As we delve deeper into credit penetration, specifically below the credit score of 850, with the support of fintechs and the use of AI tools, are we exploring a market opportunity characterised by very poor credit scores? Are banks venturing into the unknowns?

New-to-credit customers are generally considered riskier until they have completed a certain number of cycles or repaid their multiple credit lines. Fintech companies have played a crucial role in creating an alternative credit scoring system using payment data. This innovation has made NBFCs and banks see the value in collaborating with them to extend their balance sheets to these customers. The increase from 30 million to 140 million credit lines, with about 250 million live customers on the bureaus, indicates that many individuals hold multiple credit lines. Consequently, the market, especially on the consumption side, has matured rapidly, reducing the risk associated with unknowns. More customers have transitioned to formal financing from previously informal channels, partly due to the country's ongoing formalisation process initiated by government reforms like GST. This formalisation, along with developments in retail payment systems, has brought many into the realm of formal financing.

However, the sector has not experienced a normalised credit cycle for an extended period, though it did experience a spurt in non-performing loans (NPLs) during COVID-19 times. This situation has led to a lack of clarity on when lending should be curtailed, raising concerns about over-leveraging among consumers. This issue, rather than the risk of new entrants becoming delinquent, presents a significant risk to consumption-linked lending.

On the commercial side, particularly among entrepreneurs and small businesses, the risk of unknowns may still be present. Areas like merchant financing remain largely untapped, with fintech interventions not yet making a significant impact. While we have seen a few large banks successfully expand their portfolios in this segment without compromising asset quality, it indicates a market exists that requires a structured approach to minimise risk. Despite some ongoing risks, the trend towards formalisation nationwide is helping to reduce these uncertainties.

In summary, while the exploration of lower credit scores introduces new challenges, the combination of technological innovation, market adaptation, and broader economic formalisation is gradually mitigating these risks. Nonetheless, sectors like merchant financing still face the risk of unknowns, although this is also diminishing as the country continues to formalise.

At a time when household savings have reached a multi-decade low, juxtaposed against the challenges banks face in terms of deposit mobilisation amidst a massive consumption boom and a shift in savings towards Systematic Investment Plans (SIPs), the question arises: is the era of cheap Current Account and Savings Account (CASA) funds over for banks?

This is indeed a pertinent question. To provide some context from our analysis, we've conducted a deep dive into the financial savings of households, comparing these with the level of leverage being taken on by the same households. We've observed a significant decline in net financial assets to GDP on a flow basis, which has decreased from 11% of GDP in 2021 to five and a half per cent in 2023. Present trends suggest this figure may have dipped even further since March 2023, indicating that people are saving less in comparison to their borrowing. Consequently, savers are increasingly becoming consumers.

This transformation poses a growing challenge for deposit growth. Net savings are declining, and the remaining savings face competition not only from the equity market but also from a variety of financial alternatives that have emerged as the financial markets in India have evolved over the last five to seven years. For example, one interesting data point we found is that government small savings schemes have attracted close to 30% of the incremental deposits each year for the past few years. This shift towards longer-duration small savings schemes, which also offer tax advantages, represents a significant trend that competes directly with deposit growth in the banking system.

Other competitive instruments include the National Pension Scheme and insurance funds offering annuities, among others. These interest rate-sensitive alternatives are contributing to a large pool of options available to savers, thus requiring banks to work harder to attract deposits to support growth momentum. The loan-to-deposit ratio in the banking sector has reached all-time highs, with figures around 80% on average, and even higher for private banks, some of which report ratios above 90%.

Given these dynamics, banks may need to sustain higher deposit rates, potentially putting pressure on their net interest margins. Improving deposit market share, especially given that public sector undertakings (PSUs) still hold a significant portion of it, will likely necessitate investment in branch networks, technology, and human capital, increasing operational costs.

This investment requirement suggests that achieving operational leverage may take longer for some banks due to the necessity of attracting deposits. While the near-term situation may be manageable due to cyclical liquidity improvements as the government starts spending, the medium to long-term challenges require banks to adopt innovative strategies to enhance deposit growth, and that's a structural challenge banks face.

And to that end, there will be pressure on low-cost deposits also to some degree. We are baking moderate low-cost deposits in our numbers and that will also be one of the sources of margin pressures.

Not all banks will be in a position to gather deposits effectively, as their reach cannot match that of the larger banks. This raises the question: will banks take more risks on the credit side in pursuit of better margins? For instance, a bank like HDFC may opt out of the deposit pricing competition, whereas smaller banks, such as IDFC, cannot afford this stance. So, what unfolds then?

