India Commercial Banking Report Q3 2007

The recent measures to contain cedit growth are discussed at length later in this report.

India's central bank has been on an extended tightening cycle, having raised the reverse repo rate from 6.00% to 7.75% and the repo rate from 4.5% to 6.00%, since October 2004. It has also been raising reserve requirements, in order to remove liquidity from the financial system and tackle inflation, which has remained a stubborn problem, coming in at a two-year high in February.

The tightening cycle has also been undertaken with the aim of containing credit growth, which has been soaring to unsustainable levels as a con-sequence of strong economic growth (India's economy has expanded by an average of 6.4% since 2001). The relatively undeveloped retail finance sector in India has been exposed to strong demand for credit, which the central bank has sought to constrain with liquidity limitations, while the central government has simultaneously been feeding demand with tax incentives for home buyers. The fledgling financial system is built on relatively strong foundations, thanks to a high domestic savings rate and limited exposure to international financial institutions, but is starting to experience greater foreign competition.

The Commercial Banking Sector India's commercial banking sector is not as prosperous as it has the potential to be. Although it is a large economy and has been experiencing economic growth, this is being jeopardised by clients' distrust, the handling of bonds, loans and assets and the government's unproductive use of the banks as a financial and economic resource.

India's commercial banking sector is unusual in that bonds and loans account for almost all its assets.

'Other assets' - which are mainly claims on other/foreign financial institutions - are minimal. This suggests that the Indian banks are less integrated with global financial markets than their counterparts in other large developing countries. Although India has a large economy, it has long-term structural problems that are preventing customers from fulfilling their needs (i.e. borrowers from borrowing and lenders from lending). In the event of a government financial crisis - or a major sell-off in Indian bonds - the banks would face an interesting challenge. However, recent growth in loans on both the retail and corporate level indicate that the picture is gradually changing.

The good news is that deposits are large relative to some other aspects of the banks' activities, and at US$169bn or so at February 17 2007, the banks' bond portfolios are also large and rising. However, the loan/deposit ratio is also rising (although from a fairly low base), currently standing at 83.1%. This means that to an increasing extent, the banks have been recycling deposits as loans to non-bank customers. The government has not been using the banks as a captive source of capital to finance its deficit.

Prima facie, India is a market in which the banks have the potential to improve the state of the sector and should have many opportunities to distribute other financial products (e.g. insurance) through their branch networks. This would act to ensure continuing growth of the economy and stave off further potential for economic crisis.

Press Reports The Business Standard reported that the Reserve Bank of India (RBI) has proposed a differentiated banking licence policy that could allow some banks to seek licence for a specific activity such as wealth management, with the effect of lessening the regulatory restrictions on banks. Such a policy exists in countries such as Singapore and the UK, and the RBI believes that it may help improve efficiency in the Indian banking sector.

Elsewhere in the press, The Economic Times reports that UK-based Barclays is interested in investing in India's sub-prime and prime mortgage markets. The bank is also planning to enter the credit card market as a solo operator. The Press Trust of India Limited reported on the positive ratings given to India's banks by the global ratings agency, Moody's Investors Service. One of the more interesting findings by the agency was that India's public-sector banks have significantly improved, whilst the private-sector banks have remained largely unchanged in their ratings.

Reuters also reported on the RBI's plan to limit the ability of India's banks to raise funds from overseas branches, with a view to cooling money supply in the economy. The banks can continue to borrow up to 25% of their capital from abroad.