BT-KPMG Best Banks and NBFCs: Confronting the banking paradox

The banking sector hasn’t looked this strong in years. With assets worth `243 lakh crore, backed by strong asset quality, robust capital buffers, soaring profitability, and the Reserve Bank of India’s (RBI) proactive measures towards improving banks’ governance frameworks, one would expect smooth sailing ahead. But why are bankers fidgety?

That’s because they must contend with headwinds in the retail banking space, subdued private capex, falling low-cost deposit growth, competition from major corporates in the NBFC space, and must comply with the evolving regulations of a vigilant regulator.

That said, the best in the space will thrive. And the 28th edition of the BT-KPMG Best Banks and NBFCs Survey 2022-23 is proof of that. The study celebrates those that have weathered the storms in FY23, innovated in products and services, nurtured talent, and leveraged the strengths of fintech or technology partners to prepare for the future. 

But pain points persist. Here are the significant ones.

Retail Banking Pangs

In recent years, the banking industry has seen a significant increase in retail assets, driven primarily by the rapid growth of the unsecured loan book—think personal loans, credit cards, and micro loans. Sensing the possibility of overheating, the RBI has increased the risk weights for unsecured loans, requiring higher capital allocation for both banks and NBFCs. This is expected to slow consumer lending and reduce yields, as unsecured loans typically offer higher returns than mortgages.

“While economic growth remains strong, any sustained slowdown could see a sharp spike in non-performing assets (NPAs),” says Deepak Jasani, Head of Retail Research at HDFC Securities, adding that banks need to fine-tune their credit appraisal systems to protect themselves from NPAs in the unsecured book. At the same time, banks are scaling up under-penetrated businesses that offer potential for growth, such as business loans, MSME loans, consumer durables loans, and micro loans.

Private Capex Struggles

On the corporate front, loan activity remains subdued because of delayed capital expenditure by India Inc., despite government spending and the production-linked incentive (PLI) scheme. But there are signs of a pick-up as listed firms have reported double-digit growth in overall capex on a trailing 12 months basis as of September 2023, says Amey Sathe, Fund Manager at Tata Mutual Fund. “We expect private capex to pick up sharply, especially in the second half of FY25,” he says. Bankers also point towards a lending uptick in segments such as renewables, roads and ports, and construction.

Bankers say corporate lending has evolved beyond disbursing loans to include managing salary accounts on the liabilities side, offering forex and other trade-related fee-based services, and selling retail assets. “Banks are deepening their relationships with existing corporates to cross-sell other banking products, thereby improving overall returns,” says a public sector banker, who declined to be identified. There is also less concern about asset quality in the corporate book. “When the red flag is raised by lenders, promoters take action and try to find a way out of the [Insolvency and] Bankruptcy Code,” says Daizy Chawla, Managing Partner at S&A Law Offices.

Another trend is bond funding, as many infra projects need long-term financing. “We see a growing trend of corporates relying on non-bank sources for funding,” says Vishal Goenka, Co-founder of IndiaBonds.com, a Sebi-registered online bond platform provider.

Deposit Growth Dilemma

Then there are challenges on the liabilities side, with bank deposits—especially low-cost current account and savings account (CASA) deposits—growing at a slower pace than lending. Some banks are enticing customers with higher interest rates on fixed deposits, leading to a decline in the CASA ratio. India Ratings & Research explains this decline as the movement of savings from CASA to better-yielding products. Further, banks are also losing savings accounts to mutual funds and the equity market. Uday Kotak, Founder and Director of Kotak Mahindra Bank, believes that India is transitioning from a nation of savers to investors, posing a long-term challenge for the banking sector, which relies on CASA deposits as its primary funding resource.

A recent Goldman Sachs report warns that the financial sector’s era of strong growth and profitability may be coming to an end due to headwinds such as rising pressure on the cost of funds, concerns about rising consumer leverage—particularly in unsecured lending—and elevated wage inflation impacting operating costs.

Competition From Non-Banks

Competition is increasing in the NBFC space, with the entry of major corporate houses such as Reliance, Piramal, Godrej, and Poonawalla. “There is more than enough room for every player in the market... Any organisation that is agile, pragmatic, and strong on business ethics should be able to manage the impact of competition, regardless of its size,” says Sathe.

NBFCs from corporate houses aim to fill the credit gap in the space. “Entities that are agile and adapt to the fast-changing landscape, and have ample capital and risk-taking ability, may benefit the most,” says Jasani.

While RBI’s recent move imposing higher risk weights for banks funding NBFCs could restrict fund flows to these entities, India Ratings says NBFCs have begun to grow their franchise in an asset-light manner by engaging in co-lending and business correspondent arrangements with other lenders.

A Vigilant Regulator

Bankers also have to deal with an active regulator that is keen to avoid mishaps such as those in the past involving YES Bank or IL&FS. During a recent meeting with banks, RBI Governor Shaktikanta Das emphasised the importance of sustained vigilance. He highlighted several critical areas, including the viability of business models, the concerning trend of excessive growth in personal loans, adherence to co-lending guidelines, and banks’ exposure to NBFCs.

Rajeev Yadav, MD & CEO of Fincare Small Finance Bank, which will merge with AU Small Finance Bank on April 1, notes that RBI’s focus on continued vigilance against potential risks is particularly relevant for small finance banks due to their focus on underserved segments. “The surge in personal loan growth, while positive for financial inclusion, necessitates close monitoring and responsible lending practices,” he says.

The Way Ahead

While challenges persist, the next three to five years are poised to be exciting for the space with players creating a foundation for the future by investing in technology. Bankers say the use of Generative AI (Gen AI) is showing positive results across industries and has the potential to deliver significant value to the sector, by enhancing service quality and improving overall efficiency. “Scaling up capabilities through Gen AI remains a key challenge. Considering the banking sector is regulated, the probability or risk of massive disruption is relatively low,” says Sathe.

“The current (banking) cycle is likely in its early- to mid-stages. This suggests that asset growth will be robust, and growth on the liabilities side will be reasonably steady. NPA formation will generally be minimal... Nonetheless, the core business for banks will remain healthy,” says Kaustubh Kulkarni, Senior Country Officer-India and Vice Chairman-Asia Pacific, J P Morgan.

With India aiming for a $30-trillion economy by 2047, the financial sector is a significant growth engine. Kotak says that achieving a balance between appropriate regulation, risk management, and growth aspirations is crucial for the players, regulators, and the government.

Finding this balance is key.

 

@anandadhikari