ARE INDIAN BANKS MAKING EXCESSIVE

MARGINS AND PROFITS?

The Reserve Bank of India's governor has been lately coaxing Indian banks to lower
their net interest margins and improve efficiencies. So are Indian banks making
excessive margins and excessive profits? Srinivasan Varadarajan executive director
of Axis Bank, Professor TT Ram Mohan of IIM Ahmedabad and Anindo Bhowmik
banking analyst from Fitch Ratings talk about the issue of bank profiteering.

Here is the transcript of the interview. Also watch the accompanying videos.

Q: Average Indian public sector banks' net interest margins (NIMs) have been
over 3% and that of private sector banks like yours and HDFC comes to 4%,
while Stanchart’s Indian Depository Receipts (IDR) boasted NIMs of about
2.2%. So are Indian banks charging excessive NIMs?

Varadarajan: You will have to look at the context in which banks operate. If you will
look at Indian banks, you have got a market in which the capital market is not
necessarily fully developed. So to that extent the composition of loans versus the
other capital market products are going to be very different. The other contributor is
also the geographical reach and the operating expenses which banks carry as far as
Indian banks are concerned. Clearly in terms of resourcing, technology and every
other aspect of operations, I think Indian banks have lot more to do in terms of
making sure that our operating expenditure (OPEX) is much lower.

Q: But BPO companies are shifting here, many foreign banks’ labour intensive
work is done here, so we should be cheaper?

Varadarajan: One factor is OPEX and the other of course is the credit cycles here,
which are lot more volatile, more vicious than most other jurisdictions. So to that
extent you have got to look at it in the context at which Indian banks operates and
you will have to look not just at NIMs, but again net of expenses and credit cost.

Q: Indian banks did have a problem of excessive OPEX branch intensive

branching; if you looked at the last seven to eight years, you did find that the
net of the treasury gains, the return on assets (RoA) was as low as 0.5% and
0.8%, but today on an average it's about 1.2%. So clearly returns have
improved.

Likewise even if you looked at staff costs, they used to be 2.5-3% of total
assets, now they have fallen to 1.5-1.6%. So is it justified, at one point yes, it
was perhaps a more intensive cost priority sector, all that imposing costs on
Indian banks. But now clearly this fascination or this obsession with 3% plus
margins is unwarranted, isn't it?
Mohan: If you look at the trends and the net interest margin in the post deregulation
period for nearly about 10 years it was almost static at about 2.8% of total assets.
But in the last three years, we are seeing a decline. So starting in 2006-2007 it fell to
2.6% and in the last year for which we have data 2008-2009 it had come down to
2.4%.

So there is a declining trend in net interest margin (NIM). One reason for that could
be that earlier public sectors banks, which really shore up the NIM, had not woken
up to the potential for fee income. Now that they have woken up to the potential for
fee income, they are in a position to offer a lower net interest margin.

So we are seeing the beginning of a trend, but this is not something that you can
artificially accelerate because there are fundamental reasons why the net interest
margin in a context like India's may not come down for a long period of time. I say
this because you expect the NIM to decline with the deregulation and greater
competition and also with greater disintermediation. So as the financial sector
evolves, you will expect the borrowers to migrate to capital markets. So banks have
to reduce their lending rates in order to keep them. You also expect the depositors to
migrate to alternative capital market instruments. Thus you expect banks to hike the
deposit rates.

So for both these reasons you expect the NIM to decline because banks are
squeezed on both the sides. But in India disintermediation has not happened. In fact,
the opposite has happened. If you look at intermediation as measured by say the
bank deposit to GDP ratio or the bank credit to GDP ratio, it has gone up enormously
in the last few years. That is because when we started deregulation we were an
under-banked economy and we still are. So as the economy moves out of the under-
banked status and more and more people are brought into the banking system,
intermediation grows and in a context of growing intermediation you cannot expect to
see too much of a decline in net interest margins.

Q: Partially, it appears that a lot of banks are making money because we are an
under banked economy. As long as we are under banked and the demand is
more than the supply, banks are able to get away with a higher lending rate. If
you looked at the top 15 banks including private and public sector, their
averages have clearly moved higher and are all North of 3%. This average
might get down because of some of the operators, but on an average, the top
banks at least have clearly moved from a sub 3% to more than 3%. Don't you
think that bankers here are making away with more?

