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“Banking is fascinating. Not only does it provide the lifeblood of capitalism -- namely, credit -- but its history is uniquely coherent. Railroads, automobiles, telephones, airplanes, oil companies, and technology firms all came after banks” goes the saying. Banks have historically been a prime force of economic development. By providing loans banks help to support the growth and development of individuals and businesses.

India’s central bank claims that the banking sector in India is sufficiently capitalised and well-regulated. The financial and economic conditions in the country are far superior to any other country in the world. Credit, market and liquidity risk studies suggest that Indian banks are generally resilient and have withstood the global downturn well.

The Indian banking industry has witnessed the rollout of innovative banking models like payments and small finance banks. In recent years India has also focused on increasing its banking sector reach, through various schemes like the Pradhan Mantri Jan Dhan Yojana and Post payment banks. The government has consistently strived to promote financial inclusion through various initiatives targeted to bring the country’s under-banked population under the banking system.

The Indian banking system consists of 12 public sector banks, 21 private sector banks, 44 foreign banks, 12 Small finance banks. The Indian Fintech industry is estimated to be at $ 150 billion by 2025. India has the 3rd largest FinTech ecosystem globally. India is one of the fastest-growing Fintech markets in the world. There are currently more than 2,000 DPIIT-recognized Financial Technology (FinTech) businesses in India, and this number is rapidly increasing.

India aims to become a $5 trillion economy by the year 2024-25 – and for this purpose it needs to expand its infrastructure capabilities exponentially. To support its infrastructure growth, a healthy financial sector – in particular a healthy banking sector is needed. The growth of any economy largely depends on its banking sector (Liang & Reichert, 2006). An efficient banking system has to achieve three goals: profit, high-quality service to customers, and sufficient funds to lend to borrowers. Furthermore, a profitable banking sector also has more capacity to absorb shocks and provide relative stability to the economy. For this purpose, it is important to analyze the impact of bad loans on the performance of the banking sector.

Public sector banks earn record profits in 2023-24

The booming growth cycle and a continuous uptrend in financial algorithms have done wonder for India’s banking sector. Backed by a sharp earnings turnaround on asset quality improvements, robust margins and a strong credit growth, the combined net profits of 12 public sector banks (PSB) have zoomed to Rs. 141,203 crore in 2023-24 up by 35% from  Rs. 104, 649 crore in 2022-23.

Of the total profit of Rs.141,203 crore earned last year, market leader State Bank of India (SBI) alone contributed over 40%. SBI earned a profit of Rs. 61,077 crore; 22% more than the previous  year’s profit of Rs. 50,232 crore.

In percentage terms Punjab National Bank recorded the highest net profit growth of 228% to Rs. 8,245 crore, followed by Union Bank of India with a 62% rise to Rs. 13,649 crore and Central Bank of India with a 61% increase to Rs. 2,549 crore.

Three other banks have recorded a net profit growth of over 50% during the year. Bank of India recorded a net profit growth of 57% to Rs. 6,318 crore while the net profit of Bank of Maharashtra with a 56% rise went up to Rs. 4,055 crore and India Bank recorded a 53% improvement to Rs. 8,063 crore.

Punjab & Sind Bank was the only public sector bank out of 12 that reported a fall in profit last year – net profit dropped from Rs. 1,313 crore in 2022-23 to Rs.595 crore in 2023-24.

This doom-to-bloom story of the public sector banks cannot be termed as less than a miracle. Imagine, only six years ago in 2017-18, the aggregate net losses of the public sector banks were a staggering Rs.85.390 crore.

The question is: How did it happen? The success can largely be attributed to the initiatives and spate of reforms undertaken by the government. The government has implemented a comprehensive 4R strategy: Recognising NPAs transparently, Resolution and recovery, Recapitalising PSBs, and Reforms in the financial ecosystem.

As part of the strategy, the government infused an unprecedented Rs. 3,10,997 crore to recapitalise PSBs during the last five financial years -- from 2016-17 to 2020-21. The recapitalisation programme provided much-needed support to the PSBs and prevented the possibility of any default on their part.

The spectacular performance of the Indian banks is reflected in the sharp improvement in return on assets, a financial ratio that indicates how profitable a company is in relation to its total assets.. Corporate management, analysts, and investors use the return on assets ratio to determine how efficiently a company uses its resources to generate a profit.          

The return on assets of banks touched a 20-year high of 1.3% in 2023-24. It will appear healthier when compared with the long-term sectoral average of 0.75% over 20 years (average of 0.5% over the past 10 years).

Non-performing assets decline sharply

India’s financial system is bank dominated and, therefore, sound health of the banking system is important for preserving financial stability. Banks’ balance sheets are consistently improving, with multi-year low non-performing asset (NPA) ratios, higher provisioning, stronger capital positions and robust earnings. In turn, these developments are catalysing a broad-based and sustained credit expansion

The rising non-Performing Assets (NPAs) have emerged as a persistent and multifaceted challenge within India's banking sector. Non-performing assets have been a persistent and pressing concern within the Indian banking sector, casting a long shadow over the country's financial stability and economic growth. NPAs, also known as bad loans, are loans or advances extended by banks that have ceased to generate income due to borrowers' inability or unwillingness to repay them. The accumulation of NPAs has far-reaching implications, affecting not only the financial health of banks but also the broader economic landscape of India.

