From a clean slate

Infrastructure finance company IDFC has established India’s biggest new bank in 10 years after winning a coveted banking licence. Rajiv Lall, CEO of IDFC Bank, outlines the opportunities ahead for the new lender.

IDFC Bank, newly established as a full-scale lender on October 1, is taking on a crowded market.

Besides India’s 27 state-owned and 20 private sector lenders, the Reserve Bank of India has also given in-principle approval to 11 applicants to set up payment banks, which can accept deposits and remittances, but will not lend. The regulator will also allow 10 microfinance institutions to convert into small finance banks.

Rajiv Lall, managing director and CEO of newly established IDFC Bank, sees the changing landscape of Indian banking as more of an opportunity than a challenge.

“For us, the opportunity starts from the starting point itself with our many years of experience in the corporate landscape,” he said.

“There has been a flight to quality as everybody wants to lend to a handful of good companies. For us, more than making money or trying to lend to these big companies, the opportunity is in the SME segment.”

“We have very deep relationships with corporate India, which go way beyond infra lending … Clearly, we have a large opportunity to diversify our revenue base from our existing clients and start to penetrate and serve their non-infrastructure businesses.”

Having focused on infrastructure lending for almost 18 years as a non-banking financial company, the former Infrastructure Development Finance Corp won one of only two universal banking licences awarded in 2014, alongside microlender Bandhan Financial Services. The two are India’s first new banks in a decade.

IDFC shareholders will be allotted one share of IDFC Bank for every share they hold such that IDFC will own 53% of the bank through a holding company and existing shareholders will control 47% directly.

The holdco will also be the parent for IDFC’s other businesses, including the securities and asset management units and the Infrastructure Debt Fund. The lender will be listed separately on the stock exchanges in November.

IDFC’s makeover into a universal bank, however, does come with some constraints.

The RBI rules require a universal lender to have three businesses: commercial and wholesale banking; personal and business banking; and rural banking. Nearly 25% of the branches need to be in rural areas and around 40% of all lending should be to certain sectors, classified as priority areas.

“Focus has to be all the three verticals because that is what the RBI’s universal licence requirements are, but, if you look at from the other side of the coin, we see a lot of opportunities,” said Lall.

As of June, India had 120,000 bank branches to service a population of 1.2bn. At 10 branches per 100,000 people, it remains far behind the 35 in the US, according to Morningstar research analysts.

IDFC Bank started operations with 23 branches and is growing fast. Analysts expect it to have 600 as of the 2020 financial year. In the next five years, IDFC Bank aims to have 15m corporate clients from the current 400.

Between FY07 and FY14, total lending and deposits in the Indian banking sector increased at respective compounded annual growth rates of 20.7% and 18.7%, according to government data. Standard & Poor’s estimates India’s banking sector credit growth at 12%–13% in FY16.

IDFC’s has expanded at a CAGR of 13% over the past three years. Lall expects the lender to grow at over 15% in the coming years, nearly twice the pace of the Indian economy.

The bank will start with a Tier 1 capital in excess of 15% (from 22.6% of IDFC), enough to fund growth for the next 24 months at least, according to Lall. He said the lender would raise more capital before it would hit the regulatory requirements.

Leveraging a legacy

Commercial and wholesale banking will be at the heart of IDFC Bank’s operations and is likely to remain a key driver of growth as it will gain market share in other sectors.

Lall foresees the share of term lending declining over time, but the share of working-capital lending and fee-based income increasing.

In June, IDFC had a loan book of Rs533bn (US$8bn) spread across energy (42%), transportation (24%), telecommunications (18%) and other sectors (16%).

Analysts expect the infra loan book of IDFC Bank to post a 9% CAGR between FY16- and FY20 with the share of this book falling below 50% in FY20.

“Lending to large corporations in this country is not a profitable business, but, it is the easiest thing to do. Corporate lending spreads are declining due to competition. Then, there has been flight to quality as everybody wants to lend to a handful of good companies,” said Lall.

