Unnati - Banking Financial Services & Insurance - 2018

UNNATI INVESTMENT MANAGEMENT AND RESEARCH GROUP
UNNATI
SECTOR
REPORT
BANKING FINANCIAL SERVICES & INSURANCE
2018-19
Mohit Kumar | Rohit Agarwal

Banking, Financial Services and Insurance
Table of Contents
Executive Summary 8
The Macroeconomic Frontier 8
Banking 12
What is a bank? 12
How does a Bank Function? 12
What is the role of the banks? 13
What are the benefits of Intermediation? 13
Role of a bank in the economy 13
Functions of a Bank 14
How do banks minimize risk? 14
The Indian Banking System 15
A.Evolution 15
B.Structure 17
Commercial banks 17
SBI and its associates 19
Nationalized Public Banks 20
Regional Rural Banks 20
Private Sector Banks 21
Foreign Banks 21
Small Banks 22
Specialized Banks 23
Institutional Banks 23
NBFCs 23
Co-operative banks 23
Payment Banks 24
India Post Payments Bank launched 27
C.Emerging trends 28
D.Analysis of Banking Sector 29
Reserve Bank of India 29
NDTL (Net Demand and Time Liabilities) 31
Unnati Sector Report 2018-19 | 1

Cash Reserve Ratio (CRR) 31

Statutory Liquidity Ratio (SLR) 31
Why do banks need to maintain both CRR and SLR? 32
Repo Rate 32
Reverse Repo Rate 33
Bank Rate 33
Difference between Bank Rate and Repo Rate 33
LAF functioning 33
Marginal Standing Facility 34
Narrowing Interest rate corridor between the Repo and Reverse Repo rate in India 35
Interest Rate Corridor in India 35
Shift of Base rate to Marginal Cost of Lending Rate 36
RBI’s key guidelines on MCLR 39
Open Market Operations (OMO) 40
BASEL 41
Basel I Norms 41
Basel II Norms 41
Basel III Norms 41
Changes proposed in BASEL III over BASEL II norms: 42
Implementation of BASEL III in India 43
Impact of BASEL III on Indian Banks 44
Managing financial Risks for Banks-Asset Liability Management 45
Other Financial risks associated with Banks 46
Interest Rate Risk 46
Yield curve analysis and its impact on banks 47
Yield Curve – The Indian Context 50
How banks manage the yield curve 50
Credit Risk 51
Liquidity Risk 52
Money Markets 52
Money Markets in India 52
Treasury Bills 52
Call Money and Notice Market 52
Commercial Papers (CP) 53
Certificate of Deposits (CDs) 53
Collateralized Borrowing and Lending Obligation (CBLO) 53
Mumbai Inter-Bank Offered Rate (MIBOR) 53
Role of Money Markets in Monetary Policy Transmission 54
Open Market Operations 54
Cash Reserve Requirement 54
Government Finances 55
Fiscal deficit 55
Current Account Deficit 55
Major Banking Sector Reforms since 1991 56
Recent Developments 57
Repo continuously increasing 57
Government notifies Banking Regulation (Amendment) Act, 2017 58
Fed hikes interest rates despite declining inflation 58
National Payments Corporation of India success with United Payment Interface (UPI) 59
30 stressed power accounts set to go to NCLT 60
The Insolvency and Bankruptcy code, 2016 60
Asset Quality Review 61
Masala Bonds 62
Understanding a Bank Merger in the Indian Economy 63
Declining Asset Quality of Banks 63
Profitability 65
Sectoral distribution of NPAs 66
Restructured assets 67
Net NPAs 68
Some contributory factors 68
Risk Management 70
Consequences 72
Conclusion 72
Sector wise Bank credit in 2017-18 73
Priority Sector Lending: 74
Priority sector credit distribution in 2017-18 76
Analysis of a Banking Stock: 77
How to analyse a Bank? How to pick up a correct Banking stock? 77
Quantitative Analysis 77
The Balance Sheet of a bank 77
Capital and Liabilities 77
Assets 78
Specific Ratios for a Bank: 81
Financial Information for HDFC Bank and SBI 86
Qualitative Analysis 89
What the bank actually does? 89
Price: 90
Earning Power: 91
The amount of risk it's taking to achieve that earnings power 91
Promoter Backing 92
Board of Directors 92
The Indian FinTech Landscape 92
India FinTech – A Sector Snapshot 92
Strong Governmental Support 93
Startup India Program 93
Jan DhanYojana 93
India Stack 93
Aadhaar Adoption 94
National Payments Council of India Initiatives 94
Payments 94
Alternative Lending 94
PSB vs Private Banks 95
Sector Outlook: 97
Rise in CASA ratio 97

Sector wise credit deployment 98
Retail segment to be the key driver for credit growth in next two years 99
Liquidity Conditions 99
Jan Dhan Accounts 101
Credit Outlook 103
Deposits Outlook 104
Interest Income Has Seen Robust Growth 105
Growth in ‘Other Income’ also on A Positive Trend 105
Return On Assets And Loan-To-Deposit Ratio Showing An Uptrend 106
GNPAs to remain high going forward 107
Recapitalization of Public Sector Banks - Will it reduce the NPA Levels? 107
Recapitalization of Public Sector Banks 108
Demonetisation- Worth the Pain? 111
How demonetisation was unprofitable for RBI 112
Performance of the Banking Industry 113
I. Rising Rural Income Pushing Up Demand For Banking 113
II. Mobile Banking To Provide A Cost Effective Solution 114
III. Policy support 114
IV. Infrastructure Financing 115
V. Housing And Personal Finance Have Been Key Drivers 115
FINANCIAL SERVICES 116
Asset Reconstruction Company 116
What are ARCs? 116
SARFAESI Act 2002– origin of ARCs 116
Capital needs for ARCs 116
How ARCs get funding to buy bad assets from banks? 117
How do ARCs make money? 117
Problem of Capitalisation– A Changing Horizon 118
Resolution Strategies that can be followed by ARCs while restructuring the assets 120
Recent Update 121
Conclusion 121
Non-Banking Financial Companies (NBFC) 122
Factors contributing to the growth of NBFCs: 122
The NBFC sector in India 122
Mutual Funds 124
Mutual Fund Industry in India 125
Financial Assets Getting A Bigger Piece Of The Savings Pie 125
Other Financial Services 127
Intermediary Advisory Services 127
Private Equity 128
Conglomerates 128
National Housing Bank: 128
Housing Finance Company (HFCs) 128
Difference between bank and HFC: 129
Benefits of HFCs over Banks 131
Benefits of Banks over HFCs 131
Micro-banking 131
MFI industry: Huge Growth Potential 133
Recent Trends 133
Company Coverage: HDFC AMC Ltd. 137
Valuation in the Financial Services Sector 144
Insurance: 145
Life Insurance 145
General Insurance 145
Re Insurance 145
Bank Insurance Model or Bancassurance 145
Overview of the insurance sector in India: 146
Insurance Regulatory and Development Authority (IRDA) 146
Specialised insurers 147
Performance of the sector 147
Notable Trends in the Insurance Sector 148
Investments 149
Government Initiatives 149
Insurtech in India 150
Road Ahead 151
Company Coverage: HDFC life 153
Company Overview 153
Future Outlook 160

Executive Summary
The Macroeconomic Frontier
India’s economy recorded a growth rate of 6.5 per cent in terms of real Gross Domestic Product
(GDP) in 2017-18. Lingering effects of demonetization and teething problems in implementation
of GST pulled down the GDP growth. IMF projects India growth in this year to be 7.3-7.4 per
cent.
Inflation pushed to higher levels in the second half of FY18, with the average level of Consumer
Price Inflation rising to an estimated level of 5.1 per cent in 2017-18 from 4.6 per cent in 2016-
17. Firming of commodity prices, mainly of crude oils & metals and increase in Minimum
Support Price (MSP) of crops have pushed inflation to moderately higher levels. Foreign Direct
Investment inflows (FDI) increased by a mere 3 per cent in FY18 over the corresponding period
of the previous year. This is to been seen against the backdrop of global flows of foreign direct
investment fell by 23 per cent in 2017-18.
With continued progress on economic and institutional reforms, Moody, the rating agency, raised
the rating from the lowest investment grade of Baa3 to Baa2, and changed the outlook from
stable to positive. It’s the first upgrade of India’s rating in 14 years.
Globally, fear of protectionist trade policies being implemented by US and trade tensions
between US and China might pose a significant risk to global growth going forward. Tax cuts
implemented by US on corporates will increase the supply of safe assets i.e treasury bills and
bonds and hence, migration of global capital flows to US. With a gradual normalisation of the
global monetary policy, the impact of a substantial increase in supply of US dollar safe assets
concurrent with a robust US fixed income issuance across high yield and investment grades
poses risks of pushing treasury rates higher.
Going by the 2018 Union Budget, the focus of fiscal policy in the coming year will be on revival
of the rural economy and infrastructure expenditure, gradual recovery in private capital
expenditure and continued support from Government-led capital spending.
Some of the key initiatives taken by Government of India (GoI) this year are:-
1. GoI overhauled the indirect tax regime and launched GST in July 2017, with the objective of
creating a unified market. There are major five slabs in GST- 0%,5%,12%,18% and 28%.
2. The GOI has announced capital infusion of INR2.1lakh crore in the public sector bank in the
second half of 2017. Of this amount, INR 76,000 crore would be a budgetary allocation by
government and remaining amount is to be raised by sale of recapitalisation bond.
Furthermore, the government has aligned capital infusion with pre-conditions of higher
accountability and transparency. This infusion of capital would meet three objectives:-
a. Meet Basel III norms
b. Stimulate credit growth

c. Mitigate risk associated with high NPAs
3. To boost road infrastructure in the country and foster job creation, the government announced
an INR 6.9 lakh crore in investment outlay to construct road network over a period of five
years. The funding would be derived from a combination of debt funding (2.1 lakh crore),
private investments (1.1 lakh crore), central road fund (CRF) (97,000 crore) and budgetary
allocation (59,000 crore). The rest of the amount is to be arranged through Toll-Operate-
Transfer (TOT) based projects and toll collection of NHAI.
Banking Overview
Schedule commercial banks (SCB) credit growth picked up on a year on-year (y-o-y) basis
across bank groups between April 2017 and March 2018 by 3.7%. However, deposit growth
decelerated for Public Sector Banks (PSBs) (3.3% compared to 6% y-o-y) impacting the deposit
growth of all SCBs. Bank credit is expected to surge to 8-8.9 % according to CRISIL on account
of:-
1. Improving working capital demand as commodity prices are rising.

2. High government spending on infrastructure sector.
3. Improvement in CRAR with recapitalisation plan of GoI.
Though credit growth will be met with following challenges
1. Lingering poor asset quality in banks (GNPA is 11.6% in March 2018).

2. 21 PSBs in Prompt Corrective Action (PCA) have restrictions on lending.
3. Under-utilised capacity1 (74.5%) in the industry will restrict the borrowings for further
capital expenditure. Although there has been an uptick in capacity utilisation in the last
three quarters, it would take time for a growth in capital expenditure borrowings.
Macro-stress tests published in “Financial Stability Report” by RBI, indicates that under the
baseline scenario, SCBs’ GNPA ratio may rise to 12.2 % by March 2019 from 11.6 % in March

2018. We saw a continuation of the last year trend with industry sector GNPA rose from 19.4%
to 22.8 %. Gems & jewelry, infrastructure, paper and paper products, cement and engineering
showed worsening of their loans in the last year while food processing and textiles improved.
Source: RBI
SCBs capital to risk-weighted assets ratio (13.8%) as well as the Tier-I leverage ratio (7%)
remained almost same between April 2017 and March 2018 showing prudent and reserved nature
of banks while giving loans. With continuous pressure from RBI and government to recognise
bad loans and make provision for them, we have seen a continuous rise in provisioning coverage
ratio of SCBs to 48.1% by March 2018 which has led to SCBs profits getting plummeted.
The Insurance Sector

The insurance industry of India consists of 57 insurance companies of which 24 are in life
insurance business and 33 are non-life insurers. Among the life insurers, Life Insurance
Corporation (LIC) is the sole public sector company. Apart from that, among the non-life
insurers there are six public sector insurers. In addition to these, there is sole national re-insurer,
namely, General Insurance Corporation of India (GIC Re). There are two more specialized
insurers belonging to public sector, namely, Export Credit Guarantee Corporation of India for
Credit Insurance and Agriculture Insurance Company Ltd for crop insurance.
Insurance industry is one of the highly under-penetrated financial services in India and is
expected to reach $280billion by 2020, as per the industry reports.
The domestic life insurance industry registered 16.83% y-o-y growth for new business premium
for 8M FY18, generating a revenue of Rs 1,51,000 crore (US$23.32bn). The domestic life
insurance industry registered 10.99 per cent y-o-y growth for new business premium in 2017-18,
generating a revenue of Rs 1.94 trillion ($ 30.1 billion). Gross direct premiums for non-life
insurance industry increased by 17.54 per cent y-o-y in FY18.
Three public sector insurance companies—The Oriental Insurance Co. Ltd, National Insurance
Co. Ltd and United India Insurance Co. Ltd— will be merged into a single insurance company
and listed on the bourses.
LIC continues to be the market leader with around 70% market share followed by ICICI
Prudential Life.
The Government of India has taken a number of initiatives to boost the insurance industry. Some
of them are as follows:
 National Health Protection Scheme will be launched under Ayushman Bharat to provide
coverage of up to Rs 500,000 (US$ 7,723) to more than 100 million vulnerable families.
 Over 47.9 million famers were benefitted under Pradhan Mantri Fasal Bima Yojana
(PMFBY) in 2017-18. Further, allocation to Pradhan Mantri Fasal Bima Yojana is also
increased to Rs 13,000 crore in 2018-19 as against Rs 9,000 crore in 2017-18.
 The Insurance Regulatory and Development Authority of India (IRDAI) plans to issue
redesigned initial public offering (IPO) guidelines for insurance companies in India,
which are to looking to divest equity through the IPO route.
 IRDAI has allowed insurers to invest up to 10 per cent in additional tier 1 (AT1) bonds
that are issued by banks to augment their tier 1 capital, in order to expand the pool of
eligible investors for the banks.
The Financial Services Overview
The Indian financial services sector, comprising of a range of institutions from commercial and
co-operative banks, pension funds and Non-Banking Financial Companies (NBFCs) to Mutual
Funds, insurance companies, etc., is diverse and expanding rapidly. Over the years, the
Government of India has initiated several reforms to liberalize this industry and expand its reach
to individuals in the hinterlands and Micro, Small and Medium Enterprises (MSMEs) in need of
credit and other financial services. The role of the NBFC sector has been growing. The balance
sheet of the NBFC sector expanded by 14.5% during financial year 2016-17. Despite the growth,
NBFCs managed their asset quality better than the banks. Gross bad loans of the NBFC industry
stood at4.4% in March 2017, down from 4.9% in September 2016, when banks in general
witnessed a rise. Net NPAs as a percentage of total advances also declined from 2.7% to 2.3%.
Financialisation of household savings has seen steady shift in recent years from physical assets
like gold and real estate to financial instruments such as equities, mutual funds and life insurance
products. Financial savings increase from 45 per cent in 2012 to 57 per cent in 2017.The mutual
fund industry has seen a robust growth with AUM doubling in past three years and having grown
almost five times in past ten years. According to AMFI, the total inflow through SIPs in 2017-18
was 67,190 crore and has grown by 53% since previous year. Out of the nearly Rs 4,75,600 crore
growth witnessed in mutual funds in 2017-18, close to 60% Rs 2,84,000 crore was contributed
by equities.

Banking
The banking sector has a very high positive correlation with majority of the sectors of the Indian
economy, as it fuels them with the necessary credit they require to fund both their Capital and
working capital expenditures. Given the fact that the banking sector propels growth in the
economy; its importance is of great extent. Thus The Reserve Bank of India, the regulatory body
exercises stringent norms to exercise control on the banking sector to protect the economy from
any crisis. A strong and viable banking industry is extremely necessary for economic progress
while a weak banking sector is a cause for problems in the economy. Banking is used for policy
transmissions by controlling the money supply for sustaining economic growth.
Source: www.nseindia.com
What is a bank?
The term bank is either derived from the Old Italian word ‘banca’ or from a French word
‘banque’ both mean a Bench or money exchange table. It is a financial institution which is
authorized by the regulators of the regulatory bodies to accept deposit and lend money, in order
to earn differential interest between the interest paid and earned. Today banks provide various
other financial services like insurance, mutual fund investment in order to reduce the dependence
on interest income.
How does a Bank Function?

As a key component of the financial system, banks allocate funds from savers to borrowers in an
efficient manner. They provide specialized financial services, which reduce the cost of obtaining
information about both savings and borrowing opportunities. These financial services help to
make the overall economy more efficient.
A portion of money thus received by the bank is kept aside for regulatory requirements. The
remaining money is given to borrowers and used to make investments. The bank charges interest
on these borrowings and investments. The difference in the interest received and the interest paid
is the income for the bank, which the bank uses to pay for its expenses and any amount left is
profit for the bank. Banks take in money from a large number of depositors and lend money to a
large number of borrowers. This creates a flow of money in the banking system while also
spreading the risks associated with lending to a large number of borrowers. Banks charge money
for acting as intermediary in managing this flow of money and any risks they are undertaking by
the giving of loans.
What is the role of the banks?

Banks play the role of financial intermediation in the economy. For any economic activity to
happen funds (money) are a must and funds are a scarce resource for the organization intending
to involve in the activity. Here banks play a crucial role in terms of channeling the funds from
the source to the point of use. Banks act as an intermediate between those who have funds
without knowing where to deploy them and those who are in need of the funds. Banks let
demand for money meet supply for money. In other words, it provides a meeting point for both
borrowers and lenders of money.
What are the benefits of Intermediation?
1. Intermediation smoothens the borrowing and lending process in an economy. It ensures

efficient allocation and profitable use of the capital by channeling and bridging the gap
appropriately between the sources of funds and the users of funds in turn helping the
economic growth. Example, if company A has a profitable project for INR 1 crore and it
does not have its own funds to finance this project. On the other hand many individuals have
a surplus of INR 10,000/- without any idea of investing in profitable investment
opportunity. Here Intermediation helps by channeling many of the INR 10,000/- surpluses
to fund INR 1 crore need.
2. Pooling of funds bring economy of scale and reduces cost. Which of the two options would
cost less to administer? One, 10 million portfolio or ten 1 million portfolio and obviously
the answer is one 10million portfolio. Here Intermediation helps to manage and reduce cost
of managing funds by pooling. While doing the role of intermediation banks would come
out with multiple loans and deposits products to meet the risk & rewards requirement of
each individual.
Besides this intermediation function, banks also play a major role in the payment process like
cheque processing and card payments. Banks also offers other financial services like Cash
management services, Opening of Letter of credit, Locker facilities.
Role of a bank in the economy

Banks are vital institutions in any society as they significantly contribute to the development of
an economy through facilitation of business. Banks also facilitate the development of saving
plans and are instruments of the government’s monetary strategy among others.
 Credit provision — Credit fuels economic activity by allowing businesses to invest beyond
their cash on hand, households to purchase homes without saving the entire cost in advance,
and governments to smooth out their spending by mitigating the cyclical pattern of tax
revenues and to invest in infrastructure projects.

 Liquidity provision — Businesses and households need to have protection against

unexpected needs for cash. Banks are the main direct providers of liquidity, both through
offering demand deposits that can be withdrawn any time and by offering lines of credit.
Further, banks and their affiliates are at the core of the financial markets, offering to buy and
sell securities and related products at need, in large volumes, with relatively modest
transaction costs.
 Remittance of Money — Cash can be transferred easily from one place to another and from
one country to another by the help of a bank. It has facilitated transactions in distant places.
This, in turn, has expanded the internal and external trade and market. The men have become
free of the risks of carrying cash, gold, silver etc. The credit instruments issued by banks
such as cheque, draft, Real time gross settlement, credit cards have facilitated the transfer of
money.
 Rapid Economic Development — The banks make available loans of different periods to
agriculture, industry and trade. They make direct investments in industrial sectors. They
provide industrial, agricultural and commercial consultancy hence facilitating the process of
economic development.
Functions of a Bank
Functions of Banks
Primary Functions Secondary Functions
Granting loans and

Accepting Deposits Agency Functions Utility Functions
Advances
Saving Deposits, Funds Transfers,Cheque Issue of Drafts,Locker

Current deposits, Loans,Cash Credit, Bank collection,Periodic facilities,Dealing in
Fixed Deposits, Overdraft ,Discounting BIlls Payments/Collections, Foreign Exchange,Project
Recurring Deposits Portfolio Management Reports
How do banks minimize risk?

Managing and monitoring risks are at the heart of banking, and most banks have strict policies in
place at various levels to handle both financial and non-financial risk, including social and
environmental risk. But more generally speaking, banks make transactions possible that
otherwise wouldn’t have been possible, or that only would’ve been possible with huge risks. One
reason why banks can handle such transactions, and private individuals and companies can’t, is
scale.

Even though savers can generally withdraw their savings at any time, the total amount of money
held by a bank doesn’t fluctuate much because they have many customers. This scale helps
banks cover risks, such as those related to term transformation mentioned above.
Other risks, such as a borrower not being able to repay, are reduced through diversification,
meaning that banks can spread risks over various countries and industries. This doesn’t mean
that risks are non-existent, but they’re spread over the bank's portfolio and initially absorbed by
the bank’s margins, with “equity capital” there to cushion unexpectedly high losses.
Above all, banks specialise in estimating possible risks. However, it’s important to realise that
risks can never be eliminated completely. In fact, that wouldn’t be a good thing either. A certain
level of risk is necessary to keep the economy going. Economic growth is driven by
entrepreneurs who start up new enterprises, i.e. take risks. Sometimes they fail, but if no one
would take such risk, there would be no economic growth.
The Indian Banking System
A. Evolution
The traces of the banking system can be noticed from the last decades of 18th century when the
Bank of Hindustan was established in 1770.The largest and the oldest bank which is still in
existence is State Bank of India. It was originated as Bank of Calcutta in 1806 and later renamed
as Bank of Bengal in 1809. It became Imperial Bank of India when it was merged with
two other banks – Bank of Madras and Bank of Bombay in 1921. After independence it was
again renamed and became State Bank of India in 1955.

Post-Independence Period
The partition of India in 1947 adversely impacted the economies of various states especially
Punjab and West Bengal, paralysing banking activities for months. India’s independence marked
the end of a regime of the Laissez-faire for the Indian banking. The Government of India
initiated measures to play an active role in the economic life of the nation, and the Industrial
Policy Resolution adopted by the government in 1948 envisaged a mixed economy.
Nationalisation of Banks in 1960s
In early years of 60s, except SBI all other banks were owned and operated by private persons.
The Government of India issued an ordinance, ‘Banking Companies (Acquisition and Transfer of
Undertakings) Ordinance, 1969’ and nationalised the 14 largest commercial banks with effect
from the midnight of 19 July 1969. These banks contained 85% of bank deposits in the country.
Second round of nationalisation of 6 more commercial banks followed in 1980. The stated
reason for the nationalisation was to give the government more control of credit delivery. With
the second round of nationalisation, the Government of India controlled around 91% of the
banking business of India.
Later on, in the year 1993, the government merged New Bank of India with Punjab National
Bank. It was the only merger between nationalised banks and resulted in the reduction of the
number of nationalised banks from 20 to 19. After this, until the 1990s, the nationalised banks
grew at a pace of around 4%, closer to the average growth rate of the Indian economy.
Liberalization and Globalization of Indian Banking System
In the early 1990s, the government embarked on a policy of liberalization, licensing a small
number of private banks. These came to be known as New Generation tech-savvy banks, and
included Global Trust Bank (the first of such new generation banks to be set up), which later
amalgamated with Oriental Bank of Commerce, UTI Bank (since renamed Axis Bank), ICICI
Bank and HDFC Bank.
This move, along with the rapid growth in the economy of India, revitalised the banking sector in
India, which has seen rapid growth with strong contribution from all the three sectors of banks,
namely, government banks, private banks and foreign banks.

B. Structure
Commercial banks
A commercial bank may be defined as a financial institution that provides services, such as
accepting deposits, giving business loans and auto loans, mortgage lending, and basic investment
products like savings accounts and certificates of deposit. In addition to giving short-term loans,
commercial banks also give medium-term and long-term loans to business enterprises.
Commercial banks are of the following seven types:-
 Nationalized banks
Public sector banks
 SBI and associates
 Regional rural banks
 Private sector banks

 Foreign banks
 Payment banks
 Small Banks
Public sector banks include SBI & its associates, nationalized banks and Regional Rural banks.
Public sector banks (accounted for the largest share of 72.81 per cent in aggregate deposits and
69.2 per cent in gross bank credit) followed by private sector banks (23 per cent and 28 per cent,
respectively) as on March 31, 2017. The complete data is available with a lag. The Distribution
of total deposits, total credit, C-D Ratio and bank branches as per 31st March, 2018 is given
below:-

Deposit Distribution
STATE BANK OF INDIA AND

ITS ASSOCIATES
21%
27% NATIONALISED BANKS
Foreign Banks
3%
5% RRB
44% Private Sector Banks
Credit Distribution

ITS ASSOCIATES
21%
27% NATIONALISED BANKS
Foreign Banks
3%
5% RRB

C- D Ratio
100.0%
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
1 2 3 4 5 6
Mar-17 68.7% 70.4% 79.9% 62.8% 86.1% 73.8%
Mar-16 76.20% 75.3% 84.7% 67.7% 87.7% 78.4%
Branch Distribution

18% 18% ITS ASSOCIATES
NATIONALISED BANKS
Foreign Banks
15%
RRB
0%
Source: RBI
SBI and its associates
SBI and its associates are spread out across India with a presence of close to 22,414 branches,
total market share in deposits and advances are 22.84 per cent and 19.92 respectively as on 31st
March, 2018. SBI can be considered as the only Indian bank whose guarantee is accepted by
most of the Export Credit Agencies globally without seeking confirmation. The major promoters
of SBI include Government of India with a 58.47%.

Nationalized Public Banks
Banks other than SBI and associates which have more than 51% stake held by the Government
are included in this category. Currently, along with IDBI 19 such banks exist where Government
is the majority stakeholder. These banks are spread over 68,913 branches with market share of
deposits and advances 46.5 per cent and 44.5 per cent as on 31st March, 2017 respectively. Top
two banks in terms of size in this category are Punjab National Bank and Bank of Baroda.
Many of these banks were private banks earlier but were nationalized by the government in
pursuance with its socialist objectives. The primary objective of nationalized banks is to meet the
social requirements of providing financial inclusion and services to the weaker sections of the
society.
Regional Rural Banks
Regional Rural Banks are local level banking organizations operating in different States of India.
They have been created with a view to serve primarily the rural areas of India with basic banking
and financial services. The main purpose of RRB's is to mobilize financial resources from rural /
semi-urban areas and grant loans and advances mostly to small and marginal farmers,
agricultural laborers and rural artisans. The area of operation of RRBs is limited to the area as
notified by Government of India covering one or more districts in the State. These banks are
spread over 21,358 branches with market share in deposits and advances being 3.4 per cent and
2.3 per cent as on 31st March, 2017 respectively.
Till date, RRBs have seen two rounds of consolidation, after which the number of banks dropped
from 196 to 82 during 2005-2009, and further to the current level of 56 during 2011-2014.
Recent Regulations & Supervisions by RBI

RRBs were allowed to extend internet banking facility to their customers: Only Profitable
RRBs with minimum Rs 100 crore net worth and better asset quality will be allowed to offer this
service. Banks with capital adequacy ratio over 10% will be allowed to introduce the online
transaction services. They need to have their gross NPA ratio less than 7% and their net NPA
should not exceed 3%. The bank should have made a net profit in the immediate preceding
financial year and overall, should have made net profit at least in three out of the preceding four
financial years. Weak banks will be allowed to offer internet services (view only) without online
transaction facilities.
Priority sector lending (PSL): Guidelines for RRBs were revised by setting for them an overall
target of 75 per cent of the total. PSL includes Agriculture, MSMEs, Education, Housing, Social
Infrastructure, renewable energy and others.
Prescription of minimum CRAR of 9 per cent for RRBs: After the amalgamation and
recapitalization of weak RRBs, a minimum CRAR of 9 per cent on an on-going basis was
prescribed for all RRBs with effect from March 31, 2014.

