Financial Services

INDIA’S PUBLIC-SECTOR
BANKING CRISIS
WHITHER THE WITHERING BANKS?
EXECUTIVE SUMMARY
A DECISIVE TIME FOR INDIA’S
FINANCIAL SECTOR

The Indian banking sector is close to breaking point. One generation after the sector was
liberalised, assets and deposits remain dominated by government-owned banks, who are
struggling under the weight of crippling NPAs which have exposed deficiencies in their
corporate governance and risk management capabilities.

We know that the situation is bad...

•• Declared gross non-performing assets (NPAs) at public-sector banks have risen to at
least 6.2 trillion rupees, with an additional 1.5 trillion rupees of restructured standard
assets. In total, these represent 14.6 percent of advances, three times the percentage for
their private-sector peers
•• As of writing, all the nationalised banks except SBI, as well as IDBI, are trading at less
than book value, and the majority are at less than half book value. Over the 2016 and
2017 fiscal years, taxpayers have seen a loss of 400 billion rupees from the public-sector
banks, with all of them losing money except SBI. The losses would be even higher not
accounting SBI’s profits

…but we don’t know how bad the situation is. Unlike in Europe, the scope of the criteria used
to judge asset quality has been rather restricted, and the impact of asset quality could be
larger than estimated so far:
•• No public, system-wide effort has been made to assess the adequacy of provisions
against these NPAs or of the sustainability of the restructured assets. Most independent
observers, such as ICRA, India Ratings, Moody’s, and Fitch, estimate that between 1.25
trillion and 1.35 trillion rupees of capital will be needed for the banks to meet their capital
requirements for the 2019 fiscal year
•• The latest Financial Stability Report suggest that under the provisioning requirements
of IndAS, the new Indian Accounting Standards-, will be substantially higher than under
current norms. That suggests that banks’ own estimates of the recoverability of their
assets are below what is reflected in their current books

We read almost daily about the initiatives taken by the Reserve Bank of India, the
government, and even the Securities and Exchange Board of India (SEBI) to address the
problem of bad corporate loans and improve mechanisms for more-effective recovery of
these debts. More recently, we have seen the Reserve Bank asking banks to initiate forced
bankruptcy proceedings against 12 large loan defaulters that account for 25% of banking
system’s bad loans. We have also seen the government commit to limited capital infusions to
help shore up public-sector banks via its “Indradhanush” recapitalisation programme. What
we have yet to see is a comprehensive vision of how the sector can return to sustainability.

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 It is our view that a comprehensive vision is critical for the sector – for the sustained
economic growth it facilitates and for the populace to have access to quality financial
services. The questions which need to be addressed are not easy to answer and will
be best approached through a healthy public dialogue. This should encompass the
industry itself – via bodies such as the Indian Banks’ Association (IBA) as well as individual
institutions – regulators, policymakers, academia, public advocacy groups, and other
industry experts. The questions which this discourse should address include:
1. What is the extent of the damage? Will actions aimed at corporate debt recovery and
balance sheet remediation, such as limited capital infusions and regulatory relief on
accounting norms, be adequate to restore the sector to a sustainable state without
structural reforms?
2. How have the risk and governance frameworks failed so spectacularly, and what can be
done to address this going forward?
3. What is the range of ways in which the government could resolve the current problems?
These could include:
•• Low-cost government recapitalisation based on off-balance sheet solutions:
For example, a change in the reserve requirement, introduction of an asset
protection scheme, and injection of government capital in a limited manner. Some of
the smaller state banks could be merged or allowed to fail, while largely maintaining
the similar structure. Such an option might boost economic growth, but there would
be a high likelihood of the problem recurring. Further, this would be a moderate- to
high-cost option for the Indian government
•• Consolidation of the public-sector banks around a few state-owned national
champions: This would have a moderate-to-high cost for the government, but with
no guarantee of the problems not recurring. There would also be the possibility of
the government creating “too-big-to-fail” institution, while stymying private-sector
banks, which would then have to compete with large, state-owned enterprises
•• A radical restructuring of the public-sector banks: Large-scale privatisation with
the creation of specialised banks focusing on the under-served parts of the banking
sector. Privatisation will pay for the recapitalisation, so the effective cost would be
zero or negative for the Indian state, and competition would be encouraged, with
a beneficial impact on economic growth. Strong political will would be needed for
such a solution

In addressing these questions, this discourse needs to further set a medium-term vision for
the sector which articulates clear objectives for the governments continued role (if any) in
the ownership of banks. We consider three key questions aimed at probing the benefits of
public ownership.

Copyright © 2017 Oliver Wyman

 •• Does government ownership lead to systemic stability? The government-owned
banks have not proven more stable, but the implicit government support they
receive has prevented a crisis of confidence. Going forward, is government
ownership the best model?
•• Does government participation in the sector promote greater innovation, especially
with respect to financial deepening and inclusion? There is some evidence for this,
but it is not clear that other tools for the incubation of new ideas, such as seed funds
and regulatory sandboxes, could not be at least as effective
•• Are public-sector banks better positioned to deliver credit and services in ways that
serve the public interest rather than just shareholders? In recent years, it would
appear that increased access to finance for micro, small and medium enterprises
has come more from non-bank financial companies than public-sector banks, whose
appetite for large corporate exposure appears no less than those of private banks.
In terms of gathering deposits and providing banking services, new models such as
business correspondents, small finance banks, and fintechs appear likely to fill any
void that might be left by retreating public-sector banks

Before answering these questions, we seek in this paper to explore the extent to which
the status quo could be maintained, should the government choose the path of minimal
disruption. It is clear that-, if the government had unlimited appetite and capacity for capital
infusion, there would be no problem in restoring the market structure as it was prior to the
current crisis. However, we consider the scenario in which the government’s recourse to
taxpayer funds is limited to the commitments already set out in the current budget.

