The Reserve Bank of India's (RBI) roadmap for the presence of foreign banks in India could, if actually implemented, herald a significant change in the competitive dynamics of Indian banking. The proposed roadmap envisages two distinct phases of change. The first phase, for which concrete details are awaited, allows foreign banks to establish a presence in India through the wholly owned subsidiary route and also opens up the market for acquisitions of weak banks that RBI deems appropriate for consolidation. The second and more encompassing phase is slated to begin, at the earliest, from April 2009, when foreign banks may be permitted to acquire controlling stakes in privately owned Indian banks-what could be called the precursor to open markets.

This discussion emphasises that, irrespective of open markets actually fructifying, local participants-both public and private sector banks, need to act with a sense of urgency-a sense of urgency that will drive them to look more actively at both organic and inorganic means to grow their businesses in an efficient manner. The possibility of open markets in 2009 should act as a catalyst to encourage local banks to shape up. For the foreign bank, of course, open markets imply a completely new avenue of inorganic growth and it thereby assumes greater significance. This discussion focusses on the strategic process that banks need to adopt to prepare for the changing competitive dynamics in the years ahead-irrespective of when and whether markets actually open up.

A catalyst and a possible inflection point?

On the face of it, the road map appears to deal with, what is now a very small component of the Indian banking industry-foreign banks. However, the impact that this possible opening up could have on the entire banking landscape is significant. Should the regulator permit and should industry participants, particularly public and private sector banks, choose to make the best of the time they have, 2009 could turn out to be an inflection point for the industry-creating a more vibrant financial services industry that in turn has a downstream effect on the Indian economy. Open markets 2009 impacts the industry on two fronts:

External - Consolidation: Changes in the landscape due to mergers & acquisitions being undertaken across the industry; and

Internal - Markets and efficiencies: Shaping up of banks, internally with respect to target markets & customers, business models and operations.

An important point to remember is that for majority of the participants, the private and public sector banks, the above does not need Open Markets 2009 to happen. However, just the possibility of markets opening up, would act as a catalyst for these participants to evaluate their strategies and build the required capabilities. The preparation that is done by each player-public, private or foreign, prior to this point as well as competitive dynamics that follow will drive the growth of the industry and also determine the success of individual players over the longer term.

The drivers

It is important to note that the proposed opening up of markets in 2009 would be undertaken by RBI, post a host of considerations that include the experience in the first phase upto 2009. It would therefore, be important to assess if it would be realistic to expect that reforms would actually be undertaken. Let's look at it quite simply from what can be termed as, the 'demand and supply' for a change in the competitive landscape:

Supply perspective: What considerations drive the regulator? Are there any sufficient reasons for the regulator to consider opening up the market?

Demand perspective: Are there compelling reasons for global/foreign banks to look aggressively at the Indian market?

Supply side drivers

Let's first take a look at the supply perspective-what regulatory drivers could initiate an opening up of markets? Here we look only at a few of the drivers that would influence the opening up of markets. There are drivers that would also deter/hinder the opening of markets, but that is not the focus of this discussion. The enabling supply side drivers include:

• Minimising systemic risk: A healthy and robust financial system with adequate capital to support growth and manage risk. For instance, the regulator is keen for all banks to have a capital base of Rs 300 crore going forward and many old private sector banks don't meet these requirements.

• Implication for open markets: A requirement of capital for both risk and growth that can also come from foreign investments into the sector.

• Increasing banking penetration: Increasing the penetration of banking products and services in geographies and customer segments that are under-penetrated. India may have more than 90 scheduled commercial banks with nearly 70,000 branches, but this does not indicate the penetration of banking services. As per some estimates, with just around 250 million accounts for more than a billion people, without factoring multiple accounts with a single individual, the banking sector is clearly under-penetrated. There is a need to bring more people and businesses under the organised financing umbrella.

• Implication for open markets: A need for increased competition and larger banks that have the capital to invest, scale up and expand operations. Also, the presence of foreign banks would indirectly drive local banks to look at expansion and entrenchment in those geographies that foreign banks would not be easily able to reach out to in the years prior to open markets.

• Sophistication of the banking industry: Increased sophistication of products and services and the incorporation of good practices. If India or its financial hub Mumbai is to emerge as a regional financial centre, it must be well integrated with global financial markets and its participants should incorporate world-class processes and capabilities.

Implication for open markets: The presence of well developed foreign banks would definitely drive the introduction of world class practices and capabilities that they would bring to the industry. Their influence on the industry in this context is at present very small due to the limited reach that they currently have in India.

