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Creative destruction in Indian banking

In our haste to clean up the current NPA mess, we must not suffocate our nascent alternative banking construct

Creative destruction in Indian banking

Thanks to the RBI governor's intervention last year, the Indian banking system's woes are finally well understood. At the end of FY16, about 17 per cent of public-sector banks' (PSBs) assets are stressed. Again, if we optimistically assume that only a third of these assets will be written off, that would imply that nearly 50 per cent of the shareholders' equity of PSBs will be written off by the end of FY18. Based on FY16-end numbers (i.e., without assuming any incremental equity requirement for PSBs to fund future loan-book growth), that would imply that PSBs need $30 billion (equivalent to nearly 1.5 per cent of our GDP) equity infusion over FY17 and FY18. Such a figure compares to the $4 billion budgeted by the finance minister for infusion into PSBs in FY17 and the $7 billion promised by the finance ministry for PSBs over FY17-19. In short, it is highly unlikely that the government will be able to find the resources required to recapitalise the ailing PSBs.

Capital aside, PSBs - with a few notable exceptions such as State Bank of India, Bank of Baroda, Union Bank of India - also have major deficits with regard to their IT systems and their access to managerial talent. Even if the capital were forthcoming, the technology and the talent would still be unresolved issues hampering the PSBs' road to a highly unlikely recovery.

So, why does this matter? In a country full of deficits, why are we bothered about yet another deficit? Until a decade ago, PSBs used to account for nearly 90 per cent of the loans outstanding in India. After steadily losing market share to the private sector, PSBs now account for 70 per cent of the loans disbursed. Hence, even if we assume that only the bottom half of PSBs ('bottom' from an asset-quality perspective) run aground, that still accounts for nearly 40 per cent of the loans outstanding in the country. As we wheel these bottom-half PSBs into the ICU, we still don't know who or what institution will replace these PSBs in the humdrum but important job of disbursing credit to millions of Indian citizens and hundreds of thousands of small and medium enterprises (SMEs).

Until a year ago as the credit-quality crisis in India gathered steam, we were staring into an abyss. Now, however, the tantalising combination of three different initiatives taken by different arms of the Indian government over the past four years has made it possible for us to envisage a way forward in the post-PSB world:

  • The roll-out of Aadhaar since 2010 has meant that now nearly a billion Indians have unique identification numbers, along with biometric identity proof.
  • The roll-out of Jan Dhan by the NDA from August 2014 has resulted in 219 million bank accounts being created and now more than 95 per cent of Indian families have at least one bank account.
  • The launch of the Unified Payments Interface (UPI) by the National Payments Corporation of India (NPCI) and the RBI in April 2016 has meant that there is now a publicly available payment 'bridge' between all Indian individuals and firms. If the trials being conducted on the UPI are successful, then it will be the first such bridge of its form in the world, where a modern and sophisticated mode of instantaneous P2P payments through any bank (or any payment-service provider) using smartphones has been developed through regulatory push for industry-wide application.

The combination of these three initiatives creates new possibilities for financial institutions, both on the asset side and on the liability side:

  • Big-data-based lending: Rapid technological advances made in analytics are changing the way lending is being done. In China, Alibaba's financial arm, Ant Financial, in a short duration, has scaled up a range of financial products varying from online payments to lending to credit scoring. Carved out in 2011, Ant Financial and its flagship product Alipay command more than 82 per cent share in China's online-payment market. This, combined with other services such as wealth management, provides Ant Financial access to rich data (e.g., shopping history, utility bills, work and home addresses, property, family links). Analytics on this data have enabled Ant's lending business to cater to small businesses which were previously neglected by banks due to sub-par credit scores. Among the online marketplaces in India, Flipkart, Snapdeal and Amazon have begun offering working-capital loans to their merchants using merchants' selling patterns, ratings, customer feedback and social-media profile for credit scoring.
  • Liability-side innovation: Using the UPI-NPCI bridge, payment banks and small-finance banks licensed by the RBI in 2015 can extend their reach into the wallets of the 300 million Indians who receive subsidy payments from the government. Using mobile phones, rather than branches, these new types of banks can hoover up the savings of not just the currently financially excluded constituency but also of salaried middle-class workers who at present receive sub-par interest rates from their banks. Such savings-account portability will become easy if employers pay salaries to employees' Aadhaar numbers from where UPI-NPCI directs the payment to the account chosen by the employee. In effect, the UPI will make the money in savings accounts fungible between accounts. The payment bridge will make the account itself portable. Thus, if a new upstart bank offers better savings rates, employees can individually map their Aadhaar numbers to the new bank's accounts (rather than waiting for the employer to make the decision for the entire company). If one keeps in mind that accounts with less than `1 lakh of savings account for 80 per cent of the corpus deposited in the savings accounts in India, the scale and scope of the disruption becomes evident. Clearly, there are several major unanswered questions regarding the transition from the current morass to the brave new world of technology-driven banking. Most notably:
  • We haven't yet seen any one bank in India nail down the technology on both the asset and the liability side. In part, this is a function of regulation because payment banks have been focused by the RBI on the liability side, whereas small-finance banks - with their microfinance origins - have a greater asset-side orientation.
  • The scope for IT glitches, especially on the liability side, is considerable, and with the savings of millions of low-income people on the line, there is scope for heavy political interference.
  • The RBI has historically been a conservative institution, with a focus on preserving the status quo. Raghuram Rajan has been a breath of fresh air in this regard, but is the rest of the RBI behind him? PSBs are so enfeebled at present that in FY16 their loan books grew by a mere 1 per cent, thus depriving SMEs of much-needed funding. The alternative banking system has barely taken shape. It is not clear, therefore, how India swims through the timing gap between the exit of weaker PSBs and the rise of the alternative banking system. For the first time, we have a ray of hope coming from a new generation of banks in India that, in the aftermath of the PSBs' evisceration, will create a more efficient and more effective banking system. It is important that in our haste to clean up the current mess we do not suffocate our nascent alternative banking construct.

Saurabh Mukherjea is CEO - Institutional Equities at Ambit Capital and the author of Gurus of Chaos: Modern India's Money Masters.

This column appeared in the July 2016 Issue of Wealth Insight.