Banking Sector in India- Challenges and Opportunities

Banks are the institutions providing primary banking services like accepting deposits
and providing loans. Financial services are also provided by the non banking institutions
although they do not meet the legal definition of a bank. Banks are a subdivision of the
financial services industry. India is among the top 10 economies in the world with the
banks having tremendous potential to grow. Customers embraced ATM, internet and
mobile banking during the last decade. Current valuation of Indian Banking Sector is
Rs. 81 trillion (US$1.31 trillion). It is estimated that it will become the fifth largest
banking industry in the world by 2020 and third largest by, according to an industry
report. The 2025 face of Indian Banking has been changing over the years. But the
world is changing at a very fast pace. Every day brings with itself a new challenge and a
new opportunity in the dynamic globalised environment.

One of the biggest challenges faced by the Indian Banks today is the NPAs. In India,
the RBI has defined NPA as follows, if for a period of more than 90 days, the interest or
installment amount is overdue then that loan account can be termed as a Non-
Performing Asset. The financial crisis that originated in the United States in 2008 laid
the foundation for much of today’s non-performing loans plaguing the Indian banking
sector. The financial crisis emanating in the US reached the Indian shores and impacted
the markets in India as well. Money markets nearly seized up and rates went through
the roof. Foreign investors stampeded for the exits. Ex-RBI governor Raghuram Rajan
started a clean-up of bank balance sheets by a similar asset quality review (AQR).The
Financial Stability Report, 2017, released by the RBI, states that India’s gross NPAs
stands at 9.6%. India has the second highest ratio of NPAs among the major economies
of the world. The RBI’s Financial Stability Report names the basic metals and cement
industries as the most indebted, with 45.8% and 34.6% stressed assets respectively.
The metals industry continues to be hamstrung by slow demand and cheaper imports.
The construction, infrastructure and automobile industries also account for a noticeable
volume of banks’ NPAs. State Bank of India leads the list of scheduled banks with the
highest NPAs with Rs.1,88,068 crores of stressed assets. Punjab National Bank and
IDBI Bank follow suit with Rs.57,721 crores and Rs.50,173 crores of gross NPAs
respectively. The gross NPAs of public sector banks increased by 311.22% in 2017 as
compared to 2013. Likewise, the gross NPAs of private banks witness an increase of
269.47% in 2017. From 2000-2008, the Indian economy was in a boom phase and
banks, especially public sector banks, started lending extensively to companies.
However, with the financial crisis in 2008-09, corporate profits decreased and the
Government banned mining projects. The situation became serious with the substantial
delay in environmental permits, affecting the infrastructure sector – power, iron, and
steel – and resulting in volatility in prices of raw materials and a shortage of supply.
Another reason is the relaxed lending norms adapted by banks, especially to the big
corporate houses, foregoing analysis of their financials and their credit ratings. In case
the RBI asks banks to classify the loans as NPAs with retrospective effect, it will have
severe implications on their balance sheets. Provisions for bad loans increase along
with the age of the NPA. For instance, a loan that has been classified as an NPA over
five years ago would have to be fully provided for by now, whereas for a loan that has
just slipped into NPA, the provision might be around 20% of the outstanding amount.

Capital adequacy is yet another big challenge for banks. With increase in the NPAs and
frauds, capital of the banks drains. For example, PNB lost Rs. 13,000 crores due to
banking fraud just when the government had infused Rs. 11,000 crores to increase its
capital. The Basel III framework is developed by the Bank for International Settlements
to promote the stability in the International Financial System and to emphasize on
improvement of quality and quantity of capital components, leverage ratio, liquidity
standards, and enhanced disclosures.
Table 1. Minimum regulatory capital prescriptions (as % risk weighted assets).

Basel III Current Basel III

(as on (Basel (as on March
January 2019) II) 31, 2018)
A = (B + D) Minimum total capital 8.00 9.00 9.00
B Minimum tier 1 capital 6.00 6.00 7.00
C of which:
Minimum common equity 4.50 3.64 5.5
tier 1 capital
D Maximum tier 2 capital 2.00 3.00 2.00
(within total capital)
E Capital conservation buffer 2.50 2.5
(CCB)
F=C+E Minimum common equity 7.00 3.60 8.00
tier 1 capital + CCB
G=A+E Minimum total capital + CCB 10.5 11.5
H Leverage ratio (ratio to total 3.00 4.55
assets)
(Source: Address by Dr. Duvvuri Subbarao, September 4, 2012).

The Banks require additional capital to meet the capital adequacy ratio. The Indian
PSBs need Rs. 2.4 lakh crore by 2019 to meet the norms which will be a herculean task
for the banks as they have a large amount of bad loans on their books. The capital
infusion plan by the government is expected to provide a boost to the capitalization of
banks.

With increase in the credit demand because of increased investment in infrastructure

and financial inclusion, which both RBI and government are driving, will bring millions of
low income households into the financial system with many of them needing credit. This
means that banks will have to maintain higher capital requirements at the time when the
demand for credit will be expanding. This will increase the cost of credit and will go
against the growth of the economy. The introduction of leverage ratio of 3% as the ratio
of Tier I capital to total exposure will lead to decrease in the profitability of the banks as
it limits the extent to which banks can do profitable lending.

