From a macro-historical perspective, the Indian banking industry is seen as quite healthy. The industry continues to enjoy high growth rates with retail credit being at the forefront of action. Alongside this demand for personal consumption are factors such as the upward movement of interest rates, creeping inflationary pressures and escalating asset prices that are a cause for concern. Apart from these, current trends in net interest margins seem to indicate that all is not hunky dory, and banks will have to address these concerns.
As ever, each category of banks-public, old private, new private and foreign banksface its own unique challenges. For some it is surviving in the face of heightened competition, others have compressing net interest margins, NPAs, manpower and technology to deal with.
In terms of the future, a high growth scenario creates challenges of its own. Bankers cannot remain complacent as they would require managing a host of dynamics like interest rate movements, escalating asset prices on the funding side. On the operational side, significant pressure will be felt in the areas of achieving growth in earnings and returns, managing and deploying financial and human capital and proactively dealing with powerful competitive forces.
Considering this scenario, Ernst & Young has ranked the players within the Indian banking sector. These include:
1. Public sector banks (28)
2. Old private sector banks (19)
3. New private sector banks (7 and excludes those banks who merged in 2004-05 or 2005-06)
4. Foreign banks (10).
In the ranking process, five major criteria were selected to compare performances.
These criteria are:
B. Credit Quality,
C. Strength and Soundness,
Considering the current stage of evolution of Indian banking, in the backdrop of continued economic growth, we believe every Indian bank would be evaluating itself and making peer comparisons based on the major criteria mentioned above.
Basis for ranking criteria
In many ways, Indian banking is a reflection of the Indian economy. The robust growth experienced in the industrial and services sector is mirrored by the growth of the Indian banks. Therefore, if the entire economy is growing so rapidly it is but natural that the banking assets and earnings will grow. Accordingly, growth is the first criterion selected to measure performance of banks in India.
With greater emphasis on consumption loans, directionally changing interest rates, higher exposure to sensitive sectors, credit quality is one the key pivots on which Indian banks continued high performance would revolve. It is therefore selected as the next major criterion. With securitization laws in place, asset reconstruction companies established, higher regulatory provisioning policy in place admittedly, credit quality is a relatively lesser concern today than it was some years ago. Hence, from the earlier rankings, the weight for credit quality has been accordingly, reduced. Credit quality is now assigned a weight of 1.03, slightly above Growth.
Banks are specialall its stakeholders believe that. Trust of the depositors on a bank and trust of the bank on its borrowers form the bedrock of the banking business. The measure of this trust is the strength and soundness of a bank. Accordingly, this is the third major criterion selected with an assigned weight of 1.13.
As mentioned earlier, as India experiences high growth rates in almost all areas of the economy, it is only expected that the financiers of the economy will also grow and structural practices would ensure that credit quality is within acceptable levels. It is then imperative that the bank should have a minimum threshold in terms of size and adequacy of capital to reflect soundness. However, all these must be achieved profitably. Therefore, profitability is selected as the next major criterion and assigned a weight of 1.23-higher than that of growth, credit quality and strength and soundness.
In todays competitive environment, one with immense opportunities and challenges it is absolutely essential that banks utilise resources efficiently. Taking into account these dynamics, it is important to evaluate a banks growth, credit quality, strength and soundness and profitability, based on efficiency with which it has used its human, technological and financial resources. As a result, efficiency has been selected as a major criterion with a weight 1.33the highest criterion.
Further, six sub-criteria are also selected within each major criteria to cover the entire spectrum within each of the major criterion.
Growth in total assets, advances, deposits, net profits, net interest income (NII) and net worth are selected as parameters for assessing growth. The need for scale, focusing on increased market share with increased profits have resulted in assigning higher, equal weights (0.20) for growth in advances, deposits, net profits and networth.
With the current pressure on net interest margins, focus on improving these has also sharpened. Further, growth in total assets would not necessarily result from growth in banking operations as banks could use the safety-umbrella of government investment, instead of lending. Hence both these sub-criteria are assigned weights (0.10) that are a notch lower in comparison with other aforesaid sub-criteria.
Growth in gross NPA, net NPA/total assets, 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 portion of a banks gross advances comprising gross non-performing advances, the rate of increase in gross non-performing advances compared with the rate of increase in gross advances, and the rate of increase in net non-performing advances compared with the rate of increase in net advances are considered to be of relatively higher importance to a banks management.
Accordingly, these sub-criteria are assigned the highest weights (0.20) to assess credit quality. The portion of a banks total assets and networth rendered non-performing is the next important aspect of credit quality and are assigned the next level of weights (0.15). Growth of gross NPA is assigned the next level of weight (0.10).
Strength and soundness
Size, in terms of capital, networth and total assets, are indicators of the strength of a bank around the world, whereas, adequacy of capital, portion of borrowings as compared to deposits and credit to deposit ratio represent the soundness of a bank.
Accordingly, these sub-criteria were selected to measure banks based on their strength and soundness. Networth comprises both total capital and accumulated profits and accordingly, is assigned the highest weight (0.20) within the strength and soundness criterion, followed by extent of deposits deployed for lending (credit/deposit ratio) and extent of reliance on shorter duration funds as compared to deposits (borrowing/deposits Ratio) with both being assigned equal weights (0.17). Capital adequacy ratio and core capital are powerful indicators of a banks inherent strengths.
However, very high capital adequacy ratio and core capital could also indicate inefficient use of capital. Therefore, a lower weight (0.15) is assigned to these sub-criteria. Banks are often compared using total assets as a benchmark.
In the current economic context where efficiency in use of capital and effectiveness of deployment of deposits are more respected, a middle-of-the-path weight (0.16) is assigned to total assets.
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. Different constituents of banks look at different parameters e.g., the bank managements would focus on cost of deposits and controlling cost-income ratio. Accordingly, both of these sub-criteria are equally important and are assigned equal weight (0.20).
The stakeholders would closely focus on return on assets and return on shareholders funds i.e., Networth.
Accordingly, these sub-criteria are also assigned higher weights (0.20). Whereas, yield on advances and return on investments are important, in a benign-to-rising interest rate scenario, these sub-criteria are assigned weights (0.10), a notch lower in comparison.
Banks that are able to adapt quickly to the evolving economic environment, are the ones that create most value. The increased competition for human and financial capital, increased expectation on performance, improved technology platforms demand that the human, technological and financial resources be more efficiently deployed and leveraged. Therefore, business per employee, profit per employee, spread/total assets, commission and fees/total assets, profit per branch, operating expenses/ total assets are selected as sub-criteria to measure efficiency amongst banks in India.
Business per employee and profit per employee measure efficiency in use of human capital and are assigned equal weights (0.20). Spread as a percentage of total assets and operating expenses as a portion of total assets measure efficiency in use of financial resource and operational efficiency and these are also assigned equal weights (0.20). With increased use of technology and extended enterprises in creating pan-Indian footprints, branch networks, albeit considered are not vital. Commission and fee income have the added advantage of not requiring allocation of capital. Therefore, the last two sub-criteria are assigned equal weights (0.10). While some may not concur with the aforesaid dissertation, 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 question for the banking industry as well individual institutions is how banks will address the many challenges they face. Successful institutions will be those that focus on the four critically important areas-customer service: how a bank serves its customers to acquire and retain them; managing resources: how individual banks balance the various alternatives to profitably deploy resources; risk management: how a bank manages the variety of risks it faces; and managing costs: how a bank manages costs including interest, operating and credit costs.