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ndian Banking Sector Outlook - 2013

Over the past couple of years, the Indian banking sector has displayed a high level of resiliency in the face of highdomestic inflation, rupee depreciation and fiscal uncertainty in the US and Europe. In order to stimulate the economyand support the growth of banking sector, the Reserve Bank of India (RBI) adopted severe policy measures such asincreasing the key monetary policy rates such as repo and reverse repo 16 times since April 2'009 to Oct 2011 andtightening provisioning requirements. Amidst this economic scenario, the key challenge for the Indian banking system

continues in improving their operational efficiency and implement prudent risk management practices. Some of thekey trends expected to emerge in the near future are as under-Economic slowdown likely to impact the demandfor credit

High interest rates, subdued industrial production and domestic consumption impacted the growth of the Indianeconomy which slowed down from 8.4% in FY11 to 6.5% during FY12.The scheduled commercial banks' (SCBs)overall credit grew at a slower pace during FY12 at 17% y-o-y as compared to 21.5% registered during FYll.As perthe recent RBI data, the non-food bank credit increased by 15.5% in Oct 2012 over its corresponding month previousyear, as compared to 18.2% witnessed in Oct 2011 over its corresponding month previous year. Similarly, credit toindustry and services sector recorded a slower growth of 15.2% and 13.7% respectively as against 23.1% and 18.4%during the same period. As per RBI's second quarter review of monetary policy for FY13, the GDP growth estimatesfor FY13 is revised downwards from 6.5% forecasted earlier to 5.8%.Any further slowdown in the Indian economicgrowth is likely to impact the demand for bank credit.

RBI may lower key policy rates, if inflationary pressures ease

Inflation continued to remain sticky and much above the RBI's comfort zone through-out the year. In fact headlineinflation as measured by WPI remained above 7.5% from Feb to Oct 2012. As a result the RBI has kept the repo rateat an elevated level, reducing it by 50 basis points only once during 2012, in April-12 to support growth.

However, in order to support the flow of funds to the productive sectors of the economy and ease the liquidity crunchin the banking system the RBI has cut the CRR by 175 basis points during the course of the year which stands at4.25%, as on Nov 2012. Given the easing of international commodity prices, particularly of crude, decline in coreinflation as demand conditions moderate, there has been some steady moderation in inflation in the recent period. Asa result the RBI might decide to ease the policy rate during end Jan 13.

Asset quality will need to be closely monitored

During FY12, asset quality of banks was severely impaired, as revealed by the steep increase in non-performingassets (NPAs) of SCBs, particularly for public sector banks (PSBs) owing to their significant exposure to troubledsectors such as power, aviation, real estate and telecom. There was a significant increase noted in the NPA levelsduring FY12. Gross NPAs value recorded a y-o-y growth of

45.3% and net NPAs registered a y-o-y growth of 55.6% during FY12. As per RBI, this increase was due toinadequate credit appraisal process coupled with unfavorable economic situation in the domestic as well as foreignmarket.

Apart from increase in NPAs, the weakening asset quality trend was also apparent from the significant increase inrestructured assets. Restructured standard advances of the SCBs, recorded a y-o-y growth of around 58.5% duringFY12 and the ratio of restructured standard advances to gross advances also increased from about 3.5% in FY11 to4.7% in FY12.

As per the recent data available with CDR cell as on Sep 2012, a total of 466 cases have been referred to the cell,with 327 cases amounting to Rs. 1,873.9 bn have been approved since the start of CDR mechanism. Of the totalcases referred, 64 cases corresponding to Rs. 311.2 bn were under finalisation of restructuring packages as on Sep2012 as compared to 34 cases amounting to Rs. 264.5 bn as on Sep 2011.

The slowdown in the economy increases in the risk of default and restructuring of loans can increase which couldfurther lead to deterioration of asset quality. However, implementation of stringent policies could prevent a sharpdeterioration in asset quality.

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More impetus on fee based and non-interest income services

Traditionally, banks have derived limited income from fee based services such as wealth management, credit cardservices, treasury services, investment banking and advisory services. However, as the economy is showing signs ofslowdown and the demand for credit is slowed banks are struggling to keep their margins intact. Also, with changingtimes, consumer needs have changed with various avenues of investment available. This is likely to increase banksfocus on offering fee based services as the earnings from such services are more stable than interest bearing

products and it also helps in mitigating risk via diversification of products and services.