Guidelines for classification and valuation of investments by RRBs: RRBs have been advised
to introduce mark to market (MTM) norms with respect to SLR securities beyond 24.5 per cent
of DTLs held in the held to maturity (HTM) category with effect from April 1, 2014 and to
classify their investments into three categories: held to maturity (HTM), held for trading (HFT)
and available for sale (AFS).
Private Sector Banks
These are the banks in which majority of share capital is held by private individuals. These banks
can be classified into two categories:
Old Private Sector Banks

The private banks, which existed and were not nationalized at the time of bank nationalization
that took place during 1969 and 1980, are known to be the old private sector banks. These were
not nationalized because of their small size and regional focus. Some of the main old private
sector banks are Catholic Syrian Bank, Federal Bank, ING Vysya Bank(Now Kotak Mahindra
Bank), Dhanlaxmi Bank and Karnataka Bank.
New Private Sector Banks

These are the Private Banks which were set up post liberalization, with the introduction of
reforms in the banking sector. The entry of new private sector banks was permitted after the
Banking Regulation Act was amended. Banking licenses were given in two phases. In the first
phase, in 1994 banks like HDFC and ICICI were given licenses. In the next round of bank
licenses, in 2004 banks like Yes Bank were set up. In 2014, Bandhan and IDFC Ltd. were
granted license by RBI. Bandhan Bank has started its operations on 23rd August, 2015. The
prominent new private sector banks are HDFC Bank, ICICI Bank, Axis Bank, Yes Bank and
Kotak Mahindra Bank.
These banks are spread over 24,423 branches as on 31st March, 2017. Respectively and Most of
these banks have concentrated in metropolitan, urban and semi urban areas with around only
19% of branches of these banks in the rural area as on 31st March, 2017.
Foreign Banks
Foreign banks have their registered and head offices in foreign countries but operate their
branches in India. The RBI permits these banks to operate either through branches; or through
wholly-owned subsidiaries. The primary activity of most foreign banks in India has been in the
corporate segment. In addition to the entry of the new private banks in the mid-90s, the increased
presence of foreign banks in India has also contributed to boosting competition in the banking
sector.
As of 31st March 2017, there were a total of 293 branches of foreign banks in India.
A foreign bank can deploy a maximum of four expatriates for each branch opened in India and
not more than six Expatriates for their head office functions. Till recently, the 40% priority
sector loan norm was applicable to local banks; for foreign banks it was 32%. Even within this,
12% could have been given as export credit. However both these relaxations are only applicable

to foreign banks with less than 20 branches. For foreign banks greater than 20 branches only
export credit to the priority sector will be treated as priority sector credit.
Small Banks
Small finance banks are a type of niche banks in India. Banks with a small finance bank license
can provide basic banking service of acceptance of deposits and lending. The aim behind these
banks is to provide financial inclusion to sections of the economy not being served by other
banks, such as small business units, small and marginal farmers, micro and small industries and
unorganised sector entities.
Objective of a small finance bank
The objective of setting up of small finance banks is to further financial inclusion by,
a) Provision of savings vehicle and primarily to unserved and underserved sections of the
population
b) Supply of credit to small business units, small & marginal farmers; micro and small industries
and other unorganised sector entities through high technology & low cost operations.
Scope of activities
• SFBs are required to open at least 25% of its branches in unbanked rural centres.
• Further, these banks are required to extend 75% of its Adjusted Net Bank Credit (ANBC) to
priority sector.
Adjusted Net Bank Credit- It is the net bank credit(Total credit - Bills rediscounted with RBI
and other institutions) plus investments made by banks in non-SLR bonds held in the held-to-
maturity category or credit equivalent amount of off-balance-sheet exposure, whichever is
higher.
Guidelines
 No Geographical restriction on the operation of the small banks

 50% of the loan portfolio should be loans and advances up to Rs.25 Lakh
 Individuals with 10 years of experience in banking and finance and companies and societies
controlled by Indian residents together with NBFCs, micro finance institutions and local area
banks (LABs) can opt for conversion into small banks
 The minimum paid-up equity capital for small banks is Rs.100 crore
 These banks will have to maintain the mandatory CRR and SLR requirements
 Promoters of small banks must own 40% equity in the new venture initially, but will need to
bring this down to 26% within 12 years from the date of commencement of business
 Foreign shareholding in these banks has been capped at 74%

Capital adequacy framework

Minimum Capital Requirement 15%
Common Equity Tier 6%
Additional Tier I 1.5%
Minimum Tier I capital 7.5%
Capital Conservation Buffer Not Applicable
Counter-cyclical capital buffer Not Applicable
Pre-specified Trigger for conversion of AT1 CET1 at 6% up to March 31, 2019, and 7%
thereafter
Specialized Banks
There are some banks, which cater to the requirements and provide overall support for setting up
business in specific areas of activity. EXIM Bank (Export Import Bank), SIDBI (Small Industrial
Development Bank of India) and NABARD (National Bank for Agricultural and Rural
Development) are examples of such banks. They engage themselves in some specific area or
activity and thus, are called specialized banks.
Institutional Banks
These are banks which were set up by the Government with the purpose of catering to the needs
of the industry. These banks provide low cost funds to borrowers. Examples include institutions
like IFCI and the State Financial Corporation’s (SFCs).
NBFCs
Non-Banking Financial institutions or NBFCs are those financial institutions which provide
financial services without meeting the general definition of bank. These institutions do not hold a
banking license. Despite this, they provide a wide range of financial services and are regulated
by the RBI. NBFCs offer most of the services offered by the conventional banking system
including loans and credit facilities, education funding, retirement plans, wealth management and
trading in money markets. NBFCs can accept public deposits but they cannot accept demand
deposits. NBFCs do not form a part of the payment and settlement system and hence cannot
issue cheques drawn on self. NBFCs are discussed in more detail later in the report.
Co-operative banks
A co-operative bank is a financial entity which belongs to its members, who are at the same time
the owners and the customers of their bank. Co-operative banks are often created by persons
belonging to the same local or professional community or sharing a common interest. They
generally provide their members with a wide range of banking services (loans, deposits, banking

accounts, etc.). Formed under the Co-operative Societies Act, Co-operative banks are run on not
for profit basis.
Payment Banks
Payments banks are a new model of banks conceptualized by the Reserve Bank of India (RBI).
These banks can accept a restricted deposit, which is currently limited to ₹ 1 lakh per customer
and may be increased further. These banks cannot issue loans and credit cards. Both current
account and savings accounts can be operated by such banks. Payments banks can issue services
like ATM cards, debit cards, net-banking and mobile-banking. Airtel has launched India's first
payments bank. Paytm is the second such service to be launched in the country. India Post
Payments Bank is the third entity to receive payments bank permit.
Characteristics of Payment Banks:
 They can’t offer loans but can raise deposits of up to ₹ 1 lakh, and pay interest on these
balances just like a savings bank account does.
 They can enable transfers and remittances through a mobile phone.
 They can offer services such as automatic payments of bills, and purchases in cashless,
cheque-less transactions through a phone.
 They can issue debit cards and ATM cards usable on ATM networks of all banks.
 They can transfer money directly to bank accounts at nearly no cost being a part of the
gateway that connects banks.
 They can provide forex cards to travelers, usable again as a debit or ATM card all over
India.
 They can offer forex services at charges lower than banks.
 They can also offer card acceptance mechanisms to third parties such as the ‘Apple Pay’.
Regulations as per RBI:
Prudential regulation
The prudential regulatory framework for payments banks (Payment Banks) will largely be drawn
from the Basel standards. However, given the financial inclusion focus of these banks, it will be
suitably calibrated.
Large exposures limits (for investments in deposits of scheduled commercial banks)

The exposure in this regard to an individual scheduled commercial bank shall not be more than
five per cent of the total outside liabilities of the Payment Banks.
Inter-bank borrowings
Payment Banks will be permitted to participate in the call money and CBLO market as both
borrowers and lenders. These borrowings would, however, be subject to the limit on call money
borrowings as applicable to scheduled commercial banks.

Restricted banking functions

Payment Banks cannot offer direct credit facilities, but can act as a Banking Correspondent (BC)
for another bank. They also cannot accept Fixed Deposits. The payment banks need to invest at
least 75% of deposits collected in securities (having tenor of upto one year) eligible for statutory
liquidity ratio (SLR) investments. They need to hold up to 25% in current and time deposits with
other scheduled commercial banks.
Other requirements
Payment banks must have a minimum capital of Rs. 1 billion and net worth of Rs. 1 billion at all
times. The total outside liabilities should not exceed 33.33 times the net worth. The leverage
ratio requirements have been eased to 3% from the earlier proposed 5%.
Ownership regulations
Promoters should hold at least 40% of paid-up equity capital for first five years once the bank
becomes operational. Foreign shareholding limit will be at par with private banks – currently set
at 74%. Diversified ownership and listing is mandatory, within three years after the banks’ net
worth reaches Rs. 500 crore and it becomes systematically important.
Capital adequacy framework
Minimum Capital Requirement (of risk weighted assets) 15%

Common Equity Tier 1 6%
Additional Tier I 1.5%
Minimum Tier I capital 7.5%
Tier 2 capital 7.5%
Capital Conservation Buffer Not Applicable
Counter-cyclical capital buffer Not applicable
Pre-specified Trigger for conversion of AT1 CET1 at 6% up to March 31, 2019, and
7% thereafter
Investment classification and valuation norms set by the RBI
i. Payment Banks shall, on any given day, maintain a minimum investment to the extent of
not less than 75 per cent of ‘demand deposit balances’ - DDB (including the earnest
money deposits of BCs) as on three working days prior to that day, in Government
securities/Treasury Bills with maturity up to one year that are recognized by RBI as
eligible securities for maintenance of Statutory Liquidity Ratio (SLR).
ii. Further, Payment Banks shall, on any given day, maintain balances in demand and time
deposits with other scheduled commercial banks, which shall not be more than 25 per
cent of its DDB (including the earnest money deposits of BCs) as on three working days
prior to that day.
iii. The investments and deposits made according to (i) and (ii) above, together shall not be
less than 100 per cent of the DDB (including the earnest money deposits of BCs) of the
Payment Bank unless it is less to the extent of balances kept with RBI.

iv. Balances with other scheduled commercial banks in excess of 25 per cent of DDB
(including the earnest money deposits of BCs), is permissible to the extent the excess
amount is sourced from funds other than DDB (including the earnest money deposits of
BCs).
v. Payment Banks will not be allowed to classify any investment, other than those made out
of their own funds, as HTM category. The investments made out of their own funds shall
not, in any case be, in assets or investments in respect of which the promoter / a promoter
group entity is a direct or indirect obligor.
vi. Payment Banks will not be allowed to participate in ‘when issued’ and ‘short sale’
transactions.
vii. Payment Banks will be permitted to invest in bank CDs within the limit applicable to
bank deposits.
viii. The other directions on the subject as applicable to scheduled commercial banks.
KYC requirements:
Payment Banks should ensure that every customer, including customers of mobile companies on-
boarded comply with the KYC regulations, which could include simplified account opening
procedures. It is clarified here that if the KYC done by a telecom company, which is a promoter /
promoter group entity of the Payment Bank, is of the same quality as prescribed for a banking
company, Payment Banks may obtain the KYC details of the customer from that telecom
company, subject to customer consent.
Problems with Paytm, Fino and Airtel Payment Banks
Airtel, Paytm and Fino Payments Bank were forbidden from adding new customers for a few
months after it was revealed that it had violated certain norms by opening accounts without
customers’ consent. Customer acquisition has become even more difficult now. Earlier it was
easy to get customers on-board as the KYC level was really basic. The central bank declared
that the KYC done by these firms before launching their respective banks won’t be valid. This
has increased operational costs.
The other hindrance to the development is evolving digital payments ecosystem has also thrown
a spanner in their works. With the coming of the government’s Unified Payments Interface and
the entry of several other payment firms, the digital edge is lost.
One of the most important concerns is that these banks are not allowed to lend and, therefore, the
revenue stream is limited, raising serious doubts over the model’s viability. Also, they are
allowed to invest only in government securities which offer lesser returns compared to other
avenues such as mutual funds.

India Post Payments Bank launched
The bank has been incorporated as a public sector company under the department of posts (DoP)
with 100% government equity and is governed by the Reserve Bank of India (RBI). We are
looking at financial inclusion as the main mission of the bank. Our focus will be on segments
that today have challenges in either accessibility or affordability. From a vision perspective, we
are looking to bring the most affordable, accessible and trustworthy bank to the last mile
consumer.
DoP has around 1.55 lakh points of service out of which 1.30 lakh are in rural India. Today there
are around 50,000 bank branches all put together, with this the rural banking ecosystem will get
scaled up by 3.5 times. It will be a big boost for financial inclusion.
DoP has around 300,000 people out there providing postal services. These are postmen
and “gramin dak sewaks” who will offer doorstep banking services.
Some key features:
1) India Post Payments Bank will offer 4 per cent interest rate on savings accounts.
2) Payments banks can accept deposits of up to Rs 1 lakh per account from individuals and small
businesses, but do not have the mandate to extend loans.
3) But India Post Payments Bank will, in alliance with other financial service providers, offer
third-party products. For example, in case of loans, India Post Payments Bank will work as an
agent of PNB.
4) India Post Payments Bank will offer a range of products such as savings and current accounts,
money transfer, direct benefit transfers, bill and utility payments, and enterprise and merchant
payments.
5) These products, and services, will be offered across multiple channels (counter services,
micro-ATM, mobile banking app, SMS and IVR), using the India Post Payments Bank’s
technology platform.
6) India Post Payments Bank has been allowed to link around 17 crore postal savings bank (PSB)
accounts with its accounts.
7) India Post Payments Bank “has been envisioned as an accessible, affordable and trusted bank
for the common man,” the government said in statement. It will leverage the vast network of the
Department of Posts, which covers every corner of the country with more than 300,000 postmen
and grameen dak sewaks.
8) The Cabinet approved an 80% increase in spending for India Post Payments Bank (IPPB) to
Rs 1,435 crore. The increase will take the IPPB project outlay to Rs 1,435 crore from Rs 800
crore - giving it additional firepower to compete in the market with existing operators like Airtel
Payments Bank and Paytm Payments Bank.

C. Emerging trends
Diversification of revenue stream
Banks have focused on increasing their revenue streams from other sources such as fees
investment banking services and processing charges of loans to diversify and decrease their
dependence on interest income which is a market driven activity.
Source: RBI
NII- Net interest Income OOI-Other Operating Income
Focus on financial inclusion

Pradhan Mantri Jan dhan Yojana (PMJDY) - the government has opened more than 294 million
accounts. It was found that a increase in lending in regions where the PMJDY generated new
demand for formal credit. The average account balance in PMJDY accounts effectively doubled
between 2015 and 2017, zero-balance accounts declined by more than half between 2015 and
2016, and cross-bank transactions facilitated by business correspondents grew sharply.
Consolidation
With entry of foreign banks, competition in the Indian banking sector has intensified. Banks are
increasingly looking at consolidation to derive greater benefits such as enhanced synergy, cost
optimization from economies of scale, organisational efficiency & diversification of risks. One
of the reasons for consolidation is also turning out to be increase the presence in under-banked
areas as evident by merger of IndusInd with BFIL.

D. Analysis of Banking Sector
Supply- Liquidity is controlled by the Reserve Bank of India (RBI).
Demand - India is a growing economy and demand for credit is high though it could be cyclical
in nature.
Barriers to entry - Licensing requirement, investment in technology and branch network,

capital and regulatory requirements.
Bargaining power of suppliers - High during periods of tight liquidity. Trade unions in public
sector banks can be anti-reforms and orchestrate strikes. Depositors may invest elsewhere if
interest rates fall.
Bargaining power of customers - For good creditworthy borrowers bargaining power is high
due to the availability of large number of banks.
Competition - High- There are public sector banks, private sector and foreign banks along with
non-banking finance companies competing in similar business segments. Additionally, the RBI
has approved for small finance banks and payment banks which will further increase competition
in the industry.
Reserve Bank of India

The Reserve Bank of India (RBI), which commenced operations on April 1, 1935, is at the centre
of India’s financial system. Hence it is called the Central Bank. It has a fundamental
commitment of maintaining the nation’s monetary and financial stability. It started as a private
shareholders’ bank but was nationalized in 1949, under the Reserve Bank (Transfer of Public
Ownership) Act, 1948. RBI exercises its supervisory powers over banks under the Banking
Companies Act, 1949, which later became Banking Regulation Act, 1949.
Key functions of RBI include:

Is the Reserve Bank of India autonomous?
A cursory reading of the RBI Act (Section 7) lays out things quite unambiguously. Part (1) of
Section 7 states: “The Central Government may from time to time give such directions to the
Bank as it may, after consultation with the Governor of the Bank, consider necessary in the
public interest.”
There has not been any assault on the RBI’s autonomy — in the setting of interest rates or in the
regulation of banks or in other operational spheres. The government, when it exercises its right
as sovereign, whether to set an inflation target or to demonetise high-value currency, is acting
well within the norms of the law and the spirit of democracy. Any attempt by unelected officials
to obstruct would only be abuse of their autonomy.
It is important to note that is not the central bank’s discretion to decide what the targeted rate of
inflation ought to be (or indeed what the optimum rate of growth should be); that remains the job
of the elected government. But once that target is laid down, the central bank must ensure that it
meets those targets with complete operational autonomy.

NDTL (Net Demand and Time Liabilities)
Demand Liabilities
Demand Liabilities of a bank are liabilities which are payable on demand. These include current
deposits, demand liability portion of savings deposits, balances in overdue fixed deposits, etc.
Time Liabilities
Time Liabilities of a bank are those which are payable otherwise than on demand. These include
fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of
savings bank deposits, etc.
Cash Reserve Ratio (CRR)

CRR is the cash that banks need to keep with the RBI as a certain percentage of their net demand
and time liabilities. Banks are not allowed any interest on this cash. This cash requirement is
calculated on a fortnightly basis. Banks come up with their NDTL on a fortnight basis and this
value is used to compute the cash required to be kept as CRR in RBI. To maintain flexibility,
banks are allowed to choose an optimum strategy of holding reserves depending upon their intra-
fortnight cash flows. All banks are required to maintain minimum CRR balances up to 90 per
cent of the average daily required reserves for a reporting fortnight on all days of the fortnight.
Banks failing to comply with the CRR requirement are penalized with a rate of interest which is
excess of three per cent from the bank rate on the shortfall amount and if this shortfall persists,
penalty will be excess of five per cent from the bank rate. Earlier interest was paid on cash kept
with RBI for CRR, but the rate was very high causing CRR to become unproductive. As a result
the interest was gradually reduced and was finally abolished in 2007.
Currently RBI has kept the CRR at 4% of NDTL. As an illustration, if a bank has INR 100 Cr.
worth of NDTL, it is required to keep INR 4 Cr. kept at RBI account as part of its CRR
requirement.
RBI uses this tool as a means to remove extra liquidity from the market or inject liquidity in the
market. By increasing the CRR, banks are forced to keep more cash at RBI, thus reducing the
amount they have to lend, thereby creating a shortage of money supplied in the economy. This
increases the cost of capital and thus the interest rates charge by the bank for credit. Similarly, by
decreasing the CRR, RBI aims to reduce the overall interest rates in the economy.
Statutory Liquidity Ratio (SLR)

Similar to CRR, SLR is the amount that banks are required to maintain in the form of securities
or assets specified by the RBI. These assets include cash, gold, treasury bills of the government
of India, government securities, state development loans, etc.
SLR is defined as a percentage of their NDTL. Maximum permissible SLR is 40% of NDTL.
Penalty on shortfall in this reserve requirement is also same as that in case of CRR. Currently
RBI has kept the SLR at 19.5% of NDTL. As an illustration, if a bank has INR 100 Cr. worth of
NDTL, it is required to keep at least INR 19.5 Cr. in assets mentioned above or specified by RBI.
An increase in SLR would reduce the amount of money that banks can pump into the economy
and vice versa. However the effect of change in SLR is lesser compared to that witnessed with
the change in CRR.

Why do banks need to maintain both CRR and SLR?

The ultimate objective of maintaining CRR and SLR, apart from controlling credit growth in
the economy is to ensure the solvency of banks. In other words, CRR and SLR ensure that
banks are able to make necessary funds available to the public on demand as soon as possible.
The amount of funds to be kept for such purposes is determined by the RBI. Both CRR and
SLR are separated because it is like a security which is kept with the RBI against the Bank
itself. Suppose a case when bank collapses and customers are the victims and government is
not ready to revive, then RBI will use the CRR along with the sale of assets of a Bank to pay
the customers. While SLR on the other hand, is like a security which is kept with Bank itself
against the customers. Now suppose a case when bank has loaned out the total amount which
they were allowed to loan to a customer/s and now are not able to recover the loans (worst
case scenario). But bank has a responsibility to meet the demands of other customers. So,
bank uses SLR for this purpose.
If the banks keep all the required funds (around 23.5 % of NDTL) as CRR, then banks will
earn no interest on such funds and this shall add to the cost of banks, impacting the
profitability of the bank. On the other hand, banks are not allowed to maintain the entire
required funds as SLR because it does not provide immediate liquidity for the banks as
ensured by CRR.
Therefore, to provide for immediate liquidity banks keep small proportion (about 4% of
NDTL) as CRR earning no interest and the remaining as SLR earning some interest.
Repo Rate
When banks have any shortage of funds, they can borrow it from RBI or from other banks. The
rate at which the RBI lends money to commercial banks is called repo rate, an acronym for
repurchase agreement. Repo is a collateralized lending i.e. the banks which borrow money from
RBI have to sell securities, usually bonds to RBI with an agreement to repurchase the same at a
predetermined rate and date. In this way, for the lender of the cash (RBI), the securities sold by
the borrower are the collateral against default risk and for the borrower of cash (usually
commercial banks), cash received from the lender is the collateral. A reduction in the repo rate
will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI
becomes more expensive. Through repo rate operations, RBI injects liquidity in the economy.
As an illustration, if a bank has INR 100, CRR and SLR requirement would mandate the bank to
park INR 4 with RBI as CRR and it has to have RBI approved government securities worth INR
19.5. Now the bank can lend the remaining INR 76. Let us say in this case, out of the remaining
INR 76.5, bank had extra INR 1 invested in the form of government securities and it is in need of
extra capital to fund its immediate credit requirement. The bank can then enter into repurchase
agreement with RBI; RBI would pump it with cash (in case of overnight repo around INR 0.25)
by purchasing government securities worth that much money.

Reverse Repo Rate

Reverse repo rate is the rate at which the RBI borrows money from commercial banks. Banks are
always happy to lend money to the RBI since their money is in safe hands with a good interest.
An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn
higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money
out of the banking system.
Bank Rate
Bank Rate refers to the official interest rate at which RBI will provide loans to the banking
system which includes commercial / cooperative banks, development banks etc. Such loans are
given out either by direct lending or by rediscounting (buying back) the bills of commercial
banks and treasury bills. Thus, bank rate is also known as discount rate. Bank rate is used as a
signal by the RBI to the commercial banks on RBI’s thinking of what the interest rates should be.
When RBI increases the bank rate, the cost of borrowing for banks rises and this credit volume
gets reduced leading to decline in supply of money. Thus, increase in Bank rate reflects
tightening of RBI monetary policy.
Difference between Bank Rate and Repo Rate
Bank Rate and Repo Rate seem to be similar terms because in both of them RBI lends to the
banks. However, Repo Rate is a short-term measure and it refers to short-term loans and used for
controlling the amount of money in the market. On the other hand, Bank Rate is a long-term
measure and is governed by the long-term monetary policies of the RBI. In broader term, bank
rate is the rate of interest which a central bank charges on the loans and advances that it extends
to commercial banks and other financial intermediaries. RBI uses this tool to control the money
supply.
LAF functioning
Currently RBI has kept the repo rate at 6.50% and the reverse repo rate at 6.25%. RBI has
restricted lending undertaken under this facility to be 1% of NDTL for a particular bank.
Overnight repo provided under LAF is only 0.25% of NDTL for a particular bank, whereas term
(for 7-day and 14-day maturity) repos provided under LAF is 0.75% of NDTL of that bank. The
primary objective of the increased reliance on term repos is to improve the transmission of policy
impulses across the interest rate spectrum. This will mean that banks will have to borrow more
than they think they need and then use the call money market to offload excess liquidity (or
borrow even more, should they have borrowed less. The interbank call money market rate then
gives the RBI a better indicator of liquidity. This interbank money market rate should be close
enough to the repo rate, so that banks would rather borrow from each other than the RBI. This is
a change in the liquidity system, and RBI has attempted to move actively from now (lender of
first resort) to an actual lender of last resort.

Marginal Standing Facility

This facility was constituted by RBI to provide banks with overnight credit over and above the
limit of LAF. Similar to LAF, under this facility as well, banks borrow and lend money by
selling and buying excess SLR assets. The banks can borrow a maximum of 2% of NDTL from
this facility against their SLR holdings. Within this facility banks are allowed to borrow even if
they do not meet the SLR requirement, which means that even if they do not have excess SLR
funds, they can borrow up to 2% of their NDTL.
The table below aims at capturing how the banks can use the LAF and MSF facility.
NDTL 100
SLR Requirement 20
Overnight Overnight
Excess borrowing Borrowing Residual
SLR securities Comments
SLR through through SLR
Repo MSF
23 3 0.25 2 20.75 MSF limit of 2%
22.5 2.5 0.25 2 20.25 MSF limit of 2%
22.25 2.25 0.25 2 20 MSF limit of 2%
Reduces effective SLR by
21.25 1.25 0.25 2 19 1%
20.25 0.25 0.25 2 18 2%
20 0 - 2 18 2%
19 -1 - - 19 Compliance Issue
Market Stabilization scheme (MSS)

It is a monetary policy intervention by RBI to withdraw excess liquidity by selling government
securities called Market Stabilization Bonds (MSB). Initially, the MSS was launched to
withdraw the excess liquidity in the system that was generated as a result of the RBI’s purchase
of foreign currencies in the foreign exchange mark. After 2002, there was huge inflow of foreign
capital into India. This led to appreciation of rupee. Since appreciation is not good for exports,
the RBI intervened in the foreign exchange market by buying dollars. To buy dollars, the RBI
has to give rupees. In this way, high selling of rupees leads to excess liquidity (rupee) and
thereby creating a potential for inflation. To overcome this situation, the RBI has sold
government bonds on a general basis depending upon the volume of excess liquidity in the
system. Here bonds go to financial institutions and money goes back to the RBI. This withdrawal
of excess liquidity is called sterilisation.

Narrowing Interest rate corridor between the Repo and Reverse Repo rate in India
An interest rate corridor or a policy corridor refers to the range within which the operating target
of the monetary policy - a short term interest rate, say the weighted average call money market
rate - moves around the policy rate announced by the central bank.
Generally a corridor should have a discount rate or standing lending facility at the upper bound
and an uncollateralised deposit facility at the lower bound. The word standing facility means a
facility to access funds at a specified rate from the Central Bank (or deposit funds with Central
Bank) on a standing basis (i.e. non ad-hoc, operational throughout the year on a permanent
basis). The idea of a standing lending facility is to enable banks to obtain funding from the
central bank when all other options have been exhausted. Un-collateralized deposit facility (this
is also a standing facility though in many economies generally the word “standing facility” is
used only for indicating the permanent window for borrowing funds) provides an option for
banks to park their excess funds, for which there are no takers in the market. Since the funds are
parked with the central bank, there is generally no need to take securities as collateral.
The policy rate is the key lending rate of the central bank. It is generally the repo rate though the
nomenclature varies from country to country. If a bank has faced shortage of liquidity, then it can
approach the Central bank with acceptable collaterals to pledge and borrow funds at the repo
rate. The spreads around the policy rate for determination of the corridor is generally fixed such
that any change in the policy rate automatically gets translated into corresponding changes in the
standing facility rates. Notwithstanding the width of the formal corridor charted by the two
standing facilities, the overnight interest rate, in practice, varies around the policy rate in a
narrow corridor.
Interest Rate Corridor in India
In India, policy rate is the fixed repo rate

announced by the central bank - Reserve
Bank of India (RBI) - for its overnight
borrowing/lending operations through its
mechanism for managing short term
liquidity - the Liquidity Adjustment
Facility. The Repo Rate is an instrument
for borrowing funds by selling securities of
the Central Government or a State
Government or of such securities of a local
authority as may be specified in this behalf
by the Central Government or foreign
securities, with an agreement to repurchase
the said securities on a mutually agreed
future date atan agreed price which
includes interest for the funds borrowed.
The upper bound of the interest rate

corridor in India is served by the Marginal Standing Facility (MSF) rate, which is the penal rate
at which banks borrow money from the central bank and lower bound is served by the reverse
repo rate, the rate at which banks park their surplus with RBI by purchasing the securities from
central bank. As can be seen from the graph, the corridor has been reduced from +/- 100 bps to
+/- 50 bps, which was further reduced to +/- 25 bps in August 2017.
In one line: Interest rate corridor keeps the volatility of market interest rate in check and
within the prescribed corridor.
Shift of Base rate to Marginal Cost of Lending Rate

The main components of base rate system are:
 Cost of funds
 Operating expenses to run the bank.
 Minimum Rate of return i.e. margin or profit
 Cost of maintaining CRR
As it can be observed, the banks do not consider ‘repo rate’ in their calculations. They primarily
depend on the composition of CASA (Current accounts & Savings Accounts) and deposits to
calculate the lending rate. Most of the banks are currently following average cost of fund
calculation. So, any cut or increase in rates (especially key rate like Repo Rate) by the RBI is not
getting transmitted to the bank customers immediately.
As per the RBI’s new guidelines, it is mandatory for the banks to consider the repo rate while
calculating MCLR with effective from 1st April, 2016. The new method — Marginal Cost of
funds based Lending Rate (MCLR) will replace the present base rate system.
The main components of MCLR calculation are;
 Operating Expenses
 Cost of maintaining CRR
 Marginal Cost of funds
 After considering interest rates offered on savings / current / term deposit
accounts.
 Based on cost of borrowings i.e., short term borrowing rate which is repo rate &
also on long-term borrowing rates.
 Return on Net-worth
 Tenor Premium (an additional slab of interest over the base rate, based on the loan
tenure & commitments)
The main differences between the two calculations are i) marginal cost of funds & ii) tenor
premium. The marginal cost of funds will have high weightage while calculating MCLR. So, any
change in key rates (increase or decrease) like repo rate brings changes in marginal cost of
funds and hence the MCLR should also be changed by the banks immediately.

The main components of MCLR are broken down and arrived at as follows:
 Marginal cost of funds – The marginal cost of funds shall comprise of Marginal cost of
borrowings and return on net-worth. The detailed methodology for computing marginal
cost of funds is given as follows:
1. MARGINAL COST OF BORROWINGS Weightage in Marginal Cost

of funds
A. Deposits
Current Deposits
Savings Deposits
Term Deposits
Foreign Currency Deposits
B. Borrowings 92%
Short term rupee borrowings (Repo rate etc)
Long term rupee borrowings (Bank rate)
Foreign currency borrowings
2. RETURN ON NET WORTH 8%

MARGINAL COST OF FUNDS (1+2) 100%
Marginal Cost of Funds = Marginal cost of Borrowing X 92% + Return on Net worth
X 8%
Therefore, it can be inferred from the table that any change in the policy rate by RBI
(repo rate) shall have significant impact on the Marginal Cost of Funds and ultimately
the MCLR. Hence, MCLR serves truly serves its purpose of ensuring that any policy
changes by RBI gets reflected in the lending rates of the banks immediately.
 Negative carry on account of CRR– It is the cost of maintaining Cash Reserve Ratio
with the Reserve Bank of India. Banks don’t earn any interest on this deposit. Under
MCLR, banks are given some allowance for that. This is known as Negative Carry on
CRR. It is calculated as under:
Required CRR x (marginal cost) / (1- CRR)

The marginal cost of funds arrived at (iii) above shall be used for arriving at negative
carry on CRR.
 Operating Cost – All operating costs associated with providing the loan product
including cost of raising funds shall be included under this head. It shall be ensured
that the costs of providing those services which are separately recovered by way of
service charges do not form part of this component.
 Tenor Premium – These costs arise from loan commitments with longer tenor. The
change in tenor premium should not be borrower specific or loan class specific. In

other words, the tenor premium will be uniform for all types of loans for a given
residual tenor. It essentially denotes that higher interest can be charged from long term
loans.
Since MCLR will be a tenor linked benchmark, banks shall arrive at the MCLR
of various maturities by incorporating the corresponding tenor premium/ discount to
the sum of Marginal cost of funds, Negative carry on account of CRR and Operating
costs.
Accordingly, banks shall publish the internal benchmark for the following maturities:
a. overnight MCLR,
b. 1-month MCLR,
c. 3-month MCLR,
d. 6-month MCLR,
e. 1-year MCLR.
In addition to the above, banks shall have the option of publishing MCLR of any other longer
maturity.
RBI mandates at least 5 MCLR viz. overnight, 1-month, 3-months, 6-months and 1-year.
Banks can have MCLR of longer tenures if they so desire.
Banks have to declare MCLR for various tenors every month. All new loans in that month
will be offered at a spread over the MCLR. However, interest rate for existing loans will be
revised only on interest reset date, which will be specified in the agreement. Loans that are
linked to 3-month MCLR will have a 3-month interest reset period. Similarly, loans that are
linked to 1-year MCLR will have 1-year interest reset period. More on this later in this post.
Banks such as Kotak Mahindra Bank have linked home loan interest rates to 6-month MCLR
while ICICI Bank and SBI have linked home loan interest rates to 1-year MCLR.
Once you know the MCLR that you have found, you just need to adjust it with tenor
premium/discount to find MCLR for other tenors.
Interest Rates On Advances – Finally, banks arrive at the interest rates to be charged on
advances by adding a spread to the MCLR. This spread will depend on credit worthiness of
the borrower or the risk undertaken by the bank in lending to a particular person. Hence,
spread is a measure of risk. Under MCLR regime, this spread can be revised for a customer
but not without conducting the full risk profile exercise for the customer. This spread has two
components:-
(i) Business strategy:

The component shall be arrived at taking into consideration the business strategy, market
competition, embedded options in the loan product, market liquidity of the loan etc.

