AMRITA SCHOOL OF BUSINESS

Recent Banking Developments

in India
Commercial Bank Management – Assignment

Prepared By

Hariom Singh
09016
India evolve from a moderately growing traditional economy to one of the
fastest growing economies of the world in the past decade—a period of rapid
growth and transformation. Our GDP has grown by over 8 per cent in fiscal
2004 and by around 7 per cent in the first half of fiscal 2005. The
composition of the GDP has also changed significantly, with services now
contributing about 56 per cent of the total. With such robust growth trends,
the services sector has emerged as a key growth driver of the economy.

Another key development over the past decade has been the favourable shift
in India's consumer demographics. The number of households earning over
Rs 80,000 a year has increased from 40 million in 1996 to about 60 million in
2005. Parallelly, household incomes have also increased substantially.
NCAER data for the top 24 cities in India shows migration to higher income
levels at over 40 per cent per annum. At 70 per cent, India has the highest
proportion of population below 35 years of age. The Indian population also
has a large working class (58 per cent). These are the figures that have
paved the way for the robust retail credit growth in India.

The banking sector has capitalised on these positive economic developments

and has experienced rapid growth over the decade—and even higher over
the past five years. Total credit has grown at a compounded average annual
rate of about 16 per cent since fiscal 2000. While retail credit has grown by
over 40 per cent a year in the past five years, deposits have also recorded a
robust average growth rate of about 16 per cent a year. But despite such
fast growth, the sector has not compromised on asset quality. At about four
per cent of GDP, the gross NPA level of the Indian financial services sector is
one of the lowest in the world. Net NPAs of the Indian retail credit segment
are even lower at about 1.6 per cent, according to the RBI.

With the emergence of universal banking in the late 1990s, the boundaries
between the roles played by banks, institutions and various financial
intermediaries have blurred. Banks have expanded their product portfolio to
offer a wide variety of innovative products and services over and above their
traditional offerings. Technology has, of course, played a vital role in this.
Today, large players offer the full range of financial services including
banking, investment banking, mutual funds, insurance products and private
equity. Banks have introduced doorstep delivery to customers through
agency networks, thus improving customer convenience. Less expensive and
more convenient electronic channels such as ATMs, internet, mobile and
phone banking are fast replacing the traditional branch banking channel.

The globalisation of Indian companies has resulted in several international

banking opportunities. Indian banks are now focusing more and more on
building international operations to cater to the cross-border needs of their
clients and to leverage on their domestic strengths to offer products all over
the world. The significant NRI and PIO (persons of Indian origin) presence
across various geographies has also been a good market for Indian banks
and their products. The robust growth trends in retail to continue, given the
favourable demographics and the low penetration levels.

In spite of growing at about 40 per cent annually, retail credit still remains a
sector of which only a little has been tapped. Consumer credit outstanding as
a percentage of GDP is at a low 8 per cent, as compared to over 30 per cent
for many of Southeast Asian peers. Retail growth will be driven by both
acquisition of new customers and increased penetration of products in the
existing customer base. In addition to volume growth, banks will also zoom in
on leveraging scale to reduce costs and improve operating margins.
Technology will continue to drive product and process innovation in retail
banking. The retail credit industry will also witness increased consolidation
activity, with most smaller non-banking players becoming sourcing agents
for the larger players.

Corporate banking too will see robust growth due to capacity additions in
several key sectors over the medium term. Estimate is that corporates will
invest over $45 billion in projects over the next 12-18 months. There will be
substantial changes in corporate banking over the next 10 years, with an
increasing shift to non-core products and greater focus on fee income,
because corporates will move beyond traditional bank borrowing and find
newer sources of fund-raising as the capital market deepens. Banks with the
ability to structure innovative products and offer customised solutions are
more likely to meet with success than banks with a traditional product focus.

There is robust growth in currently underpenetrated segments such as the

rural and small and medium enterprises (SME) segment. But banks would
need to complement growth in such areas with deep understanding of the
segments, innovative products and structures and effective and economical
distribution channels such as rural ATMs, robust processes and sound credit
practices. Banks would also need to combine corporate and retail
banking/lending practices to cater effectively to the SME segment.

