Article on Indian Banking Sector: “The challenges that the banking sector in India faces”

It is by now well recognized that India is one of the fastest growing economies in the world.

Evidence from across the world suggests that a sound and evolved banking system is required for sustained economic development. India has a better banking system in place vis a vis other developing countries, but there are several issues that need to be ironed out.

In this article, we try and look into the challenges that the banking sector in India faces.

Interest Rate Risk:

Interest rate risk can be defined as exposure of bank’s net interest income to adverse movements in interest rates. A bank’s balance sheet consists mainly of rupee assets and liabilities. Any movement in domestic interest rate is the main source of interest rate risk.

Over the last few years the treasury departments of banks have been responsible for a substantial part of profits made by banks. Between July 1997 and Oct 2003, as interest rates fell, the yield on 10-year government bonds (a barometer for domestic interest rates) fell, from 13 per cent to 4.9 per cent. With yields falling the banks made huge profits on their bond portfolios.

Now as yields go up (with the rise in inflation, bond yields go up and bond prices fall as the debt market starts factoring a possible interest rate hike), the banks will have to set aside funds to mark to market their investment.

This will make it difficult to show huge profits from treasury operations. This concern becomes much stronger because a substantial percentage of bank deposits remain invested in government bonds.

Banking in the recent years had been reduced to a trading operation in government securities. Recent months have shown a rise in the bond yields has led to the profit from treasury operations falling. The latest quarterly reports of banks clearly show several banks making losses on their treasury operations. If the rise in yields continues the banks might end up posting huge losses on their trading books. Given these facts, banks will have to look at alternative sources of investment.

Interest Rates And Non-Performing Assets:

The best indicator of the health of the banking industry in a country is its level of NPAs. Given this fact, Indian banks seem to be better placed than they were in the past. A few banks have even managed to reduce their net NPAs to less than one percent (before the merger of Global Trust Bank into Oriental Bank of Commerce, OBC was a zero NPA bank). But as the bond yields start to raise the chances are the net NPAs will also start to go up. This will happen because the banks have been making huge provisions against the money they made on their bond portfolios in a scenario where bond yields were falling.

Reduced NPAs generally gives the impression that banks have strengthened their credit appraisal processes over the years. This does not seem to be the case. With increasing bond yields, treasury income will come down and if the banks wish to make large provisions, the money will have to come from their interest income, and this in turn, shall bring down the profitability of banks.

Competition In Retail Banking:

The entry of new generation private sector banks has changed the entire scenario. Earlier the household savings went into banks and the banks then lent out money to Corporates. Now they need to sell banking. The retail segment, which was earlier ignored, is now the most important of the lot, with the banks jumping over one another to give out loans. The consumer has never been so lucky with so many banks offering so many products to choose from. With supply far exceeding demand it has been a race to the bottom, with the banks undercutting one another. A lot of foreign banks have already burnt their fingers in the retail game and have now decided to get out of a few retail segments completely.

The nimble footed new generation private sector banks have taken a lead on this front and the public sector banks are trying to play catch up.

The PSBs have been losing business to the private sector banks in this segment. PSBs need to figure out the means to generate profitable business from this segment in the days to come.

The Urge To Merge:

In the recent past there has been a lot of talk about Indian Banks lacking in scale and size. The State Bank of India is the only bank from India to make it to the list of Top 100 banks, globally. Most of the PSBs are either looking to pick up a smaller bank or waiting to be picked up by a larger bank.

The central government also seems to be game about the issue and is seen to be encouraging PSBs to merge or acquire other banks. So in the zeal to merge with or acquire another bank the PSBs should not let their common sense take a back seat. Before a merger is carried out cultural issues should be looked into. A bank based primarily out of North India might want to acquire a bank based primarily out of South India to increase its geographical presence but their cultures might be very different. So the integration process might become very difficult. Technological compatibility is another issue that needs to be looked into in details before any merger or acquisition is carried out.

The banks must not just merge because everybody around them is merging. As Keynes wrote,  “Worldly wisdom teaches us that it’s better for reputation to fail conventionally than succeed unconventionally”. Banks should avoid falling into this trap.

Impact Of BASEL-II Norms:

Banking is a commodity business. The margins on the products that banks offer to its customers are extremely thin vis a vis other businesses. As a result, for banks to earn an adequate return of equity and compete for capital along with other industries, they need to be highly leveraged. The primary function of the bank’s capital is to absorb any losses a bank suffers (which can be written off against bank’s capital).

Norms set in the Swiss town of Basel determine the ground rules for the way banks around the world account for loans they give out. The Bank formulated these rules for International Settlements in 1988.

