INTRODUCTION TO INDIAN BANKING SYSTEM:

In the context of increasing pressures on the individual banks, to survive, to perform and succeed, we take a look at the emergence of the Indian Banking system right from its early days till such time when its very survival has become a challenging task. History of Indian Banking: The establishment of the General Bank of India in the year 1786 marked the developments of a structured banking system in India. It was setup as a joint stock company. Later the Bank of Hindustan and Bengal Bank came into existence. The East India Company established three banks, The Bank of Bengal in the year 1809, The Bank of Bombay in 1840 and Bank of Madras in 1843. These three Banks were amalgamated in the year 1920 to form a new Imperial Bank of India. The Imperial Bank was nationalized and was renamed as the State Bank of India with passing of the State Bank of India Act of 1955. The Reserve Bank of India (RBI)was constituted as the shareholders bank in 1935 and is now the Central Bank of the country. After independence, the Reserve Bank of India Bill was introduced in the Parliament to give public ownership to the bank. Since 1st January 1949, it has been operating as a state managed Central Bank. It exercises the power to control the Indian banking industry. At present, the banking system can be classified in to following categories: 1. Public Sector Banks Reserve Bank of India State Bank of India and its Associate Banks Nationalized Banks (20 in number) Regional Rural Banks sponsored by Public Sector Banks.

2. Private Sector Banks Old Generation Private Banks New Generation Private Banks Foreign Banks in India Scheduled Co-operative Banks Non-Scheduled Banks Industrial Credit & Investment Corporation of India (ICICI)

3. Co-operative Sector Banks State Co-operative Banks Central Co-operative Banks Primary Agriculture Credit Societies Land development Banks Urban Co-operative Banks State Land Development Banks

4. Development Banks Industrial Finance Corporation of India (IFCI) Industrial Development Bank of India (IDBI) Industrial Investment bank of India (IIFC) Small Industries Development Bank of India (SIDBI) National Bank for Agriculture and Rural Development (NABARD) Export-Import Bank of India (EXIM) Shipping Credit & Investment Company of India Limited (SCICI)

The Reserve Bank of India (RBI) has a centralized control over all these banks.

THE RESERVE BANK OF INDIA

The RBI began its operations by taking over from the Government the functions so far performed by the controller of currency and from the Imperial Bank of India, the management of Government accounts and Public debt. The existing currency offices at Kolkata, Mumbai, Chennai, Rangoon, Karachi, Lahor and Kawnpore (Kanpur) became branches of Issue Department. Offices of the banking department were established in Calcutta, Bombay, Madras, Delhi and Rangoon. An interesting feature of the RBI was that at its very inception, the Bank was seen as playing a special role in the context of development, especially agriculture. When India commences its plan endeavors, the development role of the Bank came into focus, especially in the sixties when the Reserve Bank, in many ways, pioneered the concept and practice of using finance to catalyze development. The Bank was also instrumental in institutional development and helped set up institutions like the Deposit Insurance and Credit Guarantee Corporation of India, the Unit Trust of India, the Industrial Development Bank of India, and the National Bank for Agriculture and Rural Development, the Discount and Finance House of India ete, to build the financial infrastructure of the country. With liberalization, the RBIs focus has shifted back to core central banking functions like Monetary Policy, Bank Supervision and Regulation, and Overseeing the Payment System and on to developing the financial markets. Establishment: The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated. Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India Preamble The Preamble of the Reserve Bank of India describes its basic functions as:

to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage

Financial Supervision:
The Reserve Bank of India performs this function under the guidance of the Board for Financial Supervision (BFS). The Board was constituted in November 1994 as a committee of the Central Board of Directors of the Reserve Bank of India. Objective: Primary objective of BFS is to undertake consolidated supervision of the financial sector comprising commercial banks, financial institutions and non-banking finance companies. Constitution: The Board is constituted by co-opting four Directors from the Central Board as members for a term of two years and is chaired by the Governor. The Deputy Governors of the Reserve Bank are ex-officio members. One Deputy Governor, usually, the Deputy Governor in charge of banking regulation and supervision, is nominated as the ViceChairman of the Board. BFS meetings: The Board is required to meet normally once every month. It considers inspection reports and other supervisory issues placed before it by the supervisory departments. BFS through the Audit Sub-Committee also aims at upgrading the quality of the statutory audit and internal audit functions in banks and financial institutions. The audit subcommittee includes Deputy Governor as the chairman and two Directors of the Central Board as members. The BFS oversees the functioning of Department of Banking Supervision (DBS), Department of Non-Banking Supervision (DNBS) and Financial Institutions Division (FID) and gives directions on the regulatory and supervisory issues. Functions: Some of the initiatives taken by BFS include: i. ii. Restructuring of the system of bank inspections Introduction of off-site surveillance,

iii. iv.

Strengthening of the role of statutory auditors and Strengthening of the internal defences of supervised institutions.

The Audit Sub-committee of BFS has reviewed the current system of concurrent audit, norms of empanelment and appointment of statutory auditors, the quality and coverage of statutory audit reports, and the important issue of greater transparency and disclosure in the published accounts of supervised institutions. Current Focus:

Supervision of financial institutions Consolidated accounting Legal issues in bank frauds Divergence in assessments of non-performing assets and Supervisory rating model for banks.

Main Functions
Monetary Authority:

Formulates implements and monitors the monetary policy. Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system:

Prescribes broad parameters of banking operations within which the country's banking and financial system functions. Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.

Manager of Foreign Exchange:

Manages the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency:

Issues and exchanges or destroys currency and coins not fit for circulation. Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.

Developmental role:

Performs a wide range of promotional functions to support national objectives.

Related Functions:

Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker. - Banker to banks: maintains banking accounts of all scheduled banks.

RBI owns four subsidiaries namely

National Housing Bank (NHB) National Bank for Agriculture and Rural Development (NABARD) Deposit Insurance and Credit Guarantee Corporation of India (DICGC) Bhartiya Reserve Bank Note Mudran Private Limited (BRBNMPL)

THE TWO PHASES OF INDIAN BANKING:

Our banking system has passed through many strenuous conditions, thats why it has reached to this level. In the past it has seen two phases, which are, - NATIONALIZATION: Why Nationalization? The era of nationalization commenced in 1969 when the countrys 14 major commercial banks were nationalized. In continuation of this process, 6 more banks were nationalized in 1980. It was felt that banks, which play a vital role in the economic growth mostly catered to the credit requirements of only the large corporate houses. Credit requirements of the small-scale, agriculture, and export sectors were given little priority. Accordingly, the Banking Companies (Acquisition and Transfer of Undertakings) Act was enacted for the acquisition and transfer of 14 banks based on their size, resources, coverage and organization. The major aim of nationalization was to give priority to meet the credit requirements of the neglected sectors as mentioned above. Further, this credit facility was supposed to be extended at subsidized rates i.e., rates of interest were to be lower than those charged to larger business units. Thus, nationalization was about providing extensive credit facility at considerably low rates. The impact on the banking structure in the process of meeting the objectives of nationalization was tremendous. Wholesale banking paved the way for retail banking resulting in an all-round growth in the branch network, deposit mobilization, credit disbursals and of course employment. In the process profitability and competition took a back seat. Post-Nationalization: In order to enhance their coverage geographically, the banks tremendously increased their branch network. The widened branch network and better techniques of deposit mobilization enhanced the number of deposit accounts and the amount of deposits mobilized. The aggregate deposits of Scheduled Commercial Banks (SCBs), which stood at Rs. 4669 cr. During July 1969 touched Rs. 2, 33,753 cr. by the end of March, 1992.