(ii) Credit risk premium:

The credit risk premium charged to the customer representing the default risk arising from
loan sanctioned shall be arrived at based on an appropriate credit risk rating/scoring model
and after taking into consideration customer relationship, expected losses, collaterals, etc.
Interest Rates on Advances = MCLR (Marginal Cost of Funds + Negative carry on CRR +
Operating Cost + Tenor premium) + Spread
RBI’s key guidelines on MCLR
 MCLR will be a tenor-based benchmark instead of a single rate. This allows banks to
more efficiently price loans at different tenors based on different MCLRs, according to
their funding composition and strategies.
 Banks have to review and publish their MCLR of different maturities every month on a
pre-announced date.
 The final lending rates offered by the banks will be based on by adding the ‘spread’ to the
MCLR rate.
 Banks may specify interest reset dates on their floating rate loans. They will have the
option to offer loans with reset dates linked either to the date of sanction of the
loan/credit limits or to the date of review of MCLR.
 The periodicity of reset can be one year or lower.
 The MCLR prevailing on the day the loan is sanctioned will be applicable till the next
reset date (irrespective of changes in the benchmark rates during the interim period). For
example, if the bank has given a one-year reset period in your loan agreement, and the
base rate at the beginning of the year is say 10%, even if the interest rate comes to 9% in
the middle of the year, the customer will continue at 10% till the reset date. Same will be
the case even if the interest rate increases above 10%.
 Existing borrowers with loans linked to Base Rate can continue with base rate system till
repayment of loan (maturity). An option to switch to new MCLR system will also be
provided to the existing borrowers.
 Once a borrower of loan opts for MCLR, switching back to base rate system is not
allowed
Exemptions from MCLR
 Loans covered by schemes specially formulated by Government of India wherein banks

have to charge interest rates as per the scheme, are exempted from being linked to MCLR
as the benchmark for determining interest rate.
 Working Capital Term Loan (WCTL), Funded Interest Term Loan (FITL), etc. granted as
part of the rectification/restructuring package, are exempted from being linked to MCLR
as the benchmark for determining interest rate.
 Loans granted under various refinance schemes formulated by Government of India or
any Government Undertakings wherein banks charge interest at the rates prescribed
under the schemes to the extent refinance is available are exempted from being linked to
MCLR as the benchmark for determining interest rate. Interest rate charged on the part
not covered under refinance should adhere to the MCLR guidelines.
 The following categories of loans can be priced without being linked to MCLR as the
benchmark for determining interest rate:
(a) Advances to banks’ depositors against their own deposits.
(b) Advances to banks’ own employees including retired employees.
(c) Advances granted to the Chief Executive Officer / Whole Time Directors.
(d) Loans linked to a market determined external benchmark.
(e) Fixed rate loans granted by banks. However, in case of hybrid loans where the
interest rates are partly fixed and partly floating, interest rate on the floating
portion should adhere to the MCLR guidelines.
How MCLR Works? (Example)
For instance, for salaried individuals, XYZ Bank has set a floating rate home loan at one-year
MCLR of 9.20% with a spread of 25 bps for loans of up to Rs.5 crore. So, the interest rate will
be 9.45% (9.20% +0.25%). This interest rate is valid till 30th April, 2017 (as given in the bank’s
website). XYZ Bank has decided to set one-year MCLR as the benchmark rate for their home
loans.
Though the MCLR is reviewed monthly, your home loan will be reset every year automatically,
depending on the agreement with the bank.
So, for an Rs.50-lakh home loan on 10th April, 2017, the home loan interest rate would be
9.45%. EMI installments at this rate of interest are to be paid for the next 12 months
Let’s say one-year MCLR gets revised to 9% in April, 2018 and the spread remains the same
then the home loan interest rate will be reset at 9.25% (MCLR of 9% plus spread of 25 bps).
Open Market Operations (OMO)

OMOs are the market operations conducted by the Reserve Bank of India by way of sale/
purchase of Government securities to/ from the market with an objective to adjust the rupee
liquidity conditions in the market on a durable basis. When the RBI feels there is excess liquidity
in the market, it resorts to sale of securities thereby sucking out the rupee liquidity. Similarly,
when the liquidity conditions are tight, the RBI will buy securities from the market, thereby
releasing liquidity into the market.

BASEL
Basel Committee on Banking Supervision, committee of the Bank for International Settlements,
an institution that promotes financial and monetary cooperation among the world’s central banks.
The Basel Committee on Banking Supervision was created in 1974 as an ongoing forum to
discuss banking supervisory matters.
The Basel Committee is guided by two overarching principles: no banking system should operate
unsupervised, and supervision of banks must be adequate. The work of the Basel Committee is
executed primarily through four subcommittees: the Accord Implementation Group, the Policy
Development Group, the Accounting Task Force, and the International Liaison Group. The
committee is best known for developing guidelines and standards in the areas of capital
adequacy, for overseeing cross-border banking activities, and for developing the core principles
of effective banking supervision.
Currently there are 27 member nations in the committee which also includes India. Basel
guidelines refer to broad supervisory standards formulated by this group of central banks - called
the Basel Committee on Banking Supervision (BCBS). The set of agreements by the BCBS,
which mainly focuses on risks to banks and the financial system, is called the Basel accord. The
purpose of the accord is to ensure that financial institutions have enough capital to meet
obligations and absorb unexpected losses. India has accepted Basel accords for the banking
system.
Basel I Norms
In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as
Basel I. It focused almost entirely on credit risk. It defined capital and structure of risk weights
for banks. The minimum capital requirement was fixed at 8% of risk weighted assets (RWA).
Basel II Norms
In June 2004, Basel II guidelines were published by BCBS, which were considered to be the
refined and reformed versions of Basel I accord. The guidelines were based on three parameters,
which the committee calls as pillars:
1. Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy
requirement of 8% of risk assets.
2. Supervisory Review: According to this, banks were needed to develop and use better risk
management techniques in monitoring and managing all the three types of risk that a bank faces,
viz. credit, market and operational risk.
3. Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily
disclose their CAR, risk exposure, etc. to the central bank.
Basel III Norms
In 2010, Basel III guidelines were released. These guidelines were introduced in response to the
financial crisis of 2008. A need was felt to further strengthen the system as banks in the
developed economies were under-capitalized, over-leveraged and had a greater reliance on short-
term funding. Also the quantity and quality of capital under Basel II were deemed insufficient to
contain any further risk. Basel III norms aim at making most banking activities such as their
trading book activities more capital-intensive. The guidelines aim to promote a more resilient
banking system by focusing on four vital banking parameters viz. capital, leverage, funding and
liquidity.
Note that Capital Adequacy Ratio is also known as Capital to Risk (Weighted) Assets Ratio
(CRAR).
Changes proposed in BASEL III over BASEL II norms:
a) Better Capital Quality: One of the key elements of Basel III is the introduction of much
stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This
in turn will mean that banks will be stronger, allowing them to better withstand periods of stress.
b) Capital Conservation Buffer: Another key feature of Basel III is that now banks will be
required to hold a capital conservation buffer. The buffer will be an additional 2.5% of Common
Equity Tier 1 capital requirement. The aim of asking to build conservation buffer is to ensure
that banks maintain a cushion of capital that can be used to absorb losses during periods of
financial and economic stress.
c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical
buffer has been introduced with the objective to increase capital requirements in good times and
decrease the same in bad times. The buffer will slow banking activity when it overheats and will
encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%
and will extend the capital conservation buffer previously described.
d) Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement
for common equity, the highest form of loss-absorbing capital, is 5.5% of total risk-weighted
assets. The overall Tier 1 capital requirement, consisting of not only common equity but also
other qualifying financial instruments, is 7%. Although the minimum total capital requirement is
9% level, yet the required total capital will increase to 11.5% when combined with the capital
conservation buffer.
e) Leverage Ratio: A review of the financial crisis of 2008 has indicated that the value of many
assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a
leverage ratio to serve as a safety net. A leverage ratio is the relative amount of Tier 1 capital to
total assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking
sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage
ratio is introduced in March 2019.
f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created.
A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be
introduced in a phased manner ending 2018.

The goal of the liquidity coverage ratio (LCR) is to ensure that banks have adequate, high quality
liquid assets to survive a short-term stress scenario. The definition of the standard is as follows:
The goal of the net stable funding ratio (NSFR) is to protect banks over a longer time horizon.
The net stable funding ratio promotes a sustainable maturity structure for assets and liabilities by
creating incentives for banks to use more stable funding sources.
Available stable funding sources (ASF) include Capital, preferred stock with a maturity of more
than one year, liabilities with an effective maturity of more than one year, non-maturity deposits
and time deposits that would be expected to stay at the bank in periods of extended stress, the
proportion of wholesale funds that would be expected to stay at the bank in periods of extended
stress.
The building blocks of Basel III are by and large higher and better quality capital, an
internationally harmonized leverage ratio to constrain excessive risk taking, capital buffers which
would be built up in good times so that they can be drawn down in times of stress, minimum
global liquidity standards, and stronger standards for supervision, public disclosure and risk
management.
Implementation of BASEL III in India
RBI has mandated implementation of BASEL III norms in India by March 2019 in a phased
manner. The table below shows the implementation of these norms:-

The LCR started on March 1, 2015 and reaching minimum 100% on March 1, 2019, while the
NSRF will be introduced by the January 1, 2018.
Impact of BASEL III on Indian Banks
Higher Capital Requirement: Due to introduction of capital conversation buffer from 2015,
banks would require capital infusion. According to an estimate, for public banks (i.e. SBI & its
associates and nationalized banks) this capital infusion would be of the order of INR 2.4 trillion.
It can be brought in by two methods

a) Divestment of promoters’ equity (Government’s stake)
b) Capital infusion by the government budgetary allocation. Since divestment of such a large
portion of equity would be impractical, the most probable choice of capital accumulation for
these banks would be through budgetary allocation, which could impact government efforts to
improve its fiscal deficit situation. In the latest budget government has allocated around INR
25000 crore for the process of capital infusion. This stress of fiscal deficit could in a way impact
economic growth, inflation and thereby bank profitability.
Return on Equity (ROE): Apart from capital infusion by the government, these banks will have
to raise capital from the market, pushing up the interest rates and subsequently cost of capital,
which would put pressure on ROE of the banks, thereby forcing them to increase their lending
rates to recover their losses.
Yield on Assets: On account of higher deployment of funds in liquid assets that give
comparatively lower returns, banks' yield on assets, and thereby their profit margins, may be
under pressure.
As part of its goal towards achieving BASEL implementation banks would look forward for the
following course of action:
Change in Business Mix: Banks would look forward to accumulate assets which have lesser
risk weight. As a result of this assets such as retail loans might be given priority over corporate
loans. Within corporate loans as well, banks would look to shift towards shorter term loans
which will have lesser risk weight associated to them.

Low Cost Funding: Implementation of BASEL III norms would be easier if banks have a stable
low cost deposit base. More banks would look forward to increase their CASA ratio which will
ensure lowest cost funds available to them.
Managing financial Risks for Banks-Asset Liability Management

The income of banks comes mostly from the spreads maintained between total interest income
and total interest expense. The higher the spread the more will be the NIM. There exists a direct
correlation between risks and return. As a result, greater spreads only imply enhanced risk
exposure. But since any business is conducted with the objective of making profits and achieving
higher profitability is the target of a firm, it is the management of the risk that holds key to
success and not risk elimination.
There are three different but related ways of managing financial risks.
 The first is to purchase insurance. But this is viable only for certain type of risks such as
credit risks, which arise if the party to a contract defaults.
 The second approach refers to asset liability management (ALM). This involves careful
balancing of assets and liabilities. It is an exercise towards minimizing exposure to risks
by holding the appropriate combination of assets and liabilities so as to meet earnings
target of the firm.
 The third option, which can be used either in isolation or in conjunction with the first two
options, is hedging. It is to an extent similar to ALM. But while ALM involves on-
balance sheet positions, hedging involves off-balance sheet positions. Products used for
hedging include futures, options, forwards and swaps.
It is ALM, which requires the most attention for managing the financial performance of banks.
Asset-liability management can be performed on a per-liability basis by matching a specific asset
to support each liability. Alternatively, it can be performed across the balance sheet. With this
approach, the net exposure of the bank’s liabilities is determined, and a portfolio of assets is
maintained, which hedges those exposures.
Asset-liability analysis is a flexible methodology that allows the bank to test interrelationships
between a wide variety of risk factors including market risks, liquidity risks, actuarial risks,
management decisions, uncertain product cycles, etc. However, it has the shortcoming of being
highly subjective. It is up to the bank to decide what mix would be suitable to it in a given
scenario. Therefore, successful implementation of the risk management process in banks would
require strong commitment on the part of the senior management to integrate basic operations
and strategic decision making with risk management.
The scope of ALM function can be described as follows:
 Liquidity risk management.

 Management of market risks.

 Trading risk management.

 Funding and capital planning
 Profit planning and growth projection.
ALM process will involve the following steps:
 Reviewing the interest rate structure and comparing the same to the pricing of both assets
and liabilities. This would help in highlighting the impending risk and the need for
managing the same.
 Examining loan and investment portfolio in the light of forex and liquidity risk. Due
consideration should be given to the affect of these risks on the value and cost of
liabilities.
 Determining the probability of credit risk that may originate due to interest rate
fluctuations or otherwise, and assess the quality of assets.
 Reviewing the actual performance against the projections made. Analyzing the reasons
for any affect on the spreads.
Other Financial risks associated with Banks

As financial intermediaries, banks assume two primary types of risk as they manage the flow of
money through their business. Interest rate risk is the management of the spread between interest
paid on deposits and received on loans over time. Credit risk is the likelihood that a borrower
will default on a loan or lease, causing the bank to lose any potential interest earned as well as
the principal that was loaned to the borrower. As investors, these are the primary elements that
need to be understood when analyzing a bank's financial statement.
Interest Rate Risk
The primary business of a bank is managing the spread between deposits (liabilities, loans and
assets). Basically, when the interest that a bank earns from loans is greater than the interest it
must pay on deposits, it generates a positive interest spread or net interest income. The size of
this spread is a major determinant of the profit generated by a bank.
As a result, net interest income will vary, due to differences in the timing of accrual changes and
changing rate and yield curve relationships. Changes in the general level of market interest rates
also may cause changes in the volume and mix of a bank's balance sheet products. For example,
when economic activity continues to expand while interest rates are rising, commercial
loan demand may increase while residential mortgage loan growth and prepayments slow.This
interest rate risk is primarily determined by the shape of the yield curve.

Yield curve analysis and its impact on banks

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal
credit quality but differing maturity dates. This yield curve is used as a benchmark for other debt
in the market, such as mortgage rates or bank lending rates, and it is also used to predict changes
in economic output and growth. The yield curve describes the differential between short-term
and long-term treasury yields – typically 3 years and 10 year government treasury bills.
Normally, the shape of the curve slopes upward as investors demand greater yields to
compensate for the risk of lending money over a longer period.
Banks are able to generate revenues from a variety of business activities. They charge fees for
credit card transactions and mortgage originations, they charge fees for investment banking and
trading services and, perhaps most importantly, they charge higher rates of interest on the loans
they issue than those that they pay on the deposits they receive. The difference between these
two rates of interest is called net interest margin. It is argued that yield curve and banks’ net
interest margins share a logical relationship.
Therefore, banks, in the normal course of business, assume financial risk by making loans at
interest rates that differ from rates paid on deposits. Deposits often have shorter maturities than
loans and adjust to current market rates faster than loans.
The key to understanding the relationship between market interest rates (yield curve) and net
interest margins is that banks typically “lend long and borrow short”. This known as "term
transformation". That is, the average maturity of the loans in a bank’s portfolio tends to exceed
the average maturity of its deposits and other debt. In other words, banks pay interest on their
deposits based upon short-term interest rates while making loans tied to long-term interest rates.
The result is a balance sheet mismatch between assets (loans) and liabilities (deposits). An
upward sloping yield curve is favorable to a bank as the bulk of its deposits are short term and
their loans are longer term. This mismatch of maturities generates the net interest revenue banks
enjoy. When the yield curve flattens, this mismatch causes net interest revenue to diminish.
Thus, the difference between interest paid and received, which is the net interest margin, is
influenced by the slope of the yield curve, defined as the spread between short term and long
term interest rates. Hence, when market interest rates fall, banks’ funding costs usually fall more
quickly than their interest income, and net interest margins rise.

The yield curves can take three shapes:-
 Up-sloped yield curve

This is the normal yield curve indicating
that yields on a longer-term bonds may
keep on rising, responding to periods of
economic expansion. An upward sloping
yield curve is favorable to a bank as the
bulk of its deposits are short term and their
loans are longer term. This mismatch of
maturities generate the net interest revenue
banks enjoy.
 Flat yield curve
A flat yield curve may arise from normal

or inverted yield curve, depending on
changing economic scenario. When the
economy is transitioning from expansion
to slower development and even recession
or from recession to recovery and
potentially expansion, the yield curve
tends to flatten out.
A flatter yield curve has an adverse impact

on banks’ returns as it compresses lenders’
net interest margin.
During this period, banks need to pay more emphasis on increasing their fee income, which
they charge for their services, as whatever the bank is earning in the form of interest income
from advances, it is spending it in the form of interest on deposits. Hence, the net interest
margin is zero (or relatively close to zero) and the only way banks can sustain their operations
is if they increase their other income.
 Inverted yield curve
An inverted yield curve occurs when short-term interest rates

exceed long-term rates. From an economic perspective, an
inverted yield curve is a major event. Typically, the yield
curve slopes upwards, reflecting higher yields for longer-term
investments. When the spread between short-term and long-
term interest rates narrows, the yield curve begins to flatten. A
flat yield curve is often seen during the transition from a normal yield curve to an inverted
one.
Historically, an inverted yield curve has been viewed as an indicator of a pending economic
recession. Under these unusual circumstances, long-term investors will settle for lower yields
now if they think the economy will slow or even decline in the future.
Since banks usually borrow on a short term basis and lend on a long term basis, this inversion
in yield curve severely impacts the profit margins of the bank. Under this scenario, banks
would borrow at a higher rate of interest than what they earn on advances. Hence, when the
yield curve inverts, banks are better-off without lending any amount.

Yield Curve – The Indian Context
India Yield Curve
As in the case of India, the yield curve is increasing, hence the banks are earning profits by
lending at a higher rate and borrowing at relatively lower rates.
Indian Government Bond Spread (10 Yr – 2 Yr)
How banks manage the yield curve
There are various ways through which banks manage the impact of the flattening of the yield
curve:-
One way may be attributed to changing banking regulations and product differentiation which
has enabled banks to diversify into non-traditional activities. The banks try to overcome the

impact by increasing the fees they charge for services. As these fees become a larger portion of
the bank's income, it becomes less dependent on net interest income to drive earnings.
Two, exposure to interest rate movements have been moderated through the development of
new financial products such as interest rate swaps, securitization and adjustable rate loans.
Three, banks have been able to offset the impact of declining yields on net interest margins of
banks by funding more of their assets through non-interest bearing liabilities such as equity and
demand deposits.
Changes in the general level of interest rates may affect the volume of certain types of banking
activities that generate fee-related income. For example, the volume of residential mortgage
loan originations typically declines as interest rates rise, resulting in lower originating fees. In
contrast, mortgage-servicing pools often face slower prepayments when rates are rising, since
borrowers are less likely to refinance. As a result, fee income and associated economic
value arising from mortgage servicing-related businesses may increase or remain stable in
periods of moderately rising interest rates.
When analyzing a bank, you should also consider how interest rate risk might act jointly with
other risks facing the bank. For example, in a rising rate environment, loan customers may not be
able to meet interest payments because of the increase in the size of the payment or a reduction
in earnings. The result will be a higher level of problem loans. An increase in interest rates
exposes a bank with a significant concentration in adjustable rate loans to credit risk. For a bank
that is predominately funded with short-term liabilities, a rise in rates may decrease net interest
income at the same time that credit quality problems are on the rise.
Credit Risk
Credit risk is most simply defined as the potential of a bank borrower or counterparty to fail in
meeting its obligations in accordance with agreed terms. When this happens, the bank will
experience a loss of some or all of the credit it provided to its customer. To absorb these losses,
banks maintain a provision for loan and lease losses.
In essence, this provision can be viewed as a pool of capital specifically set aside to absorb
estimated loan losses. This allowance should be maintained at a level that is adequate to absorb
the estimated amount of probable losses in the institution's loan portfolio.Actual losses are
written off from the balance sheet account for loan and lease losses.
Arriving at the provision for loan losses involves a high degree of judgment, representing
management's best evaluation of the appropriate loss to reserve. Because it is a management
judgment, the provision for loan losses can be used to manage a bank's earnings.An investor
should be concerned that this bank is not reserving sufficient capital to cover its future loan and
lease losses.
A careful review of a bank's financial statements can highlight the key factors that should be
considered before making a trading or investing decision. Investors need to have a good
understanding of the business cycle and the yield curve - both have a major impact on the

economic performance of banks. Interest rate risk and credit risk are the primary factors to
consider as a bank's financial performance follows the yield curve.
Liquidity Risk
Banks are also expected to provide liquidity management services. For instance, there could be a
company that is due to receive a large payment from a client in a few days but is in urgent need
of money now. It can go to a bank, sell its receivables to it at a discount, and get immediate cash
in return.
Many businesses also pay a regular fee to a bank to avail of overdraft facility. All this makes it
necessary for banks to have sufficient liquidity to be able to meet the demands made on them.
Hence the prudential norms (such as CAR) that are imposed on them and the overnight lending
window provided by RBI.
Money Markets
A money market is a market for borrowing and lending of short-term funds. It deals in funds and
financial instruments having a maturity period of one day to one year. It is a mechanism through
which short-term funds are loaned or borrowed and through which a large part of financial
transactions of a particular country or of the world are cleared. Money market securities consist
of negotiable certificates of deposit (CDs), bankers’ acceptances, Treasury bills, commercial
paper, municipal notes, federal funds and repurchase agreements (repos).
Money Markets in India
In order to enhance the transmission of monetary policy, RBI has consistently encouraged
development of money market. The Indian money market consists of highly liquid short term
instruments which are explained below:-
Treasury Bills
This market deals in Treasury Bills of short term duration issued by RBI on behalf of
Government of India. At present three types of treasury bills are issued through auctions, namely
91 day, 182 day and 364 day treasury bills. Interest is determined by market forces. Treasury
bills are available for a minimum amount of Rs. 25,000 and in multiples of Rs. 25,000. Periodic
auctions are held for their issue. T-bills are a highly liquid, readily available and risk free
instrument.
Call Money and Notice Market
Call money market is the market for extremely short-period borrowings. Under call money
market, funds are transacted on overnight basis. Mostly the participants are banks. Therefore it is
also called Inter-Bank Money Market. In this market the rate at which funds are borrowed and
lent is called the call money rate. The call money rate is determined by demand and supply of
short term funds. Under notice money market funds are transacted for 2 days and 14 days period.

The lender issues a notice to the borrower 2 to 3 days before the funds are to be paid. On receipt
of notice, borrower has to repay the funds.
The call money market rate generally hovers between the repo and the reverse repo rate as any
rate offered above the repo rate or below the reverse repo rate creates an opportunity for
arbitrage. However if still it is consistently above the repo rate then it signifies that banks have
borrowed their limit from the LAF facility. Such a situation shows that there is huge pressure on
liquidity and RBI then takes steps to ensure that there is sufficient liquidity available in the
system.
Under notice money market funds are transacted for 2 days and 14 days period. The lender issues
a notice to the borrower 2 to 3 days before the funds are to be paid. On receipt of notice,
borrower has to repay the funds.
Term money refers to borrowing/lending of funds for a period exceeding 14 days and generally
has maturity up to 1 year. The interest rates on such funds depend on the surplus funds available
with lenders and the demand for the same.
Commercial Papers (CP)
The Commercial Papers can be issued by listed companies which have working capital of not
less than INR 5 crores. CPs could be issued in multiple of INR 25 lakhs with the minimum size
of issue being INR 1 crore. At present the maturity period of CPs ranges between 7 days to 1
year. CPs are issued at a discount to the face value and redeemed at face value.
Certificate of Deposits (CDs)
CDs are issued by Commercial banks and development financial institutions. They are
unsecured, negotiable promissory notes issued at a discount to the face value. The scheme of
CDs was introduced in 1989 by RBI. The main purpose was to enable the commercial banks to
raise funds from market. The maturity period of CDs ranges from 3 months to 1 year. They are
issued in multiples of INR 25 lakh, subject to a minimum size of INR 1 crore. CDs can be issued
at discount to face value. They are freely transferable but only after the lock-in-period of 45 days
after the date of issue. However the size of CDs in India is relatively very small.
Collateralized Borrowing and Lending Obligation (CBLO)
In a similar manner like Repo, an organization with surplus funds can lend out its money in the
market to other organizations in need of funds with collateral in place. While call money market
caters to the need of banks and primary dealers, CBLO generally lends out to mutual funds,
insurance & financial companies etc. in addition to primary dealers and banks. The only
difference is that CBLO involves collateral. Interested parties are required to open Constituent
Subsidiary General Ledger (CSGL) Account with Clearing Corporation of India Limited (CCIL)
for depositing securities as collateral.
Mumbai Inter-Bank Offered Rate (MIBOR)
MIBOR can be defined as the interest rate at which banks can borrow funds, in marketable size,
from other banks in the Indian interbank market. The association of bond dealers, local currency

traders and bankers formed a new firm to fix the Mumbai Inter-Bank Offer Rate (MIBOR), in
line with a Reserve Bank of India (RBI) panel recommendation which seeks to avoid a Libor
(London Interbank Offer Rate) like fiasco in India.
Currently the application of MIBOR is meager when compared with the London Interbank Offer
Rate (LIBOR). However RBI has restructured the LAF such that the term repo window is getting
shaped. This would lead to the existence and relevance of the term curve. If the term curve
comes in the market, then MIBOR will have a larger role. Over a period of time, inter-bank term
money quotes will be based on the term curve. At that time, MIBOR may also be used for
pricing of money market instruments. LIBOR is a global benchmark for interest rates. It is used
as the base for deciding interest rates on loans, savings and mortgages. It is also used as a base
rate for many financial products, such as futures, options
and swaps.
Role of Money Markets in Monetary Policy Transmission

The money market forms the first and foremost link in the transmission of monetary policy
impulses to the real economy. Policy interventions by the central bank along with its market
operations influence the decisions of households and firms through the monetary policy
transmission mechanism. The key to this mechanism is the total claim of the economy on the
central bank, commonly known as the monetary base or high-powered money in the economy.
The central bank’s power to conduct monetary policy stems from its role as a monopolist, as the
sole supplier of bank reserves, in the market for bank reserves. Following are the instruments
used by it for the same.
Open Market Operations
When RBI buys (sells) securities, it credits (debits) the reserve account of the seller (buyer)
bank. This increases (decreases) the total volume of reserves that the banking system collectively
holds. Expansion (contraction) of the total volume of reserves in this way leads to banks to
exchange reserves for other remunerative assets. Since reserves earn low interest banks typically
would exchange them for some interest bearing asset such as Treasury Bills or other short-term
debt instruments. If the banking system has excess (inadequate) reserves, banks would seek to
buy (sell) such instruments. If there is a general increase (decrease) in demand for these
securities, it would result in increase (decline) in security prices and decline (increase) in interest
rates.
Cash Reserve Requirement
Lowering (increasing) the cash reserve requirement, and, therefore, reducing (increasing) the
demand for cash has roughly the same impact as an expansionary (contractionary) open market
operation, which increases (decreases) the supply of reserves creating downward (upward)
pressure on interest rates.
Repo Rate
The rate at which the RBI lends money to commercial banks is called repo rate, also known as
the policy rate, which usually acts as the ceiling on call rates in the short-term market. Similarly,
central bank absorbs liquidity at a rate which acts as the floor for short-term market interest rates
by borrowing reserves from banks in exchange for assets, also known as reverse repo. The repo
rate acts as a ceiling because injecting liquidity at the ceiling rate would ensure that banks do not
have access to these funds for arbitrage opportunities whereby they borrow from the central bank
and deploy these funds in the market to earn higher interest rates. Similarly, liquidity absorption
by the RBI has to be at the floor rate since deployment of funds with the central bank is free of
credit and other risks. Typically, the objective of the central bank is to modulate liquidity
conditions by pegging short-term interest rate.
Government Finances
Every year, the Government puts out a plan for its income and expenditure for the coming year.
This is known as the annual Union Budget. A budget is said to have a fiscal deficit when the
Government's expenditure exceeds its income. When faced with deficits governments have one
of the two options:
 To raise money through taxes in order to bridge the deficit
 To borrow more money in order to meet its spending requirements
Fiscal deficit
The size of fiscal deficit has substantial effect on the economy of India. While small amounts of
fiscal deficits generally have a positive effect on the economy, large amounts are detrimental for
the health of the economy. In case of high fiscal deficit, governments generally borrow more
money thereby leading to a shortage of funds for the industry and a rise in interest rates. This
hurts industrial growth in the country. Governments can also resort to printing money to pay off
their debts and this could also increase inflation.
Government’s fiscal deficit for FY 17 stood at 3.50% of GDP which was better compared to
3.92% of FY 16. The budgeted estimate of fiscal deficit for FY 18 is around 3.2% of GDP.
Current Account Deficit
Current account deficit occurs when a country's total imports of goods, services and transfers are
greater than the country's total export of goods, services and transfers. This situation makes a
country a net debtor to the rest of the world. In order to tackle with this situation the central bank
issues promissory note. This in turn tightens the money supply and increases the cost of supply
of funds for the banks.
Current account deficit narrowed down to USD 3.4 billion, or 0.7 per cent of GDP, in the fourth
quarter of 2016-17 from USD 7.9 billion, or 1.06 per cent, in third quarter, on account of lower
trade gap. The overall Current account deficit for 2016-17 shrank to 0.7% as compared to 1.1%
in 2015-16. During the fiscal, there was decline in net invisible receipts, mainly due to
moderation in both software exports and net private transfer receipts, and higher outgo on
account of primary income (profit, interest and dividends. Net FDI inflows in 2016-17
marginally declined to $35.6 billion from $36 billion reported during 2015-16.
In 2016-17, there was an accretion of USD 21.5 billion to foreign exchange reserves (on BoP
basis) as compared with USD 17.9 billion in 2015-16
Major Banking Sector Reforms since 1991