Financial inclusion to play a key role in the near future

As per census 2011, huge section of Indian population is still unbanked. The overall percentage of householdsavailing banking services in India stood at around 59% as on 2011, which means still over 40% of total households,lacks access to formal banking services. This is largely driven by rural areas and/or low income group (LIG)population, due to their financial illiteracy, low level of income and savings, lack of collateral and absence of verifiablecredit history.

Thus, in recent years, the RBI and Gol have increased its focus on providing formal banking/financial services to thehuge unbanked population. It is encouraging banks to develop low cost products and services designed to suit therequirements of this group of population.

RBI has undertaken several policy initiatives to promote financial inclusion, such as encouraging opening of no-frillsaccounts, engaging intermediaries to provide financial and banking services. In the course of action, there has beenincrease in number of no-frill accounts frorh 50.3 mn in FY10 to 105.5 mn in FY12, registering a CAGR of 44.8%during this period. Similarly, the number of business correspondent (BC) agents also noted a CAGR of 70.2% duringthe same period.

RBI also advised banks to allocate minimum 25% of the total new branches in unbanked rural centres during a year.In the process, the number of banking outlets in villages with population above 2,000 and less than 2,000 alsowitnessed a CAGR of 73.5% and 55.7% during FY10 to FY12.

Further, in India there are several micro-finance institutions (MFIs) and self-help groups (SHGs) which lend credit tothe LIG. This is expected to play a significant role in achieving financial inclusion by extending' credit to the LIG.

Banks will expand In overseas market

In order to sustain the business growth amid highly competitive market and slowing Indian economy, banks are likelyto expand in the overseas market. They will try to tap emerging opportunities by expanding into newer markets suchas Africa, former Soviet region and other South East Asian countries, in which India has maintained good traderelations. They can set up captive operations or expand through inorganic means by undergoing M&A with banks inforeign countries. However, high capital cost for setting up foreign operations can act a deterrent in the way ofexpansion.

Mobile banking, next major technological leap

With the adoption of technology, the Indian banking sector has undergone significant transformation from localbranch banking to anywhere-anytime banking. Over the past couple of years, there has been huge growth registeredin the number of transactions done through mobile devices. As per RBI, there were 49 banks with a customer base of

about 13 mn offering mobile banking services as at the end of Mar 2012. During FY12, around 25.6 mn mobilebanking transactions valued at Rs. 18.2 bn were transacted, recording a growth of 198% y-o-y and 174% y-o-yrespectively. This rapid growth is driven by availability of 3G/4G network, increasing number of smart phones andseveral telecom companies offering economical data usage packages.

In order to encourage cashless transactions, particularly for small value transactions, the RBI raised the cap onmobile banking without end-to-end encryption from Rs. 1,000 to Rs. 5,000. Further, the transaction limit of Rs. 50,0p0per customer pep day was removed, by permitting banks to fix the transaction limits based on their own riskperception.

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In the near term, it is expected to emerge as one of the most preferred medium for banking transactions.

Competition set to intensify

In Aug 2011, the RBI drafted guidelines for licensing of new banks in the private sector. Thus, with the entry of newplayers in the market, competition among banks will increase. This is expected to benefit the consumers in the long-run as with increased competition banks will adopt fresh strategies to retain and attract customers and protect theirmarket share. For instance, increasingly banks are tying up with insurance companies to sell insurance products. Inthis business model, both bank and insurance companies share the commission.

Further, with the deregulation of savings rate in Oct 2011, competition among banks has already intensified.

Passage of 'Banking Laws (Amendment) Bill' aimed at attracting more foreign investments

With an aim to reform and strengthen India's banking sector, the Lok Sabha passed the 'Banking Amendment Bill' inDec 2012. Once, the bill is passed by Rajya Sabha as well, it will pave way for RBI to issue new banking licenses toprivate sector and attract more foreign investments in the sector.

The Bill also proposes to enhance the voting rights of investors in case of both public sector and private sector banksfrom existing 1% to 10% of public sector banks and from 10% to 26% of private sector banks. This move will attract

more foreign investment in the sector.

The Competition Commission clause in the new Bill allows the RBI to continue with its role as the banking regulator,while the Competition Commission of India (CCI) will regulate mergers and acquisitions (M&A) and will have powersto investigate and clear M&As in the banking sector.

Moreover, the bill has a clause, which will allow foreign banks to convert their Indian operations into local subsidiariesor transfer its shareholding to a holding company of the bank without paying stamp duty.