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Value Creation in Indian Banking Tale of Business Model Discount

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Value Creation in Indian Banking

Tale of Business Model Discount

bcg.com

Harsh Vardhan

Saurabh Tripathi

Ruchin Goyal

July 2008

© The Boston Consulting Group, Inc. 2008. All rights reserved.

For information or permission to reprint, please contact BCG at:E-mail: [email protected]: +1 617 850 3901, attention BCG/PermissionsMail: BCG/Permissions The Boston Consulting Group, Inc. One Beacon Street Boston, MA 02108 USA

Value Creation In Indian Banking 3

Contents

Executive Summary 5

Value Creation in Banking and NBFS Space 8

Profiles of Value Creation by Segment 13

Implication for Public Sector 19

Implications for Other Sectors 28

Ranking of Top Performers 30

Epilogue: H1 2008 32

Appendix 33

4 The Boston Consulting Group

Note to the Reader

About the AuthorsHarsh Vardhan and Saurabh Tripathi are both Partners and Managing Directors at BCG’s Mumbai office. Ruchin Goyal is a Principal in BCG’s Mumbai office.

For Further ContactIf you would like to discuss the themes and content of this report, please contact:

Janmejaya SinhaBCG Mumbai+91 22 6749 [email protected]

Harsh VardhanBCG Mumbai+91 22 6749 [email protected]

Alpesh ShahBCG Mumbai+91 22 6749 [email protected]

Saurabh TripathiBCG Mumbai+91 22 6749 [email protected]

Neeraj AggarwalBCG New Delhi+91 124 459 [email protected]

AcknowledgmentsAuthors would like to acknowledge colleagues in BCG’s financial institutions practice for contributions of ideas and perspectives.

Special gratitude to BCG’s clients in financial services in India who we are privileged to serve and who provide a reality check to implica-tions drawn in this report.

Special mention of Shyan Mukher-jee, Anuj Sekhsaria, Khushnuma Dordi and Leroy Coutts for assistance in analysis.

Special thanks to Jamshed Daruwalla, Maneck Katrak and Diago Fernandes for report production.


Executive Summary

Creating shareholder value is the primary objective of any commercial enterprise. This report takes a close look at the value creation performance of the Indian financial services companies—banks, non bank

finance companies and securities companies. In addition to comparing the performance of various types of players—public sector and privately owned—we also disaggregate the total shareholders returns into its components to understand the sources of value creation.

The insights from this analysis of value creation provide clear action agenda for key stakeholders in the Indian banking and financial services.

For the government which is the majority owner of a large number of companies in the financial services sector, the following 3–point action agenda clearly emerges:

Encourage the government owned banks to 1. change their business models while remaining under government ownership. The state owned banks have to redesign their business models so as to become more customer centric, to create a performance culture with well developed performance management systems and to create role specialization.

Create robust corporate governance structure2. by strengthening the boards and providing adequate representation for the minority shareholders, delegating more authority to the boards and ensuring longer CEO tenures with smooth and pre–planned CEO transitions and reducing the oversight of the government vigilance and investigative agencies on

business decision–making.

Facilitate consolidation3. in the sector so as to create larger banks that can compete on regional and eventually global scale.

For the management of Public Sector Banks, we develop a 7–point action agenda:

Augment the vocabulary of performance 1. to include market based metrics such as total shareholder returns, valuation multiples and market capitalization.

Paradigm shift in the organization design2. to align it to the realities of the competitive market place.

Address the gaps in manpower3. both in numbers and in skills.

Get the most out of technology investments4. —in the roll out of core banking solution but also in other specific technology investments beyond CBS.

Prepare to earn higher fee income, 5. target at least a “fair” share of the fee revenues.

Create an advantaged distribution network in 6. numbers and in configuration by carefully reconfiguring and enhancing the branch and non–branch distribution.

Systematically engage staff7. in organizational transformation.

Interestingly, speed of above action (or lack of it) will determine the contours of value creation (and emerging landscape) in other segments of financial services—private banks, securities firms and NBFCs. We derive some implications for them:

New private sector banks will need to continue to 1. focus on capital efficient growth to maintain their strong trajectory of value creation. This will require enhanced focus on cross–selling, CRM, organisation change from product centric to customer centric models and finally adaptation of tools for efficient capital management.

Broking and distribution oriented companies will 2. diversify their business portfolio and will seek consolidation.

Old private sector banks, an enigma in the sector, 3. will have to focus sharply on the realizing the value creation by adopting business model changes like public sector and proactive intervention in industrial relationships.

NBFCs will thrive in niches4. that are either inaccessible or unattractive for commercial banks. Some have already become big. We expect many more to spring up and gain size.

Key highlights of our analysis are:

Accelerated growth in Indian banking and financial services led to impressive value creation. Indian banking and financial services sector has been a strong value creator. Over the 5 year period from April 1, 2003 to March 21, 2008 the total shareholder returns (TSR) for the sector was 53% which was better than the overall return of 42% by all Indian companies as a group. It also compares favourably with performance of financial services sector in other countries. The first half of 2008 saw a global stock market meltdown. This resulted in decline of value of all companies, including financial services companies in India. However, despite adjusting for this decline the Indian financial services sector performs better than its peer in the developed and other BRIC countries.

