Indian banking sector...making its mark in challenging times

Written by Husain Diwan | Viren H Mehta | Updated: Mar 30 2011, 07:20am hrs
The current edition of the FE-EY India's Best Banks Survey has been compiled amidst cautious optimism and resilience of the Indian economy to sustain growth while battling with high inflation. Strong headwinds on domestic and global fronts have made banks more risk-averse. Reserve Bank of India has played a stellar role in balancing between providing impetus for economic growth and curbing inflationary pressures and at the same time ensuring cushion to absorb shocks emanating from black swan events.

The Indian banking sector has been the major driving force supporting the country's growth over the decades. Dynamically evolving world economic order, strong Indian consumption story combined with demographic advantages, emerging regulatory framework aimed at ensuring stability of Indian banks as they continue to strongly support India Inc's growth, drive the bank's strategy of expanding market share, maintaining operational flexibility and of enhancing efficiency and profitability.

As ever, each category of banks - public, old private, new private and foreign banks face its own unique challenges ranging from shrinking margins and maintaining credit quality to managing liquidity and winning the war for talent.

Further, basis various competing demands impacting Indian banks, internally as well as externally, and their FY 2010 performance, we have decided not to change the criteria as well as the weights assigned to each of them as compared to the previous year. Considering these aspects, Ernst & Young has ranked the players within the Indian banking sector - 27 public sector banks, 13 old private sector banks, 6 new private sector banks and 9 foreign banks based on their natural genres.

Five major criteria were selected to compare performance of the Indian banks. These criteria are - Strength and Soundness, Growth, Profitability, Credit Quality, and Efficiency. In the current and foreseeable economic scenario, we believe every Indian bank would be evaluating itself and making peer comparison based on the major criteria selected as above.

Strong banks are a reflection of a strong economy. Continued faith, of the depositors on their bank and of the bank on its borrowers to repay, is the foundation of the banking business. The measure of this trust is the Strength and Soundness of a bank. The ability of a bank to survive financial turbulence is dependent on its strength and soundness. Accordingly, Strength and Soundness has been selected the first criterion to measure Indian banks with highest weight of 0.25.

The economic growth experienced in fiscal 2010 has also impacted the growth of the Indian banks. Intense competition and customer behavior played a very important role in determining banks' strategies for enhancing market share. Banking assets and earnings grew more-or-less in line with the entire economy, but those who excelled need to be recognized. Accordingly, Growth is the second major criterion selected with an assigned weight of 0.20.

Impact of higher than reasonable inflation also had its consequential impact on the financiers of the economy. To fund the growth aspirations of corporate India, it is imperative that the banks should have a minimum threshold in terms of size and adequacy of capital to reflect inherent strength and soundness. However, the banks also need to ensure they grow and become stronger whilst improving profitability. Therefore, Profitability is selected as the second major criterion and assigned a weight of 0.20 matching that of Growth.

As a result of greater emphasis on higher exposure to sensitive sectors and restructuring of debt, Credit Quality is once again a key factor on which Indian bank's performance would revolve and is therefore selected as the third criterion. Upward movement of interest rates and increase in input costs would require persistent focus on credit quality. Hence, the weight for Credit Quality has been assigned a weight of 0.20, equally to that of Growth and Profitability.

In an environment where margins are under huge pressure, customers becoming more sophisticated and demanding and greater need for financial inclusion, it is absolutely essential that banks manage their resources efficiently. Hence, it is important to evaluate a bank's performance based on efficiency with which it has used its human, technological and financial resources. Therefore, Efficiency has been selected as a last major criterion with a weight of 0.15.

Further, six sub-criteria are also selected within each major criteria to cover the entire spectrum within each of the major criterion.

Size, in terms of Capital, Networth and Total Assets, are indicators of the fundamental strength of a bank around the world, whereas, Adequacy of Capital, portion of Borrowings as compared to Deposits and Liquidity represent soundness and stability of a bank. Liquidity has been calculated based on the maturity pattern-upto one year of advances and investments less deposits and borrowings. Accordingly, these sub-criteria were selected to measure banks on Strength and Soundness. Banks are often compared using Total Assets as a benchmark, accordingly a weight of 0.20 is assigned to Total Assets. Networth comprises both total capital and accumulated profits and accordingly, is assigned the weight of 0.20, followed by Liquidity and extent of reliance on shorter duration funds as compared to deposits (Borrowing/Deposits Ratio) with both being assigned weights of 0.20 and 0.15 respectively. Capital Adequacy Ratio and Core Capital are powerful indicators of a bank's inherent strengths. However, very high Capital Adequacy Ratio and Core Capital could also mean inefficient use of capital. Therefore, a lower weight of 0.15 is assigned to Capital Adequacy Ratio and 0.10 to Core Capital.

