Indian banks: Negotiating the new paradigm

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Banks need to alter there business models in wake of disruptive technologies, changing customer requirements and evolving operating environment

banks-atmFor Kaushik Kumar, the last couple of years have been unlike the previous decade or so. Working in a semi urban branch in Bihar as a Branch Manager of one of the largest banks of the country, he is facing a dilemma. On one hand, he is pestered by the higher ups to increase business, which includes pushing more loans to priority sectors like agriculture and small businesses, and on the other hand, the fear of more loans going bad forces him to be extra cautious. Over the last few years, poor business sentiments have slowed the business decelerating demand for new loans. He hopes the slow turnaround results in improvement in credit off the tale and improved repayment profile which would reduce his NPA book. Kaushik’s counterpart in a posh South Mumbai branch of the same bank is having another problem; he is losing customers to foreign banks because they offer a larger
spectrum of services that includes house search and investment advisory. The situation of these two gentlemen pretty much sums up the predicament of the Indian banking industry today.

Banking in India has a rich history. Over last more than a century, it has been known for its conservatism, tradition and trust. It
is because of these guiding values that Indian banks have rarely faced a run by depositors and investors, have gone down sinking public money or have speculated on risky assets to the level of wiping out networth, which have all been the part and parcel of banking institutions in many developed and developing countries over last thirty years or so. A pragmatic and conservative Reserve Bank of India has overseen this orderly development. All weak banks have been efficiently amalgamated with or taken over by other banks without any erosion of shareholders’ and depositors’ wealth. The banking system as a whole has been mostly very successful in intermediating between creditors and debtors and in staying true to the confidence of all stakeholders. The changing times, however, require a different set of capabilities and expertise in not only managing money, but  also in absorbing new technologies and scaling up on the value chain to retain customers.

As is the case with all other business sectors, banking also faces new challenges in a changing  business paradigm and can cashon opportunities that are made available by the new economy which is faster, more faceless and more cashless in nature. Customers in this new world are fickle minded, more demanding and want everything in one place. Money in the new world is highly mobile, investments harder to retain and returns more volatile. As such, banking in this new complex environment requires evolved regulation, intelligent risk management and more integrated business models. This is a new paradigm in which everything changes very fast and only those survive who have stronger balance sheets, better product portfolio, higher profitability and lower cost.

Evolving customer and business environment
The customer of today is not same or similar to what he was even a decade ago. Gone are the days when he waited patiently in queue to deposit money or get a bank draft made. A large part of the routine banking transactions are today done at ubiquitous ATMs. So, customers are visiting banks more for value added services such as buying insurance and investing in mutual funds.

A private sector branch manager in a posh NCR locality says three out of four customers are stepping in branch looking for non traditional banking products. In short, customers are looking for as many types of financial services as possible under one roof, many of which are not banking services in the traditional sense. This calls for a changed product portfolio from banks. Banks are responding by adding more services to their portfolio to keep prevent existing customers from deserting and keep attracting new customers. As such, it is customary to find all banks paddling broadly similar platter of services ranging from housing loans and credit cards to personal loans and vehicle loans, insurance and investments in equities, mutual funds and even portfolio services for higher networth clients.

This universal banking platform requires deeper pockets, more diverse human capital and most importantly, effective management of risks arising out each business vertical. In a nutshell, changing customer requirements have forced banks to adopt new business models that optimize fund and fee based businesses and interest and noninterest incomes. While in a high interest rate regime, interest based income has an upper hand, in a declining or stagnant market, it is the non interest based income that differentiates winners from the also ran. And this diversification is working well; research shows that increasing diversification in income streams has led to greater profitability in Indian banks. Also, it has been found that private sector banks, which are more focused on urban business, have been able to increase non interest based income more when compared with public sector banks (PSBs) that have significant presence in semi urban and rural India where it is much tougher to push up fee based businesses. In urban centers, banks are increasingly pooling up commissions, remittances, commodity based loans, asset management and wealth management and treasury products, etc. as important income streams and this trend is likely to gather momentum. Moving forward, managing a healthy composition of income without assuming too much additional risk will be important for all types of banks as competition chips away margins in the lending business and interest rate cycles turn unpredictable.