During the first year after nationalization, total growth witnessed in agriculture loans and loans made to SSIs was 87% and 48% resp. the overall growth in the deposits and the advances indicates the improvement in the banking habit of the people in the rural and semi-urban areas where the branch network has spread. While such credit extension did enable banks to achieve the goals of nationalization, it was, however, achieved at the cost profitability of the banks.

Impact of Nationalization: The quality of credit assets deteriorated, as the process sanctioning loans became more of a mechanical process rather than an absolute credit assessment decision. Political interference also has been an additional problem. There was very little appraisal involved in the process of giving loans. With such a process of lending, obtaining credit seemed to have become the privilege of every borrower. Added to this, were the credit facilities extended to the priority sector at concessional rates. Such credit disbursals that were done without proper post-sanction supervision led to the deterioration in the quality of loan assets of the banks. Further, the subsidized lending rates coupled with high levels of low yielding SLR investments also adversely affected the profitability of the banks. Yet another outcome of this rapid branch expansion has been the squeeze on profitability of banks arising primarily due to an increase in the fixed costs. With the proliferation of branches, there was also the resulting strain on the managerial resources that enhanced manpower resources. The operational costs of the banks enhanced on account of the continuous servicing requirements of the extensive branch network of the banks. While branch expansion was taken as a means to achieve the goals of nationalization, the inherent evils of haphazard expansion of branches crept into the banking system. The existence of branches with higher operating costs resulted in profit erosion, since most of the cases the branches added more costs than returns.

- LIBERALIZATION: Why Liberalization? The Government of India framed its policies in the year 1991-92, keeping in view the benefits of liberalization. It was expected that in the process of opening its economy to

the outside world, increased competition could turn the banks more efficient, bring about improvements and ultimately benefits to the customers. Some of the root causes that were behind the dull performances of banks prompted the initiation of the banking sector reforms. Some of these causes were: Greater emphasis on directed credits; Regulated interest rate structure; Lack of focus on profitability; Lack of transparency in the banks balance sheets; Lack of competition; Lack of grasp on the risk involved; Excessive regulations on organizations structure and managerial resources; and Excessive support from Government.

The reforms were initiated with the aim to bring about a paradigm shift in the banking industry. The recommendations were made by the high level committee on the financial sector reforms, chaired by Mr. M Narasimham, laid the foundation for the banking sector reforms. The committee, which was setup in 1991, submitted its report in 1992. Another committee was constituted again the chairmanship of Mr. M Narasimham, which submitted report in 1998. These reforms tried to enhance the viability and efficiency of the banking sector. To tackle the internal deficiencies of the sector, new norms relating to accounting practices, prudential norms and capital adequacy requirements were suggested. In order to improve the external environment, the reforms aimed at transforming the highly regulated environment into a market0oriented one. While most of the recommendations made by the committee in phase 1 have been accepted for implementation, either in a single step or in phased manner, some of them are yet to be considered. The measures implemented so far that have been given further, have revolutionized the structure and operations of the banking industry. The liberalization of the Indian banking system has led to the following improvements: a. Lowered entry barriers:

The Indian banking system apparently lacked a competitive environment, thereby affecting its efficiency. To induce competitiveness in this sector, the industry was opened up to participation by private sector banks and foreign banks. Apart from allowing the Indian banks to enter into joint ventures with foreign banks ( 20% equity), the foreign banks were also permitted to set up their shop in India either as branches or as subsidiaries. With this lowering of entry barriers, many new players entered the market. b. Deregulating the interest rates: One of the major reform measures undertaken is the phased deregulation of interest rates. As against the administered interest rate regime, the banking sector now operates in a deregulated environment. Directives have been issued for total deregulation of the interest rates. With this deregulation of the interest rates, banks now have gained flexibility in their operations. Further, the concessional rates of interest in priority sector lending have been withdrawn for borrowers of higher credit amounts. The general rates of interest will be applicable to these borrowers. c. Lowered Regulations: Branch licensing has been abolished and branch expansion norms have been relaxed enabling the banks to revamp their organizational structures. Banks have been given the freedom to open or close branches as suitable to their operational/viability.

Impact of Liberalization: The onset of liberalization has brought about changes in the way the banks operate. Terms like customer relationship and competition among the existing players and the new banks have taken the front seat. The following are some of the changes seen in the banking sector after liberalization. a. Technological Revolution: Information technology has become an integral part of most of the banks throughout the world. By leveraging this technology, banks are able to develop the necessary management information systems that would aid in taking scientific decisions. Further, such information systems are also being used to analyze the customer needs to innovate their product portfolio accordingly. 10

Operational aspects and decision making process of banks are closely linked to the speed and accuracy with which information is collated and transmitted into the meaningful reports. More so, in the deregulated interest rate regime, quick investment and credit decision may also result in greater spreads to the banks. To enable quicker decision making and that too in the scientific manner, online inter-connectivity is most useful. And the first step to this would be branch level computerization. Most of the Indian banks have embarked upon the process upon the process of computerizing their branches. Since the major part of the transactions arise at the branches, data processing and transmission will become comparatively easier if these transactions are computerized. Information technology has smoothed back-office maintenance and improved the customer service as well. b. Better Customer Service: Information Technology in the banking business that is improving at the rapid pace, has a more visible impact on the customer service. It has not just resulted in product innovation, but it also enabling banks to redesign their traditional services into more sophisticated products. c. Automated Teller Machines: These self-service terminals, which popularly known as ATMs, are cash dispensers, which enable the customers to withdraw cash even if the bank is closed. Advanced features of ATMs include withdrawals at other cities, use of credit cards on ATMs, facilitating cheque statements. Also, by mutual arrangements, on ATM terminal can be used as cash dispenser for various banks. This is known as the Shared Payment Network Systems (SPNS). Further these ATMs are set up at locations other than bank branches. They are set up at public places like airports, railway stations, shopping complexes etc. d. Plastic Money: Plastic money in the form of credit cards, debit cards and SMART cards has also entered the Indian markets. While the credit and the debit cards have been in the Indian markets for over a decade, the SMART card is relatively new concept and has superior features. All the transaction taking place on the debit/credit card will be recorded on the SMART card. The SMART card reader of the bank will record the deposit amount available in the SMART account of the customers SMART card. 11

