Indian banking sector fundamentally stronger than China's - for now

Standard & Poor''s explains why Indian banks are fundamentally stronger credits than their counterparts in China despite weaker ratings.

Executive Summary

The Indian banking sector's credit quality, pre-provisioning profitability, and capitalization fundamentals are stronger than those of its Chinese counterpart, despite the credit ratings on the leading Chinese banks being higher than those on the Indian banks. The ratings differential reflects the readiness of the Chinese government to provide substantial resources through capital injections, and the sale of the banks' nonperforming assets to government-owned asset-management companies—factors that boost the Chinese banks' standing but do not necessarily add to their fundamental strength.

The two banking systems share certain attributes, such as operating in high-economic-growth environments (although China's growth historically has been the faster of the two systems), but there are key differences. The Indian banking system is subject to relatively tighter foreign ownership restrictions (however Indian authorities have indicated that they intend to review these regulations after March 2009), whereas the Chinese banks are poised to benefit from the expertise they are likely to gain from an increasing number of foreign alliances, through either minority equity stakes or technical assistance from foreign banking groups.

Credit Quality

The public-sector Indian banks and the state-owned Chinese banks dominate their banking systems, accounting for about 70%-75% and 55%-60% of system assets, respectively. However the Indian banks' strong credit quality stands in stark contrast to that of the Chinese banks. According to Standard & Poor's Ratings Services estimates, Indian banks' gross nonperforming assets—which include nonperforming loans (NPLs), parts of restructured assets, and foreclosed properties—ratio stood at an estimated 8%-10% of loans at March 31, 2005, compared with 31%-35% for the Chinese banks at Dec. 31, 2004, in a divergence that can be attributed to the factors outlined below.

Structural differences in economic models.

The Indian banks play an indirect role in the Indian government's fiscal operations, providing funding to the central government through their subscription to government bonds in line with statutory liquidity ratio requirements. In turn, the central and state governments provide support to the central and state public-sector undertakings—particularly the weaker ones—and, as such, bear the direct credit risk associated with them. Consequently the credit risk of the Indian sovereign finds its way to the banks' balance sheets, thus sparing the banks the burden of holding large amounts of delinquent exposures of the weak public-sector companies. Nevertheless, Indian banks are still required to carry out a degree of lending to designated priority sectors that typically are of lower quality relative to other business segments.

In contrast, Chinese banks—in particular the state-owned banks—are directly used as fiscal instruments to fund the state-owned enterprises (SOEs), with the government providing capital infusions to the local state-owned Chinese banking institutions to prop up their balance sheets. Accordingly, as the financial standing of the SOEs remains dismal, the Chinese banks are left with large chunks of legacy NPLs when loans to such entities become impaired. Nevertheless, a partial mitigating factor is Chinese banks' fairly sizable investments in government papers (which represent about 20%-30% of bank assets), given that the credit rating on China is relatively stronger than that on India.

India has relatively more developed risk-management and legal frameworks.

Although the risk-management frameworks of banks in India and China are still developing, the Indian banks' credit-risk-management systems are comparatively more advanced than China's, mainly because Chinese banks spent several decades under policy-lending regulations that placed very low priority on developing a credit-risk-management platform. This, however, is changing, as the Chinese banks have been adopting a more commercial basis for their incremental lending while at the same time investing substantial amounts of money and resources in technology and systems to shore up their own credit-evaluation mechanisms and internal control processes. Chinese banks that are under the direction of sophisticated strategic investors are likely to further speed up their reform, and hence close the gap with India.

Indian banks' freedom from being used as large-scale policy-lending instruments has facilitated their development of credit-risk-management systems to a basic degree. Although this is an evident comparative advantage for the Indian banking system, Indian banks are nevertheless aware that there is still much room for improvement. As such, they are preparing to bolster their credit and risk-appraisal processes, particularly as credit growth continues strongly and in light of the onset of Basel II. At the same time, although the legal system in India can be slow, it is relatively more developed than China's, a factor that promotes a higher level of confidence in the Indian legal system than for the Chinese system, particularly in cases of enforceability or foreclosures on NPLs.

India is more ahead in regulatory initiatives toward system loan quality.

The Reserve Bank of India (RBI) is ahead of China's central bank in regulatory initiatives to bolster loan quality. Key among the RBI's various initiatives is the move of NPL overdue-classification criteria to a 90-day standard from a 180-day norm, bringing it in line with international practices. Some of the RBI's other key lending-quality initiatives in recent years include tightened provisioning standards, credit- and market-risk guidelines, and the establishment of the Corporate Debt Restructuring forum.

The Chinese government also has initiated measures for improving loan quality, but in terms of regulatory prudential guidelines—in particular those pertaining to loan classification—these measures are comparatively more lenient than India's. Major Chinese banks largely disclose their NPL ratio using a five-category classification; actual classification of an NPL is more judgmental in China than it is in India, and incorporates a higher degree of discretion. In provisioning guidelines, although there are official requirements, they are relatively less developed than they are in India, where the guidelines are very much more prescriptive and based on the aging of the NPL. Nevertheless, the prudential norms pertaining to asset quality in China have been gradually improving, although further progress is needed to bridge the gap with international standards.

