Changing Trends and Challenges in the Indian Banking Sector.

The Banking system is the vanguard of providing credit to productive sectors of the economy by channelising household savings, which currently comprise approximately two-thirds of India’s gross savings. Recent trends indicate a shift in household preference to financial assets for saving purposes leading to movement of these savings beyond traditional bank deposits towards capital market assets. This shift is driven by several factors, including targeted efforts to deepen the financial sector, the growth of digital public infrastructure that offers convenient and frictionless access to capital markets, changing investment preferences due to demographic shifts, increased financial awareness, and the recent period of sustained high returns yielded by equity markets. Additionally, the rise of alternative asset classes, search for higher yields and portfolio diversification have further fuelled this trend. Over the past decade9, the number of subscribers and the assets under management (AUM) of mutual funds, pension and provident funds, and insurers have risen significantly, a trend likely to accentuate further. While this trend may not alter the aggregate funding available for banks, it may change the character of deposits having implications on cost of funds and margins for banks.

The banking industry faces a wide range of challenges, from regulatory changes to increasing competition from new digital players. The top challenges facing the banking industry are:

Regulatory Changes: poses to be one of the biggest challenges facing the banking industry.

Banks must comply with various regulations, from anti-money laundering (AML) to data protection laws. Keeping up with these changes can be a time-consuming and costly process, which can impact the profitability of banks. To address these challenges, many banks are investing in technology solutions to automate regulatory compliance. These solutions can help banks stay up to date with regulatory changes and streamline compliance processes.

It is mention-worthy that although there had been a marginal improvement in the Current Account Savings Account (CASA) deposits over the longer term, however, there has been a recent shift, with share of CASA deposits declining and that of term deposits, especially in higher interest rate buckets, increasing. These has implications for bank NIMs and profitability. Lately, banks have also increased their reliance on short term funding through Certificates of Deposits (CDs) and the average CD outstanding, which are the reminiscent of 2012. Banks however should take cognizance of the fact that the higher reliance on short term liabilities can have its own repercussions if market turns sluggish.

Cybersecurity Risks: as banks become more digital, they also become more vulnerable to cyberattacks. Cybersecurity risks are a major concern for the banking industry, and to address these challenges, many banks are partnering with cybersecurity firms to develop more robust security measures. Banks are also investing in employee training programs to help them identify and prevent cyberattacks.

Customer Expectations: as consumers become more digitally savvy, their expectations for banking services are changing. Customers now expect seamless, personalized experiences across all channels, from mobile banking apps to online portals. To meet these expectations, banks are investing in digital solutions that provide customers with easy-to-use interfaces and personalized experiences. Many banks are also adopting new technologies, such as artificial intelligence and machine learning, to better understand their customers and provide more relevant recommendations.

Banks with a more pronounced urban presence may target affluent customer segments, offering high-value deposit products tailored to high-net-worth individuals (HNIs) and corporate clients. Additionally, some banks with advanced technology stacks leverage digital platforms to enhance customer acquisition and streamline liability sourcing, providing a competitive edge in attracting both retail and corporate deposits. On the other hand, differentiated banks are seen to have a higher reliance on inter-bank deposits and wholesale funding.

Increasing Competition: The banking industry is facing increasing competition from new digital players, such as fintech startups and digital banks. These players are able to offer innovative products and services that traditional banks may struggle to match. In order to arrest the receding clientele, many banks are investing in their own digital solutions and partnering with fintech startups. Banks are also exploring new business models, such as open banking, which enables third-party providers to access customer data to develop new services.

The rise of innovative products and technologies in banking has enhanced consumer flexibility in accessing funds & managing cash flows, significantly transforming customer behaviour. Further, the evolving dynamics of information dissemination through traditional and social media can profoundly influence customer behaviour, potentially escalating and amplifying a crisis. These factors present heightened challenges and banks needs to be watchful and carefully review their modelling assumptions on stability of deposits and customer behaviour to better predict deposit retention, withdrawal patterns, pre-payments, and interest rate sensitivities.