The return on assets (ROAs) for banks, and the broader financial sector, encounters more challenges due to various factors. One significant factor is the improvement in credit penetration, which historically, tends to lead to a moderation in profitability.

Secondly, in India, we're faced with a unique situation where state-owned banks still hold a significant portion of the deposit market. These banks, currently boasting strong balance sheets, are competing in various loan markets, including corporate, home, and auto loans, and are thus reluctant to yield market share.

Lenders, particularly private banks and NBFCs, find themselves in a difficult position, caught between a rock and a hard place. The way out involves one of two strategies: either tapping into certain profit-rich areas, like specific segments of commercial retail where ROAs exceed two and a half to three per cent or leveraging strong operational efficiency, which depends on the extent of previous investments and the unit economics derived from various product segments. The combined effect should help reduce the cost-to-income ratio, bolstering profitability.

Without these strategies, banks are vulnerable within the broader market. They may be forced to pursue customers who might not contribute to a resilient balance sheet structure.

Is it safe to assume that the peak period for Indian banking, in terms of return on assets (ROA) and net interest margins (NIMs), is over?

Certainly, the so-called Goldilocks period—characterised by strong profitability and growth, as witnessed over the last two years—seems to have ended, at least for the near term. Consequently, the banking sector faces more challenges to earnings than it did in recent years. However, the impact will vary across individual institutions. Banks that have strategically chosen their growth areas, invested adequately in their distribution networks, and thus can comfortably mobilise deposits in the future, may still perform well. But broadly speaking, it seems likely that ROAs may have reached their peak, and the sector could experience headwinds in earnings, at least in the short term.

Financials continue to hold a high weightage on the index and have traditionally been a favourite among foreign investors. But if the Goldilocks period is coming to an end, will financials be perceived more as a tactical allocation rather than a long-term investment?

Through multiple interactions with investors, especially in Asia and the broader global investor universe, we've gathered insights that highlight a threefold perspective:

Positive macro: Investors recognise that India's macroeconomic environment remains promising, suggesting continued lending opportunities. The consensus is that opportunities are more pronounced in commercial retail rather than consumer retail.

Supply and demand dynamics: Despite the end of easy conditions, the banking system remains a primary capital provider, suggesting some level of pricing power. However, with state-owned banks determined not to lose market share and having the capital to compete, certain segments may face acute competition, influencing pricing based on market dynamics. This underscores the earlier point that commercial retail holds notable opportunities.

Valuations: Financials are still seen as attractive in terms of valuation. However, there's significant dispersion; some banks are trading at valuations significantly below historical averages, presenting specific investment opportunities. Conversely, institutions that have seen significant re-rating face potential pressures, especially if they encounter earnings or ROA challenges. The recent regulatory actions by the RBI have heightened investor concern, influencing a more cautious outlook in the short term. However, the medium to long-term view remains constructive, suggesting a selective approach towards investment in the sector, focusing on specific stocks or segments rather than a blanket strategy across all financials.

In summary, in the medium to long term, global investors are still fairly constructive on the space and therefore it becomes more of which stocks and segments you go after rather than painting everything with the same brush.

Given that there is a long coat-tail of smaller banks, maybe not in a year or two, but could we eventually see another round of consolidation post that of PSU banks?

M&As have traditionally been successful where there are clear synergies, either in terms of branch distribution or portfolio mix. However, the relevance of these factors may be shifting in today's banking landscape.

For instance, achieving broader distribution, a traditional motive for mergers might now be more efficiently addressed through partnerships with NBFCs or fintech companies. These partnerships can provide market access and valuable data, allowing banks to tailor their services more effectively without the need for mergers.

Similarly, when it comes to expanding product offerings, portfolio buyouts or acquisitions of specialised companies can serve as a strategic alternative to mergers. A medium-sized bank's recent acquisition of two microfinance companies to access that particular segment is a case in point.

Ultimately, market penetration, brand recognition, customer attraction capabilities, and a comprehensive product suite are key factors determining a bank's growth potential. Banks may not need to be present across all consumer segments; excelling in specific ones with strong product offerings can still ensure profitability. There are numerous examples of banks that have successfully navigated transitions or expanded through strategic acquisitions.

The regulatory environment will play a crucial role in shaping the landscape, and it remains to be seen how regulators will respond to the evolving dynamics of the banking sector.