Although Indian banks top the charts in long term value creation, they still fail to make it to the top of

the global pecking order of market capitalization. The value creation by Indian financial services sector is very robust but it is delivered from a small base. In fact, even with such a strong record of sustained value creation, Indian financial services companies do not make it to the top of the global pecking order of market value of global banks. No individual player yet finds a place in even the top 50 globally on market capitalisation. In the process of consolidation of any industry, market capitalisation and valuation levels are crucial in deciding who will be the acquirers and who would be targets. As we study the emerging landscape of Indian financial services and its evolution over next decade, it is an open question—which type of players will dominate market capitalization in India and which among them will be large enough to find place in global top 10? Much will depend on the government’s reform agenda for public sector banks and regulatory framework for non bank entities and of course their individual strategies and performance.

Private banks and NBFCs figure high on valuation and have a disproportionately high share of market capitalization of financial services sector in India. Profile of value creation across various categories of players shows an interesting pattern. We look at the performance of the publicly owned banks, privately owned banks and the “other” financial services companies which include non banking finance companies (NBFCs), housing finance companies (HFCs) and securities companies. Public sector companies (commercial banks) control close to 68% of the assets of the Indian financial services sector, the other 32% owned almost half each by private banks and other financial services companies. If we look at the share of market capitalization, it is split almost a third each across these three types of players. Thus, public sector banks have two third assets but only one third market capitalization of the financial service sector in India. When we compare the relative shareholder returns performance across these players, we note that the private players and the other financial services companies had a much stronger performance compared to the public sector companies over longer time horizon. For example over the 5 year period between 2003 and 2008, the TSR for public sector banks was 42% while it was 56% for the private sector banks and over 85% for both NBFCs and securities companies.

Dominant drivers of value creation differ across categories of players. To understand the sources of value



creation better, we disaggregate the TSR into 3 components—fundamental value measured as asset growth and improvement in profitability, valuation multiple measured as the P/E ratio and free cash flow yield which reflects changes in the free cash flow arising out of financial policy decisions such as dividends, equity issue and buyback, etc. Comparing this disaggregated TSR across the various categories of players throws interesting pattern. For the five year period between 2002 and 2007, the TSR for public sector banks was 42% and more than half, or 22% was contributed by change in valuation multiples. On the other hand the TSR for the same period for private sector banks was 67% and more than two thirds of it, or 40% was contributed by fundamental value i.e. asset growth and profitability improvement. For the other financial services companies, NBFCs, HFCs and securities companies, growth as well as changes in valuation multiple have been strong drivers of TSR.

Public sector banks suffer from a business model discount vis a vis their private sector counterparts. There is a yawning gap between the valuation multiples of public sector banks and their private sector counterparts and the gap has continuously widened over this time frame and has grown almost three times from about 7 in 2003 to about 18 in 2008. We term this gap as the “business model discount” and is a key theme of this report. It represents the immense value creation potential that lies ahead of PSU Banks and old private sector banks with suitable business model changes. It also highlights to the Government of India, the opportunity costs of not spurring the business model changes and the corporate governance reforms that have to go with it. In effect, NBFCs and brokerages are capturing value nibbling at the potential growth opportunities of incumbents.


Value Creation in Banking and NBFS Space

India’s GDP growth has been accelerating over last few decades. As shown in Exhibit 1 below, not only has the average rate of growth grown steadily higher, the volatility in the growth rate has been declining over successive time periods indicating

that the growth rate is becoming more stable. In the last few years, the growth has been sustained at over 8%.

Economic growth typically drives even faster growth in banking services due to a multiplier effect. Consequently, banking sector has also experienced faster and continu-

ously accelerating growth over last five years. As shown in the Exhibit 2, the overall growth in assets of the Indian banking industry has been at a CAGR of 17% from FY 2002 to FY 2007. Annual growth rate during this period, accelerated from 11% in FY 2003 to 25% in FY 2007.

While the overall growth was strong, it varied significant-ly across players. A lion’s share of growth went to new private sector players growing at 26% (CAGR 2002–2007), SBI and associates along with old private banks grew the slowest at CAGRs of 12% and 11% respectively.

Exhibit 1. GDP growth has been robust and accelerating

Sources: World Bank; IMF; World economic report; EIU.1Average weighted by Nominal GDP.2GDP growth rate for the period 1995–2007.


Exhibit 2. Banking has seen accelerating growth—old private banks and SBI group growing the slowest

Sources: IBA; Capitaline.

The rapid growth was not only limited to commercial banking. Broader financial services sector, which includes businesses such as investment banking, insurance, asset management, etc also grew rapidly during this period. In fact as shown in Exhibit 3, most parts of the financial services sector have been growing at rates of about 30% per annum for last 2–3 years making this sector among the fastest growing in recent times.

Sustained growth at such a high level along with reason-able levels of profitability has resulted in the financial sec-tor companies creating substantial shareholder value over the last five years. Even when we study value creation in various time horizons—one, three or five years—the per-formance of the financial services companies stands out suggesting stability in the value creation.

Exhibit 4 shows shareholder returns from some key in-dustries in India over three horizons—one year, three year and five year. Indian banking and financial services returns were at or above overall market average returns consistently over all the three time horizons. Very few industries demonstrated such a consistent shareholder

value creation. The drop in share prices for the financial services sector with the global meltdown in early 2008 was also in line with the market and did not result in disproportionate destruction of value in the industry.

The Indian banking and financial services industry also delivered the highest shareholder return compared to its peers in several other economies. The Exhibit 5 compares the shareholder returns of Indian financial services com-panies with their peers in North America, Western Eu-rope, the BRIC nations and the rest of the world for 2007 and H1 2008. Even though the correction in early 2008 in India was the highest, the net shareholder returns deliv-ered by the Indian industry were still the highest. Sev-eral banks from India topped the global charts of value creation in 2007.