Economic Uncertainty: The global economy is facing increasing uncertainty, with factors such as political instability and trade tensions impacting economic growth. These uncertainties are causing detrimental impact in the banking industry, as banks may face reduced demand for loans and other financial services that are major sources for banks to make money. Banks are relentlessly striving to diversify their portfolios and reduce their exposure to risk. Banks are also investing in technology solutions that enable them to better analyse economic data and make more informed decisions.

A reduced reliance on retail deposits, coupled with a greater share of funding from institutional sources will likely result in increased funding costs, which in turn negatively affects profitability. The quest to maintain the margins can lead to eventual transmission of increased funding cost to interest rate on loans. This would either constrain growth of loan book or may force the lenders to dilute the underwriting standards and lend to riskier borrowers to maintain earnings ratios. Banks must stay alert to the risks of certain practices that may seem less evident during strong economic growth but could lead to serious consequences during economic downturns. Banks heavily reliant on wholesale funding are more vulnerable to rollover risks and outflows in times of economic stress. Therefore, effective liability management is crucial for mitigating these risks.

Fintech Disruption: Indian Fintech industry currently is US$ 111 billion and estimated to be at US$ 421 billion by 2029. India has the 3rd largest FinTech ecosystem globally.​ The Boston Consulting Group (BCG) predicts that the proportion of digital payments will grow to 65% by 2026.​​ That demand seems particularly strong when it comes to the critical need of protecting consumer data, where incumbent banks have a trust advantage. Some super apps may also turn to banks for access to banking licenses and to meet other regulatory requirements.​​

The Reserve Bank Of India (RBI) has launched a technologically driven pilot to digitalise KCC lending in a bid for efficiency, higher cost savings, and reduction of TAT. This is expected to transform the flow of credit in the rural economy.​ In November 2022, RBI launched a pilot project on Central Bank Digital Currency (CBDC).​​ In Union Budget 2023, a national financial information registry would be constructed to serve as the central repository for financial and ancillary data.​​ In March 2023, India Post Payments Bank (IPPB), in collaboration with Airtel, announced the launch of WhatsApp Banking Services for IPPB customers in Delhi.

The digital payments system in India has evolved to be the most among 25 countries with India’s Immediate Payment Service (IMPS) being the only system at level five in the Faster Payments Innovation Index (FPII). India’s Unified Payments Interface (UPI) has also revolutionized real-time payments and strived to increase its global reach in recent years.

Contingency Funding Plans (CFP’s): It should be mandatory that Regulated Entities (RE’s) must have formal Contingency Funding Plans (CFP’s) commensurating with their complexity, risk profile, scope of operations, and their role in the financial system. Among others, it must clearly articulate the available potential contingency funding sources and the amount of funds that can be derived from these sources. It is important to note that the lender of last resort (LOLR) function of central banks is regarded as (implicit) insurance for banks against liquidity shocks that money market participants are unwilling or unable to absorb. The value of this insurance increases with banks’ exposure to liquidity risk, which increases moral hazard. Banks need to recognize that, to address this moral hazard, the central banks retain discretion to decide whether to extend emergency liquidity assistance to specific institutions. This assistance is intended as a safety net for the entire financial system through judicious use of public funds and is often accompanied by supervisory intervention and conditionalities. Therefore, the LOLR function should not be regarded as a routine component of contingency funding.

Finally, the entire nation collectively aspires for a ‘Viksit Bharat’ by 2047, the centenary of our independence. This ambition demands consistent and sustainable economic growth combined with a systemic capacity for resilience. In order to achieve the ambitious economic growth target under this vision, the financial assets and bank assets would need to achieve a consistent and high paced growth over the next two decades, which would require a corresponding increase in liabilities and capital for the financial sector. This brings forth the need to address some of the emerging challenges as customer behaviour and preferences are undergoing profound changes while global ecosystems and external factors such as third-party dependencies and technology shifts are growing increasingly complex, reshaping the business landscape. Collectively, these dynamics are creating a challenging environment for REs who would need to recalibrate their approach and business strategies. This is not just about managing risks but also seizing opportunities to optimize funding structures, enhance stability, and support economic growth. The road to a “Viksit Bharat” by 2047 will depend significantly on how well the financial system adapts to these trends and manages the complexities of resource raising and liability management.

Courtesy: Reserve Bank of India

Team Maverick