Essentially, these rules tell the banks how much capital the banks should have to cover up for the risk those there loans might go bad. The rules set in 1988 led the banks to differentiate among the customers it lent out money to. Different weightage was given to various forms of assets, with zero per cartage weightings being given to cash, deposits with the central bank/govt etc, and 100 per cent weighting to claims on private sector, fixed assets, real estate etc.

The summation of these assets gave us the risk-weighted assets. Against these risk weighted assets the banks had to maintain a (Tier I + Tier II) capital of 9 per cent i.e. every Rs100 of risk assets had to be backed by Rs 9 of Tier I + Tier II capital. To put it simply the banks had to maintain a capital adequacy ratio of 9 per cent.

The problem with these rules is that they do not distinguish within a category i.e. all lending to private sector is assigned a 100 per cent risk weighting, be it a company with the best credit rating or company which is in the doldrums and has a very low credit rating.

This is not an efficient use of capital. The company with the best credit rating is more likely to repay the loan vis a vis the company with a low credit rating. So the bank should be setting aside a far lesser amount of capital against the risk of a company with the best credit rating defaulting vis a vis the company with a low credit rating. With the BASEL-II norms the bank can decide on the amount of capital to set aside depending on the credit rating of the company.

Credit risk is not the only type of risk that banks face. These days the operational risks that banks face are huge. The various risks that come under operational risk are competition risk, technology risk, casualty risk, crime risk etc. As per the BASEL-II norms, banks will have to set aside 15 per cent of net income to protect themselves against operational risks. So to be ready for the new BASEL rules the banks will have to set aside more capital because the new rules could lead to capital adequacy ratios of the banks falling. How the banks plan to go about meeting these requirements is something that remains to be seen. A few banks are planning initial public offerings to have enough capital on their books to meet these new norms.

In Closing:

Over the last few years, the falling interest rates, gave banks very little incentive to lend to projects, as the return did not compensate them for the risk involved. This led to the banks getting into the retail segment big time. It also led to a lot of banks playing it safe and putting in most of the deposits they collected into government bonds. Now with the bond party over and the bond yield starting to go up, the banks will have to concentrate on their core function of lending.

The banking sector in India needs to tackle these challenges successfully to keep growing and strengthen the Indian financial system.

Furthermore, the interference of the central government with the functioning of PSBs should stop. A fresh autonomy package for public sector banks is in offing.  The package seeks to provide a high degree of freedom to PSBs on operational matters. This seems to be the right way to go for PSBs.

The growth of the banking sector will be one of the most important inputs that shall go into making sure that India progresses and becomes a global economic super power.

New Account Opening:

The foundation of a customer’s relationship with a retail banking institution is shaped through the account opening process, as the vast majority of new account openings still take place face-to-face in a branch. From the customer’s perspective, critical first impressions of the institution’s quality, capabilities and trustworthiness are established. In large part, the institution’s brand promise is personified by the skills displayed by the front-line employee. From the institution’s perspective, the account-opening event provides the best, and possibly only, opportunity to comprehend customers’ needs and educate them on the appropriate financial solutions.

In most cases, the institution’s overall objective in the account opening process is to become the consumer’s primary bank. And for good reason: Previous national consumer research conducted by BAI reveals that consumers keep an average of 3.4 financial products with the institution they consider to be their primary bank, compared to only 1.8 products with institutions that are considered secondary. The primary bank captures the vast majority of wallet share as well.

The same research shows that consumers keep 90% of their total checking account wallet and 80% of their total savings and money market deposit wallet with their primary bank. In addition, the account-opening event represents a prime cross-selling opportunity. Detailed benchmarking of the deposit households of 19 large banks by BAI Research and MarkeTech Systems International in an earlier study reveals that 24% of the total cross-sales that banks obtain from their checking account households actually takes place during the account opening event, and another 4% of total cross-sales take place within the first 30 days following account opening.

However, some executives acknowledge that they ultimately need to cope with a deeper issue — front-line employee selection — to improve their organizations’ abilities to maximize the new account opening opportunity. Nearly eight out of 10 bankers surveyed responded that their staffs lack the adequate sales skills. Bankers broadly recognize that many of the employees hired for front-line branch positions lack the life experience and soft skills required conducting credible conversations with customers about their financial goals. Banks are fine-tuning their recruitment procedures to attract employees who have natural aptitudes for customer service, consultative selling and multi-tasking. Potential employees with prior retail sales experience are often sought.

Relationship Expansion:

Expanding client relationships, through efforts to increase balances held with the institution or through the sale of additional products, is a responsibility that front-line staff in branches and contact centers share with other areas of the bank. Direct mail is a major contributor to cross selling, as are promotions through online channels and the direct-sales efforts of investment, trust or mortgage specialists. However, previous consumer research and benchmarking conducted by BAI reveals that the average deposit household still conducts 17 branch-based service transactions and holds several conversations with a live contact center representative on an annual basis. This volume of front-line customer interaction suggests two key areas of opportunity.

