B(l)ank future!
After a marathon year, it’s time for banks to run even harder. Will they overcome?

(column by Asif Ahmed)

The era of consumer profligacy has now finally arrived in India. And thanks to this new found spirit of indulgence, Indian banks have been smiling all their way to the bank! Statistics speak for themselves. Chetan Ahya, Executive Director, Morgan Stanley, India shares his view on the changing economic balance, “Led by leveraged purchases of new homes & automobiles, consumer debt in India has tripled, from four years earlier, to Rs.6 trillion or about 15% of annual GDP.” The Reserve Bank of India data indicates that on an average, one out of every four Indians is over-leveraged.

In FY07, banks harvested some of the best incomes and profits in the recent years. The earnings of PSU banks grew by a record 39% in the last quarter of 2007, while the figure was 24% for private sector banks. But consider a scenario, wherein the Indian consumers, who have been lately loosening their purse strings quite liberally, decide to hold back? What happens then to the fortunes of the banks? After all, it’s actually this huge appetite for money (no matter what the consequences are!), which is driving the top-line growth of the banking industry.

Easy availability of auto loans has been one of the key variables driving car sales in the country. Over 85% of car purchases are estimated to have been made using personal loans. But beginning January this year, the effects of interest rate hikes have started showing. The number of cars bought using the finance route have been declining and in May, the figure has declined to 75%.

So, if the consumers themselves start taking a back seat, which they have, what about banks. There is no denying that tough times lie ahead of Indian banking industry and year 2007 will see a bit of moderation in their growth, a fact that bankers too accept. M. B. N. Rao, CMD, Canara Bank justifies the fear, “After three successive years of high growth in credit, resource management has posed a formidable challenge for the banking industry. Monetary tightening and competitive pressures did have an influence on banks’ ability to raise resources in a cost effective manner.”

How will banks react to such a slowdown in growth? Will the overwhelmed investor, who is on cloud nine and still aiming for new heights, spare them for value erosion? And what are banks strategising at a time when their top-lines have already succumbed to successive hikes in borrowing costs, as the results for the quarter ending March 2007 indicate?

Moderation in loan growth is clearly visible. After three increases by ICICI Bank in its benchmark lending rate since December, loan disbursals on both homes and autos fell from a year earlier in the three months to March 31, a fact that has been confirmed by both Bajaj Auto and Hero Honda, India’s foremost two wheeler companies. For FY07, retail loan growth has materially slowed down, housing growth has declined to around 18-20% from a 35% growth rate in FY06. For ICICI Bank, retail advances have grown by 39% in Q4, FY07 to Rs. 1.28 trillion, which is less than the 64% growth in FY ’06 and 50% growth in Q3, FY ’07. Retail advances of HDFC Bank grew by 33.4% for FY ’07, as compared to 79.7% growth for the previous year. Even public sector banks faced a similar fate. Canara Bank reported 24% growth in overall advances to Rs.985 billion in FY ’07, which is a gradual moderation compared to 31.5% growth in the previous year and 28.6% growth in Q3, FY ’07. “Going forward, we believe credit growth to moderate to around 23-25% in FY ’08 driven partly by policy measures and to some extent by moderation in overall GDP in FY ’08 to around 8.3% (YES Bank estimates). As such, we expect pressures on resource gap to alleviate during the year.” says Shubhada M. Rao, Chief Economist, Yes Bank. “Consumer credit may slow down to 20-25% due to rising interest rate and the base effect,” adds ICICI Bank CEO K. V. Kamath.

However, if one were to have a look at the composition of available resources with banks and the competition they are facing from alternate avenues of investment, moderation in credit off -take will actually give banks some time to work on their resources. To mop up resources to fund the credit growth of over 30% in FY ’07, banks have been scrambling for deposits, which has very obviously pushed up the costs and it’s really a cat and dog fight out there. “Credit demand far outpacing deposit mobilisation did pose a challenge for most banks to meet the resource requirements which was amply reflected in the north-bound journey of interest rates, both on the assets and liabilities side of banking sector’s balance sheets since the latter half of FY ’07,” adds Rana Kapoor, CEO, Yes Bank. According to the estimates of Crisil, banks’ deposit cost was up by 60 basis points in FY ’07 to 5.1% and will go up by another 50 basis points in FY ’08. CRISIL’s analysis highlights that the proportion of bulk deposits (deposits above Rs.10 million), which carry higher interest rates and have relatively shorter tenors, has increased over the past fi ve years. Surprisingly, more than 50% of the term deposits during the last fi ve years were mobilized in 2007, and had tenures of less than one year, resulting in frequent deposit renewals and thus also exposing banks to interest rate risk. According to Tarun Bhatia, Head, Financial Sector Ratings, CRISIL “Several banks were able to fund their credit growth during the past couple of years by selling their excess statutory liquidity ratio (SLR) investments. However, this may no longer be feasible, given that the average SLR is currently estimated at 28%.”

