The banking sector has been one of the most visible beneficiaries of overall growth in the economy for the last few years. Banks, especially private sector banks, have aggressively exploited the opportunities by offering a significantly wider range of products and services, adopting better technology and service standards.

The next two years could see the banking sector facing significant challenges in attracting deposits, maintaining capital adequacy and managing bad loans, even as demand for credit remains strong. Their margins could come under pressure as interest rates become more volatile.

Credit growth

Luckily for banks, credit growth may continue to remain strong. Growth in aggregate credit for the banking sector as a whole is estimated to be more than 30 per cent for the financial year 2005-06. The growth is expected to continue this year as well, though the rate may come down modestly.

The most significant driver of credit growth, especially for private sector banks, has been retail credit. Steady growth in income levels has led to significantly higher demand for consumer finance and financial services. Banks, especially private banks, have capitalised on this boom in a major way.

Growth in retail credit should continue for the short to medium term, unless there is a sharp rise in interest rates. The growing retail customer base would also offer opportunities for banks to offer other financial services and earn fee based income.

Corporate sector lending growth, estimated to be less than 15 per cent for 2005-06, is not as high as in the retail segment as Indian companies now have access to cheaper sources of funds, like equity and overseas financing. However, as the size of investments being made by the corporate sector is quite high, the incremental demand for credit would remain strong.

The risk of incremental assets with lower credit quality always exists when banks look to sustain credit growth. This has happened many times in the past when the investment cycle peaks and is followed by a slump. Major banks have already tightened their credit appraisals, in anticipation.

The rush for deposits

The incremental credit-deposit ratio has improved substantially and for many banks incremental credit is higher than incremental deposits for the last many months. Banks have been plugging the gap by reducing their SLR and other investments.

Most banks are now focussing on attracting more deposits to meet the credit demand. Though large banks like SBI are looking at generating resources through securitisation, they many not be sufficient to meet demand.

Deposit rates have gone up in the last few months but returns from bank deposits for retail investors remain unattractive. The bull run in the stock markets is attracting more and more funds from retail investors, who traditionally preferred safer avenues like bank deposits.

New fund offers from mutual funds have collected more than Rs10,000 crore in the Jan-March quarter. A significant part of this would have been parked in bank deposits, if not for the stock market boom.

The huge appreciation in real estate and commodities like gold over the last few years has also made bank deposits unattractive for the retail investor.

The inclusion of bank deposits of 5-years or more as an eligible investment for tax benefits under section 80CC of the Income Tax Act in the recent budget would help banks in attracting more deposits. However, the cost of these long term deposits would be much higher than their average cost of funds.

The rush to attract deposits would lead to a further decline in net interest margins of banks. Some of the private banks with small branch networks would find it tough to compete with the larger banks, and PSU banks, in attracting small depositors. PSU banks definitely have an advantage if they can retain their large customer base of small depositors, a significant source of low cost funds through savings deposits.

Interest rates trend upwards

The RBI has raised key interest rates three times in the recent past and with the latest round early this year the reverse repo rate now stands at 5.5 per cent per annum. The repo rate is currently at 6.5 per cent though the bank rate, more a reference rate, is unchanged at 6 per cent.

Interest rates have been going up steadily across the globe over the last year. The US Fed rate has gone up consistently and now stands at 4.75 per cent per annum after last week's hike.

It is likely that rates may see further modest rise later this year. Banks would find this scenario challenging, as credit growth rates - especially in retail credit - would be affected by any significant change in interest rates.

Last quarter performance

Most private sector banks had a good December 2005 quarter, with excellent growth in income and profits. Retail lending growth continued to be major driver and most banks managed to bring down bad debt provisions, thereby improving the bottom line.

Growth rates for quarter ended December 2005

• Year-on-Year compares December qtr 2005 numbers with December qtr 2004
  
• Year-on-Year compares December qtr 2005 numbers with September qtr 2005
  
• Numbers of IDBI and Centurion Bank of Punjab include the results of entities merged with them and may not be strictly comparable with previous quarters

Growth in interest income would continue in the short to medium term though the growth rates would come down on high base effect. Margins would be under pressure as interest rates become more volatile. Banks would have to increasingly focus on fee based income to protect overall margins.

Need for capital

Banks also need to shore up their capital base to finance higher credit growth. Banks like ICICI have already come out with follow-on public issues and others are planning such issues.

The last few months have seen large issues of subordinated bonds by banks to build up their Tier-II capital base. Larger banks, like SBI and ICICI, have completed or are contemplating overseas bond issues.

The capital adequacy ratio of the banking sector is now comfortably above the RBI stipulated 9 per cent. The situation would change considerably next year as the Basel II norms would have to be implemented.

The road to consolidation

The Indian banking industry is highly fragmented with a large number of medium sized banks, small sized by global standards, in the public and private sectors. Indian banks are considerably smaller than even their Asian peers with only SBI, the 11^th largest bank in Asia, having some size.

Last year, the RBI came out with a road map for further liberalisation in the banking sector. Foreign banks would be allowed to acquire local banks only by 2009. The only exceptions are small domestic banks in a precarious financial condition.

In the meanwhile, foreign banks have been told to reduce their existing stakes in domestic banks to 5 per cent or lower. As a result, HSBC had to reduce its stake in UTI Bank. Large Indian private banks were also told to reduce their stakes in smaller banks and ICICI Bank exited Federal Bank and South Indian Bank. ICICI was the single largest shareholder in both these banks.

As and when acquisitions are allowed, it is very likely that some of the small and medium sized private banks would be acquired by large foreign players looking for a significant presence here. Mergers between some of the domestic banks can also be expected.

In the public sector while the government is pushing for mergers between some of the banks, the employee unions and the political parties which support them are against it on fears of job losses. It would be quite a while before these fears are allayed and some meaningful consolidation happens.

*A professional cost accountant, the author is a stock analyst and indepenent market trader