KPMG ICC Indian Banking the Engine for Sustaining Indias Growth Agenda

Indian Banking – The engine for sustaining India’s growth agenda 5th ICC Banking Summit Kolkata 18 May 2013

Foreword

Over the past couple of years, the Indian banking sector has displayed a high level of resilience in the face of high domestic inflation, rupee depreciation and fiscal uncertainty in the US and Europe. In order to stimulate the economy and support growth of the banking sector, the Reserve Bank of India (RBI) adopted several policy measures.

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Asset quality, capital adequacy, financial inclusion and talent management are some of the key issues facing the Indian banking industry, which despite serving the second largest populated country in the world with a total of 87 banks (including 26 public sector banks, 20 private banks and 41 foreign banks), as per the RBI, reaches out to only about half of the country’s households, scripting a nominal global footprint. The rising consumerism from the emerging ‘middle’ India and the higher purchasing power in rural India on account of rising employment provides opportunities for banks to look beyond the traditional customer segments. However, these segments would require flexible operating models which would ensure responsiveness at the last mile and at the same time be viable for the banks. On the other hand, global aspirations of Indian corporates calls for funding of cross-country acquisitions, greater sophistication in services and scaling up of resources from the Indian banks. RBI’s final guidelines for licensing of new private sector banks towards beefing up competition and garnering fresh capital for financial inclusion would roll in a timely debate on the need for consolidation vis-a- vis numerical expansion in the industry. Capital adequacy will start becoming a big issue for the commercial banks in India, as they start gearing for growth and becoming compliant to Basel III guidelines.

Ambarish Dasgupta

Head - Management Consulting KPMG in India

To meet these requirements and challenges, industry players are gradually harnessing technology with cloud computing and analytics based on big data becoming a key differentiator. The budget referendum of allowing banks as insurance brokers is also a welcome move for the industry, which will gradually forge out a financial supermarket for the customers. With tele-density (based on total number of mobile connections) standing at 74.21, in 2012, according to Telecom Regulatory Authority of India (TRAI), India can consider the Kenyan model of ushering in financial inclusion through mobile banking services, including money-transfer systems and savingsand-loans services, through a simple SMS network. Leadership and the ‘right’ talent would be very critical for banks over the next 4-5 years as they work towards achieving their growth agenda and ward off competition for talent from the new local and foreign banks. The future operating model for banks would force banks to choose their areas of differentiation and expertise rather than aspiring to be a single service provider. This paper discusses the opportunities and challenges that lie ahead of the Indian banking industry. It also touches on some possible avenues for augmenting banking penetration in the strategically placed Eastern and Northeastern states of India.

Rajiv Mundhra

President ICC

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Acknowledgements Ravi Trivedy Kunal Pande Neha Punater Kuntal Sur Jacob Peter Aniruddha Marathe Gaurav Batra Rohan Padhi V. Ramakrishnan Natasha Wig Ankur Jain Priya Aggarwal Bhargava Pingali Divya Kalari

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Table of Contents 01

Indian Banking – Emerging Opportunities

15

Infrastructure financing – building the foundation

29

Big Data as a source of real time business insights

05

Funding the aspirations of emerging modern India

21

The Aam Aadmi – profitably serving the unbanked and underbanked

35

Public sector banks – Challenged for growth capital

11

Micro, Small & Medium Enterprise – The next growth engine for banking

25

Innovative and cost effective operating models

39

Addressing the leadership vacuum in the PSBs

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1 | Indian Banking - The engine for sustaining India’s growth agenda

Indian Banking – Emerging Opportunities Raising capital for public sector banks (PSBs) — Yes, it could be a problem in the future! As per KPMG in India’s analysis, capital requirements of public sector banks in the future will be based on three assumptions: • GDP growth rate of 6-7 percent

that will require credit growth of 20 percent • Basel III norms applicable to higher risk assets that banks will have to develop in the future (Micro small and medium enterprises (MSME), retail) • Government ownership in the range of 50-60 percent. Assuming an annual credit growth rate from FY12-FY21 at 20 percent and the annual risk weighted asset growth rate at 22 percent, we expect the Tier-I capital requirement for public sector banks for the same period to be in the range of INR 9,60,000 crore1. Given

our current fiscal deficit, government may not be able to infuse additional capital in public sector banks. Also, the government’s intent to not dilute their stake leaves them with few options: • The Government could consider

