Banks cannot ignore weak spots: S&P

ANALYST'S VIEW

The banking sector in India is highly fragmented, with 53 domestic banks accounting for about 93 per cent of the system's assets. The top 10 banks together account for 66 per cent of the system (as of March 31, 2006), with the remaining 27 per cent market shared between 43 banks. The banking business benefits from scale, especially with the increasing role of marketing- and technology-based systems.

Niche banks can thrive as long as their niches are sustainable. With technology-based distribution and superior customer delivery allowing national banks to enter the strongholds of regional banks, the latter has come under threat and their financial profile will eventually weaken. It is already noticeable that, while most of the Indian banks have healthy key financial parameters, there are a few small players whose profitability and asset quality (level of non-performing assets) appear weak.

With about three-fourths of the banking systems' assets in the hands of 29 public sector banks, a meaningful consolidation is not possible until this segment is included in the process. Hence, it is the government that determines the extent and speed of consolidation in the Indian banking system.

Risk management

Despite some improvement in risk management capability, progress is still generally slow, and expected to remain so, especially since the implementation of the new capital adequacy framework, based on the minimum capital requirements under Basel II, was deferred to 2008 financial year.

Banks, while continuing to establish sound risk management practices, has found it difficult to keep pace with the emerging risks in the environment they operate in. Despite significant improvements in the past decade, risk management is still largely a work in progress for most Asian systems.

Unseasoned loans

With strong credit growth and weak risk management systems, especially in smaller banks, there is high potential for an understatement of problem assets. As of March 31, 2007, Standard & Poor's estimates that at least 40 per cent of all the loans were less than two years old, raising concerns that, when seasoning occurs, a significant amount of new NPA could emerge.

The high portfolio growth suppresses the NPA ratios. A steady decline in the lagged NPA (1-year lagged as well as 2-year lagged) indicates that the improvements in the portfolio quality are systemic. In the current economic scenario, potential for a significant rise in problematic assets seems low; in the event of an economic slowdown, the rise could be pronounced.