Why Indian Banks are strong compared to the US?

The demise of First Republic Bank, which sent shock waves across the globe, has raised concerns about the strength of the U.S. banking system and its impact on the broader economy. The shutdown marked the nation’s second-largest bank failure, with ~$230 billion in assets, surpassing the Silicon Valley Bank collapse. Notably, three of the four largest bank failures in U.S. history have occurred in the past two months. In the last two decades, the U.S. has witnessed a total of 566 bank failures, that’s ~25/year.

Amidst turbulence in the U.S. banking sector, the Indian banking system has demonstrated remarkable resilience. Compared to their global counterparts, Indian lenders have maintained strong capital levels, healthy asset quality, and a favorable credit-to-deposit ratio. Even in the 2007–2008 Global Financial Crisis, in the 12 months ending in March 2009, 44 American entities faced failures, while only 19 Indian cooperative banks experienced collapses. Since then, strict regulatory monitoring and stringent regulations regarding liquidity coverage ratio have enabled Indian banks to improve their capital positions and address bad debt issues.

This inevitably poses the question of the strength and stability of both the Indian and U.S. banking systems.

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Interest Rate Hikes

The US Fed’s interest rate hikes have exacerbated the U.S. banking crisis with significant deposit withdrawals. Each additional rate worsens the banking problem considerably. Despite a rise in U.S. interest rates, the real interest rates, adjusted for inflation, remain negative. This implies a decrease in the purchasing power of money over time.

1. With a 4.9% annual inflation rate and the highest-yielding money market rate at 4.5%, the nominal interest rate in the U.S. is lower than the inflation rate.
2. Negative real interest rates lower the purchasing power of U.S. consumers, with decreasing consumer spending rates of 0.3% and 0.2% at the end of 2022.
3. The Fed has increased the policy rate by 500 basis points, the fastest rate of hikes post-1980, and the U.S. benchmark rate has been pushed to 5% and 5.25% to combat higher-than-desired inflation.
4. The significant increase in rates, following a decade of historically low-interest rates, has already affected the technology industry and regional banking system.

In comparison, the Reserve Bank of India (RBI) has paused interest rate hikes and maintains the 6.5% repo rate, after a 250 basis point hike. The RBI believes that maintaining a low positive real rate, approximately 0.9% with a margin of 50 basis points, is vital for achieving a balance between managing inflation and fostering economic growth.

Additionally, Indian banks are well-equipped to handle interest rate cycles, setting them apart from advanced economies.

1. The experience and adaptation to recurring interest rate cycles have equipped Indian banks to effectively manage the volatility in trading income caused by interest rate fluctuations.
2. An unchanged repo rate is a positive development for the banking, non-banking financial companies (NBFC), real estate, and infrastructure sectors.
3. Deposit Withdrawals

The U.S. commercial banks have experienced the largest monthly decline since 1973, with total deposits falling by $318 billion (1.8% drop) to $17.37 trillion in March 2023. This amount represents the lowest level since July 2021. In comparison, Indian banks are anticipating a surge in retail deposits with rising deposit interest rates. Most major lenders currently offer interest rates of 6.75% to 7.30% for 1-2 year deposits and 5.75% to 7.25% for longer-term deposits.

India’s ownership structure of deposits reduces the probability of large-scale deposit withdrawals during times of financial stress. India is unlikely to witness large-scale bank runs, with 63% of total deposits owned by households considered sticky retail customers. The Deposit Insurance and Credit Guarantee Corporation (DICGC) provides insurance coverage for 98% of deposit accounts, while the Federal Deposit Insurance Corporation (FDIC) only insures 38.4% to 66% of the deposits of the top 10 U.S. banks.

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Limited Exposure to Bonds

U.S. banks held unrealized losses of $620 billion (assets whose value has declined but have not yet been sold). Unrealized losses diminish a bank’s potential to effectively respond to unforeseen liquidity needs in the future.

India’s ownership structure of deposits reduces the probability of large-scale deposit withdrawals during times of financial stress. India is unlikely to witness large-scale bank runs, with 63% of total deposits owned by households considered sticky retail customers. The Deposit Insurance and Credit Guarantee Corporation (DICGC) provides insurance coverage for 98% of deposit accounts, while the Federal Deposit Insurance Corporation (FDIC) only insures 38.4% to 66% of the deposits of the top 10 U.S. banks.

1. While U.S. banks remain hesitant to invest in the bond market, municipal securities are 25.1% of their total assets, while allocation to government securities is upwards of 26%.
2. The proportion of bank-held securities consisting of bonds that are anticipated to either be repriced or reach maturity in more than 15 years is 33.7%.

In comparison, Indian banks do not hold a majority of their assets in the form of bonds. Loans constitute >50% of their total assets, and their profitability is less affected by fluctuations in bond prices. Despite significant loan exposure, major Indian banks have continuously achieved high net interest margins (NIM) of 3.28%, with efficient investment practices. 4 Whereas, the net interest margin rates of U.S. banks have dropped to 2.8%. 5 The disparity highlights the contrasting positions of the Indian and U.S. banking systems with their exposure to bonds and ability to navigate challenging financial circumstances.

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Non Performing Assets

While the U.S. Non-Performing Loans Ratio is expected to increase from 1.2% in December 2022, Indian banks have steadily improved their asset quality with declining gross non-performing assets (NPAs) and increasing provision coverage ratios (PCR). Their strong funding and liquidity position safeguards them against potential losses on bond investments, underscoring their resilience in uncertain times. Indian banks’ gross non-performing assets (NPAs) are expected to reach a decade-low of 4% by March 2024, down from a peak of 11.5% in March 2018.

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Mark-to-Market Losses

MTM (Mark-to-Market) valuation provides a real-time snapshot of a bank’s balance sheet by valuing securities based on their current market prices rather than their original purchase prices. The presence of rules for mark-to-market (MTM) in India’s banking system ensures transparency and accountability. Indian banks are subject to quarterly and monthly MTM valuation for AVS and HTM securities.

MTM valuation provides an accurate and timely view of a bank’s financial position by valuing securities based on current market prices, allowing for informed decision-making and effective risk management.

Interestingly, in the case of SVB, the events leading to the downfall were known to all stakeholders; even the mark-to-market losses were disclosed to the board and regulators. However, stakeholders regarded these losses as merely theoretical, failing to perceive them as a threat to the bank’s stability. Neither liquidity-coverage mandates nor stress-test metrics raised alarms. It was business as usual until the sudden storm of deposit withdrawals occurred.

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Takeaways

RBI’s policies and regulations ensure the resilience of the Indian financial system through risk assessment, capital buffers, and audits. Effective risk management practices protect investments and minimize losses. Policymakers are prepared for potential spillover effects from the U.S. banking crisis, future-proofing India’s financial system. With measures addressing bad debts, improving capital ratios, and enhancing liquidity, Indian banks have fortified their foundations. This positions them as stable and robust pillars for investments in a secure environment.

Inri, backed by Y Combinator, is an investment platform dedicated to NRIs & OCIs to invest in Indian markets. Inri is like Wealthfront for India, making investing in India fast and hassle-free.

This article does not provide any investment advice. Please consult your financial advisor before investing.