Introduction

The Indian economy witnessed unprecedented growth during FY04-FY08 when most industries displayed good performance, the per capita income rose steadily and healthy reserves of foreign exchange accumulated on account of increasing exports. This growth also reflected at the stock markets, which zoomed up to historical levels during this period. However, the sub-prime crisis, which was largely responsible for the meltdown of the global economy, put brakes on this stupendous growth story.

The repercussions of the financial crisis were felt in the developed countries from the last quarter of FY07. However, the crisis intensified with the collapse of major global banks and institutions. Global demand plummeted and industrial production came to a halt. Developing countries started feeling the pinch of the meltdown during the second half of 2008, after the collapse of Lehman brothers.

In India, exports contracted while industries depicted sluggish growth due to lack of demand. Though the performance of equity markets was gloomy, the Indian financial institutions and the banking industry managed to weather the crisis. However, banks and FIs adopted a cautious attitude towards lending as the crisis worsened. Further, the returns on investments made in mutual funds and insurance took a hit.

Nonetheless, timely infusion of liquidity into the economy through financial stimulus packages, and provision of sops to the industries in dire need seems to have helped revive demand in the economy. Moreover, as news of global economic recovery is pouring in, the financial sectors are regaining some stability and moving back on the road to revival.

The BFSI sector broadly consists of banking, financial services, insurance, and mutual fund segments. Due to the consistent impetus on reforms and fast-paced liberalisation, these sectors have been witnessing rapid change over the years. This publication on the BFSI industry is a fair attempt to present the performance of these sectors in FY08 over FY07.

The publication profiles 248 companies, consisting 69 banks, 125 financial service (broking & NBFC) companies, 22 mutual fund and 32 insurance companies. The aggregate total income and PAT of these companies was Rs 7,562.5 bn and Rs 619.7 bn, respectively, in FY08. In the BFSI sector, the banking and insurance companies have proved to be the most prominent contributors to total income and PAT. While banks had a share of approximately 48% and 69% in the total income and PAT, respectively, insurance companies accounted for approximately 40% of total income. Out of these 69 banks, 27 are public sector banks, 22 are private banks and 20 are foreign banks. The total income of these banks increased by about 35% to Rs 3,641.9 bn in FY08 as compared with Rs 2,705.1 bn in the previous year. Public sector banks spearheaded this growth with a 65% share in total income. The absolute value of NPAs of the profiled banks was Rs 243.5 bn in FY08, after growing yearly by more than 20%, with a marginal decline in the net NPA to net advances ratio at 1.02%. In future, there might be some rise in NPAs as private banks are likely to record more loss assets; currently many banks are reporting delinquencies in their loan portfolios as corporate and individual earnings are witnessing a deceleration.

This publication profiles 32 insurance companies comprising 16 life insurance companies, 15 non-life insurance companies and one re-insurer company. The insurance penetration and density has been rising gradually in the country. The insurance density in India in the CY 2007 grew by 21% to US$ 46.6; although it is very low when compared to other countries, the insurance sector in India enjoys a healthy advantage in terms of demographics over other countries. During FY08, the total premium of life insurers grew by 29%.

NBFCs have been competing with and complementing the services of commercial banks for a long time now. Initially intended to cater to the needs of small savers and investors, NBFCs have now turned into institutions that are on a par with banks. This publication profiles 91 NBFCs, covering diverse segments of asset and lease finance, housing and personal loan companies, merchant bankers and advisory companies. During FY08, 34 of the profiled NBFCs disbursed a total of Rs 2.17 tn as loans in housing, asset, personal and infrastructure segments.

The publication also profiles 32 mutual fund houses, which had assets under management or AUM of Rs 5,176.6 bn during March 2008 that grew yearly by 60%. However, the crash in equity markets affected the total value of assets managed by them. Mutual fund houses faced difficulties in fund mobilisation as retail investor confidence in equity markets wavered. Nevertheless, some fund houses have come up with new fund offers after the recent up turn in markets, which seem like a positive sign for the industry.

Later on in this publication, an insight is provided on performance of the Indian financial sector, that is, banking, NBFC, mutual fund and insurance sectors. The insights section highlights the factors that have been providing an impetus to the growth of these sectors and explores the attributes of these industries that have helped them withstand the current crisis. In this section, an attempt has been made to depict the outlook and opportunities existing in the respective segments and the factors that may further boost or challenge these sectors’ growth. We hope that this publication provides an insightful reading on these sectors.

Overview:Banking sector

Banking In India

The beginnings of modern banking in India can be traced back as early as January 2, 1809 to the establishment of the Bank of Bengal. This was the first joint-stock bank and was sponsored by the Government of Bengal and governed by the royal charter of the British India Government. Two more banks were set up in India, the Bank of Bombay on April 15, 1840 and the Bank of Madras on July 1, 1843. These three banks came to be known as the presidency banks and marked the commencement of the limited liability and joint stock banking in India. These banks were also vested with the right to issue currency.

In 1921 the three presidency banks were merged to form the Imperial Bank of India and this Bank had multiple roles and responsibilities. It functioned as a commercial bank, a banker to the government and a banker’s bank. With the establishment of the Reserve Bank of India (RBI) in 1935, the Imperial Bank of India’s central banking responsibilities came to an end and it turned into a commercial bank.

State Bank of India, which was established in 1955, took over eight former state-associated banks as its subsidiaries in 1959. The Indian banking industry witnessed significant consolidation during the sixties and the total number of banks functioning in the country came down from 500 in 1960 to 89 by 1969. July 19, 1969, was a landmark day for the Indian banking industry when 14 major banks were nationalised. Further in 1980, eight more banks were nationalised.

In 1976, the Regional Rural Banks Act was enacted, which allowed establishment of specialised regional rural banks (RRB) to cater exclusively to credit requirements in rural areas. These banks were set up jointly by the central government, commercial banks and the respective local governments of the states in which they were located. By 2001, 196 regional rural banks operated in India but operational problems and accumulated losses marred the functioning of these banks.

