When the Reserve Bank of India (RBI) created its road map for the future of Indian banking in May 2004 as part of a World Trade Organization commitment, it projected major changes to take effect in April 2009. That’s when the RBI planned to review the road map’s first phase, which permitted foreign banks to set up wholly owned subsidiaries between March of 2005 and March of 2009. The second phase was to begin, the RBI said, “after a review of the experience gained and after due consultation with all the stakeholders in the banking sector.”

Now April 2009 has come and gone, and no foreign banks are clamoring at the gates. All that marked the occasion was a passing mention by RBI Governor D. Subbarao on April 21. “In view of the current global financial market turmoil,” Subbarao said, “it has also been decided to continue, for the time being, with the current policy and procedures governing the presence of foreign banks in India. The proposed review will be taken up once there is greater clarity regarding stability, recovery of the global financial system, and a shared understanding on the regulatory and supervisory architecture around the world.”

But back in February 2005, the RBI had set out a plan for the second phase in which foreign banks would be treated on par with domestic banks. This would allow them “to enter into merger and acquisition transactions with any private-sector bank in India,” the RBI had said.

Size matters in the Indian banking sector, and foreign banks have long petitioned the government and the RBI for freedom to grow. RBI Deputy Governor V. Leeladhar unleashed a storm in 2007 when he told a banking conference that two large Indian banks should be considered foreign, as “the non-resident ownership is close to 74%.” He didn’t name the banks, but it was assumed he was talking about ICICI Bank and HDFC Bank. Incorporated in India, they were predominantly foreign-owned.

The distinction is important because under WTO obligations, licenses can be denied to multinational banks if foreign bank assets exceed 15% of the system. Add ICICI and HDFC Bank to the Citibanks and HSBCs and the threshold is crossed by a wide margin. Bankers don’t speak out against the regulator. But in private, several foreign banks carped about being left out of the action in a booming economy.

According to The Economic Times, ICICI wrote recently to the Department of Industrial Policy & Promotion, seeking to clarify that it not be considered a foreign bank. The business daily also says the RBI has written to the department, pointing out that, under notices issued in February 2009, seven banks would cease to be counted as Indian-owned. The list includes ICICI, HDFC Bank, Development Credit Bank, and ING Vysya.

Flight to the Public Sector

Being classified as a foreign bank involves restrictions on opening branches and investing in areas reserved for Indian entities. But Indian banks may not like the “foreign” label for other reasons. If “banker” is a now a bad word in the U.S., some of the stigma applies to banks’ Indian arms.

“Multinational banks in India are going through a very difficult period,” says Viren H. Mehta, director of Ernst & Young India. “While they are well capitalized in India (from an Indian balance sheet perspective), they are highly dependent on their head offices. If the parents don’t survive, they will not be able to survive here.” Adds Robin Roy, associate director at international professional services firm PricewaterhouseCoopers (PwC): “Hit by global contagion, ransacked by investors, and almost deserted by many customer profiles, foreign banks need to consolidate and get their act together.”

But this may only be a passing phase. Says Rajesh Chakrabarti, assistant professor of finance at the Hyderabad-based Indian School of Business (ISB): “Foreign banks are certainly weakened, but it may be a mistake to write them off. They have a massive dominance in certain areas of banking, like fee-based activities and off-balance-sheet exposures, which are actually the most profitable parts of the banking business. In terms of deposits and assets they have never exceeded more than 6% to 8% in India. We may see consolidation among them, and the ones that survive the crisis will emerge stronger from it.” Adds Harsha Kapoor, financial services practice head for the Tata Strategic Management Group (TSMG): “In the short run, foreign banks will probably be passive now. However, they have always been agile and will be waiting for the right opportunities to become aggressive.”

Some Indian private-sector banks have also been affected by public distrust. RBI numbers indicate a flight to public-sector banks. In October-December 2008, nationalized banks’ deposit share rose from 47.7% in the year-earlier quarter to 48.3%. The share of the State Bank of India (SBI) and its associates rose from 22.9% to 24.4%. (SBI was created by the government in 1955 to take over a bank that accounted for some 25% of the banking system, though SBI isn’t considered a “nationalized” bank.) On the losing side were “other commercial banks,” essentially the private-sector banks, down from 20.2% to 18.6%, and foreign banks, down from 6.2% to 5.7%.