The economic reforms initiated in 1991 also embraced the banking system. Following are the
major reforms aimed at improving efficiency, productivity and profitability of banks:
 Finance Minister Mr Arun Jaitley has proposed various measures to quicken India's transition
to a cashless economy, including a ban on cash transactions over Rs 200,000 (US$ 3,100),
tax incentives for creation of a cashless infrastructure, promoting greater usage of non-cash
modes of payments, and making Aadhaar-based payments more widespread.
 The Government of India has announced demonetisation of high denomination bank notes of
Rs 1000 and Rs 500, with effect from November 08, 2016, in order to eliminate black money
and the growing menace of fake Indian currency notes, thereby creating opportunities for
improvement in economic growth.
 The RBI has cut its key repo rate by 25 basis points to 6 per cent, in order to boost growth as
according to RBI, the inflation momentum has moderated because of a normal monsoon.
 Government of India has decided to amend Section 35 A of the Banking Regulation Act that
will allow the Reserve Bank of India (RBI) to direct banks for the recovery of non-
performing assets (NPAs)
 The Ministry of Labour and Employment has successfully opened around 3,840,863 bank
accounts as on December 26, 2016, for workers especially in the unorganised sector, as part
of its campaign to promote and ensure cashless transfer of wages to workers.
 The National Bank for Agriculture and Rural Development (NABARD) plans to provide
around 200,000 point-of-sale (PoS) machines in 100,000 villages and distribute RuPay cards
to over 34 million farmers across India, to enable farmers to undertake cashless transactions.
 The Government of India’s indigenous digital payments application, BHIM (Bharat Interface
for Money), has recorded 18 million downloads since its launch on December 30, 2016,
according to Mr Amitabh Kant, Chief Executive Officer, NITI Aayog.
 The Ministry of Finance has lowered the threshold for making electronic payments to
suppliers, contractors or institutions from Rs 10,000 (US$ 150) to Rs 5,000 (US$ 75), in
order to attain the goal of complete digitisation of government payments.
 Aggregate foreign investment (FDI, FII and NRI) up to 74% allowed in private sector banks
 Phased liberalization of branch licensing. Banks can now open branches in Tier 2 to Tier 6
centres without prior approval from the Reserve Bank
 Deregulation of a complex structure of deposit and lending interest rates to strengthen
competitive impulses, improve allocative efficiency and strengthen the transmission of
monetary policy
 Use of information technology to improve the efficiency and productivity, enhance the
payment and settlement systems and deepen financial inclusion
 Improvements in the risk management culture of banks
 The minimum daily maintenance of CRR reduced from 95 per cent of the requirement to 90
per cent effective April 16, 2016.
 The policy rate corridor was narrowed from +/-100 bps to +/- 50 bps and then to +/- 25 bps
by reducing the MSF rate by 75 bps to 7.0 per cent and then to 6.50 per cent and increasing
the reverse repo rate by 25 bps to 6.0 per cent for finer alignment of the weighted average
call rate (WACR) with the policy repo rate

Recent Developments
Repo continuously increasing
The Monetary Policy Committee (MPC) till August 2018 increase the repo rate twice by 25 basis
point in a space of two months to increase it to 6.5 per cent.The decision of the MPC is
consistent with the neutral stance of monetary policy in consonance with the objective of
achieving the medium-term target for consumer price index (CPI) inflation of 4 per cent within a
band of +/- 2 per cent, while supporting growth.
CPI inflation for 2018-19 was projected at 4.8-4.9 per cent in H1 and 4.7 per cent in H2. The
inflation outlook is likely to be shaped by several factors.
1. The central government has decided to fix the minimum support prices (MSPs) of at least
150 per cent of the cost of production for all kharif crops for the sowing season of 2018-19.
This increase in MSPs for kharif crops, .It will have a direct impact on food inflation and
second round effects on headline inflation. However, there is a considerable uncertainty and
the exact impact would depend on the nature and scale of the government’s procurement
operations.
2. Crude oil prices have moderated slightly, but remain at elevated levels.
3. The central government has reduced Goods and Services Tax (GST) rates on several goods
and services. This will have some direct moderating impact on inflation, provided there is a
pass-through of reduced GST rates to retail consumers.
4. Inflation in items excluding food and fuel has risen significantly in recent months, reflecting
greater pass-through of rising input costs and improving demand conditions.
5. Financial markets continue to be volatile since the beginning of 2018.
Transmission remains on course
Liquidity in the banking system has stayed in the surplus zone, facilitating swifter transmission
of interest rate cuts across instruments. So far in the current easing cycle starting January 2015,
the repo rate has been reduced by 200 bps, while rates on commercial paper (CP) and certificates
of deposit (CD) have also fallen by the same extent. In level terms, too, rates offered on these
papers are closer to the repo rate. That suggests monetary transmission is happening. However,
there continues to be some rigidity in bank lending rates. The MPC has proposed a review of the
current marginal cost of lending rate (MCLR) mechanism to introduce a more dynamic bank
lending rate that is directly benchmarked to market rates.

Transmission in lending rates appears on track for most instruments
Note: *period-end, **6 month tenure and as of July 2017, ***major 10 banks, average, ****top 7 public sector banks,
average. For MCLR, rate change is with respect to April 2016
Source: RBI, CEIC, CRISIL Research
Government notifies Banking Regulation (Amendment) Act, 2017
The Union Government has notified the Banking Regulation (Amendment) Act, 2017. The
Parliament had approved the Banking Regulation (Amendment) Bill, 2017 which replaced an
ordinance in this regard. It amended the Banking Regulation Act, 1949 by adding provisions for
handling cases related to stressed assets or non-performing assets (NPAs) of banks.
Key Facts
The Act empowers the Central government to authorize the Reserve Bank of India (RBI) to
direct banking companies to resolve specific stressed assets by initiating insolvency resolution
process under the Insolvency and Bankruptcy Code, 2016. The RBI can specify authorities or
committees to advise banks on resolution of stressed assets. The members on the committees will
be appointed or approved by the RBI. The Act also make these provisions applicable to the SBI
and its subsidiaries and also Regional Rural Banks (RRBs).
Background
The banking sector in India is saddled with non-performing assets (NPAs) of over Rs.8 lakh
crore, of which, Rs. 6 lakh crore are with public sector banks (PSBs). The Union Government in
May 2017 had promulgated an ordinance authorising the RBI to issue directions to banks to
initiate insolvency resolution process under the Insolvency and Bankruptcy Code, 2016. The RBI
had identified 12 accounts each having more than Rs. 5000 crore of outstanding loans and
accounting for 25% of total NPAs of banks for immediate referral for resolution under the
bankruptcy law. The bulk of the NPAs are in various sectors including power, steel, road
infrastructure and textiles.
Fed hikes interest rates despite declining inflation
The Federal Reserve announced a quarter-point rate hike in June 2018. The central bank last
increased its benchmark rate in March. It aimed at staying ahead of growing inflation amid

strong growth and robust employment

The Federal Reserve approved its second rate hike of 2018 even amid expectations that inflation
is running well below the central bank's target. The new target range will be 1.75 per cent to 2.00
per cent.
Policymakers' upbeat sentiment about the US economy is substantiated by robust growth, which
is expected accelerate in the second quarter from an already respectable 2.2 percent in the first
three months of 2018. US unemployment has fallen to just 3.8 percent in May 2018, matching
the lowest in 48 years and signalling the central bank is at or near its maximum-employment
goal.
The benchmark for 2019 is now 3.1 percent, up from the previous 2.9 percent, which signals four
hikes next year rather than three. Among the clouds the Fed may see on the horizon is the threat
of a tit-for-tat escalation on global trade from US President Donald Trump's protectionist
measures. Emerging market vulnerabilities are another, given the possibility of capital flight
driven by tightening monetary policy in the US and the euro zone.
Some of the most dramatic effects of higher US interest rates have appeared in emerging
markets, as this lures back investors who had turned overseas in recent years in search of returns.
The retreat from emerging markets so far remains relatively modest, with weekly flows to bond
and equity funds down less than 10 percent from their peaks. But the trend coincides with a
stronger US dollar and is contributing to currency crises in countries such as Argentina, Turkey
and Brazil. It has also prompted central banks elsewhere, including in India, Indonesia, Malaysia
and Hong Kong, to raise their own interest rates to stem the outflow of foreign capital they need
for investment and growth.
National Payments Corporation of India success with United Payment Interface (UPI)
Transactions through India’s homegrown Unified Payments Interface — which allows mobile
apps run by retailers, airlines and other firms to take payment directly from bank accounts —
reached almost half the value of debit and credit cards swiped at stores last month, central bank
data show.

With success of UPI, GoI launched UPI 2.0 with salient features like:
1. Linking of overdraft account: In addition to current and savings accounts, customers can
link their overdraft account to UPI. Customers will be able to transact instantly and all benefits
associated with overdraft account shall be made available to the users.
2. One-time mandate: UPI 2.0 mandates are created with one-time block functionality for
transactions. Customers can pre-authorise a transaction and pay at a later date. It works
seamlessly for merchants as well as for individual users. Mandates can be created and executed
instantly. On the date of actual purchase, the amount will be deducted and received by the
merchant/individual user.
3. Invoice in the inbox: According to NPCI, this feature is designed for customers to check the
invoice sent by merchant prior to making payment. It will help customers to view and verify the
credentials and check whether it has come from the right merchant or not. Customers can pay
after verifying the amount and other important details mentioned in the invoice.
4. Signed intent and QR: This feature is designed for customers to check the authenticity of
merchants while scanning QR or quick response code. It notifies the user with information to
ascertain whether the merchant is a verified UPI merchant or not. This provides an additional
security. Customers will be informed in case the receiver is not secured by way of notifications,
said NPCI.
30 stressed power accounts set to go to NCLT
Lenders to about 30 stressed power assets will refer them to bankruptcy courts, after the
Allahabad High Court denied any relief to the sector from the Reserve Bank of India’s February
12, 2018 circular setting a 180-day deadline for resolution. As no resolution happened, they now
will be referred to NCLT for bidding or liquidating. These comprise 18 coal-run and a dozen
gas-based and hydropower projects. More than two dozen projects are incomplete and will find it
hard to attract buyers. Among stressed assets that were undergoing SDR but were incomplete are
Rattan India Amravati, Athena Chhattisgarh, GMR Vemagiri, three projects of Lanco Infra,
Vandana Vidyut and JAL Power.
The Insolvency and Bankruptcy code, 2016
The Insolvency and Bankruptcy Code, 2015 was introduced by the Minister of Finance, Mr.
Arun Jaitley, in Lok Sabha on December 21, 2015, and subsequently referred to a Joint
Committee of Parliament. The Committee submitted its recommendations and a modified Code
based on its suggestions on April 28, 2016. This modified Code was passed by Lok Sabha on
May 5, 2016. The Code creates a framework for resolving insolvency in India. Insolvency is a
situation where an individual or a company is unable to repay their outstanding debt. The
bankruptcy code has provisions to address cross-border insolvency through bilateral agreements
with other countries. It also proposes shorter, aggressive time frames for every step in the
insolvency process—right from filing a bankruptcy application to the time available for filing
claims and appeals in the debt recovery tribunals, National Company Law Tribunals and courts.
The Code will apply to companies, partnerships, limited liability partnerships, individuals
andand any other body specified by the Central Government.

The new RBI directive states that once a default has occurred, the bank will have 180 days
within which it should come up with a resolution plan. Should they fail, they will need to refer
the account to Insolvency and Bankruptcy Code (IBC) within fifteen days.
Once an account is referred to IBC, a provision of 50% needs to be made in the books of
accounts. Earlier, banks used to delay the recognition of such high provisions by restructuring
the accounts in schemes such as Corporate Debt Restructuring (CDR), Scheme for Sustainable
Structuring of Stressed Assets (S4A) etc. These schemes have now been scrapped wherein the
banks accounted for just 15% provisions. Hence, the profitability of the banks could come under
pressure going forward as the accounts are referred to IBC.
Insolvency Resolution Process: The Code specifies similar insolvency resolution processes for
companies and individuals, which will have to be completed within 180 days. This limit may be
extended to 270 days in certain circumstances. The resolution process will involve negotiations
between the debtor and creditors to draft a resolution plan. The process will end under two
circumstances, (i) when the creditors decide to evolve a resolution plan or sell the assets of the
debtor, or (ii) the 180-day time period for negotiations has come to an end. In case a plan cannot
be negotiated upon during the time limit, the assets of the debtor will be sold to repay his
outstanding dues. The proceeds from the sale of assets will be distributed based on an order of
priority.
The extant instructions on resolution of stressed assets such as Framework for Revitalising
Distressed Assets, Corporate Debt Restructuring Scheme, Flexible Structuring of Existing Long
Term Project Loans, Strategic Debt Restructuring Scheme (SDR), Change in Ownership outside
SDR, and Scheme for Sustainable Structuring of Stressed Assets (S4A) stand withdrawn with
immediate effect. Accordingly, the Joint Lenders’ Forum (JLF) as an institutional mechanism for
resolution of stressed accounts also stands discontinued. All accounts, including such accounts
where any of the schemes have been invoked but not yet implemented, shall be governed by the
revised framework.
Asset Quality Review
Reserve Bank of India inspectors check bank books every year as part of its annual financial
inspection (AFI) process. However, a special inspection was conducted in 2015-16 in the
August-November period. This was named as Asset Quality Review (AQR). In a routine AFI, a
small sample of loans is inspected to check if asset classification was in line with the loan
repayment and if banks have made provisions adequately.
However, in the AQR, the sample size was much bigger and in fact, most of the large borrower
accounts were inspected to check if classification was in line with prudential norms. Some
reports suggest that a list of close to 200 accounts was identified, which the banks were asked to
treat as non-performing. Banks were given two quarters, October-December and January-March
of 2016 to complete the asset classification.

Masala Bonds
Masala bond is a term used to refer to a financial instrument through which Indian entities can
raise money from overseas markets in the rupee, not foreign currency. These are Indian rupee
denominated bonds issued in offshore capital markets. The rupee denominated bond is an
attempt to shield issuers from currency risk and instead transfer the risk to investors buying these
bonds. Interestingly currency risk is borne by the investor and hence, during repayment of bond
coupon and maturity amount, if rupee depreciates, RBI will realize marginal saving. Experts
believe that Indian currency is still a bit overvalued. In a way masala bond is a step to help
internationalize the Indian rupee. Investors in these bonds will have a clear understanding and
view on the Indian rupee risks. Therefore, a stable Indian currency would be key to the success
of these bonds. It is believed that as the investors in a masala bond will bear the currency risk,
they would demand a currency risk premium on the coupon and hence borrowing cost for Indian
corporates through this route would be slightly higher. It may still be cheaper if one considers the
currency risk. Though raised in Indian currency, these bonds will be considered as part of foreign
borrowing by Indian corporate and hence would have to follow the RBI norms in this regard.
Under the automatic route, companies can raise as much as $750 million per annum through
Masala bonds.
RBI allows multilateral FIs to invest in masala bonds

The Reserve Bank of India (RBI) has permitted multilateral and regional financial institutions
(FIs) to invest in masala bonds.
This decision will allow multilateral agencies like Asian Development Bank (ADB) and BRICS
led New Development Bank (NDB) to invest in these bonds. It also provides more choices of
investors to Indian entities issuing rupee-denominated bonds abroad.

Understanding a Bank Merger in the Indian Economy

The Merging of banking is considered as a step towards development in the banking sector. Such
mergers give opportunities like raising fresh capital, changing the hiring policy, etc. to the
government. However, for those of you preparing for banking jobs along with government
exams, the implications appear in the form of vacancies, career prospects, salary, location,
etc.
After successful merger of country’s largest lender State Bank of India (SBI) with its associate
banks in April in 2017, a distinct possibility of merger of all other public sector unit (PSU) banks
is in the air.
The Finance Ministry has decided to keep the concept paper ready for the PSU banks’ merger in
a month or so and the proposed merger would be guided by bigger banks’ regional expansion
plans. It is expected that the final merger is likely to happen by December end this year.
The SBI had merged with five associate banks to create a behemoth with over Rs 37 lakh crore
in assets in FY17. However, the Finance Ministry wants to merge State-run banks into mega-
corporations so that they can stand up to competition from global banks which will eventually be
allowed to enter India as part of a WTO deal on services or as part of bilateral or regional free
trade pacts.
The Finance Ministry has been consistently working on the move since the smooth merger of the
SBI with its associate banks. The Ministry of Finance has sought the recommendation of RBI in
recognizing the banks which can be merged in due course of time.
Declining Asset Quality of Banks

The Indian banks in general and the Public Sector Banks (PSBs) in particular, are grappling with
the huge stock of stressed assets that has piled up in the system over the years. Any amount of
discussion on the whys and what of stressed assets would therefore never be enough, if it enables
us to discern what led to this phenomenal build-up of non-performing assets (NPAs) in our
system and determine what we should do to solve them, and identify what could be done
differently in future.
The issue is complex and it will be naive to conclude that we go back with solutions that would
work overnight.
Asset Quality
Gross NPAs and total stressed assets
SCBs’ gross non-performing advances (GNPA) ratio rose from 10.2 per cent in September 2017
to 11.6 per cent in March 2018. They still contain some amount of restructured assets indicating
potential for some more pain, albeit of lesser intensity.

Source: RBI
The SCBs’ GNPA ratio may rise from 11.6 per cent in March 2018 to 12.2 per cent by March
2019 owing to the following factors:
 Weak credit outlook for investment-led sectors continue, credit mainly driven by service
sector
 Teething problems in implementation of GST and lingering effects of demonetization
hurting MSME, Real estate and unorganized sector
 Power sector bad assets being referred now to NCLT
 Corporate cash flows continue to be strained as concentration of bad loans in industry
making difficult for banks to give fresh loans
 Recoveries to reduce due to lower ARC sales
 Revised framework for stressed asset resolution( 180 days ibc)

Source: RBI
Public sector banks (PSBs) reported substantial high GNPAs at 15.6% as of March 2018 vis-a-
vis 12.1% as of March 2017.Over the same period, the GNPAs of private banks were relatively
healthy at 4% as of March 2018 but private sector also felt the pain due to AQR initiative by the
RBI. The marked deterioration in the asset quality of PSBs can be attributed to the weak
monitoring and recovery mechanisms, slowdown in economic growth, sharp rise in interest rates,
and volatility in the currency and commodity markets. Sectors that mainly contributed to higher
NPAs were priority sectors (agriculture), construction, metals (iron and steel), engineering,
aviation and infrastructure (power and telecom).
Regulatory forbearance on loan restructuring ended on April 1, 2015. Post the sub-prime crisis in
2008; the RBI allowed banks to restructure stressed assets while maintaining the asset
classification, i.e. the asset does not become non-performing as was the case earlier. The special
regulatory treatment helped banks limit the rise in GNPAs. Currently, banks have to allocate
lower provisions for standard restructured advances - 5%, compared with 15% for sub-standard
assets (the first level of NPAs - when interest or principal is due for more than 90 days). As per
the RBI's mandate, after April 2015, banks will have to treat all restructured new standard
advances as NPAs and make provisions accordingly. As 2014-15 was the last year for
restructuring of loans, addition of such loans grew 7% despite being at high levels in 2013-14. A
weak economy led to a reduction in upgradation of restructured loans and increased slippages of
such loans into NPLs. Thus, the stock of standard restructured loans for the sector rose 23% y-o-
y to 5% of total loans. The sign of weakness in restructured loans continued to play throughout
2017-18, and expected to remain under pressure in 2018-19unless economic growth improves
sharply.
Profitability
Higher NPAs imply lower income from the assets of the bank. This has to be accompanied by
the higher provisioning requirements, adding to the cost and thus reducing the profits of the
banks. This adversely affects the NIM and ROE of the banks.
The profitability of bank decreases not only by the amount of NPAs, but the opportunity cost of
these assets also affects the profitability. This is to say that if the banks were able to invest the
amount equal to the NPAs in some other return earning project/asset, they could earn profits. But

since the funds are blocked with the borrowers, banks cannot park these funds anywhere else. So
NPAs not only affect current profit but also future stream of profit, which may lead to loss of
some long-term beneficial opportunity.
Liquidity
Money gets blocked; decreased profit leads to lack of enough cash at hand which leads to
borrowing money for shortest period of time which leads to an additional cost to the company.
Difficulty in operating the functions of a bank due to lack of money is another impact of NPAs.
Involvement of management
Time and efforts of management is another indirect cost which bank has to bear due to NPAs.
Time and efforts of management in handling and managing NPAs would have diverted to some
fruitful activities, which would have given good returns. Nowadays banks have special
employees to deal and handle NPAs, which is an additional cost to the bank.
Public Sentiment
There is a definite loss of faith associated with the NPA numbers rising and this cannot be
compensated by larger profits. Banking is a business of Trust and this will greatly affect the
deposit growth and this is turn will affect the credit growth.
Sectoral distribution of NPAs
It would also be interesting to look at the sectoral distribution of NPAs and total stressed assets.
It shows the obvious - the maximum stress in industry and infrastructure with the PSBs facing
greatest strain across most sectors.

Source: RBI
Restructured assets
During the five years to March 2015, banks had resorted to restructuring of loans in many cases
to postpone recognition of non-performance, or what we now call ‘extend and pretend’, rather
than using it as a tool to preserve the economic value of the units as intended. Stressed assets are
nothing but summation of GNPAs and standard restructured assets.
Source: Crisil Research
Down the years, as the stress deepened, these assets had to be classified as NPAs as work outs of
non-viable units did not succeed. The above chart shows that the proportion of these assets was
higher in public sector banks. The outstanding balance of these assets declined sharply in 2017
post-AQR, as a major portion of these assets has been classified as NPA post-AQR reflecting
their true quality.
Net NPAs
High levels of NPAs have been progressively causing increasing stress on banks’ earnings. As a
result, banks’ provisioning capacity has also come under pressure leading to a spike in the Net
NPAs levels as well (Chart 7). Higher net NPAs indicate lower provision coverage ratio which
should progressively improve as the strain on profitability eases
Some contributory factors
The reasons for the growth in the NPAs are also not far to seek. Table 1 and the Chart below
show that the bank debt fuelled the rise in corporate leverage steadily from 2005 to 2011. It is
worth noting that despite the `high leverage` being a well-established and most widely known
risk factor of corporate lending, bank lending to industrial sector continued at an average
elevated rate of over 20 percent. Do we call this irrational exuberance? Obviously, an overly
leveraged business is more sensitive to turbulence. Portfolio diversification is key to managing
idiosyncratic risk. The banks’ credit portfolio leaves scope for improving the diversification both
in terms of single name and sectoral concentrations. Charts 8 and 9 show that the stress is higher
in large borrowers’ accounts. In the overall credit portfolio, share of industrial advances is
around 40%. While this is partly justified based on the relatively higher credit intensity of
industrial sector, the banks have to see the need for proper balance taking into account the risk
return trade-off especially in the larger loan segment.

Source: RBI
Chart 8 Chart 9
Source: RBI

Risk Management
Banks are in the business of taking risks. If they are not taking risks they are not doing banking
business. But, what does taking risk mean? Can it mean taking chances? When would a
measured risk taking be different from recklessness? Essentially, risk management would
involve knowing the risk, measuring it, and controlling it within the risk appetite of the bank by
using appropriate mitigants. Competition from abroad apart from domestic competition should
be visualised and therefore global capacities and not just domestic capacity should be the criteria.
Banks very often also undermine the forex risk embedded in cases which involve liabilities
denominated in foreign currency. During the boom period, underwriting standards did get
lowered by what one may call irrational exuberance. What could be the right counterbalance in
such cases? A strong balance sheet of the promoter seems to be an answer. However, it appears
that there was no adequate effort to assess corporate leverage. We therefore had situations of the
promoters ending with much less skin in the game. What this does is to turn the problem of
corporate insolvency into a problem of the banks rather than that of the promoter. Therefore a
strong underwriting system that is properly steeped in understanding and mitigating risks is the
first element of credit risk management. But when would this happen? Only when risk culture
permeates across the bank. Spreading risk culture is the function of the board and top
management of the bank. In fact the Basel Committee states as under: Banks should have an
effective independent risk management function, under the direction of a chief risk officer
(CRO), with sufficient stature, independence, resources and access to the board An important
element of underwriting from a risk perspective will be the portfolio diversification. A credit
portfolio which is exposed to concentration by counterparty, geography, economic activity and
the like is more prone to shocks. There must be proper systems to monitor risks arising from
concentration and systematically address them.
Banks are quite liberal in waiving sanction terms without being mindful of the risk mitigant they
are letting off go in the process. Almost every condition of sanction is a risk mitigant.
An important part of the risk management is the manner in which a stressed asset is dealt with.
By definition one can say that a stressed asset is a loan in which anticipated and or unanticipated
risks have manifested. Again the entire gamut of activities surrounding a fresh underwriting will
have to be undertaken. But is that done? It is a matter of concern that the exercise is many a time
directed towards postponing the recognition of stress. Therefore, restructuring of large loans
became fashionable to a default that we had to finally put a stop to it. The system of restructuring
to prevent a downgrade of an account puts pressure on the banks because they are building
further leverage in an already leveraged entity. What it is does is that it takes risk management
away from the whole process.
Theoretically, the “three lines of Defense model” has been used traditionally to model the
interaction between corporate governance and internal control systems of banks in the context of
management of financial risks.

In credit risk management, the loan officers and the loan sanctioning authorities constitute the
first line of Defence. Being responsible for operational management, they have ownership,
responsibility and accountability for assessing, controlling and mitigating risk in credit exposures
together with maintaining effective internal controls. If they ignore the basics while selecting a
project for bank finance, the risk management, compliance and internal audits would have to
work really hard to see that the loan turns out to be profitable for the bank. The credit risk
management function constituting the second line of Defence facilitates and monitors the
implementation of effective risk management practices by operational management. In credit risk
management, the second line of Defence should assist the risk owners- the credit department- in
defining the target risk exposure and reporting adequate risk related information through the
organisation. If this line of Defence is to function effectively, this function has to remain
independent.
The internal audit function is the third line of Defence and is expected to provide assurance to
the organisation’s board and senior management on how effectively the organisation assesses
and manages its risks. They particularly look into the manner in which the first and second lines
of Defence operate. The assurance task covers all elements of an organisation’s risk management
framework, i.e. risk identification, risk assessment and response to communication of risk related
information.
In other words, an internal audit cannot solve all the risk management problems that primarily
are the responsibility of the operational, risk management and compliance teams. RBI has issued
detailed instructions to banks on credit risk management including the organizational and
reporting structure of risk management and internal audit departments.
If the Three lines of Defence model all institutional mechanisms have to function, they must be
put in place to play the expected role and not just as a tick box compliance. The board and the
senior management also play a major role in it as they draw up the risk strategy for the bank, set
the risk appetite for the organisation and allocate roles to employees.

Consequences
If banks continue to remain saddled with huge NPAs for a long time, it would make them risk
averse and choke the lending for economic activities in general. Another consequence is the
likely shift by the PSBs to loan segments such as personal loans and housing loans where the
banks so far have had lowest NPAs. While this may help in rebalancing the loan portfolio in
favor of less volatile sectors, care would have to be taken not to overdo this and shift the
leverage from the corporate sector to household sector. Yet another possibility is the rise in the
market share of private sector banks in industrial loans. We are seeing this already. This would
help the viable businesses continuing to have access to bank finance the broader banking sector
is still under stress. However, these banks will have to manage the resultant credit concentration
risk well. Overall, dealing squarely with stressed assets is crucial for the nation’s economic
growth.
Conclusion
Any bank which does not have a strong risk management is likely to build a highly susceptible
credit portfolio. Risk Management is not static. It evolves over a period of time. It need not be
the same for all. Its sophistication grows with the growth in the complexities of a bank’s
functioning. In fact, if a bank’s risk management function is not commensurate with the
complexity of its operations, it is prone to the risks manifesting and turning beyond its risk
appetite. Regulators have put in place a framework for risk management. How well to
operationalise it and how to ensure that the various lines of Defence play their expected role are
in the hands of the board and senior management of a bank. There is no line of Defence stronger
than a board and senior management committed to sound risk management in a bank.

Sector wise Bank credit in 2017-18

Source: RBI

Priority Sector Lending:
Categories Domestic scheduled commercial Foreign banks with less

banks and Foreign banks with 20 than 20 branches
branches and above
Total Priority Sector 40 percent of Adjusted Net Bank 40 percent of Adjusted
Credit* or Credit Equivalent Amount of Net Bank Credit or Credit
Off-Balance Sheet Exposure, Equivalent Amount of
whichever is higher. Off-Balance Sheet
Exposure, whichever is
higher; to be achieved in
Foreign banks with 20 branches and a phased manner by 2020.
above have to achieve the Total Priority
Sector Target within a maximum
period of five years starting from April
1, 2013 and ending on March 31, 2018
as per the action plans submitted by
them and approved by RBI.
Agriculture # 18 percent of ANBC or Credit Not applicable
Equivalent Amount of Off-Balance
Sheet Exposure, whichever is higher.
Within the 18 percent target for

agriculture, a target of 8 percent of
ANBC or Credit Equivalent Amount of
Off-Balance Sheet Exposure,
whichever is higher is prescribed for
Small and Marginal Farmers, to be
achieved in a phased manner.

