May 27, 2011

Sector Review:

India Banking Outlook 2011: Stability Ahead, But Some Headwinds Remain
Primary Credit Analyst: Geeta Chugh, Mumbai (91)22-3342-1910; geeta_chugh@standardandpoors.com Secondary Contact: Deepali Seth, Mumbai (91) 22-3342-4186; deepali_seth@standardandpoors.com

Table Of Contents
Asset Quality Is Likely To Improve Rising Funding Costs Could Put Margins Under Pressure Lower Provisioning Costs Could Offset The Impact On Margins Liquidity Is Likely To Improve, But The Banking Sector Is Likely To Remain A Net Borrower Credit Growth Should Remain High In The Next Three To Five Years Increased Capital Is Key To Growth Related Criteria And Research

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Sector Review:

India Banking Outlook 2011: Stability Ahead, But Some Headwinds Remain
Growth in the Indian banking sector is likely to be high in the next three to five years. Standard & Poor's Ratings Services believes the sector will benefit from India's sound economic growth, favorable demographics, and underpenetration. Nevertheless, high inflation, increased competition, and evolving risk management processes will be key challenges. The performance of Indian banks in fiscal 2011 (ended March 31, 2011) was broadly in line with our expectations. The sector's asset quality was under pressure and we expect nonperforming loans (NPLs) to peak in fiscal 2011. Earnings pressure eased amid high loan growth, low liquidity, and regulatory changes around the base lending rate and the statutory liquidity ratio (SLR). The economic revival and higher lending-related activity also boosted fee income. Nevertheless, trading gains fell as interest rates rose. Banks' credit costs also rose in sync with the asset quality pressures. Overview We expect growth in the Indian banking sector to remain high for the next three to five years. The outlook for the sector for fiscal 2012 is stable. We expect asset quality to improve. Earnings are likely to be stable as lower credit costs offset a dip in margins. High inflation, evolving risk management systems, and rising competition in a fragmented industry are challenges for banks.

The outlook for Indian banks for fiscal 2012 is stable. We expect asset quality for these banks to improve in view of the economy's sound performance. The banks could also benefit from the limited concentration in loans and lower leverage in India than in most countries. Their earnings are likely to be stable as lower credit costs offset a dip in margins. A stable retail deposit base and a prudent regulatory environment also support the industry's creditworthiness.

Asset Quality Is Likely To Improve

We expect Indian banks' overall nonperforming loan (NPL) ratio to have peaked at about 2.6% in fiscal 2011, from 2.4% at March 31, 2010. We anticipate that the ratio will decline to 2.4% in fiscal 2012. The ratio peaked with a lag due to the Indian central bank's one-time allowance for banks to restructure loans between January 2009 and June 2009 without classifying them as NPLs. About 5%-20% of the restructured loans of the banks that we rate became nonperforming in the 18 months since June 2009, when they completed restructuring exercises. We had expected 25%-50% of the restructured loans to slip into the NPL category within two years. Nevertheless, given the sharp rebound in the economy, we now expect aggregate slippages from restructured loans to be close to the lower end of our expectations. In our view, the surge in real estate prices in some pockets in India is a credit risk for banks. While prices in some of

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Sector Review: India Banking Outlook 2011: Stability Ahead, But Some Headwinds Remain

these areas may correct, we currently do not expect a hard landing. Real estate and construction sector (excluding residential mortgages) accounts for less than 5% of the total loans of banks. The low exposure will limit the direct impact of a price correction on the banking sector. We expect the sector's overall slippage to decline from the high of fiscal 2011 to levels before the global financial crisis in fiscal 2009. Our view is based on India's sound economic performance, banks' focus on low-to-moderate risk segments (81% of total loans) and the increased diversification in their loan portfolios. (See "Unraveling The Credit Risks At Indian Banks," published Jan. 28, 2011, on RatingsDirect on the Global Credit Portal) The economy's overall leverage is still reasonable. We estimate banks' nonperforming asset ratio to be about 5% in fiscal 2012. We don't expect inflation to significantly worsen the asset quality of banks. Companies have sustained their credit profiles as they have largely been able to pass on the rise in costs to customers amid strong domestic demand. Moreover, inflation has a more adverse impact on low income individuals, who typically don't have access to bank credit in India. Nevertheless, prolonged high inflation or lower economic growth could put asset quality under pressure.

Rising Funding Costs Could Put Margins Under Pressure

We expect bank margins to be under pressure in fiscal 2012 as banks are unlikely to be able to pass on the entire increase in funding costs to customers. Banks funding costs have increased for two key reasons. First, the central bank, the Reserve Bank of India (RBI), raised policy rates and interest rates on regulated savings account deposits by 50 basis points. Second, funds moved from savings deposits to significantly higher-yielding term deposits in a high interest rate environment. Any liberalization of savings deposit rate could intensify competition and put further pressure on bank margins. We expect fee income to be buoyant in fiscal 2012, although trading gains may decline. The net interest margins of Indian banks improved in fiscal 2011 because: Enhanced loan growth amid a liquidity squeeze increased the pricing power of banks; The introduction of base lending rates established a floor lending rate and improved yields on corporate lending (particularly to top-tier corporates); Banks lowered their allocation of government securities after the RBI reduced the SLR to 24% (and 23% for a transient period); and Banks delayed deposit-rate hikes and lagged repricing of liabilities in a rising interest rate scenario. These benefits more than offset the impact of the rise in effective interest rates on savings deposits by 15 basis points and the increase in the cash reserve ratio towards the end of fiscal 2010.