In its April 21 policy statement for 2009-2010, the RBI said public-sector banks’ deposits grew by 24.1% as on March 27 compared with a year earlier. For private-sector banks, deposit growth was just 8%, and for foreign banks 7.8%. A year earlier, public-sector banks’ deposit growth was 22.9%, private-sector banks’ 19.9%, and foreign banks’ 29.1%. “The fall of Lehman Brothers and the ensuing institutional uncertainty saw massive withdrawals from foreign banks and an increase in deposits with PSU (public-sector undertaking) banks, particularly SBI, as it was assumed that the government would always bail them out,” says Chakrabarti. Notes Paresh Sukthankar, executive director of the private-sector HDFC Bank, which has weathered the storm: “People see PSU banks as government-owned. They feel the government will stand by them in case they are in trouble.”

The difference was similarly apparent in credit, a measure of risk appetite. PSU banks grew 20.4%, private-sector banks 10.9%, and foreign banks just 4%. The corresponding figures for 2008 were 22.5%, 19.9% and 28.5%, respectively. “Substantially lower credit expansion by private and foreign banks also muted the overall flow of bank credit during the year,” the RBI said.

No one is writing off these banks. But critics — the left has long opposed opening the banking sector — are out in full cry. At a recent Confederation of Indian Industry meeting, Punjab National Bank Chairman K.C. Chakrabarty criticized the high-profile private and foreign banks. “You say banks are not lending, but you don’t say which banks,” he told the assembled bankers and businesspeople. “You are not saying these are the same banks that got the best-bank awards year after year.” This year, at least, they aren’t likely to corner the awards.

A New Golden Age?

So is it the dawn of a golden age for PSU banks? Hiring patterns provide some anecdotal evidence. PSU banks have never cut a wide swathe at the Indian Institutes of Management (IIMs). Students’ favorites have been foreign banks and financial-sector companies such as Goldman Sachs and Lehman Brothers. This year, 14 IIM Calcutta students signed up with Union Bank of India. Bank of Baroda wasn’t far behind. At IIM Ahmedabad, UBI recruited 18 students and Bank of Baroda six.

“In the past few years, public-sector banks have cut down on recruitment,” Ernst & Young’s Mehta says. “There have been voluntary retirement schemes, people have been retiring. These banks are now hiring professionals. This will help make the banks more efficient.” Adds Roy of PwC: “Over the next two to three years, a lot of natural attrition will happen, and the current recruitment drive is to help prepare for such a scenario.”

“PSU banks and India’s finest management schools — the IIMs — have struck a winning chord,” says Rana Kapoor, founder, managing director and CEO of Yes Bank, a private-sector bank. “This is a great time to recruit exceptional talent. Yes Bank has hired 17 top IIM graduates this year.”

The hiring isn’t limited to management graduates. The Institute of Banking Personnel Selection, promoted by PSU banks and the RBI, says PSU banks will hire 30,000 in 2009-10, even as the rest of the financial sector downsizes. The number may be an understatement. “We alone will hire about 25,000 employees this year,” says SBI chairman O.P. Bhatt. And Ananda Bhoumick, senior director at Fitch Ratings, notes: “In a market where all is doom, PSU banks are the ones with ample capacity for fresh hiring.”

According to market information provider Nielsen, the banking services and products categories in India increased ad spending by 66% in 2008 to US$500 million. SBI was the biggest spender. ICICI Bank topped the charts of private-bank advertisers. The reason? Says The Economic Times: Some “US$11 million was spent during the October-December period, when brand ambassador Shahrukh Khan was brought in to resurrect the bank’s image, as doubts were raised about its solvency.” Foreign companies meantime, including American Express and Citibank, cut their advertising spending.

Advance tax payments provide another indicator. SBI gave US$1.1 billion to the government’s coffers during the year, emerging as the country’s largest taxpayer. Its fourth-quarter payment was US$367 million, compared with US$285 million the previous year. Bank of India, with US$119 million (compared with US$39 million) and Punjab National Bank with US$95 million (compared with US$36 million) were among the PSU banks that sharply increased fourth-quarter contributions. By contrast, ICICI Bank’s payment was static at US$50 million.