Foreign banks with 20 branches and

above have to achieve the Agriculture
Target within a maximum period of
five years starting from April 1, 2013
and ending on March 31, 2018 as per
the action plans submitted by them and
approved by RBI. The sub-target for
Small and Marginal farmers would be
made applicable post 2018.
Micro Enterprises 7.5 percent of ANBC or Credit Not Applicable

Equivalent Amount of Off-Balance
Sheet Exposure, whichever is higher to
be achieved in a phased manner.
The sub-target for Micro Enterprises

for foreign banks with 20 branches and
above would be made applicable post
2018.
Advances to Weaker 10 percent of ANBC or Credit Not Applicable
Sections Equivalent Amount of Off-Balance
Sheet Exposure, whichever is higher.
Foreign banks with 20 branches and

above have to achieve the Weaker
Sections Target within a maximum
period of five years starting from April
1, 2013 and ending on March 31, 2018
as per the action plans submitted by
them and approved by RBI.
# Domestic banks have been directed to ensure that their overall direct lending to non-corporate
farmers does not fall below the system-wide average of the last three years achievement.
*Adjusted Net Bank Credit= Total bank credit + Investment in held-till maturity
instruments - bills rediscounted by RBI.

Priority sector credit distribution in 2017-18
Priority Sector Distribution 2017-18

0%
15%
1% Agriculutural and Allied activities
1% 26%
Micro & Small Enterprises
Manufacturing
9% Services
Housing
Education Loans
Micro-Credit
15% Weaker Sections
24% Export Credit
9%
Source: RBI

Analysis of a Banking Stock:

How to analyse a Bank? How to pick up a correct Banking stock?
To start off with, unlike any other manufacturing or service company, a bank's accounts are
presented in a different manner (as per banking regulations). The analysis of a bank account
differs significantly from any other company. The key operating and financial ratios, which one
would normally evaluate before investing in company, may not hold true for a bank:
Quantitative Analysis
The quantitative analysis includes the analysis of the financial statements of the bank which
includes, its Balance Sheet, its Profit and Loss Account, its Cash Flow Statement, the Notes to
Accounts and the Statement of Changes in Equity
So the details of a Bank’s balance sheet and Profit and Loss account is mentioned below:
The Balance Sheet of a bank
A bank’s balance sheet summarizes its assets and liabilities at any point of time. These terms are
explained below with respect to a bank's balance sheet.
Capital and Liabilities
These include the Bank’s net worth and the obligations of the bank to external entities. These
include:
1. Share Capital and Reserves and Surplus: Share capital includes the money invested by the
owners, or shareholders of the bank raised by way of IPO, private placements or other routes.
Reserves and Surplus include net profit transferred to the balance sheet, Statutory Reserve,
Securities premium, Currency Fluctuation Reserve etc.
2. Deposits: There are four types of deposit accounts, these are:

a) Demand Deposits: The deposits that are subject to withdrawal on demand of the depositor.
Demand deposits are cheap sources of funds for the banks, though comparatively less stable than
their counterpart. These may be of two types:
I. Current deposits: These are mainly used by businesses and have very frequent deposits and
withdrawals. These accounts have no minimum balance requirement or limit on the number of
withdrawals. No interest is paid on these accounts. Also, banks generally provide the facility of
overdraft to businesses having current accounts with them. These accounts are usually operated
by means of check books.

II. Saving’s deposits: These are the accounts that usually individuals have with the bank. They
have minimum balance requirements and a cap on the maximum number of withdrawals per
month. The interest is payable by the banks, calculated on a daily basis. The interest rate was
earlier fixed by RBI at 4% per annum, but was de-regulated in 2011 allowing banks to give
higher rates of interest. These accounts can also issue check books for transactions.
b) Term Deposits: They are not payable by the banks on demand. Depositors need to give prior
notice to the banks for withdrawal, and there are penalties imposed on withdrawal before the
maturity of the deposit. Though more expensive in terms of interest payable, term deposits are a
more stable source of fund for the banks. These are of two types:
I. Fixed Deposits: A lump sum amount is deposited with the banks for a fixed tenure. Banks
give very high rates of interest on fixed deposits when compared to the demand deposits.
II. Recurring Deposits: These deposits provide the benefit of fixed deposits to those who
cannot pay a lump sum amount, but can save regularly. Individuals deposit a fixed amount every
month and get interests very similar to those in case of FDs.
3. Borrowings: In order to meet their obligations, banks also raise money through wholesale
money market. This includes funds borrowed from RBI or market instruments such as
debentures, bonds, certificate of deposits, commercial papers and short term borrowings from
other banks and financial institutions. The cost of wholesale funding is generally high but banks
raise money through this method when they are unable to get them through deposits which are a
cheaper option. Banks may also raise funds from overseas debt market to take advantage of low
interest rates.
4. Other Liabilities and provisions: These include bills payable, interest accrued, contingent
provisions against standard assets and proposed dividend (including tax on dividend). =
Assets
An asset is a resource that leads to a future inflow of economic benefits. For a bank, assets
include:
1. Cash and balances with RBI: Along with the cash held at the branches, banks are also
required to keep a certain amount of cash with the RBI. This is given by the CRR (Cash Reserve
Ratio), which is currently 4% of the net demand and time liabilities of the banks.
2. Government Bonds and other approved Securities: It is a statutory requirement that every
bank in India has to maintain a certain percentage of its deposits in the form of gold or approved
securities with the RBI. This requirement is known as statutory liquidity ratio (SLR).
3. Loans and advances: Loan refers to the money which is lent to a borrower by a bank. Banks
charge interest on loans, which forms the primary source of income for them. Approximately
70% of the assets of a bank are in the form of loans and advances. Loans may be short term/long
term and secured/unsecured. The major types of loans that banks offer are:
a. Commercial and industrial loans
b. Real Estate Loans

c. Consumer loans
d. Interbank loans
4. Fixed Assets: These include office buildings (if owned), furniture, computers and other items
such as ATM machines. However, it constitutes a very small part of assets for a bank because
most of its branches run on rent/lease.
5. Other assets: These include investments made by banks and can be a source of income for the
bank.
Common Size Balance sheet for HDFC Bank and SBI as on 31st March 2018
2016-17 2017-18 2016-17 2017-18

Change Change
Particulars HDFC Bank State Bank of India
(%) (%)
Share Capital 0.06 0.05 1.27 0.03 0.03 11.92
Reserve and surplus 10.3 9.89 19.50 6.93 6.32 6.02
Deposits 74.51 71.49 22.27 75.56 78.34 4.71
Borrowings 8.57 14.18 22.58 11.74 10.48 9.73
Other liabilities and
6.56 4.39 -17.54 5.74 4.83 1.74
provision
Total 100 100 23.63 100 100 4.97
Asset
Cash and Balance with
4.39 9.49 176.15 4.73 4.17 -6.36
RBI
Balance with banks and
money market at call 1.28 1.67 61.16 1.63 1.23 -60.31
and short notice
Investments(Includes
government bonds and 24.83 21.62 13.13 28.31 32.73 15.24
approved securities)
Advances 64.2 63.46 19.57 58.06 54.20 3.33
Fixed Assets 1.18 0.35 -0.11 2.14 1.14 -19.07
Other assets 4.89 3.41 -11.97 5.69 6.53 19.91
Total 100 100 23.63 100 100 4.97

Income Statement
This is the bank’s Profit and Loss account, the various elements of which are given as:
1. Interest Income: The primary income of the bank comes from this category. This includes the
interest earned on loans and advances. This also includes interest on loans given to other
financial institutions and banks and deposits with the RBI, and any interest earned on bonds
which the bank owns.
2. Non-Interest Income: This is income primarily derived from fees which the bank charges.
This includes deposit and transaction fees, annual fees (for services like credit cards), brokerage
fees etc. Non-Interest income is a less volatile form of income since it does not depend as much
on interest rate changes as interest income. A higher proportion leads to more stable earnings.
3. Interest Expense: This represents the interest paid by a bank on deposits, wholesale
borrowings, and loans taken from RBI or from other financial institutions.
4. Operating Expense: This includes expenses which are incurred in running the day to day
operations of the bank, namely costs like salaries, rent, depreciation, advertising etc.
5. Provisions: Since not each and every loan will be paid back in full, banks have to make
provisions for these loans. Banks thus set aside a percentage of their income to account for these
possible losses. This ensures that the bank remains solvent and there are no sudden unexpected
huge losses to the bank. The amount set aside for provisioning depends on the size of a bank's
assets and the risk associated with each type of asset. The norms for provisioning are decided by
the RBI.
Common Size Profit and Loss for HDFC Bank and SBI
2016-17 2017-18 2016-17 2017-18

Change Change
Particulars HDFC Bank State Bank of India
(%) (%)
Revenue % % % % % %
Interest Income 85 84 16.40 83 74.70 -0.64
Other Income 15 16 24.69 17 25.30 13.73
Total Revenue 100 100 17.64 100 100 2.64
Expenditure % % % % % %
Interest Expended 44 41.82 11.41 54 47.83 -1.68
Operating Expenses 24 23.61 15.31 22 31.36 10.16
Provision and
Contingency(Including 14 16.26 36.51 19 22.17 8.51
Provision for tax)
Net Profit 18 18.31 21.41 5 -1.37 -973

Specific Ratios for a Bank:
1. NII (Net Interest Income): Net Interest Income is simply the difference between interest
earned by the bank on its assets, i.e. loans and investments and interest paid by the bank on its
borrowings. This is the major source of profit to the bank. However, being an absolute measure,
it cannot be used to compare the performance of different banks.
2. NIM (Net Interest Margin): NIM is used to measure the profitability of the banks and is a
major parameter used to compare the performance of different banks. It is defined as the
difference between the interest income and interest expense (NII) relative to the average interest
bearing assets of the bank.
3. Operating Profit Margin (OPM): This is the operating profit, i.e. NII minus the operating
expenses, relative to total interest income. Higher OPM indicates lower interest or operating
expenses in relation to interest income.
4. Cost to Income: This is the ratio of operating cost to total income. It measures the efficiency
with which bank is able to generate income. It is calculated as:-

5. Other Income to Total Income: Other income mainly consists of fees and commission. This
income is not dependent directly on the assets of the bank and has huge potential to add to the
profits of the bank even during low loan demand.
Other Income to Total Income = Other Income /Total Income
6. Spread: Spread shows us the difference between interests earned from the loans given and
investments made and interest paid on the deposits received and borrowings taken. It can be
calculated as
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝑆𝑝𝑟𝑒𝑎𝑑 = −
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
7. CASA Ratio: CASA or Current and Savings Account Ratio are the ratio of current and
savings deposits of a bank to its total deposits. As discussed earlier, banks pay less interest on the
current and savings accounts as compared to interest on term deposits. In another words, current
and savings deposits are a cheaper source of funds for the banks. Hence, a high CASA ratio
suggests availability of cheaper funds, leading to increased operational efficiency and thus higher
profits. However, demand deposits (CASA) can be withdrawn at any time by the depositors
leading to fluctuations in liquidity. So, banks also need a sufficient amount of term deposits to
fund the long term loans and avoid asset-liability mismatch.
CASA Ratio = (Current Deposits + Savings Deposits) /Total Deposits
8. Credit to Deposit Ratio: This ratio helps assess a bank’s liquidity. A very high C/D ratio
makes the bank vulnerable to adverse changes in its deposit base. Conversely, a low C/D ratio
indicates holding unproductive capital and lower than optimum earnings.
Credit to Deposit Ratio = Total Credit /Total Deposits
9. CAR (Capital Adequacy Ratio): It is the ratio of the bank’s capital to its risk weighted
assets. CAR is used to determine the ability of banks to absorb some reasonable amount of loss
without facing the risk of bankruptcy. The higher the CAR of a bank the better capitalized it is.
The current mandatory CAR in India is 9%. The ratio is to be gradually increased to 11.5% by
March 31, 2019 to align Indian standards with the Basel III norms. It is calculated as:-
Tier I Capital: This is the core capital of the bank. It primarily consists of common stock and
retained earnings of the bank. It may also include non-redeemable non-cumulative preferred
stock. Tier I items are deemed to be of the highest quality because they are fully available to
cover losses.

Tier II Capital: This is the supplement capital of the bank. It includes undisclosed reserves,
revaluation reserves and general provisions. Tier II's capital loss absorption capacity is lower
than that of Tier I capital.
Risk Weighted Assets (RWA): These are the assets of the bank weighted according to the risk
associated with them. This risk has been defined by the RBI for different types of securities,
investments and loans and ranges between 0 and 150%. For example, RBI has given risk weight
of 150 to investments in venture capital funds whereas loans guaranteed by the Government of
India have been given risk weight of 0%.
10. Price to Book Ratio (P/B): This ratio equates the market capitalization of the bank to the
book value found in the bank’s Balance Sheet. Banks are different from other companies as far
as P/B ratio is concerned. For companies, P/E ratio is more important while P/B ratio is the ratio
to look at for banks. The reason why P/B ratio is considered adequate for banks is that major
chunk of banks’ assets are in the form of loans or advances and these loans and advances are
‘Marked to Market’.
P/B ratio of 1 and below 1 for banks shows an attractive bet. However, most of the large and
stable banks have higher P/B ratio. Markets put premium on stability and quality of assets of
banks.
11. Return on Assets (ROA): Return on assets (ROA) is an indicator of how profitable a bank is
relative to its total assets. ROA gives an idea as to how efficient management is at using
its assets to generate earnings. Calculated by dividing a bank’s annual earnings by its total assets,
ROA is displayed as a percentage. ROA tells you what earnings were generated from invested
capital (assets). When using ROA as a comparative measure, it is best to compare it against a
company's previous ROA numbers or the ROA of a similar bank.
12. Slippage Ratio: Slippage ratio is defined as the ratio of fresh accretion to NPLs during the
year to standard advances at the beginning of the year. The ratio of slippages plus restructured
standard advances to recoveries (excluding up-gradations) also showed a rising trend signaling
the need for proactive management of NPAs.
Slippage Ratio = (Fresh accretion of NPAs during the year/Total standard assets at the
beginning of the year)*100
12. Classification of Assets
a) Standard Assets: Assets which do not disclose any problem and do not carry more than the
normal risk attached to the business. Such assets are not non-performing assets.
b) NPA (Non-Performing Assets): The definition of NPA as given by RBI is “an asset, which
ceases to generate income for a bank”. Hence it is a loan, the payment of which is unlikely to be

received. Any loan is recognized as NPA only when the receipt of payment for it 'remains due'
for a specified period of time.
A NPA is a loan or advance where:-
a) Interest or installment remains overdue for over 90 days in case of a term loan
b) The account remains 'out of order' in case of overdraft/cash credit facility. A current account is
treated as 'out of order' if outstanding balance is in excess of sanctioned limits or when it is
within sanctioned limits and there are no credits for 90 days or are not enough to cover the
charges for interest debited.
c) The bill remains overdue for a period of more than 90 days in the case of bills purchased and
discounted.
d) Agricultural loans are classified as NPAs, if, for short duration crops, installment of principal
or interest remains overdue for one crop seasons; for long duration crops, this period is taken to
be two crop season.
e) In case of derivative and liquidity transactions, if the dues for these remain unpaid for 90 days.
According to norms, any income received from NPAs is recorded only when it is received.
Banks are required to classify non-performing assets further into the following three categories
based on the period for which the asset has remained non-performing and the expected
realization of the dues:-
Sub-standard assets: A sub-standard asset would be one, which has remained NPA for a period
less than or equal to 12 months. Such an asset will have well defined credit weaknesses that
jeopardize the liquidation of the debt and is characterized by the distinct possibility that the
banks will sustain some loss, if deficiencies are not corrected. All the restructured loans will also
be classified as Sub-standard assets from 1st April, 2015.
Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard
category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent
in assets that were classified as sub-standard, with the added characteristic that the weaknesses
make collection or liquidation in full - on the basis of currently known facts, conditions and
values - highly questionable and improbable.
Loss assets: An asset would be considered as a loss asset if loss has been identified by the bank
or by internal / external auditors or by RBI inspection, but the amount has not been written off,
wholly or in part. Such assets are considered uncollectible and of so little value that their
continuance as bankable assets is not warranted, even though there may be some salvage or
recovery value.
NPAs are calculated in two ways:

GNPA: Gross NPAs are the total amount of loans that the bank cannot recover from the
borrowers.
NNPA: Net NPAs are GNPAs minus the provisions made against them, i.e. total NPAs less the
expected non-recovery recorded in the books.

Banks are required to maintain provisions for these NPAs. Provisioning Norms are as follows:
Provisioning Coverage Ratio: As per RBI, Provisioning Coverage Ratio (PCR) is essentially
the ratio of provisioning to gross non-performing assets and indicates the extent of funds a bank
has kept aside to cover loan losses. From a macro-prudential perspective, banks should build up
provisioning and capital buffers in good times i.e. when the profits are good, which can be used
for absorbing losses in a downturn. This will enhance the soundness of individual banks, as also
the stability of the financial sector. RBI thus requires banks to ensure that their total provisioning
coverage ratio is not less than 70 per cent.
Provisioning Coverage Ratio = Amount of Total Provision for NPA’s /GNPA

Financial Information for HDFC Bank and SBI
Parameters HDFC Bank SBI

Current Price 1929 264
Market Capitalisation (in Cr.) 4,97,682 2,35,610
Book Value 410 199
Price/BV 4.71 1.33
ROE% 16.94% -3.78%
ROA% 1.93% -0.19%
EPS 67.80 -7.67
Cost of Deposits 5.36% 5.79%
Net Interest Margin 4.30% 2.62%
Deposits(in Cr) 7,88,771 27,06,344
Advances(in Cr) 6,58,333 20,48,387
Credit to Deposit Ratio 83.40% 75.69%
CASA to Deposits 43.50% 45.68%
Cost to income 41% 50.18%
Other Income as a % of Interest income 18.83% 33.87%
CAR% 14.80% 12.60%
Tier 1 13.25% 10.36%
GNPA 1.3% 10.91%
NNPA 0.4% 5.73%
PCR 69.78% 66.17%
For comparing two companies we need to analyse the financial performance and other key
indicators for the last 5 years. In case of HDFC Bank and SBI the 5 year data is as follows:

HDFC BANK

STATE BANK OF INDIA
Source: CRISIL Research

Qualitative Analysis
There is no one method of how to analyse a bank, however the following checks will help us
understand how well a bank is placed in comparison with its peers. As investors we can get far
by focusing on four things:
 What the bank actually does

 Its price
 Its earnings power
 The amount of risk it's taking to achieve that earnings power
 Promoter backing
 Board of Directors
What the bank actually does?
When we read through a bank's earnings releases, it's easy to get sidetracked by management's
promises -- as every bank says it's customer-focused and a conservative lender. In banking, the
assets are the loans the banks make, the securities the banks hold, etc. They're the things that will
drive future profitability when they're chosen carefully, and they're the things that will force the
bank to fail (or get bailed out) when the Bank gets in trouble.
Loans are the heart of a traditional bank, the greater a bank's loans as a percentage of assets, the
closer it is to a prototypical bank. If a bank isn't holding loans, it's most likely holding securities.
For example, its business model may not be loan-driven, it may be losing loan business to other
banks, or it may just be being conservative when it can't find favorable loan terms. In any case,
looking at loans as a percentage of assets gives us questions to explore deeper. The next step of
digging into the loans is looking at what types of loans a bank makes.
Looking into the common size balance sheet of HDFC bank and State Bank of India, we can see
that the increase in advances for HDFC Bank has been almost 6 times that of State Bank of India
for FY 2017-18. Further probing deeper it can be found out that the retail advances form 57.13%
of the total advances as compared to around 26.81% for State Bank of India. This has made the
loan book of HDFC Bank more granular, thus leading to improvement in credit quality as
compared to SBI which is plagued by NPAs in the corporate and Mid Corporate group.
The one-line summary: On the assets side, look at the loans.
Just as the loans tell the story on the assets side, the deposits tell the story on the liabilities
side. The prototypical bank takes in deposits and makes loans, so two ratios help get a feel for
how prototypical your bank is: 1) Deposits/Liabilities 2) Loans/Deposits.
Deposits are great for banks as they have to pay low interest rates on savings and current
accounts. Via these deposit accounts, you're essentially lending the bank money cheaply. If a
bank can't attract a lot of deposits, it has to take on debt (or issue stock on the equity side), which
is generally much more expensive. That can lead to risky lending behavior -- i.e. chasing yields

to justify the costs. All of this confirms what we suspected after looking at the loans on the asset
side (Breakup of Loan category)
CASA deposits are low cost funds and having a high percentage of deposits in the form of
CASA reduces the overall cost of funds. The CASA deposits for both HDFC Bank and SBI are
very high owing to their widespread reach and penetration; it is as high as 45.68% for SBI and
43.50% for HDFC Bank.
Now looking at the Profit and Loss side,
The big thing to focus on here is the two different types of bank income: net interest income and
non-interest income.
At its core, a bank makes money by borrowing at one rate (via deposits and debt) and lending at
another higher rate (via loans and securities). Well, net interest income measures that profit.
Meanwhile, noninterest income is the money the bank makes from everything else, such as fees
on mortgages, fees and penalties on credit cards, charges on checking and savings accounts, and
fees on services like investment advice for individuals and corporate banking for businesses.
The non-interest income can smooth interest rate volatility but it can also be a risk if regulators
change the rules.
Other income for HDFC Bank in FY17 was at 18.83% which was less than that for SBI
(33.87%). These two banks should find avenues to increase their corporate fees. This would help
the banks earn high Fee income and hence reduce dependence on only interest income. This is
the reason majority of the banks today are focusing on increasing their Non – Interest income.
Price:
The oversimplified saying in banking is "buy at half of book value; sell at two times book value."
Book value is just another way of saying Net worth. If a bank is selling at book value that means
you're buying it at a price equal to its net worth (i.e. its assets minus its liabilities).
To get a little more conservative and advanced than price/book ratio, we can look at the
price/tangible book ratio. As its name implies, this ratio goes a step further and strips out a bank's
intangible assets, such as goodwill. A bank that wildly overpays to buy another bank would add a
bunch of goodwill to its assets -- and boost its equity. By refusing to give credit to that goodwill,
we're being more conservative in what we consider a real asset. Hence, the price-to-tangible
book value will always be at least as high as the price-to-book ratio.
From the P/B ratio, SBI has a lower valuation at 1.33 times as compared to HDFC Bank at 4.71
times.

Earning Power:
Return on equity shows you how well a bank turns its equity into earnings. Equity's ultimately
not very useful if it can't be used to make earnings.
Breaking earnings power down further, you can look at net interest margin and efficiency.
Net interest margin measures how profitably a bank is making investments. It takes the interest a
bank makes on its loans and securities, subtracts out the interest it pays on deposits and debt, and
divides it all over the value of those loans and securities.
HDFC bank enjoys a higher NIM at 4.30% as compared to SBI at 2.62%
While net interest margin gives you a feel for how well a bank is doing on the interest-generating
side, a bank's efficiency ratio, as its name suggests, gives you a feel for how efficiently it's
running its operations.
The efficiency ratio takes the non-interest expenses (salaries, building costs, technology, etc.)
and divides them into revenue. So, the lower the ratio the better.
There are nuances in all this, of course. For instance, a bank may have an unfavorable efficiency
ratio because it is investing to create a better customer service atmosphere as part of its strategy
to boost revenues and expand net interest margins over the long term.
Meanwhile, ROE and net interest margins can be juiced by taking more risk.
The amount of risk it's taking to achieve that earnings power
There are a lot of ratios that try to measure how risky a bank's balance sheet is.
 Tier 1 common ratio

 Common equity tier 1 ratio
 Tier 1 risk-based capital ratio
 Total risk-based capital ratio
 Tier 1 leverage ratio.
A much simpler ratio: Assets/equity.
This ratio tells us our capital adequacy; the NPAs that are written off are from the equity of the
Bank. So if bank does not have enough equity, it will fall short of capital to write off NPAs and
thus causing the Banks to fail or get bailed out.
We can get more complicated by using tangible equity, but this is a good basic leverage ratio to
check out. That leverage ratio gives us a good high-level footing. Getting deeper into assessing
assets, we need to look at the strength of the loans. Let's focus on two metrics for this:

 Bad loan percentage (Non-performing Loans/Total Loans)

 Coverage of bad loans (Allowance for non-performing loans/Non-performing loans)
Non-performing loans are loans that are behind on payment for a certain period of time (90 days
is usually the threshold).
Like most of these metrics, it really depends on the economic environment for what a reasonable
bad loan percentage is. During the housing crash, bad loan percentages above five percent
weren't uncommon.
Banks know that not every loan will get paid back, so they take an earnings hit early and
establish an allowance for bad loans. Banks can boost their current earnings by not provisioning
enough for loans that will eventually default. So a check on the provisioning norms also has to be
kept in mind while analyzing a bank.
From the risk side, both SBI and HDFC Bank have very good Capital adequacy ratio. For SBI
the capital infusion by the government has helped the cause. But the point of concern here is the
extremely High NPAs for SBI and on the other hand HDFC Bank looks more lucrative at a
minimal NPA level of under 1%.
Promoter Backing
The ownership pattern of a bank also has major implications in its functioning. The promoters
are the ones who promote (launch) a company, hence their level of investment in the company
conveys a lot about the fundamentals of the company. Whether the promoter of the bank holds
majority share, minority share or no share has different implications. Sometimes, too much
control by the government as a promoter, who acts in the public interest may have negative
impact on the profitability of the bank.
Board of Directors
The Board of Directors is the one which take the most important decision in any organization
and hence while analyzing a stock it is imperative to do a background check on them. All the
relevant details about each and every Key Managerial Person must be obtained to arrive at the
best decision.
So Overall HDFC Bank has a fundamentally better situation than State Bank of India.
The Indian FinTech Landscape

India FinTech – A Sector Snapshot
India’s FinTech landscape has witnessed strong user adoption through 2017, driven largely by
the payments sector which has enjoyed a boost post the demonetization of high value currency
notes. Alternate lending also enjoyed a strong year, fueled by the large number of unbanked,
new-to-bank, and under-banked consumers. However, while there is significant headroom for

growth in consumer facing solutions, India’s FinTech ecosystem still lags behind other FinTech
hubs in the number of middleware and B2B solutions, which together enable financial
institutions to provide end-to-end solutions for their users.
Strong, proactive policy level support from the government has been providing a much-needed
boost to user adoption. Initiatives such as Jan DhanYojana, Aadhaar and the emergence of UPI
2.0 provide a good foundation for FinTech companies to permeate ‘last mile’ touch points and
boost financial inclusion across the country.
The ‘Payments’ segment has been the most funded segment within the Indian FinTech
landscape, riding on the demonetization wave. However, banking technology solutions,
including B2B products, are also experiencing strong growth and enabling financial institutions
to create seamless solution delivery for end users.
There has been a surge in incoming global investments in the FinTech space, and the India
opportunity remains promising. India offers the largest unbanked or under-banked population,
along with a strong technology and entrepreneurial ecosystem.
Strong Governmental Support
A government push for financial inclusion, digitization and startup activity has led to the
introduction of policy initiatives which provide a strong foundation to the FinTech sector in
India.
Startup India Program
The Startup India program, launched by the central government, includes the simplification of
regulatory processes, tax exemptions, patent reforms, mentorship, opportunities and increased
government funding.
Jan DhanYojana
Financial inclusion in the country has grown significantly due to initiatives like the Pradhan
Mantri Jan DhanYojana (PMJDY), regarded as the world’s biggest financial inclusion program,
with an aim to facilitate the creation of bank accounts for large underserved or unserved sections
of India’s billion plus population.
India Stack
Through the introduction of India Stack, the government has provided a world-class
technological framework to entrepreneurs, innovators and corporations, allowing for the
accelerated growth of FinTech ventures. The scenario somewhat resembles the policy support
offered by the government to the telecom industry in the 90’s, with FinTech taking center stage
in many reform initiatives.

Aadhaar Adoption
The RBI recently approved Aadhaar based biometric authentication, which will allow for bank
accounts to be opened through e-KYC at any Banking Correspondent (BC) location. This will
allow financial services companies to do e-KYC checks more economically, thereby reducing
transaction costs for customers.
National Payments Council of India Initiatives
The National Payments Council of India (NPCI), through the introduction of the Unified
Payments Interface (UPI), and UPI 2.0, has leveraged the growing presence of mobile phones as
acquiring devices, substantially reducing the cost of infrastructure for FinTech ventures. With the
smartphone user base expected to expand to about 500 million users by 2020, up from about 200
million in 2017, the digital banking footprint is projected to grow faster than ever before. The
NPCI has also introduced several innovative products, such as RuPay cards, which will allow for
immediate money transfers and a more convenient experience for the customer. These initiatives
provide a solid foundation for a digitally enabled financial sector in India, giving FinTech
startups the opportunity to leverage these technologies and initiatives to be adopted into the
mainstream banking experience in India.
Payments
Globally, credit card payments overtook cash payments for the first time in history, and although
digital payments accelerated in India as well, it is estimated that 80% of economic transactions in
India still happen through cash, as opposed to around 21% for developed economies, thus
leaving significant room for growth. The digital payments sector in India is estimated to grow to
USD 500 billion by 2020, up from roughly USD 50 billion last year, and representing around
15% of GDP in 2020. Mobile payment solutions, such as wallets, P2P transfer applications and
mobile points of sale, are enjoying strong user adoption, and heading towards one-stop-shop
solutions in the future.
Alternative Lending
Alternative lending is the second most funded and one of the fastest growing segments in the
Indian FinTech space. Around 37% of GDP is contributed to by MSMEs but the supply of credit
lines is disproportionate. It isn’t surprising then that there are 225 new startups in the space as of
2017.The major contributors to the growth of this sector include a large amount of unmet
demand for loans from MSMEs, with a gap of roughly USD 200 billion in credit supply, and a
significant under-banked and new-to-bank population which lies at the heart of the Indian
FinTech opportunity.

PSB vs Private Banks

PSBs have been struggling for quite some time due to the problem of NPAs. Their loan growth
as well as their profitability is severely affected and they have underperformed private banks on
many fronts. The loan growth for PSB is consistently lower than private banks as can be seen
from the below graph.
Source: RBI
Due to dismal loan book growth, PSBs have lost a significant market share and have lost almost
7 % in a span of 2 years. The erosion of assets due to bad debts has also contributed to the shift
of balance towards private banks

Source: RBI
NIM:
Historically PSB had maintained NIM near 3% and private banks had margins higher by ~ 1%.
The gap has widened significantly in 2018 due to lower NIM of PSB and the reason of which has
been the income loss due to high slippages.

