Leading professional services firm Ernst & Young (EY) and the Associated Chambers of Commerce and Industry of India (ASSOCHAM) today released a report titled ”Financial services: state of the industry and way forward.” The report seeks to present distinct opportunities such as consolidation, development of the debt market, focus on risk management and alternate financing options, which will help India develop into an economic power and help ride out the adversities arising from the current global credit crisis.
According to the EY-Assocham report, while the subprime crisis has been manifest worldwide as an adversity of unprecedented scale, it has also concurrently opened new vistas for fast emerging economies such as India to assume a stronger role in the global financial system.
Reforms needed in the debt market
To capitalize on such opportunities, India will have to set its basics in order. The reform process, particularly in the debt markets, which lags far behind equity, must be put on a fast track. Strong debt markets provide the requisite financing to various entities in the economy, thereby reducing reliance on foreign capital as well as equity markets.
Hitherto, factors such as lengthy and cumbersome processes followed in the listing of a debt instrument, high cost of issuance and low liquidity have impeded growth. A strong impetus is required to develop and strengthen the debt market in India. Well developed debt markets have historically been seen to act as a cushion against financial crises, such as the one experienced in FY97–98.
While government securities (G-secs) dominate the debt market in India, they may decline with improving fiscal discipline and the government’s lower borrowing requirements. Yet, the corporate bond market lags behind in terms of market infrastructure, trading facilities, number of market participants, which is in contrast to developed countries where the corporate debt market is at par with the securities market.
Retail and institutional investments are necessary to develop and strengthen corporate debt markets. This requires a set of market and regulatory intervention. Regulators should provide incentives to boost issuance as well as buying of corporate papers. Further, the reforms should encompass both the markets — primary and secondary with a focus on issuers, investors and the regulatory structure, says the EY-Assocham report.
Consolidation in financial services
The Indian financial sector, particularly the banking system, needs to achieve size and scale to spread its reach both within as well as beyond domestic boundaries. Therefore, small and fragmented entities, as they exist today, will have to give way to the stronger and bigger corporations to take on the might of the global leaders. Consolidation would be the fastest and the most practical solution to achieve this.
It is quite ironical that consolidation has been the current flavor from the global perspective as well; however the reasons are starkly contrasting, says the report. In the west, consolidation has been more of a survival strategy amid the fall of the world’s largest investment banks. But in the Indian banking set up, consolidation will act as an enabler and an engine for growth to propel Indian financial institutions to come out of the shells of protectionism and compete against their much more powerful global counterparts, it highlights.
One of the significant characteristics of the Indian banking industry is that it is very fragmented. As of March 2007, the top eight banks in India have a combined market share of just 50% while the big-four state-owned banks in China alone hold a 50% market share. Besides the structural drivers for consolidation, certain additional factors driving consolidation include regulatory changes which propose opening up of the sector, the Basel II requirements, capital requirements, need to attain size, declining profitability, particularly for the smaller banks and increasing geographic presence.
Apart from the commercial banking space, there is a compelling case for consolidation among regional rural banks (RRBs), co-operative banks and NBFCs. Especially, RRBs and co-operative banks have been one of the primary vehicles to extend banking services in rural and semi-urban areas. As of March 2007, there were 96 RRBs, sharing just 3% of the total assets and 1.5% of the total profits of all scheduled commercial banks (SCBs) in India. In today’s competitive environment, it would be essential for these RRBs to consolidate either among themselves or with their sponsored banks to improve their scale, efficiency, profitability and viability of conducting business in rural areas.
In the asset management space, the impact of the liquidity crisis during the last six months has impacted some of the smaller players significantly, which may seek to exit the business. As of December 2008, 37 asset management players are registered, which had shown a CAGR of 34% in assets under management (AUM) to reach INR5.3 trillion as of September 2008. While merger and acquisitions (M&A) in the asset management space have been sporadic, with deals mainly used as an entry strategy rather than consolidation, the trend may change moderately if the smaller players are forced to opt out.
According to the report, while there is a little possibility of any consolidation in the insurance sector as its still in a growth phase, there could still be some consolidation, primarily driven by the lack of capital and the mandatory requirement for listing insurance companies within 10 years of their operation. This is particularly true for small insurance players who might find it difficult to raise additional capital for their growth in today’s difficult market conditions.
Strengthening of risk management systems is vital
The challenges and opportunities thrown open by the emerging growth paradigms also involve inherent risks for banks. The prudent path ahead for banks is to align internal mechanisms and strategies by strengthening risk management systems. A risk-focused approach will enable banks to efficiently allocate capital and manage risks. This will entail a radical shift in the treatment of loans and over a period of time, the system will move from segmental banking to individual banking. With most banks operating under the core banking solutions, data warehousing and information systems need to be in place to assist in determining individual risk allocation and prudent risk management.
In an earlier EY survey on risk governance, citing critical lessons from the current economic the chief was the vital importance of liquidity management. Fostering a risk culture and staying attuned to industry dynamics were also cited by respondents as imperatives. The subprime crisis presents invaluable lessons for countries such as India to develop the right frameworks as they chart out their future growth plans.
Alternative financing options
Among alternate financing options, Private Equity (PE) has become an important source of equity capital, but the flow of capital can become extremely uncertain during a downturn. The credit crisis in 2008 has seen a deceleration in PE activity, but given the long-term growth prospects of the economy, Indian companies would continue to attract PE. On the debt side, External Commercial Borrowings (ECBs) have grown at a brisk pace. A positive outlook on the sovereign ratings, coupled with the improved performance of India Inc., has amply supported the growing acceptance of Indian paper abroad.
The latest addition to this list is Exchangeable Bonds (EBs), which has the potential to emerge as an important source of capital for corporate groups running several companies under their umbrella. With the release of the guidelines for FCEBs, the government has provided an added option to the listed firms to raise capital from overseas markets, whose proceeds can be used to fund operations abroad.
Being a relatively new instrument for Indian issuers, it will become clearer only with time as to what extent the companies can leverage upon this option. Nonetheless, it can turn out to be an interesting tool for groups operating through multiple companies.