The remaking of the banking sector

The country’s banking architecture will sport a new look, if the plans of the Reserve Bank of India as well as the government are implemented. The author traces the likely changes to give a sense of the landscape five years down the line

Shortly after taking over as the Reserve Bank of India governor in September 2013, Raghuram Rajan had promised a “dramatic remaking” of the country’s banking sector.

Rajan has walked the talk, though the full results of his efforts would be visible only a few years from now.

For example, five years down the line, the Indian banking sector could look very different from what it is now.

To start with, the near-monopoly of public sector banks, which now account for over 77 per cent of the loan market, could well be over.

Experts say there could be fewer public sector banks, more niche banks that offer only specific products or cater to a particular group of customers and more private universal banks.

The postal department’s ambition to become a full service bank could also impact the monopoly that state-run lenders enjoy in the hinterlands.

Most importantly, customer choices would change dramatically with technological innovations, as a result of which lenders which still depend on savings deposits to attract customers, could face oblivion in the next five years.

“There is definitely change in the air with payments banks, small finance banks and more universal banks coming in.

Three years down the line, you will see many of these things happening,” said Arundhati Bhattacharya, chairman, State Bank of India, the country’s largest lender which controls 17 per cent of the total credit of the banking system.

The recent decision of the government to capitalise public sector banks based on their efficiency could go a long way in ending the muscle power that the state-run banks enjoy, if the government sticks to the strategy of selective infusion of capital.

Weaker banks’ survival would be in question as their ability to raise capital from the market would be limited because of mounting non-performing loans.

For diluting their owner’s stake by tapping equity markets, these banks need the government’s approval, and the latter is in no mood to oblige due to poor valuations.

Data compiled by the finance ministry show public sector banks’ combined market capitalisation is only 36 per cent of the banking sector’s total market cap even though they control 77 per cent of the loan market while their average price-to-book value (P/BV) is 0.67.

In contrast, private sector lenders’ market cap is 74 per cent with average P/BV at 2.35.

While observing that the government’s move to link capital infusion with efficiency is one way to incentivise banks for better efficiency, Bhattacharya said only time will tell if government banks can hold on to their dominance.

“It is difficult to predict at this point in time what will happen. We will have to see whether it (market share) remains where it is now or comes down to 50 per cent,” she added.

A new order

The response to set up niche banks in India after the banking regulator invited applications from aspirants has been stupendous.

Over 100 entities have applied to set up payments banks and small finance banks, though the central bank made it clear that it will be cautious in awarding licences.

RBI has also paved the way for wholesale banks, or to be more specific, banks which will only finance infrastructure projects. RBI has provided incentives for such banks as they can now raise resources through long-term bonds (with a tenure of at least seven years) and will not have cash reserve ratio (CRR), statutory liquidity ratio (SLR) or priority sector lending obligations. However, it is still to be seen whether the concept excites banking aspirants.

There could be another kind of niche banks.

Going by the deliberations at the two-day bankers’ retreat (gyan sangam) convened by the finance ministry in Pune, there is a proposal that small public sector banks should rather focus on their strengths and not try to sell all kinds of products.

“Re-orient portfolios of small PSU banks to differentiate and focus on specific niches to build capabilities and to optimise capital,” the summary of recommendations released after the retreat said.

This could result in some government banks selling loans only to farmers, and some selling only to small enterprises.

The one-size-fits-all theory could well be a thing of the past, so far as the structure of public sector banks are concerned.

There will be more universal banks also, with the banking regulator thinking about “on-tap” licensing of universal banks, as compared to the current “window” system of licensing. The guidelines for the same are expected to be released later this year.

Going ahead, the banking sector could look like what global consulting firm McKinsey outlined at the Pune retreat, which was attended by finance ministry and RBI officials.

McKinsey suggested a three-tier banking structure.

On top will be large banks, which can happen through consolidation of some of the public sector banks, though not many believe this is possible at this point as most government banks are now busy putting their own house in order in terms of tackling the steep rise in bad loans.

“There is no point in merging two weak banks, this will have systemic implications,” said the chief executive of a public sector bank.

The second is state-linked banks, a proposal which finds resonance with the PJ Nayak committee.

According to the recommendations of the committee, set up to review governance structure in banks, the government should cut its shareholding below 51 per cent; set up an omnibus bank investment company, which will be the holding company for all public sector banks; and constitute a bank board bureau which will appoint board members as well as chief executives.

The suggestions are radical, but if implemented, public sector banks will sport a completely different look, five years down the line.

The McKinsey report also talked about policy banks.

Such entities are also a welcome step as it will implement the government’s policy decisions such as directed lending, which is currently being done by public sector banks. If these banks are freed from the burden of directed lending, their efficiency will improve.

One step in this direction has already been taken with the setting up of the Micro Units Development Refinance Agency (MUDRA) Bank.

Addressing students of the National Institute of Bank Management in Pune last week, Rajan said the banking sector will see major changes with the entry of new players, while public sector lenders will be the biggest “change agents”.

He has already laid the groundwork for the “dramatic remaking”.

RECOMMENDATIONS OF THE RAGHURAM RAJAN COMMITTEE ON FINANCIAL SECTOR REFORMS: 2008

Entry to private well-governed deposit-taking small finance banks

Liberalising banking correspondent regulations so that local agents can extend financial services

Financial inclusion strategy not only to focus on credit but also payment services, savings product etc

Offer priority sector loan certificates (PSLC) to all entities that lend to eligible categories in the priority sector

Create stronger boards for large public sector banks, with more power to outside shareholders