creating a holding company (Holdco) and transfer its stake in the PSBs to this company. The Holdco can raise long term debt from domestic and international markets to infuse equity in the PSBs and act as an investment company for the Government of India. • The Government could consider

diluting its stake in PSBs through issuance of Differential Voting Rights (DVR) such that the economic stake dilution is also kept to the minimum. The Government could

avoid any dilution in its voting rights by first infusing money into the banks through issuance of normal shares to itself, which would raise its stake during the interim period, and follow this up with DVR issuance to the extent that its effective (voting rights) holding remains unchanged. The money can be infused either through preferential allotment of equity shares or through allotment of warrants. • The Government may consider in

the future on having a Golden share in each of the PSBs under which while the Government’s economic and voting stake may fall below 51 percent, it will always have the right to control the respective PSBs due to the possession of this Golden share.

1 KPMG in India Analysis; Based on a paper developed for a committee on ‘Funding of Capital Requirements of PSU banks by Government of India’ © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Indian Banking - The engine for sustaining India’s growth agenda | 2

M&A in PSBs will be a reality only when the Reserve Bank of India (RBI) intervenes Can two healthy public sector banks voluntarily merge to create a large bank? Considering the past record, no! Most of the mergers in the past have been either through the acquisition of a small or regional bank by a large private bank (such as the acquisition of Centurion Bank of Punjab by HDFC Bank2 or the Bank of Madura by ICICI Bank3), or through the RBI managed process of a forced amalgamation of a potentially failing bank into a strong bank (such as the post-moratorium amalgamation of GTB Bank with Oriental Bank of Commerce4 or the acquisition of Bank of Rajasthan by ICICI Bank5). The RBI has encouraged voluntary consolidation in the past but to no avail. India critically needs at least 3 to 4 large banks that are globally competitive and can meet the growing demands for cross-border acquisitions by the Indian corporate and take on larger ticket risks on their balance sheets without hitting limits ceilings. As per The Banker in 2012, there is no Indian bank in the top 10 amongst the list of top 1000 banks of the world, whereas China has 4 banks in the top 10 list. In fact, Chinese banking giant-ICBC, occupies the third rank on the top 1000 banks of the world, while

Sr.No.

Particulars

Indian banking giant-State Bank of India ranks at a low 60. Given the fact that over 70 percent of the market is dominated by PSBs, the Government of India and the RBI will have to drive consolidation amongst the large PSBs to create ‘large banks’ by mandating the merger of identified banks. This will be a significant departure from the previously stated non-interventionist policy of the finance ministry and the RBI, and as expected, will require great political will power and many levels of dispute resolution models. One of the most critical challenges of any mandated merger will be linked to the integration of the two teams in the merged entity. Efficiency gains will only accrue if the branch and skills overlaps of banks being merged are resolved amicably – both of which will severely test the relationship with strong trade unions and the working environment with bank staff competing to retain their jobs. Thus to achieve any consolidation, the Government and the RBI will have to strengthen their resolve to manage these tricky and politically sensitive issues.

Expect competition from foreign banks as they acquire ‘near national treatment’ The RBI announcement of a roadmap for seeking the conversion of systemically important foreign banks to ‘Wholly-Owned Subsidiary (WOS)’ was to have a better regulatory control over such banks, separation of ownership and management, clear and simple resolution in the event of bankruptcy and ring fencing of the capital within the country. In simple terms, the overall idea was to protect the tax-payer’s money being used as bail-out as was witnessed post-2008 when some of the foreign banks withdrew funds from India. The foreign banks operating in India with large networks would be keen to convert to WOS if they get national treatment in terms of opening branches in metros and tier-II cities and not just to expand branch network within the context of RBI regulations. Foreign banks are also circumspect about adopting this route as the RBI has insisted that foreign banks should meet the priority sector lending (PSL) norms including the sub-targets (not portfolio buys) in direct agriculture and small scale enterprises (SSE) lending.

Target (% of Adjusted Net Bank Credit (ANBC) or credit equivalent amount of off-balance sheet exposure whichever is higher) Current target (as a branch)

Proposed target for WOS

Target for domestic banks

1.

Total priority sector lending target

32%

40%

40%

2.

Export credit

12%

12%

no target

3.

Agricultural advances

no target

10% [2.5% - indirect; 7.5% - direct]

18% [4.5% - indirect]

4.