Will we see a future banking landscape where we have both bonsai banks and larger players coexisting?

This isn't a new scenario, right? Let's look back at the licenses issued in 1993. Three decades on, you can count on your fingertips how many banks have surpassed a 5% market share. How many banks are stuck with less than 5% share, and how many are between 1% and 2% market share? You have numerous examples, but investors have time and again invested in those banks because they have been focusing on certain segments which are profitable. So, they become more of a cyclical investment theme than a structural theme.

Structural themes are where the real differentiation occurs—banks that consistently surprise the market every few years by breaking through barriers, innovating, and evolving. However, the macro environment is a significant, rapidly changing factor. If we draw parallels with developed markets in the West, we see that alongside the banking giants, there's a spectrum of regional players and diversified financials serving particular regions or consumer cohorts.

Many banks opt not to engage with certain customers unless those customers evolve into more appealing profiles, seeking multiple banking services. This distinction sets banks apart from regional or specialised institutions, and this dynamic seems poised to continue in India.

Lately, many bank CEOs have embraced the mantra of being "technology companies that also engage in banking" or adopting a "digital-first" approach. What's your take on the digital advancement of Indian banks?

I'd approach this question with a slight twist, incorporating the concept of operating leverage. As long as a bank effectively onboards customers aligned with its target profile, successfully cross-sells to them, and handles retail and digital payments without technical hitches, then they have likely ticked the right boxes from a management and regulatory perspective. While there's been increased digital penetration in certain pockets, there's still considerable demand for credit, providing opportunities for operating leverage. Hence, there's no pressing need to overtly brand oneself as a technology company that also dabbles in banking.

The RBI's focus on regulatory compliance, especially on Know Your Customer and other aspects, is evident. The analyst community and investors, while valuing technological advancements, ultimately prioritise a bank's ability to meet broader objectives, maintain a steady ROE, and sustain loan growth.

What, according to Goldman Sachs, would be a steady state of ROE for Indian banks?

Private banks achieving top-quartile ROA could easily attain ROEs in the high teens, whereas state-owned banks, despite higher leverage and lower ROAs, might struggle to maintain a steady state due to fluctuating ROAs depending on the cycle that the banks are in. For NBFCs, it would vary significantly based on their business models. For those with unsecured models, rating agencies are cautious about allowing excessive balance sheet leverage, limiting their potential ROE. Consequently, outcomes vary widely and are reflected in the cost of equity. Successful banking hinges on effective risk management, which dictates the predictability of returns and growth. Despite lower ROEs on paper, instances of high predictability have resulted in the market assigning higher valuation multiples. Ultimately, it boils down to whether an entity can consistently outperform its cost of equity. If so, higher valuation multiples are warranted.

In banking, effective risk management is paramount for ensuring predictable returns and growth. Instances exist where despite lower ROEs on paper, consistent performance and risk management have led to higher valuation multiples. The key metric is whether an entity can consistently surpass its assigned cost of equity. If so, higher valuation multiples are justifiable.

Will there be enough appetite for equity issuances for banks which need capital to grow in the coming years?

Based on investor feedback, if the narrative is compelling — indicating good growth and comfortable ROAs—and fresh capital is not just patching up holes but fuelling expansion, the market seems inclined to absorb the supply. When capital is raised for growing the balance sheet, it elongates the sustainability cycle, a crucial consideration for investors. Currently, there appears to be sufficient appetite in the market to absorb capital issuances from various players, as evidenced by positive investor interactions.

Will banks consider a trade-off between growth and capital raise?

If capital is raised at a premium to book value, typically one-time book value or higher, it tends to enhance the book value per share. As long as this increase in book value per share is aligned with growth objectives and the funds are utilised for expansion, the market generally perceives it positively, especially during a growth cycle. The macroeconomic outlook for India, with GDP growth projected at 6.5%, controlled inflation, stable interest rates, and robust bank and corporate balance sheets, supports this perspective. Consequently, capital raised is likely to be seen as a positive step, aligned with the prevailing growth momentum.

Are we witnessing a structural shift where corporate credit may not rebound significantly, making retail credit the primary focus given that major corporates have delevered post-pandemic and capacity utilisation is yet to reach its peak?

In our view, corporate credit growth will eventually rebound. However, it typically takes three to four years for projects to materialise from their announcement due to their long gestation cycles. As capacity utilisation improves, currently hovering between 70-80%, initiatives like the Production-Linked Incentive (PLI) scheme by the Indian government are fostering positive momentum. However, the debate revolves around whether large corporates or smaller entities will drive this momentum. We anticipate that MSMEs will be the primary drivers, given the enhanced discipline among larger corporates following the initiation of the Insolvency and Bankruptcy Code (IBC).