Based on this, withdrawal or deposit of funds can be taken up at any branch by the SMART cardholder. e. Telebanking: In telebanking, bankers, with the help of dedicated telephone lines, will provide service to their customers. With a telephone call , customers can get the information they need which may relate to their transactions. Telebanking is also being extended as a 24-hour service. f. Electronic Funds Transfer (ETF): Through this process, banks enable their customers to remit funds using a computer terminal. Individuals and corporate can transfer funds without leaving their premises. This facility not only reduces the time lag in funds transfer, but also eliminates error prone paper work. The prerequisite for this facility is that the concerned bank branch has the network connection to receive and send coded funds transfer messages. g. Anywhere Banking: This service, which is offered by few banks in India, facilitates the customer to transact from any branch of the bank. The details regarding the customer are available in a central computer linked to various branches. All the information relating to the customer can be accessed from this system. Banks are now looking forward to Relationship Banking, which establishes a relationship with the customer- domestic or international- and relating to the assets or liabilities of the customer will be undertaken by a single bank.

CHALLENGES AFTER NATIONALIZATION AND LIBERALIZATION: In the aftermath of the nationalization of banks, increasing use of technology, continuous mergers, modernizing backroom operation and vigorous competition paved the growth of the Indian banking system. By the early 90s, the near monopoly of public sector banks faced competition from the more customer-focused private sector entrants. This competition demanded the older and nationalized banks to revitalize their operations.

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The year 1992 proved calamitous to the Indian banking system owing to the scam-tainted stock market. Large proportion of household saving moved into the banking system, which recorded an annual growth of 20% in deposits. But along with the continuous growth and modernization, several challenges still confront the banking sector. The main challenges are the deployment of funds in quality assets and the management of revenues and costs. The problems of NPAs (Non Performing Assets) and the overall credit recovery system exist too. Considering the problems, the RBI came up with a number of measures to control the situation thereby reducing the percentage of NPAs against advances and leading to better management of banks. The following steps were taken to reform bank operation. a. Prudential Norms: Prudential norms were introduced to strengthen the banks balance sheets and enhance transparency. These prudential norms which relate to income recognition, asset classification, provisioning for bad and doubtful debts and capital adequacy serve three important purposes- first, the income recognition norms reflect a true picture of the income and expenditure of the bank. Secondly, the asset classification and provisioning norms help in assessing the quality of asset portfolio of the bank. Finally, the capital adequacy which is based on the classification assets suggests whether bank is in a viable position to meet any adverse situation due to a decline in the quality of its assets. Guidelines have been issued to identify non-performing assets and classify them so that room for subjectivity is eliminated A timeframe was provided to implement the same and ensure that the system becomes compliant to the rigorous guidelines. This move was supported by the capitalization of the public sector banks to ensure that over a given timeframe, they could comply with the norms and yet strive to march towards the future. These norms have been gradually tightened and beginning with the April 1998 Monetary Policy, they were made applicable to the government guaranteed advances as well. Provisioning will also have to be made for advances which are both non-performing and performing. To assess the capital adequacy ratio, weights were assigned to the portfolio based on their riskiness. As per Narsimham committee report-I, except assigned rick weights. However, with the Committees second report, came the guidelines to assign risk weight to the government approved securities. 13

Narasimham Committee I- Recommendations.

Progressive reduction in pre-emptive reserves- Cash Reserves (CRR) and Statutory Liquidity Ratio Liberalization of the branch expansion policy Introduction of prudential norms- Capital Adequacy, Asset Classification, Provisioning, Income Recognition. Decrease in the emphasis laid on directed credit. Phasing out concessional rate of interest to priority sector Deregulation in the entry norms for private and foreign banks 33% reduction in government stake in banks Greater emphasis on asset-liability management Setting up Asset Reconstruction Funds to takeover Non-Performing Assets Consolidation of banking industry by merging strong banks

b. Capital Adequacy Requirements: Based on the rick-weighted assets of the banks, the prudential norms also prescribe the minimum capital to be maintained. Initially, the international standard of 8 % capital adequacy laid down by the Basle Committee was accepted. However, a capital adequacy of 9 % is to be maintained. These high standards are expected to strengthen the financial soundness of the banks, while continuing to keep them in line with International standards. It is aimed to induce financial discipline into the operations of the banks through these regulations. These regulations enhance transparency and accountability in the operations of the banks thereby compelling them to pay greater attention to the quality of lending. In addition, these regulations conform to the International accounting standards and would enable the Indian players to operate in the global markets. Hence, adherence to these guidelines would enhance the sustainability of banks and make them competitive.

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The reforms measures were aimed at not only liberalizing the regulatory framework, but also to keep them in tune with the international standards. And since the banks had to move from a highly regulated environment to a deregulated environment, some of the public sector banks had to bear the ordeal of reformation. In an attempt to stabilize the banks positions during this transition phase, the Government contributed capital to a few among the weak nationalized banks to strengthen their capital base. It also permitted some of these banks to set off their accumulated losses against their capital. All these measures were taken in order to ensure that the Indian banking system reaches to the global standards. c. Additional Disclosures: From the year 2002 onwards, the notes to the balance sheets contain information about the movement of provisions for NPAs as well as those held towards depreciation on investments. Non-SLR investments made through the private placement route should disclose information about the composition of the issuer and non-performing investments in a similar manner. Efforts have been made to identify and monitor early warning indicators of financial crises. The overall approach is to combine the use of micro-prudential indicators with macroeconomic indicators in order to develop a set of aggregate macro-prudential indicators. This brings about a mix between bottom-up and top-down assessment. As the methodology gets refined and the indicators are stress-tested for predictive power, financial stability surveillance will be significantly improved. This process will involve greater transparency and objectivity in the disclosure practices of banks. Steps are taken to setup a Credit Information Bureau, which collects and shares information on borrowers and improves the credit appraisal of banks and financial institutions within the domain of the existing legislation. The bureau has been incorporated by, the State Corporation (HDFC) and foreign technology partners. d. Benchmarking Against International Standards: So as to make the Indian banking system more strong, measures are being taken by the central bank. While doing this, the benchmark is being kept against the International Standards, which will certainly help our system to be more robust and better while functioning. The leading international agencies like the World Bank and IMF (International Monetary Fund) are emphasizing on the global standards.

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Narasimham Committee II- Recommendations.

