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Indian Banking Industry:Outlook and Opportunities Assessment 2007

w w w . t h e a s i a n b a n k e r . c o m

Indian Banking Industry:

Outlook and Opportunities Assessment 2007

IMPORTANT NOTICE Although the author and publisher have tried to provide information as accurately as possible, they accept no responsibility for any loss, injury or inconveniences suffered by any person using this document. The author and publisher have taken all reasonable care to ensure the data and information in this report is accurate and presents a fair representation of the subject matter. However, they do not accept the liability for damages incurred by any reader or any category of readers whatsoever. This document does not purport to provide any professional advice, and any analysis or commentary in the report should not be taken as providing any specific or general advice to any reader’s specific or general intentions whatsoever. First Publication: October 2006 ISBN: 981-05-6853-3 © 2006 The Asian Banker. All rights reserved The Asian Banker, incorporated in Singapore as T.A.B. International Pte Ltd, claims all rights as owner of intellectual property in this report. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form by any means, electronic, mechanical, photocopying, recording or otherwise, without the written permission of the publisher and the copyright owner.

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__________________________________________________________________________ Asian Banker Research – India Index of Acronyms

Index of Acronyms ALM Asset Liability Management ATM Automatic Teller Machine BANKEX Index of leading banking sector stocks listed on the Bombay Stock Exchange in India BN Billion BOB Bank of Baroda BOI Bank of India BOP Balance of payments BP Basis Point BPO Business Process Outsourcing CAGR Compound Annual Growth Rate CAR Capital Adequacy Ratio CASA Current Account - Savings Account Canara Canara Bank CBS Core Banking System CECA Comprehensive Economic Cooperation Agreement CBOP Centurion Bank of Punjab CIBIL Credit Information Bureau of India Ltd. CIR Cost-to-Income Ratio Citibank Citibank N.A. CRISIL Credit Rating Information Services of India Ltd. CDR Credit-to-Deposit Ratio CRM Customer Relationship Management CV loan Commercial vehicle loan CRAR Capital to risk-weighted assets ratio Crore Indian unit of measurement (1 crore = 10 million) DBS Development Bank of Singapore DCB Development Credit Bank DSA Direct sales agents ECB External Commercial Borrowings EFTPOS Electronic Funds Transfer at Point of Sale FDI Foreign Direct Investment FII Foreign Institutional Investor FOREX Foreign Exchange


GDP Gross Domestic Product GTB Global Trust Bank HDFC HDFC Bank ICICI ICICI Bank IDBI IDBI Bank IFCI The Industrial Finance Corporation of India IFR Investment Flucutation Reserves IMD India Millenium Deposit IMF International Monetary Fund IOB Indian Overseas Bank IPO Initial Public Offering IRB approach Internal ratings-based approach IT Information Technology KMB Kotak Mahindra Bank KYC Know-your-Customer LIC Life Insurance Corporation of India MN Million MOF Ministry of Finance MTN Medium term note NBFC Non Banking Financial Company NBFI Non Bank Financial Institution NGO Non-governmental organisation NIM Net Interest Margin NPL Non-Performing Loans NRI Non Resident Indians OBC Oriental Bank of Commerce P/B Price-to-Book (Ratio) PNB Punjab National Bank POS Point of Sales REMF Real Estate Mutual Fund RMA Rural Marketing Agent ROA Return on Assets ROE Return on Equity


RRB Regional Rural Bank Rs Rupee SBI Group SBI and its associate banks SBI State Bank of India SENSEX Bombay Stock Exchange Sensitive Index SLR Statutory Liquidity Ratio SME Small and medium-sized Enterprise StanChart Standard Chartered Bank state banks state-owned or public sector banks in India UBOI Union Bank of India UTI UTI Bank VRS Voluntary Retirement Scheme WTO World Trade Organisation Yes Yes Bank YOY Year on Year 2W loan Two Wheeler Loan e estimated figures f forcasted figures

__________________________________________________________________________ Asian Banker Research – India 4 Table of Content

Table of Contents Introduction Executive Summary Chapters 1 Macroeconomic Environment 1-1 India’s Economic Growth Prospects 1-2 Consumption and Business Outlook 1-3 Regional Comparison of Household Financial Asset Mix 1-4 Regional Comparison of Credit Depth and Credit Growth 1-5 Comparative Domestic Depth and International Penetration 1-6 Key Changes in the Regulatory Environment Governing Financial

Institutions 1-7 Policy Focus on Infrastructure and Agricultural Development 2 Macro Banking Environment 2-1 Financial Intermediation Trends in India 2-2 Bank Lending Growth vs. GDP Growth 2-3 Liquidity Profile of the Indian Banking System 2-4 Number and Types of Banking Institutions in India 2-5 Market Shares of State, Private and Foreign Banks 2-6 Banks’ Net Interest Margins 2-7 Market Position of India’s Top Ten Banks 2-8 Dominant Players: Assets and Profitability 2-9 The Role of NBFCs 3 Business Composition, Focus and Strategy 3-1 Revenue Growth vs. Growth in Market Capitalisation 3-2 Main Sources of Revenue 3-3 Non-interest Income Comparison 3-4 Asset Creation vs. Deposit Mobilisation 3-5 Cost Structure vs. Profitability 3-6 Asset Quality of Indian Banks 3-7 Bank Credit Growth 3-8 Bank Risk Management 3-9 Banks’ Capital Raising and IPO Prospects 3-10 Emerging Areas of Growth 3-11 Consolidation of Indian Banks: Rationale, Impediments and

Strategies 3-12 List of Domestic M&A Deals, 2004-2006 3-13 Foreign Banks’ Asset Growth, 2000-2005 3-14 Operations and Prospects of Foreign Banks in India 3-15 List of Foreign Acquisition Deals, 2004-2006 4 Distribution and Penetration 4-1 Branch Penetration in India and Peer Countries 4-2 Branch Growth of Indian Banks 4-3 Fee Income Generation 4-4 The Asian Banker Perception Survey on Branch Strategy 4-5 Modernising and Rationalising Branch Networks 4-6 Important Elements of Excellent Banking Service 4-7 ATM Penetration and ATM Growth


4-8 Bank Card Growth 4-9 Multi-Channel Development in India and Peer Counties 5 Tracking Technology and Infrastructure 5-1 Mapping the IT Infrastructure of Indian Banks 5-2 Level of IT Customisation and Optimisation 5-3 Level of System Integration vs. Intention to Adopt New

Technology 6 Key Challenges and Concerns 7 Conclusions 8 Appendix: Indian Banking Data Series 2001-2005 8.1 Basic statistical data

8.1.1 – Macro data (GDP, population, GDP/Capita) 8.1.2 – Price indices (Consumer and Producer price indices) 8.1.3 – Monetary statistics (Narrow money [M1], Money supply

[M2]) 8.1.4 – Inflation and unemployment (Inflation, Labour force,

Unemployment, Employment by economic activity, Labour force participation rate, Exchange rate)

8.2 Household demographics

8.2.1 – Number of households (HHs), HH income, Number of HHs by income band, Total HH borrowing

8.2.2 – Gross domestic savings (Gross domestic savings, Gross domestic savings/GDP)

8.2.3 – Poverty (Income ratio of the highest 20% to lowest 20%, Gini coefficient)

8.3 Banking industry profile

8.3.1 – GDP from Finance (GDP, GDP contribution from Finance) 8.3.2 – Number of institutions by category,

Number of inhabitants: per bank, per commercial bank, per branch

8.3.3 – Deposits in banks (Demand deposits, Time deposits) 8.3.4 – Average interest rates (Deposits: Savings, Time; Loans and

discounts) 8.4 Retail distribution

8.4.1 – ATMs (Number of networks, Number of machines, ATM penetration, Value of ATM transactions, Average value per transaction, Volume of transactions, Number of transactions/person)

8.4.2 – EFTPOS (Number of networks, Number of terminals, EFTPOS penetration, Value of EFTPOS transactions, Average value per transaction, Volume of transactions/person)

8.4.3 – Bank branches (Number of branches, Branch penetration) 8.4.4 – Infrastructure penetration rates (Fixed-line telephone,

Mobile phones, Personal Computers, Internet, Broadband)


8.5 Payment systems 8.5.1 – Cash (Cash penetration, Cash penetration as % of GDP) 8.5.2 – Credit cards (Number of credit cards, card penetration

[per person, per working population], Value of transactions [$ millions, per card, per person], Billing as a % of HH income, Volume of transactions, Average value/transaction)

8.5.3 – Debit cards (Number of debit cards, card penetration [per person, per working population], Value of transactions [$ millions, per card, per person], Volume of transactions, Average value/transaction)

8.5.4 – Cheques (Value of transactions, Volume of transactions) 8.6 Financial profile

8.6.1 – Balance sheet (Total assets, Loans, Deposits, Equity, Non-performing loans, NPLs as a % of total loans, NPLs as a % of GDP)

8.6.2 – Income statement (Net profits, Tier-1 capital) 8.6.3 – Operations: Return on average Equity, Return on average

assets, Cost-to-income ratio, Net interest margins; Liquidity: Net loans-to-total assets; Capital: Equity-to-total assets; Non-interest income as a % of total income

Charts 1 Macroeconomic Environment 1-1-1 India’s Economic Growth Prospects 1-2-1 Private Consumption Growth in India and Peer Countries 1-3-1 Regional Comparison of Household Financial Asset Mix 1-4-1 Regional Comparison of Credit Depth and Credit Growth 1-5-1 Domestic Depth and International Penetration 1-6-1 Regulatory Changes Relating to Foreign Banks and Non-Bank

Financial Institutions 2 Macro Banking Environment 2-1-1 India’s Financial Intermediation Trend by Share of Total Funds 2-2-1 Bank Lending Growth vs. GDP Growth 2-3-1 Liquidity Profile of the Indian Banking System 2-5-1 Positioning of Bank Groups in Aggregate Deposits and Gross

Bank Credit (2005) 2-5-2 Annual Growth Rates in Aggregate Deposits and Gross Bank

Credit (2005) 2-5-3 Retail Positioning and Growth of Indian Banks 2-6-1 Banks’ Net Interest Margin Forecasts 2-7-1 Market Position of India’s Top Ten Banks 2-8-1 Total Asset Comparison of State and Private Banks 2-8-2 Profitability of Indian Banks 2-9-1 Income and Expenditure of NBFCs


3 Business Composition, Focus and Strategy 3-1-1 Revenue Growth vs. Growth in Market Capitalisation 3-1-2 Top Revenue Generators for Indian Banks 3-2-1 The Asian Banker Survey on Main Sources of Future Revenue in

Retail and Corporate Banking 2005/2006 3-3-1 Non-interest Income Comparison 3-4-1 Asset Creation vs. Deposit Mobilisation 3-5-1 Cost Structure vs. Profitability 3-5-2 Growth in Core Operating Profits 3-6-1 Asset Quality of Indian Banks 3-7-1 Capital Adequacy Ratio vs. Loan-to-Deposit Ratio 3-8-1 Bank Risk Management (CAR) 3-9-1 Banks’ Capital Raising and IPO Prospects 3-12-1 List of Domestic M&A Deals, 2004-2006 3-13-1 Foreign Banks’ Asset Growth 3-14-1 Operations and Outlook of Foreign Banks in India 3-15-1 List of Foreign Acquisition Deals, 2004-2006 4 Distribution and Penetration 4-1-1 Branch Penetration in India and Peer Countries 4-1-2 Branch Penetration vs. GDP per Capita in India and Peer

Countries 2004 4-2-1 Branch Growth of Indian Banks: Private and State Banks 4-3-1 Fee income as % of Total Operating Revenue vs. Fee Income per

Branch 4-4-1 Winning Strategies in Branch Management 4-5-1 Modernising and Rationalising Branch Networks 4-6-1 Important Elements in Banking Service 4-7-1 ATM Penetration 4-7-2 ATM Growth 4-8-1 Bank Card Growth with Regards to Total Issuance 4-8-2 Growth in Credit Card Transactions: Value vs. Number of

Transactions 4-9-1 Total Customer Transactions Conducted Through Each Channel 4-9-2 Survey on Online Banking Strength of Banks in India 4-9-3 Evolution of Channel Strategies and Financial Services 5 Tracking Technology and Infrastructure 5-1-1 Mapping the IT Infrastructure of Indian Banks 5-2-1 Mapping Indian Banks in Achieving IT Customisation and

Optimisation 5-3-1 Level of System Integration vs. Intention to Adopt New

Technology

_____________________________________________________________________________ Asian Banker Research – India 8 Key Insights

Key Insights

Although strong credit growth and improving asset quality over the last years

across banks have created a positive outlook for the Indian banking industry,there are some potholes on the high road. The current resilience of the industryhas not been put to test yet in a major economic downturn or credit fall out.Weaknesses in process and service quality at front-end channels, lack of adequatedata authentication in the application and approval processes, violation of KYCnorms, incidents of home loan frauds and issues in technology advancement arestill a cause for concern.

Structurally, we believe there is no immediate systemic risk in the retail orcorporate banking sectors. The larger structural issues facing banks in the futurewill involve the challenges of smooth integration with global markets, capitalaccount convertibility and development of the corporate debt market.

A fragmented industry will find it difficult to stand up to the increasedcompetition after the expected liberalization of controls for foreign banks in2009. Despite the urgency, the consolidation of India’s state banks has notgathered critical mass although negotiations and attempts to experiment withstrategic alliances are afoot. The target of reducing the number of state banksfrom 27 to 10 seems unachievable unless the regulator develops a more forcefulstance.

We expect to see accelerated M&A activity among smaller domestic privatebanks trying to acquire peers or NBFCs to expand geographical imprint, branchpenetration or asset size. The difficulties of getting approvals for additional bankbranches and local bank acquisitions will also prompt foreign players to continueto expand inorganically by taking the less restricted NBFC route in the run-up to2009.

The opening up of the banking sector to global influences will call for enhancedcompetitive efficiency, requiring a transformation in human resourcedevelopment, IT upgrading, bundling of services and risk management practicesin line with international standards. The strengthening of the banking system willrequire a shift in focus for consolidation not for scale alone but to foster thecreation of operationally strong banks irrespective of size.

With thinning margins in corporate lending and increasing competition in tier 1cities, the emerging growth areas beyond retail lending are rural, infrastructureand SME finance. Successful lending models in the future will cover all points ofthe value chain and involve partnerships with business houses, NGOs, MFIs anddealers. Banks’ efficiency in processing small-ticket transactions and channelpenetration will become paramount. Strategic IT enhancement and networkconnectivity will be key to both.

In their retail banking evolution, Indian state banks are still largely product- orsales-focused but new private banks have taken the leap towards driving marketshare. These private banks are now leveraging on warehousing/CRM technologyand multiple channels to advance to the next stage, that is, relationship-focusedlending. They are developing diversified fee income sources and product rangelinkages for cross-selling as key competitive advantages.

Core banking rollouts for several state banks are on course but banks face thetough challenge of integrating their huge branch networks into the new systems.Once fully deployed, they will bring significant improvements in theircompetitive strength provided system integration and front-end alignments areeffected successfully.

__________________________________________________________________________ Asian Banker Research – India 9 Introduction

Introduction

The outlook for the Indian banking industry is the most positive in the

Asia Pacific. The industry is undergoing a major transformation. Yet, there

are significant differences in the evolutionary development and

competitive efficiency of the various players driving the industry.

Based on considerable demand for a greater understanding of the trends

affecting the Indian banking industry today, The Asian Banker is

publishing a comprehensive report that is of great importance to all

decision makers assessing the banks in this country.

The report reflects on our extensive and continued interviews with top

regulators, CEOs and senior executives of the full cross-section of banks in

the country as well as investors, suppliers and consultants who do business

with Indian banks. The report is supported by a strong set of data, charts

and tables that provide conceptual insights as well as hard-nosed data and

facts that decision makers can work into their own assessment.

The report provides a strong big picture perspective of the key themes

driving India’s banking industry today, supported by strong operational

and business level observations that provides the reader with an idea of the

tactical issues they will need to deal with when doing business in India.

The Asian Banker Industry Assessment Report 2006 on India assess the

profile and prospects of India’s banking industry, helps you understand the

drivers affecting the growth potential of the banking industry in the

country and learn the banks’ competitive positioning relative to each other.

__________________________________________________________________________ Asian Banker Research – India 10 Executive Summary

Executive Summary

India’s GDP growth has outstripped that of most of its Asian peers with

the exception of China. However, the low GDP per capita, rising

unemployment and rural poverty remain critical challenges to future

development.

With volatile oil prices, rising interest rates, a higher rate of inflation, and

a larger fiscal deficit and current account deficit, the GDP growth is

expected to slow down slightly in FY2007 to 7.9%. We expect to see

further monetary tightening during the year to curb inflation.

Liquidity in the market may become tighter in the later part of FY2007 due

to narrowing of the BOP surplus and slowing of forex reserve accretion.

However this may be mitigated by fresh doses of FDI, a pick-up in

portfolio investments, increased ECB limits, higher FII limits for

investment in gilts and corporate debt, and the continued inflow of

remittances.

The stock market correction of May 2006 temporarily affected

implementation of new investment plans and fresh IPO launches in the

corporate sector but with strong corporate earnings and reduction in oil

prices the market rallied to a new record in mid-October 2007. Capital

inflows have returned and pushed up the rupee value against the dollar.

Although the markets have yet to stabilize, output performance continues

to be strong and the slowdown has not derailed the overall growth of the

banking sector.

We believe the overall credit expansion will continue at strong but slightly

lower rates of 27% in FY2007 as deposit growth will not match credit

growth, the excess SLRs of previous years are drying up and Basel II

implementation will place additional demands on capital requirements.

Retail loan growth will remain strong till 2008. Besides housing loans,

auto and two-wheeler loans will see sustained growth in small cities and

rural areas in FY2007. The significant rise in purchasing power in India is

fuelling increased demand for an array of retail financial products and

services including consumer finance, wealth management and financial


planning. Corporate lending grew at a robust rate exceeding 30% in

FY2006. With the increase in investment requirements of the infrastructure

sector, capacity additions and working capital requirements, demand for

corporate credit will rise further.

The high growth potential in retail credit is motivating the mid-tier and

small banks to build up operational and strategic strengths in a range of

retail segments. In FY2006, mid-sized private banks continued to grow

their retail portfolios aggressively, especially the new private banks.

India’s retail financial services industry has been flourishing. But for most

banks, their operational development in this segment is still at the product-

or sales-driven stage. In first-tier cities, where the overall market is nearing

saturation, banks have shifted their focus from sales to market share and

the intense competition has triggered price wars. This has been reflected in

shrinking net interest margins in the retail and corporate sectors for some

banks over the last three years. Some banks are aggressively competing for

market share despite lower margins based on the premise that high

volumes bring economies of scale and thereby improve profitability.

However, these banks may see a deterioration of asset quality over time.

Banks may also need to accept that they cannot differentiate much on the

same products beyond a point. They have to build up their attractiveness to

the customer through process quality differentiation as well as superior

pricing and service delivery. Banks with strong deposit mobilisation and

risk-based pricing will enjoy more consistent and sustained profit growth

over the long run.

Credit growth has been outpacing deposit growth and there is concern that

the latter may restrict future credit expansion. For state banks, the hiking

of deposit rates with a lagged increase in lending rates will also cause the

lending during the lag period to become less profitable despite loan

expansion.

Over the past few years, there has been a shift from asset creation to

deposit mobilisation among some banks to avoid possible funding issues.

The increase in low-cost deposits is, to some extent, being driven by better

technology and expanding ATM networks.


Although state-owned banks control almost three-quarters of aggregate

deposits and gross bank credit in India, foreign banks had the highest

growth in deposits in 2005 while private sector banks led in credit growth.

In spite of their dominance in assets, state banks have the lowest

profitability. ROA has been highest for foreign banks followed by new

private-sector banks. Only a few of the larger banks will record an increase

in ROA in FY2007 compared to the previous year. Net profits of state

banks are likely to be adversely affected by bond losses.

The operating revenue margins of India’s largest banks fall within a

narrow range of 1.5% to 2.3% despite significant differences in size.

Revenue generation will become a priority for state banks in FY2007.

According to a survey by The Asian Banker, the most significant sources

of revenue growth in retail banking in the coming years will be mortgages,

personal loans, credit cards and wealth management, while corporate

revenues will be concentrated in SME financing, treasury services, cash

management and structured products.

Given the low penetration of home loans and huge demand for housing,

mortgage lending will continue to be a prime driver of retail expansion in

India. But banks must develop strong credit-underwriting ability and

innovative ways to handle sub-prime mortgage lending.

India’s young demographic profile offers high market potential for modern

retail products such as credit cards and personal loans tailored to the

younger age groups. Private banks have expanded the fastest and most

aggressively in the personal loan market but will need to watch out for

higher delinquencies.

With rising demand for wealth management products, assets under

management in India grew from $247 billion in 2001 to $355 billion in

2005. Domestically, the mass affluent segment which received little

attention from the banks initially now holds the most promise. Overseas,

banks are actively mobilising the wealthy NRI segment whose needs


generally centre on remittances and real estate acquisitions. Some banks

are also keeping an eye on the “global Indian”, i.e. those who are based in

India but have substantial business earnings and capital overseas.

Volatility in trading incomes has prompted an accelerated drive among the

banks to open up fee income sources across both corporate and retail

lending. New private banks are racing ahead of not only Indian banks but

also many of their Asian peers in driving up fee income. The development

of complex fee-based services requires the support of an integrated IT

platform to get the productisation and pricing right but many banks do not

yet have this in place. Loan trading, which started in the industry in 2003,

will become another key focus and will enable banks to increase corporate

fee income and grow their loan books without incurring acquisition costs.

So far only a few banks are active in this area.

For the industry as a whole, gross non-performing loans have been

shrinking for the last four financial years. The improving asset quality in

Indian private banks and especially the state banks is an indicator of the

increasing soundness of India’s financial system although banks’ risk

capabilities have not been tested in a major economic downturn yet.

In general, risk management across banks has improved. Treasury profits

in the past few years have been used to raise provisioning levels. However

India’s credit bureau, launched in 2004, does not have enough depth yet

and is not linked to the customer scoring systems of banks as in the United

States. Only a few banks have adopted risk-based pricing in retail lending

and, in the absence of customer credit-rating systems, this tends to be on a

product basis rather than customer basis.

Indian banks were required to commence a parallel run of the revised

Basel II framework from 1 April 2006. RBI’s expectation is that by March

2007, Indian banks would have adopted the Standardised Approach for

credit risk and the Basic Indicator Approach for market and operational

risks. Feedback from bankers indicates that most banks are on track to

meet these requirements with close supervision from RBI.


With strong credit growth ahead and preparations underway to convert

capital to comply with Basel II operational risk regulations by March

2007, capital raising activities among the banks have been increasing.

India’s exceptional growth in market capitalisation has helped to attract

international funds, not only for the large banks but also for mid-sized

banks. In fact, the growth in market capitalisation of Indian banks has

exceeded their revenue growth in the past few years, riding on the

unprecedented stock market boom and the overall positive outlook for the

banking industry. Private banks enjoy higher price-to-earnings and price-

to-book value ratios than state banks because investors perceive them as

being better managed. Indian banks raised well over $4 billion in equity

issuances from January 2005 to March 2006, but some banks will need

more capital in FY2007 to fund their loan growth.

The introduction of hybrid capital has reduced immediate concerns about

the capital raising capabilities of state banks. The move by RBI to allow

integration of investment fluctuation reserves (IFR) not only in Tier II

capital but also in the Tier I category from March 2006 will especially

assist the state banks, in the near term, to grow their loan book and Basel II

provisioning without necessarily tapping into the capital markets and

diluting their equity shares.

Retail banking will no longer be the only major source of growth as other

areas of banking gain prominence. Agricultural, SME and infrastructure

lending is set to take off. Core banking and computerisation have made it

possible for banks to viably process smaller-value accounts. This coupled

with the relatively lower returns from corporate sector lending and the

intensifying competition and thinning margins in retail lending has

encouraged them to take more interest in the rural, SME and personal loan

segments.

Pushing into unbanked rural areas will require the development of

innovative products (agricultural credit and personal loans catering to

various requirements of the rural customer) as well as simple payment

instruments suited to this segment. Banks are exploring creative ways to

develop the banking culture in rural areas through customised and

simplified channels (e.g. multilingual ATMs, multifunction smart cards)


and at the same time mitigate risks through collateralised lending in

association with partners like business houses, NGOs, MFIs, logistics

companies and dealers.

Lending methods such as dealer financing and contract farming will

become key areas of focus in the coming years. For SMEs, a cluster-based

approach promoted by the government offers the possibilities of reduced

transaction costs, lower risks and an appropriate scale for improving

infrastructure catering to this segment.

Tier 2 cities in India are viewed as a gateway for ultimately penetrating the

rural hinterland. Many of these are situated near growing industrial hubs

and have a growing mass-affluent segment ready for a large variety of

retail offerings. The improved road, electricity and telecommunications

infrastructure in remote areas – a result of the government’s plan to invest

$40 million in creating rural infrastructure – will encourage private sector

businesses and banks to set up technology-enabled offices and branches in

these areas. We expect to see renewed momentum in branch expansion

among small and mid-tier banks, to extend their reach into rural areas to

tap the tremendous revenue potential in personal, 2W, CV and auto loans,

SME finance and infrastructural projects as well as the huge opportunities

for mobilising low-cost deposit funding.

Moving into the rural segment poses a challenge from the profitability

angle due to the small ticket size of transactions and low volumes.

Economies of scale will therefore come into play and only the banks

with the best distribution channels and mechanisms will be able to profit

from this market. Bank executives perceive that the key winning

strategies for branch management will be leveraging on alternative

sales/delivery channels and turning the branch into a stronger sales

platform through better customer segmentation for cross-selling.

Foreign and private sector banks with smaller branch networks than state

banks have been more active in exploring alternative sales/delivery

channels to complement branch expansion. These include ATMs,

internet banking, telebanking and mobile phone banking, call centres,

dealer networks and direct sales agents. Cost, information security,


ignorance of the general populace about proper use of new technologies

and the broad-based preference for face-to-face interaction are the issues

that will need resolution in expanding ATM use. While ATMs and

internet banking have proved successful in some areas, banks in India

will need to assess whether and which of their customer segments are

ready for the alternative channels.

State banks are still struggling to bring down their high staff costs.

Operational expenses will rise dramatically for the majority of Indian

banks due to a strong expansion in their distribution strategies, upgrading

of IT infrastructure and increased investment in back-end technology.

However, success in leveraging on these investments could yield higher

returns in later years.

About 21 state banks have embarked on the use of CBS systems and over

14,000 branches have been CBS-enabled. They will now need to deal with

the networking of branches in remote areas and the challenges arising from

large-scale IT deployment including more scientific risk management,

better asset-liability management, effective anti-money laundering

measures, and security issues such as disaster recovery management and

fail-safe business continuity plans.

The fragmented profile of the Indian banking system has made

consolidation imperative given the increased competition that can be

expected after 2009, when the sector is opened further to foreign

competition. Vast geographical diversity, union pressures, political

interference and technological incompatibility between real-time core

banking and manual approaches have impeded the progress of state banks

on this front. We believe the regulators will need to revisit their policy and

take a more active role in pushing consolidation rather than only facilitate

and simultaneously encourage banks to develop operational strength

irrespective of size.

But M&A activity is on the increase among smaller private banks trying to

acquire peers or NBFCs to boost branch penetration or asset size,

motivated by the urgency to expand scale and/or geographical reach in

order to stay competitive after the liberalisation of controls in 2009.


Given the restrictions imposed on foreign banks, foreign acquisition deals

completed in the past few years have been limited. Foreign banks will

continue the strategy of growth through both organic and inorganic means,

subject to applications being approved by RBI, to expand their networks in

India in the next two years before the market opens up. Restrictions on

branch expansion triggered a movement towards operating through NBFCs

has helped to enhance their activity areas and market share.

As to whether the promise of 2009 will materialise, we believe that given

the pressing need for foreign investments, the government is sensitive to

global investor opinion and hence almost certain to go ahead with further

liberalisation, after consultations with all the stakeholders to smoothen the

transition (bearing in mind that 2009 will also be an election year for

India).

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This chapter discusses the economic fundamentals thatare relevant to the banking industry in India today. Welook at India’s GDP growth prospects, consumptiontrends and business outlook as well as credit depth andgrowth of the financial system compared to regionalpeers to evaluate the prospects for bank lendinggrowth. We highlight key changes in the regulatoryenvironment relevant to foreign and Indian banks andthe policy focus on infrastructure and agriculturaldevelopment that will impact future trends in banklending.

Structure of Contents 1-1 India’s Economic Growth Prospects 1-2 Consumption and Business Outlook 1-3 Regional Comparison of Household

Financial Asset Mix 1-4 Regional Comparison of Credit Depth and

Credit Growth 1-5 Comparative Domestic Depth and

International Penetration 1-6 Key Changes in the Regulatory

Environment Governing FinancialInstitutions

1-7 Policy Focus on Infrastructure andAgricultural Development

Chapter 1 Macroeconomic Environment

1-1 India’s Economic Growth Prospects

___________________________________________________________________________ Asian Banker Research – India 18 Macroeconomic Environment

• In FY2006 (year ended 31 March 2006), India’s real GDP growth

of 8.4% outstripped that of most of its Asian peers with the

exception of China. The country’s robust economic expansion was

driven largely by strong domestic demand, supported by a sharp

rise in bank credit. Although its GDP growth is projected to slow

down slightly to 7.9% in FY2007, India is expected to continue to

outperform the other Asian countries except China.

• Following a round of monetary tightening in April 2006, the

Reserve Bank of India (RBI) raised its key interest rates by 25

basis points in June due to concerns over inflation. A further

increase can be expected towards the end of the year as the central

bank seeks to curb inflationary pressure.

• India’s outstanding growth and the opening up of the economy

have attracted investors from across the world. India has

experienced one of the fastest FDI (foreign direct investment)

growth rates in Asia with FDI inflows surging between 1999 and

2005. In FY2006, FDI flows to India exceeded $5 billion.

Portfolio investments by foreign institutional investors were more

than double that at around $11 billion, driving up valuations and

contributing significantly to India’s foreign reserves.