Small enterprise advances

10%

10%

Part of overall priority sector target i.e. 40%

5.

Weaker section

No target

No target

10%

6.

DRI scheme (SC/ ST)

No target

No target

1% of total advances

Source: RBI’s notification on priority sector lending, KPMG in India analysis

2 http://economictimes.indiatimes.com/features/the-week-that-was/hdfc-bank-and centurion-bank-of-punjab-to-merge/articleshow/2808784.cms 3 http://www.icicibank.com/aboutus/history.html

4 http://www.hindu.com/2004/07/27/stories/2004072707340100.htm 5 http://articles.economictimes.indiatimes.com/2010-05-19/news/27574194_1_tayal-bor md-private-sector-banks

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3 | Indian Banking - The engine for sustaining India’s growth agenda

However, when the major banks convert to WOS, they are likely to provide another level of competition to the domestic banks. As on March 2012, there were 41 foreign banks operating in India with 323 branches and 46 foreign banks had their representative offices in India.6 Top 5 foreign banks have over 250 branches. Considering the fact that foreign banks’ have been successful in garnering demand deposit in their overall deposit mix, once foreign banks acquire domestic residency and when the major foreign banks convert to WOS, and will have more freedom in the licensing for new branches, the competition for deposits could heat up resulting in competitive pressure on domestic banks.

Closing the gap — financial inclusion will require innovative operating models

Composition of Deposits in percent (March, 2012)

Source: RBI trends and Progress 2012

The Economist in its issue dated 19 October 1929 carried an article highlighting that there was much truth in the observation that ‘the small man, living in the provinces, is neglected’. The banking sector has woken to the fact that there is potential in the unbanked areas, and to enter uncharted territories and capture unsaturated segments, the banking sector will have to come up with innovative operating models which will be different from the conventional ones.

The number of mobile banking transactions has doubled to 5.6 million in January 2013 from 2.8 million in January 2012. The value of these transactions increased threefold to INR 625 crore during January 2013 from Rs 191 crore in January 20127. Even the number of ATMs has increased from 74505 in FY11 to 95686 in FY12.8

Country

Technology will be essential to access this market, as extensive branch networks in remote regions or regions with poor physical infrastructure may not be economically viable. Break-even period for a rural branch could take upwards three years.

India

Technology-driven models such as mobile banking will inevitably change banks’ operating models and help banks in lowering their cost-income ratio. Usage trends clearly show a significant year-on-year increase in the usage of alternate channels for transactions (ATM, internet and mobile).

China

6 RBI Trends and Progress 2012

Number of ATMs (per 0.1 million adults) 8.9

Australia

166.92

Brazil

119.63

France

109.8

Russia

152.9

Mexico United States

45.77 -

(-) Data not available. All data pertain to 2011 Source: RBI trends and progress 2012 and IMF’s FAS database

8 RBI trends and progress 2012

7 http://rbidocs.rbi.org.in/rdocs/NEFT/pdfs/RTD05012013F.pdf © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Indian Banking - The engine for sustaining India’s growth agenda | 4

The internet banking channel has evolved over the years. In 2011, 60 percent of the times basic transactions in banks were conducted in North America through online channels, whereas internet banking usage in India increased from 1 percent in 2006 to 7 percent in 20119.

Further, the easing of norms on using individuals as banking correspondents, coupled with the proliferation of the UID enabled account, will enable banks to bring in a very large percentage of the currently unbanked, into their folds. To enable the success of this model, banks will have to very quickly build trust by demonstrating better control, governance and transparency in all parts of their transaction processes.

Share of population group in Increment of ATMs (FY12) (%)

Source: RBI

Mobile banking transactions for banks (2012)

Source: RBI

9 Infosys report on Consumer Internet Banking

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5 | Indian Banking - The engine for sustaining India’s growth agenda

Funding the aspirations of emerging modern India

The ‘rising middle class’ – will account for close to one third of the population in the next 20 years Middle class consumers are prominent drivers of growth and consumption in India due to their increasing disposable income. A report by National Council for Applied Economic Research’s (NCAER) Centre for Macro Consumer Research indicates that by 2015-16, India will be a country of 53.3 million middle class households, translating into 267 million people.1 NCAER defines Indian middle class as the one with income level between INR 3.4 lakh-17 lakh at 2009-10 level.

