Kotak Mahindra Bank

Dear Shareholder
 
 It was the worst of times and it was the worst of times.
 
 That sums up a year when everything that could possibly go wrong, did
 go wrong.  The world reeled under the collective assault of a financial
 market contagion, a flu epidemic, corporate fraud and the new reality
 of terrorist attacks. Nothing was more certain than uncertainty.
 
 But it was not all dark clouds. The silver lining was represented by
 landmark elections in the worlds two greatest democracies: voters in
 the USA opted for a harbinger of change and we, the people of India,
 voted decisively for stability and steady reform.
 
 In my letter of last year, I had written that global financial
 institutions have become money juggernauts with excessive leverage,
 where proprietary trading, in many cases, far outstrips client
 businesses.
 
 Over one eventful month last year, Lehman Brothers folded, Merrill was
 acquired by Bank of America; and Goldman Sachs and Morgan Stanley
 converted themselves into commercial banks.
 
 The banking landscape has undergone a sea change and I believe the bank
 of the future will have three distinguishing qualities: simplicity,
 humility and less leverage.
 
 India At A Tipping Point
 
 After the UPA government swept the polls in the most decisive Indian
 election since the early nineties, I penned a piece for The Economic
 Times, parts of which bear repeating and are reproduced here:
 
 This is a proud moment for Indian democracy and a historic opportunity
 for India to lead the world. Mr Manmohan Singh and his new government
 are at a turning point in world history. In terms of priorities, the
 agenda for the new government should comprise reviving growth in a
 steady manner, building infrastructure, further strengthening the
 financial sector, reinforcing civil institutions and uprooting
 corruption from Indian society. These initiatives will have to be done
 in the backdrop of ensuring fiscal stability in a very adverse global
 situation.
 
 The new government has the opportunity to unshackle itself from the
 baggage which the Indian system has carried: to make India a very open
 and responsible society where merit is rewarded and cronyism is
 demolished. The pillars of civil society — whether it is the judiciary,
 the police, educational institutions, or the tax and the revenue
 administration — have come under increasing pressure as institutions.
 We need to transform and strengthen each of these institutions of civil
 society to build India for the next 100 years.
 
 In the financial sector, our prudence over the last five years has held
 us in good stead.  Let us now consolidate our gains, take appropriate
 steps of reform, based on our convictions and not necessarily on dogmas
 of Western financial systems. In particular, we need to spread Indian
 banking and insurance to every nook and corner of our country. We must
 develop modern day debt markets with all the checks and balances.  The
 exchange traded mechanisms across equity, debt, commodities, currencies
 and interest rates must be given wings to make India, and Mumbai in
 particular, a national and an international financial centre.
 
 Infrastructure is our primary need and in the next five years true B
 ha rat Nirman must take place. Roads, ports, airports, power, access
 to clean water are our priority. 
 
 The Lessons Of History
 
 On the first day of every calendar year, I write a note to all
 employees at Kotak. In my letter of 1st January 2008,1 had cautioned
 against irrational exuberance, going so far as to say that the capital
 markets had witnessed turmoil in 1992 and in 2000, and since crises are
 cyclical and markets seemed to be overheating, caution was the order of
 the day.
 
 We were a young NBFC in 1992 but we already had a culture of
 conservatism that is not normally associated with the heady flush of
 youth. This very conservatism stood us in good stead during the NBFC
 debacle of 1996 when over 95% of NBFCs went out of business on the back
 of indiscriminate lending.
 
 When the tech boom rolled in at the turn of the century, venture
 capital was a fashionable business to be in but we chose to steer clear
 of the dotcom rainbow as the pot of gold was notional and elusive.
 
 Most of our senior management has been with the company through the
 aforementioned crises and has the instinctive ability to hunker down
 and navigate a crisis. But there is another instinct we value as highly
 if not more: the ability to anticipate and pre-empt a crisis thereby
 limiting the extent of damage.
 
 No business is immune to the effects of a financial crisis that has
 been ranked at par with the Great Depression of the 1930s. But here is
 how we have so far negotiated the choppy waters and rough weather.
 
 Protect The Balance Sheet, P&L Can Wait Unsecured lending: Let me start
 with retail lending, a business we have been in since over two decades.
 It is a business that has traditionally grown at 35-40% year-on-year.
 As of March 2008, we had notched up 40% growth over the previous year.
 Even in 2008-09, if you look at the first half, we were growing at a
 little over 20% (the growth in the first quarter was even higher).  But
 the figure for the year ended March 2009 stands at 8%.
 
