The banking sector in India is in the middle of a restructuring and a turnaround could take longer, John Garvey, global financial services leader at PwC, said in an interview with Fortune India. Garvey is largely concerned about the high level of non-performing loan (NPL) ratios on balance sheets of banks, the credit crunch in the economy, and the execution of the mega merger of public sector banks (PSBs) announced last year.

As for the outlook for domestic banks, Garvey says, “The central bank has undertaken various measures to revive growth, such as introducing the new rules regarding liquidity management for non-banking financial companies (NBFCs) and the resolution of stressed assets. Taken together, we believe these factors will moderate the growth of bank balance sheets and depress returns. On the other hand, stronger and better-managed institutions will have opportunities to grow and improve margins.” Edited excerpts:

Do you think the Indian banking sector has turned the corner?
The sector is in the middle of a restructuring and we expect that the turnaround will take more time. Indian banks are currently in the consolidation-and-workout stage as they focus on the NPL clean-up. The underwriting standards have been strengthened and credit supply has tightened. We can see now in the latest quarter that we may have turned the corner in the cycle. More specifically, we saw a decline in NPLs and an increase in loan growth according to the data published in the latest Financial Stability Report of the Reserve Bank of India (RBI).

There are still various challenges which need to be addressed such as the continuing workout of NPLs, navigating through the current credit crunch, and managing the impact of the slowdown in gross domestic product (GDP) growth. The credit crunch has been exacerbated by the continued reluctance by banks to lend to NBFCs.

On the positive side, the RBI has taken measures to restore the sector to a healthy state, encouraging further digitisation, mergers, and the infusion of new capital into the sector. All of these will play a pivotal role in completing the turnaround.

What’s your main concern as far as the overall health of banks is concerned?
We are monitoring a number of trends in the sector:
NPL ratios: Even after the recapitalisation drive by the government and the workout efforts of the banks, it will take more time to show significant improvement in the NPL ratios. India’s banking sector had a capital adequacy ratio of 14.1% and NPLs represented 9.2% of the total outstandings.

Credit: The below-average investment climate as well as a reluctance to lend to NBFCs and end consumers that led to the credit crunch will likely continue for some time.

Mega-merger of PSBs: Post-merger, there are concerns pertaining to synchronising the human resources (HR), information technology (IT), and business strategy of the merged banks. The synergies among the merged entities will require strong execution to be realised.

In the backdrop of current economic challenges, what’s your growth outlook for domestic banks?
The GDP growth has decelerated to around 4.5%, the lowest since 2013. For many, the tighter credit condition in the NBFC sector is said to be a key contributor to this deceleration. In addition, the traditional drivers of growth such as employment, investment, and private consumption need to be considered. Finally, as noted, the central bank has undertaken various measures such as introducing the new rules regarding liquidity management for NBFCs and the resolution of stressed assets to revive growth. Taken together, we believe these factors will moderate the growth of bank balance sheets and depress returns. On the other hand, stronger and better-managed institutions will have opportunities to grow and improve margins.

Credit growth is at a record low and business confidence is weak. When do you expect the investment cycle to pick up?
There are some green shoots in the current economic scenarios such as the rebound in sales in the auto industry. As usual, we see the recovery coming from the SME (small- and medium-sized enterprises) sector and, therefore, there must be a focus to lend to SMEs to stimulate economic growth. As agriculture employs around 50% of the Indian workforce and contributes more than 15% to GDP, the investment cycle also depends on factors such as winter crop yields; strong yields would help drive the investment cycle after the February-March period, for example.

How do you read the NBFC crisis that has contributed to the ongoing credit crunch?
The NBFC crisis arose from the reliance on short-term funds, which were then lent out as long-term loans—most of them in the relatively illiquid real estate sector, which led to an asset-liability mismatch and a liquidity crisis. The defaults of some leading NBFCs led to a contagion effect i.e. banks, mutual funds, and their investors were afraid that more such entities would default and began withholding funds from even healthy NBFCs. As this fear took hold, many institutions suffered. The cost of funds rose by as much as 150 basis points, which put further put pressure on the NBFC business model. Today, even though there has been some recovery in the NBFC sector, the structural duration risk issue noted above has not yet been resolved. Other markets such as the U.S. have developed securitisation markets to address this issue but there are many challenges to developing such a market in India.

What further steps can the RBI take to address liquidity concerns?
While there might be institution-specific liquidity concerns, there are no real liquidity concerns around the sector as a whole. Having said that, there is a structural credit shortage in the economy. In our opinion, the RBI and the government will have to take tough measures to balance liquidity concerns faced by the industry and the imperative to accelerate growth in the real economy by supplying the SME sector with sufficient credit.

What are the key opportunities and challenges for digital banking in India?
We are looking at several areas including:
Artificial intelligence (AI) and Big Data: Banks are exploring new technologies to optimise distribution channels and better understand/serve their clients.

Penetration of the rural market: Currently, the banking sector does not have the infrastructure to reach out to the market at the bottom of the pyramid (BOP). Perhaps by better partnering with NBFCs, they can extend their reach in a cost-effective manner.

Productivity and digital upskilling: A number of new technologies, including analytics tools and robotic process automation tools are being leveraged to improve the efficiency and effectiveness of end-to-end processes. Teaching non-IT staff to use these tools is a productivity game-changer.

Fraud management: India needs better guidelines on cybersecurity and fraud management. With these guidelines and the employment of new technologies and techniques, the sector can reduce both risk and actual losses.

What’s your outlook for small finance banks (SFBs) in India?
SFBs are expected to grow at a compound annual growth rate of 25%-30%, led by diversified loan growth, deposit mobilisation, improving asset quality, and better returns on equity.

SFBs are continuously working towards better mechanisms for credit underwriting, monitoring, and collections. Their aim is to better penetrate the market and increase their customer base while constructing the business model (pricing, products, and cross-selling) to drive the necessary profitability cover funding and distribution cost.

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