In international banking, the focus of Indian banks shifting from mainly

leveraging on India linkages to leveraging on operating cost advantage and
developing product and distribution capabilities to become truly regional
(Asian) and subsequently global players. International banking would
increasingly contribute a significant portion of the total business of Indian
banks, with India emerging as a strong regional hub for banking and other
financial services. The growing income levels of the Indian population, results
in wealth management and private banking as significant emerging
opportunities, at both domestic and non-resident Indian levels. The right use
of technology improve the distribution capability of players and increase
consumer convenience, with greater use of emerging channels such as
mobile banking service and rural ATMs. Technology will also improve
payment and settlement systems of banks. Indian banks will increasingly
adopt best practices such as Six Sigma from the non-banking sector to
improve operating efficiencies and customer service levels as well as reduce
costs.

The next ten years may also welcome several leading international banks
into India. Though their increased presence will mean competitive pressures,
the leading Indian banks have developed the product capability and the
technological expertise to successfully compete. Further, Indian banks have
a competitive edge in terms of their strong distribution network.
The robust economic growth and relative under-penetration of financial
services will continue to drive financial sector growth. Boundaries between
various financial service providers and geographical boundaries will blur
further and banks with scale, technological capabilities, strong processes and
the ability to innovate will emerge as winners over the next 10 years.

Source: Outlook India

The Indian banking sector has witnessed wide ranging changes under the
influence of the financial sector reforms initiated during the early 1990s. The
emphasis has been on deregulation and opening up the banking sector to
market forces. The Reserve Bank has been consistently working towards the
establishment of an enabling regulatory framework with prompt and
effective supervision as well as the development of technological and
institutional infrastructure. The developments so far have brought the Indian
financial system closer to global standards.

Statutory Pre-emptions
In the pre-reforms phase, the Indian banking system operated with a high
level of statutory preemptions, in the form of both the Cash Reserve Ratio
(CRR) and the Statutory Liquidity Ratio (SLR). Efforts in the recent period
have been focused on lowering both the CRR and SLR. The statutory
minimum of 25 per cent for the SLR was reached as early as 1997, and while
the Reserve Bank continues to pursue its medium-term objective of reducing
the CRR to the statutory minimum level of 3.0 per cent, the CRR of the
Scheduled Commercial Banks (SCBs) is currently placed at 5.0 per cent of
NDTL (net demand and time liabilities). The legislative changes proposed by
the Government in the Union Budget, 2005-06 to remove the limits on the
SLR and CRR are expected to provide freedom to the Reserve Bank in the
conduct of monetary policy and also lend further flexibility to the banking
system in the deployment of resources.
Interest Rate Structure
Deregulation of interest rates has been one of the key features of financial
sector reforms. In recent years, it has improved the competitiveness of the
financial environment and strengthened the transmission mechanism of
monetary policy.
Interest rates have now been largely deregulated except in the case of: (i)
savings deposit accounts; (ii) non-resident Indian (NRI) deposits; (iii) small
loans up to Rs.2 lakh; and (iv) export credit. After the interest rate
deregulation, banks became free to determine their own lending interest
rates. As advised by the Indian Banks’ Association (a self-regulatory
organisation for banks), commercial banks determine their respective BPLRs
(benchmark prime lending rates) taking into consideration: (i) actual cost of
funds; (ii) operating expenses; and (iii) a minimum margin to cover
regulatory requirements of provisioning and capital charge and profit margin.
These factors differ from bank to bank and feed into the determination of
BPLR and spreads of banks. The BPLRs of public sector banks declined to
10.25-11.25 per cent in March 2005 from 10.25-11.50 per cent in March
2004. With a view to granting operational autonomy to public sector banks,
public ownership in these banks was reduced by allowing them to raise
capital from the equity market of up to 49 per cent of paid-up capital.
Recently, a roadmap for the presence of foreign banks in India was released
which sets out the process of the gradual opening-up of the banking sector in
a transparent manner. Foreign investments in the financial sector in the form
of Foreign Direct Investment (FDI) as well as portfolio investment have been
permitted. Furthermore, banks have been allowed to diversify product
portfolio and business activities. The share of public sector banks in the
banking business is going down, particularly in metropolitan areas.
Transparency and disclosure standards have been enhanced to meet
international standards in an ongoing manner.