Cost to Income Ratio:

The cost to ratio for PSBs has spiked up to because revenues were impacted from large interest
reversals due higher slippages. For private banks the same improved due to better business
growth and stable margins
Sector Outlook:
Rise in CASA ratio
The current account - savings account (CASA) ratio rose to a record high of 39% in fiscal 2017
post demonetisation. It is expected that the CASA ratio will remain healthy at over 39% in the
current fiscal as well, as banks are putting efforts to increase the share of CASA on their books
to reduce their overall cost of deposits. Many public sector banks are expected to see an
improvement in their CASA ratio during the current fiscal. Though the CASA ratio is expected
to remain high this fiscal, it might come down marginally in the next few years, because of
further growth in mutual fund industry and expectation of higher returns from the stock market
on hopes of a more stable economy.
Source: CRISIL

Sector wise credit deployment
Table below shows that most of the outstanding credit was in the category of non-food credit. The
interesting facet of this profile is the higher share of personal loans in total credit outstanding. The
share has increased by 17.8% in FY18 over FY17. Banks have been more active in this segment,
where demand has been relatively robust and the quality of assets better placed.
Due to increasing NPAs, banks have reduced their credit disbursement to the infrastructure sector
and this has resulted in reduction in the share of manufacturing sector in the overall credit in the
economy.

The performance in FY18 will depend on how the manufacturing sector fares as this is required
for revival in growth in bank credit. With a share of nearly 40%, it is the driving force.
While overall growth in bank credit has shown an improvement in FY18, it has been mainly due
to the buoyancy witnessed in the personal and services sector, with the former being dominant
while credit to manufacturing continued to be down beat.
Retail segment to be the key driver for credit growth in next two years
Retail accounts for about 20% of overall system credit demand. With slow growth in the
corporate-loan portfolio, banks have shifted focus to retail, in which growth and risk-reward
opportunities are more favorable in the current leg of the cycle. High impairment in the corporate
loan portfolio and relatively lower risk in retail are leading to high growth in the retail portfolio.
It is expected that retail loan will post 18-20% on-year growth in fiscals 2018 and 2019, and its
contribution in overall loans to increase as well.
Profitability of Banks
Banks’ net profits essentially reflect the difference between interest earned on loans and
advances and investments, and interest paid on deposits and borrowings, adjusted for operating
costs and provisions. Loans and advances and investments, which are the main sources of
interest income, together constitute more than 85 per cent (61 per cent accounted for by loans
and advances and 25 per cent by investments) of banks’ consolidated balance sheet. Post-
demonetisation, there has been a surge in the current account and saving account (CASA)
deposits of banks.
With persistent high level of NPAs in the sector, there would be continued high level of
provisioning done by banks for high slippages as well fresh provisioning. Provisions for
scheduled commercial banks are expected to increase further by 15-20% in fiscal 2018. Private
banks diversification of revenue will help them in comparison PSBs to maintain their
profitability this year.
Implementation of MCLR has also impacted their yields in quarters where interest rate remained
low. Recent increase in repo rates will help better their margin further in the fiscal year.
Liquidity Conditions
With the return of SBNs to the banking system, while currency in circulation contracted, deposits
in the banking system surged. The sudden increase in deposits (given the gradual replacement of
SBNs by new notes) created large surplus liquidity conditions in the banking system, which
could be divided into four distinct phases in terms of how liquidity was managed by the Reserve
Bank using different instruments. (The active liquidity management was necessitated to ensure
that the operating target remained aligned to the policy repo rate.
In the first phase (November 10 to November 25) 2016, the Reserve Bank absorbed the excess
liquidity through variable rate reverse repos of tenors ranging from overnight to 91 days under its
Liquidity Adjustment Facility (LAF). The outstanding amount of surplus liquidity absorbed
through reverse repos (both variable rate and fixed rate auctions) reached a peak of ₹ 5,242
billion on November 25.
In the second phase (November 26 to December 9) 2016, the liquidity surplus was managed
through a mix of reverse repos and the application of the incremental cash reserve ratio (ICRR)
of 100 per cent on the increase in net demand and time liabilities between September 16 and
November 11, 2016. The ICRR helped drain excess liquidity in the system to the extent of about
₹ 4,000 billion during the fortnight ended December 9, 2016.
In the third phase (December 10 to January 13)2017, surplus liquidity conditions were
managed through a mix of reverse repos and issuances of cash management bills (CMBs) under
the MSS. With the enhancement of the limit on issuance of securities under the MSS from ₹ 300
billion to ₹ 6,000 billion on December 2, 2016 by the Government of India, the Reserve Bank
withdrew the ICRR effective the fortnight beginning December 10, 2016. Between December
10, 2016 and January 13, 2017, surplus liquidity in the system was managed by a mix of fine-
tuning reverse repo operations and auctions under the MSS. The peak liquidity absorbed was ₹
7,956 billion on January 4, 2017 (₹ 2,568 billion absorbed through reverse repos and ₹ 5,466
billion through CMBs). Subsequent to the advance tax payment in mid-December, a part of the
excess liquidity was offset by the build-up in government cash balances. The surplus liquidity in
the system declined to ₹ 7,269 billion on January 13, 2017.
In the fourth phase (since January 14)2017, the Reserve Bank has increasingly used reverse
repo operations to absorb surplus liquidity, particularly the liquidity released through the
maturing CMBs, as the magnitude of surplus liquidity has been moderating in sync with
remonetisation. Of the total surplus liquidity (net of injection under the LAF) in the system of ₹
5,537 billion on March 7, 2017, ₹ 500 billion was absorbed through CMBs under the MSS and
the remaining through variable rate reverse repo auctions under the LAF.
The surplus liquidity is expected to decline going forward as remonetisation progresses further,
which will result in decline in deposits with the banking system. Despite this, however, surplus
liquidity conditions are likely to persist for some more time.
Jan Dhan Accounts
Data till May 2, 2018, shows 315 million accounts have been opened as part of the scheme. Of
these roughly 59 per cent, or 185.8 million accounts, have been opened in bank branches located
in rural and semi-urban areas. Total deposits in these accounts have touched ~813 billion.
While there was some initial skepticism over the extent of coverage among poor households, a
recent World Bank report titled Global Findex Report 2017 shows that bank account penetration
rose by 30 percentage points among adults in the poorest 40 per cent of households, suggesting
that the gap in ownership of bank accounts between the rich and poor is shrinking.
However, challenges remain. For one, roughly 190 million Indians still do not have a bank
account. Second, usage levels continue to be low. The World Bank report notes that 48 per cent
of these accounts remained active, twice the world average of 25 per cent. Third, only 7 per cent
of adults in India reported using their accounts for savings, the study found.

Deposits under PMJDY: Number of Accounts

(in million)
Variation
As on August 8, As on March 1, (August 8, 2018
2018 2017 over
Bank-Group
March 1, 2017)
Rural Urban Total Rural Urban Total Rural Urban Total

Public Sector
141.2 121 262.1 122.1 100.8 222.9 19.1 20.2 39.2
Banks
Regional Rural
44.4 8.2 52.6 40.0 6.4 46.4 4.4 1.8 6.2
Banks
Private Sector
6 4 10 5.4 3.6 9.0 0.6 0.4 1
Banks
Note: Figures in parentheses are percentage variations.
Source: Pradhan Mantri Jan Dhan Yojana website.
Deposits Under PMJDY: Amount Mobilised

(₹ billion)
Variation
As on August As on March
Bank Group (Col. 3 over
22, 2018 1, 2017
Col. 2)
1 2 3 4
651 502.5 148.5
Public Sector Banks
141.53 118.1 23.43

Regional Rural Banks
21.98 22.3 -0.32

Private Sector Banks

Credit Outlook
Credit off-take has been surging ahead over the past decade, aided by strong economic growth,
rising disposable incomes, increasing consumerism & easier access to credit. Credit to non-food
industries increased by 9.53 per cent reaching US$ 1,120.42 billion in January 2018 from US$
1,022.98 billion during the previous financial year. Demand has grown for both corporate &
retail loans; particularly the services, real estate, consumer durables & agriculture allied sectors
have led the growth in credit.
Source:IBEF
Bank credit grew at 12.84 per cent year-on-year to Rs 86.16 lakh crore (US$ 1,285.20 billion) on
June 22 2018 from Rs 76.36 lakh crore (US$ 1,139.02 billion) on June 23, 2017. Microcredit
segment’s loan outstanding grew at the rate of 38 per cent year-on-year to around Rs 197 billion
(US$ 2.94 billion) in May 2018 from Rs 142 billion (US$ 2 billion) in May 2017 and the gross
bank credit recorded a growth of 11 per cent during the same period.

Trend in MCLR and deposit rates of banks Credit and deposit growth at divergence
Note: Average of 1Yr MCLR rate of 10 banks considered. Deposits rate is average of 1 to 2 years of maturity is considered
for 10 banks
Source: RBI, CRISIL Research
Deposits Outlook
During FY07–18, deposits grew at a CAGR of 11.66 per cent and reached US$ 1.6 trillion by
FY17. Deposits at the end of Q4 FY17-18 stood at Rs 114,792,883 million (US$ 1,781.12
billion). Strong growth in savings amid rising disposable income levels are the major factors
influencing deposit growth. Deposits under Pradhan Mantri Jan Dhan Yojana (PMJDY), have
also increased to Rs 80,674.82 crore (US$ 12.03 billion) were deposited and 32.25 million
accounts were opened in India. Bank deposits grew at 7.59 per cent year-on-year to Rs 113.54
lakh crore (US$ 1,693.62 billion) in June 22, 2018 from Rs 105.52 lakh crore (US$ 1,573.99
billion) in June 23, 2017.
Source: IBEF

Interest Income Has Seen Robust Growth
Public sector banks account for over 68.38 per cent of interest income in the sector in FY18.
They lead the pack in interest income growth with a CAGR of 6.61 per cent over FY09-18.
Overall, the interest income for the sector (including public and private sector banks) has grown
at 6.94 per cent CAGR during FY9- 18. Interest income of Public Banks was witnessed to be
US$ 102.46 billion in FY18. In FY18, private banking sector (interest income) reached US$
47.39 billion.
Source: IBEF
Growth in ‘Other Income’ also on A Positive Trend
Public sector banks account for about 63.19 per cent of income other than from interest. ‘Other
income’ for public sector banks has risen at a CAGR of 8.01 per cent during FY09-18. Other
income for public sector banks stood at US$ 17.80 billion in FY18. Overall, other income for the
sector has risen at 6.71 per cent CAGR during FY09-18. In FY18, private banking sector (other
income) was US$ 10.37 billion.

Source: IBEF
Return On Assets And Loan-To-Deposit Ratio Showing An Uptrend
Source: IBEF
Loan-to-Deposit ratio for banks across sectors has increased over the years. Private and foreign
banks have posted high return on assets than nationalised & public banks. This has prompted
most of the foreign banks to start their operations in India.

GNPAs to remain high going forward
Asset quality has remained under pressure. Gross non-performing assets (GNPAs) for the
banking system have increased to 11.6% as on March 31, 2018, from 9.6% as on March 31,
2017. We expect slippages to be lower in fiscal 2018 compared with the previous two fiscals, but
GNPAs are nevertheless expected to remain at elevated levels and touch 12.2% of advances by
March 31, 2019, due to continuous slippages and lower recoveries.
Recapitalization of Public Sector Banks - Will it reduce the NPA Levels?
A change in a company’s long-term financing mix is termed as recapitalization. Post subprime

crises banks have lost money; i.e. their liabilities are greater than their assets. Recapitalization
involves a major change in the way a bank is funded; this could come about through issuing new
shares or loan from a government. This improves the banks’ bank balance and prevents them
from going bust. If a bank is provided with loan it can help improve liquidity, but it doesn’t
improve their balance sheet, because they still owe the extra money received. i.e. the money
shows up as an asset, but also as liability because the bank has to pay it back. Recapitalization
would inject money without creating a liability. Post the financial crisis in 2008 banks in United
States formed a Toxic Assets Relief Programme (TARP) under which $700 billion were
allocated to major financial institutions like AIG, Bank of America, Citigroup etc as well as non-
financial institutions like General Motors, Chrysler etc. In the UK bank recapitalization involved
capital injections of over £45bn in the Royal Bank of Scotland (RBS) and over £20bn in Lloyds
Banking Group (LBG). In Ireland the government provided recapitalization for the major banks
such as Allied Irish Bank (AIB), Bank of Ireland (BoI) and Anglo Irish Bank. Under the plan the
Government would take €2 billion in preference shares in each of Bank of Ireland and Allied
Irish Bank and €1.5 billion in preference shares in Anglo Irish Bank, giving it a 75% control of
the latter. The IMF estimates banks need £400bn to recapitalize Spanish banks. In the Euro zone
the countries adopted European Stability Mechanism (ESM) whereby an amount of €41.3 billion
was disbursed to the Spanish government in 2012–2013, and €1.5 billion to Cyprus in 2013 for
bank recapitalization in these countries. Greece was recapitalized with a little over €5.5 billion
by ESM. Thus recapitalization has had a positive impact in the American and European
continents. Indian bank’s recapitalization will enrich the capital in banking making them more
sustainable to absorb the losses. With the introduction of Basel III; the capital norms become
more stringent for protecting the banks in times of adversity.
The amount required to keep pace with growth is large, but at present demand for credit is low.
But adhering to Basel III norms has put additional pressure on these banks. Further, as we are
talking of GDP growth rate of over 8 per cent on a sustained basis, companies will have a
problem raising funds if banks are not up to it, considering that the corporate debt market is still
to evolve.
The question is how to infuse this capital in PSBs. PSBs account for around 75 per cent of
deposits and credit. However, their share in equity capital is just 25 per cent, and reserves 60 per
cent — which are two important components of tier 1 capital.

With banks making more provisions for the restructured assets, profits will be affected, thus
impacting reserves. The usual routes for infusing capital are promoters putting in more money or
additional funds being raised in the market through public issuances.
But when it comes to PSBs, there is an ideological issue of the government retaining control.
Being the majority owner of these banks, the onus is to ensure that these banks are well
capitalized and able to meet the challenge right up to 2019 when we are fully Basel III
compliant. The immediate option is to infuse capital through the Budget.
One way is to provide such funds to banks which meet certain performance parameters. The
other school of thought is that banks which are not doing relatively well should be supported
more through such infusions. Now, if the government has limited bandwidth to provide funds or
is ideologically inclined to support only the better performing banks, then the logical conclusion
is to either merge banks that have a shortfall or let them go to the equity market.
The current thinking is that the government will continue to hold majority stake. Who would like
to buy a large stake in the bank either as a strategic partner or investor in a weak bank with the
government as owner? Based on current market prices of 21 listed PSBs (excluding the SBI
associates), the total amount that can be garnered while retaining the government stake at 51 per
cent would be around ₹47,000 crore.
To maintain status quo in ownership and structure, merging with other PSBs is an option. But
this is a short-term solution, as ultimately the same balance sheet gets to reside in another bank’s
balance sheet. The effort has to be on rationalisation of branches, infrastructure, staff, positions
and designations.
The last option is to get the undercapitalised banks to function like narrow banks by investing in
GSecs as their risk weighted assets would improve. This will hold for banks that have problems
of both capital and NPAs as the present provisioning for restructured assets would put some
additional burden on capital requirements.
PSBs have carried the cross for development all these years and have not changed focus to retail
lending to protect their balance sheets. It is only proper that we move towards a workable
solution.
Recapitalization of Public Sector Banks
As part of its reforms push, the Ministry of Finance, GoI, announced Rs 2.11 trillion
capitalization plan for PSBs on October 24, 2017. The step taken by the government is a major
positive for the beleaguered banking sector, which has seen its fortunes dwindle since 2015.
Rs 2.11 trillion will be infused into the public sector banks through recapitalisation bonds
and budgetary support & market raising (through the sale of equity shares). The banks will be
recapitalised over a period of two years. The government has decided to currently infuse Rs 0.8
trillion (by the end of fiscal 2018) in the form of recapitalisation bonds out of a total of Rs 1.35
trillion (i.e., ~60%) in the first tranche. The recapitalisation would be accompanied by a reforms
package across six themes, incorporating 30 action points.

The proposed recapitalisation package for the banking sector combines several desirable
features. First, by deploying recapitalisation bonds, it will front-load capital injections while
staggering the attendant fiscal implications over a period of time. As such, the recapitalisation
bonds will be liquidity neutral for the government except for the interest expense that will
contribute to the annual fiscal deficit numbers. Second, it will involve participation of private
shareholders of public sector banks by requiring that parts of the capital needs be met by market
funding. Last but not the least, it will allow for a calibrated approach whereby banks that have
better addressed their balance-sheet issues and are in a position to use fresh capital injection for
immediate credit creation can be given priority while others shape up to be in a similar position.
This provides for a good way of bringing some market discipline into a public recapitalisation
program compared to the past recapitalisation programs.
The government’s support to the banks already under the prompt corrective action (PCA)
framework is evident, as almost 60% of the total capital infusion in fiscal 2018 is proposed for
these 11 banks. The capital infusion in different banks will have a significant impact on each
bank’s financial stability and future growth:

The government has announced capital infusion in 20 out of 21 PSBs, of which four banks have
CET1 ratio of less than 7% and 14 have CET1 ratio of less than 8%. Since CET1 is the major
element in the overall tier 1 ratio, the capital infusion will help the stressed banks improve their
overall tier 1 and CAR and help them avoid defaulting in meeting the minimum regulatory
requirement as per Basel III norms at the end of the current and upcoming fiscal years. Of the 20
PSBs, UCO Bank’s CET1 ratio is expected to see the highest jump of 5.9%, followed by IDBI
Bank and Dena Bank, respectively. All three banks are under RBI’s PCA. For banks which are
well-capitalised, the infusion will serve the purpose of growth capital.
Source: CRISIL

Demonetisation- Worth the Pain?
The government’s claims about the fruits of “demonetisation” of ₹500 and ₹1,000notes are
analysed. The claim of the government that demonetisation of currency would help fight black
money and reducing interest rates are analysed.
A crucial assumption in the demonetisation exercise is that “black money” is hoarded as cash.
Such a view is not just narrow, but also serves to defeat the larger purpose of preventing illegal
creation and storage of unaccounted money. To begin with, it is necessary o distinguish between
three concepts: “black economy,” “black money,” and what we may refer to as “black cash.” The
term “black economy” may simply refer to a broad set of economic activities that generate
production and income flows that are under-reported or unreported or result from economic
illegality. A portion of incomes generated in the black economy, when saved, adds to the stock
of black wealth or, what we may call, “black money. “Because savings that financed the
acquisition of black money were themselves undisclosed, black money has been defined
officially as “assets or resources that have neither been reported to the public authorities at the
time of their generation nor disclosed at any point of time during their possession”.
A part of the black money is held as “black cash.” According to estimates in the National
Institute of Public Finance and Policy, cash was a “very significant” form of holding black
money in only less than 7% of the cases. The prominent forms of holding black money were: (a)
under-valued commercial and residential real estate; (b) under-valued stocks in business; (c)
benami financial investment; (d) gold, silver, diamonds and other precious metals; and (e)
undisclosed holdings of foreign assets. More recently, open economy policies, free-trade
arrangements and financial liberalisation policies have expanded the scope for holding black
money in newer forms.
However, the very concept of black money is nebulous. This is because the same person who
earns black income also typically generates income in white. He may choose to declare his
savings by claiming them to be a portion of his legitimate income. There may, in other words, be
black incomes but little or no black savings! No wonder then that economists are not very fond
of estimating the size of black money. In fact, we are not sure if there could be any realistic
estimate of black money in India.
Thus, only a small section, which stores cash in large amounts either for future use or are
evolving cash in business/trade transactions, is adversely affected by demonetisation. As we
explained above, even here, a big portion of cash might actually be legal or made legal through
myriad innovative ways. The assessment by I G Patel, the then Governor of the RBI, of the
demonetisation scheme of 1978 is as true for 2016 as it was for 1978: such an exercise seldom
produces striking results. Most people who accept illegal gratification or are otherwise the
recipients of black money do not keep their ill-gotten earnings in the form of currency for long.
The idea that black money or wealth is held in the form of notes tucked away in suit cases or
pillow cases is naïve. And in any case, even those who are caught napping – or waiting – will
have the chance to convert the notes through paid agents as some provision has to be made to
convert at par notes tendered in small amounts for which explanations cannot be reasonably
sought.

In sum, no significant unearthing of illegal cash may be expected by demonetisation, even if it

might halt or slow down illegal cash-based operations for a while.
How demonetisation was unprofitable for RBI
Source: RBI
While the jury is out on the costs and benefits of demonetisation, for the Reserve Bank of India
(RBI) at least, the note ban was one of the key reasons for lower profits. To that limited extent,
the government also had to bear the brunt in the form of the lower dividend it received from the
central bank. RBI paid only Rs30,663 crore as dividend compared to Rs65,880 crore a year ago.
Here’s how the math works:
RBI’s income for its financial year ending 30 June fell 23.56% to Rs61,818 crore. Its income fell
because of a couple of reasons. One, the central bank’s income from foreign sources fell 35.3%
because of the appreciation of the rupee and the lower yield on foreign currency assets. This was
lower at 0.8% in 2016-17 compared to 1.3% a year earlier. Two, net income from domestic
sources fell 17.11%. This was largely because RBI had to pay interest of Rs17,426 crore as it
mopped up excess liquidity in the banking system after people rushed to deposit invalidated
currency notes at banks. The previous year, the RBI earned an interest of Rs506 crore in its
liquidity management operations. On the expenditure side, the central bank spent Rs7,965 crore
on printing currency notes in 2016-17, more than double the Rs3,420 crore spent a year ago. In
its efforts to quickly remonetise the economy, the RBI issued 29 billion currency note pieces in
2016-17 compared to 21.2 billion a year earlier.
“The upsurge in expenditure during the year was on account of change in the production plan of
printing presses due to the introduction of new design notes in higher denominations as well as
the requirement of larger volume of notes for replacement of the demonetised currency,” the
central bank said in it annual report.
“To ensure availability of banknotes across the country at the shortest possible time subsequent
to the demonetisation, banknotes had to be frequently air-lifted from the presses.”

The second large expense was the Rs13,100 crore provision that the central bank made towards it
contingency fund. This fund is for meeting unexpected and unforeseen requirements such as a
depreciation in the value of securities, risks arising out of monetary/exchange rate policy
operations, systemic risks etc.
The RBI doesn’t say exactly why it topped up the fund. However, in 2013-2014, a committee
headed by Y.H. Malegam had suggested that the central bank can transfer its entire surplus to the
government, without allocating anything to its various reserve funds, for three years because it
had adequate reserve funds. That three-year period ended last year.
Moreover, the contingency fund and asset development fund put together make up only 7.6% of
the RBI balance sheet now compared to 10.1% in 2013.
In the final analysis, putting it simplistically, RBI’s extra interest expenses of Rs17,426 crore, the
extra printing cost of Rs4,545 crore and provision of Rs13,100 crore together make up just about
the Rs35,217 crore decrease in net profit.
Performance of the Banking Industry

I. Rising Rural Income Pushing Up Demand for Banking
The real annual disposable household income in rural India is forecasted to grow at a CAGR of
3.6 per cent over the next 15 years. The Indian agriculture, forestry & fishing sector has grown at
a fast pace, clocking a CAGR of 2.75 per cent over FY 12 – FY18. Rising incomes are expected
to enhance the need for banking services in rural areas & therefore drive growth of the sector.
Programmes like MNREGA have helped in increasing rural income, which was further aided by
the recent Jan Dhan Yojana.
Source: IBEF

II. Mobile Banking to Provide a Cost Effective Solution
Mobile banking allows customers to avail banking services on the move through their mobile
phones. The growth of mobile banking could impact the banking sector significantly. Mobile
banking across the world is still at a primitive stage with countries like China, India & UAE
taking the lead. Mobile banking is especially critical for countries like India, as it promises to
provide an opportunity to provide banking facilities to a previously under-banked market.
Source: IBEF
RBI has taken several steps to enable mobile payments, which forms an important part of mobile
banking; the central bank has recently removed the transaction limit of INR 50,000 & allowed
banks to set their own limits. In adoption of mobile banking, India holds 4th rank across the
globe. Mobile wallet transactions, volume grew at 16 per cent month-on month to 326.02 million
in May 2018 from 279.29 million in April 2018. Value of mobile wallet transactions grew at 4.2
per cent month-on month to Rs 14,632 crore (US$ 2 billion) in June 2018 from Rs 14,047 crore
(US$ 2 billion) in May 2018.
Tele-density in rural India soared at a CAGR of nearly 6.70 per cent during 2011 to 2018. Banks,
telecom providers & RBI are making efforts to make inroads into the un-banked rural India
through mobile banking solutions. Rural tele density reached 57.18 per cent by May 2018.
III. Policy support
The government passed the Banking Regulation (Amendment) Bill 2017, which will empower
RBI to deal with NPAs in the banking sector. The Insolvency and Bankruptcy Code
(Amendment) Ordinance, 2017 Bill has been passed by Rajya Sabha and is expected to
strengthen the banking sector. In May 2018, the Government of India provided Rs 6 trillion (US$
93 billion) loans to 120 million beneficiaries under Mudra scheme.

IV. Infrastructure Financing
India currently spends 6 per cent of GDP on infrastructure; NITI Aayog expects this fraction to
grow going ahead. As per the Union Budget 2018-19, the Indian infrastructure sector requires an
investment of Rs 50 lakh crore (US$ 772 billion).
V. Housing And Personal Finance Have Been Key Drivers
Rapid urbanisation, decreasing household size & easier availability of home loans has been
driving demand for housing. Personal finance, including housing finance provide an essential
cushion against volatility in corporate loans. The recent improvement in property value have
reduced the ratio of loan to collateral value. Credit to housing sector increased at a CAGR of
12.14 per cent during FY09–18, wherein, value of credit to housing sector increased from to US$
114.1 billion in FY16 to US$ 151.2 billion in FY18 and stood at Rs 9,983 billion (US$ 148.9
billion) in FY19. Demand in the low & mid-income segments exceeds supply 3 to 4 fold. This
has propelled demand for housing loan in the last few years.
Source: IBEF
Growth in disposable income has been encouraging households to raise their standard of living &
boost demand for personal credit. Credit under the personal finance segment (excluding housing)
rose at a CAGR of 9.89 per cent during FY09–18, and stood at US$ 144.9 billion in FY18 and
stood at Rs 9,353 billion (US$ 139.51 billion) in FY19. Unlike some other emerging markets,
credit-induced consumption is still less in India.

FINANCIAL SERVICES
Asset Reconstruction Company

What are ARCs?
An Asset Reconstruction Company is a specialized financial institution that buys the NPAs or
bad assets from banks and financial institutions so that the latter can clean up their balance
sheets. Or in other words, ARCs are in the business of buying bad loans from banks. ARCs clean
up the balance sheets of banks when the latter sells these to the ARCs. This helps banks to
concentrate in normal banking activities. Banks rather than going after the defaulters by wasting
their time and effort, can sell the bad assets to the ARCs at a mutually agreed value.
The ARCs levy higher discounts when they buy loans offering cash, but when they offer Security
Receipts for buying loans, the discount drops.
SARFAESI Act 2002– origin of ARCs
The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest
(SARFAESI) Act, 2002; enacted in December 2002 provides the legal basis for the setting up
ARCs in India. Section 2 (1) of the Act explains the meaning of Asset Securitization. Similarly,
ARCs are also elaborated under Section 3 of the of the Act.
The SARFAESI Act helps reconstruction of bad assets without the intervention of courts. Since
then, large number of ARCs were formed and were registered with the RBI which has got the
power to regulate the ARCs.
Capital needs for ARCs
As per amendment made on the SARFAESI Act in 2016, an ARC should have a minimum net
owned fund of Rs 2 crore. The RBI plans to raise this amount to Rs 100 crore by end March
2019. Similarly, the ARCs have to maintain a capital adequacy ratio of 15% of its risk weighted
assets.

How ARCs get funding to buy bad assets from banks?
Regarding funds, an ARC may issue bonds and debentures for meeting its funding requirements.
But the chief and perhaps the unique source of funds for the ARCs is the issue of Security
Receipts. As per the SARFAESI Act, Security Receipts is a receipt or other security, issued by a
reconstruction company (or a securitization company in that case) to any Qualified Institutional
Buyers (QIBs) for a particular scheme. The Security Receipt gives the holder (QIB) a right, title
or interest in the financial asset that is bought by the ARC. These SRs issued by ARCs are
backed by impaired assets.
How do ARCs make money?
They get management fees of 1.5-2%. When the investment requirement rises three times, their
returns drop dramatically. Also, the fees are now linked to the net asset value (NAV) of the
assets and not the outstanding value of the SRs. So, any shortfall in the recovery of bad loans
lowers their fees. Six months after buying bad loans, the ARCs are required to get the SRs rated,
and based on the rating—which takes into account the progress in recovery—the NAV is
calculated.
From the ARCs’ point of view, cash transactions are always better as they can levy relatively
higher discounts, but they don’t have the money to do so. Under norms, they can be 100% owned
by foreign investors who can lend money muscle and expertise, but none of them is entirely
foreign-owned and, in fact, very few have foreign stakes. In May 2016, DIPP removed the 49%
cap on single holding which resulted in their failure to attract foreign investments. As it created a
lack of drive and effective responsibility in the management of ARC.
Challenges
Funding for ARCs continues to be the biggest challenge. The RBI released guidelines stipulated
minimum cash component in the acquisition price of a stressed loan by an ARC at 15 percent,
from the earlier 5 per cent. This lowered competition for deals, as the capital requirements would
precluded some of the ARCs having lower capital bases.