• The opening up of specific sectors like banking, insurance and

retail has been slow. But despite the Left Front’s opposition to the

India’s GDP growth is outperforming that of most other Asian countries Monetary tightening to curb inflation is expected FDI flows and portfolio investments have been high

1-1-1 India’s Economic Growth Prospects

Source: Asian Banker Research

0%

2%

4%

6%

8%

10%

12%

1998

1999

2000

2001

2002

2003

2004

2005

2006

(e)

2007

(f)A

nn

ual

% C

han

ge

in G

DP

IndiaChinaMalaysiaSingaporeSouth Korea



easing of FDI regulations, privatisation and labour reform, the

Congress-led coalition government needs to address and resolve

these issues on an urgent basis. Continued inflow of FDI will

boost economic growth and employment and provide the much

needed funding for infrastructure development in India. However,

domestic savings must also be mobilised more effectively as FDI

alone may not be enough to lift the GDP growth rate to the

government’s target of 10% per annum.

• The rise in unemployment and inequality since 2003 is a critical

issue faced by the government. India’s GDP per capita has more

than doubled in the past decade but remains one of the lowest in

Asia. The benefits of increasing opportunities in the call centre

and business process outsourcing (BPO) industries have been

confined to urban areas and agriculture remains the key source of

employment in rural areas. Population under the poverty line

increased in 2005, with the rise in poverty more pronounced in the

rural areas than in the cities. A more inclusive banking culture that

allows the common man and the rural sector to benefit from the

country’s progress is imperative.

• India was not been spared the impact of rising oil prices and

interest rates and the drying up of excess liquidity in Asian

emerging markets. The equity market sell-off on 12 May 2006

triggered an almost 30% fall in the stock indices. The stock market

has recovered substantially since then due to strong corporate

earnings and the fall in oil prices. Capital inflows have returned

causing a rally of the rupee against the dollar. Although the

markets have yet to stabilise, we believe that India’s fundamentals

remain sound and its long-term potential unquestionable.

• Despite the bearish sentiment in the stock markets in the months

following the correction, major foreign and local companies have

been going ahead with their investment or listing plans, thereby

reinforcing business confidence in the country. Reliance

Petroleum and Air Deccan, among others, launched new shares.

Lotus India Mutual Fund, a joint venture launched by Temasek

…but domestic savings also need to be mobilised Financial inclusion is necessary to help reduce unemployment and poverty Since the stock market correction, companies have been going ahead with investment plans



Holdings and Sabre Capital Worldwide in August 2006, expects to

raise Rs 250 billion to invest in Indian equities and bonds.

• With the growth in investment and incomes, the consumer boom

and demand outpacing supply, the need for capacity additions and

working capital as well as the demand for corporate and retail

credit are set to increase. Banks and other financial institutions

will also be co-opted to participate in the increasing opportunities

in infrastructural and rural lending.

Corporate and retail credit as well as infrastructural and rural lending is set to increase

1-2 Consumption and Business Outlook


• In the past three years, private consumption in India has been

among the highest in Asia. Wealthy Indians have been leading the

spending spree and pushing up urban consumption, which

accounted for over 75% of the country’s total growth in private

consumption. By 2007, the combined number of middle income

earners and the very rich is expected to exceed the number of

households with less than Rs 45,000 a year. Urban and rural

spending is set to grow.

• Rural consumer spending differs fundamentally from urban

consumer spending, which has developed into predominantly

lifestyle spending that includes entertainment, eating out,

vacations and luxury goods – though groceries still account for the

largest portion of spending at over 40%.

• Emerging consumer markets like healthcare, retail, insurance,

telecom and entertainment are transforming consumption patterns.

Organised retail is growing at 40-45% each year. In the next three

years, the proportion of organised retail sales to total retail

turnover can be expected to almost triple to about 6%. The

exponential rise in middle- class incomes, especially for the

younger employees with high disposable incomes, is fuelling the

increased expenditure on entertainment, cell phones and branded

Private consumption in India has been among the highest in Asia in the past three years

With rising incomes, urban

and rural spending is set to

grow

-2%

0%

2%

4%

6%

8%

10%

China India Indonesia Japan SouthKorea

Thailand

2004 2005 2006e 2007f

1-2-1 Private Consumption Growth in India & Peer Countries




apparel and accessories. Household expenditure on transport and

communication is also rising.

• Banks will have to focus on the consumption and payment patterns

of the middle income earners and the very rich to map future

strategies, as their growing numbers will lead to a significant

increase in purchasing power and demand for an array of retail

financial products and services including housing and auto loans,

personal finance and wealth management. At the same time, the

need to push into unbanked rural areas will require the

development of innovative products including not only

agriculture-related credit and personal loans catering to various

requirements of the rural customer but also payment instruments

suited to this segment.

• Business confidence was temporarily shaken by falling stock

markets, rising inflation and interest rates and the Mumbai train

bombings. While global economic and political events can impact

the corporate investment cycle, the Indian economy is resilient

because of the huge size of its domestic market, its lower

dependence on exports and sound fundamentals. We believe that

the expanding service sector, growing outsourcing opportunities

and strong demographics will continue to ensure high revenues for

the business sector and increasing demand for corporate credit.

• Indian and foreign companies are investing resources to tap into

the consumer boom, thus presenting a growth opportunity for

banks. Reliance Industries is set to roll out hypermarkets, small

grocery stores and rural business hubs where agricultural products

can be traded. Bharti Enterprises may open a chain of grocery

stores in alliance with overseas super-store operators. Foreign

companies currently barred from retailing, plan to enter the

wholesale sector while single-brand retailers who were previously

permitted to have only franchise agreements can now own a

majority stake in their operations.

Banks will focus on the consumption and payment patterns of the middle income and the rich to map future retail strategies The push into rural areas will require the innovative products and suitable payment instruments



• In the past few years, Indian companies have focused on utilising

production capacities at optimum levels. With demand outpacing

supply, capacity utilisation is reaching saturation levels and fresh

capacity additions may exceed Rs 6,000 billion over the next few

years. Growing sales will further boost working capital

requirements and the demand for corporate credit from banks.

• Large infrastructure projects such as the development of economic

export zones in Mumbai, Mundra and Ludhiana and the expansion

of roads, ports, power and telecom sectors will provide a big push

in corporate bank lending in 2006-2007. Construction of multiplex

retail outlets is booming, with multiplier effects on ancillary

industries like steel and cement. IT parks in tier 2 cities like Pune,

Hyderabad and Vishakhapatnam will also create real estate

infrastructure opportunities there.

• Infrastructure financing grew at 50% CAGR between 2000 and

2005 and constituted 15.5% of industry credit and 5.4% of total

bank advances in March 2005. According to analysts, over $300

billion in infrastructure investments can be expected over the next

six years (2006-2012). While a part of these would be funded by

equity and foreign debt issuance, much of it is likely to be funded

by domestic banks.

Growing working capital needs, capacity additions and infrastructure development will boost corporate lending by banks

1-3 Regional Comparison of Household Financial Asset Mix


• The household asset mix of India is more advanced than that of

Indonesia, China, Thailand and many of its other Asian

counterparts. Just over 50% of the wealth is in the form of cash

and deposits in India, compared with over 70% in these three

countries. However, it lags behind Singapore and Hong Kong

where only 30-40% of household wealth is held in such form and

the capital markets are better developed and hence attractive

avenues of investment.

• Gross domestic savings in India have risen to almost 30% of GDP.

However Indian households, still invest a significant part of their

savings in physical assets especially in rural areas where parochial

attitudes are still prevalent. Reports reveal that Indians bought 850

tons of gold in 2005. Banks need to create products and a banking

culture ethos that will encourage a switch in their investments

from physical assets to financial products that yield higher returns.

• A second largest share of household savings in India is taken up

by insurance and pension funds. The Indian household sector’s

exposure to the capital markets is low as shown by the low level of

securities holdings. The government has permitted non-

government provident funds to invest 5% of their new inflows in

shares and 10% in equity-linked mutual funds to channel part of

these into the stock market.

India’s household asset mix is more advanced than that of Indonesia, China and Thailand….but lags behind Singapore and Hong Kong Cash and deposits have the largest share in the household financial assets mix The household sector’s exposure to the capital markets is low

0%

10%

20%

30%

40%

50%60%

70%

80%

90%

100%

India

Indon

esia

China

Thail

and

Kore

a

Taiwan

Hong K

ong

Malays

ia

Singap

ore

Asia

8

Miscellaneous

Securities

Insurance & Pension

Cash & Deposits

1-3-1 Regional Comparison of Household Financial Assets Mix 2006


1-3 Regional Comparison of Household Financial Asset Mix


• India’s demographic profile favours the penetration of modern

financial products and services. Compared to China, India has an

advantage in the long term, a “demographic dividend”. By 2020,

the median age in India will be 29 years while China’s will be 37

years, a result of the latter’s one-child policy of the last 30 years.

Thus, India’s population of young people is larger than that of

China and will become the largest in the region in the next two

decades, boosting the country’s consumer spending power. Youths

are generally less conservative about taking credit and are early

takers of most modern retail products like credit cards. However,

by international standards, retail credit is currently underdeveloped

especially among state banks.

• The mass affluent segment in India is growing and this has drawn

more financial players to the market. We believe Indian consumers

are becoming highly receptive to the increasing array of attractive

retail products being offered. We also expect banks in India to put

more effort into understanding the needs of rural households and

to offer personal financial services to attract these household

savings.

India’s demographic profile and growing mass affluent segment favours the penetration of modern retail financial products and services

1-4 Regional Comparison of Credit Depth and Credit Growth


India

Indonesia

Malaysia

SingaporePhilippines

Thailand China

Taiwan

-5%

0%

5%

10%

15%

20%

25%

30%

35%

0% 20% 40% 60% 80% 100% 120% 140% 160% 180%

Credit/GDP 2005

Cre

dit G

row

th (C

AG

R 2

003-

2005

)

36%

26%

17%

17%

49%

50%48%

11%

• With overall credit expansion of 28.3% per year (CAGR) between

2003 and 2005, India enjoyed one of the highest credit growth

rates in Asia Pacific during this period.

• Despite the strong growth, total lending has not increased in line

with GDP. The overall figures also hide the fact that many banks

have been reluctant or have not been ready operationally to expand

in riskier segments such as SME and rural lending.

• The overall credit-to-GDP ratio in India is relatively low at less

than 40%, compared to 250% in the United States, 150% in the

United Kingdom, nearly 150% in China and 75% in Thailand.

The corporate loan-to-GDP ratio of 38% in India is also low by

regional standards, with corporate lending in China standing at

over 140% of GDP.

• Retail credit is still in a nascent stage in India. The ratio of

household borrowings to GDP is just 4%, which is one of the

lowest in Asia. The ratio of credit cards to GDP at 0.4% and the

ratio of other retail loans to GDP at 4% are also relatively low

compared to the rest of the region. Consumer loans in India

1-4-1 Regional Comparison of Credit Depth and Credit Growth

Size indicates retail credit as a percentage of credit to total credit.


India enjoyed one of the highest credit growth rates in Asia Pacific between 2003-2005 …..but overall credit-to-GDP ratio in India is relatively low

1-4 Regional Comparison of Credit Depth and Credit Growth


make up only 8% of GDP, while in Thailand, Malaysia, Taiwan

and Korea the share ranges from 13% to 58%.

• The potential for retail and corporate lending is immense,

provided banks take a leap in increasing operational efficiency

and extending their reach beyond the comfort zone of metros

and into hitherto unbanked segments.

The retail and corporate lending potential is immense

1-5 Comparative Domestic Depth and International Penetration


• As a result of stricter control and insulation from international

markets, India’s financial system has been lagging behind its

Asian peers in terms of domestic depth and international

penetration.

• Measuring domestic depth by comparing assets, credit and

liabilities in the commercial banking system against GDP, India

ranks at the bottom in Asia with 53% while China has already

reached 131%.

• International financial penetration in terms of foreign direct

investment, loans and equity holdings as a percentage of GDP is

32% for India, way below the Asian average of 60%.

India’s financial system has lagged in terms of domestic depth and international penetration.

Source: World Bank

0%

30%

60%

90%

120%

150%

180%

210%

China India

% o

f GD

P

Domestic credit provided by banking sector

Loans, investments from overseas

1-5-1 Domestic Depth and International Penetration

1-6 Key Changes in the Regulatory Environment Governing Financial Institutions


1-6 Key Changes in the Regulatory Environment Governing Financial

Institutions

• Regulatory reforms have been designed to move the financial

system towards “competition, consolidation and convergence” and

eventually create Indian banks that are truly global players. The

Reserve Bank of India (RBI) wants to see Indian banks rise to

international standards on all levels with its strong focus in

2006/2007 on working towards greater transparency and ethical

conduct in dealing with customers.

Foreign Banks

• Foreign banks have limited participation in the banking sector as

the RBI does not want to create a two-tier system consisting of

well-performing private banks and older private sector banks.

Current regulations aim to protect domestic players till 2009,

giving them time to restructure.

• In February 2005, a two-phase roadmap for foreign bank

investments was announced. Till 2009, foreign ownership will

only be allowed under restricted conditions with no likelihood of

full takeovers. The RBI decides which banks can be sold (these are

usually distressed, older private banks beset with significant bad

Foreign banks have limited participation in the banking sector No likelihood of full bank takeovers till 2009

2001 2003 2005 2009•Cap on FDI was raised to 49%, from 40% (non resident Indians) and 20% (other foreigners)

•For non-banks: 100% direct investment was permitted in 19 business categories, but the minimum capitalisation was regulated depending on the equity ratio

•Permitted structure of presence: Branches only

•Foreign voting rights limited to 10%

•Branching limit per year:12

•Permitted structure of presence: Branches or wholly-owned subsidiaries

•Cap on FDI lifted from 49% up to 74%

•Foreign party can have voting rights according to ownership level

•Branching limit per year:>12, subject to RBI approval

•Permitted structure of presence: National treatment will be allowed, including IPO, subject to 26% of paid-in capital being held by resident Indians

2001 2003 2005 2009•Cap on FDI was raised to 49%, from 40% (non resident Indians) and 20% (other foreigners)

•For non-banks: 100% direct investment was permitted in 19 business categories, but the minimum capitalisation was regulated depending on the equity ratio

•Permitted structure of presence: Branches only

•Foreign voting rights limited to 10%

•Branching limit per year:12

•Permitted structure of presence: Branches or wholly-owned subsidiaries

•Cap on FDI lifted from 49% up to 74%

•Foreign party can have voting rights according to ownership level

•Branching limit per year:>12, subject to RBI approval

•Permitted structure of presence: National treatment will be allowed, including IPO, subject to 26% of paid-in capital being held by resident Indians

1-6-1 Regulatory Changes Relating to Foreign Banks and

Non-Bank




assets, outdated technology and poor management) and it prefers

the sale to be in a phased manner. It also keeps a tight rein on any

foreign investment in local private banks which exceeds certain

limits: 5% in the case of individual foreign banks and 10% for

foreign institutional investors or individual corporate entities.

Community banks are likely to resist such takeovers, slowing the

process. Distressed mergers like the one between PNB and IFCI

are more probable.

• Wholly-owned foreign subsidiaries must have a minimum

capitalisation of approximately $70 million. After 2009, foreign

acquisitions of local private banks may be allowed, subject to a

review of the outcome for the first phase of liberalisation. Wholly-

owned subsidiaries will be allowed to reduce their foreign stake-

holding to 74% through an IPO or offer for sale. Foreign banks

which currently own more than 5% of an Indian bank will have to

either seek RBI approval for acquisition of a private bank not

identified by RBI for takeover or scale back their investment to the

5% limit.

• Branch network expansion is limited, even for Singaporean banks

under the new Comprehensive Economic Cooperation Agreement.

RBI has questioned the proposals by DBS Holdings, Overseas-

Chinese Banking Corporation and United Overseas Bank to

restrict their activities to cities and high-end banking, as foreign

banks have been required to make 32% of their loans to “priority

sectors” since July 1993.

• Despite these constraints, international commercial and investment

banks are willing to stay and start their relationships with a small

stake that may give them preferred bidder status in future equity

acquisitions in case RBI modifies the regulations before 2009.

• Most bankers that The Asian Banker spoke to are of the view that

given the pressing need for foreign investments, the government is

sensitive to global investor opinion and hence almost certain to go

ahead with the awaited liberalisation of controls for foreign banks.

Despite constraints, foreign banks are willing to stay …as the government is expected to go ahead with liberalisation in 2009



The timing of the liberalisation however may take into account the

interests of various stakeholders as 2009 is the scheduled election

year for India.

State Banks

• The Indian banking system continues to be dominated by public

sector banks, but the system is fragmented as no one bank holds

more than 10% of total system assets except SBI. To enable these

banks to stand up to international competition after 2009,

consolidation of state banks and improvement of their operational

efficiency will become top priorities in the coming years.

• The main beneficiaries of the regulatory changes announced in

2005 are therefore the state-owned banks, which control over

three-quarters of total assets in the financial system. RBI has given

public sector banks more freedom to make autonomous decisions

across the full range of their operations, including human

resources, domestic and foreign acquisitions, establishing of

overseas branches or subsidiaries, opening or closing of branches

and changing of business lines. Rather than seeking permission to

open new branches on a piecemeal basis, banks can obtain

approval based on an annual plan. Unprofitable branches can be

moved elsewhere in the state and extended counters converted to

full branches without specific RBI permission.

• These measures were intended to strengthen state-controlled banks

so that they could compete with private banks by increasing their

efficiency and expanding into new business lines and geographies.

• In addition, banks will be permitted to issue preference shares,

thereby allowing state-owned banks to raise capital without

diluting the government’s minimum 51% stake. The existing

limits on banks’ statutory liquidity and cash reserve ratios have

also been removed, giving RBI greater flexibility in setting the

requirements.

The main beneficiaries of the regulatory changes announced are the state-owned banks …but still no comprehensive roadmap for consolidation of these banks



• The government wants to reduce the number of state banks from

27 to 10 in the next four years. However, contradictory regulations

from RBI and the finance ministry indicate that there is still no

comprehensive roadmap vis-à-vis consolidation similar to those of

Indonesia, Pakistan and Taiwan.

Retail Credit

• Currently, there are no specific regulations or laws framing the

management of consumer credit in India. The Reserve Bank of

India does not regulate the sector, though it has issued the

Guidelines on Fair Practices Code for Lender (2003). However,

there is increasing awareness and debate among banking

industry players and consumer groups on the need for specific

consumer credit regulations. With banks still focusing on

product-centred and growth-focused acquisition strategies, RBI

has set up an independent body, the Banking Codes and

Standards Board of India to ensure that these codes of conduct

for fair treatment to the customer are formulated and complied

with.

NBFCs

• There is a significant overlap in the functions of banks and

NBFCs. But NBFCs also specialise in certain products and

services that receive little or much less emphasis in the mainline

banking system including hire purchase and leasing, IPO funding,

small-ticket loans and venture capital.

• RBI set up a special committee to look into the issue of evening

out the regulatory discrepancies between banks and non-banking

finance companies (NBFCs).

• Non-deposit taking NBFCs (NBFCs-ND) enjoy a "regulatory

arbitrage'' in that they are not supervised in any substantial

manner. Bank borrowings are determined by exposure limits set

by the lenders. As there is no stipulation on the end use of the

funds, the leverage available to NBFCs-ND to gear their balance

sheet is practically unlimited. This raises major systemic issues

NBFC subsidiaries of foreign banks are allowed to undertake activities in which their parent banks are restricted



and there is an anxiety over NBFCs investing heavily in stock

markets by leveraging their balance sheets.

• RBI is examining the issues involved in the financing of NBFCs

by banks so that the bankers are able to use the core competencies

of NBFCs to extend their reach. The revised policy relating to

NBFCs’ access to external commercial borrowing (with RBI

approval) to finance infrastructure projects is expected to invite

increased participation of NBFCs in infrastructure financing, thus

shifting the activities of NBFCs towards productive project

funding with lower systemic risk.

• The regulatory arbitrage enjoyed by NBFC subsidiaries of

foreign banks with a presence in India have included among

others, exemption from the CRAR requirement, credit and

investment concentration norms, restrictions on investment

in land and buildings and branch expansion. Higher credit

ratings enable them to raise low cost debt resources easily.

The world's largest financial services group Citicorp and

engineering and financial services giant GE have a

significant presence in the NBFC segment. Whether

authorities will view foreign ownership of financial

institutions in its entirety (i.e. where banks, NBFCs and even

BPO centres providing IT services are owned by the same

set of shareholders), or continue to set restrictions on a per-

entity basis, remains to be seen.

1-7 Policy Focus on Infrastructure and Agricultural Development



• The government targeted a GDP growth of 8.1% in its 10th Five

Year Plan (FY2002-FY2007). The industry sector, which

performed poorly in the first two years of the Plan, turned around

with a growth rate of 7.7% in FY2004 and is now expanding at

over 10% per annum. The growth of the services sector has also

improved. But to accelerate GDP growth to over 8% and sustain

this rate, the government must upgrade infrastructure facilities as

well as improve agricultural growth, which decelerated sharply

from an average of 3.2% between 1980 and 1995 to a trend

average of 1.9% thereafter. This deceleration reflected a broad-

based slowdown in the country’s productivity growth.

• The government has invested Rs 1,74,000 crore ($40 billion) in

the Bharat Nirman programme aimed at creating rural

infrastructure and providing effective services benefiting millions

of rural poor in the next four years. The programme envisages

building 600,000 houses, adding ten million hectares of irrigation

capacity, connecting 66,802 hamlets with all-weather roads,

bringing electricity to 100,000 villages, and providing safe

drinking water and rural telephony to all villages.

• Besides government efforts, there is a need for private and foreign

investments in infrastructure. The increased flow of FDI in recent

years is not sufficient to fill the massive resource gap. With

improvements in the policy environment, attractive financial

returns on investments and manageable risks, the private sector’s

participation is expected to increase.

• The improved road, electricity and telecommunications

infrastructure in remote areas will encourage private sector

businesses and banks to set up technology-enabled offices and

branches in these areas. For example, Reliance Industries is setting

up rural business hubs, a move that will trigger not only

agricultural income growth but also the development of ancillary

Improvement in infrastructure facilities and agricultural growth is necessary to boost GDP …and encourage setting up of technology-enabled offices in remote areas

Improvement in infrastructure facilities and agricultural growth is necessary to boost GDP …and encourage setting up of technology-enabled offices in remote areas



industries. As the rural economy improves, banks will find it

increasingly attractive to venture into rural banking to participate

in infrastructure development funding and offer SMEs and farmers

a variety of financial products and services.

Chapter 2 Macro Banking Environment

The second chapter provides an overview of thefinancial intermediation business, both at theinstitutional level as well as balance sheet levels ofspecific banks. We profile the types of bankinginstitutions in India and use the charts collated toreveal their competitive positioning based on assetsand deposits. We analyse how banks in India will faregiven the fluctuating liquidity situation and interest raterise in the market today. Based on the strategiescommunicated to us by leading bankers we examinemotivations driving banks to differentiate themselvesin the marketplace and compete for market share. Welook at dominating players in terms of assets andprofitability and discuss ways in which investors andservice providers can assess the institutional capabilityof foreign and local banks in India to focus on profit byidentifying the successful players and their strategies.We also discuss the role of NBFCs and highlight casestudies of successful foreign NBFCs in India.

Structure of Contents 2-1 Financial Intermediation Trends in India 2-2 Bank Lending Growth vs. GDP Growth 2-3 Liquidity Profile of the Indian Banking

System 2-4 Number and Types of Banking

Institutions in India 2-5 Market Shares of State, Private and

Foreign Banks 2-6 Banks’ Net Interest Margins 2-7 Market Position of India’s Top Ten Banks2-8 Dominant Players: Assets and

Profitability 2-9 The Role of NBFCs

2-1 Financial Intermediation Trends in India

___________________________________________________________________________ Asian Banker Research – India 36 Macro Banking Environment

• India’s GDP contribution from finance is about 15%, higher than

that of Australia, Indonesia, Japan, Malaysia, Philippines, Taiwan

and Thailand but lower than the finance sector’s contribution in

China, Hong Kong, Singapore and South Korea. Its financial

evolution has not been even, as some of its financial markets are

very well-developed compared to their Asian peers while others

are in a nascent state.

• The role of banks as financial intermediaries in mature economies

is weakened by the stock market and other intermediaries. Bank

deposits generally account for less than 30% of the total funds in

the financial market as depositors prefer to invest in capital

markets for higher returns from stocks, mutual funds, insurance

policies and bonds, especially in surging capital markets, thus

creating a threat of disintermediation.

• In India bank deposits account for less than 30% of total funds but

its financial evolution has not been even. Some of its financial

markets are very well-developed compared to their Asian peers

while others are in a nascent state. Hence the threat of

disintermediation for banks is limited in the near term.

Unevenly developed financial markets have lessened the threat of disintermediation for banks in the near term Stock markets dominate

0%10%20%30%40%50%60%70%

2000 2001 2002 2003 2004 2005 2006(e) 2007(f)

Stock Exchange Banks

Pension Funds Life Insurance

Mutual Funds

2-1-1 India’s Financial Intermediation Trend by Share of Total Funds


Note: The Unit Trust of India (the largest public sector mutual fund) was bifurcated into UTI MutualFund and the Specified Undertaking of the Unit Trust of India effective from February 2003. The latterdoes not fall within the purview of Mutual Fund regulations. UTI recorded a net outflow of Rs.94,340million in that year.



• India has a very good securities market system in place. It has two

of the world's largest demutualised stock exchanges that trade

stocks online. BSE and NSE ranked among the top 5 exchanges

globally in terms of number of transactions between 2002 and

2005 and had among the lowest transactions costs. Over 5,800

domestic companies were listed on the BSE and NSE as of

February 2006. Market capitalisation rose by over 300% between

2003 and 2005 because investors perceived Indian equity shares to

have lower risks amid the booming economic environment. India

remains well positioned to attract international funds, though the

increase of interest rates in the United States affected its

investment appeal for the short term following the market

correction of May 2006.

• Although the stock markets dominate the financial sector in India,

the banking sector has held its own, commanding the second

highest share of total intermediated funds. Its share of total fund

allocation fell from about 35% in 2000 to 23% in 2004 while the

share of the stock markets rose. This coincided with the decline of

average interest rates on savings deposits and 12-month time

deposits (and also 6-month time deposits which declined from

2001 till 2003) and the boom in the stock markets. Banks share of

funds has risen sharply since 2004 as they have been on an

aggressive deposit mobilisation drive motivated by the need to

raise funds for their ambitious credit expansion plans based on the

high growth rates experienced in the past few years, especially in

retail financial services. They have been fettered to some extent by

the fact that many Indian households still feel comfortable with a

relatively high proportion of cash holdings and investing in

physical assets like property and gold.

• Compared to the equity markets, India’s bond markets are not as

developed. Government bonds are not very liquid and corporate

bonds make up just 1-2% of India's financial stock compared to

the much higher levels in Thailand, Malaysia and South Korea.

Household exposure to capital markets is low though FII limits on

debt are being liberalised gradually. Developing the capital

The banking sector commands the second highest share of funds India’s bond markets are not well developed Penetration of insurance and pension funds is low



markets will involve an array of measures to enhance liquidity and

price transparency surrounding government debt, government

securities, interest rate futures and the derivatives markets.

• The share of the insurance and pension financial intermediation

is low in India. Less than 12% of the workforce is covered by

any pension plan and less than 15% of the population has

insurance against health risks. Insurance penetration is

especially low in non-life insurance. Public sector insurance

companies have not been able to penetrate the rural sector. The

insurance industry was opened to the private sector in 2000 and

although the private sector’s role in both life and non-life

insurance has increased rapidly its share is less than one-fourth

of the market.

• The numbers of mutual fund houses have increased since 1993

but in the last two years in particular, mutual funds have become

a popular investment vehicle. This is partly because interest in

mutual funds is a function of stock market sentiments and

growth in market capitalisation in these years was

exceptional. Many mutual funds in India are sponsored by the

government, banks and financial intermediaries and hence

considered a relatively safer way to invest in equities. Bank

deposits lost ground while the share of mutual funds rose in

2004, driving up the resource mobilisation by mutual funds to

Rs. 476,840 million. The bulk of the mobilisation was accounted

for by the better performing private mutual funds. Assets under

management rose from Rs.1396160 million in March 2004 to

Rs.2318620 million by March 2006.

• The role of real estate mutual funds will increase as RBI recently

allowed them to invest directly or indirectly in property companies

as well as deal in mortgage-backed and other securities. Foreign

players are also expected to drive up competition in the mutual

fund industry. For example, Singapore’s Temasek Holdings has

tied up with Sabre Capital Worldwide to launch a Rs 250 billion

mutual fund for Indian equities and bonds.

Mutual funds are becoming popular



• This does not mean that financial intermediation patterns in India

are set to shift in the near term. The switch from bank deposits

may represent a cyclical shift based on low interest rates and the

bull-run in stock markets rather than a structural shift. With the

overall growing pie, volatility in the stock markets and increased

deposit mobilisation efforts by banks to get deposits from new

account holders, we believe that the rise of mutual funds does not

pose any immediate disintermediation threat to banks. On the

contrary, many of the players in the mutual fund, asset

management and insurance industries are the subsidiaries or non-

banking institutional arms of banking groups. They include the

subsidiaries of ICICI, HDFC and PNB, and UTI Mutual Fund Ltd

is sponsored by SBI, PNB, BOB and LIC. Most banks have started

building their wealth management propositions only in the past 2-

3 years. The new private banks are targeting a broad spectrum of

segments including the mass affluent and overseas Indian

segments but many state banks still lack staff with the advisory

skills required.

• From the systemic and customer points of view, a rise in

disintermediation is in fact a positive factor as developed capital

markets take the pressure off banks by spreading risks in times of

financial distress.

