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Sector Report:

Banking Sector in India

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Contents

# Topic Page

1 Structure of Indian Banking sector 3

2 Operating Model 5

3 Important rates in Banking 6

4 Trends across Key Metrics 7

5 Snapshot: Financial Statements of a Bank 8

6 Capital Requirements 9

7 Valuation Methods 10

8 Drivers of Growth 11

9 Constraints to Growth 14

10 Private v/s Public Sector 16

11 Impact of COVID-19 17

12 Market Opportunities 19

13 Prospective Challenges 22

14 References 23

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Structure of Banking in India

“Banking” means the accepting, for the purpose of lending or investment, of deposits of money from
the public, repayable on demand or otherwise, and withdrawal by cheque, draft, order or otherwise.
-Section 5(b), Banking Regulation Act, 1949

Indian Banking
Industry

Scheduled Non-scheduled
Banks banks

Commercial Cooperative
Banks Banks

Public Sector
Urban (1484)
Banks (12)

Private Sector
Rural (96,000)
Banks (22)

Regional Rural
Banks (43)

Foreign Banks
(46)

1. Scheduled Banks: All banks which are included in the Second Schedule to the Reserve Bank of
India Act, 1934 are scheduled banks. These are further classified into Scheduled Commercial
Banks and Scheduled Cooperative Banks.
a. Scheduled Commercial Banks: in India are categorized into five different groups
according to their ownership or nature of operation.
i. Public Sector Banks: Majority stake is held by Government of India.

ii. Private Sector Banks: Majority of share capital is held by private individuals

iii. Regional Rural Banks: RRBs were established in 1975 with a view of serving
primarily the rural areas of India with basic banking and financial services

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iv. Foreign Banks: Incorporated in foreign countries and operate their branches
in India
b. Scheduled Cooperative Banks:

i. Rural Cooperative Banks

ii. Urban Cooperative Bank

Differentiated banks:
Banks that cater to specific segments of customers are called differentiated banks.

• Small Finance Banks: Focused mainly towards financial inclusivity, small finance banks
provide basic banking services. They cater mainly to individuals from the underserved sections of
society as well as businesses from the SME sector.
o Similar regulatory requirements as regular commercial banks
o SFBs are required to extend 75 per cent of its Adjusted Net Bank Credit to the sectors
eligible for classification as priority sector lending by the RBI
o At least 50 per cent of its loan portfolio should constitute loans and advances of up to
Rs. 25 lakhs.
Eg: Ujjivan, Janalakshmi, Equitas, etc.

• Payments Banks: These banks are allowed to accept deposits of up to Rs. 2,00,00, however
they are restricted from lending and issuing credit cards. Most other banking operations like
mobile payments, remittance service, issuance of ATM, debit cards, etc. are open to payments
banks. Their main aim is to make financial services easily accessible to lower income groups,
backward regions, etc.
Eg: Paytm Payments Bank, Airtel Payments Bank, Fino, NSDL Payments Bank, etc.

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Operating Model
A commercial bank’s major function is the creation of credit by lending money to individuals as well as
institutions. For this purpose, it raises funds, by accepting deposits or borrowing from the RBI, other banks,
financial institutions or via financial markets, by means of debt, equity or hybrid securities.
Since this model itself involves some risk, there are certain mechanisms by which the central bank controls the
lending ability of commercial banks. These may be
i) Quantitative: Like changes in CRR (cash reserve ratio), SLR (statutory liquidity ratio), etc.
ii) Qualitative: Like changing margin requirements which influence the amount of collateral demand
of collateral, issuing directive principles, etc.
The following figure illustrates a bank’s operations and some specific rates associated with them.

Sources of Funds Lending Activities

• Accepted Deposits • Loans – short,
• Borrowings from
RBI medium & long
RBI (@ Repo), others term; secured &
banks (@ MIBOR) & Credit Controls unsecured
financial institutions • Quantitative • Overdraft
• Capital from debt, (CLR, SLR, etc.) • Cash Credit
equity, hybrid • Qualitative • Money market
instru. lending
• Fees for services • Discounting of Bills

Ordinarily, the RBI does not often move the CRR and SLR. Under extreme situations, however, it becomes
necessary to make use of these measures. The repo rate, on the other hand, is a highly used tool of the RBI.

As the figures show, the CRR has only seen a steep decline during the pandemic, when the RBI was trying to
infuse liquidity into the economy. The repo rate, on the other hand, shows constant fluctuations. Although it
too, has seen a considerable reduction after the pandemic.