As per industry estimates, the capitalisation of all ARCs put together adds up to $5 billion in
FY16. With the cash component increased to 15 percent, the net worth of all ARCs would be
sufficient to acquire only $3.3 billion of stressed loans. Assuming ARCs acquire stressed assets
at 60 percent of book value, all the ARCs put together can garner $5.5 billion of stressed loans.
The stressed loans of Indian banks are of the order of 9.5 percent of gross advances as of March
2017. Thus, ARCs can acquire only 3.5 percent of such loans from banks.
Other Challenges
There has been a significant valuation mismatch between the expected value by banks and bids
by ARCs, primarily on account of the discounting rates. While banks use discount rates in the
range of 10 percent to 15 percent given their access to cheap capital in the form of public
deposits, ARCs use much higher discount rates of 20 percent to 25 percent, as their cost of funds
is relatively higher than that of banks. Without realistic valuation guidelines, there is no incentive
for ARCs to participate in auctions as the reserve price tends to be high. As a result, banks are
forced to continue holding these positions until most of their value has deteriorated, resulting in
larger losses.
Another key challenge for ARCs is the ability to fund the working capital needs of stressed loans
to enable a revival. In view of this, global distressed asset funds are increasingly seeing an
opportunity here, but this option comes with a rider. To enable them to take high risk, distressed
assets funds require a cash flow priority, a clear first charge on assets and returns in excess of 25
percent. With a consortium of lenders who often act independently, bringing all the parties
together and convincing them to agree to a plan will be a major challenge for a distressed asset
fund.
Problem of Capitalisation– A Changing Horizon
Capital is the biggest problem for the ARCs. If indeed a fragmented ownership is coming in the
way to attract foreign capital, the ARCs should be allowed to tap the capital market by selling
shares to the public. To remove this hindrance, SEBI is planning to allow listing of the security

receipts issued by the ARCs. This will provide a significant boost to the capital of the ARCs.
Also, the Insolvency and Bankruptcy Code has an opportunity of becoming a game changer for
the ARCs.
The opening up of 100% FDI in ARCs coupled with the Code has addressed a key challenge
faced by ARCs — their ability to fund the working capital needs of stressed assets to enable a
revival. There are global distressed asset funds that are increasingly seeing an opportunity here.
As things stand, except for a few transactions in the market, ARCs have not been able to acquire
large cases with potential turnaround options in view of the capital constraints and the absence of
skill sets around and operational turnaround. It would be the most apt time for ARCs to
transform themselves into special situation funds with deep operational capabilities to bring
about a long-term revival in the business under the new Code.
The Code envisages a “creditor in control” regime, with financial creditors exercising control in
the event of even a single default in the repayment of any loan or interest.
Just like the Code, most regulations — be it the Companies Act 2013, CDR or SARFAESI Act
— were all well-meaning to find a resolution in a systematic manner. However, they were
misused by making the prescribed processes mere formalities. If this happens with the Code as
well, it will become just another piece of comprehensive legislation. For the Code’s successful
implementation, the government will have to ensure that the supporting infrastructure and
ecosystem is effectively created. This includes the creation of an insolvency regulator,
development of insolvency professionals, appointment of judicial officials and set-up of benches
of the adjudication authority (the National Company Law Tribunal) and detailed procedural rules
to standardize use of the law, among others. The code has the potential of solving the
capitalization problem of ARCs if followed effectively.
Lack of professional expertise for turnaround

Professionals such as bankers, lawyers and chartered accountants who join ARCs usually expect
employee stock ownership plans (ESOPs) as a major mode of compensation. Since any person
with more than 9% shareholding in an ARC is designated a ‘deemed promoter’ by the RBI, this
actually deters professionals from joining ARCs because of the responsibility associated with the
‘promoter’ status. This only increases the cost of functioning of ARCs. The general dearth of
talent and skill sets required to revive and turn around a unit is also a big challenge.
Rules for the acquisition of assets and its valuation by ARCs
NPAs shall be acquired at a ‘fair price’ in an arm’s length principle by the ARCs. They have to
value the acquired bad assets in an objective manner and use uniform process for assets that have
same features.
SARFAESI Act permits ARCs to acquire financial assets through an agreement banks. Banks
and FIs may receive bonds/ debentures in exchange for NPAs transferred to the ARCs. A part of
the value can be paid in the form of Security Receipts (SRs). Latest regulations instruct that
ARCs should give 15% of the value of assets in cash.

Bond or debentures can have a maximum maturity of six years and should have a rate of interest
at least 1.5% above the RBI’s ‘bank rate’. While dealing with bad assets, ARCs should follow
CAR regulations.
Resolution Strategies that can be followed by ARCs while restructuring the assets
The guidelines on recovery of money from the resolution process by the ARCs say that regaining
the value through restructuring should be done within five years from the date of acquisition of
the assets. SARFAESI Act stipulates various measures that can be undertaken by ARCs for asset
reconstruction. These include:
a) taking over or changing the management of the business of the borrower,
b) the sale or lease of the business of the borrower
c) entering into settlements and
d) restructuring or rescheduling of debt.
e) enforcement of security interest
The last step of ‘enforcement of security interest’ means ARCs can take possession/sell/lease the
supported asset like land, building etc. ARCs and the secured creditors cannot enforce the
security interest under SARFAESI unless at least 75% by value of the secured creditors agree to
the exercise of this right.
Besides restructuring, the ARCs can perform certain other functions as well. They are permitted
to act as a manager of collateral assets taken over by the lenders by receiving a fee. Similarly,
they can also function as a receiver, if appointed by any Court or DRT.
Performance of ARCs
During the early period of 2008 – 13 where reconstruction business was in infancy stage, the
conversion of NPAs was slow. According to an ASSOCHAM report, the average recovery rate
for ARCs in India is around 30% of the principal and the average time taken is between four to
five years.
During 2013-14, because of multiple positive factors, the reconstruction business was booming
as ARCs bought large quantity of bad assets from banks.
But after 2014, the performance of ARCs in settling the NPAs became below par. Especially in
the recent periods, ARCs became underperformers in the context of the present rising tide of bad
assets. This has caused steep rise in NPAs in the banking sector.
The declining asset reconstruction activity was started from the second half of 2014, when the
RBI has raised certain norms for securitization business. RBI released a comprehensive
‘Framework for Revitalizing Distressed Assets in the Economy’. It suggested a corrective action
plan to fight NPAs. Later, the RBI raised the cash payment to banks from 5% to 15%. Similarly,
it removed special asset classification benefits to asset restructuring from April 1, 2015 to align
with international norms. As a result of these, the asset reconstruction business witnessed a slow-
down.

At present, there are 19 ARCs in India. But collectively, their capital base is also insufficient to
tackle the country’s nearly Rs 8 lakh crores NPAs. The main problems in the sector are: low
capital base of ARCs, low funds with the ARCS, valuation mismatch of bad assets between
banks and ARCs etc.
Several steps were taken by the RBI and the government to bring life into the asset econstruction
activities. In one such step, the Government raised FDI in the sector to 100%. Similarly, the
ARCs may get a vital role for asset restructuring under the new Insolvency and Bankruptcy
Code. In 2016, the RBI has amended the SARFAESI Act to give make the ARCs more efficient.
Recent Update
Aditya Birla Capital gets RBI approval for asset reconstruction firm
Aditya Birla Capital Ltd (ABCL) subsidiary Aditya Birla ARC Ltd had received approval from
the Reserve Bank of India (RBI) to set up an asset reconstruction company (ARC).
ABCL applied for the ARC licence in April 2017. India’s banking system is sitting on a pile of
bad loans that are expected to cross Rs9 trillion by the end of the fiscal year 2018, according to a
report released by credit rating firm ICRA Ltd on 31 August 2018.
Some others who have applied for setting up ARCs include AION Capital Management Ltd, a
joint venture between ICICI Bank Ltd and Apollo Global Management, US-based stressed asset
specialist Lone Star Funds, global stressed asset specialist JC Flowers and Co. in partnership
with Ambit Holdings Pvt. Ltd, domestic financial services firm IIFL Holdings Ltd and Sudhir
Valia, the former chief financial officer of Sun Pharmaceutical Industries Ltd.
Conclusion
The changes to foreign investment in ARCs and SRs issued by ARCs should prove to be a major
shot in the arm for ARCs in India. Foreign investment being largely regulated, coupled with
challenges on enforcement of security interest resulted in merely 14 ARCs being registered with
the RBI over the last 14 years. While distressed investments was on the rise, these were
structured through alternate modes of investment, such as equity linked instruments or debt
based equity tickers. The investments in ARCs remained substantially low, since enforcement of
security interests under the ARC route meant reliance on domestic partners, which foreign
investors were not comfortable with.
However, with the Government sending the right signals to mushroom ARCs, it is expected that
investments in ARCs and SRs issued by schemes of ARCs would be on the rise. In fact, a large
number of corporate houses have already applied or initiated steps for setting up their own ARCs
in the last few months. It is expected that the steps contemplated by the RBI, coupled with the
recently passed Bankruptcy Code, and the passing of the pending Debt Amendment Bill shall
provide ARCs in India a conducive regulatory framework for its operations, and in turn help in
cleaning up bad loans of banks in India.

Non-Banking Financial Companies (NBFC)

Non-banking finance companies (NBFCs) form an integral part of the Indian financial system.
They play an important role in nation building and financial inclusion by complementing the
banking sector in reaching out credit to the unbanked segments of society, especially to the
micro, small and medium enterprises (MSMEs), which form the cradle of entrepreneurship and
innovation. NBFCs’ ground-level understanding of their customers’ profile and their credit needs
gives them an edge, as does their ability to innovate and customise products as per their clients’
needs. This makes them the perfect conduit for delivering credit to MSMEs. However, NBFCs
operate under certain regulatory constraints, which put them at a disadvantage vis-à-vis banks.
While there has been a regulatory convergence between banks and NBFCs on the asset side, on
the liability side, NBFCs still do not enjoy a level playing field. This needs to be addressed to
help NBFCs realise their full potential and thereby perform their duties with greater efficiency.
Moreover, with the banking system clearly constrained in terms of expanding their lending
activities, the role of NBFCs becomes even more important now, especially when the
government has a strong focus on promoting entrepreneurship so that India can emerge as a
country of job creators instead of being one of job seekers. Innovation and diversification are the
important contributors to achieve the desired objectives.
NBFCs lend and make investments and hence their activities are akin to that of banks; however
there are a few differences as given below:
1. NBFC cannot accept demand deposits
2. NBFCs do not form part of the payment and settlement system and cannot issue cheques
drawn on them
3. Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not
available to depositors of NBFCs, unlike in case of banks
Factors contributing to the growth of NBFCs:
 Stress on public sector units (PSUs)

 Latent credit demand
 Digital disruption, especially for micro, small and medium enterprises (MSMEs) and small
and medium enterprises (SMEs)
 Increased consumption
 Distribution reach and sectors where traditional banks do not lend
The NBFC sector in India
NBFCs are categorized

a) In terms of the type of liabilities into Deposit and Non-Deposit accepting NBFCs,
b) Non deposit taking NBFCs by their size into systemically important and other non-deposit
holding companies (NBFC-NDSI and NBFC-ND) and
c) By the kind of activity they conduct.
Within this broad categorization the different types of NBFCs are as follows:

Asset Finance Company(AFC): An AFC is a company which is a financial institution carrying

on as its principal business the financing of physical assets supporting productive/economic
activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material
handling equipments, moving on own power and general purpose industrial machines. Principal
business for this purpose is defined as aggregate of financing real/physical assets supporting
economic activity and income arising there from is not less than 60% of its total assets and total
income respectively
Investment Company (IC): IC means any company which is a financial institution carrying on
as its principal business the acquisition of securities
Loan Company (LC): LC means any company which is a financial institution carrying on as its
principal business the providing of finance whether by making loans or advances or otherwise
for any activity other than its own but does not include an Asset Finance Company
Infrastructure Finance Company (IFC): IFC is a non-banking finance company a) which deploys
at least 75 per cent of its total assets in infrastructure loans, b) has a minimum Net Owned Funds
of Rs.300 crore, c) has a minimum credit rating of ‘A ‘or equivalent d) and a CRAR of 15%.
Systemically Important Core Investment Company (CIC-ND-SI): CIC-ND-SI is an NBFC
carrying on the business of acquisition of shares and securities which satisfies the following
conditions:-
 It holds not less than 90% of its Total Assets in the form of investment in equity shares,
preference shares, debt or loans in group companies
 Its investments in the equity shares (including instruments compulsorily convertible into
equity shares within a period not exceeding 10 years from the date of issue) in group
companies constitutes not less than 60% of its Total Assets
 It does not trade in its investments in shares, debt or loans in group companies except
through block sale for the purpose of dilution or disinvestment
 It does not carry on any other financial activity referred to in Section 45I(c) and 45I(f) of the
RBI act, 1934 except investment in bank deposits, money market instruments, government
securities, loans to and investments in debt issuances of group companies or guarantees
issued on behalf of group companies
 Its asset size is Rs.100 crore or above and
 It accepts public funds
Infrastructure Debt Fund: Non-Banking Financial Company (IDF-NBFC): IDF-NBFC is a

company registered as NBFC to facilitate the flow of long term debt into infrastructure projects.
IDF-NBFC raise resources through issue of Rupee or Dollar denominated bonds of minimum 5
year maturity. Only Infrastructure Finance Companies (IFC) can sponsor IDF-NBFCs.
Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI): NBFC-MFI is

a non-deposit taking NBFC having not less than 85%of its assets in the nature of qualifying
assets which satisfy the following criteria:

 Loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not
exceeding Rs.60,000 or urban and semi-urban household income not exceeding Rs.1,20,000
 Loan amount does not exceed Rs.35,000 in the first cycle and Rs.50,000 in subsequent cycles
 Total indebtedness of the borrower does not exceed Rs.50,000
 Tenure of the loan not to be less than 24 months for loan amount in excess of Rs.15,000 with
prepayment without penalty
 Loan to be extended without collateral
 Aggregate amount of loans, given for income generation, is not less than 75 per cent of the
total loans given by the MFIs
 Loan is repayable on weekly, fortnightly or monthly installments at the choice of the
borrower
Non-Banking Financial Company – Factors (NBFC-Factors): NBFC-Factor is a non-deposit

taking NBFC engaged in the principal business of factoring. The financial assets in the factoring
business should constitute at least 75 percent of its total assets and its income derived from
factoring business should not be less than 75 percent of its gross income.
NBFC: Growing in Prominence
NBFCs finance more than 80 per cent of equipment leasing and hire purchase activities in India
.The public deposit of NBFCs increased from US$ 293.78 million in FY09 to Rs 409.15 billion
(US$ 6,089.52 million) in FY17, registering a Compound Annual Growth Rate (CAGR) of 46.10
per cent. The gross loans of India’s Non-Banking Finance Company Microfinance Institutions
(NBFC-MFIs) increased 24 per cent year-on-year in Q2 FY18 to Rs 38,288 crore (US$ 5.89
billion). NBFC’s market share in commercial loans increased to 2.8 per cent in 2016-17 from 2
per cent in 2015-16.
Mutual Funds
A mutual fund, as the name suggests, is a pool of funds of the investors. Investors pool their
money to form a corpus of funds, which is then invested in a portfolio of securities by the Asset
Management Company. The returns earned on the securities are returned back to the investors in
proportion to their investments, after charging some fees and commission.
Mutual funds provide the benefit of expert advice in investment and diversification, even to
small investors, who cannot practically conduct detailed analysis of the securities, nor can invest
in, say more than 10 of them at the same time.
Mutual funds may be open end or closed end funds, the definitions for which are given as
follows:
Open end funds: Open end funds are those mutual funds in which investors may invest and
withdraw at any time. These are the most common type of mutual funds. However, they are not
traded on exchange.

Closed end Funds: Close end funds are those mutual funds in which the investor’s money is
locked in for a particular period. Investors who want their money back cannot get it back directly
from the fund. They will have to sell their assets in the funds to other investors on the exchange.
Terms to be tracked for a Mutual Fund are:
Asset Under Management (AUM): The market value of assets that a mutual fund manages on
behalf of investors. AUM is looked at as a measure of success against the competition and
consists of growth/decline due to both capital appreciation/losses and new money
inflow/outflow.
Net Asset Value (NAV): A mutual fund's price per share value. In both cases, the per-share
dollar amount of the fund is calculated by dividing the total value of all the securities in its
portfolio, less any liabilities, by the number of fund shares outstanding.
Entry & Exit Load: Mutual fund companies collect an amount from investors when they join or
leave a scheme. This fee is generally referred to as a 'load'. Entry load can be said to be the
amount or fee charged from an investor while entering a scheme or joining the company as an
investor whereas the fee charged from an investor while redeeming or transferring a scheme is
termed as exit load. Post August 2009 in India only entry load can be charged and this load
balance is not included in the NAV calculation.
New Fund Offer (NFO): A security offering in which investors may purchase units of a closed-
end mutual fund. A new fund offer occurs when a mutual fund is launched, allowing the firm to
raise capital for purchasing securities.
Corpus: The total amount invested by a mutual fund or its scheme is called a corpus.
Mutual Fund Industry in India
The first mutual fund in India was the Unit Trust of India (UTI) set up in 1963. Privatisation was
allowed in 1993. The regulatory body for mutual funds in India is SEBI.
As of July 2018, the Assets under Management of the mutual fund industry stood at Rs 23.06
lakh crore (US$ 343.90 billion). Inflows in India's mutual fund schemes via the Systematic
Investment Plan (SIP) route reached Rs 67,190 crore (US$ 10.43 billion) during FY18 from Rs
43,921 crore (US$ 6.55 billion) during FY17. During April - June 2018 Rs 21,548 crore (US$ 3.21
billion) was collected.
Top three companies in India according to Asset under Management as on June 2017 are:
1. ICICI Prudential Mutual Funds(US$ 46.27 billion)
2. HDFC Mutual Funds (US$ 45.77 billion)
3. Reliance Mutual Funds (US$ 37.18 billion)
Financial Assets Getting A Bigger Piece Of The Savings Pie
Household savings in India has witnessed a growth from ₹20.7 trillion in Fiscal 2012 to ₹24.8
trillion in Fiscal 2017, although its share as a percentage of GDP remained subdued during the
period. With incomes on the rise and inflation under control, the household savings rate (as a
percentage of GDP) is likely to increase gradually. Physical assets such as real estate and gold
have been the preferred avenues for household savings, though in recent years, the preference
has been shifting towards financial assets. Financial savings (less financial liabilities) grew at a
healthy pace of 9.9% CAGR between Fiscals 2013 and 2017, compared with savings in physical
assets, which grew at a CAGR of 0.1%. Commensurately, the proportion of net financial assets
in total household savings has seen a sharp rise from 31% in Fiscal 2012 to 42% in Fiscal 2017.
As of Fiscal 2017, the total household financial savings (less financial liabilities) stood at ₹10.3
trillion.
Traditionally, the highest allocation

of financial assets has been to
deposits (banking and non-banking),
and was 62% of household gross
financial savings in Fiscal 2017.
However, the past two years have
seen a quantum spurt in investments
into capital markets, with the
household allocation to shares and
debentures increasing from 2% in
Fiscal 2015 to 10% in Fiscal 2017.
This can be partly attributed to the
declining interest rates and growing
equity markets.
In the recent years, we have also witnessed a sharp increase in the mutual fund assets under
management attributable to individual investors, including retail and high net-worth individuals.
For the period April 2015 to December 2017, the individual investors’ AUM grew at a CAGR of
33% to ₹11.4 trillion. Also, with lower currency in the market and high digitalisation post-
demonetisation, the share of currency declined drastically in Fiscal 2017 and investments in
capital markets and deposits increased.

The assets of the Indian mutual fund industry have grown at a healthy pace since the turn of this
millennium. At ₹21.3 trillion as of December 2017, AUM has seen a CAGR of 18% from ₹1.1
trillion in March 2000. The industry’s growth came in the backdrop of an expanding domestic
economy, robust inflows and increased participation, especially by individual investors. The
industry had 41 asset management companies (“AMCs”) as of December 2017, up from 32 in
March 2000, after a brief drop to 28 in 2004.
Other Financial Services

Financial services are the economic services provided by the finance industry, which
encompasses a broad range of organizations that manage money, including credit unions, banks,
credit card companies, insurance companies, finance companies, stock brokerages, investment
funds and some government sponsored enterprises.
Intermediary Advisory Services
These services involve stock brokers (private client services) and discount brokers. Stock brokers
assist investors in buying or selling shares. Primarily internet-based companies are often referred
to as discount brokerages, although many now have branch offices to assist clients. These
brokerages primarily target individual investors. Full service and private client firms primarily
assist and execute trades for clients with large amounts of capital to invest, such as large
companies, wealthy individuals, and investment management funds. E.g. - Sharekhan, Anand
Rathi, etc.

Private Equity
Private equity funds are typically closed-end funds, which usually take controlling equity stakes
in businesses that are either private, or taken private once acquired. Private equity funds often
use leveraged buyouts (LBOs) to acquire the firms in which they invest. The most successful
private equity funds can generate returns significantly higher than provided by the equity
markets. Greater activity in this segment supports Banking Institutions as they very often use
debt in their deals; also they create a very sound environment of investment which indirectly
boosts requirement for BIs. E.g.- Warburg Pincus, Blackstone, etc.
Conglomerates
A financial services conglomerate is a financial services firm that is active in more than one
sector of the financial services market e.g. life insurance, general insurance, health insurance,
asset management, retail banking, wholesale banking, investment banking, etc. A key rationale
for the existence of such businesses is the existence of diversification benefits that are present
when different types of businesses are aggregated i.e. bad things don't always happen at the same
time. As a consequence, economic capital for a conglomerate is usually substantially less than
economic capital is for the sum of its parts. E.g. – Indiabulls, India Infoline, MotilalOswal etc
National Housing Bank:

National Housing Bank (NHB), a wholly owned subsidiary of Reserve Bank of India (RBI), was
set up on 9 July 1988 under the National Housing Bank Act, 1987. NHB is an apex financial
institution for housing. NHB has been established with an objective to operate as a principal
agency to promote housing finance institutions both at local and regional levels and to provide
financial and other support incidental to such institutions and for matters connected therewith.
NHB registers, regulates and supervises Housing Finance Company (HFCs), keeps surveillance
through On-site & Off-site Mechanisms and co-ordinates with other Regulators.
Housing Finance Company (HFCs)

A Housing Finance Company is a company registered under the Companies Act, 1956 (1 of
1956) which primarily transacts or has as one of its principal objects, the transacting of the
business of providing finance for housing, whether directly or indirectly.
A company registered under the Companies Act, 1956 and desirous of commencing business of a
housing finance institution, should comply with the following-
(i) either it should primarily transacts or has as one of its principal objects of transacting the
business of providing finance for housing, whether directly or indirectly; and
(ii) it should have a minimum net owned fund of Rs. 10 crore.

NHB, after its satisfaction on the fulfillment of following conditions provided under sub-section
(4) of Section 29A of the National Housing Bank Act, 1987 by a company, may grant a
Certificate of Registration.
Net Owned Fund (NOF)
The aggregate of the paid-up equity capital and free reserves as disclosed in the latest balance-
sheet of the housing finance institution after deducting therefrom -
(i) accumulated balance of loss;

(ii) deferred revenue expenditure, and
(iii) other intangible assets; and
further reduced by the amounts representing –
(i) Investments of such institution in shares of-

 its subsidiaries;
 companies in the same group;
 all other housing finance institutions which are companies; and
(ii) The book value of debentures, bonds, outstanding loans and advances (including hire-
purchase and lease finance) made to, and deposits with,-
 Subsidiaries of such company; and
 Companies in the same group, to the extent such amount exceeds ten per cent
Difference between bank and HFC:
HFCs lend and make investments and hence their activities are akin to that of banks. However,
there are a few differences as given below:
(i) HFCs cannot accept demand deposits;

(ii) HFCs do not form part of the payment and settlement system and cannot issue cheques
drawn on itself;
(iii) deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not
available to depositors of HFCs, unlike in case of banks.
Can all HFCs accept public deposits?
For acceptance of public deposits HFCs can be divided into two categories, i.e. HFCs carrying
on the business of housing finance before June 12, 2000 and HFCs commencing housing finance
business after that date.
(a) Companies carrying on business of housing finance before June 12, 2000 can accept deposits
provided they have NOF of over rupees twenty five lacs and have applied for certificate of
registration with NHB before December 12, 2000 and either have been granted the certificate of
registration valid for acceptance of deposits by NHB or their application is still pending for issue
of certificate of registration with NHB.

(b) Companies commencing the business of housing finance after June 12, 2000 can accept
public deposits only after:
(i) Obtaining certificate of registration from NHB valid for acceptance of deposits; and
(ii) Having minimum net owned funds (NOF) of [rupees two crores or more].
Max Deposit Limit:
 five times of its net owned fund for HFCs with A and above rating
 two times of its net owned fund or rupees ten crores whichever is lower provided such HFC
complies with all prudential norms and also has capital adequacy ratio of not less than fifteen
percent as per the last audited balance sheet.
HFC Business
The major sources of funds for HFCs are funds from banks commercial paper, bonds and NHB.
Off late bonds have become one of the cheaper sources and HFCs are trying to reduce their
borrowing from banks
Despite the stiff pricing competition from SCBs, HFCs market share in retail housing loans has
seen a steady improvement from FY08. A comparison of housing loan growth rates for SCBs
(housing loans data from RBI)and HFCs (housing loan data from NHB) shows HFCs improved
their share in housing loans by ~10% FY08-FY14
Interest Rate Calculation

HFCs calculate interest rate using Prime Lending Rate (PLR) & Discount. The Prime Lending
Rate and Discount are the factors used by HFCs for deciding their interest rate. The PLR is
calculated by HFCs based on the cost they incur for raising their funds along with a certain profit
margin. The method for calculating PLR is not known. Let’s say an HFC’s PLR is 16%. What it

will do now, is discount this rate by a certain amount, say 5%. This Discount is decided by each
individual HFC.
Interest Rate = PLR – Discount = 16-5 = 11%.
Benefits of HFCs over Banks
 Leniency in documentation, eligibility and credit score assessment

 Quicker loan disbursal
Benefits of Banks over HFCs
 Lower interest rate

 Long term savings
 When RBI reduces Base Rate, the benefit is promptly passed to the customer
Micro-banking
Micro-banking, a formalized and regulated lending market is an outcome of the inability of the
Indian banking space to penetrate deeper into the un-served population. Micro-banking, also
termed as shadow banking, is broadly classified into Self Help Group (SHG) bank-based lending
approach and microfinance institutions (MFI) and has been in existence for years (SHG model
was first introduced in 1990s). While individual lending is also a part of microfinance credit in
India, its market size has remained limited. Further, though at a nascent stage of implementation,
and also drawing parallels from individual-based lending approach globally, the Indian MFI
industry and especially some larger players are venturing into this segment.
The door-to-door based lending model is the key to success of the joint liability group (JLG)-
based MFI model in India; further, with strong credit policies in place and stringent regulations
including cap on lending norms have led to discipline among players. On the flipside, unsecured
nature of the product, high operating costs, need for ‘feet on street’ sales and requisite collection
mechanism could be the reasons for the banking industry to have remained shy of the
opportunity.
The MFI industry has been through a roller-coaster ride in its initial and mere 10 years of
existence in India. Stringent regulations on lending norms, capital requirement and exposure
limits for the lender and borrower emerged post the AP crisis. The industry since then has
witnessed 45% AuM CAGR (i.e. during FY12-17) led by improved reach, increase in customer
profile and surge in ticket size.

Differentiated banking model – Small Finance Bank: The need for a differentiated banking
structure received greater emphasis following the discussion papers by RBI on ‘Banking
Structure in India – The Way Forward’ in August 2013, which called for thrust on financial
inclusion. Also, the need to ensure healthy competition led to the need for a separate banking
structure.
The RBI discussion paper states the following:

Small banks vs large banks: There is an ongoing debate on whether we need small number of
large banks or large number of small banks to promote financial inclusion. Small local banks
with geographical limitations play an important role in the supply of credit to small enterprises
and agriculture. While small banks have the potential for financial inclusion, their performance
in India (local area banks and urban co-operative bank) has not been satisfactory. If small banks
are to be preferred, the issues related to their size, numbers, capital requirements, exposure
norms, regulatory prescriptions and corporate governance need to be suitably addressed. Small
finance banks (SFB) have been carved out with the prime objective of ensuring financial
inclusion through credit supply to small business units, small & marginal farmers, micro & small
industries and other entities in the unorganized sector through high-technology and low-cost
operations. Accordingly, RBI has given in-principle approval to 10 entities, of which eight are

MFIs. The inclusion of MFIs in the SFB license shows the significance of the MFI industry in
enabling financial inclusion.
MFI industry: Huge Growth Potential
The microfinance industry has total loan portfolio of Rs 106,823 Cr. As on June 2017. . It is
estimated that this gross loan portfolio (glp) number roughly represents over 90% of the total
industry portfolio excluding SHGs.
The NBFC-MFI industry reported strong growth in FY18. During FY18, the industry disbursed
loans worth ₹59,629 crore, representing a 49% increase over previous year. This resulted in a
50% growth over previous year in Gross Loan Portfolio (“GLP”) to ₹48,094 crore. During the
same period, the number of clients increased by 25% to 2.53 crores, while the number of people
employed by the industry grew by 25% to 82,004 and the number of branches also rose by 25%.
Average loan amount disbursed per account was ₹22,273.
Recent Trends
As of 30 June 2018, 2.65 Cr

clients have loan outstanding
from NBFC-MFIs, which is
an increase of 31% over Q1
FY 17-18. The aggregate
gross loan portfolio (GLP) of
MFIs is Rs 51,878 Cr as on
30 June 2018. This represents
a Y-o-Y growth of 53% as
compared to 30 June 2017
and 8% in comparison to 31
March 2018. Loan amount of
Rs 17,836 Cr was disbursed
in Q1 FY 18-19 through 76

lakh accounts. Average loan amount disbursed per account during Q1 FY 18-19 was Rs 23,510,
an increase of 12% from Q1 FY 17-18. MFIs now cover 30 states/union territories. In terms of
regional distribution of portfolio (GLP), East and North East accounts for 35% of the total NBFC
MFI portfolio, South 26%, North 15%, West 14% and Central contributes 10%.
The fall and rise of the sector

With mere 10 years of existence in India, the microfinance industry has already been through a
rollercoaster ride: a) the FY06-10 period was characterized by robust growth and profitability; b)
in the period thereafter, i.e. FY11-13, wherein NPAs rose, portfolio ran down and many MFIs
went bankrupt following AP crisis; and finally c) the period post FY13 was characterized by
high growth rates due to increased reach. The sector has emerged as the fastest growing one,
with 45% CAGR in AuM, led by over 2x rise in volume (no. of borrowers at 32.5mn in FY16 vs
14.8mn in FY12) and 21% rise in value. Ticket size per borrower stood at Rs16, 379 vs.
~Rs.7,550 in FY12. The penetration has extended to cover 32.5mn (vs 13.4mn in FY13) through
branch reach of 9,669 and across 30 states/union territories.
Today, with over 45 million end clients with a loan outstanding of over Rs 1 lakh crore across the
private JLG (Joint Liability Group) and the public SHG (Self Help Group) programmes,
employing over 120,000 people across 10000 branches in 28 states of India, it is a key force for
financial inclusion in the country. The key reason for the growth of the sector has been
adaptability to change, resilience in the face of challenges and an ability to maintain high
repayment rates of almost 99.5%. The Nobel Prize winning Grameen model of social collateral
combined with a high touch model and rigorous credit bureau discipline has helped to maintain
high levels of repayment for small ticket sized unsecured loans. Unfortunately, the business is
still highly cash oriented - both on disbursements and repayments.
With demonetisation, this proved to be an Achilles heel for the sector. Lack of availability of
new notes hit the informal cash intensive economy of the low income groups served by
microfinance in the weeks following the old Rs 500 and Rs 1000 notes being declared illegal
tender. Microfinance institutions were forced to ask customers to get new notes or repay their
loan amounts in other denominations.
Clearly a business which has to manage its costs with staff (that takes about 10%), occupancy
costs (that take up almost 60-70%) cannot be viable unless there is 99% efficiency in collections,
in order to be a sustainable model. However, given the underlying strength of the business
model, collection efficiencies estimated to have moved from 78% in November 2016 to 85% in
March 2017. But there is still ground to be covered, and specific states and local areas are more
deeply affected than others.
The sector has attracted significant debt and equity capital over the past few years. In order to
grow and reach out to more clients and bridge the financial inclusion gap, the sector has to
continue to be able to tap into more debt and equity capital, primarily being a capital intensive
business. This will enable moving to the next level of evolution for the industry.
This is a sector where the inclusion and cashless agenda of the government should be pursued as
it has the potential to create significant empowerment and impact. With the opening up of more
Business Correspondents from banks, new age Small Finance Banks and Payment banks,
payment platforms such as Aadhaar Pay etc., it is indeed possible to enable a majority of the 45
million end clients to receive loan disbursals and eventually make repayments through bank
accounts - this could mean over 100 million e - transactions every month!
Interest Rate Calculation for MFI
The interest rates charged by an NBFC-MFI to its borrowers will be the lower of the following:
i. Cost of funds, plus margin
Cost of funds means interest cost and margin is a markup of a maximum of 10 per cent for large
NBFCs-MFI and 12 per cent for others. Large NBFCs-MFI are those with loans portfolios
exceeding Rs.100 crore.
ii. The average base rate of the five largest commercial banks by assets multiplied by 2.75
The average of the base rates of the five largest commercial banks shall be advised by the
Reserve Bank on the last working day of the previous quarter, which shall determine interest
rates for the ensuing quarter.
RBI has removed the cap interest rate of 26% but the maximum variance permitted for individual
loans between minimum and maximum interest rate cannot exceed 4 per cent.
Cost of funds:
At an industry level average and median cost of funds for Q1 FY 18-19 is 14.5%. Overall spread
of cost of funds ranges from 8% - 17%. For, Large MFIs, the range is between 9.8% - 15.3%.
Medium MFIs, range is between 14.5% to 15.7%. Small MFIs, range is between 8% to 16.8%.