At the time of taking over as RBI Governor, Rajan had promised a “Dramatic remaking” of Indian banking sector. RBI has announced many steps to revamp the sector since then.

To cater to the changed business requirement and newer competitive realities, the regulatory environment has also evolved. Over the last few years, banking regulations have evolved which in effect have made the banking sector structurally more sound and evolution more orderly. At the time of taking over as the RBI Governor, Raghuram Rajan had expressed his intent to radically alter the Indian banking sector, and the flurry of steps that have been taken over the last couple years do indicate towards this transformation. Examples of such changes include new holding structure for the banks, which stipulate a minimum of 25 per cent of branches in rural areas, to giving free hand to foreign banks to open branches wherever they choose to. It has also rationalized the foreign investment limits in banks to facilitate higher capital inflows and better risk management. These steps have also allowed for greater  competition and improved service quality.

PAYMENTS BANKS: What is expected out of them?

What is expected out of them? In a fundamental shake up to the banking sector, the impact of which would be fully felt after a couple of years, the RBI has given ‘in principle’ approval for payment banks to 11 entities. The list includes some of the biggest corporate names such as Reliance Industries, Aditya Birla Nuvo and Tech Mahindra, and also corporates in non fi nancial business, like Airtel and Vodafone. Basically a stripped-down version of traditional banks, these Payment Banks are expected to bypass the traditional branch model and serve customers primarily through hand held devices like mobile phones and tablets. These banks have been allowed to transfers and remittances through a mobile phone, raise deposits of upto Rs. 1 lakh, and pay interest on these balances just like a savings bank account, but have been barred from giving loans. They have also been allowed to offer automatic payments of bills, and purchases in cashless transactions. Further, Payment Banks can transfer money directly to bank accounts at nominal cost and issue debit cards and ATM cards usable on ATM networks of all banks. Targeted primarily to serve low-income households, small businesses and migrant laborers, the new system could revolutionize banking in the country. It is for the fi rst time that banking licenses have been granted for specifi c banking activities instead of the full spectrum of banking services. These banks are expected to fi ll the gap that exists because of the inability of traditional banks to open up uneconomical branches in remote rural areas. On the contrary, Payment Banks would leverage the deep and increasing penetration of mobile phones which covers the entire length and breadth of the country. The rapid decline in prices of smartphone and tabs is also contributing to the rise of cashless transactions that Payment Banks could cash on. In totality, Payment Banks could emerge as a major pillar in the financial inclusion plan of the government.

In order to foster greater financial inclusion, the RBI had mooted the idea of introducing Payment banks and Small banks.

The guidelines were issued in last November and the licenses for 11 payment banks have recently been given. The basic objective to set up such entities is to allow private participation in the domain of traditional banking and fill the void that is created by the non presence of banks in rural areas, which in turn allows inefficient and unethical players to exploit poor people.
Payment banks would promote financial inclusion by providing small savings accounts, payment and remittance services by enabling high volume-low value transactions in deposits and payments/remittance services. Small banks on the other hand are supposed to provide a spectrum of basic banking products such as deposits and credit in a limited area of operation, thus bringing in hitherto un-served sections of the population in banking services fold. In all, the RBI is interested in ushering in greater competition among players while at the same time ensuring that banks are internally strong and well capitalized. On the other hand, there is a greater push to reach out to the maximum number of people at the bottom of the pyramid which would ensure that banks are well prepared to act as efficient conduits to facilitate the socioeconomic programs of government.

Basle III to weigh heavy on PSBs

India is among the nations that have accepted Basle III norms for capital adequacy and risk management. While this is going to be applicable for all banks, the impact is going to be felt most by state run banks which are already reeling under high levels of  bad loans. Private and foreign banks, which have no social obligations and are largely confined to corporate loans, are relatively better placed. Basle III norms have kicked in from April 2013 in a phased manner and are expected to be fully implemented by March 31, 2019. These norms are essentially focused on strengthening the capital and liquidity profile of banks, which in effect  would enable them to withstand systemic shocks when crises hit. While good quality of capital will ensure stable, long term sustenance, compliance with liquidity covers will increase the ability of banks to withstand short term economic and financial stress. Keeping with the norms, Liquidity Coverage Ratio (LCR) of 60 per cent has been introduced in Jan 2015 which would be ratcheted up to 100 per cent by 2019. But a higher LCR comes as a problem for banks. On one hand, they have to focus on quality deposits and on the other they will have to increase the proportion of high quality liquid assets. This could pull down  profitability. To stave off this situation, some experts have suggested deep cuts in the overall SLR requirements which would free up more cash.