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Important rates in Banking

Current
Term Details
Level

Loans that have not yielded interest 90 days or more after Ratio of gross
Non-Performing
the interest payment NPAs: 3.9%
Assets
due date. (March 2023)

The Mumbai Interbank Offer Rate (MIBOR) is one iteration

MIBOR 6.89%
of India's interbank rate, which is the rate of interest
(Overnight) (20.12.2023)
charged by a bank on a short-term loan to another bank

The rate at which commercial banks can borrow from RBI

Repo Rate for short term liquidity adjustment (net amount after 6.50%
borrowing among themselves).

Reverse Repo The rate at which the RBI absorbs excess liquidity from the
3.35%
Rate commercial banks

Marginal The rate at which banks borrow funds, in excess of the

Standing Facility specified threshold, overnight from RBI against government 6.75%
Rate securities

The rate at which the RBI lends to commercial banks for

Bank Rate 5.15%
long term borrowing

The proportion of Net Demand and Time Liabilities that the

Statutory
commercial banks have to invest in specified government 18.00%
Liquidity Ratio
securities

The proportion of Net Demand and Time Liabilities of

Cash Reserve commercial banks that must be kept as cash or in liquid
4.50%
Ratio form so as to meet any unexpected demand of money by
depositors

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Trends Across Key Metrics

Soundness of banking sector

Deposits

• Lower slippages also contributed to a reduction in the GNPA ratio to a five-year low in 2022-23

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Trends Across Key Metrics

Return on Assets Return on Equity

• Reflects net return per currency unit of loan • Measures effective utilization of capital’

Net Interest Margin Capital Adequacy Ratio

• Measures profitability through interest spread • Measures liquidity of a bank
• Slight reduction due to low loan growth

Tier 1 Leverage Ratio

• Measures liquidity of a bank
• Tier I leverage ratio10 sustained its Mar-23 level,
with AT I capital accretion matching incremental
total exposure during H1:2023-24

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Snapshot: Financial Statements of a Bank

Income Statement

Major components of other income include commission, exchange & brokerage, insurance premium
income, P/L on sale of investments etc. Major components of operating expenses include employee
expenses, rent & utilities, insurance, expenses of subsidiary businesses etc.
Balance Sheet

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Capital Requirements

Since banks take up a considerable amount of risk through their lending operations, regulators require
them to maintain a certain amount for “cushioning” the effect of potential default. These requirements
are termed as Capital Requirements and the amount is held as a percentage of risk weighted assets.

Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a
firm's balance sheet.

The main international effort to establish rules around capital requirements has been the Basel
Accords. It sets a framework on how banks and depository institutions must calculate their capital.
After obtaining the capital ratios, the bank’s capital adequacy can be assessed and regulated.

As per Basel III regulations, all SCBs were required to maintain a CAR of 11.5% from March 31, 2020
onwards (CAR of 9.0% along with capital conservation buffer (CCB) of 2.5%). However, with the
outbreak of COVID-19, RBI decided to defer the implementation of the last tranche of 0.625%. The
current regulatory requirement is 9% (11.5% including the capital conservation buffer, which is
another capital requirement) while the ratio observed on an average for scheduled commercial banks
is 16.03%. RBI’s projections for September 2024, however, show a fall in the CAR, the most likely
estimate being around 14.8%.

Further, systemically important banks need to maintain an additional requirement of over and abovethe
9% CAR (which includes SBI: 0.6%, HDFC: 0.2% and ICICI Bank: 0.2%).

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Valuation Methods:

1. P/B Ratio: Assets held by banks are typically in the form of financial instruments (loans, bonds
and other securities as well as derivatives) that have well defined cash flows. These are relatively
liquid assets that can be valued at fair market value. Book values are much closer to market
values than is the case for non-financial corporates, where most of the assets are carried at
depreciated cost.
𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒 × 𝑁𝑜. 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒

2. Intrinsic valuation: Since the book value of equity is more reliable and cash flows are highly
volatile, and less accurate as a metric of assessing management competence, shareholders equity
can be used as a starting point for valuing banks. This method is known as the Excess Return
Model and it arrives at the value of equity as the sum of the current equity capital and the present
value of expected excess returns to equity.

𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = (𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 – 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦) × (𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙)

If a bank is earning extremely high excess returns, it is important to do a multi-period valuation

whereby returns decline to a long-term sustainable level over time. Once the firm reaches its
long-term sustainable operating level, terminal value can be calculated that incorporates this
long-run moderate growth.

Other methods: Banks can also be valued by discounting the dividend stream using projected pay-out ratios,
or asset liquidation values, or relative valuation methods with respect to the loan book etc.