Source: MFIN
Asset Quality:
Though MFI industry is perceived to be of high risk the asset quality has remained robust due to
group lending dynamics. The percentage of loans unpaid for 30, 90 and 180 days is as shown in
the below figure.
Source: MFIN
PAR >30 has reduced considerably since 30 June 2017 and is at 3.2% on 30 June 2018. In terms
of geographic spread, 66% of the portfolio is rural and 34% is urban. In terms of purpose,
agriculture loans account for 54% of the GLP. Non-agriculture (trade/services and
manufacturing) loans account for 42% and household finance loans account for 4% of the GLP.

Source: MFIN
Company Coverage: HDFC AMC Ltd.

Company Overview
HDFC Asset Management Co (HDFC AMC) is the asset management arm of the HDFC Ltd
(Promoter) and was established in 1999. In 2001, Standard Life Investments acquired 26% stake
in HDFC AMC. It is the most profitable AMC and the second largest in terms of asset under
management (AUM) with ~14% market share. As on March 2018, it managed AUM of Rs.
2,91,985 crore out of which 51% was equity AUM. It has grown its AUM at a CAGR of 25.5%
over FY2013-18.
Growth Drivers:
Equity mutual funds are perceived as long-term wealth creators
Over the years, equity mutual funds have emerged as a favored investment vehicle for long-term
wealth creation. For e.g., ₹1,000 invested in equity funds (represented by the CRISIL-AMFI
Equity Fund Performance Index) on December 31, 2007, would have grown to 2.4 times until
December 29, 2017, compared with 1.9 times, 2 times and 1.9 times of the Nifty 50, Nifty 500
and S&P BSE Sensex indices, respectively, over the same time span.
Equity-oriented schemes have markedly outperformed traditional investment avenues such as
fixed deposits in the long run, albeit with volatility. Strong growth in equity markets has
attracted substantial flows into equity oriented funds, especially since Fiscal 2015. With more
number of households including mutual funds in their savings basket, benign inflation, falling
interest rates and growing individual investor participation (especially through the disciplined
SIP route), combined with the growing equity markets, make this asset class an attractive vehicle
for long-term wealth creation.

Rising income and higher savings, along with increasing allocation to mutual funds, are
huge positives for the industry
India has witnessed a steady growth in per-capita GDP (at constant Fiscal 2012 prices) from Rs.
71,609 in Fiscal 2012 to Rs. 93,840 in Fiscal 2017, registering an absolute increase of 31%.
CRISIL Research expects the trend in per- capita growth to continue. In the short-to-medium
term, disposable income will rise as a result of the implementation of the Seventh Pay
Commission’s recommendations, One Rank One Pension scheme, and sustained low inflation.
India has traditionally been a high-savings economy, and is expected to remain so at least over
the next decade.
While the bulk of savings have historically remained in physical assets, we have witnessed a
steady growth in allocation to financial assets. Especially, the allocation to mutual funds has seen
a spurt in the recent years, because of increased participation from individual investors. We
expect the share of mutual funds in household savings to increase, supported by rising incomes
and higher savings rate.

Huge potential waiting to be tapped
Mutual fund assets in India have seen robust growth, especially in the recent years. It also
witnessed deeper penetration since the turn of the millennium, in the backdrop of a growing
investor base, healthy capital market growth, ease of transactions by advancement of technology
and the regulator’s efforts to make mutual fund products more transparent and investor-friendly.
Mutual fund AUM as a percentage of GDP rose from 5.6% in Fiscal 2000 to 11.6% in Fiscal
2017, and further rose to 12.9% in the first half of Fiscal 2018. However, the industry still has
tremendous potential for growth, considering a large untapped market with favourable
demographics of a young population


A QUICK SNAPSHOT
SOURCE: RHP

Source: RHP

KEY RATIONALES
1. Huge potential for growth (Industry) in Mutual Fund AUM: In the past five years
(FY14-FY18), equity AUM for Indian MF industry has increased 4.4x, from `2 lakh cr to `9
lakh cr. Further, overall AUM has nearly jumped 2.5x from `8.2 lakh cr to `21.3 lakh cr.
Moreover, the MF industry is receiving about `7,000cr per month through SIP (Systematic
Investment Plan). We believe that this trend would continue in the coming years owing to (1)
continuation of black money crack down; (2) lower fixed deposit rates; (3) increased
awareness; (4) low penetration (AUM/GDP -13% vs. +50% in developed markets).
2. Most profitable AMC among top 5 AMCs: HDFC AMC has been reporting the best
profitability numbers in the industry owing to operating efficiency. For FY18, HDFC AMC
had reported PAT/AAUM of 0.26%, whereas other top 5 players had reported the same in the
range of 0.21-0.14%.
3. Healthy financials to support higher dividend payout: Revenue/EBITDA has grown at

healthy CAGR of 20% over FY2013-17. Return on equity (ROE) for FY2018 was 40% and
last 5 years average ROE was 42%. For FY2018, HDFC AMC registered dividend payout of
47%, notably the company has been maintaining dividend payout of 41% on an average for
last 5 years.

Valuation in the Financial Services Sector

Nature of Historic P/B Historic Current Current
Financial NNPA P/B NNPA
Services
Company
Public Sector 0.904 4.732 0.800 6.812
Banks
Private Banks 3.549 1.207 3.576 1.904
Housing 4.904 0.257 5.774 0.236

Finance
Companies
Micro Banks 3.713 0.420 3.350 1.475
Other Financial 3.011 1.006 3.915 1.060

Services
The above table analyses the key indicators of major segments within the BFSI industry. The
above data has been compiled by taking the historic P/B as the last 5-year average. Similarly,
Historic NNPA has been calculated by taking 5-year average.
For the Public Sector Banks (PSBs), historic P/B is very low. NNPA on the other hand is
extremely high as compared to others. This is due to extreme inefficiencies in credit rollout,
exposure to long gestation sectors like infrastructure and weak recovery mechanism. Due to the
government backing and a surety of capital infusion during tough times, these banks lend credit
without much due diligence which is not the case for private banks or Housing Finance
Companies. This reflects in the data for the private banks. They have very low NNPA ratio and a
healthy P/B ratio signaling that the market values those much higher as compared to the PSBs.
Also, the Private Banks are relatively more profitable as compared to PSBs which allows them to
make healthy provisions for their NPAs. Another thing is that the Private Banks in addition to
having an elaborate due diligence process have a robust risk control process. Despite these long
processes, the loan is usually sanctioned within three days. While, in the case of PSBs, the
process is slow and usually takes a few weeks.
Micro Finance Institutions (MFIs), as can be seen from the data, have very low NNPAs. The
business model of MFI is such that the MFI has to ensure least default in order to make some
profits.
Housing Finance Companies (HFCs) have seen a huge boost due to infrastructure status being
granted to affordable housing. The HFCs have strong asset quality and stable margins and a
healthy Capital Adequacy Ratio have resulted in low NNPAs for the HFCs.

Insurance:
Insurance is a hedging mechanism wherein a large number of parties come together to share risk
by the pooling of resources. All the parties involved in pooling pay a certain amount of money or
premium to a third party called the insurer. The amount of premium paid is commensurate with
the risk involved and the value of the asset insured. This collective risk bearing is called
insurance.
Classification:
Life Insurance: Life insurance is an insurance coverage that pays out a certain amount of money
to the insured or their specified beneficiaries upon death of the individual who is insured or
maturity of the policy, whichever is earlier. It not only ensures financial security for the family
members of the insured in case of his death, but also provides attractive investment and tax
benefit options. Within life insurance a large number of options are also available and any
potential customer has the flexibility to choose from them based on his requirements and
priorities.
General Insurance: General insurance covers insurance policies other than life insurance. This
is for insuring property, such as vehicle, stock etc. against some unforeseen events which result
in a financial loss for the insured. It provides compensation to the individual in case of losses, to
the extent of the loss suffered by the individual. It also includes health insurance, covering the
risk of large bills of medical treatments.
Re Insurance: It is the insurance that is purchased by an insurance company to mitigate some of
the risks associated with its insurance business.
Bank Insurance Model or Bancassurance
Bancassurance is the selling of insurance and banking products through the same channel, most
commonly through bank branches.
The following factors have mainly led to success of bancassurance
 Pressure on banks' profit margins. Bancassurance offers another area of profitability to

banks with little or no capital outlay. A small capital outlay in turn means a high return
on equity.
 A desire to provide one-stop customer service. Today, convenience is a major issue in
managing a person's day to day activities. A bank, which is able to market insurance
products, has a competitive edge over its competitors. It can provide complete financial
planning services to its customers under one roof.
 Opportunities for sophisticated product offerings.
 Opportunities for greater customer lifecycle management.
 Diversify and grow revenue base from existing relationships.
 Diversify risks by tapping another area of profitability.
 The realisation that insurance is a necessary consumer need. Banks can use their large
base of existing customers to sell insurance products.
 Bank aims to increase percentage of non-interest fee income

 Cost effective use of premises
Disadvantages:
 Data management of an individual customer’s identity and contact details may result in
the insurance company utilizing the details to market their products, thus compromising
on data security.
 There is a possibility of conflict of interest between the other products of bank and
insurance policies (like money back policy). This could confuse the customer regarding
where he has to invest.
 Better approach and services provided by banks to customer is a hope rather than a fact.
This is because many banks in India are known for their bad customer service and this
fact turns worse when they are responsible to sell insurance products. Work nature to
market insurance products require submissive attitude, which is a point that has to be
worked on by many banks in India.
Overview of the insurance sector in India:
Insurance Regulatory and Development Authority (IRDA)
• Established in 1999 under the IRDA Act
• Responsible for regulating, promoting and ensuring orderly growth of the insurance and re-
insurance business in India

Market share for insurance companies are reported in two ways:
1. Based on the number of policies.

2. Based on first year premiums income.
The largest insurance companies in India terms of market share based on total insurance
premium collected are:-
Source: IBEF
Specialised insurers
Export Credit Guarantee Corporation of India Limited: Export Credit Guarantee
Corporation of India Ltd (ECGC) is a specialized insurer underwriting business in export credit
insurance.
Agriculture Insurance Company of India Ltd: Agriculture Insurance Company of India Ltd
(AIC) is a specialized insurer underwriting business in agriculture insurance.
Performance of the sector:
The domestic life insurance industry registered 10.99 per cent y-o-y growth for new business
premium in 2017-18, generating a revenue of Rs 1.94 trillion (US$ 30.1 billion). Gross direct
premiums for non-life insurance industry increased by 17.54 per cent y-o-y in FY18.

Source: IBEF
Gross direct premiums of non-life insurers in India reached Rs 1.51 trillion (US$ 23.38 billion)
in FY18. In April-May 2018, the gross direct premiums reached Rs 24,397.09 crore (US$ 3.79
billion), showing an year-on-year growth rate of 11.96 per cent. Over FY12-18, non-life
insurance premiums (in Rs) increased at a CAGR of 16.65 per cent. The number of policies
issued increased from 65.55 million in FY08 to 161.17 million in FY17, at a CAGR of 10.5 per
cent. There are 33 non-life insurers operating in the industry in 2018.
The country is the fifteenth largest insurance market in the world in terms of premium volume,
and has the potential to grow exponentially in the coming years.
Notable Trends in the Insurance Sector
Emergence of new distribution channels:
 New distribution channels like bancassurance, online distribution and NBFC shave widened
the reach and reduced costs
 Firms have tied up with local NGOs to target lucrative rural markets
 In April 2017, IRDAI started a webportal– isnp.irda.gov.in –that will allow the insurers to
sell and register policies online. This portal is open to intermediaries in insurance business as
well.
 India Post Payments Bank (IPPB) plans to start selling insurance products and mutual funds
of other companies by early 2018, and is to be open only to "non-exclusive" tie ups.

Shares in Non-Life Insurance Market: Motor Insurance Leads
Gross direct premiums of non-life insurers in India reached Rs 1.51 trillion (US$ 23.38 billion)
in FY18. In April-May 2018, the gross direct premiums reached Rs 24,397.09 crore (US$ 3.79
billion), showing a year-on-year growth rate of 11.96 per cent. Over FY12-18, non-life insurance
premiums (in Rs) increased at a CAGR of 16.65 per cent.
Motor insurance accounted for 36.6 per cent of non-life insurance premiums earned in India in
April-May 2018, followed by 31.4 per cent share of health insurance. Private players accounted
for a share of around 50.44 per cent in the gross direct premiums generated in non-life insurance
sector while public sector companies and specialised insurers garnering around 49.56 per cent
share in April-May 2018.
Investments
 Insurance sector companies in India raised around Rs 434.3 billion (US$ 6.7 billion)
through public issues in 2017.
 In 2017, insurance sector in India saw 10 merger and acquisition (M&A) deals worth
US$ 903 million.
 India's leading bourse Bombay Stock Exchange (BSE) will set up a joint venture with
Ebix Inc to build a robust insurance distribution network in the country through a new
distribution exchange platform.
Government Initiatives
 The Insurance Regulatory and Development Authority of India (IRDAI) plans to issue
redesigned initial public offering (IPO) guidelines for insurance companies in India, which
are to looking to divest equity through the IPO route.

 IRDAI has allowed insurers to invest up to 10 per cent in additional tier 1 (AT1) bonds, that
are issued by banks to augment their tier 1 capital, in order to expand the pool of eligible
investors for the banks.
 National Health Protection Scheme will be launched under Ayushman Bharat to provide
coverage of up to Rs 500,000 (US$ 7,723) to more than 100 million vulnerable families.
 Over 47.9 million famers were benefitted under Pradhan Mantri Fasal Bima Yojana (PMFBY)
in 2017-18.
 IRDAI has formed two committees to explore and suggest ways to promote e-commerce in
the sector in order to increase insurance penetration and bring financial inclusion.
 IRDAI has formulated a draft regulation, IRDAI (Obligations of Insures to Rural and Social
Sectors) Regulations, 2015, in pursuance of the amendments brought about under section 32
B of the Insurance Laws (Amendment) Act, 2015. These regulations impose obligations on
insurers towards providing insurance cover to the rural and economically weaker sections of
the population.
 The Government of Assam has launched the Atal-Amrit Abhiyan health insurance scheme,
which would offer comprehensive coverage for six disease groups to below-poverty line
(BPL) and above-poverty line (APL) families, with annual income below Rs 500,000 (US$
7,500).
 The government will merge three of the public sector insurance companies - The Oriental
Insurance Co. Ltd, National Insurance Co. Ltd and United India Insurance Co. Ltd and list the
merged entity.
 The select committee of the Rajya Sabha gave its approval to increase stake of foreign
investors to 49 per cent equity investment in insurance companies.
Insurtech in India
Despite the presence of a large underserved population, InsurTech is seeing a slow start in India.
Currently, Insurance aggregators are the most funded companies of this segment, with a total
funding of USD 87 million.
Insurance companies are approaching this sector with an experimental approach, not as an
innovation milestone. Once, it proves a profitable value addition to the insurers, whether through
process efficiencies, improved customer acquisition or through reduced cost, it will be integrated
into the mainstream insurance value chain. The complex regulations governing the insurance
industry also serve as a barrier for innovators. Due to the high cost of compliance and high risk,
new players need to be able to ensure the coverage of risks with significant funds. This becomes
a barrier for startups who work with limited resources. This provides an impetus and calls for a
collaboration between insurance companies and InsurTech firms to provide more customer
centric solutions. India is yet to witness the disruptive power of InsurTech, but by studying the
trends in markets where InsurTech has made a mark, it can be concluded that startups will need
to work closely with insurers to provide real benefits to end-customers.

Road Ahead
The future looks promising for the life insurance industry with several changes in regulatory
framework which will lead to further change in the way the industry conducts its business and
engages with its customers. The overall insurance industry is expected to reach US$ 280 billion
by 2020.
Demographic factors such as growing middle class, young insurable population and growing
awareness of the need for protection and retirement planning will support the growth of Indian
life insurance.
Terminologies to understand Insurance Annual Report

 Embedded Value: It is sum of the Company’s Net Worth and the present value of all
future profits to shareholders from the existing book of the Company (including new
business written in the year). Future profits are computed on the basis of assumptions
such as persistency, mortality, morbidity and external factors like interest rates and equity
market performance.
EV= Net worth + Value In force of Policies (VIF)
o VIF= Present value of future profits, adjusted for the risks from the in-force
policies or the policies which have been sold in previous years is called VIF.
 Gross written Premium (GWP): Total premium collected during the fiscal year. It
comprises premium from new customers (new business premium) and existing customers
(renewal premium).
 Annualized Premium Equivalent (APE): Sum of annualized first year premiums on
regular premium policies plus 10% of single premium policies.
 Retail Weighted Received Premium (RWRP): 100% of the first year premiums on retail
regular premium policies plus 10% of single premiums received from retail customers
during the year. It is a metric used for calculating the market share, since it is a publicly
reported number by all life insurance companies.
 Value of New Business (VNB), Value of New Business Margin: VNB determines the
expected profitability of the new business written during the year. It is the present value
of future profits to shareholders as measured in the year in which the business is written.
Future profits are computed on the basis of assumptions set keeping in mind actual and
expected experience on various parameters which are typically reviewed annually. VNB
margin is the ratio of VNB for the period to APE for the period. It is similar to profit
margin for any other business.
 New Business Strain: The accounting loss associated with the initial years of a life
insurance contract is referred to as Strain.
 Asset Under Management (AUM): AUM refers to the carrying value of investments
managed by the Company and includes loans against policies and net current assets
pertaining to investments
 EVOP: Is the EV Operating Profit for the year. The key components of EVOP are
expected investment income on opening EV (unwind), Value of New Business added
during the year and EV variances. EV variance is a measure of the performance as

compared to what was assumed in arriving at the EV at the beginning of the year. The
key relevant factors are mortality, persistency and renewal expenses.
 Persistency: It measures the proportion of policy holders who have continued with their
policies. It indicates the ability of the company to retain customers. Maintaining a high
level of persistency is critical as it provides scope of regular revenues through renewal
premiums. The 13th month persistency ratio typically reflects the quality of sales
performance, while the 49th month persistency ratio enables us to assess the proportion
of customers paying all premiums as majority of regular premium contracts have a
minimum premium payment period of five years. From a customer’s point of view, they
benefit from lower effective charges the longer they continue with the policy.
 Solvency Ratio – Solvency is a regulatory measure of capital adequacy. It is expressed as
a ratio of available capital and required capital. It is critical in determining our ability to
meet future contingencies and fund growth plans. A high solvency ratio instills
confidence in customers and investors in the ability of the company to pay claims. The
control level of solvency ratio is 150 per cent, below which the IRDAI will intervene
with remedial measures.
Type of Products
 Protection products: These products offer a plain vanilla life cover at a very low cost for
the period of time the customer continues to pay the premium. Some products offer
critical illness benefits wherein a benefit amount is paid out upon being diagnosed with a
critical illness as defined in the product. Typically the life cover could be as high as 700-
1000 times one year premium. Term plans would be an example of a pure protection
product. Our endeavour in offering these products is to provide a range of value added
covers.
 Savings products: The key factors that determine value delivery to the policyholders are
how long they stay (persistency) and the cost ratios of the Company. Our endeavour in
offering these products is to operate at cost ratios that ensure that value is delivered to
both continuing as well as discontinuing policyholders. These products, except pension
and annuity products, typically offer a life cover of 10 times annual regular premium and
also provide returns on the premiums invested. The savings products can be further
classified based on their structure into ULIP, Participating (Par) and Non-Participating
(Non-Par).
 ULIP (Unit Linked Insurance Policy) – In this, the policyholder chooses the asset class he
wants to invest in (Fixed Income or Equity) and has the option of switching the asset
class. The NAV on the portfolio is declared daily and the portfolio composition is
disclosed on a monthly basis. The investment risk and rewards on these products are
borne by the policyholder.
 Participating – In participating products, the investments, expenses and claims of policy
holders are pooled and the return to the policy holder is in the form of bonus declared
from the surplus at the end of the year. The surplus is distributed between the
policyholders and the Company in the ratio of 90:10. The investment pattern is decided

by the Company in line with regulations and typically a large part of the investment goes
into Fixed Income and the balance in other asset classes like Equity and Property.
 Non-Participating – In this product, the customer is guaranteed a fixed rate of return on
the premiums paid/to be paid by him. Accordingly, the investment risk is borne by the
Company
Company Coverage: HDFC life

Company Overview
Established in 2000, HDFC Standard Life Insurance Company Limited is a leading long-term
life insurance solutions provider, offering a range of individual and group insurance solutions
that meet various customer needs such as Protection, Pension, Savings, Investment, and Health.
As on March 31, 2018, the Company had 34 individual and 11 group products in its portfolio and
8 optional rider benefits.
HDFC Life is a joint venture between Housing Development Finance Corporation Limited
(HDFC Ltd.), and Standard Life Aberdeen, a global investment company. As on March 31, 2018,
HDFC Ltd. holds 51.6% and Standard Life (Mauritius Holdings) 2006 Limited holds 29.3% of
equity in HDFC Life, while the rest is held by others.
HDFC Life completed its Initial Public offer by way of an offer for sale of 14.92% of the fully
diluted post-offer paid-up equity share capital of the Company.


Fundamental Values by HDFC Life
1. Significant Improvement in Persistency Ratios:
There has been a consistent rise in persistency ratio for years of insurer which bodes well for the
future. Increase in persistency was led by focus on better quality of business and increased use of
technology to enhance customer service experience. The dip in the 61st month persistency is
because of a specific product type distributed 5 years back and is likely to improve going ahead.
2. Product Mix

HDFC Life was the pioneer in the industry for group credit life product. Protection (Term) plans
are more profitable than other plans like ULIP and Non-participating. It has developed a lead in
this segment with its two biggest two competitors that are, ICICI and SBI life.
In FY18, 26% of first-year premiums and 11% of APE came from pure protection products. 25%
of companies individual policies sold during FY 2018 were protection business policies. In group
segment, protection continued to be a key focus area and formed 50% of the Company's group
new business in FY18.
3. Distribution Channel
The company has well diversified distribution channel with tie ups with banks a major one. The
company so far has 149 banca relationships, including HDFC Bank. One-third of the partners are
exclusive to HDFC Life. For the individual business, 70% of new business is driven by the
bancassurance channel, despite a relatively lower share of ULIPs than at peers.
Direct channel: The Company has 414 branches spread across India, which it is leveraging to
increase the direct sales. The direct channel has seen significant growth over the past five years,
from 9% of individual APE to 14% in FY18 and 19% as of 1Q19, and will be key to driving
factor with online channel emerging strongly (7% of APE in 1Q19).

4. Steady increase in RoE and RoIC:
The Company continues to deliver long-term sustainable RoE and RoIC over a period of time.

5. Significant market share and ranking
The Company continues to rank consistently amongst top 3 private players with focus on healthy
growth across segments and distribution channels.
A quick snapshot

Outlook
HDFC Life continues to deliver strong operating and financial performance during the year
under review. In line with the stated long-term strategy, the Company has maintained balance
across the business. Creating value for all our stakeholders, while maintaining profitable growth,
has been the key focus for the Company. The Company is driving this by re-imagining the life
insurance business journey by leveraging technology and catering to continuously evolving
customer preferences.
We note that the quality of earnings for HDFC Life has improved over the past few years, as the
share of investment income and surrender profits have both declined. The company has wiped
out its accumulated losses and is delivering healthy return ratios, with RoE and RoIC>25% and
is thus capable of supporting healthy business growth.

Future Outlook
The global economy expanded at a strong pace in the first half of 2018. In advanced economies
(AEs), activity was accompanied by tightening labour markets, firm commodity prices and
resilient trade dynamics. Emerging market economies (EMEs) front-ran the AEs in Q1 but fell
back somewhat in Q2 as capital flows exited on risk aversion generated by a cocktail of trade
wars, rising interest rates in the US, geo-political tensions and the unrelenting hardening of crude
oil prices. As per the International Monetary Fund’s (IMF’s) estimate, global growth is expected
to pick up by 0.2 percentage points to 3.9 per cent in 2018 and is projected to sustain at the same
level in 2019.
The initial lull in the progress of the southwest monsoon got reversed, including in the spatial
dispersion, and in response, cropping gaps are closing. Overall, agricultural production is likely
to remain strong for the third consecutive year. Meanwhile, growth impulses in industry are
strengthening, propelled by a sustained pick-up in manufacturing and mining activity, especially
coal.
Going forward, the up-tick in credit growth is likely to be supported by the progress being made
under the aegis of the Insolvency and Bankruptcy Code, 2016 (IBC) in addressing stress on
balance sheets of both corporates and banks, recapitalisation of PSBs, and a positive outlook on
the economy.
Several initiatives set in motion to secure the soundness of the banking system are expected to
reach critical mass during 2018-19. Keeping in view the IBC process and the need to put in place
a harmonised and simplified generic framework for resolution of stressed assets, the Reserve
Bank has introduced a new framework for resolution of stressed assets, which is more outcome-
oriented and provides considerable flexibility for banks to determine the minutiae of the
restructuring process. The recent amendments to the IBC are expected to improve the
efficiencies in decision making under it.
The Reserve Bank has been playing a catalytic role in permeation of FinTech into the economy,
propelled by its Payment and Settlement System Vision – 2018. The report of the Reserve
Bank’s Working Group on FinTech and Digital Banking covers granular aspects and envisages a
reorientation of the regulatory framework so that it can respond to the dynamics of a rapidly
evolving scenario. This year will also see the gaining of traction of initiatives for consumer
protection in the area of financial transactions, especially by leveraging on technology. Among
them, the ombudsman scheme for redressal of complaints related to NBFCs aims to provide a
cost-free and expeditious complaint redressal mechanism.
The ombudsman scheme for NBFCs will be reviewed during the year, and its scope will be
widened to encompass other eligible NBFCs. Furthermore, efforts will be made to raise customer
awareness on safe banking habits and access to grievance redressal.

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UNNATI INVESTMENT MANAGEMENT AND RESEARCH GROUP

Mohit Kumar | Rohit Agarwal

Unnati Sector Report 2018-19 | 1

Cash Reserve Ratio (CRR) 31

Rise in CASA ratio 97

Unnati Sector Report 2018-19 | 7

b. Stimulate credit growth

1. Improving working capital demand as commodity prices are rising.

1. Lingering poor asset quality in banks (GNPA is 11.6% in March 2018).

Unnati Sector Report 2018-19 | 9

The Insurance Sector

and listed on the bourses.

The Financial Services Overview

Unnati Sector Report 2018-19 | 11

How does a Bank Function?

What is the role of the banks?

What are the benefits of Intermediation?

1. Intermediation smoothens the borrowing and lending process in an economy. It ensures

Role of a bank in the economy

Unnati Sector Report 2018-19 | 13

 Liquidity provision — Businesses and households need to have protection against

Primary Functions Secondary Functions

Granting loans and

Saving Deposits, Funds Transfers,Cheque Issue of Drafts,Locker

How do banks minimize risk?

Unnati Sector Report 2018-19 | 14

The Indian Banking System

Unnati Sector Report 2018-19 | 15

Nationalisation of Banks in 1960s

Liberalization and Globalization of Indian Banking System

Unnati Sector Report 2018-19 | 16

 Private sector banks

Unnati Sector Report 2018-19 | 17

STATE BANK OF INDIA AND

44% Private Sector Banks

STATE BANK OF INDIA AND

44% Private Sector Banks

Unnati Sector Report 2018-19 | 18

STATE BANK OF INDIA AND

SBI and its associates

Unnati Sector Report 2018-19 | 19

Nationalized Public Banks

Regional Rural Banks

Recent Regulations & Supervisions by RBI

Unnati Sector Report 2018-19 | 20

Private Sector Banks

Old Private Sector Banks

New Private Sector Banks

Unnati Sector Report 2018-19 | 21

Objective of a small finance bank

 No Geographical restriction on the operation of the small banks

Unnati Sector Report 2018-19 | 22

Capital adequacy framework

Unnati Sector Report 2018-19 | 23

Characteristics of Payment Banks:

Regulations as per RBI:

Large exposures limits (for investments in deposits of scheduled commercial banks)