Our analysis indicates that the immediate options – such as the sale of stakes in joint
ventures, changes in the revaluation reserve discount factor, partial privatisation, and
government guarantees – would be just sufficient to recapitalise the banks under base case
assumptions of their capital needs. Any significant deterioration in asset quality from current
levels would require disruptive thinking on ways to recapitalise the banking system-, and
could not be accomplished by the above initiatives alone. For a sustainable solution, the
government and the supervisor need to fundamentally review the role of the government in
the banking system. Given the headwinds (and tailwinds) facing the Indian banking sector
today, an endgame outcome would be a banking structure where public-sector banks
become more specialised, with a much clearer strategic focus on public goods: they could
support small businesses and strategic interests such as defence and utilities, for example.
The largest private-sector players would provide mainstream banking services in the
corporate, SME, and retail segments.

Such a transformation of the banking sector would be a Herculean task given the socio-
political challenges, and would require strong political will and a well-planned transition.
We hope the discussion in this document will act as a thought-starter for all the stakeholders
and facilitate further discussion and debate on how to make the Indian banking sector
world-class.

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 1. WHAT IS THE PROBLEM?

The distressed assets situation in India has worsened over the last few years, with banks’
NPA levels at an all-time high. Our analysis indicates that the extent of NPAs in the system
is worse than those seen in Italy, Greece, and Portugal at the height of the global financial
crisis of 2008-10. The annualised growth rate of NPAs over the last five years has been more
than 25 percent. NPAs have been mostly concentrated in the public-sector banks, whose
gross NPAs have grown from 1 trillion rupees in the 2012 fiscal year to 6.2 trillion – six times
as much – in the 2017 fiscal year. The acute stress in the public-sector banks is due to a
combination of external factors, such as problems related to infrastructure projects and
the global slowdown in commodity prices, and internal, such as risk mismanagement and
excessive growth in lending books.

The gap between the average stressed-asset ratio of public-sector banks and that of private-
sector banks has increased significantly in the last five years, from about 500 basis points
to about 900. We believe that the scale of NPAs is unknown and under-reported, and that
efforts to date have failed to transparently report NPAs. This remains a material barrier in
dealing with the problem. The RBI has recently taken assertive action, by mandating banks
to disclose the divergences between their asset classification and provisioning and the
RBI’s assessment.

This growing stock of non-performing assets has adversely impacted the growth,
profitability, and capital adequacy levels of the public-sector banks. They account for more
than two-thirds of the banking sector, so their stress levels now jeopardise credit growth,
which recorded its lowest levels in over 60 years in the 2017 fiscal year. India continues to be
an asset-poor country, with a loan-to-GDP ratio of 52 percent, compared to 152 percent in
China, 151 percent in Thailand, 134 percent in the United Kingdom, and 189 percent in the
United States. While much of the impact can be attributed to a slowdown in corporate credit
demand, the public-sector banks’ lower capital adequacy levels are restricting their lending
capacity, reducing their lending to the retail and SME segments.

Public-sector banks’ asset quality is expected to weaken further, putting pressure on internal
capital generation and making it harder to meet capital requirements under the Basel III
capital adequacy framework. Under Basel III norms, banks must have a capital adequacy
ratio of at least 11.5 percent by March 2019. Various analyst reports have recently estimated
that the public-sector banks need to raise between 1.25 trillion and 1.35 trillion rupees in
capital during the 2018 and 2019 fiscal years, of which more than 60 percent will be in core
equity capital. This is in line with estimates we made late last year in our report “Indian
Banks: Tacking into the Wind”.

Copyright © 2017 Oliver Wyman

Exhibit 1: Public- and private-sector banks’ shares of gross advances and non-performing
loans and the trend in stressed-asset ratios
Foreign Banks
4.6%

Private-Sector Banks 8.1%

24.2%
2.0% Share of
Advances 2017

Share of 89.9%
GNPA 2017
Public-Sector Banks
71.2%

IMPAIRED ASSET RATIO

17.5
16.1

13.5

11.2
9.9 9.6 9.5
9.1 9.3
Private-Sector
7.9 Banks
7.3
6.1
5.1
4.0 4.4 4.4 Other Government
3.2 3.5 Owned Banks

SBI Group
2012 2013 2014 2015 2016 2017

1. Impaired Asset = GNPA + RSA (Restructured Standard Assets)

2. SBI Group for 2017 represent only SBI
Source: RBI, Oliver Wyman analysis

We do not believe that the government should resort to bail out the troubled banks as it
will result in direct losses to the state, increase fiscal deficit and finally, create moral hazard
issues. Rather, policymakers should develop a comprehensive reform plan that includes
not just mechanisms to get the system back on its feet in the near term, but also a clear,
strategic vision for the sector, a structural reform plan, and investments in transforming
risk and governance. Where government control remains, substantial improvements in
governance and professionalisation will be required; and where private capital is allowed in,
the supervisory oversight mechanism will need to be reviewed to minimise the impact on
macro-economic stability. We discuss aspects of the immediate capital situation next, and
long-term structural reforms later in this report.

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 2. HOW TO FIX THE IMMEDIATE
CAPITAL SITUATION?

For the size of the problem, little effort has been made to recapitalise the banks. In fact, a
sustainable solution can only be achieved by addressing the NPA situation. This requires a
systematic assessment of asset quality followed by creation of management incentives to
address NPAs, for example via Prompt Corrective Actions. The current approaches to NPA
management are inadequate and result in economic inefficiencies that reduce value. A more
coordinated approach is warranted to work out multi-bank assets that have remained too
long in an indecisive state of limbo. The recent actions by the government and RBI, such as
a bankruptcy code for the 12 largest defaulters, definitely go in the right direction. In this
paper, we focus not on improving the recovery of NPAs, but rather on addressing the capital
shortfall that will remain even after NPAs have been addressed.

