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Beyond Just Growth

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The global credit crisis may have faded from public memory, but the consequences continue to linger. For banks, it has changed the structure of their balance sheets so that the way they do business in the future is different. Some of that change is permanent: here, and overseas, banks are readying for new regulatory norms — and perhaps with more stringent compliance — for capital adequacy and management.

The future of banking, say experts, is about more capital, more liquidity and less risk. For banks the returns on capital are lower; the costs of doing business are higher; and with slower economic growth, the effects will be felt by shareholders and bank customers.

As some banks in Europe teeter on the edge of insolvency and the threat of bank failures looms larger, the balance between capital-plus-liquidity and lending-plus-profitability is shifting to the former.

The debate has also shifted the emphasis on different forms of capital resources (read deposits) that banks use. For instance, several mid-size and private sector banks that grew at very high rates in past years by relying on wholesale deposits, have now shifted strategies to gather core retail deposits. Recently, a number of them raised savings account rates as soon as the Reserve Bank of India (RBI) deregulated savings account interest rates.

But it is not just the question of resources that is a source of concern, but also how the resources are allocated. In other words, it is about bank capital management, and how bank strategies shift between allocation as per the regulatory capital (for compliance purposes) and economic capital (to generate financial returns).

In practical terms, that translates into the following questions: how will banks raise capital for growth? How will they meet capital adequacy norms? What balance sheet risks will they take, and how will they manage those? What kinds of businesses will they go in for?

Capital Ideas
"At least every two years, banks raise capital in one form or another," says Rashesh Shah, chairman and CEO of Edelweiss Financial Services, a Mumbai-based firm. True. But public sector banks account for nearly 70 per cent of the banking industry, which means that the government must pony up the additional capital that must help them meet regulatory capital standards, as defined by the Basel II norms, and soon Basel III.

The government faces two challenges in addressing this. First, fiscal space: it does not have the revenue resources to put in a lot of capital. Even in the boom years, bankers were concerned that the government would be limited by not being able to divest beyond 49 per cent of its stake in public sector banks.

The second is allocation. Traditionally, the government capitalised the weakest banks to shore up their balance sheets. But more recently, it began — rather paradoxically — to increase its stake in the stronger banks. Take Bank of Baroda, this year's fastest-growing large bank in our survey.

In this year's budget, out of the allocation for capitalising banks, the government increased its stake from almost 53 per cent to 58 per cent. "It is the smaller banks that are likely to face problems on the capital front," says Rupa Rege-Nitsure, chief economist at Bank of Baroda.

Monish Shah, director at global consulting firm Deloitte sees it as a system issue rather than an institutional one. "A lot of the new capital in the banking system will come from new banks that will be licensed," he says. "They will have greater degrees of freedom, and will be entering a much more mature market than their predecessors."

But the issue of larger capital needs to maintain the pace of growth of the industry cannot be ignored either. "Banks can grow only as fast as their retained earnings," says Edelweiss' Shah. "That has been growing at 15-16 per cent, and to keep that growth rate going, banks will need larger amounts of capital as they grow bigger."

Shah is not off the mark. Almost every bank CEO these days talks about growth opportunities and how his bank plans to exploit them. The only problem: how does he propose to achieve and maintain those growth rates.

Speed Breakers
It would be unkind, even wrong, to think of the RBI as an impediment to banks' growth. If anything, the prudence of the central bank over the years has ensured that banks do not get too carried away and try to grow at breakneck speed.

If anything, the Indian banking system is well prepared to meet the stringent prospective capital requirements under Basel III ahead of schedule. In many ways, Basel III is like Basel I, but with tougher capital standards defined by higher capital definition restrictions and risk-weighted assets, additional capital buffers and higher minimum capital ratios.

Since banks in India have minimal or very small capital markets businesses, the higher risk weights associated with trading books will not be a problem. "But banks will still have to devise better stress-testing mechanisms and counterparty risk measures," says the head of the financial service practice from a global consultancy. "That is where Indian banks may be a little weak."

Business models may also have to be re-visited in light of the new norms. For instance, retail portfolios, including housing and personal loans that led to large-scale securitisations, may find less favour. If nothing else, the downgrade of State Bank of India (SBI), the nation's largest bank, by rating agencies will make its rivals reduce their speed in retail lending.

Does that mean growth has to sacrificed at the expense of safety? "How they propose to tackle the all-important growth question is something that banks will have to address individually," says Deloitte's Shah. "Up to now, they have been growing at two-and-a-half times the rate of the economy."

Both higher prudential capital requirements and changes in the structure of the economy will pose challenges for capital allocation and business models. Efficiency will be a key differentiator, and pricing strategy will undergo some changes; already, the savings and deposits market, if we can call it that, is subject to some serious competitive pressures.

Rules Of Risk
Risk management will be a key concern for most Indian banks, and for a number of reasons. "In many banks, non-performing assets (NPAs) have been growing faster than retained earnings," says Edelweiss' Shah. "That puts stress on available capital, both regulatory and economic, and on banks' return on equity."

"The awareness of economic risk within our banks is low," says a senior consultant from another consulting firm who requested anonymity. "Often, the risk assessments are not commensurate with the pricing of that risk." Could that be the reason for the higher NPAs, rather than a consequence of a slowing economy?

"Regulation is more evolved now," says Deloitte's Shah. "Risk management is in a sense enforced by prudential regulation." He agrees that many banks have their own internal risk models — our survey demonstrates that risk awareness is growing — but also that risk pricing could be improved considerably.

One way to do that is through technology. Banks can go in for more data warehousing, better data analytics and institutionalising the process. Another is to take a leaf out of the book of insurance companies — they have similarly high and restrictive capital standards — that have been building these for years. Yet another is the development of internal risk models.

Bank of Baroda's Nitsure suggests that the new rules have big implications for cost of capital or the cost of funds. "It will affect how banks meet credit demand," she says. "Net interest margins will in all probability decline, and force greater efficiency gains. Big trading profits would become harder to achieve too."

Ultimately, banks may have to quickly better their risk management practices, and integrate them into business strategy and implementation. As one analyst puts it, "risk management is a business requirement beyond growth".

Therefore, it is apparent that having high levels of capital adequacy will not be enough by itself. Managing that capital, and the capital deployed through lending, will be just as important, if not more.

Much of the research into capital management suggests that integrating regulatory and economic capital decisions into performance is not easy. But that does not mean it should not be attempted. Indian banks are halfway there, with more than adequate capital and a watchful regulator. They now need to take that additional step and manage it actively.


(This story was published in Businessworld Issue Dated 28-11-2011)