What came first, the chicken or the egg? Philosophers have been debating this question for years and the answer still remains a mystery. A similar but no less challenging question is unfolding in the Indian banking sector currently. Can the banking system grow without signals that GDP growth is improving? Or should banks continue lending to try and stimulate the economy? Well, the usual thumb rule is that banking sector growth is 2.5 x GDP growth. So if the economy is growing at 7%, the banking space should grow by around 17-18%. But, now with India seeing a number of GDP growth downgrades, this figure for credit growth can have a wide range.

We recently attended an event hosted at the Indian Merchant's Chamber on the "Current Trends and the Unfolding Banking Scenario". Mr Krishna Kumar, Managing Director & Group Executive of National Banking and Whole Time Director of State Bank of India (SBI) was the speaker at the event. According to him, with Europe in a debt crisis and the US stagnating, India continues to remain a growth driver. It has favourable demographics and a number of infrastructure and retail lending opportunities. However, there are a number of challenges on the ground that needs to be addressed, especially by the financial services sector.

Four pillars of focus for banks:

1. Basel III: The Basel III requirements will be a new challenge for Indian banks to meet. As per these international regulations, banks need to maintain a minimum total capital (including a capital conservation buffer) of 11.5% of risk weighted assets by FY18. As per RBI estimates, Indian banks would require additional capital of Rs 5 trillion to meet Basel-III norms by March 31, 2018. These projections are based on the conservative assumption that banks will show a uniform growth of 20% per year. Public sector banks will need an infusion from the government, their majority shareholder. Reserve Bank of India (RBI) Governor D Subbarao, stated that the Center would need to infuse Rs 900 bn in PSU banks in order to maintain its current shareholding after the new norms come into force. If it is willing to reduce its stake in these banks to 51%, the burden may come down to Rs 700 bn. But, this is still a tough task for a government facing twin deficits. Indian banks are currently adequately capitalized (FY12 CRAR - 14.3%). However as they grow in size more capital would be required.
   
   
2. Asset quality deteriorating: The economic slowdown, elevated interest rates and mass restructurings of state electricity boards (SEBs) and airlines all caused asset quality to sharply deteriorate for the banking sector. State run banks were the worst affected in this regard. The gross Non Performing Assets (NPAs) of the public sector banks (PSBs) increased sharply to 3.2% of gross advances at the end of FY12 from 2.3% at the end of FY11. In net terms, their ratio went up to 1.5% from 1% over the same period as can be seen in the chart below. Agri, SME and MSME accounts are seeing stress. Plus the iron and steel, mining, and textile sectors have all been seeing pressure in making their interest payments.
   
   
   Source: RBI Annual report
   
   What is worrying is that the restructured standard advances of the PSBs increased to 5.7% of gross advances by at the end of FY12 from 4.2% a year ago. If macro stress remains in the system this year, the RBI expects the gross NPA ratios for all banks to increase to 3.7-4.1% at the end of FY13 from 2.9% at the end of FY12. The ability to maintain good asset quality in a tough environment will really separate the men from the boys in the banking space.
   
   
3. Falling Net Interest Margins (NIMs): NIMs are a measure of operating profitability of a bank. On account of higher cost of funds, NIMs reported a decline in FY12. Banking NIMs thus decreased from 3.14% in FY11 to 3.07% in FY12. This was on account of slower CASA accretion and higher growth in term deposits (FDs). This growth in FDs was on account of higher deposit rates in the system on the back of RBI's monetary tightening. Accordingly Return on Equity of banks posted a slight decline from 13.7% to 13.6% during the same period and the Return on Assets stayed constant at 1.1%. However, in the long run the banking sector's NIMs are expected to normalize. According to a report by the Boston Consulting Group (BCG) the Indian banking sector's NIMs are expected to reduce to 2% by 2020.
   
   
4. Financial Inclusion: It is indeed unfortunate to note that in India 40-45% of the rural populace does not have access to banking channels. Thus they are forced to borrow from moneylenders at usurious rates. Microfinance Institutions (MFIs) were established to help plug the gap; however they were also impacted by adverse regulations in Andhra Pradesh in 2011 and still haven't fully recovered. But yet, the need for the penetration of formal banking into smaller townships cannot be underscored. India also fares poorly in respect of credit cards, outstanding mortgage, health insurance, adult origination of new loans, mobile banking, etc. The new challenge for banks would be to cover villages with a population below 2,000 as well as to expand the scope of the business correspondent model.

Conclusion

Well going forward the banking sector is expected to have a tough time managing 18-20% credit growth in light of slowing GDP growth. Plus containing gross NPAs below 2% will also be a huge challenge as it is an issue affecting the economy at large. Certain large industries such as mining, textile, iron and steel, power, airlines etc are all seeing stress. However on the retail front auto and home loans are seeing robust growth.

Infrastructure financing also remains a challenge as the country needs to build new roads, ports, airports, etc and repair its aging ones. This requires investments that need to come from the banking space. A new structure needs to be put in place to address the issue of sectoral caps, risk averseness and asset liability mismatches. A few other challenges could be the issue of new banking licenses and the advent of competition. Consolidation in the space may also be required as there are a number of smaller banks in the system. SBI has already merged three of its associate banks, with 5 still remaining to be merged.

Technology is also said to be the way forward with India seeing a mobile and internet revolution and more traditional banks need to accept the same. Human resources is also another challenge as 40-50% of PSU banking staff is expected to retire over the next few years. Plus attrition in the banking sector used to be low with staff staying in the same bank for their entire career. Stickiness is however low among new employees, thus the realignment of HR policies along with employee needs is required. But while there are a lot of challenges on the ground we believe that the banking sector can meet them head-on as they have done in the past. We hope to see a fresh face of banking in India.

By Equitymaster - India's leading share market research initiative. Our research coverage includes both large and small companies, including the the BSE Sensex stocks.

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