The RBI constituted Working Groups on RRBs (for better working and regulation of RRBs) to strengthen their presence in India and these groups suggested mergers between RRBs of the same sponsor bank in the same state or mergers of RRBs sponsored by different banks in the same state to strengthen the RRB presence in India. Subsequently, on September 12, 2005, the first set of amalgamations took place when 28 RRBs were amalgamated to form 9 new RRBs. The process of amalgamation still continues. As a result of such amalgamations, the number of RRBs came down to 91 as on March 31, 2008 as against 133 and 196 RRBs as on March 31, 2006 and 2005, respectively.

After the banks were nationalised, there was a rapid rise in their business, and a consequent thrust on national savings, which leapfrogged from 10-12% during 1950-70 to about 25% post-nationalisation. Aggregate deposits registered an annual growth of over 20% in the eighties. Branch network expanded significantly leading to wider banking coverage.

However, Indian banking began to face pressures on asset quality by 1980s. Simultaneously, the banking world everywhere was gearing up towards new prudential norms and operational standards pertaining to capital adequacy, accounting and risk management, transparency and disclosure etc. In the early 1990s, India embarked on an ambitious economic reform programme, which included major banking sector reforms.

The Committee on Financial System (1991) also called the Narasimham Committee prepared the blue print of these reforms. Reforms laid emphasis on opening up the banking sector, greater transparency and disclosure norms, adoption of Basel accord and introduction of technology in banking operations among others.

Reforms strengthen Indian Banking Sector

The reforms changed the banks’ approach towards competition, profitability and productivity, and the need and scope for harmonisation of global operational standards and adoption of best practices. The reforms focused on deriving efficiencies through improvement in banks’ performance and through rationalisation of resources. Further it also promoted greater reliance on technology that included computerisation of banking operations and introduction of electronic banking.

Reforms brought about radical changes to the strength and sustainability of the Indian banking sector. In addition to significant growth in business, Indian banks experienced sharp growth in profitability, greater emphasis on prudential norms with higher provisioning levels, reduction in the non-performing assets and surge in capital adequacy.

However, the real test for the Indian banking sector and the regulatory framework came when global financial crisis began towards the end of 2008. Indian banks, including the Indian operations of foreign banks, were shielded by the global financial meltdown to a certain extent because of high levels of regulations that ensured banks had minimum direct exposure in toxic structured assets and were cautious in lending to sensitive sectors. Although bank credit growth during 2004-07 remained at about 30%, the lending standards were not relaxed. In view of the rapid credit growth to certain sectors, the RBI pre-empted disciplinary actions through tightened prudential norms (provisioning requirements and risk weights) for these sectors to safeguard financial stability. Further it also raised provisioning norms for standard assets across the board except for agriculture and SMEs.

Structure of The Banking Industry

The banking industry consists of scheduled (including RRBs) and non-scheduled commercial banks. The major bank groups (as defined by the RBI) functioning in India include the State Bank of India and its seven associate banks, 19 nationalised banks and the IDBI Ltd, old private sector banks, new private sector banks and foreign banks. Over a period of time, the Indian banking scene has witnessed consolidation among various bank groups. The table below summarises the existing players in the industry:

Indian banking industry at a glance

Performance of the Indian banks during FY08

Total asset size equivalent to 91.8% of GDP

During FY08 the total assets of the banking industry increased by almost 24% at Rs 43,264.86 bn. The total assets to GDP ratio was 91.8% in FY08 as against 83.5% in FY07. During FY08 the banking sector also reported robust growth in business despite slowdown in financial markets. The total income and profit of the scheduled commercial banks (SCB) grew y-o-y by more than 30% and 35%, respectively. Strong demand from infrastructure, cement, real estate sectors among others boosted these banks’ business. During FY08 the total business of the SCBs grew by 24% to Rs 57,970.1 bn. During the same period, advances and deposits grew by approximately 25% and 23%, respectively.

The table below shows the performance of the 69 banks that have been featured in this publication. Among these banks, the foreign banks have gained the most from strong credit demand in the Indian markets and their total business grew by almost 29% y-o-y in FY08 which increased the credit offtake. On the other hand, public and private sector banks reported approximately 25% growth in total business.

During the last quarter of FY08, the global liquidity crisis started to affect domestic money supply. At this time, the RBI ensured adequate flow of credit to the productive sectors of the economy. The overall credit growth during FY08 was about 25%. However, following the global crisis, demand slowed down and moderated in the commercial sector; therefore, credit growth was expected to be modest in FY09.

The RBI’s monetary policy, however, was effective in preventing this moderation as its objective shifted from containing inflation to promoting growth and creating liquidity. Hence, during FY09, aggregate deposits of SCBs grew by about 18% as against 23% in the previous year; similarly, non-food credit growth was 17% as against 25% in the previous year.

Term loans form a major chunk of advances, but unsecured loans may be a concern

The SCBs’ advance composition can be primarily classified as term loan, cash credits and O/D and bills purchased and discounted. During FY08, term loan constituted about 58% of the total advances whereas cash credits and O/D accounted for more than 35% of the advances. Both cash credit and term loan reported similar growth, however, the unsecured advances of SCBs grew by more than 40% y-o-y in FY08 and constituted 23% of total advances as compared with 20% in the previous year.

Domestic banks, both private and public, reported a yearly increase of about 40% in unsecured advances and contributed 20% to total advances. In the meanwhile foreign banks reported a y-o-y increase of more than 45% in the unsecured advances, due to aggressive business policies, and their contribution to total advances was as high as 53%. These unsecured loans may pose problems for the banks to profitably recover them in the current scenario of economic slow down and falling corporate earnings.

Banks continue to favour government securities

During last few years Indian companies displayed superior performance aided by the global economic boom; the consequent run up in stock markets made banks invest in the capital markets also besides gaining exposure in government securities or G-sec.