It is important to note that while the value creation by Indian financial services sector has been very robust, it is delivered from a small base. In fact, even with such a strong record of sustained value creation, Indian financial services companies do not yet make it to the top of the global pecking order of market capitalisation.


Exhibit 3. Unprecedented growth in Indian financial services

Source: BCG Analysis.

Exhibit 4. Indian banking/NBFS sector has consistently created value—impacted in line with overall market by sub prime crises in Q1 2008

Sources: Capitaline; RBI; BCG Analysis.Note: Updated till 31-Mar-2008; Financial services include NBFC, HFC, broking companies, credit rating companies.


Exhibit 5. Indian banking has delivered among the highest shareholder returns—also high volatility in line with the market

Sources: T. F. Datastream; BCG Analysis.Note: All TSRs were calculated after conversion to U.S. dollars.1TSR comprises capital gains and free-cash-flow yields. 2Brazil, Russia, India, China. 3Comprises 31 countries. 4Benelux countries, Denmark, Finland, France, Germany, Italy, Norway, Spain, Sweden, Switzerland, United Kingdom. 5United States and Canada.* 12 month trailing TSR taken for Indian Banks to match the calendar Fiscal Year End Dec 31 2007 used globally.

The pecking order of banks in terms of market capitalisation has been changing dramatically every decade. In the early 1990s, Japanese banks dominated thepecking order with eight out of top ten banks from Japan in the global top ten list. By 1998, the top ten list included mostly American banks as shown in the Exhibit 6. Not one Japanese bank was on the list. By 2007, three Chinese banks were among the top four banks in the world by market capitalisation. This year two Brazilian banks have entered the top 30 list. While the value creation by individual players in India has been very high, they do not yet find a place even in the top 50 globally on market capitalisation. In the process of consolidation of any industry, market capitalisation and valuation levels are crucial in deciding who will be the acquirers and who would be the targets. This dynamics raises a key question—will any Indian financial service company find a place in the global top 10 in market value by 2015?

To explore this question, we plotted the pecking order by market capitalization in India over last five years. As shown in Exhibit 7 on next page, in 2003, the top ten

comprised 6 banks from public sector, three private sector banks and one non bank finance company. By 2008, we have only 3 public sector banks in the top 10. There are 4 new private sector banks and 3 non bank finance companies. As we study the emerging landscape of Indian financial services and its evolution over next decade, it is an open question—which type of players will dominate market capitalization in India and which among them will be large enough to find place in global top 10? It could be one of the new private banks, one of the public sector banks, or a non bank finance company. Much depends upon the government’s reform agenda for public sector banks and regulatory framework for non bank entities and of course their individual strategies and performance.

This report studies the value creation in different classes of players within the Indian financial services sector and articulates potentials themes that will determine the extent of value creation in the future and the likely “winners”.


Exhibit 7. Who will win from India?

Source: Capitaline. 1By market capitalisation as on 31st March.

Exhibit 6. Will Indian banks be in global market value pecking order?

1By market capitalisation.


This report is based on study of value creation in six distinct categories of players in financial services. We divide commercial banks into three categories—public sector banks, new private sector banks and old

private sector banks. The non bank financial services entities are also divided into 3 categories—non banking finance companies (NBFCs), housing finance companies (HFCs), and securities companies.

Overall, the sample included 60 listed entities with over

Rs. 30,000 crores of profits in FY 2007 and about Rs. 600,000 crore of market capitalization as on March 31, 2008 as depicted in Exhibit 8. This sample includes 21 public sector banks, 7 new private sector banks, 11 old private sector banks, 10 NBFCs, 4 HFCs, and 7 securities firms.

1. Share shifts

Share of assets of the industry held by the different segments shows interesting trend over last 5 years.

Profiles of Value Creation

Exhibit 8. Indian banking/NBFS sector can be studied in segments

Source: BCG Analysis.Note: All figures in Rs. Crores.1Listed companies with market cap > Rs. 300 cr.2As on 31 March 2008.3Numbers are for 2007.


Exhibit 9 depicts the movement in market share of assets from 2000 to 2007 between PSU banks, new private banks, old private banks, foreign banks, and other financial services (NBFC, HFC and securities firms). While the share of the public sector continues to be dominant, there is a remarkable market share shift to the new private sector banks. SBI and associates lost most of the share during this time frame.

The share shift in market capitalization is much starker. Already, the total value of the industry is roughly split one–third each between PSU banks, new private banks, and NBFC/securities firms. Value has shifted to the new private sector banks and lately to the non bank finance entities and securities firms. While the new private sector banks have maintained their share in market capitalization, the PSU banks have lost significantly and the gainer has been the non banking industry. This is a major trend in value creation in Indian banking.

2. Total Shareholder Returns (TSR)

Another lens to review value creation in the sector is to look at the Total Shareholder Returns (TSR) generated by

different categories of players across different time horizons in last five years. Exhibit 10 shows the TSR of the six categories studied over last 1 year, 3 year and 5 year. For definition of TSR and the methodology, please refer appendix at the end of the report.

As expected, the NBFC, HFC and securities firms delivered highest TSR over these time frames. The strongest shareholder returns have been delivered at the fringes of banking industry by the non bank entities. These companies are moving fast to leverage the opportunities thrown up by growing economy that the banking sector is not able, willing or ready to go after. The non banking entities have rapidly rolled out distribution network to distribute mutual funds and insurance along with retail equity brokerage, personal lending, wealth management, commercial vehicles and auto lending to capture the opportunity that the rapid market growth has thrown up.