This committee constituted in January 1998 submitted its reports in April 1998. the major recommendations were: - Capital adequacy requirements should take into account market risks also. - In the next three year, entire portfolio of Government securities should be marked-to market. - Risk weight for the Government guaranteed account must be 100 %. - CAR to be raised to 10 % from the present 8 %; 9 % by 2000 and 10% by 2002. - An asset should be classified as doubtful if it is in the sub-standard category for 18 months instead of the present 24 months. - Banks should avoid ever greening of their advances. - There should be no further re-capitalization by the Government. - NPA level should be brought down to 5 % by 2000 and 3 % by 2002. - Banks having high NPAs should transfer their doubtful and loss categories to ARCs, which would issue Government bonds representing the realizable value of the assets. - Move towards international practice of income recognition by introducing the 90-day norm instead of present 180 days. - A provision of 1 % on standard assets is required. - Government guaranteed accounts must also be categorized as NPAs under the usual norms. - Banks should update their operational manuals, which should form basic document of internal control systems. - Institute an independent loan review mechanism especially for large borrowal accounts to identify potential NPAs. - Recruitment of skilled manpower directly from the market to be given urgent consideration. - Rationalize staff strength; introduce as appropriate VRS. - A weak bank should be one whose accumulated losses and NPAs exceed its net worth or one whose operating profits less its income o n recap bonds is negative for 3 consecutive years.

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Types of risk to which banks are exposed to: Based on their origin and nature, risks are classified into various categories. The most prominent financial risks to which banks are exposed are: Interest rate risk: Risk that arises when the interest income/market value of the bank is sensitive to the interest rate fluctuations. Foreign Exchange/Currency risk: Risk that arises due to unanticipated changes in exchange rates and becomes relevant due to the presence of multi-currency assets and/or liabilities in the banks balance sheet. Liquidity risk: Risk that arises due to the mismatch in the maturity patterns of the assets and liabilities. This mismatch may lead to a situation where the bank is not in a position to impart the required liquidity into its system- surplus/deficit cash situation. In the case of surplus situation, this risk arises due to the interest cost on the ideal funds. Thus idle funds deployed at low rates contribute to negative returns. Credit risk: Risk that arises due to the possibility of a default/delay in the repayment obligation by the borrowers of funds. Contingency risk: Risk that arises due to the presence of off-balance sheet items such as guarantees, letters of credit, underwriting commitments etc.

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CHALLENGES FACED BY INDIAN BANKING INDUSTRY

The banking industry in India is undergoing a major transformation due to changes in economic conditions and continuous deregulation. These multiple changes happening one after other has a ripple effect on a bank trying to graduate from completely regulated sellers market to completed deregulated customers market.

o DEREGULATION This continuous deregulation has made the Banking market extremely competitive with greater autonomy, operational flexibility, and decontrolled interest rate and liberalized norms for foreign exchange. The deregulation of the industry coupled with decontrol in interest rates has led to entry of a number of players in the banking industry. At the same time reduced corporate credit off take thanks to sluggish economy has resulted in large number of competitors battling for the same pie.

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o NEW RULES As a result, the market place has been redefined with new rules of the game. Banks are transforming to universal banking, adding new channels with lucrative pricing and freebees to offer. Natural fall out of this has led to a series of innovative product offerings catering to various customer segments, specifically retail credit. o EFFICIENCY This in turn has made it necessary to look for efficiencies in the business. Banks need to access low cost funds and simultaneously improve the efficiency. The banks are facing pricing pressure, squeeze on spread and have to give thrust on retail assets. o DIFFUSED CUSTOMER LOYALTY This will definitely impact Customer preferences, as they are bound to react to the value added offerings. Customers have become demanding and the loyalties are diffused. There are multiple choices; the wallet share is reduced per bank with demand on flexibility and customization. Given the relatively low switching costs; customer retention calls for customized service and hassle free, flawless service delivery. o MISALLIGNED MINDSET These changes are creating challenges, as employees are made to adapt to changing conditions. There is resistance to change from employees and the Seller market mindset is yet to be changed coupled with Fear of uncertainty and Control orientation. Acceptance of technology is slowly creeping in but the utilization is not maximized. o COMPETENCE GAP Placing the right skill at the right place will determine success. The competency gap needs to be addressed simultaneously otherwise there will be missed opportunities. The focus of people will be on doing work but not providing solutions, on escalating problems rather than solving them and on disposing customers instead of using the opportunity to cross sell.

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STRATEGIES OPTIONS WITH BANKS TO COPE WITH THOSE CHALLENGES Leading players in the industry have embarked on a series of strategic and tactical initiatives to sustain leadership. The major initiatives include: o Investing in state of the art technology as the back bone of to ensure reliable service delivery o Leveraging the branch network and sales structure to mobilize low cost current and savings deposits o Making aggressive forays in the retail advances segment of home and personal loans o Implementing organization wide initiatives involving people, process and technology to reduce the fixed costs and the cost per transaction o Focusing on fee based income to compensate for squeezed spread, (e.g. CMS, trade services) o Innovating Products to capture customer mind share to begin with and later the wallet share o Improving the asset quality as per Basel II norms

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THE BANKS IN INDIA

The backbone of Indian banking system is made of the strong players which are active in the public as well as private sector. So lets have a glance through the banks which are functioning in India. PUBLIC SECTOR BANKS IN INDIA: Banking system in India is dominated by nationalized banks. The nationalization of 14 banks in India took place on 19th of July 1969 by Mrs. Indira Gandhi the then prime minister, with an another installment of nationalization of 6 banks on 15th of April 1980. The major objective of nationalization was to ensure mass banking as against class banking with banking infrastructure aimed at hilly tracts and terrains of the country. Prior to 1969, State Bank of India (SBI) was the only public sector bank in India. SBI was nationalized in 1955 under the SBI Act of 1955 as mentioned in the introduction to Indian banking. Currently the following are the public sector Banks in India: o o o o o o o o o o o o o o o o o Allahabad Bank Andhra Bank Bank of Baroda Bank of India Bank of Maharashtra Canara Bank Central Bank of India Corporation Bank Dena Bank Indian Bank Indian Overseas Bank Oriental Bank of Commerce Punjab and Sindh Bank Punjab National Bank State Bank of Bikaner and Jaipur State Bank of Hyderabad State Bank of India (SBI)

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o o o o o o o o o o

State Bank of Indore State Bank of Mysore State Bank of Patiala State Bank of Saurashtra ( Merged with SBI) State Bank of Travancore Syndicate Bank UCO Bank Union Bank of India United Bank of India Vijaya Bank