Banks on the whole invested aggressively in subsidiaries or joint ventures (JV), and their total investment in overseas subsidiaries and JVs grew by 145% over the previous year. SCBs in particular invested greater amounts overseas in G-secs and these investments increased y-o-y by approximately 49%. Apart from the G-secs, SCBs’ investment in domestic capital market and JVs surged by 35% and 58%, respectively. Even though SCBs increased their investments in subsidiaries or JVs, their investment in G-secs constituted more than 80% of their total investments; private banks were an exception as their investment in G-secs constituted only 70% of their total investments. One of the reasons why the Indian banking sector is well poised to cope with challenges arising out of deteriorating capital markets globally is that the investments in G-secs have been rising over the years and the provision for these investments has decreased by over 50% in FY07 and FY08. The RBI’s policy of not allowing Indian banks to over expose themselves to toxic structured products seems to have paid-off well.

Sensitive sector lending poses higher risk

In the high credit offtake scenario, banks lent money to every other sector assuming very high risks to increase their returns. The real estate sector, which is one of the sensitive sectors, was the recipient of such loans as high real estate prices and booming equity markets attracted banks towards making these advances.

The total outstanding exposure to sensitive sectors as on March 31, 2008, grew by 25% on a yearly basis to around Rs 5,109.9 bn. More than 20% of the total advances were extended to sensitive sectors, and out of the 25%, about 87% was outstanding to the real estate sector.

The massive upward rally in the stock markets during the last few years attracted many investors to either the secondary or primary market. Commercial banks also tried to capitalise on this trend and extended advances to all sets of investors for making investments. The capital market exposure of banks in the sensitive sectors increased to 12.3% from 8.6% in the previous year. In terms of absolute value the exposure was valued at Rs 629.9 bn and had grown by almost 79.0% y-o-y. Considering the present downturn in the equity markets and the consequent impairment in investor positions, the banks may find it difficult to recover these advances.

The real estate sector and the capital markets were the largest borrowers of funds during the economic boom. However, with the onset of the financial crisis and the economic slowdown during the last quarter of 2008, these sectors faced solvency and credit risks. In the meanwhile, the equity market downturn during the whole of 2008 increased the banks’ challenges to recover the advances made for capital market exposure. Among the banks, private sector banks had a larger exposure to sensitive sectors in FY08 in terms of contribution to the total advances, followed by foreign banks.

The inability of real estate players to service their outstanding debts, and impairment in the value of their investments (financed by banks) in the capital market formed the challenges that confronted the banks. The immediate impact of these challenges was that banks increased the write downs and/or provisions, which rose to more than 30% in FY08, for suspected NPAs in the sensitive sector advances. Many real estate players who faced the credit crunch restructured their loans. Also, many banks started to restructure the loans that could turn into NPAs as a proactive measure.

The RBI’s prudential lending norms paid off well and averted risky lending, a fact that was evident from the controlled losses incurred by the Indian banks, in spite of a global liquidity crisis.

Riskier lending increases NPAs

Over the last few years the banks have been lending aggressively to inflate their balance sheet size. Credit demand from all industries and segments was on the rise and banks were very bullish in lending to the retail segment and high growth sectors like real estate, retail, among others. However, this aggressiveness cost the banks as they assumed higher risk as regards to quality of the advances made. The lending increased the gross NPAs in FY08. The gross SCBs’ NPAs rose 12% over the previous year to Rs 564.36 bn. The increasing NPAs in the advances portfolio of banks over the years pose a significant threat to the banking sector in terms of sustainability and credibility.

While directed lending has been a problem area for public sector banks in terms of NPAs, aggressive lending to retail and sensitive sectors has been a problem area for private banks. During FY08, the NPAs in priority sector as a ratio to total NPAs rose to 52.1%. During the same year, priority sector advances increased by about 18%, but its contribution to total advances slipped by 2%. Among the banks, private sector banks reported higher y-o-y growth in NPAs due to more than 70% increase in the NPAs in the agriculture sector.

During FY08, the banking sector’s gross and net NPAs increased significantly by 12% and 22% y-o-y, respectively, as growth moderated in the sensitive sectors like the real estate sector and in the capital markets; as a result, the provision against NPAs increased by 31%.

During FY07, SCBs reported negative net recovery¹ of approximately Rs 0.33 bn in NPAs, which constituted approximately 0.07% of the gross NPAs. During FY08, however, NPAs increased further and net recovery deteriorated due to substantial rise in priority sector lending and exposure to sensitive sectors.

In FY08, the negative net recovery rose to approximately Rs 61.36 bn and reported a negative ratio of net recovery to gross NPAs of about 10.87%. Taking into account the grim outlook for the real estate sector and the capital markets, the rising delinquencies are likely to further decrease net recovery. Further, the likely rise in gross NPAs and higher provisioning may depress the sector’s bottomline.

Distressed assets on the rise

The NPAs are not the only growing concern for the banking sector but the advances that have been restructured are equally risky. The restructured loans are non-performing as the process of restructuring involves additional overheads and results in loss of efficiencies. Due to this exercise, the banks’ energies are diverted towards either recovering or restructuring bad loans rather than towards deploying resources or lending to potential customers.

Distress assets, which include not only NPAs but also restructured loans, are a potential threat to the banking industry. During the year, the total distressed assets of banks grew by about 24% yearly to Rs 751.4 bn. The public sector banks had a 74% share in the total distressed assets, whereas private sector banks reported a significant yearly increase of more than 60%.

Further, private sector banks reported more than two fold increase in the C-DR, followed by foreign banks that reported y-o-y increase of more than 175% in C-DR.

In the coming years the total distress assets are bound to increase considering the slowing demand all across the globe and the falling income levels. Banks have already reported rising delinquencies in their personal and sensitive sector portfolios. Fall in corporate earnings are adding to the woes of companies that are struggling to meet their debt obligations and have started opting for debt restructuring. If these events continue, the profits of banks will erode further and will leave a burden on the economy.

Off-balance sheet exposure

Off-balance sheet items are the contingent liabilities that do not reflect in a balance sheet. These items are so called because they are not directly funded by banks, and the bank’s actual liability towards these arises only when its client fails to fulfil commitments. These exposures thus pose a significant risk to the banking sector. The notional principal amount of off-balance sheet exposure increased from Rs 8,420 bn by the end of March 2002 to Rs 144,273 bn by the end of March 2008.