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Drivers of Growth: Strengths of the Banking Sector

Steady healthy growth in bank credit and deposits
In the past month, bank credit growth has stayed steady at 16% (ex-HDFC Bk merger). We expect rising capex
intensity to provide upside but in FY25/26. Deposit growth is also stable at 13% YoY & with rising preference
for term (higher rates) over savings.

Liquidity & Rates: Liquidity is in deficit; G-Sec yields fell

System liquidity continues to be in deficit with banks borrowing Rs1.3tn avg over the month through Repo &
Call rate staying 20-30bps above Repo Rate. While G-Sec yields were flat in shorter tenure, they fell by 10-
15bps in 3-10yr bucket. Similarly, yields fell for corp. & NBFC bonds but by a lower extent of 3-8bps. MCLR
rates rose 10bps for SBI but were largely stable for others. Select banks have raised term deposit rates in
December, especially shorter-term.
Improving NPAs
The improvement in SCBs’ asset quality has been broad-based (Chart 2.3 a). The GNPA ratio of the agriculture
sector remains high at 7 per cent. At an overall level, asset quality in the personal loans segment has improved,
although there has been a marginal impairment in credit card receivables (Chart 2.3 b). Within the industrial
sector, asset quality improved across all major sub-sectors barring infrastructure (other than electricity) and
petroleum (Chart 2.3 c).

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Increasing Number of Accounts

Over the past few years, the number of bank accounts in India has increased briskly. Around 80% Indians now
have bank accounts. In a country with a massive informal economy, an increasing number of bank accounts
helps integrate the unorganised economy into the organised one.

Although many of these accounts are “zero-balance”, which means that they might end up not garnering any
significant deposits, the percentage of zero-balance accounts has been falling over the years – from 75% in 2014
to 17% in 2018 [3].

This shows that the degree of financial inclusion is gradually rising. Although people from lower income groups,
do not save a significantly high proportion of their income, since a major chunk of Indian households falls
within this group, the collective amount that they add to bank deposits is considerable.

Rise of UPI
United Payments Interface (UPI), launched by the National Payments Corporation of India (NPCI) in 2016,
facilitates inter-bank, peer-to-peer and person-to-merchant payments. With the increasing internet and mobile
penetration, more and more transactions are being undertaken using UPI. It is the most-used mode of cashless
payment, although the average size of transactions remains low. However, the growth in both, volume and
magnitude of transactions has been considerable.

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Constraints to Growth: Weaknesses of the Banking Sector

Loan Growth: Low for Industry
Despite a reasonable growth rate of deposits, loan growth in India has remained tepid. This was further
exacerbated by the pandemic – as lockdowns were declared, the operations of numerous companies had to
abruptly cease. This rendered a lot of enterprises, especially small and medium ones, risky investments, making
banks wary of lending. MSMEs have historically been one of the most credit starved sectors in India, with a
credit gap of $240 billion.
Growth in personal loans, however, has been very strong. Growth in loans to the service sector too, have also
been highhistorically and the pandemic has not much dampened the long term average.

Public sector banks have been more wary of lending, perhaps considering their already high levels of NPAs.
Suchlow loan growth to non-service industries has resulted in low leverage ratios of companies, which in turn,
haverestricted their growth.

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Private v/s Public Banks

Income Growth
The income growth of private sector banks has historically been higher than public sector banks. But during
2020, the income growth of public banks has improved substantially, lowering the gap between the growth of
public and private sector banks.

Share in Assets
Currently, in India, public sector banks own about two thirds (63%) of the total assets; the average for other
developing economies is around one third (33%). Since public sector banks are more vulnerable to undue
influences and malpractices in lending and managerial decisions, them being in-charge of a majority of the
assets, can adversely affect growth due to high defaults.

Growth Prospects
Over the years, private banks have managed to bridge the gap between the market shares of private and public
sector banks. As the following trend shows, private banks now have a much higher share in both, loans and
deposits, as compared to previous years. This rise has been secular and if it continues, private sector banks are
poised to overtake public sector banks in terms of market share.