PRIVATE SECTOR BANKS IN INDIA: Prior to nationalization, Banks in India with the sole exception of State Bank of India were in private hands with community and trade orientation. Nationalization of 14 banks in the year 1969 and another set of 6 banks in the year 1980 reduced the importance of private sector banks and public sector banks started playing a major role in extending the horizon of the banking services to the nook and corner of the country. With history repeating itself, private sector banking got a fillip with the Government of India relaxing the conditions for opening of private sector banks in the year 1994, as a part of their liberalization programme. Housing Development Finance Corporation Limited (HDFC) was amongst the first to receive an in principle approval from the Reserve Bank of India (RBI) to set up a bank in the private sector. As on 31 st of March 2005, there are 30 private sector banks operating in the country. Private banks have been playing a crucial role in enhancing customer oriented products with no choice left with the public sector banks except to innovate and compete in the process. Reserve Bank of India has come out on clear-cut terms their guidelines on ownership and governance in private sector banks. The broad principle underlying the guidelines on ownership and governance in private sector banks is to ensure that the control of private sector banks is well diversified to minimize the risk or imprudent use of leveraged funds. The guidelines require that:

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o Important shareholders ( i.e., with shareholding of five percent and above) are fit and proper as per the Reserve Bank guidelines on acknowledgement for allotment and transfer of shares; o The Directors and the Chief Executive Officer who manage their affairs of the bank are fit and proper observe sound corporate governance principles; o Banks have minimum capital/ net worth for optimal operations and systematic stability; and o Policy and processes are transparent and fair. Some additional requirements are: o Banks maintain a net worth of Rs. 300 crore a all times; o Shareholding or control in any bank in excess of 10% of the paid up capital by any single entity or group of related entities requires the Reserve Banks prior approval; o Banks ( including foreign banks having branch presence in India) / financial institutions are not allowed to exceed equity holding of 5% of the equity capital of the investee bank; o Large industrial houses are allowed to acquire shares not exceeding 10% of the paid up capital of the bank subject to the Reserve Banks approval; o The Reserve Bank would permit a higher level of shareholding on a case by case basis for restructuring of problem/weak banks or in the interest of consolidation in the banking sector; and o In the shareholding exceeds the prescribed limit of the net worth is below Rs. 300 crore in any bank, a time bound programme to reduce the stake or to augment the capital should be submitted to the Reserve Bank. On the issue of aggregate foreign investment in private banks from all sources (FDI, FII, NRI), the guidelines stipulated that it cannot exceed 74% of the paid up capital of the bank. If FDI (other than by foreign banks or foreign bank groups) in private banks exceed 5%, the entity acquiring such stake would have to meet the fit and proper criteria indicated in the share transfer guidelines and get the Reserve Banks acknowledgement for transfer of shares. The aggregate limit for FII investments is restricted to 24% which can be raised to 49% with the approval of board/shareholders. The current aggregate limit for all NRI is 24% with the individual NRI limit being 5 %, subject to the approval of the board/shareholders. Major private banks in India are:

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o o o o o o o o o o o o o o o o o o o

Axis Bank Bank of Rajasthan Bharat Overseas Bank Catholic Syrian Bank Centurion Bank of Punjab Dhanalakshmi Bank Federal Bank HDFC Bank ICICI Bank IDBI Bank IndusInd Bank ING Vysya Bank Jammu & Kashmir Bank Karnataka Bank Karur Vysya Bank SBI commercial and International Bank South Indian Bank United Western Bank YES Bank.

LOCAL AREA BANKS: The concept of Local Area Banks was launched by the Reserve Bank of India on 24 th of August 1996 with the purpose of developing backward and less developed districts. In order to facilitate its formation, RBI prescribed a minimum capital of Rs. 500 lakhs for its formation by Individuals/ Trusts/Societies/Corporate. RBI had also laid down some guidelines for the same. The Local Area Banks are allowed to open branches in rural and semi-urban areas of their area of operation. However, one urban branch (centre of population above one lakh) in each district will be allowed. Four Local Area Banks were functional at the end March 2005, they were Coastal Area Bank Limited, Vijayawada, Andhra Pradesh,

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The Coastal Local Area Bank Ltd. established on December 27, 1999 with its head-quarters at Vijayawada has 8 branches in Krishna, Guntur and West Godavari districts of Andhra Pradesh. This is to be compared with 945 branches of various commercial banks in the operational area of this LAB. The deposits and advances of the bank as on March 31, 2002 stood at Rs. 21.90 crores and Rs. 17.80 crores respectively. The priority sector advances of the LAB formed 45.45% of the total advances. The bank has been showing profit since inception and posted a profit of Rs. 103.28 lakhs for the year ended March 31, 2002 Capital Local Area Bank Limited, Phagwara, Navsari, Gujarat: The Capital Local Area Bank Ltd. established on January 14, 2000 with its head-quarters at Phagwara has 8 branches in Kapurthala, Hoshiarpur and Jalandhar districts of Punjab. As against this, there are 595 branches of various commercial banks in the operational area of this LAB. The deposits and advances of the bank as on March 31, 2002 stood at Rs.47.29 crores and Rs. 30.00 crores respectively. The priority sector advances of the LAB formed 50.05 % of the total advances. The bank has been showing profit since inception and posted a profit of Rs.116.32 lakhs for the year ended March 31, 2002. South Gujarat Local Area Bank Limited: The South Gujarat Local Area Bank Ltd. established on October 3, 2000 with its head-quarters at Navsari has 6 branches in Navsari, Bharuch and Surat districts of Gujarat. It may be relevant to mention that there are 564 branches of various commercial banks in the operational area of this LAB. The deposits and advances of the bank as on March 31, 2002 stood at Rs.19.10 crores and Rs. 13.89 crores respectively. The priority sector advances of the LAB formed 49.94% of the total advances. The bank has posted a marginal profit of Rs.6.88 lakh for the year ended March 31, 2002. Bank had suffered net losses in consecutive years and witnessed a significant decline in its capital and reserves, was merged with Bank of Baroda on June 25, 2004

Krishna Bhima Samruddhini Local Area Bank Limited, Mahbubnagar: 25

The Krishna Bhima Samrudhi Local Area Bank Ltd. established on February 28, 2001 with its head-quarters at Mahbubnagar has 3 branches in Mahbubnagar district of Andhra Pradesh and Raichur and Gulbarga districts of Karnataka. There are 465 branches of various commercial banks in its operational area and Sangameswara Grameena Bank sponsored by State Bank of India is also operating in the operational area of this LAB. The deposits and advances of the bank as on March 31, 2002 stood at Rs. 0.40 crores and Rs 2.53 crores respectively. The priority sector advances of the LAB formed 98.3% of the total advances. The bank has posted a profit of Rs. 15.12 lakh for the year ended March 31, 2002 Subhadra Local Area Bank Limited, Kolhapur

SOME IMPORTANT FINANCIAL INSTITUTIONS: National Bank for Agriculture and Rural Development (NABARD) Export Import Bank of India (EXIM Bank) National Housing Bank (NHB) Housing and Urban Development Corporation Ltd.(HUDCO) Housing Development Finance Corporation (HDFC) Industrial Development Bank of India (IDBI) Industrial Finance Corporation of India Ltd. (IFCI) Industrial Investment Bank of India ( erstwhile Industrial Reconstruction Bank of India) Industrial Credit and Investment Corporation of India Bank (ICICI) (erstwhile Industrial Credit Investment Corporation of India Limited) Small Industries Development Bank of India (SIDBI) Infrastructure Development Finance Co.(IDFC) Power Finance Corporation (PFC) Life Insurance Corporation of India and General Insurance Corporation of India.