• In most markets, large NPLs, declining deposit rates and high

operational inefficiencies strengthen the case for financial

disintermediation for savers and move them away from banks, and

towards NBFCs. With the rising deposit rates and declining NPLs

in India, banks in the country need to focus more on improving

their operational efficiencies to maintain their position in the

financial markets. A structural shift away from banks will

eventually depend on the development of a greater variety of

alternative capital market instruments and a higher risk-taking

mindset by the Indian people.

Banks can proactively offset the disintermediation trend by diversifying



• Due to the thinness of the capital markets, banks’ traditional

intermediation role is secure for the time being. In the longer

term, the rise of mutual funds and other NBFIs may affect

their role as intermediaries but it is premature to predict a

decline in banks’ share of intermediated funds because of

greater investment in capital markets. India has a long way to

go before banks have to confront that threat structurally. We

believe that the winning banks will be those who proactively

offset the disintermediation trend by diversifying into these

areas.

2-2 Bank Lending Growth vs. GDP Growth


• Overall loan growth for the industry has increased dramatically in

the last five years. Industry perceptions in 2005 reflected the view

that even in the major cities it would not reach a plateau until

2008, continuing at around 30% a year. The retail financial

services industry has been growing at an even faster rate, at 40%

annually, albeit from a low base.

• However, we are of the view that with the increasing interest rate

environment and inflationary pressure in 2006, overall credit

expansion will continue to be strong but at a slightly lower rate of

27% in FY2007.

• Retail finance tends to be less sensitive to interest rates compared

to corporate credit, as demand for retail products like housing,

auto and personal loans and wealth management is correlated to

people’s life cycle stages/needs and changes in living standards

over time. Retail loan growth is expected to remain strong till

2008.

• Retail credit has been soaring since the year 2000. The easy

availability of housing loans, credit cards, small loans for

vehicles and household items through dealers, and instalment

schemes, as well as the rise of double-income families and

doubling of incomes across the board in recent years have

Bank lending has increased dramatically in the last five years Strong credit expansion to continue but at slightly lower rates

2-2-1 Bank Lending vs. GDP Growth


0%

5%

10%

15%

20%

25%

30%

35%

2003 2004 2005 2006(e) 2007(f )

GD

P G

row

th &

Len

ding

Gro

wth

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Lend

ing

as %

of G

DP

& Y

oY In

flatio

n R

ate

GDP Grow th Lending Grow th Inf lation Lending as % of GDP

2-2 Bank Lending Growth vs. GDP Growth


fuelled the consumer boom. The share of retail credit in the total

credit portfolio of the industry increased to 26% in March 2005.

• Favourable demographics, a burgeoning middle class,

urbanisation and under-penetration in the retail banking segment

will drive the future growth of consumer credit. Besides housing

loans, auto and two-wheeler loans will see sustained growth in

the coming years, especially in small cities and rural areas.

• Corporate lending also grew at a robust rate of more than 30% in

FY2006. With the expected increase in capacity additions,

working capital requirements and infrastructure investments,

corporate credit growth will accelerate.

• We believe that consumer credit will continue to be the main area

of competition in the foreseeable future as the appetite for retail

products is likely to grow for another 2-3 years at least. Even if

retail credit were to weaken slightly, we expect the strong

corporate sector to ensure that overall credit expansion will

continue unabated.

Consumer credit will be the main area of competition …but corporate credit growth will also pick up further

2-3 Liquidity Profile of the Indian Banking System


• There was ample liquidity in the system in 2005, with many banks

having a statutory liquidity ratio (SLR) well above the required

minimum of 25% and adequate growth in deposits to meet credit

demand.

• Liquidity in the market may become tighter in the coming year for

a variety of reasons:

- Liquidity has become dependent on forex reserve

movements. A liquidity crunch was triggered by the

redemption of India Millennium Deposits (IMD) in

December 2005. But shortly after, in March 2006, an

unprecedented increase of $11 billion in forex reserves

created surplus liquidity.

- According to analysts, forex reserves will need to increase

by about 10% to support credit growth of 25% without

straining liquidity. The narrowing of the balance of

payments surplus given the current account deficit and

consequent slowing of forex reserve accretion may tighten

liquidity.

• However fresh doses of foreign liquidity in the later part of

FY2007 (year ending 31 March 2007) may come from the pick-up

in portfolio investments and increased limits on external

commercial borrowings (ECB) and foreign institutional

Liquidity may become tighter if forex reserve accretion slows down


2-3-1 Liquidity Profile of the Indian Banking System

0

500

1,000

1,500

2,000

2,500

3,000

1Q03

2Q03

3Q03

4Q03

1Q04

2Q04

3Q04

4Q04

1Q05

2Q05

3Q05

4Q05

2006

e20

07f

Rs

(bill

ion)

50%

55%

60%

65%

70%

75%

80%

Deposits Credit CDR

2-3 Liquidity Profile of the Indian Banking System


investments in gilts and corporate debt, in addition to the

continued inflow of FDI and remittances.

• By February 2006, short-term (one-month) interest rates had

moved up by 130 bps from October 2005 to hit 6.33% due to

pressure on liquidity. The interest rates settled at around 6% after

the easing of liquidity in March 2006. State banks' interest rates on

deposits of over one year maturity moved up between April

2005 and March 2006 but their benchmark prime lending rates

(BPLRs) remained unchanged while those of private sector banks

moved up. Between March 2006 and July 2006, the further

upward adjustments in deposit rates made by some private sector

and foreign banks were higher than those by state banks. The

BPLRs of state banks and private sector banks moved up into a

range of 10.75-11.5 % and 11.00-14.5 % respectively while

BPLRs for foreign banks remained unchanged at 10.00-14.5 %.

Going forward, the movement of Indian banks' interest rates in

FY2007 will depend on global developments, domestic liquidity,

inflationary expectations, demand conditions and the lagged

impact of previous policy rate hikes.

• The record high credit-to-deposit ratio (CDR) of 72% in March

2006 points to a strong demand for credit which is likely to

continue for the next 2-3 years. But for state banks, with credit

growth outpacing deposit growth and deposit rates being hiked

with a lagged increase in lending rates, lending during the lag

period would have been less profitable even as it expanded.

• There is also concern that deposit growth may restrict credit

expansion. We believe that banks have been tapping into their

excess SLR reserves to fund credit growth. The SLR ratio which

was close to 42% for the industry in March 2004, fell to 30% in

September 2006. The strong growth lending growth is fast

depleting banks’ SLR holdings down to the minimum required

holding of 25%. This is intensifying competition for deposits

among banks and triggering a spate of deposit rate hikes.

Interest rates have moved up… Deposit growth may restrict credit expansion

2-4 Number and Types of Banking Institutions in India



• The development of the extensive public sector banking network

in India has been aimed at serving national development

objectives and targets. Banks were nationalised at various points in

the post-independence period to spread banking services. Credit

was directed to specific sectors like agriculture and small-scale

industries based on mandatory priority lending requirements often

at subsidised interest rates regardless of returns.

• The commercial banking structure in India consists of Scheduled

Commercial Banks and Unscheduled Banks. Scheduled banks

have to meet certain criteria set by the RBI and are subject to some

conditions and obligations towards RBI regulations. But at the

same time, banks conferred this status enjoy regulatory benefits.

For the purpose of performance assessment, RBI categorises them

as: public sector banks, old private-sector banks, new private-

sector banks, and foreign banks. Each group has its own regional

or sectoral target markets. Besides banks’ own operational

efficiency levels, the level of regulatory support or restrictions

relating to each group determines the benefits and limitations of

operating in India.

• Public sector banks (collectively referred to in this report as ‘state

banks’) comprise the SBI group and 19 nationalised banks. They

have extensive branch networks and enjoy the backing of the

central government. In addition, there are 196 regional rural banks,

40 foreign banks and 86 other scheduled commercial banks in

India.

The development of India’s banking network has been aimed at serving national development targets



Nationalised Banks Old Private Sector Banks New Private Sector Banks

Allahabad Bank Bharat Overseas Bank Centurian Bank of Punjab Andhra Bank City Union Bank Development Credit Bank Bank of Baroda Development Credit Bank HDFC Bank Bank of India Ing Vysya Bank ICICI Bank Bank of Maharashtra The Karnataka Bank IndusInd Bank Canara Bank Lord Krishna Bank Kotak Mahindra Bank Central Bank of India Nainital Bank UTI Bank Corporation Bank State Bank of India Yes Bank Dena Bank Tamilnad Mercantile Bank Indian Bank The Bank of Rajasthan Indian Overseas Bank The Catholic Syrian Bank Oriental Bank of Commerce The Dhanalakshmi Bank Punjab & Sind Bank The Federal Bank Punjab National Bank The Ganesh Bank of Kurundwad Syndicate Bank The Jammu & Kashmir Bank UCO Bank The Karur Vysya Bank Union Bank of India The Lakshmi Vilas Bank

The Ratnakar Bank The Sangli Bank The South Indian Bank The United Western Bank

Source: RBA

• State Bank of India (SBI) is India’s largest commercial bank

and serves as a proxy for the Indian economy. It has an asset

size of over Rs 4,900 billion and an 18% market share of

deposits in the country. The SBI group, including SBI and its

seven associate banks, has more than 13,000 branches and

controls over 25% of the national banking assets. SBI enjoys

a 60% share of government transactions and a 35% market

share in the foreign exchange market. The government and

foreign institutional investors (FIIs) own about 57% and

20% of the bank respectively. The bank has been expanding

its international presence and overseas assets now constitute

11% of its loan book.

• ICICI is the largest bank in India after SBI and the largest private-

sector bank. FII holding in the bank is permitted up to 74%. It is

the market leader in almost all its business lines including



mortgages, auto loans, CV (commercial vehicle) loans, life

insurance, general insurance and asset management. Its wide

distribution network and growing asset book are enabling a rapid

expansion of its insurance, asset management, venture capital,

investment banking and equity brokerage businesses.

• Private and foreign banks generally have much smaller networks

than the state-owned banks but are more efficient. Many of the

new private-sector banks burst onto the scene in the past few

years, bringing new products, more efficient systems and state-of-

the-art technology. They enjoy better profits and are set on

aggressive growth paths limited mainly by regulatory licences.

They have increased competition in the high-grade corporate

market, where margins had already declined with growing access

to global capital markets. They have also been catalysts for

dramatic changes in retail banking. The joint market share of

foreign and privately-owned banks in India is now 25% of total

assets.

• Regional rural banks (RRBs) emerged after 1975 as part of a

multi-agency approach to providing credit to the agro-sector. They

are state-sponsored and regionally-based commercial banks

focused on the development needs of the rural economy including

agriculture, small-scale industries and crafts, particularly small

and marginal farmers, agricultural labourers, artisans and small

entrepreneurs. SBI has sponsored 30 RRBs, which operate in 102

districts in 16 states. HARCOBANK, NABARD, SUCOBANK,

UBI and Syndicate Bank also operate in this space. But despite the

existence of RRBs, a large part of the rural economy still has

access to only informal finance and remains in the grip of

moneylenders.

New private and foreign banks have smaller branch networks than the state-owned banks but are generally more efficient

2-5 Market Shares of State, Private and Foreign Banks


• The public sector banks control almost three-quarters of aggregate

deposits and gross bank credit in India, with the single largest

entity being the SBI group. Together, the nationalised banks

account for the biggest shares of aggregate deposits and gross

credit. Local private-sector banks, a fragmented group of mostly

small and mid-tier banks, account for less than one-fifth of

deposits and credit while the foreign banks hold market shares of

just 7% and 5% respectively. The expansion of foreign banks in

India has been restricted and the public sector banks protected. But

this is expected to change after 2009 when the restrictions are

eased.

• In line with the higher incomes and greater acceptance of modern

financial products in the cities, deposit and credit size in

urban/metropolitan areas is higher than that in semi-urban and

rural areas for all bank types except regional rural banks. Among

commercial banks, the nationalised banks – a highly fragmented

group but each often strong in specific sectors or regions – are

clearly dominant in all areas.

Public sector banks control almost three-quarters of aggregate deposits and gross bank credit in India Deposit and credit size is higher in urban/metropolitan areas

2-5-1 Positioning of Bank Groups in Aggregate Deposits and Gross Bank Credit (2005)

Foreign Banks(7%)

Regional Rural Banks

(3%)

Other Scheduled

Commercial Banks(19%)

SBI & its Associates

(23%)

Nationalised Banks(48%)

Nationalised Banks(50%)

SBI & its Associates

(24%)

Other Scheduled

Commercial Banks(18%)

Regional Rural Banks

(3%)

Foreign Banks(5%)

DEPOSITS CREDIT




• Foreign banks’ participation in extending credit and mobilising

deposits in semi-urban and rural areas has been negligible as they

have chosen to focus on the wealthier population segments and

hence competed mainly with local banks in urban areas. But in

terms of annual growth, foreign banks showed the highest rate of

increase in deposit mobilisation last year while private sector

banks led in credit lending growth.

• ICICI and HDFC together hold the bulk of market share in many

of the retail loan categories and are likely to be among the main

beneficiaries of the increased penetration of retail credit in India.

But UTI and PNB are also making their mark in the retail sector

and their share of the growing pie can be expected to increase.

2-5-3 Retail Positioning and Growth of Indian Banks

Source: RBI and Asian Banker Research

0%

10%

20%

30%

40%

50%

60%

70%

80%

State B

ank o

f India

HDFC B

ank

Syndic

ate B

ank

Punjab

Nati

onal

Bank

Canara

Ban

k

Bank o

f Baro

da

Orienta

l Ban

k of C

ommer

ce

Union B

ank o

f India

Bank o

f India

UTI B

ank

Centur

ion B

ank o

f Pun

jab

ICIC

I Ban

k

0%

10%

20%

30%

40%

50%

60%

70%

Retail Loan as a percentage of total loan (2005) Retail Loan as a percentage of total loan (2006) Retail loan grow th

Private sector banks led in credit lending growth in 2005

Annual Growth Rates in Aggregate Deposits and Gross Bank Credit (2005)

0%

5%

10%

15%

20%

25%

30%

35%

Rural Semi-Urban Urban Metropolitan TotalAg

gre

gate

Dep

osit

s a

nd

Gro

ss B

an

k

Cre

dit

Deposits Credit

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

SBI & itsAssociates

NationalisedBanks

Foreign Banks Regional RuralBanks

Other ScheduledCommercial Bank

Total

Ag

gre

gate

Dep

osit

s a

nd

Gro

ss B

an

k C

red

it

Deposits Credit

Source: RBI, Asian Banker Research

2-5-2 Annual Growth Rates in Aggregate Deposits and Gross Bank Credit (2005)



• The tremendous potential in the retail credit business is motivating

mid-tier and small banks to build up operational and strategic

strengths in a range of retail segments. UTI, PNB and HDFC

showed strong year-on-year growth in their retail assets in FY2006

at 55%, 52% and 40% respectively. HDFC is among the top three

players in CV loans, auto loans, 2W (two-wheeler) loans and

personal loans. UTI is growing its incremental fee income from

credit cards and NRI (non-resident Indian) remittances. PNB is

focusing on vehicle, educational and flexi housing loans and

developing fee income sources. CBOP, after a successful

integration of the Bank of Punjab franchise, grew its retail loan

book in FY2006 to 70% of its total loans by broadening its

portfolio to include mortgages, personal loans and credit cards. It

also has plans to increase its fee income through cross-selling of

other retail products like third-party products and brokerage,

wealth management and financial advisory services.

Mid-tier and small banks are building up operational and strategic strengths in a range of retail segments

2-6 Banks’ Net Interest Margins


• Net interest income has been declining for some banks due to a

deteriorating net interest margin (NIM). The reasons are: a sharp

fall in investment yields, a slight rise in incremental deposit costs,

and pressure to keep lending rates for customers low (especially

with the price wars in the mortgage business).

• Banks aggressively undercut each other in 2005 to the extent that

the market saw the first signs of cartelised price fixing, namely by

SBI and PNB who were unwilling to lend below a fixed threshold.

In one instance, the undercutting even resulted in negative net

interest income in corporate lending. While corporate financing is

being offered at increasingly fine rates, the agricultural and SME

sectors are being charged interest of 9% to 10% and above. At

some banks, the position taken for short-term loans is that an

interest rate below 8% will not be acceptable even for prime

borrowers.

• ICICI, with its margin at 2.13% was among the weakest players in

NIMs in 2005. We believe that the bank’s strategy of aggressively

competing for market share rather than quality despite lower

margins is based on the premise that high volumes bring

economies of scale and thereby improve profitability. Other than

margins, profitability also depends on operating cost structure,

quality of portfolio and fee income. The management believes that

transaction volumes and CRM techniques can therefore be

Net interest income declined for some banks due to a deteriorating NIM Banks aggressively undercut each other in 2005

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%

2003 2004 2005 2006(e) 2007(f)

Net In

teres

t Marg

in

Punjab National Bank Oriental Bank of CommerceUnion Bank of India HDFC BankCanara Bank Bank of BarodaState Bank of India Bank of IndiaUTI Bank ICICI BankYes Bank Average NIM

2-6-1 Banks’ Net Interest Margin Forecasts


2-6 Banks’ Net Interest Margins


leveraged on to earn fee income simultaneously with interest

income by bundling products and services through cross-selling to

boost profits.

• The HDFC management, on the other hand, takes the view that

product differentiation can be achieved only up to a certain point.

Differentiation in process quality as well as superior pricing and

service delivery are deemed more important. HDFC’s strategy is

to focus on quality, customer retention and relationship deepening

rather than acquisition. The bank’s margin of 4% in 2005 was the

highest in the industry.

• With the increase of lending rates in the retail and corporate

sectors, there was an improvement in NIM in FY2006 for banks

like HDFC, UTI, ICICI, SBI and PNB. Improvement in margins

can be expected for banks with excess SLR reserves and

substantial CASA (current account and savings account) deposits.

Banks with a high SLR need lower deposit growth to fund the

same growth in advances. With an increase in deposit rates, HDFC

and UTI have an advantage because of their high proportion of

low-cost deposit accounts, as do PNB and SBI. However, ICICI’s

margin can suffer if there is a sharp rise in interest rates as its

deposit mix has a relatively higher share of bulk deposits.

• With Basel II preparations, as banks will have to cater for

operational and market risks by March 2007, additional capital

will need to be provided for high-risk assets. The impact on

margins will see a stronger response from banks on a variety of

fronts in 2006. Rather than undercutting each other, banks need to

decide what business they want to be in and for what price, and the

capital adequacy level and deposit-mobilising ability of banks will

determine their loan growth potential. The reinforcement of the

drive by banks to mobilise low cost deposits is indicative of their

attempts to stabilise NIMs.

NIMs will improve for banks with higher SLR reserves and low cost deposits

2-7 Market Position of India’s Top Ten Banks


Total Assets

State Bank of India(20%)

ICICI Bank(11%)

Punjab National Bank (6%)

Canara Bank (6%)

Bank of India (5%)

Bank of Baroda(5%)

Union Bank of India(4%)

HDFC Bank (3%)

Central Bank of India(3%)

UCO Bank (3%)

Syndicate Bank(3%)

Others (31%)

Total Deposits

State Bank of India(18%)

ICICI Bank (8%)

Punjab National Bank(6%)

Canara Bank (6%)

Bank of India (4%)

Bank of Baroda (4%)

Union Bank of India(4%)

Central Bank of India (3%)

UCO Bank (3%)HDFC Bank (3%)

Syndicate Bank (3%)

Others(38%)

2-7-1 Market Position of India’s Top Ten Banks

2-8 Dominant Players: Assets and Profitability


• The huge branch networks of the larger state banks have accorded

them a major advantage that is reflected in their dominance in

aggregate assets in an otherwise fragmented banking structure.

The combined assets of the top three state banks are more than

double that of the top three local private-sector banks and this

huge gap is likely to prevail in the coming years.

• What is noteworthy about the leading private banks like ICICI and

HDFC is that their assets have been built up over a short span of

only four to five years through aggressively growing retail

franchises. By comparison, the state-owned banks like SBI, PNB

and Canara have been more focused on corporate lending and

priority sectors.

• We believe the future competition between banks will be played

out in retail lending, rural and SME finance as state banks have

started to build their retail portfolios more actively while some

new private banks are trying to expand their reach in rural areas

and lending to SMEs .

State banks dominate aggregate assets given a fragmented banking structure …but leading private banks built their assets in a much shorter span of time


2-8-1 Total Asset Comparison of State and Private Banks

*State Bank of India, Punjab National Bank, Canara Bank ** ICICI Bank, HDFC Bank, UTI Bank

0

2

4

6

8

10

2005 2006 (e) 2007(f)Agg

rega

ted

Ass

ets

(Rs

billi

on)

Top 3 State-Owned Banks* Top 3 Private Banks**



• According to RBI estimates for FY2005, foreign banks had the

highest return on assets (ROA) in the industry at 1.3%, followed

by new private-sector banks at 1.1%. Despite their dominance in

assets, the profitability of state banks was the lowest at 0.9%.

• The higher ROAs of foreign banks and private banks were

possible because they managed their NIMs better, developed

diversified sources of fee income and were able to meet operating

expenses from non-interest rather than interest income, and had a

lower cost of funds. Additionally, foreign banks have successfully

leveraged on their direct sales channels to become the dominant

players in the most profitable niches in mass retail. Their sales

forces comprise 60-70% of total headcount.

• We believe that only a few of the local banks (included in the

chart above) will record an increase in ROA in FY2007 compared

with FY2006. The strongest ROA performers among local banks

in FY2007 will be HDFC, IOB and OBC. Not only does HDFC

have the highest NIM and high fee income, but it has also

consistently maintained its asset quality and its provision coverage

of bad loans is the highest among Indian banks. Besides having

one of the best cost-efficiency ratios in the industry, IOB has

enjoyed consistent growth in core earnings and its NPLs have been

declining. For OBC, its merger with GTB has given it an

Profitability of Indian Banks

0.00.20.40.60.81.01.21.41.61.82.0

2004 2005 2006(e) 2007(f)

Retu

rn o

n As

sets

(%)

State Bank of India ICICI BankPunjab National Bank Canara BankBank of India Bank of BarodaUnion Bank of India Oriental Bank of CommerceIndian Overseas Bank HDFC BankUTI Bank Average


Foreign banks enjoy the highest ROA dominating the most profitable niches in mass retail



expanded pan-India presence. OBC’s cost-income ratio (CIR) is

expected to fall as GTB’s salary levels are brought in line with its

own.

• RBI’s recent restriction on the writing back of general provisions

into the profit and loss account will have some adverse impact on

banks that have been using current profits to provide for future

losses.

2-9 The Role of NBFCs


• Non-bank financial institutions (NBFIs) in India include All-

India Financial Institutions , created for long-term development

financing, non-banking financial companies (NBFCs) and

primary dealers who trade in government securities. The

operations and regulatory focus of each group are different.

• NBFCs are a heterogeneous group including: equipment leasing

companies, hire-purchase companies, loan companies, and

investment companies. Hire-purchase companies have the

highest share (59.6%) of total borrowings by all NBFCs.

Unsecured loans are the single largest source of funds for

NBFCs followed by secured loans, while advances constitute

their main assets.

• The boundaries separating commercial banks and NBFIs are

getting blurred. NBFCs are allowed to enter the credit card

market on their own or in association with other NBFCs or

scheduled commercial banks. Permission is granted selectively

by RBI based on the financial standing of the NBFC.

• In January 2006, there were 12,615 non-deposit taking NBFCs,

of which 104 have assets of at least Rs 100 crore (Rs 1 billion).

The boundaries separating commercial banks and NBFIs are getting

2-9-1 Income and Expenditures of NBFCs

Source: RBI

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

2001 2002 2003 2004 2005

Inco

me

and

Expe

nditu

re to

Ass

ets

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

Net

Pro

fit to

Ass

ets

Income Expenditure Net Prof it



Citigroup, with five group companies, heads the list in terms of

aggregate assets followed by GE Capital and its associates. Just

ten companies hold 43.3% of the total assets of this segment,

and five of these are foreign-owned entities.

• NBFCs came into being to fill a void in mainline commercial

banking. They have greater cost efficiency than banks and

greater flexibility in product selection and in pricing of services.

Hence deposit-taking NBFCs in India have been able to pay

more on public deposits than banks. Their contribution to the

development of products such as hire-purchase and leasing is

well recognised.

• Regulatory restrictions on foreign banks in India have triggered

a movement of foreign players into non-bank channels to exploit

the huge retail potential. By forming joint ventures with local

NBFCs, foreign players can gain wider branch access without

the need to engage in priority-sector lending, which RBI

requires of all banks.

Case Studies of Successful Foreign NBFCs in India:

• GE Consumer Finance in India is a pioneer of consumer durable

finance and a key player in two-wheeler loans. The business

model focuses on a direct-to-customer approach through personal

loans, mortgages and home loan products and stronger customer

connection to build long-lasting relationships. It consolidated

under a new global umbrella brand name GE Money in 1994 to

deliver one consistent customer experience country-wide, using it

as a key differentiator across touch points and products.

GE’s growth strategy is to be the preferred lender in the under-

penetrated middle- and mass-market segments, which are still

largely unorganised and have not been credit-tested, by providing

financial solutions for their unique needs. It operates in the small-

ticket segment of personal loans which is not covered by banks

like ICICI. To ensure easy accessibility to customers, it set up

innovative alternative distribution channels to offer its personal

Restrictions on banks have prompted foreign players to move into non-bank channels to exploit the huge retail potential



loans, e.g. kiosks at India Post outlets, HPCL retail outlets (one of

India’s premier petroleum companies), railway and metro stations,

and bus terminals. Its NBFC status allows GE to effect segment

expansion at a much faster rate than RBI would permit for banks.

The GE model is being emulated by several companies. It now

faces the challenge of competitors scaling up in the middle/mass

segment including foreign banks like HSBC, StanChart and DBS.

However we believe it will come up with innovative ways to

decrease costs and grow distribution to counter the competition.

• Citifinancial is also a top player in consumer durable financing.

Although it entered the market only in 2000, later than GE, it has

grown at an aggressive pace with quick approvals and distribution.

Customers acquired through this segment can potentially be

migrated to personal loans ranging from $500 to $8,000. With an

increasing loan portfolio, more favourable interest rate options are

offered to the customer.

Citifinancial’s branch-based lending model achieves superior

returns through a credit evaluation process which minimises

lending risks. Its market leadership in personal loans and in prime

and sub-prime credit cards can be attributed to strong credit-

underwriting and collection systems, a distribution network of 300

branches and sales points in 150 cities, presence in market places,

effective storefront signage, and continuous training. It has over a

million accounts and is engaged in insurance, mortgage and

unsecured loan products. Unlike Citigroup’s banking arm in India,

it faces no restriction to branch growth.

• The GE model in India has been successful because it is based on

simple products made easily accessible to the customer.

Citifinancial’s success has come from its ability to up-sell, made

possible by its strong analytic capability and good understanding

of the interest rate continuum across products. However the two

models have some commonalities in their success: fast approval

process, strong credit and underwriting systems, robust evaluation

….to build market share before the expected liberalisation in 2009



to minimise risk, and sound technology platform to simplify

operations and processes.

• Clearly, the NBFC route offers many advantages and gives

foreign banks an opportunity to build up their market share

before 2009, when foreign participation in the banking sector is

liberalised. But going forward, conditions may get less

favourable for fresh players as RBI has increased its vigilance of

NBFC activities and existing players will try to set up cost

barriers for new entrants.

Chapter 3 Business Composition, Focus and Strategy

Structure of Contents

3-1 Revenue Growth vs. Growth in MarketCapitalization

3-2 Main Sources of Revenue 3-3 Non-Interest Income Comparison 3-4 Asset Creation vs. Deposit Mobilization 3-5 Cost Structure vs. Profitability 3-6 Asset Quality of Indian Banks 3-7 Bank Credit Growth 3-8 Bank Risk Management 3-9 Banks’ Capital Raising and IPO Prospects3-10 Emerging Areas of Growth 3-11 Consolidation of Indian Banks: Rational,

Impediments and Strategies 3-12 List of Domestic M&A Deals, 2004-20063-13 Foreign Banks’ Asset Growth, 2000-20053-14 Operations and Prospects of Foreign

Banks in India 3-15 List of Foreign Acquisition Deals, 2004-

2006

This chapter is designed to give readers an insight intothe business composition of the banks down to theproduct level. We assess their revenue growth, futuresources of revenue and prospects in emerging growthareas and how banks will develop a good mix ofbusinesses to strengthen their balance sheets. Wecompare and assess their potential for developing fee-based income and sustaining credit growth based ontheir capital adequacy and deposit mobilization andcapital-raising activities. We examine their assetquality and risk management capability especially inrelation to Basel II readiness. We examine the trendsand issues in the consolidation of Indian banks and thegrowth and outlook for foreign banks in India.

3-1 Revenue Growth vs. Growth in Market Capitalisation

___________________________________________________________________________ Asian Banker Research – India 61 Business Composition, Focus and Strategy

• The growth in the market capitalisation of Indian banks surpassed

the growth in their revenue in FY2004-FY2006, riding on the

unprecedented stock market boom and the overall positive outlook

for the banking industry given its high rate of loan growth.

Moreover, declining NPLs, better asset quality and improved risk

management have increased public confidence in Indian banking

institutions.

• The outlook for India’s banking industry is the most positive

among its Asian peers. Revenues in the Indian banking sector are

expected to grow significantly faster than those of any country in

the rest of the world until 2007.

• ICICI is one of the best performers in terms of shareholder value.

The positive market perception of ICICI is a result of the high

profile it maintains on account of its leadership in almost all retail

loan categories and a strong focus on expanding its reach through

distribution and sales.

• For top value performers HDFC and PNB, market valuations and

revenue performance are relatively closer when compared over a

The growth in market capitalisation of Indian banks exceeded their revenue growth The major banks were valued higher than their intrinsic revenue performance

BOI

Canara

PNB

OBC SBIUBI

BOB

HDFC

ICICIUTI

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

0% 20% 40% 60% 80%

Growth in Market Capitalisation (2003-2006)

Gro

wth

in R

even

ue (2

003-

2006

) Banks valued according to or below their performance

Banks valued higher than intrinsic performance

3-1-1 Revenue Growth vs. Growth in Market Capitalisation




three-year horizon. Both banks have been consistent performers in

loan growth momentum with better margins, high CAR and high

ROA.

