Asset Quality Is Passé. Indian Banks Now Face These Challenges, Says McKinsey

Despite healthy return on assets, there are multiple trends that could exert pressure on Indian banks' profitability, according to McKinsey & Co.

The trends are expected to be seen over the next three to five years, and if left unchecked, it could pose some problems for the Indian banking system, it said in a report released on Wednesday.

On paper, 2022 was the best year for banks in more than a decade, especially with bank profitability reaching a 14-year high, according to the report. However, in the last six months, the sector has faced severe turmoil, primarily due to the pace and quantum of interest rate fluctuations.

While Indian banks have held their ground, trouble looms. Elaborating on the challenges facing the sector, McKinsey listed three key drivers: net interest margin, fee income, and operating expenses.

Challenges To Indian Banking Sector

Fee Income

So far, the Indian banking space has witnessed a decline in fee income. Now, the rising customer awareness, regulatory push towards transparency of charges and schedule, and the disintermediation of financial services may lead to further decline, the report said.

Net Interest Margin

In line with the sector expectations, the NIMs in banks have started to decline, primarily due to deposit repricing. The new-to-credit pools are expected to limit yield expansion opportunities, especially due to increased penetration, the report said. Since the country is also undergoing a shift in household financial product allocation levels, the growth of deposits is also likely to be constrained.

Operating Expenses

While the report highlighted the need for operational resilience, it suggested that intensifying competition and a shift in talent profile may lead to a rise in personnel costs. As Indian banks adjust their strategies around talent and technology capex, a "large variance" in operating expenses may emerge across banks.

Despite the expected challenges, McKinsey also listed some key actions that Indian banks may undertake in order to mitigate any problems and stay resilient in their approaches.

Some of the key action areas include:

• Building capabilities for digital commerce in order to capitalise on consumer and merchant finance. This could also help banks in tapping the mid-affluent and mass-affluent segments, as they could be the contributors to wealth creation in India over the next decade.

• Leveraging co-lending and digital partnerships in order to drive scale. Here, fintechs also present an opportunity along with integration of large-scale B2B and B2C consumer platforms.

• As customers become tech-savvy, banks are presented with immense opportunity to use digital and analytics-led collections, in order to improve the customer experience and tailor their strategies accordingly.

• Banks can also focus on reorganising and reworking their compensation structures, as it can help in addressing the existing talent challenge, especially with high attrition levels.

However, the report suggested that financial benchmarks alone can't drive banks out of volatility. In order to maintain resilience and overall health, it is important that the sector looks at other financial and non-financial metrics through a holistic lens.