By Yogendra Singh, CQF, FRM, PRM, CAIA
The Indian Commercial Lending industry is in the throes of a multi-year transformation journey as the confluence of secular trend of disintermediation and the cyclical trend of rising NPAs in a climate characterized by ongoing economic deceleration is challenging the future viability of the current business model.
The structural factor of rising disintermediation – increasing propensity of the corporate sector to go in for market-based instruments like commercial papers and corporate bonds and diversifying funding sources by accessing non-banks and foreign funding – is likely to be the biggest trend impacting the competitive situation of the Indian Banks in the mid-to-long term scenario.
FY17 was a seminal year for this trend as the share of the Banks has fallen below that of the non-banks in aggregate corporate resource mobilization for the first time. This was primarily a result of diverging trends of declining bank funding (driven by rising NPAs and consequent capital adequacy based binding constraints) offset by robust fund flows from non-banks sources like financial market financing, foreign funding and NBFCs.
The experience of the developed countries where financial markets have disintermediated the role of banks in funding for the large corporate sector is a harbinger of the future scenario. Over the course of the next few years, intensification of the disintermediation trend is likely to translate into the following business model dynamics:
• Corporate lending portfolio reallocation towards short-term working capital financing as the banks’ share of the medium-to-long term funding market is likely to suffer comparatively much higher erosion
• Increasing adverse selection of clients as better quality borrowers are likely to migrate towards financial markets at much higher pace
• In conjunction, the above two trends should result in meaningful decline in growth and profitability
• Enhanced focus on the MSME sector on account of its immunity to the disintermediation trend
The specter of ever-increasing NPAs is further compounding the woes of the Indian banking system. The genesis of the current NPA imbroglio lies in the boom times in the mid-2000s when the Indian economy had started growing at the rate of 9%-10%. The ensuing euphoria kicked off the biggest credit fueled investment boom in the country. Between FY05 and FY08, investments to GDP ratio increased by around 9 pps to 35% and the non-food credit doubled in outstanding volume.
However, the boom came to an end in FY08 as the bursting of the global credit bubble in FY08 led to a change in the growth expectations. The double whammy of adverse headwinds of rising costs, higher expenses, margin compression from FY08 onwards and sharp increase in financing costs from FY10 onwards ensured that the debt servicing ability of the Indian corporate sector declined precipitously in the past few years resulting in the ballooning of the NPAs in the Indian banking system.
The situation was exacerbated by the fact that the Banking sector kept increasing its Manufacturing Sector exposure in an economy that was increasingly characterized by the dominance of the Services Sector.
Heterogeneity of NPAs along various dimensions and the resultant short-term portfolio re-allocation by market participants is leading to the following cyclical compositional changes within the aggregate industry:
• Comparatively lower NPAs have led to market share gains by the “MSME (CMR)” segment borrowers
• Private Banks and NBFCs have grown at the expense of PSU banks due to sharply lower NPAs and comparative higher focus on the
“MSME (CMR)” segment
• There has been a shift in the regional market share towards the West and the South regions due to the comparatively lower NPA trends in these two regions.
These cyclical changes are likely to become secular in nature if the NPA crisis continues for long.
It is axiomatic that a business realignment towards MSME lending is the antidote to the ills afflicting the Indian banking system currently. This is one of the rare instances where the commercial imperative of higher growth and profitability is aligned with the societal imperative of financial inclusion.
Even though the banking system has made some progress in improving the access of financing to the MSME sector, a vast swathe of the MSME sector continues to face significant financing challenges thereby representing significant potential demand. However, lending to this sector is beset by several challenges like high cost, lengthy process and turnaround times, inadequate risk assessment systems and consequent low growth and profitability.
Financial institutions can glean valuable insights from the success of the Retail Lending segment in facilitating robust volume growth whilst maintaining risk under control. Credit scoring based risk assessment in an information technology heavy business model – key hallmarks of the retail lending success – can be successfully applied for lending to the micro and small businesses.
Credit scoring based information lending paradigm should provide the following principal benefits to a lender – lower bad debt expense, reduced turnaround time, lesser processing / operational cost. This in turn should result in expanded credit at comparatively lower cost to the micro and small enterprises. Additionally, there would be a meaningful improvement in the se