• The major state banks including SBI also enjoy a market

perception exceeding intrinsic value because they are viewed as

reliable government-backed institutions even though they have

much lower revenue growth rates. Their high SLR holdings and

national- and priority-sector commitments mean that relatively

less credit is available for private sector lending. They tend to opt

for less risky clients as their long-term strategy is based on

keeping their risks in check. SBI has a 60% share of government

transaction business. Most of its lending is conducted close to the

prime lending rate, resulting in reasonable but not the highest

range margins as enjoyed, for example, by HDFC Bank.

• In FY2006, Bankex under-performed Sensex by 37%. But what is

noteworthy is that some private banks out-performed Sensex while

state-owned banks underperformed the benchmark. The under-

performance of state banks may be due to fears of the effect of a

rising rate regime on margins and subdued growth in reported

profits.

• Low FII limits tend to depress state banks’ valuations. Among the

19 listed state banks, nine were close to their 20% FII limit

towards the end of FY2006. Among state banks with at least $1

billion in market capitalisation, only BOI, Syndicate Bank and

IOB still had leeway for incremental FII investment. However,

valuations of state banks sometimes fail to take into account their

vast reach, access to low-cost funds and improvement in asset

quality. On the other hand, private banks enjoy higher price-to-

earnings and price-to-book value ratios than state banks because

investors perceive them as being better managed.

Better managed private banks tend to have higher price-to-earnings and price-to-book value ratios than state banks



• There is little correlation between size and profitability as banks

seldom differentiate themselves in pricing. Despite significant

differences in size, India’s largest banks have operating revenue

margins within a narrow range of 1.5% to 2.3%.

• The Indian banking system has seen strong asset generation and

revenue growth over the last few years. Between 2001 and 2005,

assets of commercial banks grew by 30% CAGR while their

operating revenues rose by 41.5% CAGR. Combined revenues are

expected to expand further by 20% annually in the next two years.

• Overall, Indian banks enjoyed healthy net profits in FY2006.

However a closer look reveals that most of the state banks had

shown weak signals for revenue generation in the first half of

FY2006 and that their reported profits had come from drastically

reshuffling provisioning and hiding accelerated human resource

expenses. Revenue generation will take on high priority for state

banks in FY2007.

Indian banks’ operating revenue margins lie within a narrow range Revenue generation will become a high priority for state banks

0

20

40

60

80

100

120

State Bank of India

ICICI Bank

Punjab National B

ank

Canara Bank

Bank of B

aroda

Bank of In

dia

Union Bank of India

HDFC Bank

Oriental B

ank of Commerce

Syndicate Bank

UTI Bank

Oper

atin

g Re

venu

e (in

Rs B

illion

)

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

Reve

nue a

s % o

f Ave

rage

Ass

ets

Operating Revenue (Rs Billion) Revenue as % of Average Assets

3-1-2 Top Revenue Generators for Indian Banks


3-2 Main Sources of Revenue


• According to a survey conducted by The Asian Banker, the most

significant sources of revenue growth in retail banking in the

coming years will be mortgages, personal loans, credit cards and

wealth management, while corporate revenues will be

concentrated in SME lending, trade and export finance, treasury

services, cash management and structured products.

• Penetration of home loans, credit cards and personal loans in India

is among the lowest in Asia, pointing to the huge untapped

potential in these retail segments.

• All banks in India have a foot in the booming mortgage market

which is growing at about 35% annually in terms of outstanding

loan value. Housing loans make up at least 50% of retail loans, yet

Retail banks’ revenues will be focused in mortgages, wealth management, personal loans and credit cards …and corporate revenues in SME lending, trade and export finance, treasury services, and cash management. Penetration points to the huge untapped potential in retail segments

0

1 0

2 0

3 0

4 0

5 0

Mortgages

Wealth Management

Personal Loans

Credit Cards

Bancassurance

Auto Finance

Subprime Lending

International Banking

Internet Banking

Num

ber o

f Res

pond

ents

3-2-1 The Asian Banker Survey on Main Sources of Future Revenue in Retail and Corporate Banking 2005/2006

0

1 0

2 0

3 0

4 0

5 0

6 0

SMEsTrade & Export Finance

Treasury

Cash Management

Structured Products

Middle Market

Equity Capital Markets

Financing

M&AsPrivate Equity

Investments

Debt Capital Markets

Num

ber o

f Res

pond

ents

Corporate Banking

Retail Banking




penetration is still low at 4% of GDP. Thus, the potential for

growth is huge with increasing urbanisation, rising disposable

incomes and tax incentives.

• Foreign banks showed the strongest growth in the housing loan

market between 1999 and 2002 but have since been overtaken by

domestic banks. However HDFC has been leading in outstanding

loans, having financed 2.4 million housing units in the last 27

years. It has been estimated that there is a shortfall of almost 40

million housing units in India, which suggests significant room for

growth in the demand for housing loans.

• Banks have more than doubled their share of housing loan

disbursements in the past five years. GE Money, an NBFC, is also

expected to see its mortgage portfolio grow substantially in the

long term because of its well developed sub-prime lending model

and aggressive direct-to-customer approach with easily accessible

and unique distribution channels.

• Competition in the mortgage market has been mainly based on

pricing and interest rates, and banks have been trying to expand

their customer base with similar strategies and minimal

product/value differentiation. Most banks offer a combination of

fixed and floating rates coupled with a life insurance policy or free

credit card. Structured home loans have become more attractive

since the launch of the Credit Information Bureau of India Ltd

(CIBIL) in April 2004. We believe that in the rising rate

environment, more and more customers will opt for fixed loan

rates. This poses a risk to the future profitability of banks as NIMs

for mortgages are already small compared to other retail loans.

• Another challenge that banks face is the rising incidence of frauds

in home loans, with builders pocketing loans taken in fictitious

names or for non-existent properties mortgaged to the banks.

Reports reveal that to win more business, some foreign and

private-sector banks have been disbursing loans without the

borrower having to give any margin money. RBI has warned

banks to undertake strict due diligence for disbursing these loans

Housing loan disbursements by banks increased sharply

Housing loan disbursements by banks increased sharply Indian banks need to learn to handle sub-prime mortgage lending to the mass market



and recently increased the risk weight on residential mortgages to

75%, much higher than the Basel II requirement of 35%.

• The mortgage business has been focused on medium to high net-

worth customers in urban areas, though 90% of the housing

shortage occurs in the economically weaker segments. Given the

low penetration of home loans and huge demand for housing,

mortgage lending will continue to be a prime driver of retail

expansion in India. But banks must develop innovative ways to

handle sub-prime mortgage lending and cater to mass-market

demand while keeping their retail portfolios and asset/liability

compositions balanced to avoid adverse effects on profitability.

• With the growing purchasing power across multiple age groups in

India, banks will increasingly focus on the consumption and

payment patterns of the middle class and the very rich to map their

future business strategies. Given India’s large population of young

people, who tend to have higher aspirations and are more receptive

to financial products, there is also tremendous market potential for

modern retail products such as credit cards and personal loans

tailored to the younger age groups.

• Earlier, many banks were not keen on lending to the personal

segment because they did not have the technology to process

small-value loans. This has now changed. Core banking, consumer

banking applications and computerisation have made it possible to

viably process both large-and small-value accounts. Moreover,

relative earnings from the corporate segments have fallen because

corporate entities are enjoying higher bargaining power given their

access to global markets and so tend to dictate the prices. This has

fuelled the interest of both private and state banks in growing the

personal loan segment. At Canara Bank, for instance, personal

loans grew by 36% in FY2006, almost as much as the growth in its

agricultural lending (a priority sector) which grew at 37%.

However banks will need to watch out for higher delinquencies in

this segment.

The market potential in credit cards and personal loans for the younger age groups is high Technology has made processing of small-value personal loans viable for banks With rising incomes, wealth management products are in high demand



• GE Money and Citifinancial, with their strong credit-underwriting

systems, are among the biggest players in sub-prime lending. State

banks have been losing market share in consumer durable

financing to small and mid-sized private banks such as HDFC,

UTI and ICICI, but they have been out-performing private banks

in mortgage and personal loan growth.

• With rising prosperity, the demand for wealth management

products has increased. The Asian Banker estimates that assets

under management in India grew from $247 billion in 2001 to

$355 billion in 2005. Banks have responded with a range of

offerings covering different customer segments. Most banks

entered the market only about two years ago. Products include

mutual funds, insurance, direct equity or real estate funds,

investment advice and commodities.

• Most foreign banks have targeted the upper-end private banking

segments. At Citibank, the top-end CitiGold customers are

serviced by dedicated relationship managers and the mass affluent

segments through the internet and other channels.

• On the other hand, India’s largest private bank ICICI operates in a

broad spectrum of segments ranging from salaried customers to

private banking clients and has garnered a large market share.

• Data warehousing and CRM technology, product linkages and

well-trained relationship managers are critical to establishing a

competitive wealth management business as they enable the bank

to pitch the right products to customers at the right time. HDFC,

which expects to increase its wealth management business to

about Rs 200 crores (Rs 2 billion) in the coming year, has spent

over Rs 10 crores (Rs 100 million) to develop a technology

platform focused on CRM and portfolio execution.

• Many state banks which engage in merchant banking are as yet

reluctant to offer investment advisory services in the absence of

Foreign banks have mostly targeted the upper-income segments



well-trained staff, although online trading and mutual funds are

offered.

• Domestically, the mass affluent segment shows the most promise

and is beginning to receive more attention from the banks. At the

same time, banks are actively pursuing the wealthy non-resident

Indians, whose needs generally centre on remittances and real

estate acquisitions. Banks are also keeping an eye on the “global

Indian” segment, comprising those who are based in India but

have substantial business earnings and capital overseas.

• Competition in wealth management has intensified among foreign

and new private banks. Poaching of relationship managers is on

the increase and staff attrition rates are high. Bankers have

revealed that the average tenure of relationship managers in India

is 1-2 years only. We believe the high turnover will prompt some

banks to reduce the role of relationship managers and instead rely

more on automated systems and centralised research tools to

process asset management in order to protect their customer base

and intellectual capital and, where possible, develop a team rather

than one-to-one approach to CRM.

New private banks are investing in the technology and human resources required… The mass affluent and non-resident Indian segments show the most promise

3-3 Non-Interest Income Comparison


• Increased pressure on NIMs in the last few years and slowing

down of treasury sales accelerated the drive to open up fee income

sources across the banks’ entire lending business, both corporate

and retail. Moreover, trading incomes from forex, bonds and

equities, though more lucrative, are also more volatile. Indian

banks are therefore striving to push up fee income from diversified

sources such as cash management, mutual funds, insurance,

remittances, credit cards and a variety of transaction services for

which they charge processing fees.

• New private banks like ICICI, UTI and HDFC are ahead of not

only other Indian banks but also many of their Asian peers in

driving up fee income. Their fee income growth ranged from 40%

to 60% CAGR over the last three years.

• For ICICI, fee income was a key growth driver in FY2006 and

60% of it came from its retail business. This no doubt accounts for

its ability to compete in a low NIM environment. About half of its

auto and home loans are bundled with fee income from insurance.

Its fee income/operating income ratio is almost three times higher

than that of SBI, India’s largest commercial bank. Fee income

earned simultaneously with interest income through bundling is

the underpinning factor behind its profits.

New private banks are driving their fee incomes towards international standards


3-3-1 Non-Interest Income Comparison

19.3%

28.1%

36.6%

39.9%

45.2%

47.4%

Bank of China

Top State Banks Average***

DBS Group

Top Foreign Banks Average*

Bank of America

Top Private Banks Average**

* Citibank India, HSBC India ** ICICI Bank, HDFC Bank, UTI Bank *** State Bank of India, Punjab National Bank, Canara Bank



• UTI’s strong fee income showing is powered by diversification of

its fee income sources including credit transactions, cash

management, ATM sharing, distribution of third-party products

and capital markets. It is the third-largest debit card issuer and the

dominant player in debt syndication and placements in India.

• Besides transaction banking products, HDFC also focuses on

third-party product distribution, depository accounts, insurance,

investment advisory and POS terminals to generate higher fee-

based income.

• The much smaller CBOP and Yes Bank are equally banking on

cross-selling, wealth management, third-party product distribution

and advisory services to grow their fee income aggressively over

the next few years.

• With improvements in loan growth and asset quality, state banks

are beginning to focus on increasing their fee-based income,

though these tend to be linked to business from the government.

• Improved commissions from government business and an increase

in its service charges have helped boost SBI’s fee income.

• Another public sector bank, PNB, has tied up with Princeton

Financial Group of the United States for mutual funds and

insurance products and plans to launch its own credit card to help

generate fee income. Cross-selling has so far been limited and will

be viable only after its data warehousing and CRM programme

become operational.

• The development of complex fee-based services requires the

support of an integrated IT platform that enables the bank to get its

productisation and pricing right with respect to such services and

enhances its cross-selling ability. But many banks do not have this

in place yet.

State banks’ fee income is mostly linked to business from the government But cross-selling and diversified fee income sources will take-off only after their technology is upgraded ….as complex fee-based services require an integrated IT platform



• Loan trading, which started in the industry in 2003, will become

another key area of focus as banks attempt to increase corporate

fee income because it enables banks to grow their loan books

without incurring acquisition costs. Nationalised banks that lack

the analytical skills to acquire big-ticket assets rely on the analysis

provided by larger banks to acquire assets in smaller bites of

around Rs 25 crores (Rs 250 million) at a time. So far only a few

banks such as ICICI, Citibank, StanChart and UTI are active in

this area.

• We believe that while the new private banks and foreign banks are

moving rapidly towards international standards in fee income

generation with their innovative product offerings and aggressive

cross-selling, state banks are falling behind as a result of their

continued dependence on government business, cards and

traditional fee-based products. Diversification and development of

their fee income sources is likely to take off only after their

technology upgrading is advanced to the next level.

Loan trading will become another key source of fee-based income

3-4 Asset Creation vs. Deposit Mobilisation


• The overall CDR of the Indian banking system reached a record

high of 72% – which is still low by regional standards – in March

2006 while the incremental CDR exceeded 100% for the last two

consecutive years.

• In the past few years, banks have increased their efforts in deposit

mobilisation to provide low-cost funds for rapid asset growth. The

trends in deposit growth and credit growth show that some banks

started preemptively strengthening their deposit base three years

ago to avoid potential funding issues. The increase in low-cost

deposits has, to some extent, been driven by better technology and

growing ATM networks.

• With the increase in deposit rates, the ability to maintain a low-

cost funding base will become critical to the success of Indian

banks in the longer term. They need to tailor strategies to ensure

continuity of this fund base, since the secondary money market is

not developed and borrowing for various tenures is limited and

costly. Furthermore, India does not have an interbank market with

a long-term money market where banks can borrow one- or two-

year funds easily as in the United States.

With the increase in deposit rates, the ability to maintain a low-cost funding base will become critical for banks

0%

5%

10%

15%

20%

25%

30%

35%

40%

0% 10% 20% 30% 40% 50% 60%

Loa n Grow th 2004-2006 (CAGR)

Dep

osit

Gro

wth

200

4-20

06 (C

AG

R)

BOI

UTI

ICICI

HDFC

HSBC (India)

PNBCitibank (India)

CanaraBOB

SBI

StanChart (India)Kotak


3-4-1 Asset Creation vs. Deposit Mobilisation

Deposit/Credit Growth 1:2

3-4 Asset Creation vs. Deposit Mobilisation


• In FY2006, while many banks grew their lending much faster than

they mobilised deposits, the pace of deposit mobilisation in ICICI

and HDFC exceeded their loan growth. But for ICICI, this came

with higher deposit costs because of its low CASA (current

account and savings account) deposit base. On the other hand,

banks with high CASA deposits benefit from the fact that only

non-CASA deposits are re-priced with an increase in deposit rates.

• Aggregate deposit growth among foreign banks as a group was the

highest in the industry in 2005. Even at a well-capitalised foreign

bank like Citibank, a strategy of complementing asset creation

with deposit generation is favoured and fresh campaigns

advertising flexibility of deposits have been launched. Salary

increases across the board are expected to feed the deposit

mobilisation drive.

• While stronger deposit mobilisation is necessary to maintain the

industry’s high loan growth in the coming years, we believe that

banks will also have to keep a watchful eye on the composition

and cost of their deposits. With lending and deposit rates going up,

banks such as HDFC Bank, PNB and SBI will have more success

at increasing net interest margins in 2006-2007 due to their high

proportion of low-cost deposit accounts (at 40% or more of total

deposits).

Banks with a high proportion of low-cost deposits will have more success in increasing NIMs

3-5 Cost Structure vs. Profitability


• The cost structure and profitability profile of the largest Indian

banks reveal that many state banks are still struggling to bring

their operational costs under control, while the top private banks

have been able to manage their costs more efficiently and hence

achieve higher profits.

• Among the revenue optimisers, i.e. banks with the highest ROAs,

HDFC is the clear leader with a low CIR and an ROA exceeding

2.5% in FY2006 while ICICI, Canara, UTI and OBC have ROAs

in the range of 1% to 2%.

• In contrast, the ROAs of SBI, BOB, BOI, Syndicate Bank and

UBOI were below 1%. We believe the reason for the inferior

performance of most state banks is their high CIR resulting from

excessive staff expenses which are difficult to bring down partly

because of union sensitivities. However for UBOI, one of the

fastest growing state-owned banks, its poor ROA in FY2006 was

due to a sudden fall in treasury profits as yields hardened, which

led to a fall in non-interest income given the lack of well-

diversified fee income sources to act as a buffer.

• PNB stands out among the state banks for its higher profitability.

In FY2006, it achieved the highest ROA among the public sector

banks because of good margins and a high proportion of low cost

deposits. It is developing its fee income source base.

State Bank of India

ICICI

Punjab National Bank

Canara Bank

Bank of Baroda

Bank of India

Union Bank of India

Oriental Bank of Commerce

HDFC

Syndicate Bank

UTI

Yes Bank

40%

45%

50%

55%

60%

0% 1% 2% 3%Return on Assets

Co

st-

to-I

nco

me R

ati

o

3-5-1 Cost Structure vs. Profitability


Revenue Optimisers

Many state banks are still struggling to bring their huge staff costs under control ….leading to inferior ROA performance



Nevertheless, it has also been burdened with a high wage bill.

Fresh recruitments at PNB are now limited and it appears to be

moving in the right direction by deploying surplus staff towards

data loading and direct marketing.

• Area-focused banks tend to have a low CIR. Oriental Bank of

Commerce (OBC), which has the lowest operating expenses in its

peer group, has historically had a strong presence in northern and

western India. It was only after the merger with GTB (then

roughly 15% of the asset-size of OBC) in 2004 that it acquired a

southern presence.

• We expect that in the next few years, operational expenses will

grow dramatically for the majority of Indian banks due to a strong

expansion in their distribution strategies, the upgrading of IT

infrastructure and increased investment in back-end technology.

This is likely to be the case for state banks for several years to

come as they computerise their branches and put in core banking

systems. Large investments in technology result in a high CIR and

weak ROA in the beginning but will yield higher returns in the

future, provided banks are able to leverage on their investments

successfully.

Large investments in technology will also result in a high CIR and weak ROA till banks start to leverage on these investments

-100

0

100

200

300

400

500

600

FY05 1Q06 2Q06 3Q06 4Q06 FY06

Gro

wth

in C

ore

Ope

ratin

g P

rofit

(YoY

, %)

Oriental Bank of Commerce UTI Bank Canara BankBank of Baroda Corporation Bank State Bank of IndiaICICI Bank HDFC Bank

3-5-2 Growth in Core Operating Profits




• The profit performance of many public sector banks has been

disappointing despite robust credit growth in some of them.

Growth in operating profits of banks such as Canara, BOB and

SBI has been muted primarily because of bond losses and declines

in trading income. SBI and some mid-sized state banks have also

reported a decline in net profits. However the picture is not

entirely gloomy as BOB, Corporation Bank and Canara Bank

moved from negative to positive net profit growth in FY2006.

• On the other hand, mid-sized private sector banks like ICICI,

HDFC and UTI sustained or increased the annual growth rate of

their net profits in FY2006 on the back of strong retail loan growth

and high fee income, with UTI Bank experiencing the sharpest

increase in net profits.

• Many financial companies assume that profit growth potential is

determined primarily by external factors such as market

movements, competition and technology, but forget that internal

organisational and operational qualities are vital to the delivery of

a consistent profit line. UTI, HDFC and ICICI have been strong

performers in both operating profit and net profit, but it is HDFC

Bank that has managed to sustain the most consistent profit growth

in both areas over the years. Strong management, high brand

value, good asset quality, good risk management and low net

NPLs distinguish HDFC from other players in the sector.

The profit performance of many state banks has been disappointing despite robust credit growth Internal organisational and operational qualities are vital for consistent performance in operating and net profit

3-6 Asset Quality of Indian Banks


• The average of the gross and net NPL ratios for the selection of

major Indian banks shown has declined since 2004 reflecting the

continued trend towards the improving asset quality across Indian

banks. This trend is expected to continue through FY2007.

• According to RBI estimates, the overall NPL-to-capital ratio

(which shows the combined effect of improving capital adequacy

and asset quality, both crucial indicators of the soundness of the

country’s financial system) had dropped from 71% in March 1999

to 15.5% in March 2005.

• For the industry, gross non-performing loans (NPLs) declined for

two consecutive years in FY2003 and FY2004. High treasury

profits in these years enabled banks to write off their NPLs more

aggressively, while the recovery of NPLs was aided by better

economic conditions and banking reforms. This was a notable

achievement given the more stringent NPL classification standard

based on a 90-day overdue period, halved from 180 days

previously. The setting up of the Asset Reconstruction Corporation of

India also helped boost banks’ recoveries of NPLs. Amelioration of

non-performing assets remained robust in FY2005 and continued

apace for most banks in FY2006.

• ICICI’s comparatively high NPL rate among private sector banks

indicates higher risk taking in its portfolio management. With over

0

2

4

6

8

10

12

Bank of B

aroda

Punjab National Bank

Bank of In

dia

State Bank of India

Union Bank of India

Syndicate Bank

Canara Bank

Oriental Bank of C

ommerce

ICICI Bank

UTI Bank

HDFC Bank

Gros

s non

-perf

ormi

ng lo

ans a

s a %

of to

tal lo

ans

NPL'04 NPL'05 NPL'06(e) NPL'07(f)

3-6-1 Asset Quality of Indian Banks


Asset quality in both private and state banks has been improving

3-6 Asset Quality of Indian Banks


• 70% as retail loans, its asset portfolio is vulnerable to system-wide

deterioration in the quality of retail assets and increased

delinquency may come with robust loan growth. Other banks like

UTI Bank and CBOP which are aggressively growing their retail

portfolios will also have to be mindful of this. For UTI Bank, a

rise in delinquencies in the retail segment could hurt profits

significantly given its low provision cover.

• NPLs continued to decline in FY2006 for all the major state banks

except UBOI which saw a sharp deterioration in asset quality in

the third quarter. The UBOI management believes the increase in

NPLs is of a technical nature and would be reversed in FY2007.

UBOI had one of the highest net NPL levels among the state-

owned banks in FY2006, as did SBI. But for SBI, the decline of its

NPL ratio to 1.87% is a good achievement considering its huge

asset size. The bank is believed to be seeking a buyer for its NPLs

as RBI is keen to resolve the country’s NPL issue through bad-

debt disposal.

• The level of NPLs for the housing segment has been one of the

lowest, but could go up with the rising incidence of home loan

frauds. Weak credit-risk monitoring and documentation processing

could worsen asset quality amid massive demand.

• Banks will have to look beyond acquisition and towards better risk

management to contain the NPL problem. HDFC Bank, with its

low net NPL ratio, has one of the best prudential policies in the

industry. Citibank, given its large volume-based business, has a

strong collection mechanism which accounts for its low charge-off

rates (as a percentage of total credit outstanding) compared to

other banks.

• While the improving asset quality among Indian banks is an

encouraging sign, the country’s banking sector has not gone

through a major economic downturn in the recent years and so the

banks’ risk capabilities, although strong, have not been tested yet.

Banks with a high proportion of retail assets are vulnerable to system-wide deterioration in retail asset quality Indian banks’ risk management capabilities have not been tested through a severe downturn

3-7 Bank Credit Growth


• Most of the banks in India achieved loan growth exceeding 20% in

FY2006 with some like Yes Bank, ICICI and UTI growing

aggressively at 55% or more. Going forward, some banks may be

constrained by insufficient capital and/or a low funding base.

• Among the public sector banks, PNB and Bank of Baroda have

strong loan growth potential as they are maintaining a good

balance between their capital adequacy ratio (CAR) and loan-to-

deposit (LDR). The largest state bank SBI is also well placed for

future credit expansion. Its LDR is just above 65% and its CAR is

only slightly below 12%. With a large base of CASA deposits, its

average cost of deposits is less than 5%, which is hard for other

banks to match.

• The state banks in greatest need of raising more capital and

deposits are Bank of India, Union Bank of India and Syndicate

Bank, with their LDR exceeding 65% and CAR less than 12%.

Bank of India is likely to go for hybrid instruments overseas to

raise capital. To sustain its high loan growth, at 33% in FY2006,

Union Bank of India needs to shore up its Tier I capital which

remains low even after a recent capital-raising exercise. It is also

Bank of India(19%)

UTI Bank (55%)

HDFC (37%)

Union Bank of India (33%)

Syndicate Bank (36%)

State Bank of India (29%)

Punjab National Bank (24%)

Canara Bank(32%)Oriental Bank Of Commerce (32%)

ICICI (60%)

Bank of Baroda(38%)

Yes Bank(216%)

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%

10% 11% 12% 13% 14% 15% 16% 17%

Capital Adequacy Ratio

Loan

-to-D

epos

it Ra

tio

Banks need to raise both capital and deposits

Banks need to compete for deposits more aggressively than for credit growth

Banks with excess liquidity but need to raise more capital

Banks with strong loan growth potential

Size indicates loan growth.

3-7-1 Capital Adequacy Ratio vs. Loan-to-Deposit Ratio


Some banks may be constrained by insufficient capital and/or a low funding base

3-7 Bank Credit Growth


likely to use hybrid instruments in the later part of the year rather

than dilute its equity further. Syndicate Bank underwent a capital

raising exercise in 2005 which diluted government stakeholding in

the bank but it still needs more funds to support credit expansion.

• New private banks UTI and HDFC have excess liquidity, being

well stocked with low-cost deposits. UTI plans to raise capital

through hybrid instruments and subordinated bonds at home and

abroad (taking advantage of the MTN route) but may still require

an injection of equity capital in FY2007 because of its strong loan

growth (at 55% in FY2006). HDFC, with a higher CAR and

slower loan growth (37% in FY2006), should be fairly

comfortable sustaining its current growth rate without equity

dilution. But if the bank grows any faster and does not raise hybrid

capital, it would need more equity capital in FY2008.

• ICICI and Yes Bank have been growing their loan portfolio at an

aggressive pace. ICICI’s mega capital-raising in 2005 has given it

a favourable CAR. But although its deposit growth exceeded

growth in advances in FY2006, ICICI will need to maintain its

efforts in mobilising low-cost deposits if it is to keep up its rapid

acquisition going forward.

• As its deposit mobilisation and fee income generation are limited

by a still small branch network and delays in branch expansion

plans, Yes Bank’s NIM will be under pressure because of rising

cost of funds. Despite a comfortable CAR, it will need to raise

enormous amounts of equity capital to fund its phenomenal

growth rate which exceeded 200% in FY2006.

• Indian banks will have to do a fine balancing act between raising

capital and low-cost funding and pursuing their credit expansion

plans. Besides a deposit mobilisation drive, we believe the next

year will see increased use of hybrid instruments rather than equity

issuance to make up for deficiencies in capital adequacy without

diluting equity.

An increased used of hybrid instruments to make up capital deficiencies is likely in the coming year

3-8 Bank Risk Management


• The average CAR of Indian banks, at 12%, is higher than that of

China, Taiwan, Korea and Thailand though lower than the levels

prevailing in Indonesia, Hong Kong and Singapore. India’s loan

delinquency ratio of 7.2% is also significantly lower compared to

its Asian peers.

• The outlook for NPL clean-up is positive. The practice of joint

corporate debt-restructuring among banks, the use of Debt

Recovery Tribunals for realisation of dues, and the power given by

the Securitisation Act to take recovery measures without court

intervention are facilitating faster resolution of bad debts. A

committee has also been formed to share best practices in risk

management among banks.

• Credit risk in India has been an area of concern mainly because of

the rapid growth in retail credit over the past 4-5 years and doubt

about whether banks have put in place appropriate risk

management practices for the whole spectrum of retail loan

categories. Many banks continue to process loan approvals at the

branch level, while foreign banks and a few of the new-generation

banks are run on more advanced models.

India’s loan delinquency ratio is much lower compared to its Asian peers Joint corporate debt-restructuring is facilitating faster NPL clean-up

3-8-1 Bank Risk Management (CAR)


0%

5%

10%

15%

20%

25%

India

Indon

esia

Hong K

ong

Singap

ore

Malays

ia

Thaila

ndKore

a

Taiwan

China

Cap

ital A

dequ

acy

Rat

io

Tier 1 Total (Inc. Tier 2) CAR



• Risk management at state banks has been improving. Treasury

profits in the past few years have been used to raise provisioning

levels to cater for any future downturns. As part of a long-term

strategy to keep its asset risk in check, SBI is not pursuing riskier

clients.

• Foreign banks like Citibank and Standard Chartered Bank have

strong risk-management capabilities. Among other things, they

have sophisticated segmentation and data-mining strategies, which

local bank HDFC has also developed. In addition, HDFC has a

centralised credit policy and a regional structure for credit

approvals distinct from its sales channels. This allows for

uniformity in approval processing and portfolio homogeneity and

removes dependence on the decisions of individual branch

managers.