Rise in middle class

Source: NCAER

1 India’s middle class population to touch 267 million in 5 yrs dated February 6, 2011 in Economic Times © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Indian Banking - The engine for sustaining India’s growth agenda | 6

Investment in banking products may not be the default choice for the middle class

Period

Currency

Bank deposits

1970s

13.9

45.6

3

1980s

11.9

40.3

1990s

10.3

2000s

Banks will have to revisit their strategies for attracting current account, savings account (CASA) and term-deposits. Most banks will need to start putting together strategic plans and identify teams to focus on deposit raising, and move from the model of servicing walkin customers, to aggressively pursuing new customers through innovative bundling, promise of better returns, higher levels of customer service and attractive rewards programmes.

While a rise in consumption is a given, all savings and investments going to banks is not. Banks would have to strive hard to attract deposits in the future as the rising segment opens up to other avenues for savings and investments such as mutual funds, insurance, real-estate and commodities. Statistics by the Reserve Bank of India (RBI) indicate that the share of claims on the government, which largely reflects small savings, that had picked up over the years, particularly during the first half of 2000s, declined during the second half largely in response to the unchanged (administered) interest rates on small savings since 2003-04. In fact, households disinvested their holdings of Small Savings during 2007-08 and 2008-09.

Non- banking Life insurance deposits fund

Provident and pension fund

Claims on govt.

Shares and debentures

Units of UTI

Trade debt (Net)

Gross financial assets

9

19.6

4.2

1.5

0.5

2.7

100

4.6

7.5

17.5

11.1

3.9

2.2

0.9

100

34.7

6.8

10.1

18.8

9.5

7

3.8

-1

100

9.6

44.7

1.3

17.4

12.4

11.1

4.1

-0.5

0

100

(i) 2000-05

8.9

37.8

2

14.7

15.1

19.5

2.8

-0.9

0

100

(ii) 2005-11

10.7

49.9

1.7

19.9

10.3

3.5

4.3

-0.2

0.4

100

Source: Report of the Working Group on Savings during the Twelfth Five-Year Plan (2012-13 to 2016-17)

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7 | Indian Banking - The engine for sustaining India’s growth agenda

Retail credit will bloom – not all banks will be able to manage the challenges

Middle class not only wields increasing purchasing power, but also has an evolving appetite to take on debt for acquisition of assets and supporting their aspiring lifestyle. Significant growth has been witnessed in the financing of automobiles, mortgages, white goods and consumer durables. However, India has massive room for high growth in all these areas, as the level of retail credit penetration is extremely low compared to other developed and developing economies. From a demand side perspective, rising incomes, asset ownership aspirations

and low perception of risk is fueling the rapid growth in demand for retail credit. The supply side (banks and NBFCs) needs to step up to this significant opportunity by leveraging credit data from the recently setup credit bureaus, speedier assessment of risk and rapid processing of credit. According to CRISIL, aggregate car and UV loan disbursements will grow at a CAGR of 18-20 per cent till 2016-17. A steady growth in underlying vehicle demand, increase in finance penetration and higher LTV ratios will drive disbursements over the next 5 years.

Growth in Car and Utility Vehicle finance disbursements (INR billion)

Source: CRISIL report on retail finance on Autos

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Indian Banking - The engine for sustaining India’s growth agenda | 8

Growth in Housing Finance Disbursements (INR billion)

Source: CRISIL report on housing finance

In terms of housing loans, high prices and interest rate kept the buyers on tenterhooks and growth in disbursements fell from 22.1 per cent in 2010-11 to 16.1 per cent in 2011-12. However, the property prices are expected to stabilize and CRISIL forecasts disbursements to grow by 16.0 per cent CAGR to reach Rs 4,269 billion by 2016-17. A few leading banks are likely to gain dominant market share through a focussed approach that identifies the needs of these middle income customer segments, and aligns products and operating models, to meet these needs. New risk assessment

models that consider future cash flows, ownership of other financial products and behavioural data from alternate sources (such as track record of mobile bill payments etc.), shall be increasingly deployed by these banks to assess credit risk in real-time. Further, these banks shall also change their operating model to centralise credit decision and support it with innovative tools to analyse behavioural data at an individual and segment level. A major opportunity exists for retail lenders to develop and implement skills and tools that shall enable them to make credit pricing decisions at each individual’s level, rather than at a product level.

