A strategic agenda for Indian banks in the post-Covid world

Indian banks are at risk of losing hard-won efficiency gains and should quickly rework how they operate to tackle new challenges, write Akash Lal, Alok Kshirsagar, Siddhartha Gupta and Shikha Gupta from McKinsey & Company. 

Unlike other shocks, Covid-19 is not a banking crisis; it is, instead, a crisis of the real economy. This still means, however, that banks will be affected as credit losses cascade through the economy and demand remains uncertain. Globally, the average return on equity (RoE) for banks could go below 1.5% in 2021 before recovering to the 2019 pre-crisis levels of 9% by 2024 – effectively a loss of five years for the banking industry. 

This will likely play out in two stages – loan loss provisions that far exceed the 2008 crisis levels over a period of 12-18 months (‘the deep freeze’), followed by a period where banking revenue growth lags gross domestic product growth, or GDP (‘the gradual thaw’).

The heartening news for Indian banks is that India has entered this crisis well-capitalised and ‘on the up’. Their provision coverage ratios improved to 65% in 2019-20, compared to 41% in 2016-17, and RoE has turned positive to 2.5% after two years of negative readings. The banking system is playing a critical role in the economic recovery by supporting businesses and individuals through the Covid-19 crisis. 

New challenges, however, continue to emerge. These, if left unmitigated, will lead to severe losses in efficiencies gained. In fact, banking revenue growth could be 5% lower than previously forecast, leading to a cumulative loss till 2024 of R12 trillion in post-risk revenue. This could result in RoE for the system dropping to -9% by 2021-22, when the full impact of credit costs will be seen.

Four strategic pillars

Therefore, to shape the recovery and growth trajectory of banks, we recommend four imperatives. 

Productivity imperative

The first is the productivity imperative. Indian banks start at a materially higher cost-to-assets ratio of 2.2% versus 1.4% globally. Interestingly, it increased from 1.8% to 2.2% over the last five years, compared to a decline from 1.6% to 1.4% for global banks. Regaining pre-Covid-19 RoE levels and negating higher risk costs and margin compression will, however, require that Indian banks improve productivity by over 30%.

The Indian banking sector has also lagged its peers in other industries for a long time when it comes to structural cost take-outs and efficiency improvements; other industrial peers have leveraged a combination of digital adoption and analytics, and strong governance.

The productivity transformation will comprise multiple agendas and banks will have to equip themselves to successfully deal with each of them. To start with, there will be a branch format and network re-configuration brought about by customers having shifted to digital channels and seeming happy to stay online. To drive a permanent digital shift, banks will need to accelerate digital engagement via contact centre transformations and by sweating their digital assets (the top 3-5 most valued Indian banks have been outperforming their peers on this count). 

In conjunction with these digital journeys, there will be the equally important need to create minimum viable support functions (zero-based operations, demand management across human resources, finance, marketing). And, finally, there will be the need to re-skill the workforce for digital operations.

Risk management

The second imperative is pre-emptive risk management that will enable a clear separation from the pack. Banks must rapidly rewire their policies and analytical models such that they reflect fast-moving indicators of risk. The ability to process structured and unstructured alternate data streams (e.g., transaction analytics, newsfeeds, call-centre interactions) and incorporate near-time feedback loops into decision-making mechanisms will require a step-change in traditional operating models.

Moreover, digital-first customer assistance will need to be a priority. This means investing in self-serve channels, digital nudges and frictionless journeys across payments, settlements and recoveries. The overall collections strategy will have to be underpinned by micro-segmentation, and also leverage analytical models to drive efficiency (e.g., customers who will self-cure versus those who will most likely default). 

Technology imperative

The third is the technology imperative that must scale with demand and analytical complexity. As banks get wired to handle high digital traffic and process enormous data sets, and as regulators get increasingly sensitive on downtimes, modernising core banking platforms, creating the data architecture that supports the analytics life-cycle, instituting modern engineering practices and moving towards automated infrastructure will become increasingly important to enable breakout levels of efficiency and customer experience. 

Capital management

The final imperative will be the shape of the lending book and efficiency of capital management. Banks with exposure to hard-hit sectors will face more of a challenge, and existing risk models are unlikely to be tuned to the differentiated impact the pandemic has had on various sectors. Risk teams will need to review critical models and add overlays to account for idiosyncratic credit risk as well as assess counterparties’ ability to pay by assessing the expected shock and recovery trajectories for individual borrowers in each sector.

Scenario planning, stress testing and balance sheet optimisation will need to become core to planning and management decisions. The ability to accurately measure profitability at a sub-product and geographical level will determine which banks are able to use scientific portfolio steering to unlock 2-3% of incremental RoE over an 18-24 month horizon. 

Conclusion

Nine months in, the covid crisis has changed the way work gets done. Business cycles have shortened from quarters to weeks, banks have shifted millions of decisions out of long-running processes to videoconferences. In its own way, the pandemic has given banks a glimpse into the art of the possible. Banks should take this opportunity to embed their newfound speed and agility, reinvent their business model, and collaborate with the communities they serve to recast their contract with society.

Akash Lal and Alok Kshirsagar are senior partners at McKinsey & Company, Siddhartha Gupta is a partner and Shikha Gupta is a leader of McKinsey’s Global Banking pool.