• Although mortgages comprise almost 50% of the retail portfolio of

most major banks, it is perceived by banks as a relatively low-risk

segment. However, with the expected surge in housing loan

disbursements, delinquencies in this segment could increase

significantly in the absence of strong credit-risk management.

There is also concern that in the event of a credit squeeze and

consequent slowdown in construction, delinquencies could rise as

a major part of loans disbursed are for residential properties under

construction. We also believe that delinquencies on personal loans

and 2W (two-wheeler) loans could also rise as banks expand

aggressively into these segments, but this is unlikely to raise

systemic risk as they are secured and small-ticket loans.

• While there is now a credit bureau in India, it does not have

enough depth with respect to comprehensive information on the

customer and is not linked to scoring and customer performance

systems of banks. Some local banks have internal rating systems

based on application or behaviour scoring. A few banks like

HDFC have risk-based pricing in retail lending but, in the absence

of a customer credit-rating system, this tends to be on a product

basis rather than customer basis. By developing surrogate credit

Treasury profits have been used to raise provisioning levels …but India’s credit bureau lacks sufficient depth …and few banks have risk-based pricing



evaluation tools and risk profiling of existing customers, these

banks are able to profile what potential customers may want and

are able to price based on risk and cost of funds.

• On the corporate side, banks can make use of the ratings by

CRISIL. However some banks do have an internal rating model

based on the value and performance of the relationship to the

bank.

• The efficiency of a bank’s risk management system is influenced

by its staff incentive and remuneration structure. Some Indian

banks are learning to incorporate the demands of risk management

into remuneration structures but it is only partial, as a number of

financial and non-financial parameters come into play and there is

a need to strike a balance between loan targets and risk.

• Banks will be forced to convert capital to meet market and

operational risk guidelines prescribed under Basel II by 2007. As a

preemptive measure, since March 2006, RBI has allowed banks to

integrate investment fluctuation reserves into not only the Tier II

category but also Tier I. This will lift the Tier I capital by over

20%. Banks with a higher Tier I CAR and a high SLR such as SBI

and PNB will be better equipped to support strong loan growth in

the coming year.

• RBI has been increasing risk weights on several retail categories

including mortgages to deter irrational pricing. These risk weights

are currently much higher than those required under Basel II. We

believe there could be a reduction in these weights in March 2007

to bring them closer to Basel II requirements.

• The rush to meet Basel II implementation deadlines has led to an

increased focus on risk management practices in banks across the

board. With a host of consultants and software providers offering

Basel II-related services and systems, there has been a definite

strengthening of the system as a whole. Indian banks were

required to commence a parallel run of the revised Basel II

Risk management incentives have not been fully incorporated into remuneration structures Risk weights on several retail categories have been increased Most banks will meet Basel II requirements by March 2007



framework from 1 April 2006. RBI’s expectation is that by March

2007, Indian banks would have adopted the Standardised

Approach for credit risk and the Basic Indicator Approach for

market and operational risks. RBI is maintaining close supervision

on a bank-by-bank basis. Feedback from bankers indicates that

most banks are on track to meet these requirements.

• Beyond March 2007, a few banks may aspire to move to

Internal Ratings-Based (IRB) approaches. While

implementation of the Standardised Approach is possible

with core banking systems which most local banks are

putting in place, the IRB approaches require both current and

historical data and hence data warehousing which most

banks do not have. Only the foreign banks and leading

private banks like HDFC and ICICI have the potential to

move on to IRB approaches.

Most banks will meet Basel II requirements by March 2007 …but very few will move to the IRB approach

3-9 Banks’ Capital Raising and IPO Prospects


• Many Indian banks need huge capital injections as they transform

themselves into modern banking institutions. With strong credit

growth ahead and preparations underway to convert capital to

comply with Basel II operational risk regulations by March 2007,

capital raising activities among the banks have been increasing.

Since RBI wants to keep a stake of 51% in state banks, it has

introduced new schemes to enable banks to raise capital without

diluting equity.

• The year 2005 saw many of the mid-sized banks seeking to

leverage on the strong markets by launching their second public

offerings. Strong performance indicators have helped large and

mid-sized banks to successfully tap into the international markets

for first- and second-tier capital mobilisation.

• From January 2005 to March 2006, Indian banks raised over $4

billion from equity issuances. The eye-turner was ICICI’s mega

capital-raising venture in 2005 which raised Rs 79.56 billion and

put it ahead of SBI in terms of market capitalisation.

• Many of the mid-tier and small banks including Canara Bank, UTI

Bank and Development Credit Bank (DCB) need additional capital

in FY2007. UTI announced a new debt issue in August 2006.

DCB has seen deterioration in its financials during the last two

years and several delays in its IPO plans, but an IPO is a

0

20,000

40,000

60,000

80,000

100,000

Andhra

Bank

Bank o

f Baro

da

ICIC

I Bank

Syndic

ate B

ank

Yes Ban

k

Orienta

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ommerce

Allaha

bad B

ank

Punjab

Nati

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Bank

Dena B

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Union B

ank o

f india

South

India

Bank

Centur

ion BOP

Federa

l Ban

k

Issu

e si

ze (R

s m

illio

n)

3-9-1 Bank’s Capital Raising and IPO Prospects (January 2005-March 2006)


Indian banks’ capital-raising has increased to cater for strong loan growth and Basel II preparations Large and mid-sized banks have successfully raised capital from international markets

3-9 Banks’ Capital Raising and IPO Prospects


possibility for FY2007. UBOI will also need more capital even

after its latest Tier I issue. Indian Bank and Central Bank may go

for listing in FY2007 while BOI and UCO are considering hybrid

capital instruments.

• The introduction of hybrid capital has reduced concerns about the

capital-raising capabilities of state banks. The move by RBI to

allow integration of investment fluctuation reserves into not only

the Tier II category but also Tier I from March 2006 will also help

the state banks in the near term to grow their loan books and Basel

II provisioning without necessarily tapping into the capital markets

and hence diluting their equity.

• Commercial banks in general are much better placed to meet Basel

II requirements by March 2007 than co-operative banks and

regional rural banks, who will find it difficult to do so. After the

recent capital expansions, most of the major banks are reasonably

well-capitalised vis-à-vis Basel II readiness and their loan growth

plans. With the availability of hybrid instruments for Tier I capital

raising, we believe there will be less need for equity dilution and

consequently lower equity issuance in the coming year.

Hybrid capital availability has reduced state banks’ capital-raising concerns ….and lessened the need for equity issuance

3-10 Emerging Areas of Growth



• Retail banking will no longer be the only major source of growth

in the coming years as other areas of banking gain prominence.

Agricultural finance, SME and infrastructure lending as well as

lending to the automobile and telecommunication markets are set

to take off. This would not only help offset any deceleration in

demand growth for consumer financial products due to interest

rate increases but also boost asset building.

• Core banking and computerisation have made it possible for banks

to viably process smaller-value accounts. This coupled with the

relatively lower returns from corporate sector lending and the

intensifying competition and thinning margins in retail lending has

encouraged them to take more interest in the rural, SME and

personal loan segments.

Rural Lending

• Over 75% of India’s population live in rural areas, yet this

segment remains severely underserved. Close to 45% of the

country’s GDP is generated in rural India but credit penetration is

only 16%, less than half of the national average. We believe rural

banking now offers viable opportunities for lending and

investment products.

• Lending methods such as dealer financing and contract farming

will become key areas of focus in the coming years. State agencies

are partially privatising the food-grain distribution process,

fuelling infrastructure investments that will give a boost to bank

lending. In dealer financing, banks pay farmers directly once the

produce (e.g. rice and wheat) is ready to be picked up by private

operators taking over the transportation, safe storage and

warehousing logistics of the commodities.

• The practice of contract farming has become more common

since PepsiCo, which entered India’s agro-business in 1989,

Thinning margins in corporate and retail lending are prompting banks to explore other viable growth areas Interest in rural and SME lending ha increased Dealer financing and contract farming will become a key focus



successfully used this system for its export commitments.

Agricultural finance, conventionally based on production needs,

is more profitable if banks unlock and re-assess the entire value

chain from production to consumption. The new commodity

exchanges operate through the same intermediaries but pay

better prices to farmers. Banks are now involved in sugar cane,

pulses and fertiliser production, funding inputs, insurance

(including weather insurance), storage, warehousing and

transportation through dealers, thus enabling better pricing and

lower risks for the farmers. Farmers can store excess produce in

warehouses and sell when prices improve, and in the meantime

they can take loans from banks based on these warehouse

receipts.

• Several state banks and private banks are participating in micro-

financing for farmers through non-governmental organisations

(NGOs) and self-help groups which assist in the maintaining of

financial discipline and the recovery of loans. External

coordinators from NGOs are engaged to create awareness about

the financial assistance facilities and products available.

• With the largest branch networks in rural and semi-urban areas,

nationalised banks clearly have an advantage in terms of rural

bank lending. However, some private banks are trying to go

beyond traditional branch banking by operating through

franchisees, micro-finance institutes, rural marketing agents

(RMAs) and corporate partnerships which offer lower

operational costs and better information.

• RBI has directed state banks to double their lending to the

agricultural sector within three years. Thus agricultural lending

at public sector banks is expected to increase on average by 33%

annually during this time span. Unlike loans for farm machinery

which are time-specific, crop loans are of a recurring nature and

hence likely to become an attractive segment for banks. Farmers

and SMEs are primarily concerned with being given timely help.

Returns on agri-loans are becoming comparable to – and in

Banks are getting involved in financing various parts of the value chain from production to consumption ….and micro-financing for farmers through NGOs Returns on agri-loans are becoming favourable



many cases more favourable than – returns on corporate loans,

where banks have to contend with the stronger bargaining power

of corporations given the latter’s access to global markets.

• For PNB, agricultural financing is a thrust area. Procedures for

opening bank accounts have been simplified for farmers. It has

also launched a Kisan Credit Card with liberalised provisions

that allow it to be used not only for crop loans and farm

machinery but also for personal purposes such as education,

weddings and other social functions. This additional facility can

help save farmers from the clutches of local moneylenders. PNB

sees the card as the most profitable part of its agri-segment.

• Besides distributing crop loans through the Kisan (farmer)

Credit Card programme, SBI offers a micro-financing scheme

that provides funding to women in rural India. ICICI and UTI

have used the kisan card as a means of payment. Dues to dairy

farmers, for example, are loaded onto the credit cards and can

then be converted to cash through a simple ATM transaction.

HDFC has launched a “Kisan Gold Card" with Visa at a 9%

interest rate with a 30% allocation for personal loans.

• While the main idea behind the kisan card concept is to create a

banking habit among rural dwellers across a spectrum of needs,

the core proposition in commodity financing through

commodity exchanges is to allow the farmer to receive money

against collateral. Collateralised commodity financing is likely

to become an attractive segment for banks.

• Bankers reveal that delinquencies in metro cities are often higher

for loans at lower pricing than for loans to the agricultural sector, a

fact that favours the increased focus on the latter. The viability of

extending branches to rural areas is also not likely to be an issue as

the costs of setting up a branch such as rentals and staff salaries

are lower in these areas. Moreover, it is unnecessary to have a

presence in every village, as small towns can be used to service

The farmer’s credit card serves a spectrum of needs and is profitable for banks Collateralised commodity financing will also become an attractive segment



several villages through a hub-and-spoke model and centralised

processing.

• Agri-financing is increasingly looking to be a promising segment

that is not only profitable but also highly scalable. The lending

will be aligned with multi-product and infrastructure investment,

encompassing the consumption needs of the farmers and also

shifting towards the most profitable sectors in the agri-business.

SME Lending

• Banks will also ramp up their SME business in 2006-2007. The

government’s earlier focus on the SSI (small-scale industry) sector

has now expanded to encompass SMEs. With the government and

the Reserve Bank of India urging banks to step up lending to this

sector, most banks are offering dedicated services and products to

cater to the needs in this segment.

• The definition of SME in terms of turnover and assets varies

among banks. With the regulator providing no clarity on this,

banks define it to suit their portfolio management requirements.

For some banks, an SME is a company with total assets of Rs 100

crores (Rs 1 billion) or less. Other private and foreign banks are

using higher asset norms or turnover thresholds. Confusion reigns

in accounting terms too as some banks classify SME lending as

retail lending while some put it under the corporate middle market.

• A few years ago, the newer private-sector banks were averse to

scaling up SME lending. But now this segment is expected to see

growth of over 30% in FY2007. Banks are drawn by the high

returns with the annual yield on SME loans at above 9%, higher

than that in retail lending. That bank-switching costs for SMEs are

relatively high and SMEs are more likely to be loyal customers

would also add to this segment’s attractiveness to banks.

• ICICI has more than doubled its business in this segment in the

last three years. For Bank of India, the SME segment is driving the

For some state banks the SME segment is a growth driver New private-sector banks are no longer averse to scaling up their SME lending



growth of its current account portfolio and is expected to grow to

become a key revenue source.

• Lending to the SSI/SME segment currently constitutes 11-12% of

the total lending at PNB. The bank has established special credit

cells for SMEs. It has four hubs devoted to SMEs and plans to

increase the number to ten in the coming year. Large volumes and

good interest rates help to cover the cost of transactions.

• The two main challenges that banks have been facing in SME

lending are the lack of information regarding small borrowers

and consequent costs incurred to develop the required

information systems, and the lack of expertise in small-ticket

loan pricing and risk assessment. Collateralised lending can help

mitigate these risks.

• Some banks have tied up with credit rating agencies with a view

to assigning ratings to SME borrowers. This ensures the quality

of lending is maintained and enables banks to determine the

appropriate interest rates, margins and collateral requirements

for these borrowers.

• A cluster-based approach for financing the SME sector may help

to reduce transaction costs, mitigate risks and provide an

appropriate scale for improving infrastructure catering to this

segment. Government agencies have initiated the process of

establishing Small Enterprises Financial Centres for identified

clusters where the risk profile of each cluster will be studied by

a professional credit-rating agency and the risk-profile reports

produced will be made available to commercial banks.

• Banks have become savvier in SME lending compared to a few

years ago. Moving away from working capital financing and

changing the chain of credit reflect innovative banking. Earlier,

manufacturers borrowed for work in progress, receivables and

finished goods. By switching from lending to the manufacturer

to lending to the dealer, banks are increasingly also able to lend

Collateralised lending mitigates the risks of lack of information and expertise in small-ticket loan pricing A cluster-based approach can help reduce transaction costs



indirectly to SMEs via the dealer. Dealer financing not only

enables banks to take on the risk of lending to an SME customer

but also decreases the exposure for the manufacturer, who

receives his dues as soon as the finished goods are transferred to

the dealer who then carries the credit till the goods are passed to

the customer. For banks, their ability to leverage on this win-win

arrangement will therefore depend crucially on the extent of

their dealer network penetration.

Dealer financing enables banks to take on the risk of lending to an SME customer

3-11 Consolidation of Indian Banks: Rationale, Impediments and Strategies


3-11 Consolidation of Indian Banks: Rationale, Impediments and

Strategies

• No Indian bank except SBI is of a global scale. The still

fragmented profile of the Indian banking system has made

consolidation imperative given that increased competition can be

expected after 2009, when the sector is opened further to foreign

competition.

• RBI has mandated that consolidation of the state banks should be a

top priority to prepare banks for increased competition from

foreign players, but implementation in this area has been

extremely slow. Contradictory regulations from RBI and the

finance ministry have impeded the materialisation of a

comprehensive roadmap similar to those in Indonesia and Taiwan.

With the goal of RBI being to create five or six banks that will be

among the world’s top 100 banks based on asset size, the number

of state banks will have to be reduced from 27 to 10 in the next

four years. This will be very challenging, considering that only 34

banks and non-banking finance companies have been merged in

the last 45 years, and most were directed to do so by RBI to

preserve stability in the banking system.

• There are three major reasons why an acceleration of

consolidation would be difficult in the Indian context: huge

geographic disparity within the country, unionisation of banks, and

technological incompatibility between real-time core banking and

manual approaches. Moreover, there is still room for organic

growth in the yet-to-mature consumer and wholesale markets.

• Nonetheless, state banks are already communicating behind the

curtain to pave the way for mergers and we expect to start seeing

more visible progress in consolidation efforts soon. For instance,

ongoing merger talks between Union Bank and Bank of India may

be finalised in the coming year. While the large state banks are

striving to enter the league of the world’s top 100 banks, small and

The fragmented profile of the Indian banking system has made consolidation imperative RBI wants to reduce the number of state banks to ten in four years Negotiations are afoot but the consolidation process has not yet taken off in a big way

3-11 Consolidation of Indian Banks: Rationale, Impediments and Strategies


mid-sized banks are trying to make acquisitions and alliances to

fill regional gaps and expand their distribution network.

• Consolidation will bring huge cost savings to the banks but the

potential job losses remain a sensitive issue. Despite the strong

business case for consolidation, political factors dim the prospects

of faster negotiations and regulatory approvals.

• There is a need to build more awareness among unions to gain

their cooperation in the process but this would take time. Getting

the buy-in of unions would lower the possibility of strikes like the

incident in November 2005 which brought banking transactions to

a standstill.

• We believe there will be a shift in the motivation behind bank

mergers in India. Earlier mergers between weak or smaller banks

or agricultural banks were prompted by directions from RBI. But

increasingly, even reasonably healthy small banks are becoming

receptive to synergistic merger opportunities, motivated by the

urgency to expand scale and/or geographical reach so that they can

compete with foreign banks after the liberalisation of controls in

2009.

• In a positive move, Corporation Bank, Oriental Bank of

Commerce and Indian Bank have recently formed a first-of-its-

kind alliance to circumvent the sensitivities of consolidation as it

will not impact employees or customers. They will share both

infrastructure and staff and jointly look for larger loans (that

would typically go to bigger banks) as well as fee-based income

products. Cost savings on infrastructure and operations will help

improve profitability. How well these banks will be able to

coordinate back-end operations with front-line initiatives remains

to be seen. If successful, it will be the harbinger of a new trend

towards such alliances.

Potential job losses remain a sensitive issue The motivation behind bank mergers is shifting…..to expand scale and reach before 2009 Banks are also exploring alternate routes through unique alliances

3-12 List of Domestic M&A Deals, 2004-2006


*Acquirer name not available.

• Since the completion of the merger between Centurion Bank and

Bank of Punjab in 2005, a deal involving Lakshmi Vilas Bank and

another involving Bank of Rajasthan have been announced. Tamil

Nadu Mercantile Bank and Catholic Syrian Bank are looking for

buyers and rumours of talks between several other local banks are

rife. The merger between Bharat Overseas Bank and IOB is

pending while there is speculation that another between UBOI and

BOI could go through this year. A merger involving Centurion

Bank of Punjab and Lord Krishna Bank has received the approval

of the respective boards of directors and now awaits the

shareholder and regulatory approvals. United Western Bank was

placed under moratorium in September 2006 and an amalgamation

% Stake Acquired

Estimated Transaction

Value ($)

Acquirer's Asset by 2004 ($)

Date of Acquisition Deal Status

Lakshmi Vilas Bank Ltd* 50% 21.2 mil n.a July-06 Announced Bank of Rajasthan Ltd* 83% n.a. n.a January-06 Announced Centurion Bank Ltd - Bank of Punjab Ltd. 100% 77.6 mil 774.5 mil October-05 Completed Industrial Development Bank of India Ltd - IDBI Bank 100% 385.5 mil 17.5 mil May-06 Completed ING Vysya* 75% 70.5 mil n.a April-05 Pending HDFC Bank Ltd –HDFC Securities 59% n.a. 9.6 mil October-04 Pending Oriental Bank of Commerce Ltd - Dena Bank Ltd n.a n.a. 9.3 mil September-04 Rumour ICICI Bank Ltd - Federal Bank Ltd n.a. n.a. 29.6 mil September-04 Rumour Oriental Bank of Commerce Ltd - Global Trust Bank Ltd. 100% n.a. 9.3 mil August-04 Completed

3-12-1 List of Domestic Acquisition Deals 2004-2006


3-12 List of Domestic M&A Deals, 2004-2006


with Industrial Development Bank of India has been proposed by

RBI.

• Indian banks have also been exploring potential acquisitions of

local securities, mutual fund and finance companies to expand

their product portfolios.

• Foreign participation in domestic M&As will remain limited till

2009. State banks can only be merged with other state banks due

to ownership restrictions. Well performing mid-tier banks like

HDFC do not think small private banks are worth targeting

because there will be little impact on their geographical imprint,

market share and cost. At the same time, the small banks are

looking frantically to scale up and the M&A scene is already much

more active – but less talked about – at this layer than for the mid-

tier or large banks. Thus, what we are likely to see in the run-up to

2009 is accelerated activity among smaller private banks as they

try to acquire their peers or NBFCs in order to increase branch

penetration or asset size.

There is accelerated activity among smaller private banks to acquire peers or NBFCs to increase branch penetration or asset size

3-13 Foreign Banks’ Asset Growth, 2000-2005


• The entry strategy of foreign banks in India can take the form of:

- Setting up a branch

- Setting up a wholly-owned subsidiary

- Acquiring a stake in a private bank, subject to a cap of

74%

- Taking over a distressed private bank identified for

acquisition by RBI

• Wholly-owned foreign subsidiaries must have a minimum

capitalisation of approximately $70 million. Individual foreign

banks are limited to equity stakes of 5% in local private banks

while foreign institutional investors and individual corporate

entities can hold up to 10%, with voting rights based on ownership

level. Foreign banks are now permitted to exceed the earlier

branching limit of 12 per year per bank, subject to RBI approval.

(Please refer to section 1-6 for details of the regulatory roadmap

for foreign banks.)

• More than 35 foreign banks currently operate in India, but they

account for a mere 7% of total assets. Until 2009, the presence of

foreign players will remain small, as foreign ownership will only

be allowed under restricted conditions and branch network

expansion will be limited, even for Singaporean banks under the

new Comprehensive Economic Cooperation Agreement. Just 15 to

20 new branch licences are given to foreign banks each year under

the WTO agreement.

Foreign banks share of total assets is low due to regulatory restrictions

Foreign banks share of total assets is low due to regulatory

3-13-1 Foreign banks’ Asset Growth


0

5

10

15

20

25

30

35

40

2000 2001 2002 2003 2004 2005U

S$ b

illio

ns0%

2%

4%

6%

8%

10%

12%

Total Assets (Foreign Banks) Foreign Banks' Assets as % of Total Banking assets

3-14 Operations and Prospects of Foreign Banks in India


• The promise of 2009 combined with the phenomenal growth of the

Indian consumer and corporate credit markets is attracting several

foreign players.

• After its takeover of ANZ in India in 2000, Standard Chartered

Bank became the largest foreign bank in the country. The three US

banks that have banking operations in India are: Citigroup, Bank

of America and JP Morgan Chase. Several other banks have

expressed interest in setting up business in India including: Royal

Bank of Scotland, Switzerland's UBS, US-based GE Capital,

Credit Suisse Group, and Industrial and Commercial Bank of

China. General Electric (GE) has already announced its intention

to enter the retail banking business in India, having already created

a significant presence in consumer finance through its NBFC arm

GE Money.

• ANZ, Commonwealth Bank of Australia, National Australia Bank

and Royal Bank of Scotland are believed to be on the lookout for

stakes in private sector banks while ABN AMRO, Barclays,

Deutsche Bank, GE Money, BNP Paribas, Citigroup and JP

39

41

8

4 83

9

5 19

35

0

0.5

1

1.5

2

2.5

3

3.5

4

-2,000 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000

Total Asset Size ($ million)

RO

A (%

)

Size indicates number of branches

Standard Chartered Bank

Citibank

HSBC

ABN AMRODeutche Bank

Bank of America

BNP Paribas

American Express

Bank of Novia Scotia

DBS

3-14-1 Operations and Outlook for Foreign Banks’ in India


The phenomenal credit growth and expected liberalization in 2009 is attracting several foreign players



Morgan may opt for acquisitions. Large international securities

firms such as Merrill Lynch, Goldman Sachs and Lehman

Brothers are also eyeing the private banking segment of India’s

wealth management market.

• Given the tight regulations, foreign banks have adopted the

strategy of starting their relationships with local banks through a

small stake that may give them preferred bidder status in future

equity acquisitions in case RBI modifies its regulations before

2009. Even though this environment looks discouraging,

international banks have been fairly content with the status quo

behind the scenes.

• Although major acquisitions are ruled out for now, international

banks are circumventing this restriction by expanding their reach

through finance companies, which are not subject to the same

network limitations. For example, while Citibank has only 38

branches, Citigroup’s NBFC arms have over 300 branches. (Please

refer to section 2-9 for case studies of foreign NBFCs.) However,

RBI’s supervision of the NBFC segment has become more

rigorous and it has expressed concern over KYC (know-your-

customer) standards, stock manipulation and capital market

exposure of NBFCs. Besides tighter RBI control, new entrants

who want to explore this route may face “entry barriers” in the

form of cost advantages enjoyed by existing players.

• Foreign banks have been successfully leveraging on their direct

channels, where their sales forces make up between 60% and 70%

of total headcount, and dominating the most profitable niches in

mass retail. With their branch presence constrained by licences,

foreign banks have also made use of alternative channels including

ATMs, the internet and telebanking to increase customer reach.

• In wealth management, foreign banks already dominate the

segment comprising customer portfolios exceeding $250,000. The

greatest incremental scope, however, lies in the urban and rural

mass-affluent segments. Distribution networks are the key to

Foreign banks are circumventing the restrictions by expanding their reach through NBFCs …and leveraging on alternate channels



tapping these segments, but foreign banks have not extended their

operations to rural or even semi-urban areas so far. To some

extent, they may have mistimed the market in not expanding their

presence beyond tier 1 cities.

• As product offerings increase, foreign banks may aim for market

leadership within segments rather than overall leadership. Foreign

banks have been pursuing profitable niches wherever possible and

using branches judiciously. The use of internet banking is likely to

increase. At Citibank, it is being used even for first-time sales to

mass affluent customers besides after-sales service to high net-

worth customers.

• In the run-up to 2009, we believe foreign banks will continue to

grow aggressively so that they can take advantage of the

liberalised market conditions on a large scale. They will grow by

both organic and inorganic means and through alternative

channels, to expand their distribution network, scale up their

infrastructure and broaden their franchise and market share. The

learning process triggered by restrictions that led them to find

innovative solutions – such as experimenting with NBFCs selling

third-party products – may give them an advantage in terms of the

knowledge and experience gained.

• While credit cards have been an important product, expansion is

limited by the fact that working with lower-income groups is

considered viable by some foreign banks only if they can be

moved to high value-added products through good relationship

management and up-selling programmes.

• Clearly, confidence in the market is high and competition for

market leadership among existing players is set to increase. For

example, Citigroup will invest over $500 million in 2006 to grow

its business in India. This is the group’s largest investment in India

to date and a significant proportion of it will be injected into its

NBFC arm.

Competition for market leadership among existing foreign players is set to increase in the run-up to 2009



• As to whether the promise of 2009 will materialise, we believe the

market players are optimistic regarding the regulator’s

commitment to opening up the banking sector. Most bankers and

analysts that The Asian Banker spoke to are of the view that given

the pressing need for foreign investments, the government is

sensitive to global investor opinion and hence almost certain to go

ahead with the liberalisation expected in 2009 although the exact

timing will depend on consultations with the various stakeholders

involved bearing in mind that 2009 is an election year for India.

3-15 List of Foreign Acquisition Deals, 2004-2006


• RBI continues to wield considerable discretionary power to

approve or reject foreign applications for takeover. Given the

restrictions, foreign acquisition deals completed in the past few

years have been limited as reflected in the table above. They have

been largely confined to buying small stakes or NPLs of local

banks or the Indian branch operations of other foreign banks.

• The branch licences granted by RBI are zone-specific and so

where licences are scarce, foreign banks are likely to look at

acquiring entities which have the licence for their targeted zone.

Bigger foreign banks that already have a presence in India may opt

for the inorganic route by taking over weaker banks that come

with large branch networks.

• Banks identified by RBI for takeover are usually the weak private

banks with bad assets. (Please see section 2-4 for a list of old

private banks.) But unless RBI declares these, foreign banks are

left to identify a suitable bank based on their own assessment and

% Stake Acquired

Estimated Transaction

Value ($)Date of

AcquisitionDeal

StatusStandard Chartered Bank-ICICI Bank Ltd. NPLs n.a 20.2mil May-06 Completed

International Finance Corp (IFC)-Federal Bank Ltd. 8% n.a. May-06 CompletedInvestor Group1-Development Credit Bank . 19% n.a. February-06 PendingJP Morgan & Co-HSBC NPLs 5.7mil February-06 CompletedInvestor Group2-Bank of Punjab Ltd. 13% 83.2mil December-05 CompletedStandard Chartered Bank plc - Bank of Bahrain and Kuwait BSC's Indian operations 100% n.a. June-05 AnnouncedEM Warburg Pincus & Co LLC - Kotak Mahindra Bank Ltd. 5% 20.7mil June-05 CompletedDeutsche Securities (Mauritius)-HDFC Bank Ltd. 4% 164.3mil March-05 CompletedStandard Chartered Bank-Sumitomo Mitsui Banking Corp (Indian Branch Operations) 100% 17mil September-04 CompletedBarclays Capital Mauritius-UTI Bank Ltd. 5% 29.6mil September-04 CompletedBank Muscat Al Ahli Al Omani-Centurion Bank Ltd. 7% 6.5mil August-04 CompletedAga Khan Fund for Economic Development, The - Development Credit Bank Ltd. 69% 30.9mil March-04 PendingKephinance Investment (Mauritius) Pte Ltd-Centurion Bank Ltd. 5% n.a. February-04 Completed

1An investor group including Housing Development Finance Corp Ltd, Khattar Holdings Pte Ltd and Amtel Finance.2An investor group, comprised of India Value Fund Trustee Co Pvt Ltd (4.73%), Johann Ltd (4.73%), a wholly-owned unit of Chrys Capital III LLC, and Citigroup Venture Capital International Growth Partnership Mauritius Ltd (3.99%), a wholly-owned unit of the Citigroup Venture Capital International Jersey Ltd which is asubsidiary of Citigroup Inc's Citigroup Venture Capital International.