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9 | Indian Banking - The engine for sustaining India’s growth agenda

Gold loan business will continue to thrive in the future – banks will have to fight for their niches

India has among the largest consumers of gold with an annual consumption of 900 tonnes2 and the middle class is waking up to the fact that taking a loan against gold is relatively easy due to its high acceptance as a collateral and liquidity. Organized gold loan market has grown at a robust CAGR of over 55 percent in India during FY 2008 to FY 2012. Among the segments of gold loan market, gold loans from banks have increased at a CAGR of 57.5 percent and NBFCs have increased at a CAGR of 98.5 percent during the same period.3 Gold loans disbursed by NBFCs have witnessed rapid growth in the recent past. Therefore, it seems that NBFCs account for the majority of gold loans disbursed. However, contrary to the popular belief, share of banks in

total gold loans is the highest. Banks dominate this market with a share of 72 percent in total gold loans as of March 20123. Banks will have to identify the niche customer segments in the middle income class – those seeking higher value loans, small businesses that need capital for expansion – that they have the power and model to address. It is very likely that NBFCs will continue to dominate the market for customers seeking small ticket and high flexibility loans. This segment focus will enable banks to build a branch led operating model, where the speed of disbursement and flexibility of repayment terms will be of less importance when compared to size of loan and other bundled services.

Share of banks and NBFCs in gold loans outstanding (in percent)

Source: “Report of the Working Group to Study the Issues Related to Gold Imports and Gold Loans by NBFCs”, RBI, January 2013

2 http://www.thesmartceo.in/growth-enterprise/the-golden-eye.html 3 Report of the Working Group to Study the Issues Related to Gold Imports and Gold Loans by NBFCs, RBI, January 2013 © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Indian Banking - The engine for sustaining India’s growth agenda | 10

What will the emerging middle class seek? Will banks be able to provide?

The new middle class is likely to be fickle in its banking relationship – given the very low costs of, and multiple available options for, switching. The key to building and profiting from a longterm relationship with this segment will be the ability to build trust over a series of transactions. The current trend in banks of disproportionately rewarding the ‘aggressive seller’ of fee based products and services will thus need to be replaced with rewarding relationship sustainers – those who balance a holistic view of customer profitability with equally high customer satisfaction ratings.

According to a study, about 69 percent of the customers in the high and upper middle income group would tend to remain with their bank when choosing to buy a financial product even if the bank did not quote the best price.5 A key aspect to this challenge will be the bank’s ability to build and retain a team that is trained, not only in the nuances of the products and services they sell, but also in the development of soft skills and trust building skills. The emerging middle class is likely to value the relationship higher; if their point of contact is someone they trust.

5 http://www.iibf.org.in/scripts/monthlycolumn_july.asp

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11 | Indian Banking - The engine for sustaining India’s growth agenda

Micro, Small & Medium Enterprise – The next growth engine for banking The Micro, Small & Medium Enterprise (MSME) sector is a major driver of growth for the Indian economy. In 2009-10, there were around 29.8 million registered and unregistered enterprises (as classified by the banking definition of companies with a turnover in the range of 20 to 200 crores) across various industries. Out of these, about 60,000 are public or private limited companies, 1.5 million are partnership companies and the rest are proprietorships. There are another 30 million micro enterprises in the unorganised sector.1 Under a broad categorisation, approximately 77 percent of the total turnover of the MSME sector is linked to various industries in the manufacturing

1 MSME Census, IFC Intellecap Analysis

sector (agri and food products, textiles, metals etc.) and the balance is contributed by the entities linked to the services sector (agriculture, trade, retail, maintenance, IT etc). All together the MSME segment accounts for 45 percent of the country’s industrial output and 40 percent of exports. The overall contribution of this segment to India’s Gross Domestic Product (GDP) has been holding steady at 11.5 percent a year2. And yet, the MSME sector faces a chronic shortage of bank financing to aid its growth and improvement agendas.