The TSR for new and old private banks has been coming down over the years in subsequent time horizons while TSR of PSU banks showed an increase in last one year. This report analyses the value creation potential of

Exhibit 9. Public sector accounts for 2/3 of assets and 1/3 of value

Sources: Capitaline; Annual Reports; BCG Analysis.


different categories of players in greater depth in subsequent chapters. The first step in analyzing value creation is to disaggregate TSR into its components. Exhibit 11 presents the dis–aggregation of the TSR of different categories of players into individual components.

TSR is broken down into four components, each of which is driven by a different factor. The four components are:

Profitability change (represented in Exhibit 11 as 1. RoA change)

Growth (represented in Exhibit 11 as asset growth)2.

Change in P/E multiple (represented in Exhibit 11 as 3. multiple change)

Cash flow parameters that include dividends, share 4. buy back, new equity induction, etc. (represented in Exhibit 11 as free cash flow yield—FCFY)

The first two components—profitability change and growth—represent in essence the “fundamental” value

creation drivers. The third component, change in P/E multiple, captures the market re-rating for the sector and the company and the last component, FCFY, captures aspects of financial policy of the company.

In Exhibit 11, the five year TSR of the six categories of players is broken down into the four components. Data availability compelled us to use the five year period from FY 2002 to FY 2007 (as against the previous chart that is till 2008). The composition of TSR varies widely across the categories of players providing important insights into the sources of value creation and also future prospects for each segment.

For PSU banks, out of the 42% TSR delivered, 22% is contributed by increase in the P/E multiple. Re–rating has thus been the biggest contributor of TSR for PSU banks. As against that for new private banks, re–rating of multiple contributed only 9% out of the total TSR of 57%. The biggest contributor of TSR for new private sector banks was asset growth that contributed 31% out of 57%. In case of NBFCs, all three factors—asset growth, multiple re-rating and profitability improvement contributed to TSR. Consequently, the TSR of the segment has been the

Exhibit 10. Total Shareholder Returns (TSR) vary by segment

Sources: Capitaline Plus; BCG Analysis.Note: TSR numbers updated till 31-Mar-08.


Exhibit 11. Levers of value creation differ across segments—PSU driven by multiple, private sector banks driven by profitable growth, others driven by both

Sources: Capitaline; BCG Analysis.Note: FCFY includes change in Divident Yield, change in number of shares and allocation term.

highest. Similarly in case of securities firms, the high TSR was contributed to by both multiple re–rating as well as growth.

Of these four levers of value creation, multiple re–rating depends significantly on the overall market sentiment. Also, there is a limit to the extent to which multiples can increase and hence for companies with very high multiples, there is not much scope for improvement. For individual companies, growth and profitability improvement are the only viable levers provided they do not come at the cost of higher capital levels.

Thus, for new private sector banks, with significantly high multiples, capital efficient profitable growth is crucial if value creation track record is to be maintained. On the other hand, for old private banks and for PSU banks, the multiple re–rating has been the largest driver of value creation. Growth and profitability should be primary focus of PSU banks and old private sector banks. Nevertheless, there is still significant room for multiple re–rating when you compare them to the new private banks as shown in Exhibit 12.

3. The business model discount

Exhibit 12 depicts the movement of P/E multiple of three different categories of banks over last five years. The multiples of all the segments have gone up over last five years. Private sector bank multiples have gone up from 10 to 29. For PSU banks and old private sector banks, they have gone up from 2 to 11–12.

The gap between the valuation multiple of new private sector banks and the rest has continuously widened over this time frame and has grown almost three times from about 7 in 2003 to about 18 in 2008. We term this gap as the “business model discount”. The PSU banks as well as old private sector banks suffer from a discount that reflects market’s lack of confidence in their business model’s ability to deliver high growth and profitability in wake of increasing competition from new private sector banks and increasingly from NBFCs.

It is interesting to note that old private sector banks and PSU banks suffer almost equal discount. The PSU banks’ multiple has always been slightly behind the old private


Exhibit 13. P/E multiples of banks

Sources: Thomson One Banker; BCG Analysis.Note: Figures in bubbles are market capitalizations in Rs. Crores.

Exhibit 12. The widening “business model discount”

Sources: Capitaline; BCG Analysis.Note: EPS for Private New and Public sector banks have been estimated in order to compute P/E ratio for FY2008.1Delta is the difference between P/E for Private New banks and PSU banks.


sector banks reflecting perhaps the further “discount” for state ownership. However, in our view, setting aside the ownership debate, business model changes themselves can create tremendous value for the PSU and the old private banks.

The “business model discount” is a key theme of this report. It represents the immense value creation potential for PSU Banks and old private sector banks with suitable business model changes. It also highlights to the Government of India, the opportunity costs of not spurring the business model changes and the corporate governance reforms that have to go with it. Additionally it shows a curious trend in value creation in India where NBFCs and brokerages are capturing value, nibbling at the potential growth opportunities of incumbents.

If the business model changes were to bring about a multiple re–rating in PSU banks from the current levels to average for the industry as shown in Exhibit 13, there

is additional Rs. 175,000 crore of value to be unlocked. Given the overall ownership pattern of these banks, Rs. 110,000 crore of this additional value will accrue to the government and Rs. 65,000 crore will accrue to the other non government shareholders.

This may be a notional number since Government of India may not want to sell off its stake in PSU banks below 51%. However, ensuring business model changes to improve the P/E multiples of PSU banks has very tangible benefits for the government. Higher multiples mean that these banks could raise much higher level of capital for the same level of dilution, reducing the pressure on the government to capitalise these banks. Value of Government of India stake above 51% in all PSU banks will go up by Rs. 20,000 crore with the upward adjustment in P/E ratio. This is the amount of cash that is available to the government without diluting below 51% in any bank. This amount can be used to further infuse equity in banks to support their growth.


