With the Reserve Bank of India, or RBI, dishing out bank licences, the question is: Who will win the race? We believe there is enough room for everyone to grow, although the survivors will be the most cost-efficient banks.
We anticipate that the Indian banks with narrow moat ratings will continue generating returns above their cost of equity for the next decade, as these banks retain their floats and moats. Weaker public sector banks, however, will feel the squeeze as they scramble to improve loan quality and find cheaper client-serving methods in an increasingly cost-competitive banking environment. With the increase in cashless payments, each customer will leave a digital trail that can be tapped when making loans in the future. At some point in the next few weeks, we will publish a detailed report on payment banks.
Lending has never been the only prerogative of a full-fledged bank. However, the sticky CASA deposits, asset management and cross-sell capabilities will continue to remain with the banks; as the banking relationship with a client deepens, these are a source of customer switching costs. The Indian banking space is set for competition between the weak banks. Those that keep up with the chase will be able to defend their narrow economic moats, though they cannot hope to develop stronger 'wide' economic moats, which dictate that returns surpass costs for the next two decades.
This confirms our 'Poor' system rating for the Indian banking system, as per our financial services observer 'Where Wide Moats Are', published in June, which analyses the global banking systems that are most conducive to wide moats. India has a low bank credit/GDP ratio, low banking system ROAs and ROEs and increasing competition from newly licensed entities. This indicates that Indian banks are unlikely to develop like the oligopolies of Australia and Canada, where the top five banks hold 93% and 81% share of total assets, respectively, versus 44% in India's fragmented market.
Institutional section
The RBI is issuing new banking licences to promote financial inclusion and digitisation of payments. So, where does India stand at present? The country has 120,000 bank branches, as of June, to service a population of 1.2 billion, which means 10 branches per 100,000 people. This stacks up against 35 for the U.S. and 8 for China on the same metric. Although 38% of these branches are in rural areas, Indian bank credit/GDP ratio remains at 51%. Bank credit is growing faster than GDP, and we see this improving over the longer term.
However, we believe that nonbanking financial companies, payment banks and small banks will play a large part in improving financial inclusion. Credit/GDP ratio, including all nonbanks, is 76%, as per the RBI data for September. It shows that 25% (76%–51%) of the credit gap is being filled by nonbanking institutions.
Furthermore, while 182 million new accounts were opened under the Pradhan Mantri Jan-Dhan Yojana, or PMJDY, the number of bank accounts per citizen has increased to 53% in 2015, against 35% in 2011, as per the World Bank financial inclusion study. But 43% of PMJDY accounts are zero-balance accounts, and the average balance across accounts remains low at Rs 1,300, as per government data from Sept. 9. The next step is to activate these accounts by linking them to subsidy payments, thus making cash flow through these accounts.
We believe that new full banks Bandhan and IDFC will take nearly a decade to build a strong deposit franchise, which would lead to the competitive advantages of customer switching costs and cost advantage. As per Morningstar's equity research methodology, these are the two most important sources of economic moats in banking. While the growth of technology, the Internet and telecoms may shorten the time for franchise building to seven years, we believe that new banks will ensure that the banking sector continues to find cost-effective ways to service its clients, while using a mix of branch and digital banking.
We think payment banks will operate as fee-based, volume-driven services, which will essentially earn revenues on the basis of the number of transactions made on their platform. Telecom players are best placed to win in the payments market, as 74% of Indians have a mobile subscription, while only 19% have access to the Internet. They have outlets to help customers adopt digital payments by walking them through the procedure. Cheaper data plans and low introductory prices for smartphones will aid in quick adoption. While financial inclusion is a long-term objective of the RBI and the Indian government, we believe that these first few steps are in the right direction.
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