3-15-1 List of Foreign Acquisition Deals, 2004-2006


Foreign acquisition deals have been largely confined to buying small stakes or NPLs of local banks

3-15 List of Foreign Acquisition Deals, 2004-2006


then await RBI’s verdict. Foreign banks which own more than 5%

of an Indian bank have to either seek RBI approval for acquisition

of a private bank not identified by RBI for takeover or scale back

their investment to the 5% limit.

• After the playing field for foreign banks expands further in 2009,

they should be able to cast their net wider to include not only

distressed banks with attractive branch networks but also better

run banks with potential for fast loan growth. Attributes that

foreign banks are likely to look for in acquisition targets are:

strong product range, good loan growth, adept management,

advanced technology, and presence in emerging growth segments.

• The smaller new-generation private banks like Indusind Bank,

Kotak Mahindra Bank, Centurion Bank of Punjab and Yes Bank

could thus become targets for acquisition. For instance, the loan

growth of Centurion Bank of Punjab is expected to be 52% CAGR

over the next two years, retail advances constitute over 70% of its

loan portfolio, and its NIMs are among the highest in the industry.

For Yes Bank, its key differentiator is knowledge banking and fee

income is already the mainstay of its business strategy, though

delays in branch expansion could hamper its loan growth.

• For some of the smallest banks, survival in the increasingly

competitive environment will become more difficult. Having to

gear up for attracting the right M&A opportunity after 2009 could

be a motivation to develop attractive product portfolios and

suitable processes and segment strengths that foreign banks are

likely to seek in potential acquisition targets.

After 2009, foreign banks may target not only distressed banks but also better-run banks …they will target banks with a strong product range and loan growth, good management, advanced technology and presence in growth segments

Chapter 4 Distribution and Penetration

In this chapter we look at the penetration and growth ofchannel infrastructure in India as well future prospectsand the different strategies and technologymodernization programs undertaken to develop itfurther. We compare and analyse the differences in thefee generation capabilities of banks’ branches andexamine the progress and issues for state banks inmodernising and rationalizing their branch networks.We highlight key service quality elements to watch intimes of massive customer acquisition. We look atdevelopments in India’s promising payment cardmarket. We examine and compare banks’ positioningfor multiple channel development especially on-linebanking and the prospects for channel integration inthe future.

Structure of Contents 4-1 Branch Penetration in India and Peer

Countries 4-2 Branch Growth of Indian Banks 4-3 Fee income generation 4-4 The Asian Banker Perception Survey on

Branch Strategy 4-5 Modernising and Rationalizing Branch

Networks 4-6 Important Elements of Excellent Banking

Service 4-7 ATM Penetration and ATM Growth 4-8 Bank Card Growth 4-9 Multiple Channel Development in India

and Peer Countries

4-1 Branch Penetration in India and Peer Countries

___________________________________________________________________________ Asian Banker Research – India 104 Distribution and Penetration

• Given India’s geographical size and diversity, distribution of

delivery channels such as branches and ATMs plays an

important role in expanding the customer franchise. In a market

where demand is outpacing supply in retail financial services,

having the right distribution of channels is critical.

• Overall branch penetration in India is low compared to some

other countries in Asia Pacific. But within India, it varies

between rural, semi-urban and urban/metropolitan areas.

• In India’s rural areas, which are spread across states with diverse

language-culture mixes, vernacular and cultural identification with

the financial service provider is important to the customer. Banks

with strong localised knowledge are better placed to penetrate this

segment. Customer loyalty in the semi-urban and rural segments is

still to some extent driven by cultural and political factors rather

than based on pricing and efficiency alone.

• Not surprisingly, nationalised banks as a group have the highest

branch presence in rural India, followed by regional rural banks.

SBI and other state banks have placed about 40% to 45% of

their branch networks in rural areas, whereas for private banks it

is less than 20% on average. Foreign banks have no branch

presence in rural areas so far. Once the state banks’ branches

With demand outpacing supply having the right distribution channels is critical Overall branch penetration in India is low but varies across different areas Nationalised banks have the most branches in rural India

4-1-1 Branch Penetration in India and Peer Countries


*2004

264

182166

111

64 62

31

0

50

100

150

200

250

300

US* Hong Kong Mumbai Singapore China India Indonesia

Num

ber o

f Bra

nche

s 20

05 (p

er m

illio

n po

pula

tion)



come online with core banking, their operational efficiency and

competitiveness in this segment are expected to improve.

• In semi-urban areas too, state banks including the SBI Group

dominate, followed by private sector banks, while the presence

of foreign banks is negligible.

• Branch growth in semi-urban areas in the past year has been

rapid especially among the new-generation private banks. Many

tier 2 cities in India have already reached branch penetration

levels comparable to Singapore’s as these are viewed as a

gateway to the rural hinterland. Also, many of these are situated

near growing industrial hubs and have a growing mass-affluent

segment ready to be tapped for a large variety of retail offerings.

• In urban/metropolitan areas, state-owned banks lead in branch

numbers but local private banks and foreign banks enjoy higher

visibility. With the customer base here more IT savvy and

literate, the appeal of these banks’ better appointed offices,

superior technology, innovative product offerings and delivery

through alternative channels has helped them to collectively

garner a higher share of deposits and lending in this segment

than the SBI group. The numerous other state banks are

individually more prominent in their respective states or regions.

• Besides affordability issues, the relatively simpler appearance of

state bank branches even in metros is attributed to their

alignment to national policy and the common man’s needs.

Ostentatious trappings in government-linked institutions can be

questioned in a country with huge inequalities in income

distribution.

• By focusing on metros, foreign banks have to some extent

miscalculated on their expansion of branch presence into tier 2

cities. But in addition, they were disadvantaged by limits on

branch licences granted by RBI. It was also partly a matter of

choice, as they simply opted to focus on wealthier segments in

Private and foreign banks enjoy better visibility in urban areas and metros New private banks are rapidly expanding branches in semi-urban areas Foreign banks’ branch presence beyond metros is limited



metros and to use less-regulated NBFC arms and alternative

channels to expand beyond metros. With heightened competition

in urban retail segments, increased regulatory vigilance of

NBFCs and limitations on future penetration with alternative

channels, foreign banks may need to revisit their organic

expansion strategies or use the M&A route for banks identified

by RBI for takeover.

• Plotting the number of branches per million population against

GDP per capita, we are able to assess the level of branch

penetration in the context of the demand for financial services

commensurate with the country’s economic development.

• India’s overall branch penetration is higher than that in the

Philippines and Indonesia and close to Thailand’s even though

its per capita income is lower. Partly, this is a reflection of the

much higher branch density in India’s tier 1 and tier 2 cities,

where branch penetration is comparable to that of more

developed countries. Another reason is that face-to-face

transactions are still important to customers in semi-urban areas

and especially rural areas, where a large part of the population is

still illiterate or semi-literate.

Face-to-face transactions are still important in semi-urban and rural areas

Australia

JapanSingapore

South KoreaHong Kong

Taiw an

Malaysia

IndonesiaPhilippines

Thailand

ChinaIndia

0

50

100

150

200

250

300

0 10,000 20,000 30,000 40,000 50,000

GDP per capita

Bra

nche

s (#

) per

mill

ion

popu

latio

n

Branches/million populationSource: Asian Banker Research

4-1-2 Branch Penetration vs. GDP per capita in India and Peer Countries 2004

4-2 Branch Growth of Indian Banks


• Developed and developing countries across Asia have had

differing patterns in branch growth. While China, Hong Kong,

Singapore, Taiwan and Indonesia have seen a decline in the past

few years, India, Thailand, Malaysia, Japan and the Philippines

have witnessed expansion.

• Overall branch expansion in India during 2004 and 2005 was

around 1.2% and 1.5% respectively. We expect branch growth

to be 1.6% in 2006, subject to branch licence approvals by RBI.

• While state banks will be more concerned with rationalisation

than with expansion of branch networks, we will see renewed

momentum in expansion among private banks in the coming

years. Specifically, we expect small and mid-tier banks to

expand their reach into rural areas to tap the huge revenue

potential in personal, 2W, CV and auto loans, SME segments

and infrastructural projects, and to build up their low-cost

funding base through deposit mobilisation.

• HDFC, UTI, Andhra and IDBI in particular are expanding

rapidly. HDFC had 530 branches in 230 cities as of December

2005 with 55% of these outside the ten most populous metros. It

aims to add at least 150 branches and 40-50 cities per year for

62,000

64,000

66,000

68,000

70,000

72,000

2000

2001

2002

2003

2004

2005

2006

(e)

2007

(f)Nu

mbe

r of B

ranc

hes

0.0%0.2%0.4%0.6%0.8%1.0%1.2%1.4%1.6%1.8%2.0%

Bran

ch G

row

th (Y

oY,%

)

Total Number of Branches Branch Growth

4-2-1 Branch Growth of Indian Banks: Private & State Banks


State banks are concerned with rationalization of branch networks The momentum in branch expansion is coming from small and mid-tier private banks



the next two years, subject to approvals, to prepare for its push

into the rural unbanked segments. UTI aims to have one branch

in each of the 572 districts in India. It has been adding one

branch per week for the last few years and already covers half

the total number of districts.

• Rapid expansion into rural areas is not considered detrimental to

the cost-income ratio at banks which have central processing

systems, as there is no difference between urban and rural areas

in the processing of customer approvals. Since branches in rural

areas can take advantage of the lower rental and staffing costs

prevailing in these areas, profitability is not perceived to be an

issue.

• The branch expansion strategy of these banks is based on a hub-

and-spoke model focused around specific retail and corporate

lending hubs. Being in every village is not considered critical.

All branches are expected to be liability-oriented with a view to

capturing a large number of current and savings accounts, while

asset growth is driven by different sales teams. For instance, in

retail banking, UTI’s asset centres are in 30 cities and growing

at the rate of 20 cities per year. For corporate lending, only 11

centres are considered critical as most corporate decision-

making takes place in HQs which tend to be concentrated in

specific locations in the country. Manufacturing plants outside

these centres can be looked after by service branches.

• While the mid-tier banks have aggressive branch expansion plans,

actual growth will depend on the award of RBI licenses. Under the

old policy, individual licenses had to be approved for each branch.

Under the relaxed licensing policy introduced in 2005, banks are

required to submit an annual plan of branches and ATMs they

wish to set up. Between October 2005 and July 2006, only CBOP

was granted approval – for 30 licenses in total. RBI has not

explained the delay in sanctioning branch licenses. A possible

explanation may lie in the IPO scam and demat scam in the first

quarter of FY2007 that led to accusations by foreign banks that

Branch expansion strategy of these banks is based on a hub-and-spoke model Branches are expected to be liability-oriented Delays in grant of branch licences will be detrimental for these banks



some local banks are not following KYC norms. RBI may be

waiting for the report of the Joint Parliamentary Committee

investigating the demat scam before granting fresh licenses.

Delays in the granting of branch licenses by RBI will be

detrimental to the growth plans of small and mid-tier private

banks.

4-3 Fee Income Generation


• Increasing competition, pressure on NIMs, volatility in trading

incomes and disintermediation are some of the factors galvanising

some banks to put more effort into moving out of their comfort

zones, to look beyond their interest income and develop

diversified sources of fee income.

• State banks continue to be heavily dependent on interest income,

with fee income still comprising a small part of their revenues. On

the other hand, the new-generation private banks are aggressively

building up fee income not only as a buffer but also as a key

growth driver. Low fee income coupled with much larger branch

numbers has resulted in weaker fee income per branch for state

banks.

• SBI as the largest bank, generates the most total fee and other non-

interest income among the Indian banks. But ICICI, despite having

a branch network less than one-fourth the size of SBI’s, is fast

catching up with SBI in total fee income generation and is already

way ahead of SBI and other local banks in terms of fee income per

branch. It has leveraged on its CRM system for extensive product

cross-selling through its branch networks and direct sales agents.

A sizeable part of its fee income stream comes from the NRI

business from overseas branches.

UBIPNB

BOISBI Canara Bank

HDFC Bank

ICICI

UTI Bank

0

5,000

10,000

15,000

20,000

25,000

0% 10% 20% 30% 40%

Fee Income as % of Total Income

Fee

Inco

me

per B

ranc

h (in

Rs

'000

)

4-3-1 Fee Income as% of Total Operating Revenue vs. Fee Income per Branch


State banks have low fee incomes per branch on account of low fee income and large branch networks ….while new private banks are ahead of them

4-3 Fee Income Generation


• Increasing customer reach through direct selling agents (DSAs)

puts less cost-pressure on the branch and boosts fee income per

branch, but many state banks are reluctant to outsource marketing

as they view the commission-based arrangement as a dilution of

commitment to the bank and its products. Some do not have

separate sales staff at all. The teller staff handle accounts and

market products simultaneously.

• Still burdened with over-staffed branches and in the process of

putting core banking systems in place, state banks will take several

more years to raise their fee income per branch to levels

comparable to those of the new private banks.

4-4 The Asian Banker Perception Survey on Branch Strategy


• Banking executives in India perceive that the key winning

strategies for branch management are leveraging on alternative

sales/delivery channels and turning the branch into a stronger

sales platform through better customer segmentation for cross-

selling. Centralisation of branch processes and restructuring of

oversized branches are also considered important and, notably,

have been given more prominence by bankers in India than in

other Asian countries like Thailand and Malaysia.

• Since the top 40 urban locations (by population size) in India have

been contributing almost 80% of total retail lending, banks have

been actively experimenting with distribution channels beyond

branches and strengthening or refocusing product lines for rural

area penetration. Banks have been rapidly expanding into tier 2

cities in recent years with the ultimate goal of penetrating rural

areas.

• Moving beyond tier 1 cities poses a challenge from the

profitability angle due to the small ticket size of transactions and

low volumes. Economies of scale will therefore come into play

and only the banks with the best distribution channels and

mechanisms will be able to profit from this market.

• Private sector banks with smaller branch networks than state banks

have been more active in exploring alternative sales/delivery

0

10

20

30

40

50

60

70

80

90

Alternat ivedeliverychannels

Turningbranches into

salesplat forms

Centralisat ionof the

processes ofbranches that

areindependent

Restructuringof oversized

branches

Centralisat ionof the

managementof branches

that areindependent

Expansion ofbranch

network

Establishingspecialised

businessbranch units

Internationalexpansion

% o

f Res

pond

ents

4-4-1 Winning Strategies in Branch Management


Banks will leverage on alternative sales/delivery channels and using the branch as a stronger sales platform Centralisation of branch processes and restructuring of oversized branches will also be important



channels to complement branch expansion. These include ATMs,

internet banking, telebanking and mobile phone banking, call

centres, dealer networks and direct sales agents. At ICICI, more

transactions are now done through ATMs and internet and mobile

phone banking than through branches. For foreign banks, because

of the regulatory limit on their number of branches, alternative

sales/delivery channels including dealer networks and direct sales

agents are critical.

• Banks are sometimes wary of opening additional branches to

penetrate new markets as the branch is the most expensive

distribution channel. The renewed focus on branches among

private sector banks has to do with the focus on relationship

banking. For existing branches, at the margin, the branch can be

regarded as the cheapest sales channel in the sense that the channel

is already in place driving liability generation and much of the

origination comes from existing customers. With appropriate

CRM and data warehousing, the effectiveness of cross-selling at

the branches can be improved. The origination costs would be

lower and it would be easier to offer preferential pricing to

existing customers.

• Cross-selling will be a major thrust at branches of private banks

including ICICI, UTI and HDFC. Most state banks have weak

cross-selling capabilities due to the absence of data warehousing

systems.

• Channel transformation and technology advancement go hand in

hand. With the deployment of core banking, more state banks will

acquire the ability to offer new products across multiple channels.

The establishment of regional processing will remove back-office

functions from branches, thus enabling branch staff to devote more

time to customer service and cross-selling.

• Over time, as processing and approvals are moved to centralised

systems and ATMs, telebanking and internet banking provide

cheaper means of servicing customers, the branch will become

Banks with smaller branch networks are exploring alternative channels more actively Cross-selling is a major thrust at new private banks’ branches State banks need technology advancement to effect multiple channel and product development



primarily a sales rather than processing channel. But branches will

remain important for many years to come because: India’s rural

masses favour across-the-counter transactions and are likely to be

conservative towards alternative channel usage, SME clients

prefer to deal with banks through this channel, and they are an

effective means of generating low-cost deposit funding.

• Given the inflated property prices, banks concerned with rising

costs could move towards flexibility in managing their branch real

estate, leasing rather than buying premises and “right sizing”

branches to suit the products, clientele and location. Banks are also

encouraged to prioritise customer convenience, consider the

location of competitors and their own retail focus in devising their

branch location strategy. Good staff skills and operational

efficiency cannot substitute for the right location.

Branches will remain important …but “right sizing” branches will help contain costs

4-5 Modernising and Rationalising Branch Networks


• Indian banks’ branch expansion drive, high human resource

expenses and technology upgrading initiatives have pushed up

the industry’s cost-to-income ratio from 47% in 2003 to 54%

by end-2005. Strong expansion of the branch network and

direct sales forces in 2006 without immediate returns on the

investment will further increase CIRs.

• The ratio of staff expenses to operating expenses for several

state banks is as much as two to three times higher than that of

the more technology-intensive foreign banks and new-

generation banks like ICICI, HDFC and UTI. State banks are

weighed down by a surplus in headcount, with the proportion of

human resource expenses in their total operating cost being one

of the highest in Asia.

• Implementation of the voluntary retirement scheme (VRS) in

2000-2001 led to a slight reduction of staff count in state banks.

But in the post-VRS years, pension provisioning has increased

significantly, the per-employee cost has risen with the composition

of staff showing a shift towards having more officers than general

staff and operating expenses increased with the higher salaries

negotiated by unions.

• The larger state banks saw a deterioration of operational cost

efficiency in FY2006. For SBI, total staff expenses increased by

The industry CIR has increased State banks are weighed down by a surplus in headcount and high IT costs

SBI

ICICI

PNB

CBBB

BOIUBI

OBC

SB

UTI

IOB

YES

HDFC

0%

10%

20%

30%

40%

50%

60%

70%

80%

0% 10% 20% 30% 40% 50% 60% 70%

Cost-to-Income Ratio

Staf

f Exp

ense

s/O

pera

tiona

l Exp

ense

s

4-5-1 Modernising & Rationalising Branch Networks


New Private Banks

State Banks



18% because of higher wage costs following a revision of wages

in line with economic growth. The bank may also have to set

aside around Rs 8 billion to create a fund to pay additional

pensions. This cost would have to be amortised over three years

to reduce the impact on profits.

• PNB has already implemented core banking in 77% of its branch

network, so incremental technology costs are likely to be lower

in the next few years. However its wage bill remains substantial.

• State banks in India are in dire need of rationalising and

modernising their branch networks. Not only does their

headcount cost make up a higher proportion of their total

operating cost compared with other banks, but they are also

running into a demographic crisis. These banks urgently need to

refresh their aging human resource pools to face the new

challenges in a digitalised environment and to cater to the

changing requirements of customer service.

• A fundamental problem is that autonomy of decision-making

at state banks is constantly curtailed by union pressures and

political interference and, as public sector institutions, they are

often expected to be employment providers as well. Natural

attrition, rather than proactive downsizing, is expected to bring

operating costs down.

• Some state banks are making moves in the right direction. At

PNB, for instance, fresh recruitment is limited and some

surplus staff are being redeployed to direct marketing in cities,

creation of customised products and data-loading operations

(in anticipation of the increased informational requirements of

cross-selling). But generally, redeployment at state banks is

taking place slowly and needs to move faster.

• Success in rationalising and modernising branch networks will

depend on how quickly the banks are able to redeploy surplus

staff and leverage on their investments in IT upgrading. We

State banks need to refresh their human resource pools …but autonomy of decision-making at state banks is curtailed



therefore do not believe we will see significant progress till after

2007-2008 when their core banking rollouts are completed, as

many state banks are still working on the basics of branch

networking.

4-6 Important Elements of Excellent Banking Service


• Processing and service quality in times of massive customer

acquisition is likely to emerge as a key issue. While Indian banks

are becoming quite tech-savvy in their operations, they have

neglected the human factor. Quality not only depends on

sophisticated back- and front-end applications but also requires,

first and foremost, well trained front-line staff who are able to

discern how and when customers have to be approached with

appropriate products.

• According to an AC Nielsen survey conducted for The Asian

Banker Excellence in Retail Financial Services Programme in

2004, what Indian banking customers want most from their banks

are: improvement in customers’ access to banking services by

enhancing the branches, fast turnaround times, excellent customer

service, and low rates and fees. The survey shows that these

factors are more important to customers, not only in India but also

in most other Asian countries, than an extensive range of products

or aggressive advertising and promotions.

• For the banks, developing product width has become important for

driving profits through cross-selling. However, banks need to be

careful of “customer fatigue” and over-investing in providing

products that the customers may not value as much as the basics of

convenient access and efficient customer service on vanilla

products. This will be an especially critical issue in servicing the

semi-urban and rural areas in India.

0% 20% 40% 60% 80% 100%

Aggressive advertising and promotions

Extensive range of products

Good image

Low rates and fees

Excellent customer service

Short processing time

Easy access to banking services

Customer Responses

4-6-1 Important Elements in Banking Services

Source: AC Nielsen

Indian banks have neglected the front-line factor in processing and service quality Customers value the basics of convenient access and efficient service

4-7 ATM Penetration and ATM Growth


ATM Penetration

• With the bulk of the Indian population living in rural areas, low

literacy and prevalence of conservative attitudes, branch banking

remains pervasive rather than self-service channels. ATM

penetration in India is much lower than that of its Asian peers.

ATM growth, after a big spurt in 2002, settled at just over 27% per

annum for the last two years.

• In Japan and Australia, which are developed countries with more

mature financial systems, the number of ATMs exceeds the

number of branches by over 10:1 and 4:1 respectively. Even in

countries like Malaysia and Thailand, the ratio is at least 2:1. In

India, it is the other way round.

• Branches outnumber ATMs by almost 4:1 in India. Branch

numbers surpass ATM numbers because of the dominance of state

banks, which are “branch-heavy”. State banks and old private

banks have introduced ATM networks but these are small

compared to their sprawling branch networks.

• On the other hand, foreign banks and the new-generation private

sector banks, with their centralised back-end operations, have

leveraged strongly on ATMs as an alternative channel while trying

1304

410 405

192

50 43 160

200

400

600

800

1000

1200

1400

US*

Singap

ore

Hong K

ong

Mumba

i

China

Indon

esia

India

Num

ber o

f ATM

s 20

05 (p

er m

illio

n po

pula

tion)

ATM penetration in India is low Branches far outnumber ATMs for state banks …but ATMs outnumber branches for private and foreign banks


*2004



to optimise use of their limited branches for sales and deposit

mobilisation. Their number of ATM counters is more than thrice

the number of branches, and they have more than twice as many

off-site ATMs as they have on-site ATMs. The largely urban

customer base of foreign banks is relatively IT-savvy and

comfortable with ATM usage.

• The total number of ATMs in India increased from 4,500 in 2000

to over 17,500 in 2005. Collectively, new private banks have the

most number of ATMs followed by state banks, old private banks

and foreign banks. Individually, SBI has the highest number of

ATMs followed by ICICI.

• The earliest ATMs were offline, unconnected to the ledger. Hence

limits were set on individual customer withdrawals. Although this

limitation can now be removed with more recent technology,

problems of unauthorised access and information stealing have

come to the fore and many local banks are not fully ready to deal

with these. Information security at remote locations therefore has

been one of the factors impeding ATM growth.

• The cost of expanding ATM networks is also an issue for state

banks. Ignorance of the general populace about proper use of new

ATM numbers have increased substantially over the past five years Many banks are not fully ready to deal with the problems of unauthorized access


4-7-2 ATM Growth

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

2000

2001

2002

2003

2004

2005

2006

(e)

2007

(f)

Num

ber o

f ATM

s

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

ATM

Gro

wth

(YoY

, %)

Total Number of ATMs ATM Grow th



technologies can add to maintenance costs. Some state banks like

PNB have placed ATMs in public places like railway stations and

are now experimenting with a new cost-cutting scheme whereby

ATMs will be owned, developed and maintained by other parties

and the bank would make payments only on a transaction basis.

• Cost and security issues aside, some state bank officials also

believe that the rural population and ageing customers prefer the

human touch and branch banking to ATMs.

• For these reasons, more state banks are opting for ATM sharing

arrangements besides growing their own ATM networks. For

instance, Union Bank of India has 500 ATM counters on its own

but its customers have access to the 1,500 ATMs of Bank of India,

Dena Bank, Indian Bank, Syndicate Bank and United Bank of

India under the Cash Tree arrangement. Recently, the bank signed

a sharing agreement with SBI that would give its customers access

to over 5,500 SBI counters.

• With increasing interest in rural banking, several banks including

ICICI are experimenting with a simplified version of their teller

machines for rural areas. Some banks currently effect payments to

farmers through prepaid kisan credit cards to be encashed at

ATMs. It will take more of such initiatives and time to accustom

the rural customers to the ATM habit.

• While the overall number of ATMs is increasing, we do not expect

ATM growth rates to escalate substantially in the coming year

given the cost and security issues and the inclination of state banks

towards ATM sharing arrangements.

Rural customers need simplified and customized ATMs Banks are exploring cost-cutting schemes like ATM-sharing

4-8 Bank Card Growth


• Given the under-developed revolving culture in India, debit cards

are the most used payment instruments in India and are popular

due to their accessibility and convenience and because there is no

risk of running up large debts. They are used for low-value

purchases, although there has been a movement towards higher-

value purchases which has undermined the relative share of credit

cards.

• The debit card market has grown faster since 2004 with the

conversion of ATM cards into debit cards as banks started to issue

debit cards for savings account holders and introduced new

variants of debit and charge cards and the overdraft function. The

number of debit cards is now thrice that of credit cards.

• Starting from a very low base in the 1980s, the growth rate of

credit cards in India is one of the strongest in Asia. By 2010, India

will have 35 to 40 million credit cards, according to industry

players.

Debit cards are the most used payment instruments in India

56% 59%66%

71%76% 73%

76%

44%41%

34%

29%

24%27%

24%

0.00

20.00

40.00

60.00

80.00

100.00

120.00

2001 2002 2003 2004 2005 2006 2007

Tota

l Num

ber o

f Ban

k C

ards

(in

mill

ion)

Number of Debit Cards Number of Credit Cards

14.8

59.0

42.230.2

20.5

98.0

70.0

4-8-1 Bank Card Growth with regards to Total Issuance




• However, credit card penetration is still low with the card base

covering only about 3% of the working population compared to

14% in China, 75% in Malaysia and even higher levels in

developed countries. The value of credit card transactions in India

also grew at a slower pace than the number of transactions

between 2001 and 2005. Card spending as a percentage of

consumer expenditure is expected to reach just 2% in 2007

compared to 19% for Singapore and 37% for South Korea.

• Thus the industry still has a long way to go to reach regional

standards. Currently, the credit card industry is in a phase where

banks primarily want to acquire more customers rather than focus

on usage and retention strategies. The majority of Indians spend

less than $35 per card on average each month.

• Traditionally, Indian consumers are reluctant to incur debt unless

it is considered necessary, such as for large purchases like houses

or vehicles, and prefer to use payment options which do not allow

for revolving credit. Where credit cards are used, consumers have

a tendency to pay bills in full each month rather than use a

revolving credit option. This limits the potential of high returns on

credit cards, even where they are in wide circulation. The new

generation of young IT-savvy professionals, however, is more

receptive to the credit habit.


Australia

China

Hong Kong

India

Indonesia

Japan

Malaysia

Philippines

Singapore

South KoreaTaiwan

Thailand

0%

5%

10%

15%

20%

25%

30%

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Growth in Number of Transactions 2001-2005 (CAGR)

Gro

wth

in V

alue

of T

rans

actio

ns

2001

-200

5 (C

AG

R)

4-8-2 Growth in Credit Card Transactions: Value vs. Number of Transactions

Credit card growth in India is one of the strongest in Asia but penetration is still low The credit card industry is still in an acquisition phase



• Earlier, banks too were reluctant to issue credit cards to consumers

without a proven credit history, since many consumers had only

recently opened bank accounts.

• Foreign banks in India have taken the lead in credit card

penetration. Citibank enjoys the highest credit card spend and best

profitability, while Stanchart claims to have the edge in the

revolving segment. Domestic banks started their credit card

business later than foreign banks. The large initial investment that

the business requires prevented state banks and smaller banks

from entering earlier. SBI Cards was launched as a joint venture

company with GE Money in 1998 but PNB is only now

planning to launch its own card.

• New credit-card businesses took about two years to become

profitable for some of the new private banks. However, as the gap

between the better-run domestic banks and foreign banks in

standard cards closes, ICICI could overtake Citibank in terms of

card spend in the classic card category. SBI Cards has recently

overtaken Citibank to become the second largest credit card issuer

after ICICI by focusing on a strong distribution network especially

in the less penetrated non-metros, salaried and self-employed

customers, relying on sales executives and its co-branded strategy.

• Most of the Indian banks have weak cross-selling capabilities

despite their large customer base. On average, less than 30% of

new credit card customers come from an existing customer base.

Since the credit card market is demand-driven, acquisition cost is

still relatively low, ranging between $20 and $30 per card.

However this could go up significantly in the coming years and

could hit between $45 and $55, according to industry sources.

Banks therefore need to start focusing on cross-selling credit cards

to existing customers early on since they are the more profitable

and loyal ones.

• ICICI has made cross-selling a significant driver in its retail

expansion with almost one-third of credit card issues coming from

The gap between the better-run domestic banks and foreign banks in standard cards is closing Banks need to focus on cross-selling credit cards to existing customers



cross-selling activities. However, delinquencies in the credit card

business will remain high for some time and its aggressive

acquisition strategy will come with the price of higher charge-off

rates.