In the following chapters, the key themes in value creation in different segments have been illustrat-ed. The resulting action agenda in the PSU banking industry is the most complex. It also has the poten-tial to unlock the most value. Most importantly, the

movement on this agenda will determine the future land-scape of Indian banking and financial services industry.

The action agenda for PSU banking industry revolves around addressing the “business model discount”. A com-prehensive road map, comprising corporate governance reforms and consolidation have to be chalked out by the government (Refer box: The 3 pronged roadmap for the government of India). In the interim, appropriate busi-ness model changes, within current ownership and cor-porate governance, can add significant value.

The business model changes required to address the “business model discount” can be structured under the “7 point action agenda” for the PSU banks:

Augment the vocabulary of performance.1. Paradigm shift in organisation design.2. Address the manpower gap–in numbers and in 3. skills.Get the most out of technology.4. Prepare to earn higher fee income.5. Create an advantaged distribution network–in 6. numbers and in configuration.Systematically engage the current staff in transfor-7. mation.

1. Augment the vocabulary of performance

The first step in changing a business model is to change

the vocabulary used to measure performance. In the past decades, changes in vocabulary have had profound im-pact on business model of PSU banking industry. As shown in Exhibit 14, the vocabulary of performance mea-surement has continuously changed since the 1980s. Dur-ing the 1980s, the predominant metrics were growth in number of branches, total advances and total deposits. The resultant impact was a rapid expansion of branches in the country, deposit mobilization and credit expansion. In 1990s, proactive intervention by RBI introduced pru-dential metrics like NPA ratio and capital adequacy ratio. Over a decade later, Indian PSU banking industry has an enviably healthy balance sheet. In early 2000s, new pri-vate sector banks emerged and several PSU banks were listed. Profitability, share price and market share shifts were introduced in the vocabulary of performance mea-surement. Several banks have initiated efforts to contain market share decline. There is a strong profitability con-sciousness in key decisions.

The power of vocabulary in focusing management atten-tion has a proven track record. The time has come for the vocabulary to be further strengthened with introduction of Total Shareholder Returns (TSR), valuation multiples (P/E, P–BV), market capitalization and risk adjusted re-turns (RORAC). BCG’s experience has shown that such metrics encourage the management to focus on the align-ment of business model with the market reality.

2. Paradigm shift in organization design

The second and the most crucial lever in bridging the business model discount is to bring about a paradigm shift in organization design. As shown in Exhibit 15, there are six key changes proposed in the way PSU banks are organized. First four can be implemented by the banks

Implications for the Public Sector


Business model transformation will unlock the potential of PSU banks and unleash higher growth and profitability which will reflect in their higher valuations. But this will still not make them reach their full potential. In order to prepare the banks for unbridled competition and nurtur-ing the winners at global scale, business model transfor-mation has to be accompanied with parallel reforms in corporate governance framework and structure of the banking landscape. Both these levers are squarely in the domain of the government.

While state ownership of the banks is not an impediment in itself, some elements of the current corporate gover-nance framework definitely weaken their competitive-ness:

Top management slots can continue to be vacant for • quite a while as the government machinery take time to make up its mind.

Tenure of some CMDs is often too short to make any • meaningful difference to the organization. Entire top team could get “transferred” in short time frames leading to serious discontinuities in strategy and ex-ecution.

Oversight framework (CVC, CAG and CBI) can inflict • severe punishment for some times even genuine, mistakes. This continues to inhibit fast decision mak-ing.

Crucial policies continue to stay beyond the board de-• cision rights—salary structures, incentive pool, selec-tion of individuals for top management positions, and even organization design in terms of number of positions at different levels.

Finally the minority shareholders continue to have • very little say in the board with voting rights capped at 1% irrespective of the share ownership.

A three pronged parallel approach is required to address the issues in a comprehensive manner. As shown in fig-ure below, the three areas are:

Business model refinements—most of which are 1. possible within the framework of state ownership though are retarded by the current corporate gover-nance framework.

Corporate governance reforms—starting with 2. strengthening of the boards and setting a roadmap for delegation of decision rights to the Board from the government.

Consolidation in the PSU banking industry to facili-3. tate creation of few large banks with national scale and global potential.

As shown in the figure below, the delegation of decision rights to the boards has to be a phased process. The first step should be to strengthen the Boards with right skills and systems and delegate the performance linked incen-tive compensation entirely to the Board’s discretion. This can be followed up with a series of further delegations as shown in figure below.

We believe that the three pronged strategy could get un-veiled over a 3 year horizon if all the relevant stakeholders were to be aligned. It is then that one could consider that the PSU banking industry is fully prepared for global com-petition and it could aspire to be on the top 10 list of banks by value.

The 3 pronged roadmap for the government of India


Exhibit 15. Paradigm shift in organization design

Exhibit 14. The vocabulary of performance


themselves. The last two will require government inter-vention and initiative.

First change is in the way organization structure is de-signed. Most of the PSU banks are designed on geo-graphic basis. This design philosophy was appropriate a decades back when information was scarce and its flow across the organization levels was slow. This design phi-losophy has to give way to a customer centric organiza-tion design with advent of information technology. Fur-ther, the nature of demand has changed. Customer needs are distinctly different across segments and are constantly evolving. It is important to create focus on different customer/product segments with dedicated or-ganization.