J. Moses, Head Wholesale Banking Group, IndusInd Bank makes an appeal to RBI, “We have also seen money with the public moving away from banking system to other financial entities – mainly Mutual Funds due to the tax incentives. I would expect RBI to open up more avenues for the Bank for the purpose of resource mobilization – which will also address the ‘cost-push’ factor and reduce dependence on large value depositors.” Banks are looking at every nook and corner to keep pace with credit growth – be it through high cost deposits to reduce SLR investments or by issuing commercial papers and certificates of deposits, banks in India have gone all the way. Interestingly, despite the 60 basis points increase in cost of deposits, the banks’ net profitability margin increased to 1.55% in 2006-07 from 1.32% in 2005-06, as banks passed on the cost increase to borrowers. But till when will they be able to do so, remains the lingering question.

There are exceptions, though; some banks managed to do well in this time of tightness and turbulence. At one extreme, you have ICICI Bank, whose deposit cost increased from 4.6% in Q4, FY ’06 to 6.5% in Q4, FY ’07, and on the other hand, you have Union Bank and HDFC Bank, whose cost increased from 4.8% to 5.2% and 4.4% to 4.7%, respectively, for the same time period. “We don’t compromise on our core liability strategy of building low-cost transactional deposits. Besides, our focus on risk management has enabled us to maintain healthy margins and impeccable asset quality in this challenging environment” says a spokesperson from HDFC Bank.

Some banks have dared to think beyond this cycle of monetary tightening, which most of the pundits think is momentary. Private banks like ICICI Bank and public sector banks like Punjab National Bank and State Bank of India have lined up huge equity dilution plans so as to mop up funds to serve the needs of the growing economy and factor in the current monetary tightening & the impact of Basel II norms. “Banks do and will need to mobilise resources from time to time to be able to fund their growth or to meet capital adequacy obligations... we too have recently announced our plans to raise $1 billion.” adds Neeral Jha, Head, Corporate Communications, HDFC Bank. SBI will also tap capital markets for funds to the tune of Rs.150 billion in the current fiscal & Punjab National Bank will raise around Rs.20 billion.

While analysts have appreciated this foresightedness of banks, investors have not, since they fear massive valuation losses. Perhaps that’s why ICICI shares plummeted by almost 10% when K.V. Kamath, CEO, ICICI Bank announced an equity dilution plan of Rs.200 billion. Sarika Lohra, banking analyst, Angel Broking comments, “At the moment, the return on equity for the core business and growth will be subdued and remain so, for the next two years.” A report by Kotak Securities predicts, “The ROE will come down to between 10-11% in 2009, while the cost of equity will be 13%,” mentions a brokerage note by Kotak Securities. There is a possibility of EPS coming down as credit growth is expected to slow down; which for ICICI Bank will be at around 27-30%, added the report. However, the decision of banks to build the war chest of funds is logical and timely, considering the potential funding pipeline, which goes to as much as $500 billion (estimates of K.V. Kamath). “Given the long terms prospects of the economy and opportunities in each of our areas of business, we strengthened our capital base by raising additional equity capital, which will significantly enhance our ability to capitalise on the growth opportunities,” says a ICICI spokesperson.

As far as the FY ’08 goes, the effect of hike in borrowing costs in the last one and a half years will affect the economy this year. “For 2007-08, high interest rates will have their impact. Salaries will rise with inflation. Profit growth rates will be under pressure for banks and NPAs will rise marginally”, foresees Gautam Vir, CEO, Development Credit Bank. Perhaps, it’s time for Indian banks to reorganize their loan book & increase exposure to corporate borrowers and to those for whom the current high interest rates aren’t a big deterrent, as most of them are looking beyond the present business cycle. Even the Finance Minister stated in a recent meeting, “Th ey must rebalance their portfolio so that credit at correct prices is available to productive sectors.”

The continued focus of Indian government on infrastructure & SMEs and emergence of new businesses like organized, big-box retail presents a great opportunity for Indian banks to expand horizons. Power sector will get a boost, airports will be upgraded, new ports and townships will be built. These industries are already demanding and will eventually get a lot of capital. Business drivers do keep on changing according to the macro economic needs of an economy. That’s the reason why almost all banks should take banking in above mentioned areas, seriously. Banking in rural areas is also an area, especially for private sector banks.

Some companies will obviously be bolder than others in fund raising; others will be wiser in investing their resources. A small subset of companies will be both audaciousin spotting growth opportunities & judicious in using shareholders’ money. Hence, discovering them will require skill, patience & luck. But the opportunity is only available to those who survive competition and overcome hurdles like Basel II and the proposed banking sector liberalisation of 2009. Clearly, there’s a very long marathon ahead. And the message for Indian banks clearly is Citius, Altius, Fortius!

(End of Asif Ahmed column)