The current set of options available for raising capital – notably through a combination of
regulatory intervention and private-sector capital injections – is just about sufficient to
address the currently projected capital requirements.

Considering that most of the private-sector banks are trading below book value with feeble
investor appetite, it would be difficult to attempt to recapitalise the country’s 20-plus state-
run lenders with private capital. Hence, we think that a first wave of action should include
quick-win initiatives such as the sale of stakes in investments and the sale of government
stakes in private-sector banks such as Axis Bank. These resources could then be used to
shore up the capital of the selected banks. This would strengthen their balance sheets,
making them more attractive to private investors (See Exhibit 2). There are four initiatives
that could generate up to 1.25 trillion rupees of value:
1. A strategic review of investments, resulting in the sale of partial stakes in select core
ventures such as insurance and the complete sale of non-core investments such as
stock exchanges
2. Temporary revision of the discount factor used to determine the property
revaluation reserve considered as common equity tier 1 capital
3. Raising private capital by diluting the government’s share in selected public-sector
banks with better market valuations, as well as through the complete sale of government
shares in Axis Bank and IDBI Bank
4. Adopting active management of foreign exchange reserves by the RBI, leading to an
additional yield of between 1 and 2 percent on about 23 trillion rupees of reserves

Copyright © 2017 Oliver Wyman

Exhibit 2: Short-to medium-term impact initiatives

110,000
30,000 10,000
Sale of stake
40,000 Wave 1 Wave 2
in investments
Stake sale in SBI Others
Life, SIDBI, UTI MF,
Revision of NSE, BSE, CARE,
Discount Factor ICRA, CIBIL
for Revaluation 21,000
Reserve from 10,000
55% to 30%
15,000 34,000 6,500 8,000
Private 73,500
Capital Raise
SBI QIP Axis Bank IDBI Others
Bank
SBI
~ 135,000

Note: The values in the chart are indicative estimates and have not been computed using detailed methodology. In the absence of data,
sale value represents estimated gross value and not the profit on the sale of the investments in question
Source: RBI, Moneycontrol, Oliver Wyman analysis

Significant efforts have been done to quantify the bad loan situation. However, any further
increase from the current NPA levels (driven by new disclosures or new NPAs) would require
disruptive thinking on ways to recapitalise the banking system. It would not be possible to
accomplish it through the above initiatives alone.

2.1. SALE OF STAKES IN SUBSIDIARIES, JOINT VENTURES

AND NON-CORE INVESTMENTS
Public-sector banks have significant investments in various complimentary segments, for
example life and general insurance, asset management, stock exchanges, credit rating
agencies, asset reconstruction companies, and depositories. These are often profitable
and could attract investors. The government may consider the complete sale of certain
investments that provide good returns and that have achieved the original investment
objective, such as credit rating agencies and stock exchanges; or of investments that are
non-core or conflicting, such as rating agencies; or of banking businesses. It could consider
selling partial stakes in strategic ventures in segments like insurance.

For example, the mutual-fund joint ventures of various public-sector banks – namely BoB,
PNB, Bank of India, Canara Bank, Union Bank of India, and IDBI Bank; but not SBI – are very
small. They cumulatively account for only 2.2 percent of industry assets under management.
It would be beneficial to sell these stakes and schemes to LIC Mutual Fund, thereby also
achieving consolidation in the asset management industry. Further, extant Securities and
Exchange Board of India regulation does not allow the sponsor of one asset management
company (AMC) to be associated with the sponsors or promoters of another. The present
situation has provided the catalyst for public-sector banks to strategically review their
investment portfolios and re-align their focus on investments, ventures, and segments that
form part of a strategic vision for the coming decade.

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 Exhibit 3: Public-sector banks have several types of investment that could be monetised to
raise capital
10,200 40,000

1,000
3,800
Based on
15% stake sale 5,500
assumption
10,200

9,300

SBI Life SIDBI NSE + BSE UTI AMC CARE + Others Total
ICRA + CIBIL estimate
State Bank SBI, IDBI State Bank Punjab National
Banks

of India and various of India Bank

other PSBs
Bank of Baroda Canara Bank
Punjab National IDBI Bank
Bank
Indian Overseas
Bank
OTHER INVESTMENTS WHICH COULD BE CONSIDERED FOR DIVESTMENT
(ILLUSTRATIVE AND NOT EXHAUSTIVE)

•• SBI General Insurance, SBI Cards & Payment Services, SBI Mutual Fund,
STATE BANK OF INDIA
SBI Global Factors, SIDBI
•• PNB Housing Finance Limited, PNB Metlife India Insurance, Principal PNB
PUNJAB NATIONAL BANK
Asset Management, CRIF High Mark, SIDBI
•• Indiafirst Life Insurance, Baroda Pioneer Asset Management,
BANK OF BARODA
India Infradebt Limited
•• Star Union Dai-Ichi Life Insurance, BOI AXA Investment Managers,
BANK OF INDIA
ASREC India
•• Canara HSBC Oriental Bank of Commerce Life Insurance, Canara Robeco
CANARA BANK
Asset Management, Can Fin Homes Limited
•• Star Union Dai-Ichi Life Insurance, Union KBC Asset Management,
UNION BANK
National Securities Depository Limited

ALLAHBAD BANK •• Universal Sompo General Insurance, ASREC India

ANDHRA BANK •• Indiafirst Life Insurance, ASREC India

INDIAN BANK •• Lakshmi Vilas Bank, Ind Bank Housing

•• IDBI Federal Life Insurance, IDBI Asset Management, Stock Holding

IDBI BANK Corporation of India, Clearing Corporation of India, National Securities
Depository Limited, SIDBI