Growth in Total Assets, Advances, Deposits, Net Profits, Net Interest Income ('NII') and Increase in Net Worth are selected as parameters for assessing Growth. The need for dominance in market share of deposits to fuel its funding and liquidity requirements have resulted in assigning higher weight to growth in Deposits of 0.30, followed by equal weights of 0.20 for growth in Advances and Net Profits. Growth in Total Assets would not necessarily result from growth in banking operations as banks could use the safe-habour of government investment, instead of lending. Hence it is assigned a weight of 0.10. Further, with the current stress on net interest margins, focus on improving these has also sharpened. Hence, this sub-criteria is assigned a weight of 0.10 that are a notch lower in comparison with other aforesaid sub-criteria.

Return on Assets, Yield on Advances, Return on Networth, Cost of Deposits, Cost-Income Ratio and Return on Investments are the sub-criteria selected to measure banks based on Profitability. The stakeholders would closely focus on Return on Assets and Return on Shareholders' Funds i.e., Networth. Thus, these sub-criteria are also assigned higher weights of 0.20. Currently, different constituents of banks would focus at Cost of Deposits and managing costs. Accordingly, both these sub-criterion are equally important and are also assigned equal weights of 0.20. Whereas Yield on Advances and Return on Investments are important, in the current interest rate scenario, these sub-criteria are assigned weights of 0.10, a notch lower in comparison.

Increase in Gross NPA, Restructured Loans, Net NPA/Networth, Gross NPA/Gross Advances, Increase in Gross NPA/Increase in Gross Advances and Increase in Net NPA/Increase in Net Advances are the sub-criteria selected to compare banks on Credit Quality. The rate of increase in gross NPA compared with the rate of increase in gross advances, and the rate of increase in net NPA compared with the rate of increase in net advances are considered to be of relatively higher importance to a bank's management. Accordingly, these sub-criteria are assigned the highest weights of 0.25 to assess Credit Quality. The increase of Gross NPA has been assigned the next level weight of 0.20. One of the policy measures to assist businesses to tide over economic slowdown, was to encourage banks to restructure loans to customers without affecting their classification. Through this special regulatory accounting treatment, although considered performing, these assets evidence inherent credit weakness. Hence, the quantum of restructured loans rendered non-performing is the next important aspects of Credit Quality and is assigned the weights of 0.10. Additionally, the portion of a bank's gross advances comprising gross NPA and the portion of a bank's networth comprising net NPA is each assigned a lower weight of 0.10.

The increased competition for human and financial capital, increased expectation on performance, improved technology necessitate that the human, technological and financial resources be more efficiently deployed and leveraged. Therefore, Spread/Total Assets, Operating Expenses/Total Assets, Business Per Employee, Profit Per Employee, Non-Interest Income/ Total Assets, Profit Per Branch are selected as sub-criteria to measure Efficiency amongst banks in India.

Spread/Total Assets and Operating Expenses/Total Assets measure efficiency in use of resources and these are assigned weights of 0.25 and 0.15 respectively. Business Per Employee and Profit Per Employee measure utilization of human capital and are assigned weights of 0.15 and 0.20 respectively. With the objective of financial inclusion and penetrating under banked areas and population, Indian banks are increasing their branch network and accordingly profit per branch has been considered as one of the sub-criteria to measure efficiency. NII reflects the ability of the bank to charge its customers for its services and augment the bottom line of the bank without requiring allocation of capital and hence reflects use of organization skills and network. Therefore, the last two sub-criteria are assigned weights of 0.15 and 0.10 respectively.

The results of the ranking are based on financial performance of banks during FY 2010. While some may not concur with the aforesaid dissertations, we believe that in the current Indian environment, the above ranking methodology is most appropriate - so much so that when stress-tests were performed, the resultant top ranking banks were significantly the same.

Looking ahead, the success for the Indian banking industry as well as individual institutions is predicated how banks will address the many challenges they face. The challenges of differing pace of growth in the emerging markets, the challenges of identifying and taking advantage of vastly under and un-banked regions and population, the challenges of managing costs and above all, the challenges of maintaining growth levels, profitably.