CAR-graph
PSBs have led the decline in capital adequacy ratio (CAR) of Indian banking sector

As for the Capital Adequacy Ratio (CAR), any bank’s buffer against current and future losses, against 9 per cent level in March 2015, it would go up to 11.5 per cent by March 2019. This increase in the required CAR is going to impact banks badly as it translates into a lower return on equity (ROE) because of a fall in leverage. The situation of PSBs is worse as they are working hard on another front to rid themselves of the high NPAs. According to the Financial Stability Report of the RBI, PSBs are leading the decline in the CAR profile of Indian banking sector as a whole. The CAR for PSBs fell to 11.24 per cent as on March  31, 2015, from 11.4 per cent in the year-ago period. For the system as a whole, it went down from 13.01 per cent a year ago to 12.70 per cent at the end of March 2015.

PSU banks account for two thirds of India’s banking system. If they are hit by capital shortage, it would not be a good news for the manufacturing sector and the Make-in-India initiative of the government. In order to remain solvent to keep lending, these banks will need to increase their capital base. Also, there will be a fiscal burden, if majority shareholding has to be retained by the Indian government. According to CARE, till 2019, banks’ capitalization need could range from Rs1.5 to 1.8 lakh crores, assuming an average GDP and credit growth rate of 6 per cent and 16 per cent respectively. A Fitch report pegged the capital requirement at $200 billion to continue growing at the current rate and still meet the Basel III norms.

Now the tricky part. The government feels banks could mobilize up to Rs 1.60 lakh crore from the capital market over the next four years. But if market opinion is anything to go by, investors don’t like PSBs because of their poor asset quality and lower profitability, which is reflected in their price to earning (P/E) and price to book value (P/BV) ratios. That in essence means banks would have a really tough time raising money from the market. SBI, the largest public sector bank, commands valuations that are about fourth of private sector banking major HDFC Bank. Most other PSBs command worse valuations.

AN ‘INDRADHANUSH’ FOR PSBs Realizing the critical role that public sector banks have to play in the ambitious fi nancial plans of the government and in kickstarting industrial growth cycle, the government has introduced a seven point program for revitalizing PSBs. The components of the program are as follows:

Capitalization of Banks: The government would pump in Rs 20,058 crore this fi nancial year in 13 PSBs this year. An  additional Rs 5,000 crore would be allocated based on effi ciency criteria. SBI will get the highest Rs 5,511 Cr, followed by Bank of India at Rs 2,455 Cr, IDBI at Rs 2,229 Cr, PNB at Rs 1732 Cr and IOB at Rs 2009 Cr.

Bank Board Bureau: The Bank Board Bureau, expected to start functioning from the next fi nancial year, would house the government’s stake in PSBs. Planned as a panel of eminent professionals, the bureau will advise banks and act as a link with the government. It would be headed by the RBI governor.

Destressing Banks: To help banks tackle bad debts, a de-stressing plan has been chalked out. The government would try to get projects moving through expeditious approval and hand holding, taking over management control of equity infusion by promoters, rejigging the duty structure, pushing for flexibility in restructuring of existing loans. Major impacted sectors are steel, power, highways, power distribution utilities and sugar.

Empowerment: The government would ensure that there will be no interference from the government and banks will be encouraged to take their decision independently keeping the commercial interest of the bank in mind.

Fixing Accountability: A new framework of key performance indicators for state-run lenders is going to be set up. A robust grievance redressal mechanism will also be put in place for customers of banks as well as staff.

Appointments: Executives from the private sector have been hired to run state-owned banks.

Governance: The government has established the Gyan Sangam conclave, which is a platform for deliberations on how to improve the banking system.