CENTRAL BANK OF INDIA •• IL&FS, Cent Bank Home Finance

1. The value estimate is indicative and not based on a detailed valuation exercise or methodology. In the absence of data, the sale value
represents estimated gross value and not the profit on the sale of such investments
2. Finance Minister Arun Jaitley said in his budget speech for 2016-17, “The government is committed to reducing its stake in IDBI Bank
to under 50 percent.” The value from the sale of non-core assets may be paid out as dividends to the government prior to complete
divestment in IDBI Bank, and used for recapitalisation of other public-sector banks
3. Later in the document, we mention the scenario of mergers between Andhra Bank and Bank of Baroda, Union Bank of India and Bank of
India, and Oriental Bank of Commerce and Canara Bank. Hence, divestment in Indiafirst Life Insurance, Star Union Dai-Ichi Life Insurance,
and Canara HSBC Oriental Bank of Commerce Life Insurance would eventually assist in strengthening the financial health of Bank of
Baroda, Bank of India, and Canara Bank respectively
Source: Orbis, news articles, Moneycontrol, Oliver Wyman analysis

Copyright © 2017 Oliver Wyman

2.2. TEMPORARY REVISION OF REVALUATION RESERVE
DISCOUNT FACTOR
We estimate that a revision in the discount factor of property revaluation reserves from
55 percent to between 20 and 40 percent would help shore up the capital of public-sector
banks by between 130 billion and 300 billion rupees and raise their capital ratios by between
about 22 and 50 basis points.

There are a few reasons why a decrease in the discount factor makes sense. Such a
reclassification would shore up capital with a mere account entry. It would provide a fillip
to lending of between 2 trillion and 2.5 trillion rupees. And the revaluation gain on physical
property in India is relatively permanent, so a downside risk buffer of between 30 and
40 percent might be adequate.

At the same time, there are reasons not to consider such an approach. Because such a
reserve is relatively illiquid and cannot be immediately used to absorb losses, it could
promote adverse behaviour by banks, and its treatment could differ from the extant
Basel guidelines.

Considering the present stasis in credit growth and other factors discussed above, we
believe one potential approach could be to reduce the property revaluation reserve discount
factor – say from the extant 55 percent to 30 percent. This could be done for a temporary
period of the next three years, and then gradually revised back to extant levels, for example
by revising it 5 percent each year over five years.

2.3. INCREASE IN PRIVATE CAPITAL

The central government has given approval for public-sector banks to raise capital to meet
their requirements by reducing the state holding as low as 52 percent. It is estimated that the
banks could mobilise around 1.60 trillion rupees from capital markets via this route over the
next four years. However, such a strategy is not attractive at the moment, given the public-
sector banks’ low price-to-book multiples and the subdued investor interest in their stocks.
Reasons for the low interest include a lack of transparency over their balance sheets and the
unappealing prospect of a minority stake without any substantial right to alter the banks’
management or strategy.

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 Exhibit 4: Values of available stock above 52 percent in public-sector banks

MARKET CAP P/B GOVT STAKE VALUE OF STAKE

BANK (INR BILLION) (TIMES) (%) ABOVE 52%2
STATE BANK OF INDIA 2,203 1.21 56.6 101
VIJAYA BANK 71 0.97 70.3 13
CENTRAL BANK OF INDIA 165 0.94 81.3 48
INDIAN BANK 135 0.92 82.1 41
BANK OF BARODA 360 0.83 59.2 26
PUNJAB NATIONAL BANK 290 0.74 65.0 38
CANARA BANK 194 0.66 66.3 28
IDBI BANK 1 111 0.64 74.0 98
UCO BANK 52 0.56 76.7 13
INDIAN OVERSEAS BANK 61 0.53 79.6 17
BANK OF MAHARASHTRA 32 0.52 81.6 10
CORPORATION BANK 58 0.48 70.8 11
UNION BANK OF INDIA 100 0.48 63.4 11
BANK OF INDIA 146 0.46 72.5 30
SYNDICATE BANK 66 0.46 72.9 14
UNITED BANK OF INDIA 26 0.46 85.2 9
ORIENTAL BANK
49 0.39 58.4 3
OF COMMERCE
DENA BANK 26 0.38 68.6 4
ALLAHABAD BANK 50 0.34 65.9 7
ANDHRA BANK 37 0.33 61.3 3
PUNJAB & SIND BANK 20 0.33 79.6 6
TOTAL 4,254 53

1. Finance Minister Arun Jaitley said in his budget speech for 2016-17: “The government is committed to reducing its stake in IDBI Bank to
under 50 percent.” Hence, the value in the column “Value of dispensable stock above 52%” for IDBI Bank denotes the combined value of
the stakes of the government and Life Insurance Corporation of India
2. Value of dispensable stock above 52 percent excludes LIC stake
3. Market cap and P/B are as of 28 June 2017
Source: RBI, respective bank websites, Bloomberg, Capital IQ, Moneycontrol.com, Oliver Wyman analysis

Hitting the markets to raise capital for minority stakes in public-sector banks is an uphill
task. Several of the banks have mandates from their boards to raise capital through qualified
institutional placement, but none have been able to raise significant amounts. The large
banks should be able to raise capital given their relatively good fundamentals, but most
small banks will struggle because their balance sheets and earnings are relatively weak.