And also there are many Co-operative Banks as well as Regional Rural Banks in India.

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IMPORTANT BANKING INDICATORS

CASH RESERVE RATIO

Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks. The amount of which shall not be less than three per cent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not exceeding twenty percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934. Right now CRR is 5.00% (as on 29-03-2009) STATUTORY LIQUIDITY RATIO

In terms of Section 24 (2-A) of the B.R. Act, 1949 all Scheduled Commercial Banks, in addition to the average daily balance which they are required to maintain in the form of. o In cash, Or o In gold valued at a price not exceeding the current market price, Or o In unencumbered approved securities valued at a price as specified by the RBI from time to time. And right now SLR is 24.00% (as on 29-03-2009) REPO RATE 27

Repo rate, also known as the official bank rate, is the discounted rate at which a central bank repurchases government securities. The central bank makes this transaction with commercial banks to reduce some of the short-term liquidity in the system. The repo rate is dependent on the level of money supply that the bank chooses to fix in the monetary scheme of things. Repo rate is short for repurchase rate. The entity borrowing the security is often referred to as the buyer, while the lender of the securities is referred to as the seller. The central bank has the power to lower the repo rates while expanding the money supply in the country. This enables the banks to exchange their government security holdings for cash. In contrast, when the central bank decides to reduce the money supply, it implements a rise in the repo rates. At times, the central bank of the nation makes a decision regarding the money supply level and the repo rate is determined by the market. The securities that are being evaluated and sold are transacted at the current market price plus any interest that has accrued. When the sale is concluded, the securities are subsequently resold at a predetermined price. This price is comprised of the original market price and interest, and the pre-agreed interest rate, which is the repo rate. At present repo rate is 5.00% (as on 29-03-2009). BANK RATE

Bank rate is referred to the rate of interest charged by premier banks on the loans and advances. Bank rate varies based on some defined conditions as laid down the governing authority of the banks. Bank rates are levied to control the money supply to and from the bank. From the consumer's point of view, bank rate ordinarily denotes to the current rate of interest acquired from savings certificate of Deposit. It is most frequently used by the consumers who are concerned in mortgage Some commonest types of bank interest rates are as follows: Bank rate on CD, i.e., on certificate of deposit o Bank rate on the credit of a credit card or other kind of loan o Bank rate on real estate loan
o

INTERBANK RATE

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The rate of interest charged on short-term loans made between banks. Banks borrow and lend money in the interbank market in order to manage liquidity and meet the requirements placed on them. The interest rate charged depends on the availability of money in the market, on prevailing rates and on the specific terms of the contract, such as term length. Banks are required to hold an adequate amount of liquid assets, such as cash, to manage any potential withdrawals from clients. If a bank can't meet these liquidity requirements, it will need to borrow money in the interbank market to cover the shortfall. Some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the interbank market, receiving interest on the assets. There is a wide range of published interbank rates, including the LIBOR & MIBOR, which is set daily based on the average rates on loans made within the London interbank market & Mumbai Interbank Market.

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FOREIGN DIRECT INVESTMENT IN INIDAN BANKING SECTOR:

The Reserve Bank of India (RBI) has received some enquiries regarding regulations pertaining to Foreign Direct Investment (FDI) in the Banking Sector. The position has been reviewed in the light of Government policy announced from time to time as well as guidelines laid down by RBI under various statutory provisions. The present position in this respect is clarified as under in a consolidated form. 1. Limit for FDI under automatic route in private sector banks a. In terms of the Press Note No.4 (2001 Series) dated May 21, 2001 issued by Ministry of Commerce & Industry, Government of India, FDI upto 49 per cent from all sources will be permitted in private sector banks on the automatic route, subject to conformity with the guidelines issued by RBI from time to time. b. For the purpose of determining the above-mentioned ceiling of 49 per cent FDI under the "automatic route" in respect of private sector banks, the following category of shares will be included: i. IPOs, ii. Private Placements, iii. ADRs/ GDRs, and iv. Acquisition of shares from existing shareholders [subject to (d) below]. c. It may be clarified that as per Government of India guidelines, issue of fresh shares under automatic route is not available to those foreign investors who have a financial or technical collaboration in the same or allied field. This category of investors requires FIPB approval. d. It may be further clarified that, as per Government of India guidelines, automatic route is not applicable to transfer of existing shares in a banking company from 30

residents to non-residents. This category of investors require approval of FIPB, followed by "in principle" approval by Exchange Control Department (ECD), RBI. The "fair price" for transfer of existing shares is determined by RBI, broadly on the basis of SEBI guidelines for listed shares and erstwhile CCI guidelines for unlisted shares. After receipt of "in principle" approval, the resident seller can receive funds and apply to ECD, RBI for obtaining final permission for transfer of shares. e. Under the Insurance Act, the maximum foreign investment in an insurance company has been fixed at 26%. Application for foreign investment in banks which have joint venture / subsidiary in insurance sector should be made to RBI. Such applications will be considered by RBI in consultation with Insurance Regulatory and Development Authority (IRDA). f. Foreign banks having branch presence in India are eligible for FDI in the private sector banks subject to the overall cap of 49% mentioned above with the approval of RBI. 2. Limit for FDI in public sector banks FDI and Portfolio Investment in nationalized banks are subject to overall statutory limits of 20 per cent as provided under Section 3 (2D) of the Banking Companies (Acquisition & Transfer of Undertakings) Acts, 1970/80. The same ceiling would also apply in respect of such investments in State Bank of India and its associate banks. 3. Voting rights of foreign investors In terms of the statutory provisions under the various banking acts, the voting rights, when exercised, have been stipulated which are indicated as under: Private Sector Banks [Section No person holding shares, in respect of any share held 12(2) of Banking Regulation by him, shall exercise voting rights on poll in excess Act,1949] of ten percent of the total voting rights of all the shareholders. Nationalized Banks [Section 3(2E) of Banking Companies (Acquisition and Transfer of Undertakings) Acts, 1970/80] No shareholder, other than the Central Government, shall be entitled to exercise voting rights in respect of any shares held by him in excess of one percent of the total voting rights of all the shareholders of the nationalized bank.