Off-balance sheet exposure largely includes forward exchange contracts, including derivatives, LCs and guarantees on behalf of constituents. Guarantees, acceptances and endorsements are a part of normal business and are extended quiet often. During FY08, the outstanding forward exchange contract for SCBs constituted more than 75% of the total off-balance sheet exposure, whereas guarantees had a 2% share. Acceptances and endorsements accounted for the balance 23%.

Due to the fluctuations in the currency market, many banks hedged their positions through currency forward contracts. Unlike the lending business, no fresh capital is required to back up the derivative business, therefore, in the event of any unforeseen currency movement, this exposure can jeopardise the balance sheet of banks.

During FY08, the banking sector witnessed y-o-y increase of more than 90% in the forward exchange contracts, as many companies and banks entered derivative contracts to hedge their positions following a surge in currency fluctuation. As a result, the total off-balance sheet exposure as a percentage of total assets in FY08 was approximately 3.33 times as compared with 2.21 times in the previous year. Private sector and foreign banks are more vulnerable to the downside of such exposures.

The forward exchange contracts pose significant credit risk and exchange rate risks for banks. Increase in these contracts could lead to an increase in the mark-to-market (MTM) provisions of banks when these positions are not properly hedged by banks. As a result their profits or to a greater extent their solvency could be in danger and to save the situation they may have to infuse additional capital to maintain their deteriorated capital adequacy ratio. The public sector banks have been able to maintain their ratio of total off-balance sheet exposure as a percentage of total assets to approximately 0.52 times by their very conservative nature of banking and their focus on basic banking rather than on exotic derivative products. At the same time, this ratio has been significantly higher for foreign banks, at approximately 18.0 times.

Banks work towards comprehensive financial inclusion

India’s banking sector reflects a concentrated banking structure in terms of extending products and services; most of the sophisticated products and services are extended to urban and metropolitan cities. The rural and semi-urban regions, in the meanwhile, are largely covered for basic banking facilities only like deposit and withdrawal at branches and are deprived of premium banking products like credit, investment products, insurance, ATM access etc. The rural areas have been always under-served despite their huge potential to easily avail these banking facilities.

The report submitted by the government-appointed Committee on Financial Inclusion, Chaired by Dr C Rangarajan, stated that 45.9 mn farmer households in the country out of a total of 89.3 mn households (or 51 per cent) do not have access to credit, either from institutional or non-institutional sources. The Committee made several recommendations to improve overall financial inclusion, which includes improvement in the credit delivery mechanism, launch of a National Rural Financial Inclusion Plan (NRFIP), and targets for rural/semi-urban branches of commercial banks including RRBs. Moreover, the Union Budget 2007-08 proposed the following two funds: Financial Inclusion Fund for meeting the cost of development and promotional interventions, and the Financial Inclusion Technology Fund to meet the costs of technology adoption, for an overall corpus of Rs 5 bn that was to be funded by the Central government, the RBI and NABARD.

In its efforts to meet the objective of mass banking and to increase average customer population per branch, the RBI promoted financial inclusion by extending banking products and services to relatively weaker and poorer sections in the form of no frills accounts, self-help groups, Kisan credit cards (KCC). Since its inception in 1998-99 up to August 31, 2008 around 76 mn KCCs were issued. The banks in general and private banks in particular are expanding their services in these areas, which is evident from their growth in semi-urban and rural areas during FY08.

Among the banks, public sector banks have been the front-runners of the financial inclusion initiative. The banking services’ reach within the country are assessed by the ratio of deposits and advances in rural and semi-urban locations to the total deposits and advances of SCBs, respectively.

In FY08, the deposits in rural and semi-urban areas were merely 9.4% and 13.3% of the total deposits of all SCBs respectively. Likewise, the credit offtake shared by rural and semi-urban branches was approximately 7.6% and 9.6% respectively of the total credit extended by all SCBs. In the past 5 years, the total business in these branches as a percentage of total business of SCBs decreased consistently. However, this decrease was on account of a high base effect, as the business of SCBs grew rapidly in urban and metropolitan locations as compared with rural and semi-urban areas. This trend was evident from the growth of approximately 28% in non-priority sector lending as compared with priority sector lending, which increased by approximately 18% during FY08.

In India, financial inclusion has always been initiated by or done through government organisations. Off late even the private sector has initiated these measures. Directed lending has been the major cause of NPAs in the Indian context, as the advances are extended to consumers without due diligence and with less efforts to recover them. One way to look at the problem is to see the level of NPAs in the priority sector lending which account for approximately 52.1% of the total NPA’s during FY08.

Global banking scenario: Subprime crisis

During 2004 to 2007, the global economy witnessed a sustained period of expansion at an average rate of more than 5%. However, during the second half of CY 2008, the international financial markets witnessed turbulence, which was triggered by the delinquencies that swept the US sub-prime mortgage market during 2006. The crisis affected different economies in varying magnitudes. In developed economies, for instance, the crisis originated in the financial sector and spread to the real sector; however, in most emerging economies, including India, slowdown in the real sector led to a stress in the financial sector. The capital flow reversals intensified in September and October 2008. Even though these reversals have stabilised since then, international credit channels have been constrained, capital market valuations have fallen, industrial production and export growth have slackened, and overall business sentiment has deteriorated.

Many banks and financial institutions recorded huge losses on account of increase in NPAs and MTM losses in the structured products following these global turn of events. Even today, the global banking sector is going through a challenging phase and India is no exception. The global financial crisis intensified following the bankruptcy of Lehman Brothers in September 2008. Since then the world stood witness to the downfall of many large global banks. Banks worldwide suffered huge losses since then, and consequently are now refusing to lend despite massive bailouts by the respective governments.

CY 2008 proved to be difficult for global banking as banks were marred with heavy losses and write downs due to bad mortgages. According to The Banker, the aggregate profitability of the top 1000 global listed banks plunged by 85.3% to US$ 115 bn. However, the capital raised by Western banks, despite heavy losses, helped them to retain their dominance among the top banks.