PSU banks are also making public waves in their retail drive. With encouragement from the government (which wants to boost lending to fight the economic slowdown), they have come out with inexpensive housing, auto and education loans. They’ve taken the lead in financing Nano auto purchases, for instance, and their housing loan rates are two to three percentage points lower than those charged by other banks and mortgage companies, such as Housing Development Finance Corporation. In an unusual twist, the usually nimble and proactive private-sector companies have complained about SBI’s tactics. HDFC chairman Deepak Parekh told TV channel CNBC-TV18 that SBI’s scheme was a gimmick. “SBI is not trying to get any new money or loans in the housing finance market but is only trying to get existing customers,” he said. His fear, of course, was that borrowers would switch from HDFC. “Competition is inevitable,” SBI’s Bhatt responded. To many, the private and public sectors appear to have changed roles.

A Matter of Perception

Is the PSU bank resurgence for real? The global financial crisis and the follow-on economic slowdown present policymakers with many challenges, says Yes Bank’s Kapoor. And while the government and the RBI have endorsed active policies and announced wide-ranging stimuli, the key to channeling the moves these effectively rests with the banking sector, and particularly “with PSU banks as front-runners of the Indian financial system,” Kapoor says. While the private-sector banks have been trying to balance out a relatively higher cost of funding, PSU banks — backed by a huge CASA (current account/savings account) base — enjoy a lower cost of funding and “have been quite prompt in cutting lending rates.” According to Kapoor, that means “The future belongs to those who have not only been proactive in building trust-based relationships with their stakeholders, but have also used these trying times to innovate, introduce new technology, and improve operational efficiencies, thereby setting the base for long-term sustainable growth.”

Ernst & Young’s Mehta notes that “over the past few years public-sector banks in India have pulled up their socks. They have improved technology, infrastructure and their service mentality, and have been more driven in terms of ensuring that they don’t lose more turf to either the private-sector banks or the foreign banks. This has got accentuated in the recent months with the steady weakening of the private-sector and the foreign banks. Earlier, savvier customers used to like the sophistication of the foreign banks, but this has completely changed with the fear that has set in regarding the credibility of these banks.” PSU banks have always been ultraconservative, whether in underwriting loans or trading Treasuries, Mehta adds. “This has now helped them demonstrate that their balance sheets are stronger than foreign banks’ in India. The combination of all this has put PSU banks in the limelight.”

Kapoor of TSMG believes it is largely a matter of perception. “PSU bank performance is always relative,” he says. “When foreign and private banks were growing at a faster rate, PSU banks were called laggards. Now that the foreign banks have slowed down, the stability and steady growth of PSU banks has been noticed.” He calls it “satisfactory underperformance.”

Skeptics raise two other issues. First, are PSU banks merely following government orders? Will they be as dynamic and proactive once the crisis is past? “PSU boards often have more government representatives than the shareholding of the government would warrant,” says Chakrabarti, of ISB. “Also, the chairman is practically picked by the government without the benefit of a clearly independent appointments committee. There is certainly a lot of ‘cooperation’ between the Finance Ministry and large PSU banks, and they can be called on to serve ‘public interest,’ whether in currency trading or rescuing a sinking bank or implementing a broad credit policy. That said, the chairmen still have some leeway in day-to-day operational issues, in improving the efficiency of the bank, in motivating employees, and in figuring out competitive strategies within each banking silo.” Notes Kapoor of TSMG: “Reasonable levels of independence in decision-making exist, and some do exercise this effectively.”

The second issue involves non-performing assets (NPAs). In their new aggression, are PSU banks risking piling up bad loans? “Some of the PSU banks that went into housing loans a few years ago have not done too well,” says Sukthankar of HDFC Bank. “They have chalked up 3% to 4% NPAs in what is one of the lowest-risk retail loan products. Successful retail lending requires the right segmentation, distribution channels, systems and credit policies and processes. Banks which have learned from their experience and have all of this in place will be fine. But those that are becoming aggressive without the back end in place and are reducing rates simply because they have money sloshing around may feel the pain in the future. Building a retail lending business without pricing in the expected loss for every loan product, particularly in an uncertain macro environment, could mean burning the candle at both ends.” Adds Chakrabarti: “A sudden expansion in lending is likely to increase the chances of having future NPAs.”