Second profound change to be brought in organization is introduction of performance accountability at all levels. Currently, the only meaning of the word accountability means punishment for a mistake. Only a few roles are accountable for performance targets. Every individual in the organization has to be accountable for meeting cer-tain KRA and this measurement has to have meaningful linkage to rewards, recognition and career progression.

Third key change is regarding roles specialisation. The legacy of the regulated era has made most of the staff in banks generalists. Customer centric organization can work best only when people specialise in the nuances of different verticals of products and customers. The organi-zation design has to include career tracks that could be on business unit lines (e.g. corporate banking) or func-tions (IT, finance, HR, etc).

Fourth change is about compensation. Currently com-pensation in the PSU banks is mostly undifferentiated by performance levels. This has to give way to a more transparent linkage of performance with incentive com-pensation. While this has been allowed by the govern-ment in a limited manner, the effective adoption by banks is lagging.

Finally, the paradigm shift in organization is incomplete so long as the PSU banks are expected to compete in the market with their compensation levels completely de–linked to market realities. An associated but reciprocal issue is market linkage for talent induction. Currently, lat-eral induction of talent is miniscule. This is partly due to

policies and partly due to compensation levels. Talent, especially for senior positions, will have to be also induct-ed from the market along with internal development.

These last two changes hinge upon a broader reform agenda to be initiated by the government.

3. Address the manpower gap—in numbers and skills

PSU banks face manpower challenge at two levels. Firstly, the virtual freeze in recruitment for almost a decade has created a gap in manpower pipeline. Resultant high aver-age age of staff imposes a significant challenge in re–skilling the staff as changes in technology and customer expectations require new skills and behaviours. The staff has as much to un–learn as to learn. Secondly, the virtual freeze in recruitment came about due to entrenched be-lief that productivity levels in PSU banks are too low. While that might have been true for years gone by, it is fast approaching a stage where hiring in large numbers is a necessity if the banks are to continue to grow.

Exhibit 16 demonstrates the stark contrast in manpower induction across the three segments in banking between 2004 and 2007. While the rate of manpower induction in private sector leads the asset growth, it is actually nega-tive in PSU banks. And this analysis does not include the outsourced staff used by the private and foreign banks. One might argue that the low productivity in PSU banks could justify the continued growth with same manpower. Analysis of productivity including outsourced staff does not support the argument any more.

Exhibit 17 shows the productivity of employees in terms of total business per employee for last three years for the new private banks and PSU banks. Productivity per em-ployee of PSU banks almost doubled in three years while that of new private banks stayed almost constant. The picture changes when we adjust the employee strength of the new private banks with outsourced staff in sales and back office roles. The productivities of the two categories of banks converge. There is a significant variation within the PSU banks on manpower situation and it is much starker for those PSU banks who are relatively more tightly staffed compared to peers. For such banks, to hire in large numbers is crucial to growth.


Exhibit 17. Adjusted for outsourced staff, productivity of private and public sector is converging

Sources: IBA; Capitaline; BCG Analysis.

Exhibit 16. Unsustainable disequilibrium in talent induction

Sources: Capitaline; IBA; BCG Analysis.


Our analysis shows that in order to maintain their current growth rates, PSU banks have to hire over 70,000 people per year over next five years even after assuming a 50% jump in productivity. In five years’ time, this would imply that almost half of employees of a PSU bank would be new staff recruited in last five years! That will be one indicator that the banks are ready to compete in the new market reality.

4. Get the most out of technology

There has been significant investment in information technology, adding upto over Rs. 10,000 crores, by the PSU banking industry over last decade. Most of it has gone into implementation of core banking platform. A lot remains to be done.

Exhibit 18 plots the four year average of ‘IT spend as a percentage of revenue’ of PSU banks against their four year ‘average cost income ratio’. As seen from the exhibit below, there is practically no correlation between the two. One would have expected banks with higher invest-ment in technology to have better cost income ratios. Clearly, the method of investment has to be further fine

tuned to “get the most” of the technology investments. The IT projects have to be run with a “return on invest-ment” lens and activities have to be focused on those areas that have a direct customer services or productivity enhancement objective.

This is especially important given that the banks have just started on investments in technology. As compared to American/Western European banks, who spend almost 7% of their revenues in IT, the PSU banks spend is at 2.5%. Even assuming that technology costs are lower in India and low cost labour replaces technology to some extent, there are more investments that will be made in the future.

Exhibit 19 shows a technology roadmap that goes beyond the core banking implementation. As a next step, the ex-isting technology has to facilitate 100% paper less MIS and customer and product profitability information. Banks have to further invest in sales force management systems including lead management. Thereafter, the banks have to invest in customer relationship manage-ment systems and integrate across all applications to give “one view” to the customer. This will be a long journey

Exhibit 18. Linking technology investment with cost advantage

Sources: RBI progress and trends in banking in India.


with continuous high investments. Banks have to lay out their technology roadmap and employ the right project management metrics that focuses the management on the right levers to get the ROI on these investments.

5. Prepare to earn higher fee income

Exhibit 20 shows comparison across categories of players on key metrics of financial performance. On most finan-cial metrics PSU banks compare favourably with new private banks except fee income. On key aspects of cost–income ratio, provisions for NPA, and NIM, the PSU banks score as much or better than the new private banks. Foreign banks follow a very different business model with much smaller asset size and branch reach and hence are not comparable directly. It can be noted that fee income of new private banks is more than double of the PSU banks as a percentage of assets. For the for-eign banks it is even higher.

What is the genesis of this low fee income share? Exhibit 21 shows the market share of different categories of the banks in different pools of fee income. As can be noted, the PSU banks have 70% share of assets and 69% share of

net interest income. However, they have only 51% share of the commission, exchange and brokerage fee and an even lower share in FX income at only 40%. In some ar-eas like corporate finance advisory, investment banking, wealth management and derivatives business the share of PSU banks is miniscule.