Bhowmick: Comparing the margins that Indian banks have vis-à-vis other emerging
markets, the 3% number is not necessarily very high, when we put it in context of the
kind margins that Latin American Banks or even banks in many parts of Asia like
Indonesia has.

That possibly might have to do with the portfolio composition. It is perhaps the level
of consolidation that we have in the banking system. Competition is also one of the
reasons that account for somewhat higher margins in other geographies.

Q: Do you mean there is lack of competition?

Bhowmick: Indian market is far more competitive, if you compare the market share
of top five banks which are around 40% for India, whereas in a Latin American
country, it is around 70-80%.

We do see higher margin there which is the point. The margins could have been
higher, but there is more competition. In an economy like Taiwan where competition
is intense, net interest margins are under 1.5%. NIM is the first line of defence that a
bank has against credit costs.

On a long-term basis, the kind of credit cost that Indian banking system is reporting
currently, is necessarily an adequate reflection of buffers that the banking system
should have against counter cyclical situations, partly reflected by the kind of specific
loan loss reserves that the banking system has. On an average, it is lower by many
other emerging market banking systems.

Without commenting on whether necessarily the margins are high or low, it's a good
time to use some of those margins. Return on assets (ROA) at 1% is attractive, to
use some of those profits to actually provide better in good times.

Q: Do you think our margins is competition enough now to pull down margins
in the quarters to come? Or do you think it will be a while before that
happens?

Varadarajan: Ultimately, the market decides. The deposit costs have gone up over
the last few months. The lending rates have gone up. There is a continuous pressure
on NIMs. These are the cycles which we need to go through. The market will decide
in terms of what NIMs we can live with. There are pressures for it to sort of nudge
lower over a period of time over the medium term.

Q: Would you expect that there are forces at work which will pull it down? Or
do you think considering that we are under banked, at least the top 10-15 will
still be able to make much better margins than their developed country
competitors?

Mohan: If we look at trends in NIM, we look at the composition of loan portfolio. As

we get more retail loans, where certain types of retail loans tend to predominate like
vehicle loans, credit cards or even loan made to small borrowers, we will see an
increase in lending rates resulting to an increase in margins.

If microfinance institutions (MFIs) lend at 24%, which is the Malegam recommended

rate and if banks started lending to the same borrowers at 18%, it would be still
higher than the rates they are charging now.

As banks extend their loans to newer types of borrowers and retail borrowers, we will
expect the lending rate and the NIM to go up, which is not necessarily a sign of
inefficiency.

Q: Do you mean that RBI governor is unjustified in the request he is making?

Mohan: It's good for the regulator to be always on the side of the consumer and to
seek a reduction in rates. It's appropriate for the RBI to take that kind of a stance and
to keep the consumers interest in view. It should not look like some kind of systemic
defect or sign of inefficiency in the system, as it is not substantiated by the numbers
or the larger trends.

Q: Global banks do have a way more retail audience. We do often find the large
corporates moving away from banks and completely into the capital markets.
In spite of it, they have lower margins than Indian banks and developed
country competitors. Are the RBI Governors coaxing because he is on behalf
of the customer, or is there a justification that these margins need to come
down?

Bhowmick: The Indian banks also have portfolio of somewhat higher riskier pieces
as well, including lending to smaller industries or smaller companies, where the risk
return paradigm maybe different.

When the Governor spoke about lower margins, he might have referred to need for a
higher deposit cost in the context of increasing loan-to-deposit ratios. The trend for
NIMs for Indian banks has a cyclical element to it, which would get influenced by
price of deposits and banks’ ability to pass that on to customers.

There is a very encouraging trend in terms of the improving profile of the liabilities
including the low cost deposits. It will be a crucial differentiator between banks as far
as margins are concerned.

Tags: RBI, reserve bnak of india, NIM, bank profit, Srinivasan Varadarajan, Axis
Bank, TT Ram Mohan, IIM Ahmedabad, Anindo Bhowmik, Fitch Ratings