Additionally, the above are only internal drivers-there are external drivers such as increased integration with global financial markets as well as international pressure for the same.

Demand side drivers

To understand demand side drivers, let us look at the example of China. Just five years back, China's banks were not considered in good fiscal shape, with significant non performing loans and being hampered by bureaucracy. However, the situation from an attractiveness point of view has turned on its head. Investments last year, in Chinese banks by global financial services players have been rather significant-Global banks and investors that include players such as Bank of America, Citigroup, Temasek, HSBC, Goldman Sachs and American Express have invested an aggregate of $15-20 billion into Chinese financial institutions. The important point to note is that even these significant investments do not provide these foreign banks with control. With stakes of just ~ 5-10 per cent and limited board presence, these investors have little say in matters of strategy or structure.

Compare this with the potential that the Indian market has to offer. The Indian financial system is in much more robust shape than the Chinese. It may be significantly smaller in size but the retail market is still significant compared to other countries. The returns in the Indian market are also considered more attractive than those in the Chinese market. More importantly, foreign banks will be able to own 74 per cent of a local bank-providing them with the required management control to steer strategy. India may not be as big a market as China but the potential avenues for growth, better returns as well as strategic control would make India a very attractive market when it opens up.

The pointers towards the direction the industry is likely to gravitate over a period of time are clear. There may be a question mark on the timeframe for the opening up of the market, but not on its eventuality.

Banking Buzz: As competition intensifies, players will have to carefully weigh their strategies

An opportunity

The connotations of open markets for each of the banking groups (public sector, private sector and foreign banks), is quite different. Even within a banking group, views differ depending on the financial and market position that the particular bank finds itself in. For example, within the public sector group, some banks could view this as an opportunity to put as much ground between themselves and foreign banks. Others may view this with apprehension as they would be vulnerable takeover targets. Some others even see this as a chance to grow inorganically through alliances/mergers. To the foreign banks, of course, this would be an opportunity to establish a significant foothold in the Indian market-a means to get instant access to geographies and customers through acquisitions.

All banks, particularly public and private sector banks have a choice before them-use the time frame before open markets to prepare for the coming change or remain unprepared and vulnerable to the changes ahead. For banks that make the most of the next three years in building capabilities and reshaping themselves both organically and inorganically (feasible in the case of private and public sector banks), 2009 could be an inflection point that will see them in a much stronger position in a possibly changed world. For banks that fail to make use of this opportunity and progress in a reactive manner, 2009 onwards could see a weakening of their relative competitiveness. What each bank makes of this opportunity depends on how they view 2009 and prepare for the run-up to open markets.

Strategies for a changing world

The question then is, how should banks prepare for change? The strategy each player should adopt would depend on the unique positioning that the player finds itself in. What is needed is for each player to adopt a structured approach towards assessing the implications of changes in the landscape and preparing for what may lie ahead.

The first step would be for each participant in the industry to assess its position along specific dimensions. There are five key dimensions that banks should carefully assess themselves on.

These dimensions include:

Markets

• Positioning with respect to the products and services within its portfolio; its target segments; penetration and reach in terms of geography.

• For example, with a strong retail presence and significant reach through branches in smaller towns and cities, large public sector banks are likely to be concerned with protecting their competitive advantage and cementing relationships with the customer segment in this geography. These markets may prove to be the next frontier of growth as reach acquires importance and penetration in tier 2 and 3 towns increases. On the other hand, with restrictions on their ability to expand, foreign banks may focus on strategies to increase their penetration in areas they are already present-other parts of the portfolio can be grown through acquisitions in 2009.

Capability

• To be effectively executed, strategy must be supported by internal capabilities that include technology, efficient processes, enabling structure and capable human resources. Banks would need to assess their positioning on these internal capabilities as they drive operational efficiencies that determine their competitiveness in the marketplace.

• For example, public sector banks and old private sector banks are likely to be focussed on ensuring that appropriate processes are in place-supporting innovation in product structuring and efficiency in delivery. Foreign banks would need to ensure that they are well integrated with their global operations-best practices and processes need to be in place and imbibed internally before they expand their operations through acquisitions.

Fiscal

• It would be important to assess the fiscal health the bank is currently in-Is there adequate capital from a regulatory perspective? Are there profitability concerns? Is there adequate capital for growth?

• While weak public and private sector banks would need to assess the availability of adequate capital from risk and regulatory requirements, the strong private sector banks would be concerned about infusion of capital to support aggressive growth plans.