In the current scenario, we believe the government should consider diluting equity only in
selected banks with better market valuations, and should consider complete sale of Axis
Bank and IDBI Bank. (See Exhibit 5)

Copyright © 2017 Oliver Wyman

Exhibit 5: Scenario for private capital increases through selling stakes in banks

SALE SCENARIO/ ESTIMATE

BANK ASSUMPTION (INR BILLON) REMARKS
SBI QIP (amount raised in June 2017) 150 –
AXIS BANK Complete promoter stake sale (28.7%) 340 –
IDBI BANK Complete promoter stake sale (87.8%) 100 –
SBI Sale of Govt stake > 55% 65 Amount could be raised via:
BOB + PNB + CBI + BoB – 5% stake + PNB/CBI/ (i) Individual issue;
115 (ii) PSB ETF route; (iii) BIC route
INDIAN BANK Indian Bank – 10% stake each
TOTAL 735

Source: Moneycontrol, Oliver Wyman analysis, IDBI stake include stake held by LIC

Potential approaches for raising private capital (other than equity issue by
individual banks)
PUBLIC-SECTOR BANK •• The Central Public-Sector Enterprises exchange-traded fund, or CPSE ETF, was
EXCHANGE TRADED constructed to facilitate the Government of India’s (GOI) initiative to reduce its
FUND (ETF) stake in selected central public-sector enterprises. It has raised funds three times
since March 2014
•• Similar ETF structures may be envisaged for public-sector banks, and proceeds
may be used to recapitalise the banks without increasing the fiscal deficit and
diluting the government’s control. The success of the CPSE ETF over the last few
years, when it has produced a track record of good returns, is an indicator of the
instrument’s success and of investor appetite
•• Further, instead of individual banks hitting the market separately, a PSB ETF
comprising all or selected public-sector banks could raise capital simultaneously
SETUP OF A BANK •• The total equity value of a government stake in public-sector banks would be
INVESTMENT COMPANY (BIC) approximately equivalent to 3.2 trillion rupees. A bank investment company
AND DIVESTMENT OF STAKE (BIC) could be constituted into which the government transferred all its public-
IN SUCH A BIC sector bank holdings. The government’s powers in relation to the governance of
banks could also be transferred to the bank investment company
•• The public-sector banks’ significant capital requirements could be met by
divesting minority stakes in such a bank investment company and infusing the
funds raised into banks. However, there may be little private investor appetite
for such large investments without managerial or operational control over the
banks. The sale of a minor stake, using innovative mechanisms like discounts for
CPSE ETFs, might help entice private capital

The government may have to create suitable conditions to attract private investors to take
a majority stake in IDBI Bank. Measures could include easing norms for promoter and
foreign investor shareholding; extending the timeline for diluting single shareholder limits;
incentivising employees with employee stock ownership plans, with privatisation as one
of the vesting conditions; and rationalising employee numbers via appropriate voluntary
retirement schemes.

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 2.4. SCHEMES TO PROTECT AND GUARANTEE ASSETS
The UK government created the Asset Protection Scheme as a way to recapitalise Royal Bank
of Scotland. Under this scheme, the government insured a set of distressed assets: The first
tranche of losses would be retained by the bank, but the government provided protection
for unexpected losses. This scheme had the advantage of reducing the downside risk to the
bank from potential loss emergence, and providing substantial capital requirement relief,
thus recapitalising the bank. For the UK government, the scheme was cashflow-positive:
RBS paid insurance premia for the benefit of the scheme, which were more than offset by the
capital relief, and no insurance claim was ultimately made.

Similarly-configured plans tailored to an Indian context could serve as potentially material

sources of recapitalisation without any negative effect on short-term fiscal targets and
without creating moral hazard.

Copyright © 2017 Oliver Wyman

3. THE FUTURE OF THE
BANKING SECTOR

The Indian banking sector has shown strong progress over the last few decades and has
supported the country’s fast economic growth. However, the current crisis has exposed the
industry’s structural challenges in the midst of multiple headwinds and tailwinds and has
rekindled debate over the desired industry structure and context.

Exhibit 6: Indian Banking in the midst of a renaissance: multiple headwinds and tailwinds
shaping the industry

1 ONGOING INDUSTRY
HEADWINDS
• Slowing credit growth with declining credit-deposit ratio after demonetisation
• Increasing stressed assets and pressures on profitability and capital adequacy

• On-tap licensing of universal banks in the private sector; issue of

new bank licenses – IDFC Bank and Bandhan Bank
DYNAMIC REGULATORY • Concept of differentiated banks with focussed activities targeting niche areas;

2 LANDSCAPE FOSTERING
COMPETITION AND
SPECIALISATION
issue of multiple licenses to small finance-and-payment banks
• Specialised and focussed banking and non-banking players addressing social
objectives and furthering financial inclusion more efficiently than incumbent
universal banks, regional rural banks, local area banks, and cooperative
banks and societies

• Long, fragmented tail of state-owned banks with limited differentiation or

specialisation in products, services, operations, or target segments
• Consistent outperformance of private-sector banks over public-sector banks,

3
UNSUSTAINABLE PRESENT leading to shifting market share; public-sector banks lag private-sector banks
INDUSTRY STRUCTURE in terms of profitability, branch and employee productivity, customer service,
AND MARKET SHARE SHIFTS asset quality, and pace of technology adoption
• Absence of large banks with capacity to finance large infrastructure projects
• Regulatory twilight for bottom-of-the-pyramid players such as cooperative
banks and societies

• New entrants with disruptive, niche business models, such as

4 TECHNOLOGY DISRUPTIONS
crowd funding, peer-to-peer lending, and fintechs using divergent
data sources for new credit underwriting models
• Artificial intelligence and robotics replacing banking jobs

• Shifts in customer behaviour; rapid increase in use of digital channels

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DRAMATIC SHIFTS IN • Government support and initiatives for technology infrastructure,
DIGITISATION AND such as Aadhaar UID (unique identification number) and UPI
TECHNOLOGY ADOPTION (unified payments interface), as well as an unprecedented push
for digitisation

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• New banks and fast-growing fintech start-ups increasing competition
HUMAN CAPITAL CRUNCH for limited skilled human capital
• New technology and automation leading to skills gap

There is sufficient change in the environment today to warrant experimentation with the
existing banking structure to make it more dynamic and amenable to the needs of the

13
 economy and to accelerate the evolution of a deeper, more-mature financial sector. We
believe that the journey of the Indian banking sector over the coming decade will be driven
by a strong interplay between two factors. One is the external environment, primarily in
terms of economic growth supporting credit demand and a resolution of the NPA problem.
The other is decisive action by all stakeholders, especially policymakers steering the
reform agenda.