Mounting bad debts
Bad debts or Non Performing Assets (NPAs) have become the Achilles heel of Indian banking sector. Banks, especially, the public sector ones are reeling under the unprofitable advances they had made in order to stave off an all out economic recession in the wake of the 2008 financial crisis. Things have now come to a stage where the menace has started to impact the viability of the entire sector. As on March 2015, the levels of gross NPAs (GNPAs) and net NPAs (NNPAs) for the system have reached 4.45 per cent and 2.36 per cent for the system as a whole. Numbers are especially bad for PSBs; The Gross NPAs for PSBs as on March 2015 stood at 5.17 per cent, while the stressed assets ratio, defined as the ratio of Gross NPA plus Restructured Standard Advances to Gross Advances, stood at 13.2 per cent, about 2.3 per cent more than that for the system. The Global Financial Stability Report of the IMF paints an even scarier picture.

It says that 36.9 per cent of India’s total debt is at risk, among the highest in the emerging economies. Against this, the report mentioned that banks have a loss  absorbing buffer of less than 8 per cent, among the lowest among comparable economies. Finance minister Arun Jaitley said recently that bad loans of state-run banks have reached “unacceptable” levels.

Such high level of risky and doubtful assets has important implication for the new business generation activities of the banks and requires careful analysis of  options that can be adopted to improve the system. While RBI is trying to put in place mechanisms to detect stressed assets early in the loan life, through programs such as guidelines on Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders: Framework for Revitalizing Distressed Assets in the Economy, Corrective Action Plan (CAP) and Sale of NPAs by Banks etc., the government is setting up mechanism to pump in money in these banks.

However, at the end of the day, it is the banks that have to do the real work of strengthening their systems.

Leveraging technology to improve and innovate
This is where new age technologies and number crunching methodologies could come handy. The developments in computing and communication technology on one hand and business analytics on the other hand allow banks to do things they could not earlier. Not only technology renders physical interaction between banks and customers unnecessary, it also allows banks to gather enormous volumes of data in no time and process that data to derive information that can assist better decision making. In the banking industry, the business and data analytics have emerged as a major go-to tools to manage bad and risky debts.

Through improved data availability, banks can and must undertake ex–ante assessment of risk as against the ex–post analysis which is the current norm, especially in PSBs. Access to real time data also allows for early detection of stress in asset from information through different channels. But risk assessment and management is not the only operational arena in which technology could help. It is allowing other existing and new banking services to improve and change. According to a leading private banker in Mumbai, his bank is spending as much on high-end data analytics and IT personals as on banking staff.

Payment management is an area that can be radically improved with technology. Even today, over 60 per cent of all payments in the country are being made in cash. However, as is evident from the rise of card and internet transactions, cashless payment are the future, a trend which has been strengthened by the Payment and Settlement Systems Act, 2007, which enabled the RBI to regulate, supervise and lay down policies involving payment and settlement. Following this Act, RBI has encouraged e-payments in the banking sector. The emergence of PayPal, T-Mobile and Google Wallet at global level and Pay TM and Pay U Money in India show that the space for banks in many financial transactions is shrinking. Banks would need to embrace and absorb such disruptive technologies in their business models in order to sustain. As Payment Banks become a reality, the trend  towards digitally enabled transactions in small and micro payments space would be accentuated.

Moving forward, most of the banking service would migrate to online platform which means that banks would need to have  presence on the internet, allowing banking to be undertaken on handheld devices like mobile phones and tablets. According to estimates, in the next ten years, as many as 250 million customers would access banking services over the mobile. Internet banking and customer care services together account for less than 10 per cent of banking services access in India against over 60 per cent in the US. Needless to say, the share of internet banking and customer care would rise sharply in years to come. And to cater to this demand, banks, especially the state run banks need to start making serious investments in tech and human resources from today. Big Data and Customer Relation Management (CRM) are going to be huge business enablers in this transition.

That’s not all, if international banking is any indication, banks would also innovate to offer allied and value added services on anywhere anytime philosophy. These may range from helping customers locate the best shopping destination to informing customers about the actual price of a product instead of the listed price.

These trends indicate towards the evolution of a service environment in which banks would provide traditional banking as a core service, besides offering value added services by pooling host of other market related information and also offer advice, very often free of cost, based on customers’ interest as evidenced by prior financial transactions. Technology has allowed banks to go much beyond their brief to serve customers.