Regulatory support.

An area in which the Chinese authorities have been more supportive than their Indian counterparts is the use of asset-management companies to clean up NPLs. These state-owned asset-management companies have shaved about $300 billion off China's NPLs since 1999—mostly at favorable prices to the Chinese banks. Although asset-reconstruction companies (ARCs) are established in India for the acquisition of NPLs from the commercial banks, such ARCs are not owned nor funded by the central government, and any NPL transfer transaction is undertaken on a mutually agreed price between the selling bank and the ARC.

Underlying Profitability and Capitalization

Underlying profitability

Underlying profitability, as measured by pre-provision net operating income to average assets, has been stronger for the Indian banks relative to the Chinese banks rated by Standard & Poor's over the past five fiscal years (see Chart 1). Standard & Poor's rated banks account for about 75% and 70% of the Indian and Chinese banking systems, respectively.


Indian banks' better underlying profitability can be mainly attributed to the Chinese banks' lack of pricing ability, although the Indian banks have also benefited from good treasury profits generated during the low interest rate environment between fiscals 2002 and 2004. Going forward, such gains are not expected to recur and hence will moderate the Indian banks' underlying profitability. In the past, the Commercial Banking Law in China set interest rates for loans and deposits within interest rate bands defined by the People's Bank of China, but there has been a gradual relaxation of the band over recent years, and in 2004 the ceiling on lending rates charged by commercial banks and the floor on deposits rates were officially removed. Nevertheless, although the law has changed, Chinese banks will still need to take time to transform their loans and deposit-pricing practices. Additionally, Chinese banks' interest margins remain very thin, owing to their exposures to the SOEs—both the strong and weak ones. For weak SOEs, the banks are not able to price their loans higher as the borrower is already facing financial difficulty; for the strong SOEs, such corporations will command much finer pricing, owing to their relatively strong financial profiles.

On the other hand, India's banking and financial system interest rates have been mostly deregulated, with the exception of certain segments, such as savings-deposit accounts, postal deposits, nonresident Indian deposits, small loans of up to Indian rupee 200,000 ($4,445), and export credit. Although interest rates for these segments are regulated, they only have a minimal impact on the system's interest margins given that there are certain constraints in place, such as maximum limits imposed on postal deposits. As such, lending-pricing practices are relatively more commensurate than they are in China, and the viability and the underlying profitability of Indian banks relative to their Chinese banking peers is stronger.


With relatively better interest margins and lower provisioning needs, and in turn stronger overall net profitability, the Indian banks have been able to build a stronger capital base relative to the Chinese banks. Capitalization, as measured by adjusted common equity to assets, demonstrates stronger positions for the rated Indian banks (see Chart 2).

Although the Chinese banks generally lag behind India in their internal-capital-generation ability, the Chinese state-owned banks stand to gain from capital injections by the central government as well as strategic investors—as three banks already have (Bank of China, Industrial and Commercial Bank of China, and China Construction Bank)—to bolster their capital position. Going forward, their capital positions are also expected to be further strengthened by planned initial public offerings.

Foreign Bank Ownership

The Chinese banking sector has been relatively more liberal than its Indian counterpart in foreign-ownership limits for domestic banks, allowing a single entity to hold up to 20% and capping total foreign investment at 25% in any domestic bank. Further relaxation of this restriction is being discussed among regulators.

In this respect, Chinese banks that open up to foreign ownership are relatively better positioned than Indian banks to reap the benefits that are expected to flow through from their new foreign shareholders. Although such acquisitions give the foreign banks new or greater access into local growing markets, the domestic banks themselves are expected to gain from the inflow of foreign skill-sets and best practices accumulated abroad. Such additional knowledge can benefit the domestic banks' credit-, market-, and operational risk-management capabilities, and their I.T. systems. Foreign-bank shareholders could also provide additional financial flexibility to the domestic institutions to support future lending-growth potential, while benefits could also arise from intangibles such as the potential transfer of management expertise, which could translate into more efficient and effective corporate strategies. This, however, remains to be seen, particularly when viewed against the strong control-culture exerted by majority shareholders in the Chinese banks.

In contrast, Indian regulatory guidelines impose a more gradual pace of opening the sector to foreign ownership. Such regulations state that any one foreign bank with a current presence in India can hold up to 5% of a domestic bank (10% for foreign banks with no current presence in India); cumulatively, total foreign investment in a private-sector bank may reach 74%, but the voting rights of foreign investors remain capped at 10%. Any consideration for a higher ownership stake by a single banking entity would be subject to the central bank's agreement—the RBI has stated it will consider granting higher ownership rights to Indian private-sector banks requiring restructuring.

By Adrian Chee, Director, Financial Services Ratings, Standard & Poor’s  
Ryan Tsang, Director, Financial Services Ratings, Standard & Poor’s

[The article is an abstract from RatingsDirect, Standard & Poor's Ratings web-based credit research and analysis system ( To learn more, please click on About RatingsDirect.]

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