 9%, the peak rate being that for senior citizens. "The current deposits keep their overall interest rates low and margins high," Chakrabarti notes.

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."

On the measure of "credit and risk best practices," Indian banks fare well against their global peers, although incumbent banks fall short, the report says. This measure covers banks' performance on credit underwriting , rating , risk-based pricing, credit portfolio management and credit monitoring. On a scale of 0 to 4, McKinsey gives Indian attacker banks the top score of 3.3, while the top global banks average 3.2 and Asian banks average 3.1.

India's incumbent banks manage a score of just 2.8 on that scale of credit and risk best practices. "On the whole, they lack advanced early warning systems and use only basic funds transfer pricing methodologies to conform to regulatory and compliance measures," the report says.

McKinsey's surveys also reveal that Indian banks have done better than their global peers in organizational performance, "given their historic access to superior talent." The report also puts Indian banks ahead of their Asian counterparts in "distribution efficiency," while both share equal scores in "marketing and sales." Asian banks and the top 10 global banks do better than their Indian counterparts in corporate leadership, IT capabilities and credit skills. However, the Indian attacker banks are ahead of the incumbents on all fronts, including what McKinsey calls " corporate leadership ."

Technology and Performance

In using technology to shore up their performance, the best banks in India (including five leading private and foreign banks operating in the country) "are among the most efficient in the world," the McKinsey report says. In one specific measure of IT spending per 1,000 accounts, the "best Indian banks" spent an average $10.2 in 2007, while European banks averaged $76, the firm notes.

The Indian attacker banks with "best-in-class" IT capabilities "are truly the best in the world," McKinsey adds, identifying three factors driving this trend: "the ability to avoid using legacy systems, superior governance practices that often entail direct CEO involvement and the India advantage a reference to the country's established IT skill base ."

Sengupta says that while incumbent banks have been relatively slower to embrace IT and other technology, they will still derive advantages on that front. "In an ironic way, they are able to leapfrog as they have been later adopters of technology," he says.

On customer satisfaction, which McKinsey rates as "the biggest driver of value," the report says the attacker banks have "revolutionized levels of convenience and provide customers with superior service." At the same time, the attacker firms also have "more customers with negative experiences" than the incumbents. "Customer experience and tailored offerings will be a big driver of bank profitability, as young, affluent customers are more demanding and discerning and are less credit-averse."

"That is scary for the incumbent banks," says Chakrabarti. He adds that while the incumbent banks fare as well as the attacker banks on profitability measures, they are unable to win over the younger, upper middle class group of customers that is commonly referred to as the "mass affluent." India's mass affluent class is heading towards private banks and foreign banks, driven mainly by customer service needs, he notes.

"That is where your cheap deposits will come from, and those are the people who will use your banking services and to whom you can sell your insurance products and other fee-based services," says Chakrabarti. "That is the customer service the incumbent banks want to hold on to, to maintain your profitability."

Allen says that "the big banks across the world seem to have a problem with customer satisfaction," and he raises some fundamental issues here. "If you make a mistake like bouncing a check, the bank charges you a high penalty price; that may get people upset with them," he says. "On the other hand, they provide a lot of services for free, such as when you use your own bank's ATM or when they process the checks you write. If they charge you for those services, it may get people even more upset."

It isn't easy to determine what drives customer satisfaction while banks try to stay both competitive and profitable, says Allen. "They have to make money somehow, and it is interesting the way they do it. The question is whether the way they do it is actually the best. Maybe the way they do it -- subsidize a lot of services and make it up somewhere else -- is the best way."

According to Sengupta, McKinsey's research reveals that the corporate customers of Indian banks tend to be less forgiving about inferior customer service than individuals. "For the corporate customer, the ability to access funding overseas at a relatively cheaper rate very quickly and conveniently is a big dimension, besides access to innovative products and best-in-class risk-management systems," he says.

However, the leading Indian banks are able to meet those requirements for the top-tier corporations, he adds. "The challenge Indian banks face is in the next tier -- the slightly smaller corporations -- for whom they need to provide the same level of service and range of products."

Although Indian banks look good in select areas vs. their global peers, they are relatively small, says Sengupta. But India's economic growth and the banking industry's efforts to meet global standards will change that picture dramatically in a decade, he notes.

"Five years ago, no Indian bank had a market capitalization of more than $5 billion or $6 billion. Today, you have at least two banks (the State Bank of India (no ADR ) and ICICI Bank ( IBN)) with market caps of $30 billion to $40 billion. Roll the clock forward 10 years, and you can easily see that crossing $100 billion to $150 billion, and at least two or three truly global banks emerging from India."

ICICI Bank, Housing Development Finance Corp. (no ADR) and HDFC Bank (HDB) are the current top bank/financial sector holdings in Blackstone's (BX) India Fund (IFN) and Barclays' (BCS) iPath MSCI India Index ETN (INP).