State Bank of India (SBI) - No shareholder, other than RBI, shall be entitled to (Section 11 of State Bank of exercise voting rights in excess of ten percent of the India Act,1955) issued capital, (Government, in consultation with RBI

31

can raise the above voting right to more than ten percent). SBI Associates - [Section 19(1) No person shall be registered as a shareholder in and (2) of SBI (Subsidiary Bank) respect of any shares held by him in excess of two Act, 1959] hundred shares. No shareholder, other than SBI, shall be entitled to exercise voting rights in excess of one percent of the issued capital of the subsidiary bank concerned. 4. Approval of RBI and reporting requirements i. Under extant instructions, transfer of shares of 5 per cent and more of the paid-up capital of a private sector banking company, requires prior acknowledgement of RBI. For FDI of 5 per cent and more of the paid-up capital, the private sector banking company has to apply in the prescribed form (Annexure I to this circular) to the Department of Banking Operations & Development in the Regional Office of RBI, where the banks Head Office is located. Under the provisions of FEMA 1999, any fresh issue of shares of a banking company, either through the automatic route or with the specific approval of FIPB, does not require further approval of Exchange Control Department (ECD) of RBI from the exchange control angle. The Indian banking company is only required to undertake 2-stage reporting to the ECD as follows: a. In the first stage, the Indian company has to submit a report within 30 days of the date of receipt of amount of consideration indicating the name and address of foreign investors, date of receipt of funds and their rupee equivalent, name of bank through whom funds were received and details of Government approval, if any. b. In the second stage, the Indian banking company is required to file within 30 days from the date of issue of shares, a report in Form FC-GPR (Annexure II) together with a Certificate from the Company Secretary of the concerned company certifying that various regulations have been complied with. The report will also be accompanied by a Certificate from a Chartered Accountant indicating the manner of arriving at the price of the shares issued. 5. Conformity with SEBI Regulations and Companies Act Provisions

ii.

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Wherever applicable, FDI in banking companies should conform to the provisions regarding shareholding and share transfer, etc. as stipulated by SEBI, Companies Act, etc. 6. Disinvestment by Foreign Investors In terms of Regulations 10 and 11 of RBI Notification No. FEMA 20/2000-RB dated May 3, 2000 issued under FEMA 1999, disinvestments by foreign investors would be governed by the following: (i) Sale of shares by non-residents on a stock exchange and remittance of the proceeds thereof through an authorized dealer does not require RBI approval. (ii) Sale of shares by private arrangement requires RBI's prior approval. RBI grants permission for sale of shares at a price that is market related and is arrived at in terms of guidelines indicated in Regulation 10 above. 8. All commercial banks which either have foreign investments or intending to have foreign investments should mandatorily observe the above guidelines.

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BASEL II NORMS:

Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. The final version aims at: 1. Ensuring that capital allocation is more risk sensitive; 2. Separating operational risk from credit risk, and quantifying both; 3. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic. Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place. Basel II uses a "three pillars" concept

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(1) Minimum capital requirements (addressing risk), (2) Supervisory review and (3) Market discipline to promote greater stability in the financial system. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

The first pillar The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or STA, and advanced measurement approach or AMA. For market risk the preferred approach is VaR (value at risk). The second pillar The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. The third pillar The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.

Approach to Basel II: Basel II aims to encourage the use of modern risk management techniques; and to encourage banks to ensure that their risk management capabilities are commensurate with the risks of their business. Previously, regulators' main focus was on credit risk and market risk. Basel II takes a more sophisticated approach to credit risk, in that it allows 35

banks to make use of internal ratings based Approach - or 'IRB Approach' as they have become known - to calculate their capital requirement for credit risk. It also introduces, in addition to the market risk capital charge, an explicit capital charge for operational risk. Together, these three risks - credit, market, and operational risk - are the so-called 'Pillar 1' risks. Banks' risk management functions need to look at a much wider range of risks than this interest rate risk in the banking book, foreign exchange risk, liquidity risk, business cycle risk, reputation risk, strategic risk. The risk management role of helping identify, evaluate, monitor, manage and control or mitigate these risks has become a crucial role in modern-day banking. Indeed, it is probably not exaggerating the importance of this to say that the quality of a bank's risk management has become one of the key determinants of a success of a bank. The policy approach to Basel II in India is to conform to best international standards and in the process emphasis is on harmonization with the international best practices. Commercial banks in India will start implementing Basel II with effect from March 31, 2007 though, as indicated by Governor, a marginal stretching beyond this date cannot be ruled out in view of latest indications of the state of preparedness. Though the Basel II framework provides various options for implementation, special attention was given to the differences in degrees of sophistication and development of the banking system while considering these options and it was decided that banks in India will initially adopt the Standardized Approach (SA) for credit risk and the Basic Indicator Approach (BIA) for operational risk. The prime considerations while deciding on the likely approach included the cost of implementation and the cost of compliance. Overall capital is makes financial systems stable. In general, expected losses are to be covered by earnings and provision and hence the need to price risk appropriately. Unexpected losses or losses beyond the normal range of expectations need have to be met by capital. The steps taken for implementation of Basel II and the emerging issues.

The RBI had announced in its annual policy statement in May 2004 that banks in India should examine in depth the options available under Basel II and draw a road-map by end-December 2004 for migration to Basel II and review the progress made at quarterly intervals. The Reserve Bank organized a two-day seminar in July 2004 mainly to sensitize the Chief Executive Officers of banks to the opportunities and challenges emerging from the Basel II norms. 36

Soon thereafter all banks were advised in August 2004 to undertake a selfassessment of the various risk management systems in place, with specific reference to the three major risks covered under the Basel II and initiate necessary remedial measures to update the systems to match up to the minimum standards prescribed under the New Framework. Banks were also advised to formulate and operationalise the Capital Adequacy Assessment Process (CAAP) as required under Pillar II of the New Framework. Reserve Bank issued a Guidance Note on operational risk management in November 2005, which serves as a benchmark for banks to establish a scientific operational risk management framework. We have tried to ensure that the banks have suitable risk management framework oriented towards their requirements dictated by the size and complexity of business, risk philosophy, market perceptions and the expected level of capital. Risk Based Supervision (RBS) in 23 banks has been introduced on a pilot basis. As per normal practice, and with a view to ensuring migration to Basel II in a non-disruptive manner, a consultative and participative approach had been adopted for both designing and implementing Basel II. A Steering Committee comprising senior officials from 14 banks (public, private and foreign) had been constituted wherein representation from the Indian Banks Association and the RBI was ensured. The Steering Committee had formed sub-groups to address specific issues. On the basis of recommendations of the Steering Committee, draft guidelines to the banks on implementation of the New Capital Adequacy Framework have been issued. The Reserve Bank has constituted a sub group of the Steering Committee for making recommendations on the guidelines that may be required to be issued to banks with regard to the Pillar 2 aspects. The guidelines with regard to Pillar 2 aspects proposed to be issued would cover the bank level initiatives that may be required under Pillar 2.