Preparing to earn higher fee income finds a place in top seven priorities of PSU banks because it is crucial to the long survival and profitability of the banks. This is espe-cially true in Indian banking context where the NIMs are very high compared to other developed markets and will inevitably go down as the banking and debt market re-forms take place. Fee income generation is a crucial indi-cator of success of business model transformation and hence a trigger for P/E multiple re–rating of the banks.

Generating fees is a difficult business. Traditional fee pools are drying up. For example, the demand drafts and letters of credit (LC) and guarantees are going out of fash-ion. They were a staple source of fee income to banks. New pools are emerging in wealth management, 3rd party product distribution, treasury products and corpo-rate advisory business. These are new areas which do

Exhibit 19. Technology is a long journey—most PSU banks not yet over with the first step


Exhibit 20. Fee income is a key gap for PSU banks—NIM, Cost, NPA levels in line with competition

Sources: Annual Reports; Capitaline; BCG Analysis.

Exhibit 21. Fee income concentrated in foreign and private banks

Sources: IBA; Annual Reports; BCG Analysis.


not lend themselves to traditional business models. They require new expertise. Such expertise needs to be devel-oped through internal development or external alliances and joint ventures.

6. Create an advantaged distribution network—in numbers and in configuration

The sixth strategic priority for the banks is to strengthen their foothold in distribution. As Exhibit 22 suggests, In-dia is grossly under penetrated in terms of number of branches and ATM per lakh population. Several thou-sands of branches need to be opened and players who gain share of distribution will have an upper hand in cus-tomer acquisition and retention. For PSU banks, there is additional element to distribution excellence—network optimization, branch redesign and mastering the alter-nate channels—internet, call centre and ATMs. The dis-tribution channel has to reflect the changing nature of demand. Alternate channels like call centre and internet have to be perfected to attract young customers. Branch banking has to be made a pleasurable experience for the new customers who walk in to the branch.

7. Engage the current staff in transformation

Single biggest challenge for the PSU banks is to re–orient staff towards behaviours required in the current market reality. This cultural change is to happen in the hearts and minds of the officers and clerks who have had their “world view” shaped over decades in the context of pri-macy of state policy priorities and a highly directive regu-lation. The shift in mindsets required is dramatic and the extent of it is not fully appreciated. Credit scarcity and rationing has to give way to proactive credit sales and marketing. Quasi bureaucratic set up built to administer credit disbursement and resource mobilisation has to give way to customer centric organization focussed on cus-tomer service. Many officers used to being waited upon by customers have to go out and solicit business against fierce competition. For some employees, the original mo-tivation for joining a public sector bank is fundamentally challenged by business model transformation. The change programmes at the banks have to acknowledge this challenge. Creating engagement with the staff has to be the central theme of the transformation efforts.

Exhibit 22. India lags global standards in penetration of branches & ATM—as bankable households grow, there will be a need to increases branches and ATM’s

Sources: World Bank; Literature search.


Implications for Other Sectors

Value creation and even the industry landscape in financial services in India over next decade will be influenced by the actions in public sector as described in previous chapter and their pace (or the lack of it). While the public sector readies itself completely for the new market demands, the rapid economic growth is throwing up opportunities that are increasingly harnessed by the new private sector banks and increasingly NBFCs and securities firms. In a sense, the business model discount is metaphorically the corner stone of value creation in the whole sector over next few years.

Implications for different segments within financial services sector are different.

New private sector banks: Capital efficient profitable growth

New private sector banks have delivered very high TSR. This was due to high growth as well as multiple re–rating. As shown in Exhibit 23, the TSR of new private banks has been coming down in successive time horizons (5 year, 3 year, 1 year). This is because the multiples have grown

Exhibit 23. Value creation in new private banks

Sources: Capitaline; BCG Analysis.


steadily over the last 5 years and have reached levels beyond which there is little room for further increase. Therefore, high value creation track record of the new private sector banks can be maintained only with continued profitable growth. The caveat is that the continued high growth, coming at a higher base, has to be profitable as well as capital efficient. New private sector banks have to focus on:

Cost optimization with process excellence.•

Cross selling to ensure that the high cost of customer • acquisition is matched by higher per customer revenue.

Introduction to advance customer relationship • management (CRM) and anlytics.

Tie–up and alliances to reduce customer acquisition • costs.

Fine tuning of organisation structure from high • growth focused product based structures to more customer centric structures.

Adoption of advanced capital management • techniques (e.g. use of RORAC for business decision making) to ensure key decisions are tightly tied in with efficient capital usage.

In general, the new private sector banks need to adopt a TSR based strategy. Define discussion on linking TSR to strategy can be found in BCG’s report “Creating Value in Banking 2008”.

Old private sector banks: The latent opportunity

Old private sector banks are an enigma. They do not suffer from the constraints of state ownership that the PSU banks do. Their performance on all counts is often worse than PSU banks. Their multiples languish at the same levels at PSU banks. Business model discount is valid here as well. In fact, except for the ownership, it is very difficult to differentiate between an old private bank and a PSU bank in terms of their business model. Adequate management determination and aspiration is required to set these banks in motion on a path of business model transformation which will involve significant industrial relations management beyond the 7 steps to business model change prescribed for PSU banks. We estimate Rs. 10,000 crore value to be unlocked in the process.