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Market Opportunities
Bad Banks
The FY ‘22 Budget introduced the idea of setting up the National Asset Reconstruction Company Limited
(NARCL) – an organisation funded, mainly, by public sector banks like SBI, Bank of Baroda, Punjab National
Bank, etc. in order to purchase the NPAs of banks and obtain maximum salvage value out of them.
Since 2016, the Insolvency & Bankruptcy Code has been instituted for the resolution and as necessary,
liquidation of sick units. Although the duration for resolution is, on paper, 330 days, in practice cases take an
average of around 440 days [4]. It has been reported that, as the time for resolution increases, the recovered
value falls from the average of 43% to 15-20% [5].
However, the introduction of NARCL will open multiple avenues for recovering the value of NPAs. The bad bank
will purchase the stressed assets from the banks. In doing so, it is required to pay a fixed proportion of the value
of the asset upfront. Considering the volume of NPAs in India is as high as Rs 6 lakh crore, an ARC would need
to possess adequate capital if it wants to buy a significant chunk of the stressed assets. Although the required
minimum capital for setting up an ARC is Rs. 100 crore, the contributing banks are providing capital worth Rs.
7000 crore for the NARCL. This would be adequate to cover the estimated upfront costs (Rs. 2000 crore) of
buying the assets.
Moreover, it would also open up other avenues of recovering maximum value out of the assets.

After purchasing the stressed assets, apart from initiating the I&B process, the ARC can sell the business to
interested PE/VC firms, can consider merging with a firm that can possibly gain synergy through a acquisition
of the stressed asset; it can even hire experts to turn around the business if it seems feasible.

Fintech Solutions & Digital Lending

With increasing internet penetration and mobile phone usage, there has been a surge in the number of digital
and fintech solutions offered for banking problems.

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For instance, a number of players have sprung up in the alternative lending space - India has 769 startups
functioning in this arena, Navi, Lendingkart, CapitalFloat, InCred, etc. being the notable few [6]. While some of
these cater to both personal finance as well as loans to MSMEs, some cater exclusively to the latter. They
provide solutions to MSME borrowers’ lack of credit history by using machine learning and data analytics to
identify alternative credit scoring metrics.

The digital lending market in India is set to witness a meteoric rise, attracting big players. Facebook announced
that it would introduce a digital lending program for small businesses, with loans from Rs. 500,000 to Rs. 5
million. There have also been acquisition of Indian fintech startups through acquisitions and VC investments [7].

Neobanking
Neobanking delivers banking services via the internet and electronic media. Globally, the neobanking market is
set to rise at a CAGR of 46.5% between 2019 and 2026, taking it to around $ 395 billion [8].

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While neobanks have the same offerings as traditional banks, their processes for delivering them are more
efficient and cost-effective. In India, as of now, neobanks are not issued banking licenses. Hence, there has not
been significant development of neobanks in particular, it is mainly fintech players from other areas that
partner with regular banks to provide non-branch banking services. On the backdrop of the revolution in
fintech, some easing of regulatory restrictions would help reap the benefits of the burgeoning neobanking
market.

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Prospective Challenges
NBFC Crisis
In 2017, commercial banks saw their share in credit fall from 62% (2014) to just 35%, while that of non-banking
financial companies went up from 20% to 30%. During this period, due to demonetization banks also had
excess liquidity and were wiling to lend to NBFCs. Mutual funds too, were a source of finance for NBFCs. Since
the were after high returns, the NBFCs focused more on generating high returns rather than appropriately
assessing the risk. In June 2018, IL&FS began a stream of successive defaults till its debt had piled up to Rs.
91,091 crores. This served to highlight the fundamental flaws in NBFCs model of borrowing for the short term
and lending for the long term; investors became skeptical of their future and mutual funds discarded the
commercial papers of NBFCs. Their cost of funding increased by around 150 basis points. Ultimately, it also
hampered growth.

During the pandemic, apart from the risk aversion to lending, the lockdowns also affected collections of
repayments; 35-40% of NBFCs’ collections are on-field collections, done mostly in cash. Due to restrictions on
movement, on-field collections have been difficult, leading to a rise in defaults. The effect of these issues cannot
be seen in the data for 2020, mainly because about 85% of the loans they restructured during the pandemic
have a moratorium of upto 12 months; a rise in NPAs is expected by Q3 2021.

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Problems in Fintech
High Default Rates
More than 33% of Indian fintech borrowers today have never borrowed from a bank. Most digital lenders tend
to operate in the unsecured lending markets, which exposes them even more to default risks. Research from the
Harvard Business School suggests that within 15 months, default rates for fintech loans become twice as high as
those of regular loans [9].

Data Protection
A survey conducted in 2019 found that most fintech firms did not adequately adhere to data security norms.
There have been instances of lending apps collecting data from unauthorised sources in order to gauge
borrowers’ credit history.
Payment apps also require details like credit card number, account number, etc. Whether, where and in what
form these data get stored needs to be appropriately regulated. Recently, the RBI put a ban on Visa and
Mastercard for storing data of Indian users overseas. As digitalisation in banking becomes ubiquitous, multiple
such questions will have to be tackled.

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