Ownership structure of enterprises in the MSME Type of structure Proprietorship

Share of MSME enterprises 94.5%

Partnership, Cooperatives

1.2%

Private Limited, Public Limited

0.8%

Others

3.5%

Source: MSME Census , IFC Report on micro-small and medium enterprises in November 2012

2 Report of the Working Group on Sick Micro, Small and Medium Enterprises, Reserve Bank of India (RBI), 2009-10

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Indian Banking - The engine for sustaining India’s growth agenda | 12

Distribution of enterprises in the MSME sector and prevalent ownership structures

Source: MSME Census, IFC - Intellecap analysis

Only one third of the MSMEs have access to organized financing channels in India

The slow growth of MSME is broadly attributable to the lack of financing or lack of facilities and skills. Given the high growth aspiration levels of MSME promoters, both are debilitating factors. It is estimated that only 33 to 34 percent of the MSMEs had any access to bank or institutional financing channels and in the absence of this finance, prefer to raise financing through personal channels (friends, family, informal financiers etc). By any stretch of imagination, this unmet demand presents a significant opportunity for the flow of banking credit. To encourage greater bank led financing, the Reserve Bank of India (RBI) had increased its focus on this sector through directed lending policies such as priority sector lending (PSL) norms. However, given the significant demand-supply constraints, the financing chasm has grown. Small Industries Development Bank of India (SIDBI) has estimated the overall debt finance demand of the MSME sector at INR 32,50,000 crore (USD 650 billion)3. 22 percent of this amount is the debt financed through the formal sector, in which banks have the largest share (approximately 85 percent). Most

of this debt flows to the registered enterprises. The risk perception attached to unregistered or unorganised enterprises due to a lack of transparent financial data, limited immovable collateral and lack of credit assessment skills of some sub-segments and the preference for ‘less hassled’, informal financing, reduces addressable demand considerably. Working capital financing, and to a lesser degree debt for capital expenditure are the two key offerings sought by MSMEs. MSMEs in Eastern Indian and particularly North Eastern states have been lagging behind the other states in terms of access to financing from the banks. Low access to infrastructure and electricity and roads has significantly hindered the growth of the MSME industries in these regions and consequently their access to organized lending from banks. The MSME industry clusters in these states are varied and range from the trade and metal processing centres in Orissa, Jharkhand and Chattisgarh to forest product and handloom related centres in the North Eastern states.

3 IFC report on MSME

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13 | Indian Banking - The engine for sustaining India’s growth agenda

Arunachal Pradesh

Assam

Manipur

Meghalaya

Nagaland

Arts and Craft

Tea

Handlooms Handicrafts

Food Processing

Bamboo

Weaving

Tourism

Sericulture

Horticulture

Food processing

Cane and Bamboo

Traditional Cottage Industry

Food Processing

Mining

Horticulture

Mizoram

Tripura

Bihar

Chhattisgarh

Jharkhand

Bamboo

Food Processing

Food Processing

Food Processing

Mining/Iron and Steel

Energy

Bamboo

Rubber and Plastics

Gems and Jewelry

Rubber and Plastic

Sericulture

Handloom Handicrafts

Transport Equipment

Iron and Steel

Handloom

Orissa Iron and Steel Aluminum Handloom Source: IBEF, IFC – Intellecap Analysis

While challenges for financing this sector continue, Reserve Bank of India (RBI) is creating an impetus for banks to finance

As awareness of formal financing opportunities grows within the addressable parts of the MSME sector, banks have an opportunity to grow their credit exposures, limit risks and seek better spreads by developing and implementing MSME sector specific policies and operating models. The regulatory framework defined by the RBI (and recently strengthened by the Nair Committee report) has set targets for banks to achieve in lending to the MSME sector (7 percent to 15 percent of lending portfolio to be allocated for financing micro enterprises) and an overall 40 percent of their annual credit to be allocated to priority sector lending. Further, the Nair Committee has also sought to limit to 5 percent, the indirect lending portfolio earlier used by banks who lent to NBFCs to further lend to MSMEs, to meet PSL norms. Given the significant variance in MSME knowledge, extensive branch network linked liability relationships and regional versus centralized credit assessment skills between public sector banks (PSBs) on one side and private and foreign banks on the other, it is no

surprise that PSBs account for over 70 percent of the debt financing to this sector, while private and foreign banks account for 22 percent of credit flow. However, traditional challenges of bank financing of MSMEs remain: • Broad, rather than niche

segmentation of the market • Limited market assessment skills

at branches (and limited ability to gather and analyse proxy data) • Centralised product design rather than customised products that address the needs of specific subsegments • Vanilla models of fund based products and limited credit assessment skills for knowledge based industries with limited immovable collateral. Many banks also treat credit to this segment as a necessity for meeting compliance norms, rather than as an opportunity. Many such banks tend to narrow the definition of such enterprises (investment in assets) rather than seek a broader definition that could include revenues, order flows, past cash flows etc.