3.1. VISION OF THE FUTURE OF PUBLIC-SECTOR BANKS

Any debate about the structure of the Indian banking sector must start with the question:
“What is the future role we see for the public-sector banks?” There are a number of reasons
why the state should own banks. There are parts of the economy where the overall social
good from the provision of banking services is strong, while the incentives for the private-
sector to provide services are weak – such as services for weaker sections of the society and
in remote areas. Banks can be a vehicle to deploy the state’s excess liquid resources and
state banks can create a valuable market where otherwise one wouldn’t exist, such as in the
infrastructure segment.

One aim could be a banking structure where public-sector banks become specialised, with
a much clearer strategic focus on the public good. For example, there could be an “Indian
Infrastructure and Investment Bank”, an “Indian SME and Enterprise Bank”, a “State Strategic
Interests Bank” (for the defence industry or for lending to major state-owned utilities).
These banks would be smaller, have liabilities guaranteed by the government, and be given
privileged access to government accounts. All these factors would help them survive and
profit. They would be continually evaluated to assess whether there could be a superior
private-sector solution without the need for state intervention. In that case, the state would
sell, and realise a profit – though exceptions could be made if there was a threat to strategic
national interests.

Under such a scenario, public-sector banks would be discouraged, or even explicitly barred,
from conducting mainstream banking in well-served areas, such as mortgages in tier-1 and
tier-2 cities. The current asset portfolios of these banks could be sold, and proceeds used
to recapitalise the banks, providing an immediate windfall for the government to pursue its
wider agenda. In addition, governance and management improvements would be needed to
make these public-sector banks fit for purpose, as the existing model is failing.

The largest banks in the economy would, by definition, be the largest private-sector banks
catering to mainstream banking across the corporate, SME, and retail segments. We
understand and appreciate that transforming the banking sector, as outlined here, is a
Herculean task and presents a number of socio-political challenges. It therefore requires
strong political will and a well-planned transition. The next sub-section looks at a more
amenable approach to restructuring the banking system in the near future.

Copyright © 2017 Oliver Wyman

3.2. A MORE-AMENABLE AND NEARER-TERM SOLUTION
FOR THE BANKING SECTOR
Taking into consideration the significant challenges to the targeted changes in the Indian
banking sector, there is an alternative vision. This reorients and re-focusses the banking
system with distinct tiers of institutions based on their systemic importance, size, ownership,
and sector-segment specialisations. We describe a structure in Exhibit 7-, that would
continue to involve the government in moderate-to-high costs, with no guarantee that the
problems would not recur and a possibility that the government might create too-big-to-bail
institutions. Although by no means a perfect solution, we believe that such a structure would
act as a catalyst for deliberation over the next round of transformative initiatives to reorient
the Indian banking sector, as outlined in Section 3.1.

Exhibit 7: Existing and proposed structures for the banking sector

EXISTING BANKING STRUCTURE IN INDIA PROPOSED STRUCTURE FOR 2030

Tier 1 Tier 2 Tier 3

CATEGORY

CATEGORY

Commercial Banks Cooperative Banks D-SIBs Scheduled Specialised

Commercial Banks
Banks

Public Sector Banks 21 State Cooperative Banks Domestic Private Sector Small Finance
(18 Scheduled and 14 32 Systemically Banks Banks
Private Sector Banks 32
Non-Scheduled)
SUB-CATEGORY

Important
CONSTITUENTS

Foreign Banks 44 Banks Subsidiaries Payment

Urban Cooperative
Regional Rural Banks 56 Banks (54 Scheduled 1,582 (3-4 Public of Foreign Banks
and 1,528 Non-Scheduled) and 2-3 Banks
Local Area Banks 3 Private Large incorporated Others
Small Finance Banks 6 District Central Banks) in India specialised
366 banks
Payment Banks 2 Cooperative Banks

1. Others include Regional Rural Banks, Local Area Banks, Multi-State Urban Cooperative Banks, Single-state Urban Cooperative Banks,
District Central Cooperative Banks, etc.
Note: Regional Rural Banks, Local Area Banks and Cooperative Banks to be phased out – Well managed and financially sound to convert to
SCB or merge with existing banks

The first tier would consist of domestic, systemically-important banks (D-SIB) with four
or five public large banks and two or three private. These large banks would command
international acceptance and recognition and reap advantages from their efficiency, risk
diversification, and capacity to finance large projects and support investment needs and
economic growth.

The second tier of scheduled commercial banks (SCB) would include the private-sector
banks and subsidiaries of foreign banks incorporated in India. The foreign banks could
play a significant role in providing services in international banking and global wealth
management, as well as ensuring that the private-sector banks remained competitive. We
do not envisage a role for public-sector banks in this tier and, as discussed earlier, we believe
that all the public-sector banks must merge to form fewer large banks providing anchors to
the sector.

15
 The third and final tier would be of specialised banks (SB), such as small finance banks
and payment banks. We believe that, as the financial sector deepens, it may be necessary
for the system to evolve multiple formats of specialised banks that provide services in their
areas of competitive advantage. As these niche banks develop core competencies, expertise
will be fostered that could lead to enhanced efficiency in the banking system. Deeper
understanding of the segment and improved capital allocation would reduce intermediation
costs, produce better prices, and make risk management more robust.

RBI has also floated the idea of various other specialised or differentiated banks, for example
wholesale banks and custodian banks. Since the activities permitted for differentiated
banks would mostly be a subset of those allowed for universal banks, new formats should
be considered only under certain conditions: They should address niche segments currently
underserved by existing players, and licensing such specialised banks should result in a net
positive for the development of those segments.

Further, we think that other segments of the present banking structure – including regional
rural banks, local area banks, multi-state urban cooperative banks, single-state urban
cooperative banks, district central cooperative banks, and cooperative societies – must be
phased out gradually. Well-managed and financially sound institutions may be encouraged
to convert to scheduled commercial banks or specialised banks, or to merge with
existing banks.