Prudential Regulation
Prudential norms related to risk-weighted capital adequacy requirements,
accounting, income recognition, provisioning and exposure were introduced
in 1992 and gradually these norms have been brought up to international
standards. Other initiatives in the area of strengthening prudential norms
include measures to strengthen risk management through recognition of
different components of risk, assignment of risk-weights to various asset
classes, norms on connected lending and risk concentration, application of
the mark-to-market principle for investment portfolios and limits on
deployment of funds in sensitive activities. Keeping in view the Reserve
Bank’s goal to achieve consistency and harmony with international standards
and our approach to adopt these standards at a pace appropriate to our
context, it has been decided to migrate to Basel II. Basel II is the second of
the Basel Committee on Bank Supervision's recommendations, and unlike
the first accord, Basel I, where focus was mainly on credit risk, the purpose
of Basel II was to create standards and regulations on how much capital
financial institutions must have put aside. Banks need to put aside capital to
reduce the risks associated with its investing and lending practices. Banks
are required to maintain a minimum CRAR (capital to risk weighted assets
ratio) of 9 per cent on an ongoing basis. The capital requirements are
uniformly applied to all banks, including foreign banks operating in India, by
way of prudential guidelines on capital adequacy. Commercial banks in India
have started implementing Basel II with effect from March 31, 2007. They
initially adopted the Standardised Approach for credit risk and the Basic
Indicator Approach for operational risk. After adequate skills have been
developed, at both bank and supervisory level, some banks may be allowed
to migrate to the Internal Ratings-Based (IRB) Approach. Banks have also
been advised to formulate and operationalise the Capital Adequacy
Assessment Process (CAAP) as required under Pillar II of the New Framework.
Some of the other regulatory initiatives relevant to Basel II that have been
implemented by the Reserve Bank are:
1. Ensuring that banks have a suitable risk management framework
oriented towards their requirements and dictated by the size and
complexity of their business, risk philosophy, market perceptions and
expected level of capital.
2. Introducing Risk-Based Supervision (RBS) in select banks on a pilot
basis.
3. Encouraging banks to formalise their CAAP in alignment with their
business plan and performance budgeting system. This, together with
the adoption of RBS, should aid in fulfilling the Pillar II requirements
under Basel II.
4. Expanding the area of disclosures (Pillar III) so as to achieve greater
transparency regarding the financial position and risk profile of banks.
5. Building capacity to ensure the regulator’s ability to identify eligible
banks and permit them to adopt IRB/Advanced Measurement
approaches.
With a view to ensuring migration to Basel II in a non-disruptive manner, a
consultative and participative approach has been adopted for both designing
and implementing the New Framework. A Steering Committee comprising
senior officials from 14 banks (public, private and foreign) with
representation from the Indian Banks’ Association and the Reserve Bank has
been constituted. On the basis of recommendations of the Steering
Committee, draft guidelines on implementation of the New Capital Adequacy
Framework have been issued to banks. In order to assess the impact of Basel
II adoption in various jurisdictions and re-calibrate the proposals, the BCBS is
currently undertaking the Fifth Quantitative Impact Study (QIS 5). India will
be participating in the study, and has selected 11 banks which form a
representative sample for this purpose. These banks account for 51.20 per
cent of market share in terms of assets. They have been advised to
familiarise themselves with the QIS 5 requirements to enable them to
participate in the exercise effectively. The Reserve Bank is currently focusing
on the issue of recognition of the external rating agencies for use in the
Standardised Approach for credit risk. As a well-established risk
management system is a pre-requisite for implementation of advanced
approaches under the New Capital Adequacy Framework, banks were
required to examine the various options available under the Framework and
draw up a roadmap for migration to Basel II. The feedback received from
banks suggests that a few may be keen on implementing the advanced
approaches. However, not all are fully equipped to do so straightaway and
are, therefore, looking to migrate to the advanced approaches at a later
date. Basel II provides that banks should be allowed to adopt/migrate to
advanced approaches only with the specific approval of the supervisor, after
ensuring that they satisfy the minimum requirements specified in the
Framework, not only at the time of adoption/migration, but on a continuing
basis. Hence, banks desirous of adopting the advanced approaches must
perform a stringent assessment of their compliance with the minimum
requirements before they shift gears to migrate to these approaches.