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Indian Banking - The engine for sustaining India’s growth agenda | 14

Banks will need to develop multiple operating models and goto-market strategies for the MSME market

Banks need to work with SMEs linked to the supply chains of their large corporate customers and leverage this relationship to better manage and control credit exposures. Many banks have successfully implemented supplier and dealer financing products and processes and will seek to increase penetration deeper and across a larger number of corporate clients. Co-write credit with a trusted Non Banking Finance Company (NBFC) partner, where first lien on collections remains with the bank. The advantage of this model is that both partners leverage their respective strengths (banks’ ability to provide an envelope of services such as forex hedging, LCs/guarantees and debt, and NBFCs providing subsidiary debt, specialised knowledge of the MSME, local collections capability and other non-banking services). Given the recently imposed limits on indirect financing, this model shall become more attractive. 1. Cluster based financing has already been demonstrated successfully by some banks by focussing on small sub-sectors that are geographically concentrated into specific areas and have very similar market cycles and supply chain linkages. By creating specialist credit capabilities for each sub-sector, banks have been able to reduce their credit risks substantially through the modulation of credit flows based on knowledge of business cycles.

2. Linking personal and small business accounts has enabled many banks to develop a close link with promoters and proprietors. The availability of data linked to personal accounts provides good insight to support credit decisions to this group. 3. Strengthening of support infrastructure a. Legal and regulatory framework – such as a single consistent definition of the sector, extending the Securitisation Asset Reconstruction and Enforcement of Security Interests (SARFAESI) coverage, expanding the coverage of credit rating agencies, enhancing credit guarantee coverage, securitisation of trade receivables through conducive legal infrastructure, creating a single collateral registry for immovable assets, supporting Asset Reconstruction Companies (ARCs) etc. b. Governmental support – such as providing platforms for market linkages, skills development, technology upgradation and promoting cluster development, enhancing advisory support, supporting the growth of venture funds.

Segmentation of customers

Source: KPMG in India analysis

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15 | Indian Banking - The engine for sustaining India’s growth agenda

Infrastructure financing – building the foundation

Given India’s size and relative under-development, there exists an immense need to setup basic infrastructure across the country As per the Planning Commission’s XIth and XIIth 5-year plan, the investment requirement in infrastructure is expected to grow at CAGR of 14.6 percent from FY 08 to FY 17. In order to sustain the long term growth momentum, India needs significant investment in the infrastructure sector. Planning commission has projected infrastructure investment of more than INR 40 lakh crore in the XIIth 5-year plan, which is nearly twice that of the XIth 5-year plan.

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Indian Banking - The engine for sustaining India’s growth agenda | 16

Infrastructure investment, FY08 - FY17 (at 06-07 prices)

Source: Planning Commission, KPMG in India analysis

However, private investments which are required to increase significantly to INR ~20.5 lakh cr for FY13-FY17, have not seen the required traction in the first year of this plan.

Public/ Private investment break-up (at 06-07 prices)

Significant private sector investments are required for bridging infrastructure investments gap and meeting revised targets by the Planning Commission. Considering the 70:30 debt to equity ratio, the overall debt requirements (disbursement potential) is expected to be INR ~14.3 lakh cr.

Source: Planning Commission, KPMG in India analysis

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17 | Indian Banking - The engine for sustaining India’s growth agenda

Policy inaction, reluctance of promoters to invest additional equity, and specific issues like lack of reliable fuel supply or issues in land acquisition have increased risk in the largest infrastructure sectors i.e. power and roads

As of April 2013, several power sector projects are stalled due to the lack of assured coal supply leading to unseen levels of risk averseness amongst lenders. Contrasting with the scenario of 2009-10 where lenders would sanction funding to projects with the assumption of eventual signing of Fuel Supply Agreements (FSA), today they require a signed Power Purchase Agreement (PPA) as well, in order to have clear visibility of project cash flows prior to sanction. The roads sector has also faced a number of issues on the regulatory front, primarily land acquisition, environmental clearances, right-of-way clearances and occasional resettlement problems with local population.

Roads have traditionally been considered a lower risk sub-sector within infrastructure, with quicker commencement of commercial operations as compared to power projects. This has led to intensification of competition amongst road developers and aggressive bidding to win projects. However, significant deviations in toll revenues in recent times have forced lenders to restrict disbursements even to sanctioned projects based on the increased perception of construction and operational risks.