Due to the dual impact of significant decline in profitability and NPA write-offs, along with booking of MTM losses, banks had to infuse additional capital to maintain their capital adequacy. There was a substantial growth in tier 1 capital and aggregate total assets despite the losses being written-off. Due to the re-capitalisation, which was often conducted with governmental support, the total tier 1 capital rose by 9.7% to US$4,276 bn. Assets also grew by 6.8% to US$96,395 bn but at a much slower pace than the previous years.

During 2008 developed country banks incurred huge losses due to deterioration in asset quality and investments. According to The Banker, the global financial industry booked write down and losses worth US$1,040.7 bn since the crises began. The banks from the Americas and Europe were most-affected and out of the total losses and write-downs, the banks from Americas and Europe reported write-downs and losses worth US$582.6 bn and US$420.7 bn, respectively.

Genesis of the global financial crisis

The genesis of the global financial crisis lies in the defaults in the subprime mortgage market in the US. However, many economists have blamed the excessively loose monetary policies in major developed economies during the early part of this decade to be behind the crisis. Traditionally, it is believed that the developed countries run high current account surpluses and the developing/emerging countries run a deficit (high demand for imports from developed countries). However, in the last few years till the crisis the world saw large imbalances being created on the current account front. The US ran high current account deficits and low savings rates, which mirrored in the substantial surplus in current accounts of Asia, particularly China, and oil exporting countries in the Middle East and Russia.

The world has witnessed different global crises over the past 2 decades, be it the Asian financial crisis of 1997-98, or the dotcom bubble or the slowdown after September 2001. However, the most striking part of current crisis is its origin and the magnitude with which it has affected the entire world. In the past, most crises started from the developing and emerging countries resulting from excessive inflow of capital inflows, internal monetary or domestic policies. The subprime crisis, however, started from the US due to uncontrolled overconsumption, exuberance in value of asset classes, and investment by banks and financial institutions in exotic derivate products.

Following the dotcom bubble burst in the early part of this decade, many developed countries eased their monetary policies (including the US), which resulted in easy and cheap availability of credit. This fact is evident from the level of policy rates that existed in the US during 2003. The policy rates ruled at 1% and remained at this level till June 2004. Excessive reliance on monetary policy boosted consumption and investments in the US. Due to the low nominal and real interest rates, asset prices recorded strong gains, particularly in housing and real estate sectors, and provided further impetus to consumption and investment. The large consumption demand in the US was met by the East Asian countries and China that provided goods and services at lower cost. Consequently, the developing countries witnessed a growth in surpluses. Further, the level of inflation in developed countries remained low despite higher demand and consumption due to availability of cheap goods and services from China and other emerging economies. The low level of inflation led to an unrestricted monetary stance in developed countries.

The table below illustrates the surpluses in the developing and emerging economies and the corresponding deficits in developed countries.

Due to higher consumption levels, low interest rates and ever-increasing prices of different asset classes, the prudential lending norms of banks and financial institutions were relaxed or overlooked. As inflation increased in the US, the Fed tightened its monetary stance, which led to an increase in mortgage payments. When aggregate demand and output began to fall, there was a steep fall in housing prices and a consequent rise in defaults in the subprime category of loans, which were disbursed by financial institutions. Investors also felt the pinch when these loans were bundled into derivate products through securitisation, and borrowers defaulted. However, the losses were finally borne by the banks, which led to write-offs and depletion of capital. Due to the growing financial globalisation, banks and financial institutions in other major advanced economies, especially from Europe, were also adversely affected by losses and capital write-offs. The over-leverage status of banks and institutions, complex deal structures and falling net worth of banks led to a crisis of trust between them. The inter-bank money operations froze and there was global liquidity crunch.

As the credit lines froze and consumption slowed down, many inter-connected events took place. The equity markets all over the world, for instance, which were giving excellent returns till then, stumbled as investments dried up. The elevated level of commodity prices (until the third quarter of 2008) corrected due to fall in demand and consumption, and the value of major asset classes crashed.

The financial global meltdown, started from default in a particular section of loans in the US during 2006 (defaults in subprime category loans). During this period, large global banks collapsed and the US banking business suffered huge losses. The bankruptcy of Lehman brothers in September 2008 worsened the situation. According to the Federal Deposit Insurance Corporation (FDIC), till July 7, 2009, 88 commercial banks failed in the US alone.

Impact on business of banks: Developed countries

Banks in the US write down more than US$ 88 bn worth of bad loans

The global financial slowdown had an adverse impact on the business of all commercial banks in the US. The year-to-date financial results of all commercial banks (7,085 reporting banks to FDIC) as on December 31, 2008, showed a yearly decrease of 13.2% in total interest income earned. The root cause of the crisis, subprime loans, also had an impact on the profitability of banks as the rising delinquencies in the loan portfolio and the prudential capital adequacy norms raised the banks provisioning. The provisioning required for loan and lease losses increased by almost 166% during CY 2008 over the previous year.

In a haste to earn supernormal profits, banks invested in exotic derivative products; however, with the fall in value of underlying securities, the banks incurred heavy losses. During CY 2008, the losses from the investment in securities increased by more than 2,000%. The table below summarises the performance of FDIC reporting banks during CY 2008 over the previous year.

The government and the treasury have taken various steps to rein in the damage caused by the financial crisis. These measures range from purely monetary steps to legal restructuring of the financial system. The government has gone in for re-capitalisation by aiding some banks or allowing mergers among different sets of institutions. Banks, on the other hand, have resorted to restructuring loans and write-offs. As of the year-ended December 31, 2008, the reporting banks to FDIC restructured loans and leases to the tune of US$ 16 bn. The total restructured loans and leases went up by 487% over CY07. Bad quality of loans and rising defaults in the loan and mortgage portfolio led banks to write-off loans to the tune of US$ 88 bn. During the CY 2008, the total write-offs rose by 132.5%, which made banks firm up their capital base with the help of the US treasury or through investors.

The failure of some banks and the crisis also hit the credibility of the entire sector. There was a widespread erosion in the goodwill of banks. The value of goodwill and other intangibles fell by 7% over the previous year, and the value of goodwill alone deteriorated by 12%.