Strategic

• Strategic aspirations of the bank are also an important dimension-ultimately growth has to be linked to risk appetite of the bank. For instance, some foreign banks may not have the risk appetite to look at expanding inorganically into less penetrated geographies.

Competition

• The above four dimensions are internal to a bank. However, in a situation where consolidation rules, competitive dynamics can change, quite literally, with a signature on the dotted line. Competitive movements can set back all the planning done, if strategies by key competitors are not factored in.

Assessing one's position on these dimensions will enable a bank to understand its relative competitiveness. The choice then some banks would need to make is-do they aggressively grow the business through organic means and inorganic acquisitions or do they merge with larger players for survival-predator or prey?

Open markets should not be perceived as just an opportunity for foreign players to acquire Indian banks

Complementary strategies & resource allocation

Next would be to understand where the bank wishes to position itself in the future. This would involve articulating the desired vision in terms of growth, customer segments, products & services and relative market share.

However, as mentioned earlier, the 2009 scenario adds a new perspective that would drive vision-banks would also need to consider the impact of potential competitive movements. For instance, the strategic aspiration of a private sector bank to grow its market share could be significantly impacted by the merger of a key private sector competitor with a public sector bank. The merger would enable its key competitor to leverage its technology platform to reach out to the larger umbrella of customers of the public sector bank. Similarly, alliances with players operating in other financial services spaces, such as insurance and asset management, would give competitive advantages in terms of product portfolio as well as distribution efficiencies to competitors.

The question that the bank in question would need to ask is whether the competitor's action could significantly impact them and would they prefer to act faster? Strategies may therefore involve targeting markets that are difficult to penetrate for other bank groups or taking pre-emptive action in existing markets that may be targeted by new entrants. An example of the former is that of public sector banks tying up with micro finance institutions as well as expanding their presence in smaller towns. An example of the latter is State Bank of India's (SBI) advertising campaign that seeks to educate Indian consumers on the products and services offered by the bank. The communication attempts to emphasise SBI's innovativeness and service quality-areas that are normally considered to be the characteristics of private sector and foreign banks.

The desired positioning that the player wishes to reach over, say, the next five years, would then need to be translated into a strategic action plan. However, given the potential for consolidation in 2009, this plan would need to have two components-organic and inorganic, both of which need to be complementary to each other. This means that each plan should focus on building those capabilities and strengths that the other cannot facilitate.

An inorganic strategic plan would only be actionable for foreign banks post 2009, when such activities would be feasible. However, public and private sector banks can and should look towards complimentary inorganic strategies from day one. Irrespective of open markets actually fructifying in 2009, they would need to add an inorganic dimension to their strategies-actively looking at mergers and acquisitions that build capabilities, grow business and increase shareholder value. Failure to incorporate this component of strategy would only mean a rude shock when markets open up and competitive dynamics change. For the public and private sector banks, the interim period is a golden opportunity to move a step ahead in the race.

In the three years to the run-up to 2009, for foreign banks, it would be the organic strategy that would set the foundations for growth. The bank's existing organic strategy would need to focus on complementary assets and capabilities, keeping in mind that the rest of the portfolio could possibly be completed through acquisitions. A distinct advantage of such an approach is that management attention and economic resources are invested in focussed areas such as specific target segments or internal capabilities. However the most evident disadvantage is the uncertainty associated-the opening up of the sector, the nature of players available for alliances and willingness of players to consolidate. Having said that, given that resources are always scarce, it would be better for foreign banks to adopt the combination of a two-phased organic and inorganic strategy.

In conclusion

Russell Parera is Head, Financial Services and Anand Giridhar is a Manager, Advisory Services with KPMG in India. The views expressed in the article are the personal views of the authors and do not reflect the views of KPMG

Open markets should not be perceived as just an opportunity for foreign players to acquire Indian banks. The inevitability of an inorganic component of strategy would need to be accepted by public sector and private sector players. Today each of the banking groups-new private, old private, public and foreign-has a certain profile, which in turn causes distinctions between the groups. Over the long term, as markets open up and cross investments and mergers are undertaken, these distinctions between banking groups would blur. Open markets 2009 is an opportunity for all players to shape up and prepare for the growth that is likely to come from increased competition. It is important to note that this actually does not need 2009 to occur-however, irrespective of when markets open up, 2009 will only act as a catalyst to drive home the urgency to achieve scale and efficiencies.

The bank that makes the most of the next three years and is best prepared for the changed landscape that could emerge five years hence would emerge on top. Hopefully, open markets 2009 will be the catalyst for action-bringing in a transformational phase, with players shaping up to make the most of growth to come. .