Opportunity mapping across sub-sectors within infrastructure shows the current balance of risk and attractiveness as perceived by lenders in infrastructure finance

Source: KPMG in India analysis Note: - Investment in Storage does not include investment requirement in land - Numbers corresponding to the bubbles indicate financing opportunity in INR cr

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Indian Banking - The engine for sustaining India’s growth agenda | 18

Due to lack of depth in the corporate debt market, bank finance to the sector is of critical importance and the banks have currently taken a cautious approach as they are experiencing portfolio stress

Approximate total supply XIIth Plan Period IFCs

450,000

Banks – fund based (Direct to clients)

350,000

Primary debt funding

750,000

Source: KPMG in India anaysis

INR Cr.

Banks had been the mainstay for infrastructure funding during the XIth plan period, especially for the power sector. However the banks are taking highly cautious approach towards lending to the infrastructure sectors. Several key reasons exist for banks’ reluctance in further funding. Most banks have already reached their internally approved sector-wise exposure norms. Limited availability of take-out finance is leading to the asset being on the bank’s balance sheet longer than expected. Difficulties in recovering dues from promoters due to stalled projects not generating revenue has increased the overall portfolio stress. Also, the banks have limited appetite for complex structures, which are more popular with NBFCs for smaller deals. The lack of depth in the corporate debt market in India restricts the channelization of capital flows towards the infrastructure sector. The corporate bond issuer profile is dominated by banks and public sector companies, with minuscule participation from nonfinancial private issuers. Additionally, nearly 100 percent of such issues are raised through private placement, with nearly no secondary market in place to encourage market-making, liquidity and price efficiency of debt issues. Without this key avenue for diversification of funding sources away from the bank dominated financial system, infrastructure developers are finding it difficult to raise long term money efficiently from the capital markets. The takeout financing scheme introduced in 2010 by the government through Indian Infrastructure Finance Company Limited (IIFCL) sought to assist banks in avoiding an asset-liability mismatch and also free up funds to finance new projects. However, the scheme experienced limited success since the government restricted IIFCL

from continuing to fund the project after the lead bank exits. In April 2013, a committee comprising finance ministry officials was setup to make takeout financing work better. The government is considering relaxing these rules which could help the state-owned IIFCL provide longer-term funding to such projects at economical terms. Insurance companies, who have access to long term funds, are restricted by regulator-imposed sector investment limits which further restricts the flow towards infrastructure projects. The current supply constraint has led to the rise of External Commercial Borrowings (ECBs) as a competitive alternate source of supply. Infrastructure developers have raised money in foreign currency at a significant cost advantage; however they continue to remain wary of global group policies of the lending banks which had created issues in the sector in 2008. Developers are willing to accept a higher cost for structured products. Nearing the end of their equity investment capacity, increasing number of developers are looking for options such as quasi equity, mezzanine debt, holding company debt, viability gap funding, etc. Indian banks are wary about innovative structures as is evident from long cycle time for sanctions, primarily a result of strict regulatory capital standards for products deemed riskier by RBI. Smaller NBFCs and foreign banks active in this space have demonstrated a more nimble and fast-moving approach towards closing deals of this nature. These products remain significantly higher yielding than standard project loans or corporate term loans.

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19 | Indian Banking - The engine for sustaining India’s growth agenda

Owing to inherent benefits and significant potential, the government is taking several initiatives to drive growth of renewable energy sources

Installed capacity - renewable energy*

Source: Central Electrical Authority

(*) As on 31 December 2011

The evolving process maturity amongst developers in solar, and increasingly in wind energy generation has created a niche space for financiers who have cultivated technical expertise amongst their personnel.

Renewable energy capacity mix - FY12**

Source: Central Electrical Authority

(**) As on 30 June 2011

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Indian Banking - The engine for sustaining India’s growth agenda | 20

Several financial institutions are flocking to the opportunity represented by renewable energy due to the overall cautious stance on thermal sources of generation

Total capacity to be added during XIIth Plan (MW)

Benchmark cost (INR Cr/MW)

Total investment requirement (INR Cr)

Debt requirement (INR Cr)

Wind

11,000

6

66,000

46,200

Solar

4,000

13

52,000

36,400

Other RES (Biomass + Small hydro [