Exposure Norms
The Reserve Bank has prescribed regulatory limits on banks’ exposure to
individual and group borrowers to avoid concentration of credit, and has
advised banks to fix limits on their exposure to specific industries or sectors
(real estate) to ensure better risk management. In addition, banks are also
required to observe certain statutory and regulatory limits in respect of their
exposures to capital markets.

Asset-Liability Management
In view of the growing need for banks to be able to identify, measure,
monitor and control risks, appropriate risk management guidelines have
been issued from time to time by the Reserve Bank, including guidelines on
Asset-Liability Management (ALM). These guidelines are intended to serve as
a benchmark for banks to establish an integrated risk management system.
However, banks can also develop their own systems compatible with type
and size of operations as well as risk perception and put in place a proper
system for covering the existing deficiencies and the requisite upgrading.
Detailed guidelines on the management of credit risk, market risk,
operational risk, etc. have also been issued to banks by the Reserve Bank.
The progress made by the banks is monitored on a quarterly basis. With
regard to risk management techniques, banks are at different stages of
drawing up a comprehensive credit rating system, undertaking a credit risk
assessment on a half yearly basis, pricing loans on the basis of risk rating,
adopting the Risk-Adjusted Return on Capital (RAROC) framework of pricing,
etc. Some banks stipulate a quantitative ceiling on aggregate exposures in
specified risk categories, analyse rating-wise distribution of borrowers in
various industries, etc.
In respect of market risk, almost all banks have an Asset-Liability
Management Committee. They have articulated market risk management
policies and procedures, and have undertaken studies of behavioral maturity
patterns of various components of on-/off-balance sheet items.

NPL Management
Banks have been provided with a menu of options for disposal/recovery of
NPLs (non- performing loans). Banks resolve/recover their NPLs through
compromise/one time settlement, filing of suits, Debt Recovery Tribunals,
the Lok Adalat (people’s court) forum, Corporate Debt Restructuring (CDR),
sale to securitisation/reconstruction companies and other banks or to non-
banking finance companies (NBFCs). The promulgation of the Securitisation
and Reconstruction of Financial Assets and Enforcement of Security Interest
(SARFAESI) Act, 2002 and its subsequent amendment have strengthened the
position of creditors. Another significant measure has been the setting-up of
the Credit Information Bureau for information sharing on defaulters and other
borrowers. The role of Credit Information Bureau of India Ltd. (CIBIL) in
improving the quality of credit analysis by financial institutions and banks
need hardly be overemphasised. With the enactment of the Credit
Information Companies (Regulation) Act, 2005, the legal framework has been
put in place to facilitate the full-fledged operationalisation of CIBIL and the
introduction of other credit bureaus.

Board for Financial Supervision (BFS)