• Aggressive acquisition strategies have also spawned consumer

complaints. These usually relate to offers of unsolicited cards, lack

of information on terms and conditions of repayment, wrong

activation and outright harassment. Most of the complaints that

RBI receives against foreign banks are related to credit cards.

4-9 Multi-Channel Development in India and Peer Countries


• Comparing the average monthly value of customer transactions

conducted via each channel for the best 15 retail players in the

Asia Pacific region and retail players in India, we see that channel

distribution in India is still “branch-heavy”. On average, Indian

banks’ alternative channel penetration is low compared to some of

its Asian peers.

• In India, the penetration levels of telephones, mobile phones,

Internet and PCs are among the lowest in Asia. This limits the

possibilities of alternative channel use to specific groups of

customers in the immediate future. For instance, while mobile

Internet banking is taking off in Japan, South Korea, Hong Kong

and Singapore, it has yet to make a mark in India given the low

mobile/internet penetration and the general preference for face-to-

face transactions.

• Attitudes, capabilities and experiences in alternative channel

development differ across Indian banks. While some Indian banks

have ”entry level” Internet sites, others offer Internet banking

services at more advanced levels such as online fund transfers,

payments and cash management.

• SBI’s online services include account opening, fund transfers,

utility bill payments, ticketing, mutual fund investments, credit

card payments, and even donations to charities. At PNB, the

Indian banks’ alternative channel penetration is low …and their level of development differs vastly across banks

Brick and mortar 47%

ATM, cash deposits 19%

Internet banking 15%

Call centre7%

Mobile banking9%

Self-service Kiosk3%

Brick and mortar 79%

ATM, cash deposits 11%

Internet banking 7%

Call centre2% Mobile banking

1%

4-9-1 Customer Transactions (Value) conducted through each Channel Best Banks in Asia Indian Banks




Internet is proving more popular than telebanking and mobile

phone banking. A key benefit of offering railway and air ticketing

through the internet has been a big decrease in the cost of

transactions. It plans to start outward calls from call centres

shortly. The management’s expectation is that 25% of the business

would be transacted through alternative channels in the next two

years. Canara Bank and some smaller state banks offer online

banking to a limited extent, but net banking is confined to

branches networked under a core banking system (CBS). Evolving

up the e-chain will involve not only providing basic information

but also offering interactivity and transaction capability as well as

collaborating with partners.

• Our survey of the online strength of banks in India rated banks on

two aspects:

1. Transactional strength – Comes from options to ‘move’

money, e.g. fund transfer, bill payment, investment and loyalty

point redemption.

2. Administrative strength – Denotes options to retrieve

information and customise transactions, e.g. balance enquiry,

scheduled fund transfer and bill payment, and personalised

menu.

The ability to compete on functionality is still a majordifferentiator as banks vary significantly in our strength ranking

4-9-2 Survey on Online Banking Strength of Banks in India


0%

10%

20%

30%

40%

50%

60%

70%

0% 20% 40% 60% 80% 100%

Administrative Strength

Tran

sact

iona

l Str

engt

h

Canara, PNB, BOI BOB

StanChart (India)

Citibank (India)

ICICI

SBI

CBI

UTI

HDFC

YES

UBI



• New private banks ICICI, HDFC and UTI achieved the highest

scores on transactional strength and are well-developed on the

administrative side as well. In fact, in terms of online banking

transactional strength, ICICI and HDFC are comparable to or not

far behind some of the best performers in Singapore and Hong

Kong. SBI has developed its transactional and administrative

strengths evenly but other state bank sites surveyed have yet to

develop these to a significant level. Foreign banks which do not

offer online trading in various categories for which the online

demand is yet to mature scored lower than new private banks that

have put up these facilities.

• Geographically, some state bank officials perceive that a limited

online banking network is enough in smaller towns and rural areas

as Internet banking facilities are not relevant in these segments.

• Foreign and new private banks are much more advanced than the

state banks in terms of the number of Internet sites and their level

of development. ICICI’s channel usage is relatively balanced

across its multiple channels and branches account for only about

25% of total transaction volume. Citibank’s Internet channel plays

a dual role. It provides transactional convenience to customers and

is used as a sales channel to sell wealth management products to

the younger mass-affluent segment as the branch is no longer

considered suitable for small-ticket transactions. It thus augments

the bank’s direct marketing and telecalling strategies. Account

opening, customer profiling and transacting are accomplished

seamlessly.

• Citibank in India has also discouraged branch visits by imposing a

service charge for branch processing of transactions that could be

conducted over the Suvidha ATM and Internet channels. For state

banks, it would be extremely difficult to use such practices given

public expectations with regard to the obligations of these banks.

Foreign and new private banks are more advanced than state banks in their on-line banking development



• When banks evaluate the various distribution/sales channels, two

factors are considered most important: customer acquisition

capability and origination cost and quality. Beyond branch and

ATM expansion, banks in India have been trying to rapidly

expand coverage of the dealer networks across consumer products.

Different channels have different levels of origination cost and

quality. For example, although the car dealer channel may be large

for auto loans, it is expensive as loans are passed to the banks

offering the highest origination commission. Customer acquisition

costs are increasing because of higher dealer/channel fees. Even

new private banks which are actively experimenting with

alternative channels have found that sourcing through branches or

exclusive sales channels yields lower costs and better origination

quality.

• As they weigh the use of alternative channels, Indian banks and

Asian banks in general need to carefully assess the readiness of the

customers or risk leaving behind those who would like to deal

with simple and easy-to-understand channels like the branches.

Overestimating the acquisition potential of some channels and

underrating others is another possible pitfall in using the multiple-

channel approach.

• Banks also need to ensure that they are ready to harness the full

power of the alternative channels. Some banks in Asia, for

instance, have placed an overweight focus on Internet banking and

installed powerful platforms but do not know how to market or

strategise it. Compounding the problem is that besides higher

development costs for new products, accelerated homogenisation

of banking products, more competition from NBFCs and higher

customer expectations, online channels carry the additional risk of

diminished customer loyalty given the ease of moving to another

site.

Banks are also expanding coverage of the dealer network channels Banks need to assess customer readiness and their own ability to mobilize alternative channels



• Channel strategies ought to evolve in tandem with the focus of

financial services. Looking at the evolution of channel strategies in

Asia, we believe that the majority of players across the region

have not reached the stage of channel integration.

• In India, most of the state banks are still in the product- or sales-

focused stage of their financial services evolution and have yet to

move on to developing significant alternative channel distribution.

But for banks that have invested in core banking systems, cross-

channel expansion will now be more cost-effective. Some are in

negotiations with MNCs or have set up alliances with other

financial intermediaries to distribute mutual funds and insurance

products in preparation for increased cross-selling.

• New private banks which have moved to focusing on market share

are increasingly taking a multiple-channel approach, including tie-

ups with other parties for micro-finance and distribution of third-

party products, to increase their reach and expand product lines

and distribution channels beyond first-tier cities. At HDFC and

ICICI, there is a definite thrust to identify the most economical

Channel strategies move in tandem with the evolution of financial services Banks in India have a long way to go towards developing a CRM focus and channel integration

Product Market Share Focus

Relationship Focus

Sales Focus

Evolution of Financial Services

Migration Channel Distribution

Channel Optimisation

Channel Integration

Evolution of Channel Strategies

4-9-3 Evolution of Channel Strategies and Financial Services

NNeeww PPrriivvaattee BBaannkkss

SSttaattee BBaannkkss

• Customisation

• Market demand still strong

• Market demand becomes stable

• New products

• Consolidation

• Heavy investment in CRM and staffing

• Linking CRM system with front-end channels

• Striving to put out new products

• Growth is demand-driven



channels for each product segment, signifying channel

optimisation commensurate with their market-share focus.

• The next stage of evolution entails shifting the focus from market

share to customer relationships. In the coming years, smart banks

will increasingly leverage on their investment in CBS and CRM

systems to reap the competitive advantages of channel

optimisation and integration.

Some new private banks are moving towards channel optimisation

In evaluating the current level of IT evolution we mapout a profile of Indian banks’ infrastructure. We look attheir operational profile to answer which banks areahead in the race. By using highly insightfuloperational and conceptual charts, we position futurewinners on their customization and optimization insales and analytic capabilities and reveal which banksare more inclined to systematically integrate newtechnology in their operations. Based on our interviewswith leading banks’ technology seniors and vendors,we identify the key areas of future technologyrequirements and spending by Indian banks and foreignbanks in India. IT vendors and consultants will findthis chapter useful from a prospecting point of view,but investors will also understand better the roadmapthat Indian banks will have to take in investing in newtechnology to become better players.

Structure of Contents 5-1 Mapping the IT Infrastructure of Indian

Banks 5-2 Level of IT Customization and

Optimization 5-3 Level of System Integration vs. Intention

to Adopt New Technology

Chapter 5 Tracking Technology and Infrastructure

5-1 Mapping the IT Infrastructure of Indian Banks

_______________________________________________________________________________ Asian Banker Research – India 132 Tracking Technology and Infrastructure

• Sales-driven competition is not sustainable over the long run. We

believe that some of the players in India need to begin moving their

focus from accounts to customer relationship management and build

on their CRM programme on a continuing basis. This requires IT

enablement to shift from an account-based IT system to a CRM-based

IT system.

• Mapping the IT infrastructure of banks in the country provides a sense

of the operational profile of banks. We believe most of India’s state

banks are now in the process of getting core banking systems into

place. The new-generation private sector banks like ICICI and HDFC

started out with automated platforms but have moved to CRM

technologies and data warehousing, joining the league of some leading

foreign banks which already have these systems.

• India has been an active market for core banking in the past few years.

The big push came from the entry of new-generation private banks,

whose centralised core processing systems empowered them with

stronger product and channel distribution capabilities. This led to

customer attrition for the reigning state banks, forcing them to upgrade

to more competitive, advanced and cost-effective centralised systems.

At the time, foreign banks with centralised core banking systems had

already attracted the high net-worth customers.

Account Centric Relationship Centric

Singapore Banks

Australia Banks

PNB

SBI

CB

BOI

BOB

ICICI

HDFC

StanChart

HSBC

Citibank

Ban

k S

ize

by

Ass

ets

UTI

Account Centric Relationship CentricAccount Centric Relationship Centric

Singapore Banks

Australia Banks

PNB

SBI

CB

BOI

BOB

ICICI

HDFC

StanChart

HSBC

Citibank

Ban

k S

ize

by

Ass

ets

UTI

Integrated CBS

RobustMiddleware

e-EnablementandCRM

BranchNetworking

CentralisedData

Centre

Branch

Computerisation

5-1-1 Mapping the IT Infrastructure of Indian Banks


India’s state banks are still in the process of getting core banking systems into place ….while new private banks started with automated platforms and are now moving towards CRM technologies



• Over 50% of core banking deals in that have come to the market in the

last three years were from India. Unlike the situation in China, where

large banks have tended to dish out piecemeal contracts to a few

vendors at often incredible bargains, many Indian banks have gone into

the core banking market for centralised, integrated and packaged end-

to-end solutions because of the complexity of integrating new

applications with the archaic existing structures. The banks have

preferred local vendors due to familiarity with the local system and

business requirements, reliability of domain knowledge, sophistication

of technology and cost effectiveness. The leading vendors have been

Infosys, TCS (with FNS) and I-flex.

• Top Indian banks have opted for open-architecture core banking

solutions with real-time processing capability, relational databases

supporting easy customer-information access and complex products,

user-friendly product development tools for non-technical staff, and

interfaces with in-house or third-party legacy systems. For systems

integration, they have opted for third-party services from companies

such as Infosys, TCS, HP and IBM. With the exception of PNB, all the

largest state banks have also outsourced their data centre operations

given the lack of experience in centralised data processing.

• State banks now face a tough challenge in integrating their branches

into the new systems because of their extensive network which

includes branches in far-flung areas where telecommunications and

infrastructure facilities are still developing. We believe the top two

state banks, SBI and PNB, will complete their rollout by 2007-2008

with other major state banks like Canara, BOB and BOI following in

the two years thereafter.

• The scale and impact of SBI’s core banking exercise, encompassing

around 14,000 branches and more than ten million customers, cannot

be underestimated. If successful, it will result in a massive

transformation across people, systems and processes. It will improve

corporate governance and turn SBI into a pacesetter, triggering

technology adoption among lagging banks and consolidation of

Indian banks are opting forend-to-end solutions …and have preferred local vendors because of their domain knowledge Integrating far-flung branches into the new systems will be challenging The scale of SBI’s core banking exercise will empower it with a huge competitive advantage



smaller banks as they try to acquire sufficient scale to face SBI’s new

competitive advantage.

• Several small and mid-tier banks have also modernised their core

processing systems, using mostly the same vendors as the top banks.

These include Union Bank of India, UTI Bank, Syndicate Bank, Indian

Bank, Karnataka Bank, Central Bank of India and Centurion Bank of

Punjab.

• While the Indian operations of major foreign banks like Citibank,

StanChart and HSBC are supported by IT systems comparable to those

of their operations in Singapore and Hong Kong, we believe their

project management experience in India may not match that in these

countries.

• Among domestic banks, we believe that HDFC and ICICI are leading

in infrastructure construction and are trying to focus on developing

accurate customer targeting. For example, HDFC is able to extract data

from different businesses and consolidate these into their data

warehouse to generate a single 360-degree view of the customer, with

the objective of offering preferential pricing and pre-approval based on

the relationship. These data warehouse extracts are available to

personal bankers at branches for individual high-end customers with

managed portfolios, while other customer touch points have access to

segment data displaying customer profitability and campaign eligibility

based on predictive modelling and analytics.

• With the market evolving from proprietary technology to packaged

solutions, the majority of banks will find it increasingly easy to

upgrade to CRM-based IT systems. Commensurate change

management and human resource training will be critical. CRM

integration must be effected at the institutional level rather than for

specific business lines alone.

Change management and human resource training commensurate with the new technologies will be critical



• With largely similar system capabilities in place, banks will need to

compete on efficient front-end services. Not many banks, however,

have additionally invested in systems like secure front-end processes

or appropriate staff training and incentives for CRM execution.

5-2 Level of IT Customisation and Optimisation


• To move towards CRM and customer retention strategies, we believe

that banks will need to build up both their sales capabilities and their

analytical skills to get the best from the available tools and existing

customer pool.

• Size does not influence who takes the lead on CRM implementation.

The mapping of Indian banks’ sales and analytical capabilities reveals

that India’s second largest bank ICICI and the smaller HDFC are both

doing well on the operational and analytic tracks in a complementary

manner.

• The experiences of Asian banks show that the best practice is

prioritising one aspect of CRM first and then developing capabilities in

the other, as this reduces the teething problems of a CRM rollout. For

smaller banks, customer acquisition and retention take precedence.

Hence, it would make sense to give priority to operational CRM with

front-end customer systems to support the automation of sales service

and marketing. On the other hand, large banks with strong business

silos may find merit in giving priority to the development of a good

segmentation strategy based on analytics.

Banks need to build up both sales capabilities and analytical skills in moving towards CRM strategies Banks can prioritise one aspect of CRM first and then develop capabilities in the other

PNB

Chinese banksRecency , Frequency, MonetaryAnalysis

Customer Modelling

Addition of credit riskscore

Activity -basedcosting

Channel preference

Profitability Analysis

Targeting Productcustomisation

Data Warehouse

Single customer

view

Currentcustomer

data capture

Service customisation

and optimisation

Leadmanagement

Sales forceautomation

Analytics Track

Op

era

tio

na

l Tra

ck

Customization and Customization and optimization enable optimization enable

banks to offer the right banks to offer the right customers the right customers the right product at the right product at the right

timetime

BOB

SBIUTI

HDFC

ICICI

HSBC (India)

StanChart (India)

Citibank (India)

PNB


Customer Modelling



Channel preference



Data Warehouse

Single customer

view

Currentcustomer

data capture


and optimisation

Leadmanagement


Analytics Track

Op

era

tio

na

l Tra

ck



timetime


Customer Modelling



Channel preference



Data Warehouse

Single customer

view

Currentcustomer

data capture


and optimisation

Leadmanagement


Analytics Track

Op

era

tio

na

l Tra

ck


Customer Modelling



Channel preference


Recency , Frequency, MonetaryAnalysis

Customer Modelling



Channel preference


Customer Modelling



Channel preference



Data Warehouse

Single customer

view

Currentcustomer

data capture


and optimisation

Leadmanagement


Analytics Track

Op

era

tio

na

l Tra

ck



timetime

BOB

SBIUTI

HDFC

ICICI

HSBC (India)

StanChart (India)

Citibank (India)


5-2-1 Mapping Indian Banks in Achieving IT Customisation and Optimisation



• ICICI’s experience illustrates the point. In the initial stages, it focused

on sales and service. As it grew its customer base, effective customer

segmentation became necessary so as to allow the most profitable

customers to be identified, prioritised and retained. This was achieved

through analytics, which prompted a forced attrition strategy whereby

extra charges were imposed on unprofitable segments with low

balances to deter the customers from transacting heavily with the bank.

Having developed a large customer base, it could afford to lose a few,

although the bank’s overall strategy continues to have a dual focus on

customer acquisition and customer retention.

• Banks that have developed a strong analytic track can derive cross-

selling/up-selling strategies from this. HDFC Bank is a good example.

The bank was able to formally introduce its retention and up-selling

strategy last year and ran hundreds of campaigns covering several

thousand customers who were selected based on predictive modelling

and analytics, which required the use of its data warehousing facility to

analyse customer history, assess product eligibility at that point in

time, and determine the approval limits and waivers that would apply.

• We believe that passing the benefits of lower rates and better service to

existing customers rather than aggressive customer acquisition can

better serve a long-term CRM strategy for banks that are already

profitable and have reached a state where higher volumes per se may

not bring substantial incremental economies of scale but add to credit

risks over time. In India, despite the growing market, the rationale of

paying attention to deepening relationships with existing customers

through retention and cross-selling/up-selling efforts is partly based on

the rising costs of additional customer acquisitions through dealers

who charge high commissions thus rendering the product less

profitable.

• The cross-sell ratio is a good indicator of a bank’s customer modelling

capability. Not many banks in India report theirs. But we believe cross-

sell ratios are in the range of 1.2 to 2.1 (lower than in many of India’s

Asian peers) with the new-generation private banks at the upper end of

the spectrum.

Smaller banks benefit by focusing on sales and service first Banks have used segmentation strategies based on analytics once they grew larger Profitable banks can pass the benefits of lower interest rates and better service to existing customers



• While some Indian banks have application scoring, we believe very

few Indian banks have advanced applications such as behaviour

scoring and the extent to which these are actively used at this stage

remains questionable as they are hard to implement.

• Banks without CRM and data warehousing capabilities will find it

difficult to make offerings based on accurate cost-benefit analytics.

Among state banks, it will be a few years before CRM systems and

culture take root because they are still in the process of putting core

banking in place or networking their branches under CBS. Banks that

already have core banking systems are encouraged to adopt advanced

CRM systems as incremental costs to install these are low.

• Even with core banking systems in place, banks without data

warehousing will have difficulty moving to IRB (internal ratings-

based) approaches for Basel II, as such approaches require not only

current data but also historical data.

• SBI, PNB and Canara Bank have expressed interest in data

warehousing. We are told that PNB is looking for a vendor for data

warehousing and hopes to proceed on its plans within the next two

years. Typically, however, decision making at state banks is a long-

drawn-out process that takes two to three years. Thereafter, data

warehousing itself would take a few or several years to evolve

depending on the cooperation of all the stakeholders involved.

• Some state banks, if they do invest in a CRM system, have the

potential to become formidable competitors given their already

dominant asset sizes, provided they are also able to align their human

resource capabilities and management culture to it. But this is unlikely

to happen in the short term, given the slow progress on the

rationalisation and modernisation of branch networks and the

redeployment of staff as a result of political and union pressures.

After CBS, the incremental costs of installing CRM systems are low …but adoption of CRM systems by state banks will have to await till their core banking roll-outs are completed

5-3 Level of System Integration vs. Intention to Adopt New Technology


• Banks in India can be divided into three broad categories according to

their level of system integration and intention to adopt new technology:

The Traditional Institution

• This category includes most of the state banks in India. They tend to

have a conservative attitude towards adoption of technology and low

integration abilities. They adopt a “wait and see” approach, letting

others experiment first. While global banks understand that IT

spending is essential to business growth, traditional banks sometimes

tend to view it as a necessary evil. They are encumbered with mindset

issues. Their large rural branch networks are difficult to bring under a

central processing system till there is commensurate development in

telecommunications and infrastructure.

The Progressive Institution

This classification applies to the new-generation private banks with a

strong interest in experimental technology, good system integration,

and sufficient skills to successfully implement new technology. We

believe the more forward-looking state banks including SBI and PNB

will evolve into progressive institutions in due course.

State banks are more conservative about technology adoption than new private banks

5-3-1 Level of System Integration vs. Intention to Adopt New Technology


UTIOther new private banks

System Integration

Adoption of New Technology

Low

ExperimentalConservative

HighThe systemic institution

The experimental institution

The progressive institution

The traditional institution

PNBSBI

BOB

ICICI

HDFC

Canara

Citibank

Stanchart

HSBC

Other state banks


System Integration


Low






PNBSBI

BOB

ICICI

HDFC

Canara

Citibank

Stanchart

HSBC

Other state banks


System Integration


Low






PNBSBI

BOB

ICICI

HDFC

Canara

Citibank

Stanchart

HSBC

Other state banks


System Integration


Low






PNBSBI

System Integration


Low






PNBSBI

System Integration


Low






System Integration


Low






PNBSBI

BOB

ICICI

HDFC

Canara

Citibank

Stanchart

HSBC

Other state banksOther state banks



The Systemic Institution

The banks in this group have a very strong in-house development

capability and a highly advanced level of system integration.

Technology-wise, their attention is primarily on operational efficiency

and effectiveness of the underlying systems, not merely system

integration and implementation. We believe that this covers the major

foreign banks operating in India and that some of the leading new-

generation private banks like ICICI, HDFC and UTI will also become

systemic institutions over time.

• For large vendors marketing core banking systems, their experience in

dealing with Indian banks may be slightly different from that of

smaller vendors marketing other software applications. For the core

banking systems, banks appear more amenable to sourcing the best

systems. Cost is an issue and the negotiations are typically demanding

and lengthy. But banks are serious about transforming their systems

given the perceived benefits and competitive pressures. The fact that

world-class IT vendors with good domain knowledge are available

locally is reassuring to Indian banks. The scale and duration of these

projects demand a certain level of commitment to maintaining a long-

term relationship with the vendor and system integrator.

• For smaller vendors selling software application packages, the state

banks tend to ask for rate cuts and are often slow on payments. Their

approach to dealing with the small vendor is transaction-oriented rather

than aimed at developing a long-term relationship. Mainline

application fixes are not always strategically planned and often take

place only when the applications have broken down.

• Private banks generally take a longer-term view on applications and

plan the timing of installations and enhancements strategically. They

also bargain with vendors but are more on time with payments.

• There may be fewer opportunities in the future for vendors selling core

banking systems as most of the top and mid-tier banks have already

Indian banks are serious about transforming their systems …but cost is an issue and negotiations often lengthy



made their decisions. However once Indian banks complete their core

banking rollouts, there will be opportunities in data warehousing,

payments, channels, CRM and other business applications. We believe

that information security, mirroring and backup technology for data

centres (to ensure business continuity in the event of disasters) and

faster delivery of services will also become key concerns for banks.

• In addition, we are likely to see increased demand for ALM (asset-

liability management) and other treasury enhancement applications

that enable better exposure management, speed-enabling technology,

risk management systems to meet Basel II requirements, and

identification software to identify individuals across multiple

databases.

• For Basel II risk management requirements, banks have found it better

to use different software specifically suited for different businesses

along with a system for integration. For certain businesses, local

vendors with domain expertise have been preferred based on the

perception that foreign systems would need modification in the Indian

context.

• Going forward, we will see more focus on front-end rather than back-

office systems. The main areas of technology spend by banks will

likely be security systems, CRM-related data warehousing, and

information management and business intelligence systems.

Indian banks will need security systems, CRM-related data warehousing, and information management and business intelligence systems

We look into the major challenges for the bankingindustry as a whole and also for the various players, inthe wake of banking consolidation and thetransformation of domestic banks into modern salesand customer orientated financial institutions. Byidentifying key areas of concern in risk and assetmanagement, performance and operations, capitalraising activities, distribution and penetration channelsas well as IT infrastructure, we bring together our keyfindings in a unified and comprehensive view forbusiness applications and strategy discussions for thebenefit of investors, players in the marketplace, as wellas service providers and consultants wanting to servethe Indian banks. Readers will find our key conclusionsuseful for their business decision-making needs.

Chapter 6-7 Major challenges, key concerns and conclusions

6 Key Challenges and Concerns

_______________________________________________________________________________ Asian Banker Research – India 142 Key Challenges and Concerns


• Although with strong credit growth, improving net interest margins

and asset quality the outlook for the Indian banking industry is

positive, some challenges remain and new ones are emerging.

• The benefits of increasing employment opportunities and rising

incomes have not spread to the rural poor. Despite strong credit

growth, total lending in India has not increased in line with GDP as

many banks have been reluctant or have not been ready operationally

to expand in segments such as SME and rural lending which are

perceived to be riskier than others. A more inclusive banking culture

that allows these sectors to benefit has become imperative for

sustaining India’s economic growth and boosting credit lending.

• A large part of household savings, especially in rural areas, is still

invested in physical assets and gold. Banks now face the challenge of

creating innovative products to attract these savings so that they can be

mobilised into financial assets which can then be channelled towards

the financing of productive investments.

• The country’s increasing dependence on volatile capital inflows from

FIIs in maintaining foreign exchange reserves is a cause for concern.

Liquidity in the banking system has become closely tied to forex

movements and hence subject to fluctuations which banks need to cater

for to maintain consistent loan growth.

• With loans growing faster than deposits, there is concern that deposit

growth will be a restricting factor for credit expansion, although banks

with a higher SLR will need much lower deposit growth to fund the

same growth in advances. But to ensure profitability, Indian banks will

have to keep a watchful eye on not only the volume of deposit

mobilisation but also the composition and cost of those deposits. The

loan growth will be less profitable for state banks because their lending

rate increases have been lagging deposit rate hikes.



• Operationally, retail financial services in India have not yet reached the

front-end stage of being driven by CRM to maximise the returns from

an existing customer base, as in more mature financial systems. State

banks are still largely in the product- or sales-focused stage, while

some private banks have shifted their focus to increasing market share

but not yet fully evolved to customer relationship management.

• In first-tier cities, where the overall market is nearing saturation, price

wars have emerged amid aggressive customer acquisition. This has

been reflected in net interest margins in the retail and corporate sectors

over the last three years with some banks showing negative net interest

income. Rather than engage in undercutting, banks need to decide what

business they want to be in and for what price, and their capital

adequacy level will determine their risk-taking ability on different

assets and the sustainability of loan growth.

• Some banks are focusing on market share in existing segments despite

lower margins and high cost of funds to keep up high volumes.

However these banks need to be wary of deterioration of asset quality

over time although growth in delinquencies may be dwarfed by strong

asset growth in the short run. We are concerned that banks which focus

on customer acquisition without appropriate pricing may end up with

poor asset quality in the long run.

• All banks, including the foreign players, are departing from the

strategic marketing rule of either targeting the rich or catering

primarily to the mass market and not both. In a trend towards universal

banking, banks previously focused on wealthier segments are

venturing into micro-financing while mass market players are

extending their business into wealth management and bancassurance.

Creating innovative strategies to appeal to both target groups will be

the name of the game.

• Many banks are targeting the same customer segments with similar

strategies and little product/value differentiation. We believe that

banks should build up their attractiveness to customers through

superior pricing and service delivery.



• While Indian banks are very good in processing large volumes given

their advanced technology, these banks must now learn to develop and

maintain process and service quality at the front-end channels.

Technological progress does not equal significant improvement in

customer service quality in the industry. Quality not only depends on

sophisticated back- and front-end applications but also requires, first

and foremost, front-line staff who can discern how and when

customers have to be approached with appropriate products. The basics

of convenient access and efficient customer service need to be

prioritised above product range.

• The trend of poaching and consequently high attrition rate of

relationship managers among foreign and new private banks may

compel some of these banks to increase their reliance on automated

systems and centralised research tools to process asset management in

order to protect their customer base and intellectual capital.

• Interest-based income still dominates revenues at the state banks. Their

continued dependence on government business, cards and traditional

fee-based products will see them lagging behind the foreign banks and

new private banks in developing diversified sources of fee income.

• The development of complex fee-based services requires the support of

an integrated IT platform for the bank to get its productisation and

pricing right with respect to such services and optimise cross-selling.

But many banks do not yet have this in place.

• Banks need to balance their retail asset portfolios. Those with asset

portfolios highly skewed towards specific retail segments could be

vulnerable to any system-wide deterioration in the quality of these

retail assets. We are concerned that higher delinquency may arise with

robust loan growth if not provided for by an adequate provision cover.

• Asset quality has improved across private and state banks. However,

they must remain vigilant as the Indian banking sector has not gone



through a major economic downturn in the last few years and hence

their risk capabilities have not been tested yet.

• India’s credit bureau still lacks depth and is not linked to scoring and

customer performance systems of banks as in the United States. In the

absence of customer credit-rating systems, very few banks have

adopted risk-based pricing in retail lending.

• Indian banks must learn to implement staff reward systems to shore up

risk management capabilities. In the few banks that have tried, the

incentives are still only partial because of the need to strike a balance

between loan targets and risk.

• After a recent spate of capital issuances, many banks are adequately

capitalised for now vis-à-vis Basel II requirements and their loan

growth plans, but some of the smaller banks may need further equity

capital. The introduction of hybrid capital instruments has reduced

immediate concerns about the ability of state banks to raise capital

without diluting government ownership. However, continued

dependence on hybrid instruments may be a weak resolution if capital

account convertibility is introduced and capital requirements go up

even further to cater for higher risks.