 The slowdown is not because of fewer applications. We anticipated
 turmoil and decided to slow down on lending. We took a call that it was
 time to be cautious. Mind you, this was a time when you could pick and
 choose borrowers and lend at the rate you want. And though we could
 push interest rates, we took a call not to lend as it would potentially
 create a problem later.  This was not a time to blindly chase yields,
 it was a time to protect ones balance sheet. If you only chase P&L at
 a time like this, you could end up with a problem on your balance
 sheet.
 
 For a financial institution, the most important thing is reputation.
 But immediately after reputation comes protection of capital. The area
 where you can lose a lot of capital, aside from exotic structured
 products, is in the lending space.
 
 We began with cutting down on unsecured personal loans since the
 fastest drop in credit quality was happening in small-ticket loans.
 Despite that, we had our share of problems with collections. But an
 early call helped limit the extent of damage.
 
 In 2007, when we got into the business of unsecured personal loans,
 there were large players lending money at 35%+ and the market was
 throwing up huge growth numbers across the gamut of NBFCs, private
 banks and foreign banks. Rather than step up lending, the business head
 took a call that we should complete one cycle from lending to
 collection, see the pattern and then take a call. That approach held us
 in good stead.
 
 Which brings me to Kotak Credit Cards. As a bank, this was the missing
 piece in our product suite. We launched credit cards in April 2008 with
 an initial target of 350,000 cards. Of course, we were quick to realize
 this is an area where people are not paying and so we slowed down
 dramatically to end the year with just over 100,000 cards.
 
 We took a call to discontinue outsourced acquisition and only source
 customers through internal sources or referrals. Ours woes are not as
 bad as the rest of the industrys (credit cards are less than 1 % of
 our book) but there were problems and some valuable lessons learned
 early on.
 
 Agri business: One area we have not shied away from lending is the
 agricultural sector.  The net interest margin is good, the
 delinquencies low and the segment is holding up very well even in this
 economic environment.
 
 Corporate lending: Since a lot of the problems in the lending business
 stemmed from the retail end, we placed a greater focus on lending to
 corporate clients. There was a time when retail lending made up 89% of
 our book. Today, that number is 80%. The number will not fall
 dramatically as the term is three years but on an incremental basis,
 corporate lending is much higher.
 
 Among small and medium corporates, we chose to work with companies that
 have a track record for raising capital. And among larger corporates,
 we worked with large companies (most of whom had raised money at
 attractive rates from overseas markets) and PSUs.
 
 In this segment, the yield is lower but the customer profile is in
 keeping with our emphasis on protecting the balance sheet.  Besides,
 what we may lose in yield is made up through growing the corporate
 banking relationship as clients count on us for transaction flows, LCs,
 guarantees, pay orders, DDs, transaction fees and so on. In many cases,
 we go on to sign up salary accounts, which helps build depositors.
 
 Secured lending: Lets start with commercial vehicles and construction
 equipment: April to September 2008 saw the commercial vehicle segment
 chugging along. October to December 2008 witnessed an alarming drop in
 business and the largest spike in NPAs. The scare was, if this trend
 continued for two more quarters, there would be a glut of bad loans.
 
 Fortunately, things picked up in the last quarter. Im not saying there
 are no more bad loans but the trend is vastly reduced.
 
 As far as construction equipment goes, we were focused on large,
 reputed players with secured contracts.
 
 Car finance was not much of a problem area. October to December 2008
 was slow and registered negative numbers. But the last quarter saw very
 strong numbers and delinquency was reasonably contained.
 
 Home finance held steady, we grew the book (advances were Rs 3,166.42
 crore as of 31st March 2009), underwriting is stricter and
 delinquencies are low given that most home loans are consumed by
 residents (as opposed to investors).
 
 Beyond Conventional Statistics
 
 Like I said earlier, no one has been spared the ramifications of last
 years global crisis.  The damage was universal, only the extent of
 damage varied. Here are a few key learnings in the lending space:
 
 1) Parameterized credit and conventional statistics are not a
 substitute for having your ear to the ground. For instance, regular
 parameters will not tell you people are losing jobs. You need to have
 signals in place. You may rate a customer on todays credit score but
 he may borrow from three other lenders so that score needs careful
 watching.
 
 2) Once you recognize there is a problem, accept the borrower is an NPA
 and take him on your books. Any form of procrastination will only serve
 to compound the problem.
 
 3) In late 2007, a lot of banks, including us, had a problem with FX
 derivatives. Around October 2007, we took a call that we would stop
 derivatives. A number of other banks realized there was a problem only
 around late January, early February.  By taking an early call, we were
 able to limit our losses.
 