Banks have written off bad loans worth Rs.14.56 lakh crore in nine years, between 2014-15 and 2022-23, Out of the total Rs. 14,56,226 crore, written off loans of large industries and services stood at Rs. 7,40,968 crore. Scheduled Commercial Banks (SCBs) have recovered an aggregate amount of Rs 2,04,668 crore in written-off loans, including corporate loans, since April, 2014 and up to March, 2023.             

Digital payments drive digital economy

The Indian banking system has not only grown in size over the years but has also undergone a massive technological upgradation. The demonetization policy of the government had a significant impact on the country’s economy that accelerated the growth of digital payments in India.

Digital Banking gives one the luxury of freely accessing and performing all traditional banking activities 24*7 without having to personally go to a bank branch to get your work done.

The growth of digital ecosystem in India has been driven by a number of factors, including the government’s push towards digitalization, an increase in internet and smartphone penetration, and the rise of e-commerce.  This has led to a significant increase in the use of digital payment methods, such as mobile wallets, UPI, and card payments. 

The total digital payment transactions volume increased from 2,071 crore in 2017-18 to 13,462 crore in 2022-23 at a CAGR of 45%. During 2023-24, digital payments transactions reached 11,660 crore till 11.12.2023.                 

The digital transformation of financial services providers has led to the arrival of a number of new players that offer solutions such as robo-advisors, peer-to-peer (P2P) lending platforms and digital wealth management tools. These initiatives have been boosted by the open banking APIs that allow customers to seamlessly manage more than one account through digital self-service channels.

Fintech companies were among the first to introduce digital innovation in many areas such as payments, lending and money transfers. Many of these startups have now become major competitors with banks as they expand their services and customer bases. Banks are already partnering with fintech companies to bolster their own digital transformation initiatives and keep up with startups that are successfully disrupting the banking industry.

High credit growth powers economic growth

Amid concerns from the RBI about the slower pace of deposit growth than that of loans, a report by SBI Research said that incremental deposit growth at `61 trillion has exceeded incremental credit growth of ` 59 trillion since FY22.

“Thus, the myth of a flagging deposit growth appears as just a statistical myth with credit growth outpacing deposit growth being tom-tommed as a deceleration in deposit growth…,” the research report noted.

The concern occurred as credit growth surged by over 15% in fiscal 2023-24 over the previous yearagainst a deposit growth of 13%. India’s banking sector has seen remarkable growth in credit expansion in 2023-24, driven by strong demand across major segments. Bank credit growth accelerated from 15.4% year-on-year in May 2023 to an impressive 19.8% in May 2024. This broad-based expansion highlights the resilience of the Indian economy and the growing confidence among consumers and businesses alike.

Interestingly, the biggest surge in credit growth was contributed by personal loans, which outperformed all major segments with a 28.7% YoY increase. This was sharp increase in personal loans was primarily accounted for by the booming housing sector, which saw a massive 38.7% growth, alongside significant gains in vehicle loans (17.9% YoY) and other personal loans (19.3% YoY). These figures reflect a strong consumer-driven demand, indicative of a vibrant economy where individuals are increasingly seeking credit to meet their personal requirements.

The services sector also experienced robust growth, with credit expanding by 23.2% YoY. Within this, trade and Non-Banking Financial Companies (NBFCs) saw substantial gains, with YoY growth rates of 17.7% and 16% respectively. Despite a temporary moderation in credit offtake to the NBFC sector due to increased risk weights in October 2023, the recent uptick to a six-month high indicates a resurgence in demand for credit in this segment.

On the industrial front, credit growth reached an 18-month high of 9.4% YoY, marking a significant recovery in the sector. Micro and small enterprises, along with medium-sized enterprises, played a pivotal role, each recording a 15.5% YoY growth. Additionally, large enterprises saw their credit growth rise to 7.1% YoY, up from 4.7% the previous month. Key industries such as infrastructure, chemicals, textiles, and other manufacturing sectors contributed to this robust credit offtake, aligning with the positive trends observed in industrial production indices.

However, despite this growth, the share of industry in total bank credit has been declining since September 2022. This shift has been counterbalanced by increased allocations to personal loans and services, with agriculture maintaining a stable share of around 12.5%. The decline in industrial credit share can be attributed to large corporates deleveraging and shifting to bond markets, reflecting a strategic shift in their funding preferences.

The priority sector lending, particularly in agriculture, micro and small enterprises, and housing, has also seen significant growth, bolstered by the merger of HDFC and HDFC Bank (NS:HDBK) in July 2023. Meanwhile, the Credit to Deposit (C-D) ratio rose to 79.6, driven by faster credit growth relative to deposits

But while banks have been serving the country’s growth initiatives by providing timely funds, they are facing a lot of challenges to keep their own businesses in good place. One of the biggest challenges facing the banking industry is regulatory changes. Banks are subject to comply with various regulations, from anti-money laundering (AML) to data protection laws. But keeping up with these changes is a time-consuming and costly process, which impacts the profitability of banks.

As banks become more digitalised, they also become more vulnerable to cyber attacks. Cybersecurity risks are a major concern for the banking industry today and banks are compelled to invest heavily in cybersecurity solutions to protect their customers' data and prevent fraud. Many banks are partnering with cybersecurity firms to develop more robust security measures to protect customers’ interest. Banks are also investing in employee training programs to help them identify and prevent cyber attacks.

Another big challenge is the rise of fintech companies that is disrupting the traditional banking business. Fintech companies are often able to offer faster, cheaper, and more innovative services than traditional banks. This is forcing banks to adapt and compete by investing in their own technology and partnering with fintech companies to offer new services.