In 1966, through an amendment to the Banking Regulation Act, 1949, banking laws were
made applicable to cooperative societies. This gave rise to cooperative banks chiefly
catering to the credit needs of the agricultural sector in rural areas and to micro and small
businesses in urban areas. Today, differentiated or specialised banks – small finance banks
and payment banks – along with non-banking sector specialists like non-banking financial
companies and microfinance institutions, are better equipped and have evolved to provide
community-level and grass-roots banking. Moreover, cooperative organisations operate in a
regulatory twilight zone, which has further been highlighted in recent public news reports.
A number of these multi-state credit societies are under investigation by government
agencies for suspicious activities.

Copyright © 2017 Oliver Wyman

3.3. HOW TO CONSOLIDATE PUBLIC-SECTOR BANKS?
The capital of most of the public-sector banks is relatively low, and only a handful have levels
above the threshold mandated for March 2019-. (See Exhibit 8). Hence, mergers between
public-sector banks may not contribute much to efforts to shore up their capital in the short
term. But they could lead to larger, more-efficient banks with higher profitability in the
medium to long term.

Exhibit 8: Total assets and capital to risk (weighted) assets ratio (CRAR) of public-sector
banks (%) – March 2017
TOTAL ASSETS (INR BILLION)
Mar19 minimum threshold Mar19 minimum threshold + 100 bps
2,750
State Bank of India
750 Punjab National Bank
Bank of Baroda
Bank of India
600
Canara Bank
Union Bank of India
450
IDBI Bank Limited
Central Bank of India
Syndicate Bank
300 Indian Overseas Bank Corporation Bank
Oriental Bank of Commerce
UCO Bank Allahabad Bank Andhra Bank Indian Bank
150 Bank of Maharashtra Vijaya Bank
United Bank of India
Dena Bank
Punjab and Sind Bank
0
0 10.6 11.0 11.4 11.8 12.2 12.6 13.0 13.4 13.8
CRAR%

Source: Bank websites and quarterly analyst presentations

There is lack of differentiation in products and services among most public-sector banks.
There is also a long, fragmented tail, with the bottom 16 accounting for a share of just
38 percent of the market, while the biggest five account for 62 percent. This long,
fragmented, and undifferentiated tail also leads all banks to target the same segments,
geographies, and customers, which results in redundancies and inefficient capital allocation.
Bank consolidation could entail the rationalisation of infrastructure, such as branches
and information technology, as well as of human resources. This could lead to significant
cost efficiencies.

Factors limiting mergers of public-sector banks, such as staff unions, must be addressed
using innovative mechanisms like employee stock ownership plans. Mergers should be
presented as a vesting condition and a quid pro quo for timely government capital injection.

17
 HOW DOES ONE GO ABOUT IT?
Should the relatively strong banks take over weaker banks at the risk of being infected
by the weaker banks’ problems, thus defeating the very purpose of consolidation? Could
some of the weak banks in different geographies be bundled? Should small, healthy banks
be merged with large, strong banks to create even stronger, larger banks? Should weak
banks be put through strict restructuring under the revised Prompt Corrective Action (PCA)
framework issued by RBI in April 2017? There are no easy answers.

We can classify the present 20-plus state-owned banks into distinct categories, for each
of which there is a suitable plan of action. In the first set are anchor banks, which are large
and have fundamental strengths in their significant customer bases and wider physical
footprints. Some of the anchor banks may not be in a very healthy state at present, but
they have the inherent strength to overcome their bad-asset problems and bounce back.
The second set of banks, the non-anchor banks, can be categorised either as strong or
weak banks.

We propose a strategy with the core principle of merging strong banks with other strong
banks while shrinking the balance sheets of weak banks. This would strengthen the banking
system over the medium term and lead the stronger, better-managed banks to be merged
to form a smaller number of efficient banks. It would also put the onus of improving systems
and procedures on the weaker banks. (See Exhibits 9-13).

Exhibit 9: Categorisation of public-sector banks

1 ANCHOR/
LEAD BANKS
Large banks with inherent strength – significant customer bases and wide
physical footprints: SBI, BoB, PNB, BoI, Canara Bank

STRONG BANKS

2 WEAK BANKS
Based on CAR (%) and net NPAs (%)

Note: Categorisation of strong and weak should be based on robust stress tests and strategic reviews by the RBI

Exhibit 10: Classification

Weak Banks criteria and short-to-medium term strategies

CAPITAL ADEQUACY RATIO (CAR) %

Weak Bank
> 12.5%

Strong – CAT 2 Bank Strong – CAT 2 Bank

Zombie Banks –
Deploy overhaul strategy Merge with Anchor Banks Merge with Anchor Banks
11.5 - 12.5%

Weak Bank Strong – CAT 2 Bank

Strong – CAT 2 Bank
Zombie Banks – Merge with Anchor Banks
Deploy overhaul strategy Merge with Anchor Banks

Weak Bank Weak Bank

< 11.5%

Strong – CAT 2 Bank

Zombie Banks – Zombie Banks – Merge with Anchor Banks
Deploy overhaul strategy Deploy overhaul strategy

> 9% 6-9% < 6%

NET NON-PERFORMING LOANS (NNPA) %

Copyright © 2017 Oliver Wyman

 Weak Banks of banks based on March 2017 positions
Exhibit 11: Categorisation
CAPITAL ADEQUACY (CAR)
> 12.5%

SBI (Anchor)
Canara Bank (Anchor) Indian Bank
Vijaya Bank

PNB (Anchor)
11.5 - 12.5%

BoI (Anchor)
Union Bank of India BoB (Anchor)
Oriental Bank of Commerce Syndicate Bank
Andhra Bank

IDBI Bank Limited

Central Bank of India UCO Bank
< 11.5%

Indian Overseas Bank Allahabad Bank

Bank of Maharashtra Corporation Bank
Dena Bank Punjab and Sind Bank
United Bank of India

