The Indian banking sector is at a critical juncture in its evolution. It is now clear that the slump in credit growth and increase in stressed assets has affected the profitability of all banks, and threatens the very survival of some of them.
State-owned banks account for more than three-fourths of the stressed asset load, which is now far higher than their net worth. Provision levels are inadequate, as the banks hold only 28% of gross non-performing assets and restructured assets, as provisions. There is a $110 billion gap between the stressed assets in the system and the provisions made. Shifts in consumer preferences, combined with changes in technology and regulations, have created a perfect storm. The way out will depend to a large extent on the speed and direction of stakeholder reactions.
The core challenge is that many of the public sector banks (PSBs) are undifferentiated, sub-scale, and with limited capabilities to be full universal banks. About 80% of them own only 25% of the assets. They also operate in virtually every market segment with very limited sector or vertical-focused specialization. In fact, they focus on the same customer segments, offer similar products, and very often compete only on price. Some of this is because PSBs face challenges that impede them from competing effectively. They have to shoulder a disproportionate share of social and nation-building obligations. Policies on compensation and human resources reduce management autonomy, and inhibit their ability to attract and manage talent.
The recent bank consolidation debates often ignore the underlying challenges of India’s banking industry structure. While it is clear that an industry with over 20 undifferentiated, state-owned banks is not working, a country of India’s scale and diversity needs more and varied banks. The industry plays a fundamental role in the delivery of social schemes which are critical at this stage of India’s economic development.
Empirical evidence from bad-loan crises in other parts of the world suggests that resolution often coincides with a consolidation of the banks. To that extent, it is probably inevitable in India. However, our argument is that consolidation by itself is not enough. The perils of force-fitting state-owned institutions are well documented; a lasting solution will need to offer the banks more freedom with capital and talent. Targeting a robust “end-state” industry structure and thinking beyond consolidation, are necessary for this to happen. And even as consolidation happens, innovation from existing and new players need to be encouraged to serve the large and diverse needs of the country. If well executed, such a restructuring could catalyse a transformation of India’s banking sector.
PSB reform is a complex issue and there could be several paths to building a robust industry structure. One option could be to continue the status quo, where the 21 PSBs (after the merger of State Bank of India with its associates and Bharatiya Mahila Bank) operate as before, but with greater autonomy for their boards. This option will have limited impact on improving the stability and performance of the system. A far more effective but disruptive option, would be to create mega-PSBs by consolidating entities into three or four players. While this would enhance their performance, it would be extremely challenging to implement.
Given the ground realities, the target end-state of the industry could well be a hybrid approach, creating one or two global banks and two to three large national banks through mergers. This would ensure that India has three to five banks, each with sizeable global or national presence. These large banks would offer a full-range of commercial banking services to corporate, small and medium enterprises (SMEs), retail, mass banking and international customers. The remaining banks could continue under government ownership, but eschew lending to large corporates. They could specialize, with focus on select products or geographies, largely for retail and SME customers. Alternatively, they could shed their public ownership and chart a growth plan that best suits their expertise.
Identifying anchor banks for consolidation would be a logical first step to restructuring. The top three or four high-performing PSBs with sizeable scale (including international presence), better balance sheets, progressive management and global aspirations, could be the anchors. National-scale players could be anchored by PSBs with strong national or regional brands, a multi-state presence and stronger balance sheets than regional counterparts. Some regionally focused banks could be grown through mergers to bring them to national stature.
Restructuring of banks is a multi-year journey. Aligning the sequencing of the consolidation is essential for success. The first set of mergers could be initiated by global and national anchors. Each anchor could select one or more consolidation partner, based on expected benefits from the merger and the relative ease of implementation. How smoothly the mergers are implemented would depend largely on the capital requirement, level of digitization and technological-commonality among the banks. Banks could opt for a 12- to 18-month “smart merger”, prioritizing easier decisions, and stagger more complex ones. Selecting the right architecture is vital to the process. The choice of merger-architecture could well determine the speed of business and functional integration after the merger.