“For us, more than making money or trying to lend to these big companies, the opportunity is in the SME (small and medium-sized enterprises) segment.”

SMEs will be part of the wholesale banking operations, alongside treasury, cash management, government and transaction banking, investment banking and large corporations.

The lender has built a strong treasury and will rely on its solid link to the government to extend financial services to state-owned entities, according to Lall.

Post-demerger from IDFC, the Indian government’s direct stake in IDFC Bank will fall from 17% to around 8%. The government has not indicated any plans to dilute its stake further.

Foreign investors’ holdings will fall to around 22%, leaving enough room for further capital raisings. Indian rules cap foreign ownership in Indian banks to 49%.

While IDFC Bank will start with a clean slate, it will inherit a 15% stressed-asset ratio (including restructured assets) from its parent’s infrastructure lending legacy. It has set aside Rs25bn of capital to guard against any asset-quality issues – far more than required under regulations. Fitch Ratings said IDFC had “aggressively provided” for potential problem assets prior to the launch of the bank, noting that the spike in the stressed asset ratio contrasted with IDFC’s past asset-quality performance. Non-performing assets stood at 1% in June.

Because of its legacy in the sector, Lall believes it will be easy for IDFC Bank to ramp up its infra lending business once the sector starts growing. For now, however, he remains wary.

“It will be very foolish to grow our infra book under current circumstances. Our goal is not to grow that book until all the issues in the sector are sorted out,” he said.

Funding will come largely from the capital markets.

IDFC Bank will be using the concession that the central bank implemented in 2014 to all lenders to fund assets from offerings of onshore senior bonds that will enjoy regulatory exemptions, resulting in cost savings.

Analysts estimate nearly Rs350bn of IDFC Bank’s assets will be eligible for funding through such long-term onshore infra bonds, and market players expect the lender to issue such bonds of up to Rs100bn in the current financial year to end-March.

Bank within bank

IDFC Bank has labelled its rural business Bharat (meaning India in Hindi) banking and aims to serve many unbanked and under-banked segments in rural areas.

IDFC Bank is targeting agriculture trading and farming communities, players involved in the agriculture supply chain, in addition to the rural retail customers, especially women.

“Most banks regard their priority-sector lending obligations, particularly to agriculture, as a compliance requirement, but we believe there is actually, if properly done, a huge opportunity,” he said.

The bank will ”simplify digital” for rural communities to integrate into the country’s larger its government-initiated digital revolution. Its staff will carry sophisticated yet cost-effective handheld devices to reach out to rural customers. The aim is to save cost and time.

“I can invest in 50 of those people for the cost of building one branch,” Lall said, adding that return on equity from the rural business will exceed the wholesale business in the next five years.

Kotak research analysts expect the lender’s RoE to be subdued at 7%–11% until 2018 due to investments in the bank, before increasing gradually to about 17% in 2021, according to a note published in August.

Of its initial 23 branches, 15 are in rural areas. In five years, the lender aims to grow this unit to have a business of Rs150bn.

Smarter approach

Lall sees personal and business banking as one of the hardest segments to build, but also one of the most valuable over time.

“Our goal in personal banking will be to connect to the rapidly evolving customer and give him or her the ability to connect with us through any channel – particularly digital and smartphone based,” he said.

In business banking, IDFC Bank will focus on a very large community of small entrepreneurs, who are the real drivers of job creation, according to Lall.

Mindful of its key strengths, challenges and the opportunities that lie ahead, Lall feels it is the effective combination of service and technology that will differentiate the lender from others.

“We will use technology to improve the service and productivity. It will help bring costs down, and improve the consistency and the quality of the customer experience,” he said.

Analysts expect the lender’s net interest margin to decline around 50bp from 3.2% come 2018 due to rising costs, but is likely to improve later. During the next three years, the cost-asset ratio will also rise to 1.2% from 0.8%.