NBFC & HFC: Exploiting the niches

Indian economy is growing and with it the demands of business and individual customers. All banks are not ready to innovate and create products and services for the new demand. This is creating space for NBFCs to flourish. It is well known fact that NBFC meet a significant share of credit demand from the SME segment through products like factoring, equipment leasing, etc in most developed economies. This growth is waiting to happen in India. Further, certain product segments are out of bounds for banks (e.g. operating leases) and such regulatory arbitrages could be leveraged by NBFCs to create a profitable franchise. We expect value creation in NBFC space to be driven by product specialist niche players leveraging regulatory or capability arbitrages.

Sensing the opportunities many major industrial houses have announced ambitious plans in financial services through NBFC and brokerage route.

Broking & distribution: Consolidation and diversification

Broking and distribution business has grown in last few years on the back of soaring equity markets. With stock market correction and resultant dip in trading volumes, the smaller players are expected to find it difficult to sustain a profitable business model. There is scale in branding and technology that favours larger players with deep pockets. Therefore, we expect the value creation in retail brokerage space to be driven by consolidation and diversification. The brokerages that are diversified into mutual fund and insurance distribution, wealth management, investment banking, private equity, etc are expected to be more stable and hence have higher valuations. Such players with higher valuations can be the drivers of consolidation.


Ranking of Top Performers

Exhibit 24. Top value creators among large cap banks—Axis Bank and Bank of India in top 5 among banks in 3 time horizons

Exhibit 24 shows the large cap banks arranged in descending order of their Total Shareholder Return (TSR) for various time periods (5 year, 3 year and 1 year ending 31st March 2008). While, it is commendable to deliver high TSR in any given time period, the real test of true performance is being a top performer across different time frames. By that yard stick, two banks stood out among all the listed banking entities in India—Axis Bank and Bank of India. Axis Bank has consistently been among the top 3 and Bank of India among top 5 in terms of TSR over different time frames.

Exhibit 25 shows the same pecking order for top 10 large cap performers with all the financial services companies including NBFC, securities firms and HFCs along with banks. Shriram Transport Finance and Reliance Capital appeared in the top 5 consistently.

Note: Only large cap banks (market capitalisation >Rs 4,000 crores as on 31st March 2008) in sample.


Exhibit 25. Top value creators across large cap banks and NBFS—Shriram Transport, Reliance Capital and Axis Bank consistent value creators

Note: Only large cap entities (market capitalisation >Rs 4,000 crores as on 31st March 2008) in sample.

The global markets have been unkind to the financial services companies in the first 2 quarters of calendar 2008. The sub–prime crisis in the US resulted in several banks across the world having to book significant losses resulting in erosion of capital. Capital markets severely penalized banks and globally financial services sector was among the worst performing in the first half of 2008 as depicted in Exhibit 5.

Indian banks, while immune by and large, from the sub–prime crisis and its aftermath, also suffered significant value erosion in the first half of 2008. As depicted in Exhibit 5, Indian financial sector lost over 56% value in first half of 2008 after gaining over 110% in 2007. The performance of the Indian financial sector has been more volatile compared to its counterparts in developed economies as well as in the other BRIC nations. However, as can be seen from Exhibit 5, net value creation in India even after correction was higher than average of BRIC countries.

The value erosion in the first half of 2008 has certainly tempered the overall long term shareholder returns. However, we believe that the long term fundamentals of the Indian financial services remain attractive which will result in sustained high TSR over the long term, short term dips notwithstanding.

The implications of the TSR performance highlighted in this report remain valid. As shown in Exhibit 26, the different sub segments within banking and financial services sector got negatively hit in almost the same measure in H1 2008. This implies that the relative share holder returns, valuations and multiples (and hence the action agenda) across sub segments follow the same pattern as discussed in the report.

Epilogue: H1 2008


Exhibit 26. Significant value erosion across the financial services players in India in H1 2008

Sources: T.F. Datastream; BCG Analysis.Note: All TSRs were calculated after conversion to U.S. dollars.1TSR comprises capital gains and free-cash-flow yields.


Appendix

Exhibit 27. Component of share price

1. Understanding TSR and its decomposition

Total Shareholder Return (TSR) is simply the return that a shareholder gets over a time frame as a result of capital appreciation and dividend yield. TSR can be broken down into its components as shown in Exhibit 28 into growth rates of profitability (RoA), assets, P/E multiple, number of outstanding shares and dividend yield. Due to conversion of multiplicative equation into additive equation, an allocation term also stays as an error that is

usually small and can be ignored while making relative comparisons. This methodology has been used to break up the TSR performance of different categories of players into their components.


Exhibit 28. Decomposition of TSR into its components


Exhibit 29. List of banks in 5 year, 3 year and 1 year TSR horizons

2. Sample used for analysis


Exhibit 30. List of FS companies in 5 year, 3 year and 1 year TSR horizons


For Further Reading

The Boston Consulting Group pub-lishes other reports on the topic of value creation and financial services, in general, which may be of interest to senior executives. Recent examples include

Creating Value in Banking—Man-aging Shareholder Value in Turbu-lent TimesA report by The Boston Consulting Group March 2008

Bigger, Better Banking—Emerging Titans, Soaring Profitability and Continued GrowthA report by The Boston Consulting Group March 2007

The Next Billion Consumers—A Road Map for Expanding Financial Inclusions in IndiaA report by The Boston Consulting Group November 2007

Retail Banking: Facing the FutureA report by The Boston Consulting Group November 2007

For a complete list of BCG publications and information about how to obtain copies, please visit our Web site at www.bcg.com/publications.

To receive future publications in electronic form about this topic or others, please visit our subscription Web site at www.bcg.com/subscribe.

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