However, the total liability of these banks on account of derivate exposure remains a big cause for worry. These liabilities are with respect to the various contracts (like futures, forwards, currency and other commodity contracts) the banks have entered during the course of last few years. The total outstanding derivative exposure of these banks, as on Dec 31, 2008, was US$ 212,088 bn. In the coming years these exposures will continue to pose a grave challenge for the American banks.

European region banks take a hit

Due to globalisation of the financial system over the years, the financial crisis spread across the globe and major banks in developed countries also started feeling the heat. The banks held cross positions among themselves through structured products or held guarantees with each other. With the rise in defaults, credit squeeze and falling trade, major European banks reported losses and write-offs. The governments of various countries rushed to help the ailing banks by providing funds and the much-needed liquidity.

Many countries’ governments had to intervene with massive re-capitalisations and other measures to support the stability of the financial system. After an initial phase of purely national interventions, the European governments coordinated their actions, adopted measures to protect depositors and maintain banks’ liquidity and strengthened their capital at adequate levels. The European Commission announced that between October 2008 and March 2009 it received notifications of more than 50 public support interventions, including guarantee schemes, re-capitalisation programmes and specific measures for some intermediaries. The total support for the banking sector was worth €3,000 bn, and included €2,300 bn for possible guarantees.

Profits of Banks in Switzerland decline by 40.3% during CY 2008

According to the data available with the central bank of Switzerland, Swiss National Bank, interest and discount income of all banks (327 banks) decreased by 21% during CY 2008. The number of banks that registered loss advanced significantly from 11 in 2007 to 43 in 2008. The total annual loss for all the banks rose substantially from CHF 4.3 bn to CHF 38.9 bn.

In 2008, the aggregate balance sheet total for all banks in Switzerland fell by 10.9% to CHF 3,079.6 bn. This drop was attributable to a number of balance sheet items on both the asset and the liability side, reflecting banking transactions with entities abroad.

According to the available data, interest income decreased by almost 30% in CY 2008. Securities and lending businesses also took a hit, as their revenues went down by 18%. Moreover all banks reported total provisions of around CHF 6.3 bn up by 41.5% over the previous year due to rising defaults and losses.

Banks across the Western countries took huge positions in derivative contracts (currency, interests and the likes). For all the banks the negative replacement² value stood at CHF 1,043.4 bn suggesting the huge potential loss that they could suffer. Overall, the banks lost CHF 8.1 bn in trading operations as compared with 2007.

As consumerism took a dip across the Western world after the crisis, there was a shift in the saving pattern of people in Switzerland. Customers again placed more of their funds in savings and sight deposits, as well as in medium-term bank-issued notes. Holdings of time deposits, by contrast, reduced considerably due to interest rate considerations. In quantitative terms liabilities towards customers in the form of savings and deposits rose by CHF 23.3 bn to CHF 358.2 bn.

Profits of Italian banks decrease by almost two-thirds

According to the the Bank of Italy’s provisional data for CY 2008, lending by Italian banks to the private sector slowed markedly in 2008. The growth rate fell by nearly four percentage points to 7.3%. The slowdown in credit was gradual in the first 9 months of 2008 and intensified in the last quarter of CY 2008. There was an increase in the number of substandard and bad loan accounts also.

Though the net income increased it could not offset the fall in other incomes. Due to difficulties in the asset management sector the fee income contracted by 11.7%. Likewise, the net result on trading activity, which was heavily affected by the performance of the international financial markets, worsened considerably.

The gross income of banks fell by about 7.0% and the net profits decreased by 53.0%. Further, rising delinquencies increased provisions by 74.0%.

Global crisis: Impact on Indian banks

Initially the impact of the crisis on the domestic economy was thought to be minimal due to the almost negligible exposure of Indian banks in exotic derivative products and India’s merchandise exports at less than 15% of GDP that was relatively moderate.

However, like all emerging economies, India too has been affected by the crisis, and by much more than what was expected earlier. The impact of the crisis on India makes it evident that globalisation has its effect on India’s growing two-way trade in goods and services and it is financially-integrated with the rest of the world. In fact, in the first 2 quarters of 2008-09, the growth slowdown was quite modest as seen by the performance of Dun & Bradstreet’s Top 500 companies; these companies on an average managed 32% y-o-y topline growth. The full impact of the crisis was felt post-Lehman’s downfall in the third quarter, which recorded a sharp downturn in growth. The slowdown was seen in the high growth sectors like construction and real estate, transport and communication, trade, hotels and restaurants sub-sectors. For the first time in 7 years, exports declined in absolute terms for 5 months in a row during October 2008-February 2009. The demand for bank credit slackened despite comfortable liquidity in the system. Dampened demand dented corporate margins while the uncertainty surrounding the crisis affected business confidence.

Performance of Indian banking industry

Despite the slowdown in overall global demand for goods and services and corporate earnings, there was a silver lining in the form of easing headline inflation and moderation of consumer price inflation and normalcy in the functioning of domestic financial markets, particularly banks. But the most striking event was the robust rural demand.

The global financial turmoil has had repercussions on the Indian financial markets, particularly in the equity and foreign exchange segments. However, the banking sector has not been significantly affected, which is evident from the RBI committee on financial sector’s assessment report that cites comfortable capital adequacy, asset quality and profitability indicators for the half-year ended September 2008 and the third quarter ended December 2008.

There are many reasons why India’s banking system has shown so much resilience during the past year. Some of them include:

1. Banking regulations

Apart from the Banking Regulation Act, there are various legislations that govern different bank groups. So apart from the BR Act, the banks have to adhere to other regulations as well.

2. Financial soundness indicators

The capital adequacy ratios across the bank groups remain above the regulatory requirements. Even though the NPAs have decreased over a period of time, especially for the public sector banks, in the current global financial scenario, the off balance sheet exposure of private and foreign banks could be a concern.

3. The committee on financial sector assessment conducted credit risk test with different scenarios and found that the overall risk is low at present for Indian banks. However, continuous monitoring is required to avoid any unforeseen and significant asset quality deterioration over the medium term.