But Kapoor of TSMG sees it differently. Interest rates and the probability of NPAs are directly proportional, he says. “The higher the interest, the higher the chances of NPAs. PSU banks are in a position to reduce interest rates on loans because their cost of funds is lower compared to other banks. Also, PSU banks adhere to prudential norms quite strictly. More than 90% of their loans are well securitized and collateralized. If the quality and the standard of loans are maintained, the chances of an NPA problem in PSU banks are quite low.”

A Global Opportunity

Some analylsts see in this scenario another opportunity for Indian banks. Many have recently started venturing overseas — though some have gotten their fingers burnt in the recent meltdown. Still, the Indian banks seem relatively better off than their foreign peers. “The Indian banking sector as a whole — whether the public or private sector — remains safe, profitable and well capitalized,” says Sukthankar of HDFC Bank.

Could this be an opportunity to move faster on global plans? Should PSU banks pick up cheap banking assets abroad? “From a long-term perspective, they should explore the options, provided that has some alignment to their existing business strategy,” says Kapoor. “They should not attempt to do something which is different from their core.” Adds Chakrabarti of ISB: “It may be a good strategy of global expansion. In any case, major countries take forever to issue fresh branch licenses to Indian banks — much longer than the RBI takes to allow foreign banks in — so well-priced banking assets may provide quicker ways of getting into some markets.”

Roy of PwC sounds a warning note, however: “While this is an opportunity, the banks need to do suitable due diligence, what with many assets still bleeding under toxicity.” At the same time, it would be wrong to treat all foreign and private banks as suspect. “All foreign banks can’t be treated the same way,” Naina Lal Kidwai, recently promoted as country head of HSBC India, told the economic daily Business Standard. “The ministry of finance has to factor in that all banks are not in trouble. We have been in this country for 155 years. They should not paint every bank and every country with the same brush.”

The private banks have winners and losers. “During this period, Yes Bank has continued to persevere, and further augment its capital and liquidity, while simultaneously de-risking, and yet demonstrating revenue sustainability,” CEO Kapoor says. “Yes Bank’s management philosophy during this period is to pursue ‘opportunities in adversity,’ and they are numerous: further human capital acquisition, learning and development, implementing waste management initiatives, further strengthening systems, controls and processes, achieving superior customer delivery, and investing in the Yes Bank brand. (We will) be in a lean and efficient position for the turnaround.” Yes Bank’s profit for the fourth quarter ending March 2009 was up 24%. For the entire year, the increase was 52%.

HDFC Bank did one better. Its profit was up 35% for the March quarter — and 41% on the year. “Some private banks may be consolidating while others are continuing to grow,” says Sukthankar. “We for one saw huge deposit inflows and gained market share. Over the 14 years that we have built up this franchise, we have always tried to maintain a balance between growth, quality of assets and profitability. Our portfolio and revenue streams are well diversified. We have never gone overboard in any particular customer segment or grown for the sake of growing. Our strong deposit franchise gives us a lower cost of funds and a strong customer base to cross-sell our loan and third-party products. Our market leadership in transactional banking products has been an advantage. We also believe we have a strong risk culture which has held us in good stead.”

At ICICI Bank, India’s largest private-sector bank, things weren’t so rosy. Net profit for the fourth quarter declined 35%. “In the coming year, the loan growth rate for us would be pretty moderate,” new CEO Chanda Kochhar told Bloomberg News. “In times like these, you have to conserve capital, you have to maintain liquidity, and you have to contain risk.”

Although it may seem like a fairly clear picture, it is worth noting that “generalizing the performance of banks across ownership segments may not be correct,” says Sukthankar. Consider two extremes. Standard Chartered, India’s largest foreign bank in terms of number of branches, is thinking expansion. It has appointed lead managers for a US$1 billion India Depository Receipts issue in the domestic market. At the beleaguered Royal Bank of Scotland, meanwhile, a fire sale is on. HSBC and Standard Chartered are in the race to pick up the Asian assets of the bank, which is now 70% owned by the British government. RBS country head Meera Sanyal has taken a sabbatical to contest in the general elections as an independent candidate. For some bankers, it’s the right time to take a holiday.

Besides, are the categorizations merely academic in today’s environment? As Roy of PwC notes, “A lot of the global foreign banks have become PSU banks in their own territories.”