An independent Board for Financial Supervision (BFS) under the aegis of the
Reserve Bank has been established as the apex supervisory authority for
commercial banks, financial institutions, urban banks and NBFCs. Significant
progress has been made in implementation of the Core Principles for
Effective Banking Supervision. The supervisory rating system under CAMELS
has been established, coupled with a move towards risk-based supervision.
Consolidated supervision of financial conglomerates has since been
introduced with bi-annual discussions with the financial conglomerates.
There have also been initiatives aimed at strengthening corporate
governance through enhanced due diligence on important shareholders, and
fit and proper tests for directors.
A scheme of Prompt Corrective Action (PCA) is in place for attending to banks
showing steady deterioration in financial health. Three financial indicators,
viz. capital to risk-weighted assets ratio (CRAR), net non-performing assets
(net NPA) and Return on Assets (RoA) have been identified with specific
threshold limits. When the indicators fall below the threshold level (CRAR,
RoA) or go above it (net NPAs), the PCA scheme envisages certain
structured/discretionary actions to be taken by the regulator.
The structured actions in the case of RoA falling below the trigger level may
include, among other things, restriction on accessing/renewing costly
deposits and CDs, a requirement to take steps to increase fee-based income
and to contain administrative expenses, not to enter new lines of business,
imposition of restrictions on borrowings from the inter-bank market, etc.
In the case of increasing net NPAs, structured actions will include, among
other things, undertaking a special drive to reduce the stock of NPAs and
containing the generation of fresh NPAs, reviewing the loan policy of the
bank, taking steps to upgrade credit appraisal skills and systems and to
strengthen follow-up of advances, including a loan review mechanism for
large loans, following up suit filed/decreed debts effectively, putting in place
proper credit risk management policies/processes/procedures/prudential
limits, reducing loan concentration, etc.
Discretionary action may include restrictions on capital expenditure,
expansion in staff, and increase of stake in subsidiaries. The Reserve
Bank/Government may take steps to change promoters/ ownership and may
even take steps to merge/amalgamate/liquidate the bank or impose a
moratorium on it if its position does not improve within an agreed period.

Technological Infrastructure
In recent years, the Reserve Bank has endeavoured to improve the efficiency
of the financial system by ensuring the presence of a safe, secure and
effective payment and settlement system. In the process, apart from
performing regulatory and oversight functions the Reserve Bank has also
played an important role in promoting the system’s functionality and
modernisation on an ongoing basis. The consolidation of the existing
payment systems revolves around strengthening computerised cheque
clearing, and expanding the reach of Electronic Clearing Services (ECS) and
Electronic Funds Transfer (EFT). The critical elements of the developmental
strategy are the opening of new clearing houses, interconnection of clearing
houses through the Indian Financial Network (INFINET) and the development
of a Real-Time Gross Settlement (RTGS) System, a Centralised Funds
Management System (CFMS), a Negotiated Dealing System (NDS) and the
Structured Financial Messaging System (SFMS). Similarly, integration of the
various payment products with the systems of individual banks has been
another thrust area.

An Assessment
These reform measures have had a major impact on the overall efficiency
and stability of the banking system in India. The dependence of the Indian
banking system on volatile liabilities to finance its assets is quite limited,
with the funding volatility ratio at -0.17 per cent as compared with a global
range of -0.17 to 0.11 per cent. The overall capital adequacy ratio of banks
at end-March 2005 was 12.8 per cent as against the regulatory requirement
of 9 per cent which itself is higher than the Basel norm of 8 per cent. The
capital adequacy ratio was broadly comparable with the global range. There
has been a marked improvement in asset quality with the percentage of
gross NPAs to gross advances for the banking system declining from 14.4 per
cent in 1998 to 5.2 per cent in 2005. Globally, the NPL ratio varies widely
from a low of 0.3 per cent to 3.0 per cent in developed economies, to over
10.0 per cent in several Latin American economies. The reform measures
have also resulted in an improvement in the profitability of banks. RoA rose
from 0.4 per cent in the year 1991-92 to 0.9 per cent in 2004-05.
Considering that, globally, RoA was in the range -1.2 to 6.2 per cent for
2004, Indian banks are well placed. The banking sector reforms have also
emphasised the need to review manpower resources and rationalise
requirements by drawing up a realistic plan so as to reduce operating cost
and improve profitability. The cost to income ratio of 0.5 per cent for Indian
banks compares favourably with the global range of 0.46 per cent to 0.68
per cent and vis-à-vis 0.48 per cent to 1.16 per cent for the world’s largest
banks.
In recent years, the Indian economy has been undergoing a phase of high
growth coupled with
internal and external stability characterised by price stability, fiscal
consolidation, overall balance of payments alignment, improvement in the
performance of financial institutions and stable financial market conditions
and the service sector taking an increasing share, enhanced
competitiveness, increased emphasis on infrastructure, improved market
microstructure, an enabling legislative environment and significant capital
inflows. This has provided the backdrop for a more sustained development of
financial markets and reform.

Source:
Vittaldas Leeladhar