Risk management is an essential part of the functioning of banking sector. Mainly the
banks have to face two types of risk management challenges: credit risk and
operational risk. Credit risk is the risk which a bank is subjected to because of the
defaults made by any debtor. Inefficient data management and constant reworking can
be two big challenges in credit risk management.
Operational risk is the risk of effects on a bank’s financial results and capital caused by
any shortcomings in employees’ work, inefficient management of information and
internal procedures and processes, as well as by unforeseeable external events. It also
includes legal risk. As was seen in the fraud case of PNB, wherein, a few employees
were allegedly helping Nirav Modi and Mehul Choksi to take credits by issuing LoUs &
FLCs. These incidences are examples of corruption prevailing in the Indian Banking
System.
Another major challenge for the Indian banks is cyber threats. The proliferation of
smartphones and internet has definitely delivered convenience to customers but it has
also manifested the evils of hackers and cyber crimes. In 2017, it was reported that over
200 people in Bengaluru lost approximately Rs. 10 lakh to ATM frauds within a week.
Phishing and card skimmers are widely used for breaching customers’ accounts. “Social
security, bank account, and credit card numbers aren't just data. In the wrong hands
they can wipe out someone's life savings, wreck their credit and cause financial ruin.”-
Melissa Bean
Almost all the banks have faced this and thus are losing the trust of their customers. On
one side where technology and financial inclusion are being targeted, cyber threats are
deterrents-hurdles to be skipped very diligently.
Frauds are probably the biggest fear a bank lives in because of the fact that it thrives on
the payments made against the loan customers have taken from it. The increasing
numbers of NPAs & FIRs are alibis to the dangerously increasing cases of frauds. To
detect frauds is one of the most difficult tasks on part of the banks. Credit lending was
quite easy a few years back and therefore banks used to lend carelessly which has led
to a lot of frauds uncovering only now when a lot of policy changes have happened.
Vijay Mallya & Nirav Modi are names on the lips of everyone because of the alleged
fraud they committed leading to a loss of trust among the citizens. Frauds take a toll on
the capital of the banks too and leave them in need of new capital inflow.
These challenges are not the only pictures in the economy right now. A new pool of
opportunities lies in front of the banks which they should utilize for their benefits.
Perhaps the biggest opportunity for them is to tap the rural market. Although the
banking sector has reached the rural market, but they have not given much attention to
the opportunities offered by this segment because of the lack of infrastructure in rural
areas and an increased focus on the urban sector. Because of unavailability of the
organized sector in the rural market, the informal credit sector has been thriving and is
able to lend as high as 25-36% per annum depending on the borrower’s risk profile.
Some nationalized and private sector banks have adopted inorganic growth strategy to
face upcoming challenges in banking industry. ICICI Bank Ltd. Merged with The Bank of
Rajasthan Ltd. to increase its reach in the rural market. With the introduction of better
credit delivery systems in the rural sector, it will be a win-win situation for both the banks
and the creditors as banks can cater to the requirements of large population and
creditors can get credit at rates lower than the unorganized sector.

Financial Inclusion is the availability of the financial services and equal opportunity to
access them by each and every individual. This is the vision of the government and
hence a fresh target for the sector. Retail deposits are slothful, cheap and unaffected by
risks as compared to wholesale funding. With financial inclusion, banks will get an
opportunity to pick up large amount of funds from a vast customer base which will
enable them to reduce their costs and risks, and thus make them more stable and
profitable. For any industry, the biggest opportunity in today’s world is technology.
Technology has been developing at lightning speed and therefore to increase customer
base and to improve customer satisfaction, technology has a vital role to play.
Technologies like block chain can be used in banking sector to make it more
transparent and safe. Banks like HDFC & ICICI are now experimenting with robotics
and AI to give customers a better experience and also ease the work burden of
employees. HDFC already has a humanoid Ira employed at a Mumbai branch. IoT,
digital banking and other emerging technologies should be included as soon as possible
for this sector to flourish.

The banks should also consider “raising capital” to address the problem of NPA.The
government could create a provision and transfer unclaimed deposits to its account.
These funds in return can be transferred to banks as capital. Banks with retail
franchisees should create value by auctioning a bank assurance association rather than
running it themselves as an insurance company. The current set-up blocks capital
inflows and doesn’t generate much wealth for the owners. At present, the RBI asks
Indian banks to maintain a certain limit on CRR on which the RBI doesn’t pay interest
and hence, banks lose out a lot on interest earnings. If the CRR is made more
financially rewarding for banks, it can reduce capital requirements. The US Federal
Reserve spent $700 billion to purchase stressed assets in 2008-09 under the “Troubled
Asset Relief Program.” Indian banks can adopt a similar arrangement by involving the
RBI directly or through the creation of a Special Purpose Vehicle (SPV).The
compensation structure and accountability of banks create a problem for the market.
Banks should be governed by a board while aiming to reduce the government’s stake
and making the financial institutions attractive to private investors. The problem of NPAs
in Indian banks can be effectively monitored and controlled, allowing the banks to
achieve a clean balance sheet.

Hence, we do see that the banking sector in India has both challenges and
opportunities. But the beauty of any win lies in the graceful act of fighting challenges
and tapping opportunities. And to excel, the banking sector has to put all its might to do
this, for it is after all, the backbone of the economy.