India's banking sector going from strength to strength

Going through the RBI's latest Financial Stability Report (June 2024), one has to pinch oneself in disbelief. The turnaround in India's banking sector has surpassed all expectations. One key indicator: the ratio of gross NPAs to advances is 2.8 per cent, below the international benchmark of 3 per cent.

Even more surprising is the improvement in profitability, measured by return on assets, in 2023-24. Analysts had warned us that, with deposit costs rising, banks' margins would be squeezed. A greater focus on retail loans would result in higher bad loans and result in high provisions. Both these would dent banks'  returns in 2023-24. They have been proved wrong.

In my latest article in BS, I explain how this has happened:

 

FINGER ON THE PULSE

Banking sector continues to confound sceptics

It has shown remarkable resilience in the post-pandemic years despite challenges and warnings about instability

T T Ram Mohan

India’s banking sector continues to astonish. Its performance in 2023-24, revealed in the Financial Stability Report (FSR) of June 2024, is as much of a pleasant surprise as its turnaround in the preceding years.

The sector entered the first year of the Covid-19 pandemic, 2020-21, with a non-performing asset (NPA) level of 8.5 per cent of advances. Analysts warned that the improvement seen in the previous two years was in jeopardy. The chances were that NPAs would shoot up instead of declining. Vast amounts would again be needed to recapitalise public sector banks (PSBs). 

Later, as the Reserve Bank of India (RBI) announced various restructuring schemes, we were warned of the perils of “kicking the can down the road”. If you don’t recognise NPAs now, be prepared for higher NPAs to show up later, analysts said. It was better, they argued, to “bite the bullet” now. 

They were proved wrong.  Out-of-the-box thinking enabled the RBI to nudge the banking sector back to normalcy in the post-pandemic years despite the Ukraine shock and the shocks emanating from banking instability in the US and Europe. By 2022-23, NPAs had fallen to 3.9 per cent.

Fair enough, the analysts said. However,   sustaining the secular improvement in financial indicators of the previous years would be difficult in 2023-24.  Banks would face a liquidity crunch, with deposits failing to keep pace with growth in loans. The net interest margin would be squeezed and asset quality would suffer from the rapid build-up of loans. Returns were bound to fall. 

Wrong again, it turns out. Yes, banks’ liquidity at the margin was indeed stretched- the incremental credit-deposit ratio for all scheduled commercial banks was over 100 per cent, as the FSR points out. For private banks, the incremental credit-deposit ratio was nearly 120 per cent.  But banks seem to have had no difficulty in passing on the higher costs of deposits to their borrowers. The net interest margin (NIM) fell by only 1 basis point relative to the previous year (3.6 per cent compared to 3.7 per cent).  

How did banks manage to maintain NIM in the face of rising deposit rates? Well, they did so by maintaining a high rate of growth in high-yielding retail products, such as credit cards, personal loans, loans against property, and auto loans. The growth rate in these products in the past two years is a good 7 to 14 percentage points above aggregate loan growth rate of 15.4 per cent and 16.3 per cent in the years 2023-23 and 2023-24, respectively.

In what was predicted to be a challenging year for bank, the return on assets for banks as a whole increased from 1.1 per cent to 1.3 per cent. Apart from NIM staying high, several factors contributed to the improvement: A higher rate of loan growth, lower provisions, higher trading income, and higher fee income. The return on assets for PSBs is 0.9 per cent, pretty close to the figure of 1 per cent that is something of an international benchmark. We seem to be getting back to banking’s heady days of the early 2000s. 

Privatisation of PSBs, promised in successive budgets of the past, has been on hold. The privatisation of IDBI Bank, which was initiated in 2018, is yet to be completed. At a return on assets of 1 per cent, PSBs can generate enough capital through internal surpluses and from the market to sustain themselves. They will not pose large demands on the exchequer. The return to health of PSBs means that privatisation will likely lose its impetus. 

Banks have increased the share of retail and service sectors in total credit over the last two decades. Sustained growth in these sectors has so far not told on asset quality. Gross NPAs in retail loans declined from a high of 2.1 per cent in June 2022 to 1.2 per cent in March 2024. Unsecured retail lending has long been seen as a vulnerable area in retail loans. However, asset quality of unsecured retail lending too is showing improvement, with gross NPA ratio at 1.5 per cent compared to 1.6 per cent a year ago. 

It’s almost as if, after the infrastructure imbroglio of the early 2000s, banks can’t put a foot wrong now. Tighter regulation and supervision, an improvement in risk management at the bank level and better selection of leaders at PSBs through the Financial Services Institutions Bureau have all contributed to the improvement.

Can Indian banking keep going the way it has in the past few years? On the face of it, there seems to be little reason why it can’t. Banking is a play on the economy. The Indian economy looks set to grow at around 6.5 per cent over the long-term. The FSR thinks credit growth of 16-18 per cent can happen without seriously impacting asset quality.  

At the same time, competition for deposits will remain intense. Net financial saving, the FSR notes, has declined to 5.3 per cent of GDP during 2022-23 from an average of 8.0 per cent during 2013-2022. The RBI Annual Report shows that the share of deposits in gross financial savings has declined from a peak of 6.3 per cent in 2016-17 to 4 per cent in 2022-23. 

The crucial question, then, is whether retail loans can continue to drive bank revenues and profits as they have in the recent past. The FSR sounds a note of caution. It points out that household debt to GDP at 40 per cent in India is below that in emerging markets. However, in relation to GDP per capita, it is quite high.  Nevertheless, the record of the past five years suggests that we are still some distance away from the point where banks’ focus on retail loans may turn counter-productive. 

Many have commented on the remarkable resilience the Indian economy has displayed in the post-Covid years in the face of lacklustre global growth. The banking sector’s stability is a key factor underpinning that resilience. Our banking sector model drew scathing criticism from several quarters in the post-reform era. Its remarkable success in recent years should silence critics.