 Branch banking: Our initial target was to touch 260 plus branches by
 the end of the year. The eventual number was 217. We initially slowed
 down since rentals were falling really fast and we wanted to get better
 rates considering most branch leases are typically signed for nine-year
 periods.  The slowdown call then continued due to the economic climate.
 
 While we will continue to grow our branch network, it is worth noting
 that 16% of our customers actively use the online banking channel. In a
 young country, this number will only increase and we will relentlessly
 work to make this channel simpler and more secure to use.
 
 While income from equity mutual funds was affected, it was partly
 compensated by income from debt funds (Rs 44 billion) and new life
 insurance premium collection (Rs 2.6 billion). Non-Resident and TASC
 (trusts, associations, societies, cooperatives) business grew as did
 the corporate salary book.
 
 During the year, we crossed the 1-million mark in customer deposits.
 
 Wholesale banking: In keeping with our focus on corporate business, 200
 new clients were added during the year. In October 2008, when liquidity
 was rapidly drying up, we were one of the few banks that were lending
 money, and we took the opportunity to initiate and expand
 relationships. Going forward, we will bring increased product emphasis
 particularly on transaction banking, debt capital markets, working
 capital products, and supply-chain initiatives.
 
 Life insurance: Kotak Life Insurance grew new business at 25%, which is
 significantly higher than the growth in the private sector. Capital
 deployed per rupee of premium stands at 0.43, among the lowest in the
 industry. Going forward, we see slower growth on the back of economic
 developments in the last year; equally, we foresee no capital infusion
 in FY 2010.
 
 Kotak Life reported a profit for the year but, more importantly,
 renewal premium is closer to first-year premium and the bancassurance
 model is very strong (28% of the individual premium came through Kotak
 group distribution channels).
 
 Broking and investment banking: Kotak Securities and Kotak Investment
 Banking were expectedly the worst hit by the downturn in capital
 markets. However, we occupy leadership positions in both businesses and
 the focus was on hunkering down through the downturn while protecting
 the franchise in readiness for the upturn.
 
 After prolonged crises, markets are known to make a V-turn so it is
 important to prepare for the upswing. Witness the 2,111-point gain on
 18th May after the election results delivered a decisive mandate in
 favor of political and economic stability. While this is clearly as
 much of a black swan event (albeit a positive one) as the election
 results that caused it, it demonstrates the mercurial nature of the
 market and the need to be equipped for its peaks and troughs
 
 Asset Management: Over .7 billion of assets are managed / advised
 through mutual funds, insurance, portfolio management and offshore
 funds (including alternate assets).
 
 Kotak Mutual Fund crossed two milestones (Rs250 billion AUM and 1
 million investors) and was ranked 5th in the private sector.
 
 Alternate assets (private equity and realty fund) have total
 commitments of .3 billion.
 
 And our international subsidiaries manage / advise equity assets to the
 tune of  billion (including an Australian listed fund, SICAV fund and
 a Shariah-compliant fund).
 
 People Power
 
 The Hewitt Best Employer Survey 2009 ranks Kotak Mahindra Bank number
 19.  We are the only bank in the top 20.
 
 Among the many awards, rankings and distinctions we have earned, (last
 years list is detailed on the Year at a glance page later in this
 report) the ones for best employer and best workplace are possibly
 closest to my heart since they reflect our people culture.
 
 Technology and infrastructure are very important and we continue to
 invest in these areas but at the end of the day, technology and
 infrastructure are enablers and tools. In a scenario where everyone has
 the same technology and infrastructure, it is the people who make the
 difference.
 
 I have already shared with you in this report, and in earlier reports,
 how our key people know what it takes to navigate a downturn and
 prepare for an ensuing upturn. And how our culture is one of
 conservatism and professional entrepreneurship, one that draws and
 retains people who can start, nurture and grow businesses
 
 At the time of this writing, all indications are the worst is over for
 India. As for Kotak, whether it is our ability to manage the downside
 or our capacity to capture the upside, the point is we are in a state
 of preparedness (group capital adequacy is at 23%).
 
 I would like to reinforce the uniqueness of our business model.
 Banking, insurance and asset management provide a steady stream of
 growing annuity base. Businesses like broking and investment banking
 are more cyclical in nature and have the ability to capture upside when
 the economy and markets recover. Our strategic goal is to minimize
 downside while capturing the upside.
 
 In sum, it is a business model that works towards lower risk while
 retaining the ability to provide high returns. Verily a business for
 all seasons.
 
 Uday Kotak
 
 Executive Vice Chairman and Managing Director