4. The banks actively monitor and manage their interest rate risk by bringing down the duration of their portfolios; hence, the duration of equity was decreased from 14 years in March 2006 to 8 years in March 2008 – a pointer to better interest rate risk management.

The banks’ normal functioning ensured credit availability to companies when other funding options dried up due to credit crunch. The weak domestic and international stock markets made it difficult for corporate India to raise funds through primary issuances. Money inflows through the FDI route also slowed and so did the issuance of ADRs/GDRs. The non-food bank credit growth during the first 2 quarters of FY09 was in the range of 25-26% and rose to 29.4% as on October 11, 2008.

In the subsequent period, however, the demand for credit moderated as it reflected the slowdown in the economy in general and the industrial sector in particular. Due to decline in commodity prices and drawdown of inventories by companies their working capital requirements decreased. The demand for credit by oil marketing companies also moderated. Additionally, lower credit expansions by private and foreign banks muted the overall flow of bank credit during the year. The non-food bank credit growth decelerated to 17.0% by March 2009.

Due to the government’s emphasis on agriculture spending, the credit deployment to this sector surged. Public sector banks’ credit to agriculture and allied sectors grew by 19.2% during FY09. Also the credit deployment to the industry came from PSU banks, which increased by 31% y-o-y. However, with the overall slowdown in the economy, falling income levels and rising defaults, banks were wary of extending loans to individuals. Growth moderated in personal loans disbursed by public and private sector banks, while it turned negative for foreign banks.

Financial performance of Indian banks

The regulatory framework and prudential lending norms made sure that the Indian banks do not take unwarranted risk. Indian banks were saved from huge derivative losses and higher rate of defaults in sensitive sectors. The financial performance of Western banks took a hit due to investment losses and bad loan write-offs, as seen above. However, the impact of the crisis was much beyond the financial sector. In India, the crisis affected the real sector, as demand plunged, and this was passed on to the financial sector. Moreover, the credit offtake by the commercial sector slowed down in the last 2 quarters of FY09.

To analyse the impact on the financial performance of Indian banks, D&B India studied the yearly results of 28 listed banks for FY08 and FY09. A cursory look at the financials showed that the Indian banks managed to better their performance as compared to the previous year. The total income of the 28 banks grew by about 24% during FY09. The then prevailing high interest rates helped banks to garner high treasury gains. Income earned from treasury operations for these banks increased by 25% over the previous year.

Overall the performance of Indian banks has been better than their global peers post-September 2008. Although the topline of these banks has registered decent growth, their bottomline seems depressed. Due to slowdown in economic activity and resultant slowdown in demand, growth moderated in the corporate sector. Also, the credit crunch and high interest rates in the economy made it difficult for companies to service their loan obligations. As a result, the banks’ delinquency rates increased and in turn banks total provisions for FY09 rose by 25%, which directly affected their profitability. Also the retail portfolio of Indian banks (including, Indian branches of foreign banks) showed signs of weakness. Over the previous years, the robust economy and earning levels made these banks go for massive expansions in their loan portfolio (comprising personal loans, credit cards and housing loans). The falling income levels and slowing economy, however, posed many challenges for banks to profitably recover these advances. Banks are already witnessing a rise in delinquency levels in their personal loan portfolio, which again will require higher provisioning at the cost of their profitability.

The worst hit sectors during this slowdown were real estate and construction. Banks extended heavy loans to these and other sensitive sectors, much to their chagrin. However, the regulatory requirement pertaining to sensitive sectors forced banks to make proper provision for their advances. These measures not only checked the uncontrolled lending to sensitive sectors but also safeguarded the banking system from outside shocks.

Although the Indian banks had no direct exposure in the toxic derivate products, which caused mayhem in the global financial world, they could not shield themselves from the losses in their investments. Banks suffered due to unexpected movement in foreign exchange markets, as the bet placed against a strong dollar resulted in huge forex losses; as a result, banks had to write-off some of these losses and the total write-offs during FY09 rose by 61% over the previous year. The off-balance sheet exposure of banks is another reason for worry. Although the total contingent liabilities have gone down from the previous year, the fall in corporate earnings and confidence can spill trouble for the banks, if their clients are unable to fulfil their commitments.

Steps taken back by countries to tackle subprime crises

In the developed countries, substantial liquidity injection and successive cuts in policy rates have softened short-term interest rates, particularly in the overnight segment. However, the credit market is still to benefit from this softening and it remains impaired; this suggests that the process of deleveraging is incomplete, and asset prices need to stabilise and credit spreads need to narrow further.

Banks and financial institutions are still in the process of recognising losses arising out of off-balance sheet exposures, which raises concerns about the extent of required re-capitalisation. These uncertainties are inhibiting fresh lending. Most importantly, the global financial system is yet to recover the forfeited trust and confidence.

Post-September 2008, various countries reacted to the challenges posed to them in different proportions. The table below gives some of the steps taken by the countries in response to global financial problem.

Steps taken back by countries to tackle subprime crises

Way ahead for the Indian banking industry

Move towards greater capital adequacy: Need to capitalise public sector banks

The RBI has initiated a process for convergence of capital measurement across the globe with the introduction of Basel II norms in April 2007. Basel II is different from Basel I framework as it requires banks to implement an internal process for assessing their capital adequacy in relation to their risk profiles and also implement a strategy for maintaining their capital levels vis-à-vis Basel I. The Basel I norms had addressed only the credit and market risks.

Under the revised guidelines for measurement, foreign banks operating in India and Indian banks having operational presence outside India are required to adopt a new framework with effect from Mar 31, 2008, while all other commercial banks, except RRBs and local area banks, were required to migrate to these approaches not later than Mar 31, 2009. Under these norms, banks are required to maintain a minimum capital to risk-weighted assets ratio (CRAR) of 9.0% on an ongoing basis with a minimum of 6.0% allocated for tier 1 capital.