Thus, this cycle will likely be more diversified compared to previous ones, driven by a broad range of industries and sectors, including SMEs focusing on themes such as battery manufacturing, medical devices, electric vehicles, and premiumisation. In the previous cycle, a handful of companies and sectors, particularly in infra, steel, iron, and EPC were the main drivers. This time around, it will be broad-based.

Regarding commercial retail and merchant lending, while these may not traditionally fit into the category of corporate credit, they play a crucial role in supporting corporate capex. For instance, when corporates embark on expansion plans, they require support from SMEs, which in turn contributes to various sectors such as housing, steel, and tiles. This symbiotic relationship between corporates and SMEs ultimately drives corporate credit growth, albeit with a lag of two to three years from reaching capacity utilisation thresholds.

In terms of the broader credit landscape, we anticipate a broad-based growth trajectory in this cycle. Lenders have gained considerable expertise in retail lending, which offers predictability in future earnings. However, large-ticket corporate lending will remain within the purview of major banks due to the significant capital requirements involved. On the other hand, capturing opportunities within the SME ecosystem presents lucrative prospects for generating business. Therefore, the future growth trajectory of Indian credit is expected to be multifaceted and inclusive of various sectors and segments.

In the case of MSME credit, Fortune India had recently analysed credit flow, pre and post-GST. The analysis revealed a notable decline in credit flow to large corporates, while mid-sized enterprises experienced significant growth. However, considering the simultaneous increase in CGTMSE guarantees alongside heightened credit exposure to mid-sized firms, can we reasonably infer that banks might be hesitant to engage in MSME lending without such guarantees?

That's true. The Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) has played a pivotal role and continues to do so in facilitating MSME lending. Particularly in the immediate aftermath of COVID-19 in 2021, its utilisation acted as a catalyst, effectively unlocking liquidity channels and enabling SMEs to rebound. Without this support, the trajectory of asset quality outcomes might have been markedly different. This bolstered MSMEs' credit profiles, allowing them to sustainably access financing and negotiate favourable terms with bankers. The presence of the government guarantee instils confidence among lenders, thus contributing to their comfort in offering favourable conditions.

So, the government continues to do the heavy lifting both on the spending side and now through guarantees on the credit side…

Weak credit can still result in non-performing loans (NPLs), regardless of the guarantee. In a recent report, we demonstrated that on a 12-month on-book basis, the 90-plus NPL rate in the MSME sector remains around 5-6%, down from a peak of 12% before COVID-19. While this signifies improvement, the rate is still elevated. Companies facing challenges, whether due to a tough business environment or internal issues, continue to struggle. However, resilient businesses persist. The government's support potentially lowers funding costs and provides financial backing, covering around 20% of the credit guarantee while leaving the remaining 80% on the lender's books. So, if NPLs manifest, banks would have to bear the brunt of any potential losses.

In your discussions with bank CEOs, are you noticing a shift towards prioritising market share retention or profitability?

From our interactions with both CEOs and investors, we've observed a sensible approach among CEOs. They are placing greater emphasis on operating profit growth or ROAs as key focal points, rather than solely focusing on market share expansion. This emphasis on profitability is particularly evident among private banks, which adhere to their desired profitability matrices. Hence, we continue to favour private banks, as they maintain a commitment to driving profitability, as evidenced by the prevailing narrative.

Is your view an outcome of the banking universe tracked by Goldman Sachs?

The combined market share of the institutions we track covers significant ground in the industry. As you move further down the curve, there's an increasing imperative for banks to adhere strictly to fundamentals. This is crucial for securing funding and capital, which serve as the bedrock of any banking operation. Over the years, particularly since 2015, both private sector banks and NBFCs have undergone numerous cycles, leading to a notable enhancement in their discipline.

In contrast, state-owned banks are currently experiencing a resurgence in market activity after a prolonged period of dormancy. However, our high-frequency data suggest that they may have begun compromising on profitability prematurely. This is evident in stagnating margins and lending spreads, which are showing a downward trend on a monthly basis. This heightened competition in both deposit and lending markets poses a significant risk, particularly when compared to the relatively disciplined approach of private banks and NBFCs.

India banking sector

Era of peak profitability and growth for Indian banks is over: Goldman Sachs’ Rahul Jain