In coming years, the ability to absorb the quantum leap in high end computing, communication and data management is what is
going to decide who would wean away the maximum number of high value customers and high margin businesses. While new age private sector banks and foreign banks are investing heavily in technology, public sector banks are lagging both in terms of application of technology and having the sufficient number of adequately trained manpower that can facilitate the transformation from a legacy banking system to a modern, agile and technologically sound banking platform. On good development is that all PSBs have moved onto the Core Banking Solution (CBS) platform and many have developed capabilities to offer  online banking. But they must invest more to leverage technology for offering value added services on one hand and to do data mining and analytics on the other. The basic idea is to use data for effective decision making at various levels, including product customization, developing business models and delivery channels.

Even as traditional banking is about to take a huge stride by adopting technology to promote its existing business as well as add  on to its services platter, the government is trying hard to push banking to hinterlands. Financial inclusion is the keyword that finds mention not only in government’s welfare programs, but also routinely in major banks’ annual reports and future plans. The RBI is chipping in with the creation of the Payment and Small banks with sole intention to bring in unbanked population in banking ambit.

A successful financial inclusion drive would allow people in rural areas to save/ remit/ receive money efficiently and avail  cheaper loans. On the other hand, it would prevent leakages in subsidy programs of the government by allowing direct cash transfers, something which has already begun. The ambitious Jan Dhan Yojana of the government is also a solid foundation of the financial inclusion program and new types of banking entities could act as major catalysts in this drive.

UNIQUE BANKS SERVICES

Garanti Bank, Turkey: Offers a free mobile app that uses GPS and Foursquare to tell customers about nearby stores with special offer, based on their past spending.

Commonwealth Bank, Australia: Offers a mobile app that helps home buyers by using augmented reality. By just pointing a smartphone camera and any house, all relevant information about the property, along with the estimated monthly mortgage and insurance payment can be fetched. The app covers more than 90 percent of all residential properties in the country.

Alior Bank, Poland: Provides its corporate clients through a single-bank foreign exchange trading platform that confi gure and manage FX rates that are sent to its FX platforms.

BBVA, Argentina: Makes available to its US customers information on the actual selling price of cars against list price by using TrueCar data, in order to sell its auto loan and auto insurance products. This helps customers in price negotiation.

Banks, big or small, can leverage technology to better reach out to the rural masses in a cost efficient manner. The primary  constraint in achieving significant financial inclusion has so far been the cost of servicing small value customers that have no credit and irregular income history. The combination of IT and mobile telephony, to a large extent, obviates the need for physical presence, thus allowing banks to circumvent the cost  problem. Technologies such as Unstructured Supplementary Services Delivery (USSD), General  packet radio service (GPRS), Wireless Application Protocol (WAP), Subscriber Identity  Module (SIM) – based application, and Near Field Communication (NFC) allow banks to offer services on hand held devices. In this regard, IT kiosks can act as a useful vehicle which could have cheque and cash deposit, internet banking as well as for noncash ATM transactions. Other tools such as mobile payments, biometric ATMs for semi or illiterate people, biometric hand held devices etc. can hugely increase banks’ ability to reach the rural customer and allow less educated people to undertake banking activities.

Banking industry stands at a crossroads today. Increased risk in the business environment, stricter regulatory norms, globally integrated markets, evolved customer requirements and emergence of disruptive technologies have made the traditional banking business models obsolete and ineffective. To stay profitable and competitive in a changed market, banks need to mutate into financial supermarkets  having a complete range of banking and financial services on one hand and exotic and innovative value added services on the other. And competition in today’s market comes from not only other banks, but also from non-banking tech companies that can impinge on business segments. But banks are not the only ones that need to evolve. Government and the RBI have to do some work as well.

They have to provide regulatory support and put in place systems that can allow efficient competition and orderly sectoral development. The government also has the responsibility to keep PSBs healthy as they have the lion’s share in the industry and are the prime vehicles for financial inclusion. Ultimately, the success of the banking sector would be measured on a few simple parameters such as the availability of credit to all those who want it, profitability, capital and liquidity position and the quality of assets. The tools may change, but the objectives hardly do.