The first is service quality, which lays a foundation that will eventually lead to increased share of customer wallet. Second, institutions are certainly missing relationship expansion opportunities if they do not provide the support mechanisms required for front-line staff to recognize opportunities and capitalize on them.

The key idea here is to recognize opportunities. Benchmarking of retail deposit households by BAI and MarkeTech reveals that it takes four or more years before banking institutions start to experience meaningful increases in retail deposit and loan cross-sell rates. After the initial account-opening event, relationship expansion opportunities tend to emerge slowly as a large portion of consumers. Consumers are not necessarily motivated by cross-selling offers from their financial institutions. A key to relationship expansion, earlier research suggests, is to provide customers with solid, reliable service quality and to use service transactions, when appropriate, to understand customer needs and educate customers about the options available to them.

On an overall basis, banking executives surveyed cross selling as very important, but are generally not satisfied with their results. Relating to oversight and measurement, a principal challenge experienced by banks of all sizes is the ability to measure the effectiveness of these models and ensure that cross-sell leads sent to the front-line are acted upon in a timely fashion, if at all. The research indicates that bankers recognize the importance of these challenges and are taking steps to address them.

Retention Management:

Heightened competition for consumers’ banking wallets and increased consumer mobility has elevated retention management to a top-of-mind concern for banks of all sizes, as reflected in recent research conducted by BAI. Customer retention is difficult to manage because there are a multitude of drivers that prompt customers to terminate relationships. Often these key drivers are interconnected, meaning that customers decide to defect due to a combination of circumstances that build up over time. The common controllable drivers of customer attrition include service quality problems, dissatisfaction with product pricing and/or minimum balance requirements, unexpected fees, and the attraction of a competitive product offer.

No matter their size or technological sophistication, all banks rely significantly on front-line staff to implement retention programs. Bankers in our survey recognize the urgent need to upgrade the skills set and training of their employees — 68% of the surveyed bankers stated that they needed to do a better job of giving front-line employees the tools and training required to identify and react to customers whose accounts are at risk.7. Successful retention intervention requires employees who can quickly pick up on the cues of a potential defection, formulate a response and effectively communicate a proposal to the customer. How quickly? Most executives agree that attrition intervention leads, as generated by centralized modeling units, must be acted upon within 72 hours, or it’s generally too late. That’s a lot to ask from otherwise occupied branch employees.

An Opportunity for Banks

Execution of relationship strategies is feasible for many institutions, but only if it is aligned with strategy and correctly supported by a variety of critical programs and activities. Our research suggests that vital investments in the three primary domains of relationship management activities — new account openings, relationship expansion and retention management — should be prioritized to directly support an institution’s top strategic growth initiatives.

Very few institutions will be able to simultaneously invest in all three domains, so competitive and market realities may dictate that some activities be valued more than others. For example, institutions that are based in mature, slow-growth markets may opt to prioritize relationship expansion among the existing customer base and invest in the related cross-selling capabilities. For institutions that operate under different market dynamics, prioritization of new household growth and new account opening competencies may be more appropriate.

No matter which strategy or domain is selected, The Factor shows that the vast majority of institutions share a common set of tactical opportunities to improve relationship management. For banks that focus on the new account-opening domain, the key is process improvements, as most institutions tend to be relatively more comfortable with the skill set of their front-line staff. The top performance improvement priorities across banks in this domain are the consistency and systemization of customer profiling, as well as the storage of this information for future relationship management efforts. Establishment of new customer on boarding processes is also important.

In the relationship expansion and retention management domains, certain process improvements in the areas of sales performance tracking and the use of cross-sell and attrition models are clearly warranted. However, the research also suggests that banks focus additional attention on the capabilities of front-line employees and supervisors. The need for additional staff training to identity customer retention and cross-sell opportunities is important, as is the need for front-line management to allocate more time to coaching and training.

Retail banking is a people-oriented business, and will remain so for some time to come. This point is driven home by the fact that 90% of the banking executives participating in our research state that their institutions are attempting to differentiate themselves via relationship banking or service quality. These value propositions are founded upon the institution’s ability to build trust based on a reliable, service-oriented delivery model that provides front-line staff with the capability of responding to customer needs. While technology and process can facilitate that objective, executing on that vision depends on front-line employees and their immediate managers. Quite simply, those who execute better will win.

We believe such achievements will increasingly require senior and mid-level managers to perform the type of assessment prompted by the factor: understand your front-line sales and service strengths and weaknesses and then determine your priorities for allocating management attention and financial resources to improve performance.