> 9% 6-9% < 6%

NET NON-PERFORMING LOANS (NNPA)

Exhibit 12: Overall strategy map for public-sector bank mergers

PRESENT STRUCTURE SHORT TO MEDIUM TERM MEDIUM TO LONG TERM

Anchor/Lead Banks Anchor/Lead Banks Anchor/Lead Banks

a. Merger with anchor banks

Strong Banks Merge b. Niche strategy and mergers
with similar business models.
Non-Lead Bank

E.g. Merger with NBFCs,

AMC of NPAs, Conversion in
Differentiated banks, etc.
OVER HAUL

Successful
Weak Banks Zombie
Banks
Unsuccessful Gradual oblivion1

1. Gradual oblivion – Such banks should stop lending, taking fresh deposits, sell performing loan assets, focus on recovery of bad loans
and invest resources in government bonds. Once all deposits are redeemed and loans repaid/recovered/sold, they will turn into shell
companies. Their branches and other physical assets could be auctioned off

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 Exhibit 13: Public-sector banks: present structure and structure after rollout of overall
strategy. (Data in brackets denote: Total assets (rupees)/CAR/NNPA – as of March 17)
PRESENT MEDIUM TERM LONG TERM
State Bank of India State Bank of India
State Bank of India
(27.1 trillion/13.0%/3.7%) (27.1 trillion/13.0%/3.7%)

Bank of Baroda Bank of Baroda

Bank of Baroda
(6.9 LCR/12.2%/4.7%) (14.3 trillion/12.4%/5.0%)

Punjab National Bank Punjab National Bank

Punjab National Bank
(7.2 trillion/11.7%/7.8%) (11.1 trillion/11.7%/7.2%)

Bank of India Bank of India

Bank of India
(6.3 trillion/12.1%/6.9%) (10.8 trillion/12.0%/6.3%)

Canara Bank Canara Bank

(5.8 trillion/12.9%/6.3%) (8.4 trillion/12.4%/6.9%) Canara Bank

Union Bank of India

(4.5 trillion/11.8%/6.6%)

IDBI Bank Limited Zombie Banks

(3.6 trillion/10.7%/13.2%) (20.0 trillion)

Syndicate Bank
IDBI Bank Limited
(3.0 Trillion/12.0%/5.2%)

Central Bank of India

Central Bank of India
(3.3 trillion/11.0%/10.2%)

Indian Overseas Bank

Indian Overseas Bank
(2.5 trillion/10.5%/14.0%)

UCO Bank
UCO Bank
(2.3 trillion/10.9%/8.9%)

Oriental Bank of Commerce

Corporation Bank
(2.5 trillion/11.6%/9.0%)

Allahabad Bank
(2.4 trillion/11.5%/8.9%) Bank of Maharashtra

Corporation Bank Dena Bank

(2.5 trillion/11.3%/8.3%)

Indian Bank
United Bank of India
(2.2 trillion/13.6%/4.4%)

Andhra Bank
(2.2 trillion/12.4%/7.6%) Punjab and Sind Bank

Bank of Maharashtra
(1.6 trillion/11.2%/11.8%)

Vijaya Bank
(1.5 trillion/12.7%/4.4%)

Dena Bank
(1.3 trillion/11.4%/10.7%)

United Bank of India

(1.4 trillion/11.1%/10.0%)

Punjab and Sind Bank

(1.0 trillion/11.1%/7.5%)

1. The selection of individual strong banks for merger with anchor or lead banks is primarily based on an even distribution with regard to
total asset size, eventual capital ratio, net NPAs, and some basic strategic rationales such as joint-venture partners in insurance companies.
Use of these criteria is not equivalent to a detailed evaluation of the strategic rationales of mergers, such as benefits from synergies based
on the compatibility of businesses, culture, policies, technology platforms and locations. The eventual asset sizes, capital ratios, and net
NPAs have been calculated based on a basic fusion
2. Total assets and net NPAs are standalone figures

Copyright © 2017 Oliver Wyman

The zombie banks must be put on strict overhaul plans and their eventual fate should
depend on the success or failure of such plans. Such overhauls could contain some of the
following elements:
•• Manage NPAs
•• Shrink the balance sheet by selling assets and performing portfolios
•• Restrict any new large, corporate exposure
•• Close non-profitable segments and branches

Such plans would lead to an immediate cash release and reduce risk-weighted assets,
supplementing the objective of zero government capital infusion in weak institutions. By
downsising and shrinking through focus and rationalisation, weak banks could evolve into
specialised banks. For example, Punjab & Sind Bank could become a North India-centred
bank specialising in the agriculture sector.

The government could pursue a number of options for those weak banks which are able to
turn around their balance sheets. These include:
1. Mergers with anchor banks
2. Niche strategies and mergers with banks with similar business models:
•• Finance house (asset-led) – merger with non-banking financial company in the
medium term
•• Deposit-led business model (liability-led)
•• Asset-management company (perhaps of NPAs) – merger with non-banking financial
company in the medium term
•• Retail distribution model (without any product engines) – merger with a generalist
retailer in the long term

The unsuccessful weak banks must be gradually wound down, while ensuring the protection
of their deposit holders.

Reorientation of the Indian banking sector will not be a discrete, onetime

event, but a continuous, endogenous process that matches the structural
changes taking place in the Indian economy. Therefore, the policy environment
should be flexible in order to allow this to evolve. The spirit and the thrust of
the reorientation exercise should be to tweak the existing policy regime in
a dynamic way, so as to create the conditions for a stronger, more dynamic
banking structure.

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AUTHORS

David Bergeron, PhD Timothy Colyer Amit Deshpande Anshul Jain

Partner Partner Principal Senior Consultant
David.Bergeron@ Timothy.Colyer@ Amit.Deshpande@ Anshul.Jain@
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