• Expansion of the formal finance sector into previously unbanked

segments has often been associated with increased prudential risk in

other countries. In rural areas, banks face the challenge of low

transaction values, higher transaction costs and low literacy levels of

target customers. Indian banks’ increased focus on rural and SME

lending is prompted by improved prospects and better technological

capability to handle small-ticket transactions cost-effectively, and is

aided by supportive measures from the government and RBI in the

form of information sharing and credit rating models for SMEs. They

will need to find innovative ways to develop the banking culture in

rural areas through customised and simplified channels (e.g.

multilingual ATMs, multifunction smart cards) and at the same time

mitigate risks through collateralised lending in association with

partners like NGOs, micro-finance institutions, logistics companies



and dealers. Turnover and asset norms for SMEs need to be defined

and standardised across banks to track and compare estimates of

lending to this sector.

• In penetrating the rural segments, economies of scale will be

paramount and only the banks with the best distribution channels and

mechanisms will be able to leverage on this market to boost

profitability. As the branch continues to be the preferred channel in a

cultural milieu that favours face-to-face interaction, many small and

mid-tier banks have formulated aggressive branch expansion plans for

the coming years but delays in getting branch licences could hurt their

growth plans in FY2007.

• Having significantly smaller branch networks than the state banks will

prompt private local banks and foreign banks to increase their reliance

on alternative delivery and sales channels. For now, multiple-channel

development in India is still under-evolved. Few players have moved

their focus from channel distribution to channel optimisation and the

industry is still a long way from channel integration. Low penetration

of telephones, mobile phones, internet and PCs limits the possibilities

of alternative channel use to specific groups of customers.

• Many state banks are on course for their core banking rollout, but now

face a tough challenge in integrating their branches into the new

systems given their wide network and numerous branches in far-flung

areas where telecommunications and infrastructure facilities are still

developing. Moreover, banks will need to translate the benefits of

superior technology into better products and front-end service quality

for customers.

• Few Indian banks have CRM and data warehousing technology.

Without this technology, banks will find it difficult to make cross-sell

or up-sell offerings based on accurate cost-benefit analytics. For those

who do have it, the challenge is to effect CRM integration at the sytem

level rather than for specific business lines alone.



• Aggressive acquisition strategies in credit cards have spawned

consumer complaints. These usually relate to offers of unsolicited

cards, lack of information on terms and conditions of repayment,

wrong activation and outright harassment. The rising number of such

complaints has prompted the regulator to develop a code on ethical

banking but compliance by banks will need to be monitored.

• The profitability of state banks continues to be low compared to that of

foreign and new private banks because of their large investments in

technology, the difficulty of bringing down their high staff costs and

their lack of developed fee-income sources. These banks need to

urgently refresh their ageing human resource pools to meet the new

challenges in a digitalised environment and the operational

requirements of customer service. Redeployment of surplus staff to

direct sales and data loading has started but is proceeding slowly.

• Despite the strong business case and urgency for the consolidation of

India’s state banks, sensitivities over the potential job losses, political

restraints, union issues and difficulties in technological integration are

slowing the progress on this front.

• The deregulation of the banking industry coupled with the emergence

of new technologies is enabling new competitors to enter the financial

services market quickly and efficiently. There has been some switching

away of savings from bank deposits to the mutual funds industry which

has experienced strong growth in the past few years fueled by the stock

market boom. In the long term, banks will need to find ways to counter

this disintermediation trend by diversifying into new areas.

7 Conclusions

_______________________________________________________________________________ Asian Banker Research – India 148 Conclusion

7 Conclusions

• India’s Banking Industry: Outlook and Opportunities Assessment

Report is an essential resource for industry practitioners doing business

in India, including bankers, investors, consultants and vendors. Here,

we draw a list of conclusions that are specific to their business

decision-making needs.

For bankers:

• With the increasing interest rates and inflationary pressure continuing

in 2006, overall credit expansion in India will continue at a slightly

slower, but still strong, pace compared to the previous year. We expect

credit growth of 27% in FY2007.

• Banks that adopt a universal banking model by expanding into mutual

funds, asset management, insurance, corporate advisory and

investment banking through subsidiaries or non-banking institutional

arms will be able to maintain a dominant position in the financial

market and generate more fee income.

• Despite strong demand for credit, deposit growth may be a restraining

factor for credit expansion in FY2007. But banks with a higher SLR

will need much lower deposit growth to fund the same growth in

advances (though a high SLR also hits their balance sheet as less credit

is available for private sector lending).

• With the increase in deposit rates, the ability to maintain a low-cost

funding base will be critical to the profitability of Indian banks in the

long term. Banks will have to tailor their strategies to ensure continuity

of this fund base, since the secondary money market is not developed

and borrowing for various tenures is limited and costly. Those with

substantial CASA deposits will benefit from the fact that only non-

CASA deposits are re-priced with an increase in deposit rates.

7 Conclusions


• Banks may need to accept that they cannot differentiate much on the

same products beyond a point. Those who focus on asset quality,

customer retention and relationship deepening, low-cost deposit

mobilisation and risk-based pricing will enjoy more consistent and

sustained profit growth over the long term.

• Consumer credit will continue to be the main area of competition in the

foreseeable future, as the appetite for retail products is likely to keep

growing for another two to three years at least. Our survey shows that

in the coming years, the most important sources of revenue growth in

retail banking in India will be mortgages, personal loans, credit cards

and wealth management, while corporate revenues will be

concentrated in SME lending, treasury services, cash management and

structured products. In wealth management, banks will strengthen the

mass affluent and overseas Indian segments.

• Currently, some of the biggest players in sub-prime lending are foreign

NBFCs with their strong risk management and credit underwriting

systems that can handle higher delinquencies. Local banks must

develop the ability to handle the risks of sub-prime lending in order to

compete effectively in this segment.

• Banks need to diversify their revenue mix. Fee income earned

simultaneously with interest income through bundling can boost

profits, but requires an integrated IT platform that allows banks to get

their productisation and pricing right. Loan trading can also enable

banks to increase corporate fee income and grow loan books without

incurring acquisition costs.

• With rapid credit expansion, risk management will take on greater

significance. We encourage banks to build reward/bonus systems into

remuneration structures to incentivise staff and increase the efficiency

of risk management.

• RBI’s risk weights on retail categories are currently much higher than

those required by Basel II. However we believe there could be a

7 Conclusions


reduction in these weights in March 2007 to bring them closer to Basel

II requirements. Banks are on track to adopting the Standardised

Approach for credit risk and the Basic Indicator Approach for

operational risks by March 2007. But beyond March 2007, banks

without data warehousing will find it extremely difficult to move to the

IRB approach as this will require not only current data but also

historical data.

• SME lending and rural finance have become increasingly viable

propositions with annual yields even higher than those of some retail

segments. The kisan credit card, covering a spectrum of farming and

personal loan requirements, and collateralised commodity financing

through commodity exchanges are likely to become attractive growth

segments for banks.

• In penetrating the rural segment, only the banks with the best

distribution channels and mechanisms will be able to profit from this

market. The key winning strategies for banks in branch management

will be leveraging on alternative sales/delivery channels and turning

the branch into a stronger sales platform through better customer

segmentation for cross-selling.

• Processing and service quality in times of massive customer

acquisition is likely to emerge as a key issue. Banks which lose sight

of the basic requirement of providing efficient customer service

through well trained front-line staff do so to their own detriment. We

believe that banks will need to go beyond acquisition strategies and

determine the optimal customer-quality base given the linkages in their

product range and their operating structures and systems, within which

cross-selling can be conducted effectively without compromising

process quality.

• While ATMs and internet banking have proved successful in some

areas, banks in India will need to assess whether or which of their

customer segments are ready for alternative channels. There will be

7 Conclusions


customers who continue to prefer branch transactions and a one-size-

fits-all approach will not work.

• The practice of having “flexible branches” (e.g. leased premises,

mobile banking) and “outsourced ATMs” (owned, developed and

maintained by other parties) as well as ATM-sharing arrangements will

be useful for banks concerned about cost issues. Those with advanced

IT systems, however, are encouraged to leverage better on their

investment in CBS and/or CRM systems to reap the cost advantages of

channel optimisation and eventually channel integration.

For investors:

• In FY2006, Bankex under-performed Sensex. But on the whole, strong

loan growth, declining NPLs, better asset quality and improved risk

management have increased public confidence in Indian banks over the

past few years. Some private banks out-performed the Sensex while

state-owned banks under-performed the benchmark.

• The under-performance of state banks was due to fears of margins

being adversely affected by rising deposit rates coupled with lagged

lending-rate increases and the subdued growth in profits as a result of

high IT and other operational costs. These banks’ valuations are

depressed by their low FII limits but do not take into account their vast

reach, access to low-cost funds and improvement in asset quality.

Although their ROA is likely to remain comparatively low for a few

years due to the ongoing IT upgrading, the completion of their core

banking rollout is expected to put the top state banks on an enhanced

competitive footing.

• Analysts reveal that since the stock market meltdown in May 2006,

almost all banks have under-performed the market and bank stocks

were trading at or below “worst scenario” values around mid-July 2006

indicating that the stocks may have bottomed out. Bankex has since

moved up but we believe bank stocks will remain volatile in the short

7 Conclusions


term. Operating and net profits of private banks should improve with

strong credit growth and better liquidity, but net profits of the state

banks may be adversely affected by bond losses and hence show

relatively modest growth.

• Many banks are well-capitalised for now after a spate of capital raising

measures in the past 18 months to cater for Basel II requirements and

their loan growth plans. Furthermore, hybrid instruments can now be

used for raising Tier I capital. Thus, we believe there will be less

equity issuances in the coming months. However some of the smallest

private banks experiencing exponential loan growth may opt for equity

issuance in FY2007. Delays in getting branch licences could impact

the loan and deposit growth plans of private mid-tier banks and compel

them to go for equity issuance as well. Not many other banks will

launch IPOs; we believe only a few old private banks and small state

banks may go for a listing in FY2007.

• A key thrust in the next three years will be to speed up consolidation of

local banks through mergers and acquisitions before the anticipated

liberalisation in 2009. As state banks can only be merged with other

state banks due to ownership restrictions, we expect more alliances

among state banks as well as accelerated M&A activity among smaller

private banks trying to scale up inorganically by acquiring peers or

securities, insurance and home-finance companies to expand branch

penetration, asset size or geographical footprint.

• Due to RBI‘s restrictive stance, the scope for foreign acquisition deals

in the next three years will be limited to taking over of the distressed

assets of old private banks and small stakes in local banks subject to

the regulatory caps on investment (5% for individual foreign banks and

10% for foreign institutional investors). Foreign players may continue

to explore investments in registered NBFCs, especially in fast moving

areas like two-wheeler finance, personal credit and other sub-prime

consumer segments which tend to have higher profitability. But the

period of unrestricted proliferation of branch channels and unethical

credit borrowing and collection techniques on the part of some NBFCs

7 Conclusions


may be over soon, judging from recent signals from RBI and its

increased vigilance of the activities of foreign NBFCs.

For consultants and vendors:

• The upgrading of technology infrastructure will continue in 2006-

2007. State banks, especially, are increasing their efforts in data

centralisation, branch networking, upgrading of application layers and

core banking.

• Most tier 1 and tier 2 banks have already made decisions but some

small banks may enter the market for core banking systems. The trend

among Indian banks is to opt for centralised, integrated and packaged

end-to-end solutions and bottom-up infrastructure change because of

the complexity of integrating new applications with the existing

archaic structures. They tend to prefer using third-party services for

systems integration and outsourcing their data centre operations given

the lack of data processing experience. Since multinational vendors

with domain knowledge are locally available, foreign vendors

interested in pursuing these deals will need to convince Indian banks

that they can deliver comparable or superior service and/or offer

favourable pricing.

• Core banking system rollouts for the top state banks will be completed

by 2007-2008 with the other state banks following in 2009-2010. Once

these are completed, there will be opportunities for vendors in data

warehousing, payments, channels, CRM-related information

management and business intelligence systems, and other business

applications. A few of the top state banks have already started speaking

to vendors about data warehousing.

• The core banking and CRM culture will trigger transformation across

people, systems and processes. We believe banks will need consulting

services on change management and HR training to align staff

mindsets and skills to the new systems.

7 Conclusions


• We believe that in the coming years, banks will prioritise information

security, mirroring and backup technology for data centres (to ensure

business continuity in the event of a disaster) and faster delivery of

services. There will be increased demand for ALM and other treasury

enhancement applications that enable better exposure management,

effective anti-money laundering systems, speed-enabling technology,

and identification software to identify individuals across multiple

databases.

• Rapid credit growth will require further investments in risk

management systems and in the hiring of qualified staff and

consultants to help implement Basel II requirements. For Basel II risk

management systems, banks have had a better experience with using

specific software suited to specific businesses along with an

appropriate system for integration rather than a single application.

• Currently, only a few private banks have data warehousing and CRM

systems and not many have invested in systems like secure front-end

processes and appropriate training and incentives for CRM execution.

As system capabilities converge with more banks adopting core

banking systems, banks will begin to focus on creating service

differentiation through more efficient front-end services.

• Very few local banks have behaviour scoring applications. We do not

believe local banks are ready to implement these yet.

• Expansion of operations beyond first-tier cities to cover the 75% of the

population living in rural areas will require additional investments.

Small and mid-tier private banks are investing in aggressive branch

and ATM expansion beyond metros. For greater flexibility, some

banks are opting to lease rather than buy premises. Local banks are

also experimenting with a cost-saving scheme whereby third parties

are invited to develop and maintain the ATMs while banks pay

commission on a transaction basis.

7 Conclusions


• Bankers will be on the lookout for more dealer networks and tie-ups

for transportation, safe storage and warehousing arrangements as

alternative sales/delivery channels given the success of this model in

agricultural and SME lending.

• Products that address the infrastructural deficiencies in remote areas

hold promise in enhancing financial inclusion. These include:

computer systems which do not require uninterrupted electric power

supply; networking systems using radio frequency or other

unconventional communication methods; and customised systems such

as low-cost multilingual ATMs or multifunction smart cards with built-

in security and identification features.

The report is supported by a full range of latestavailable primary data at the operational and businesslevels that decision makers will need for making theirown assessments.

Chapter 8 Appendix: India Banking Data Series 2001-2005

8 Appendix

_________________________________________________________________________ Asian Banker Research – India 156 Appendix

India –8.1. Basic statistical data

2001 2002 2003 2004 2005

Table 8.1.1 Macro data GDP (Rupees billions) at current prices 22,821 24,696 27,483 30,949 35,058 Growth 9.2% 8.2% 8.5% 6.5% 7.0% GDP (US$ millions) at current prices 473,661 514,179 622,841 710,154 779,936 Growth 6.0% 8.6% 21.1% 14.0% 9.8%

Population (millions) 1,037 1,055 1,077 1,094 1,107 Growth 1.8% 1.7% 2.1% 1.5% 1.2% Population age distribution 0-14 33.2 33.0 32.2% 31.7% 31.2% 15-64 62.1 62.4 63.0% 63.5% 63.9% 65+ 4.7 4.7 4.8% 4.8% 4.9%

GDP/Capita (Rupees) 22,007 23,409 25,518 28,289 31,669 Growth 7.3% 6.4% 9.0% 6.4% 11.9% GDP/Capita (US$) 457 487 578 649 705

Table 8.1.2 Price indices Composite consumer price index (1982 = 100) 458.0 476.3 499.2 529.1 549.2 YoY change 3.9% 4.0% 4.8% 6.0% 3.8% Producer price index (1993-94=100) Agriculture, 1981-82 = 100 148.4 150.7 179.4 168.6 170.5 YoY change 0.0% 1.5% 19.0% -6.0% 1.1% Mining, 1993/94 = 100 131.9 132.4 157.8 165.4 162.5 YoY change 1.2% 0.4% 19.2% 4.8% -1.8% Manufacturing, 1993/94 = 100 167.0 172.3 210.7 231.4 245.0 YoY change 2.7% 3.2% 22.3% 9.8% 5.9%

Table 8.1.3 Monetary statistics (Rupees billions) Narrow money supply (M1) 4,228 4,736 5,787 6,463 7,363 Currency in circulation 2,414 2,763 3,200 3,625 3,980 Demand Deposits 1,792 1,988 2,586 2,840 3,371 Quasi money 10,775 12,532 12,617 14,942 17,383 Money supply (M2) 4,279 4,786 5,838 6,513 7,414

Monetary Statistics (US$ millions) M1 87,763 98,601 131,154 148,293 163,814 Growth 8.0% 12.3% 33.0% 13.1% 10.5% M2 88,809 99,651 132,296 149,450 164,935 Growth 8.0% 12.2% 32.8% 13.0% 10.4%

Table 8.1.4 Inflation and unemployment Inflation (YoY change, %) 3.9% 4.0% 3.8% 3.8% 4.3%

Labour force (million) 458 475 486 472 496 Unemployed (million) 42 41 31 34 44 Unemployment rate (%) 9.2% 8.7% 6.3% 7.2% 8.9% Employment by economic activity Agriculture (%) 24.6% 22.7% 23.1% 21.1% … Industry (%) 25.4% … … … … Service (%) 49.7% 51.5% 50.9% 51.7% … Labour force participation rate Women (%) 29.2% 28.6% 28.3% 28.1% … Men (%) 70.8% 71.4% 71.7% 71.9% … Exchange rate (domestic currency vis-a-vis US$) Year-end 48.180 48.030 44.125 43.580 44.950

Note: All information as at financial year ended March (e.g. 2004 is as at 3/2004), unless otherwise stated.

8 Appendix


India –8. 2. Household demographics

2001 2002 2003 2004 2005

Table 8.2.1 Number of households ('000) 188,391 194,559 199,028 198,900 … % urban population 27.8% 28.2% 28.5% 28.7% …

Household income (Rupees billions) at current prices 18,197 19,757 21,972 23,686 29,005 Household income (US$ billions) at current prices 378 411 498 543 645 Household income/GDP (%) 80% 80% 80% 77% 83%

Number of households ('000) by income band US$'000 p.a. 0-1 79,086 80,786 81,549 49,725 … 1-3 53,907 56,110 55,692 65,637 … 3-5 19,120 19,902 21,879 35,802 … 5-10 17,318 18,026 19,890 23,868 … 10+ 18,960 19,735 20,018 23,868 … Total number of households ('000) 188,391 194,559 199,028 198,900 …

Total household borrowings (Rupees billions) 4,577 4,939 5,359 5,707 6,080 HH borrowings/HH income 25% 25% 24% 24% 21% HH borrowings/GDP (%) 20.1% 20.0% 19.5% 20.0% 17.3%

Table 8.2.2 Gross domestic saving (Rupees billions) 4,963 5,380 6,490 7,975 9,074 Gross domestic saving (US$ billions) 103 112 147 183 202 Gross domestic saving/GDP (%) 21.7% 21.8% 23.6% 25.8% 25.9%

Table 8.2.3 Poverty Population in poverty (%) … … … 25% 29% Rural … … 27% 27% 29% Urban 30% … 24% 24% 25%

Income ratio of highest 20% to lowest 20% … … 5.7X … …

Gini coefficient 1) … … 0.38 0.41 0.42

1) The Gini coefficient is the most commonly used indicator of inequality. The coefficient ranges between 0, where there is no concentration (perfect equality and income is distributed completely equally), and 1 where there is total concentration (perfect inequality in income distribution).

8 Appendix


India –8.3. Banking industry data

2001 2002 2003 2004 2005

Table 8.3.1 GDP from finance GDP (Rupees billions) at current prices 22,821 24,696 27,483 30,949 35,058 GDP contribution from finance 2,671 2,962 3,483 3,966 4,523 % contribution 11.7% 12.9% 13.0% 13.1% 14.8%

Table 8.3.2 Number of financial institutions by category Central bank - State Bank of India 1 1 1 1 1 State Bank of India associates 7 8 8 8 8 Nationalized banks 19 19 19 19 19 Regional rural banks 196 196 196 197 196 Foreign banks 42 40 36 36 40 Other scheduled commercial banks 100 98 93 90 86 Combined total 365 362 353 351 350

Number of inhabitants: Per bank 3,437,500 3,502,373 2,988,669 3,068,376 3,626,246 Per commercial bank 10,277,778 10,542,857 10,762,861 11,039,026 11,322,277 Per branch 15,033 15,151 15,531 15,723 15,839

Table 8.3.3 Deposits in banks (Rupees billions) Demand deposits 1,594 1,691 1,878 2,304 3,007 Time deposits 8,297 9,621 11,239 13,151 15,590 Deposits in banks (US$ millions) Demand deposits 31,482 35,207 42,569 52,874 66,895 Time deposits 197,242 231,468 254,714 301,771 346,820

Table 8.3.4 Average interest rates (%) Deposits: Savings 4.0 4.0 3.5 3.5 3.5 Time 6 months 6.6 6.3 4.0 5.3 5.9 12 months 7.1 7.0 5.3 4.3 5.0 Loans and discounts: Commercial bills ... ... ... ... … Export credit 10.0 ... ... ... …

8 Appendix


India – 8.4. Retail distribution

2001 2002 2003 2004 2005

Table 8.4.1 Automated teller machines (ATMs) Number of networks 2 2 2 2 2 Number of machines 5,800 9,000 11,000 14,000 17,800 ATM penetration (ATMs/million population) 5.6 8.5 10.2 12.3 16.1

Value of ATM transactions (Rupees millions) 456,212 550,000 548,803 572,216 596,627 Value of ATM transactions (US$ millions) 9,469 11,451 12,593 13,130 13,273 Average value per transaction (Rupees) 898 670 547 448 367 Average value per transaction (US$) 19 14 12 10 8

Volume of ATM transactions (millions) 508.1 821.3 1,003.8 1,277.5 1,624.3 Number of transactions/person 0.49 0.78 0.93 1.17 1.47

Table 8.4.2 Electronic fund transfer at point of sale (EFTPOS) Number of networks ... ... ... ... … Number of terminals 40,000 50,000 65,000 84,000 98,000 EFTPOS penetration (EFTPOSs/million population) 38.6 47.4 60.4 76.8 88.5

Value of EFTPOS transactions (Rupees millions) 1) 38,883 51,839 53,170 61,641 74,630 Value of EFTPOS transactions (US$ millions) 807 1,079 1,205 1,414 1,660 Average value per transaction (Rupees) 1,187 1,184 1,087 1,074 1,108 Average value of per transaction (US$) 25 25 25 25 25

Volume of EFTPOS transactions (millions) 1) 32.8 43.8 48.9 57.4 67.4 Number of transactions/person 0.032 0.042 0.045 0.052 0.061

Table 8.4.3 Bank branches Number of branches 65,933 66,259 66,514 67,313 68,339 Branch penetration (Branches/million population) 65.8 64.4 63.6 63.1 61.6

Table 8.4.4 Infrastructure penetration rates Fixed-line telephone (millions) 39.4 41.4 48.7 44.3 49.0 Phone penetration (Phones/million population) 38,000 39,261 45,173 40,338 44,235 Phone penetration (% of population) 3.8% 3.9% 4.5% 4.0% 4.4%

Mobile phones (millions) 3.6 12.7 22.0 46.0 62.4 Mobile penetration (Mobile phones/million population) 3,449 12,026 20,420 42,048 56,348 Mobile penetration (% of population) 0.3% 1.2% 2.0% 4.2% 5.6%

Personal computers (millions) 4.6 6.0 18.3 24.2 32.0 PC penetration (PCs/million population) 4,436 5,687 17,000 22,091 28,909 PC penetration (% of population) 0.4% 0.6% 1.7% 2.2% 2.9%

Internet users (millions) 10.0 12.0 14.0 33.5 50.6 Internet penetration (Users/million population) 9,643 11,375 13,000 30,608 45,709 Internet penetration (% of population) 1.0% 1.1% 1.3% 3.1% 4.6%

Broadband subscribers '000 20.0 61.1 147.1 231.4 364.0 Broadband penetration (users/million population) 19.3 57.9 136.6 211.5 328.8 Broadband penetration (% of population) 0.0% 0.01% 0.01% 0.02% 0.03%

Note: All information as at financial year ended March (e.g. 2004 is as at 3/2004).

8 Appendix


India –8.5. Payment systems

2001 2002 2003 2004 2005

Table 8.5.1 Cash penetration Cash penetration (Rupees/person) 2,336 2,575 2,971 3,313 3,595 Cash penetration (US$/person) 48 54 67.3 76.0 80.0 Cash penetration as % of GDP 12.8% 12.9% 11.1% 11.6% 11.8%

Table 8.5.2 Credit cards Credit card density Number of credit cards (millions) 6.5 8.4 10.3 12.2 14.2Credit card penetration (credit cards/person) 0.006 0.008 0.010 0.011 0.013Credit card penetration (credit cards/working population)

0.016 0.019 0.023 0.028 0.031

Credit card transactions Value of credit cards transactions (Rupees millions) 124,903 142,885 154,020 183,570 238,000Value of credit cards transactions (US$ millions) 2,592 2,975 3,491 4,212 5,295Value of credit cards transaction/card (Rupees) 19,180 17,000 15,000 15,000 16,808Value of credit cards transaction/card (US$) 398 354 340 344 374Value of credit cards transaction/person (Rupees) 120 135 143 168 215Value of credit cards transaction/person (US$) 2.5 2.8 3.2 3.9 4.8Credit card billing as a % of household income 0.7% 0.7% 0.7% 0.8% 0.8%

Volume of credit cards transactions (millions) ... … 63 103 114 Average value per transaction (Rupees) ... … 2,444 1,783 2,086 Average value per transaction (US$) ... … 55 41 46

Table 8.5.3 Debit cards Number of debit cards - ATMs and EFTPOS (millions)

8.3 12.1 19.9 30.0 44.8

Debit card penetration (debit cards/person) 0.008 0.011 0.019 0.027 0.041

Value of debit cards transactions (Rupees millions) 495,095 601,839 752,299 1,015,604 1,371,065 Value of debit cards transactions (US$ millions) 10,276 12,530 17,049 23,304 30,502 Value of debit cards transaction/card (Rupees) 59,736 49,759 37,743 33,896 30,577Value of debit cards transaction/card (US$) 1,240 1,036 855 778 680Value of debit cards transaction/person (Rupees) 477 570 699 928 1,239 Value of debit cards transaction/person (US$) 10 12 16 21 28

Volume of debit cards transactions (millions) 540.8 865.1 864 1,019 1,691.6 Average value per transaction (Rupees) 915 696 871 997 811 Average value per transaction (US$) 19 14 20 23 18

Table 8.5.4 Cheques Value of cheques transaction (Rupees billions) 125,753 134,243 115,960 110,595 115,822 Value of cheques transaction (US$ billions) 2,610 2,795 2,628 2,538 2,577

Volume of cheques transactions (millions) 901.5 1,013.9 1022.8 1128.9 1163.8 Number of transactions per inhabitant 0.87 0.96 0.95 1.03 1.05

8 Appendix


India –8.6. Financial profile of commercial banks1)

2001 2002 2003 2004 2005

Table 8.6.1 Balance sheet US$ billions Total assets 103.8 257.9 366.6 470.8 542.9 YoY change 11.0% 148.5% 42.1% 28.4% 15.3% Net loans 42.9 106.1 159.9 208.1 266.1 YoY change 14.0% 147.3% 50.7% 30.1% 27.9% Equity 4.9 12.9 19.3 26.4 32.5 YoY change 7.9% 163.3% 49.6% 36.8% 23.1%

Non-performing loans 4.8 5.0 5.9 5.6 4.9 YoY change 20.4% 4.2% 18.0% -5.1% -12.5% NPLs as a % of gross loans 11.2% 4.7% 3.7% 2.7% 1.8% NPLs as a % of GDP 1.0% 1.0% 0.9% 0.8% 0.6%

Table 8.6.2 Income statement US$ billions Net interest revenue 3.1 6.8 10.3 13.9 16.2 YoY change 20.7% 117.0% 52.1% 34.9% 16.6% Other operating income 1.3 3.9 6.9 9.7 8.9 YoY change 8.1% 195.2% 77.6% 39.8% -8.3% Total operating income 4.4 10.7 17.2 23.5 25.0 YoY change 16.6% 140.3% 61.4% 36.9% 6.4%

Overheads - Personnel expenses 1.8 3.5 5.2 6.2 6.8 - Other operating expenses 0.9 2.2 3.2 4.7 6.0 Total overheads 2.8 5.7 8.4 10.9 12.8 YoY change 18.8% 107.9% 45.9% 30.4% 17.3%

Loan loss provisions 0.6 1.6 2.6 3.5 1.3 YoY change 29.0% 156.7% 56.7% 34.8% -63.0% Others -0.2 -0.5 -1.1 -1.4 -4.4 Profit before tax 0.9 2.8 5.2 7.8 6.6 YoY change 11.6% 222.9% 82.8% 50.6% -15.5% Net profits 0.7 2.2 3.7 5.4 4.4 YoY change 3.4% 228.7% 72.9% 45.1% -19.2%

Tier 1 capital 0.6 0.7 0.8 1.7 2.8 YoY change 38.1% 18.8% 15.3% 112.5% 64.7%

Table 8.6.3 Ratios Operations: Return on average equity (ROAE) 12.2% 21.1% 22.4% 24.7% 17.1% Return on average assets (ROAA) 0.6% 1.0% 1.2% 1.4% 1.0% Cost-to-income ratio 62.2% 53.8% 48.7% 46.3% 51.1% Net interest margins 3.4% 4.0% 3.5% 3.5% 3.4%

Liquidity: Net loans-to-total assets 41.3% 41.1% 43.7% 44.2% 49.0% Net loans-to-deposits 47.7% 49.1% 51.5% 52.3% 57.7%

Capital: Equity-to-total assets 4.8% 5.0% 5.3% 5.6% 6.0%

Non-interest income as a % of total income 29.8% 36.6% 40.3% 41.1% 35.4%

Note: All information as at financial year ended March (e.g. 2005 is as at 3/2005). Note:1)Including banks with more than US$1 million in assets.

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