The CRAR for SCBs increased sharply to 13.0% as of March 2008 against the regulatory requirement of 9.0% and the tier-I capital ratio of 9.1%. Even though these ratios are much above the prescribed limits, equity was removed from the list of eligible financial collaterals due to the excess volatility in the stock markets across the world. Moreover to sustain rapid growth in the credit portfolio of the banks, these banks needed additional capital in the near future.

Keeping this requirement in mind, the RBI allowed SCBs to raise capital through instruments such as innovative perpetual debt instruments (IPDI), debt capital instruments, perpetual non-cumulative preference shares and redeemable cumulative preference shares. All SCBs complied with the minimum CRAR requirement of 9% with minimum 6% in tier I, except for four public sector banks, whose tier I CRAR fell below 6%.

In the past, PSBs relied on the government for capital infusion, but given the growth momentum of the economy, the lending portfolio of banks is expected to witness a manifold increase in the near future, and consequently banks will need to infuse a larger quantum of funds. Based on these propositions, the RBI has projected the number of banks and the amount required to be infused by the government, depending on the increase in the risk weight of asset, as shown in the following table.

Consolidation, is the need of the hour

The Panel on Financial Stability and Stress Testing has observed that competitive pressure has led to a gradual decline in the share of public sector banks in the total commercial bank assets. It has also noted that capital requirements could trigger another phase of consolidation in the banking industry. In the context of the Indian banking sector, the industry is fragmented, particularly PSBs. In such a scenario, the ever-increasing competition in business environment, pressure on profit margins and the need to garner scale for efficiencies may lead banks to look out for consolidation. Also, size is the most important factor as it increases the risk-bearing capacity of banks. Consolidation experiences from across the world reveal that banks derive greater benefits than an individual entity; cost benefits due to economies of scale, organisational efficiency, cost of funding, and risk diversification are the most important benefits that accrue to banks.

Indian banking industry remains largely fragmented

Herfindahl-Hirschmann Index (HHI) has been used to analyse the concentration of Indian banking sector. The use of this Index provides a picture of industry concentration in terms of total assets. This Index is calculated as sum of square of share of each bank in total assets and the Index value falls between zero to 10,000. Markets in which the HHI is between 1,000 and 1,800 points are considered to be moderately concentrated and those in which the HHI is in excess of 1,800 points are considered to be concentrated³.

On analysing the SCBs of India based on the total assets, it was seen that 50% of assets were owned by the top 9 banks. The HHI score (for all SCBs) stood at about 536 and suggested that domestic banking industry is highly-fragmented. If foreign banks were excluded because their presence and size is marginal with respect to Indian banks, the score changes to about 626.

Based on the ownership, the HHI revealed interesting facts about the banking industry in India. Among the banks, assets of private sector banks were found to be highly concentrated, as more than 75% of their assets were managed by top 5 private banks. Similarly the assets of public sector banks were found to be highly fragmented, a fact that calls for consolidation of these banks as higher economies and operational efficiency could arise out of such synergies. The Narasimham Committee (1991 and 1998) also suggested mergers among strong banks both in public and private sectors.

Over the years, there has been considerable progress in consolidation in India in the private sector banks and the mergers have happened not only between weak and healthy banks but also, of late, between healthy and well-functioning banks. The RBI has been supportive of the initiatives for consolidation and there have been no cases so far where the approval for merger of banks was denied by the RBI, as the proposals conformed to the requirements and guidelines of the RBI. The consolidation efforts in the Indian banking sector can be broadly placed, as per the nature of the entities involved and of the mergers, into several categories namely, (a) voluntary amalgamation between private sector banks; (b) compulsory amalgamation of a private sector bank; (c) mergers between public sector banks; (d) mergers of a non-banking financial company (NBFC) with a private sector bank; and (e) merger of a housing finance subsidiary with the parent public sector bank.

As the process of consolidation of banks continued during 2007-08, the number of SCBs declined from 83 at the end of March 2007 to 79 at the end of March 2008. The following chart shows the consolidation process from 2001 to 2008.

Since 1961, 77 bank amalgamations have been carried out in the Indian banking system as per the provisions of the Banking Regulation Act 1949; out of these 77 amalgamations, 46 took place before the nationalisation of banks in 1969, while the remaining 31 occurred in the post-nationalisation era. Of the 31 mergers, in 25 cases, the private sector banks were merged with a public sector bank while in the remaining six cases mergers took place between private sector banks. However, prior to nationalisation of banks, weak financial conditions of these banks triggered mergers.

During May 2005, the RBI issued guidelines for the voluntary merger of healthy banks. Since then, six voluntary mergers took place between private sector banks and the results of consolidation have been favourable in most cases.

However, differences in business process and technological platforms between two organisations posed problems in the path of consolidation. Moreover, stiff resistance from the union and employees added to the bottlenecks. The committee on financial assessment recommended mergers/amalgamations to be market-driven with due consideration for human resources and technical aspects.

Universal banking

Increasing competition among the banks and increasing operating costs have increased the need for banks to shift their focus from basic banking functions of deposit and lending to universal banking. Universal banking allows a bank to offer a range of financial products to its customers under one roof. This shift in the focus of banks also calls for consolidation. Among the banks, private sector banks have been more adaptable to the universal banking model as compared to public sector banks, which has increased the former’s operational efficiency. These benefits of the universal banking can be analysed by comparing the burden ratio of the public sector banks and private sector banks. Burden ratio is calculated as burden to interest income.

Both public and private sector banks reported similar growth y-o-y during FY08; however, the operating expenses of private banks grew significantly. During FY08, the burden ratio of the public sector banks improved significantly to 6.8 from 11.9 in FY07, due to considerable decrease in operating expenses. Even though there was a fall in the burden ratio of public sector banks, it was quite high as compared to private banks because private sector banks were actively involved in para-banking and cross-selling of products like mutual funds, insurance, et al. Thus their burden ratio decreased owing to the y-o-y growth in commission and brokerage incomes.

¹Net Recovery = Recovery of NPAs during the year minus additions during the year

²the negative replacement value represents the theoretical loss on closing the currency transactions open as of 31 December 2008

³HHI parameter as defined from the U.S. Department of Justice website.