Lower Provisioning Costs Could Offset The Impact On Margins

We expect credit costs to decline for most large Indian banks, except State Bank of India (SBI; BBB-/Stable/A-3), in line with an improvement in the asset quality. The new RBI regulations are also less stringent than the earlier policy that required minimum 70% provisioning. Therefore, despite the pressure on margins, we expect overall return on

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Sector Review: India Banking Outlook 2011: Stability Ahead, But Some Headwinds Remain

average assets (RoAA) to be stable. SBI and a few smaller banks have received an extension from the RBI to comply with the 70% provisioning norm by September 2011. These banks will have to step up provisioning in fiscal 2012, and their earnings will therefore remain under pressure. Credit costs were high in fiscal 2011 as slippages from restructured loans surfaced and banks stepped up provisioning to comply with the minimum 70% provisioning norm. The overall RoAA therefore benefited in fiscal 2011. SBI was badly hit as its increase in credit costs depressed earnings. (See "State Bank of India Rating Unaffected By Underperformance In Fiscal Year 2011," published May 19, 2011.)

Liquidity Is Likely To Improve, But The Banking Sector Is Likely To Remain A Net Borrower
We anticipate that liquidity for Indian banks will improve in fiscal 2012 as their deposits soar due to a significant increase in interest rates on deposits in the past few months. The government has also resumed spending. The RBI prefers liquidity in the system to be at plus or minus 1% of net demand and time liabilities of banks. Its current preference is to be in deficit mode as the RBI finds low liquidity more conducive for monetary policy transmission. Liquidity for banks was low for most of fiscal 2011, primarily due to: Large borrowings by telecommunication companies to participate in the auction of 3G spectrum; Reduced government spending; and Increased currency holdings with the public due to high inflation. To ease the liquidity situation, the central bank reduced the statutory liquidity ratio requirement and provided greater access to its liquidity adjustment facility, where banks can borrow or lend. The RBI also increased open market operations, buying about Indian rupee (INR) 670 billion in government securities from the market. As a result, inter-bank call money rates remained below 8% in fiscal 2011, although they were higher than the previous year.

Credit Growth Should Remain High In The Next Three To Five Years
We expect credit growth to exceed the nominal gross domestic product (GDP) growth for the next five years. We estimate credit growth for fiscal 2012 at 20%, which is 1.3x nominal GDP growth. Our view is based on India's stable political environment, growing economy, underpenetrated market, favorable demographics, and prudent regulations. Loans to the infrastructure, and metals and mining sectors are likely to lead the increase in credit growth. Credit growth in fiscal 2011 was about 21%, marginally above our original estimate of 20%. Large loans to telecom companies for 3G auctions largely drove the increase in credit growth.

Increased Capital Is Key To Growth

We believe capitalization at Indian banks' could dip due to the sector's steady growth. The weighted average Tier 1 capital adequacy ratio (CRAR) of the banks we rate was 9.4% (9.7% as at March 31, 2010). Risk adjusted capital for the banks is moderate.

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Sector Review: India Banking Outlook 2011: Stability Ahead, But Some Headwinds Remain

The private sector banks we rate are well capitalized and have adequate access to capital markets. Nevertheless, government-owned banks could need additional capital to support their growth plans. The government's limited resources and regulations that necessitate state shareholding of at least 51% have partly constrained these plans. State-owned banks could benefit from the government's proposed recapitalization program that seeks to ensure that these banks' Tier I CAR is at least 8%. Simultaneously, the government is considering increasing its stake in these banks to a minimum of 58% to ensure that they have headroom to raise capital. The government injected INR31 billion of capital into state-owned banks in fiscal 2009 and fiscal 2010. The infusion was entirely in the form of investments in preference shares or innovative perpetual debt instruments. In fiscal 2011, the government infused INR201 billion bank capital. The majority of the infusion was in the form of equity; and the rest in perpetual non-cumulative preference shares. These shares qualify for 33% capital credit in our rating methodology. The government is also reportedly considering converting these preference shares to common equity, which should also help the sector. We believe pressure on the banks' capital is likely to ease in fiscal 2012. The government has made a budgetary allocation of INR60 billion for recapitalizing banks. Many banks are also considering equity issuances.
Table 1

SWOT Analysis Of The Indian Banking Sector

Strengths/Opportunities Continued sound economic growth prospects Favorable demographics Underpenetrated sector Relatively low leverage in the economy Low sector concentration in the loan portfolio Stable retail deposit base Limited exposure to high risk sectors Table 2 Weaknesses/Threats Fragmented banking sector Intense competition causing continuous pressure on margins Risk management is still a work-in-progress and below-average for many banks Mandatory investments in government securities, and priority sector obligations lead to inefficient utilization of resources Asset-liability management gap in infrastructure lending, with negligible scope to downsell the portfolio Attracting human capital, particularly for government owned banks

Ratings On Major Indian Banks

Axis Bank Ltd. Bank of Baroda* Bank of India Canara Bank* HDFC Bank Ltd. ICICI Bank Ltd. IDBI Bank Ltd. Indian Overseas Bank Indian Bank State Bank of India Syndicate Bank Union Bank of India *Unsolicited ratings Counterparty credit ratings Stand-alone credit profiles BBB-/Stable/A-3 bbbBBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 BBB-/Stable/A-3 bbbbbbbbbbbbbbbbb+ bb+ bbbbbbbb+ bbb-

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Sector Review: India Banking Outlook 2011: Stability Ahead, But Some Headwinds Remain

Related Criteria And Research

Inflation And Rising Interest Rates Present Challenges For Banks In Asia-Pacific, March 30, 2011 Financial Institutions Criteria, July 2008

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