The underlying philosophy while prescribing the Basel II principles for the Indian banking sector was that this must not result in further segmentation of the sector. Accordingly, it was decided that all scheduled commercial banks in India, both big and small, shall implement the standardized approach for credit risk and the basic indicator approach for operational risk with effect from March 31, 2007. However, the existing three-tier structure in respect of SCBs, the cooperative banks and RRBs may continue. Currently, the commercial banks are required to maintain capital for both credit and market risks as per Basel I framework; the cooperative banks, on the second track, are required to maintain capital for credit risk as per Basel I framework and through

37

surrogates for market risk; the Regional Rural Banks, on the third track, have a minimum capital requirement which is, however, not on par with the Basel I framework. By opting to migrate to Basel II at the basic level, the Reserve Bank has considerably reduced the Basel II compliance costs for the system. In a way, the elementary approaches which have been identified for the Indian banking system are very similar to the Basel I methodology. For instance, a. there is no change in the methodology for computing capital charge for market risks between Basel I and Basel II; b. the computation of capital charge for operational risk under the BIA is very simple and will not involve any compliance cost; c. the computation of capital charge for credit risk will involve compilation of information in a marginally more granular level, which is expected to be achieved with a slight re-orientation of the existing MIS. In the above circumstances, it might not be an entirely correct assessment that implementation of the elementary levels of Basel II significantly increases the cost of regulatory compliance. No doubt some additional capital would be required, but the cushion available in the system, which at present has a Capital to Risk Assets Ratio (CRAR) of over 12 per cent, provides for some comfort. The banks have also started exploring various avenues for meeting the capital requirements. The Reserve Bank has, for its part, issued policy guidelines enabling issuance of several instruments by the banks viz., innovative perpetual debt instruments, perpetual non-cumulative preference shares, redeemable cumulative preference shares and hybrid debt instruments so as to enhance their capital raising options. With a view to have an objective assessment of the true cost of implementation of Basel II, banks would be well advised to institute an internal study to make a true assessment of the costs involved exclusively for the elementary approaches. The informal feedback that we have from banks reflects that they do not see Basel II implementation as a costly proposition. However, banks need to ensure that expenditure incurred by them to improve their risk management systems, IT infrastructure, core banking solutions, risk models etc. should

38

not be included as Basel II compliance costs, since these are expenses which a bank would incur even in the normal course of business to improve their efficiencies. Operational Risk Operational risk was one area which was expected to increase capital requirement for the banks. The Reserve Bank had announced in July 2004 that banks in India will be adopting the Basic Indicator Approach for operational risk. This was followed up with the draft guidelines for the Basel II framework in February 2005 where the methodology for computing the capital requirement under the Basic Indicator Approach was explained to banks. Even at the system level, we find that the CRAR of banks is at present well over 12 per cent. This reflects adequate cushion in the system to meet the capital requirement for operational risks, without breaching the minimum CRAR. There is also a perception that the capital requirements for operational risk will be lower under the advanced approaches rather than under the Basic Indicator Approach. In the absence of details of the quality of operational risk management systems in banks and their operational risk loss experience, it may not be correct for the banks to assume that adoption of the advanced approaches would result in lesser capital than under the BIA. Lets have a look in some other important issues. Rating agencies In terms of Basel II requirements, national supervisors are responsible in determining whether the rating agencies meet the eligibility criteria. The criteria specified are objectivity in assessment methodology, independence from pressures, transparency, adequate disclosures, sufficient resources for high quality credit assessments and credibility. India has four rating agencies of which three are owned partly/wholly by international rating agencies. Compared to developing countries, the extent of rating penetration has been increasing every year and a large number of capital issues of companies has been rated. However, since rating is of issues and not of issuers, it is likely to result, in effect, in application of only Basel I standards for credit risks in respect of non-retail exposures. While Basel II provides some scope to extend the rating of issues to issuers, this would only be an approximation and it would be necessary for the system to move to rating of issuers. Encouraging rating of issuers would be essential in this regard.

39

An internal working group is examining the process for identification of the domestic credit rating agencies which would be meeting the eligibility criteria prescribed under Basel II. It is expected that by this process would be over soon and banks would be informed the details of the rating agencies which qualify. Thereafter, the borrowers are expected to approach the rating agencies for getting themselves rated, failing which banks would be constrained to assign 100% risk weight at the minimum for unrated borrowers. The Reserve Bank had invited all the four rating agencies to make a presentation on the eligibility criteria and a self assessment with regard to these criteria. The rating agencies have since made their presentations and these are under examination vis--vis the eligibility criteria for recognizing the rating agencies, whose ratings can be used by banks for risk weighting purposes. Migration to advanced approaches After adequate skills are developed, both by the banks and also by the supervisors, some banks may be allowed to migrate to the Internal Rating Based (IRB) Approach. The obvious corollary is that only a few banks are expected to migrate to the advanced approaches though after some time, and not immediately. Hence, the small banks would be well advised to focus their resources on understanding the mechanics of the functioning of the elementary approaches and identify the minimum requirements that these approaches demand. It would be in their interests to take the necessary initiatives which make the implementation of the elementary approaches effective and meaningful. As a well established risk management system is a pre-requisite for implementation of advanced approaches under the New Capital Adequacy Framework, banks were required to examine the various options available under the Framework and lay a road-map for migration to Basel II. The feedback received from banks suggests that a few banks may be keen on implementing the advanced approaches but all are not fully equipped to do so straightaway and are, therefore, looking forward to migrate to the advanced approaches at a later date. Basel II provides that banks should be allowed to adopt / migrate to advanced approaches only with the specific approval of the supervisor, after ensuring that they meet / satisfy the minimum requirements specified in the Framework, not only at the time of adoption / migration, but on a continuing basis. [The minimum requirements to be met by banks relate to (a) internal rating system design, (b) risk rating system operations, (c) corporate governance and oversight, (d) use of internal ratings, (e) risk quantification, (f) validation of internal estimates, (g) requirements for recognition of leasing, (h) calculation of capital charges for equity exposures and (i) disclosure requirements.]

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Hence, it is necessary that banks desirous of adopting the advanced approaches do a stringent assessment of their compliance with the minimum requirements before they shift gears to migrate to these approaches. In this context, current non-availability of acceptable and qualitative historical data relevant to ratings, along with the related costs involved in building up and maintaining the requisite database, does influence the pace of migration to the advanced approaches available under Basel II. Banks which are internationally active should look to significantly improve their risk management systems and migrate to the advanced approaches under Basel II since they will be required to compete with the international banks which are adopting the advanced approaches. This strategy would also be relevant to other banks which are looking at adoption of the advanced approaches. As you are aware adoption of the advanced approaches might help these banks to maintain lower capital. However, it would be relevant to refer here to the inverse relationship between the capital requirements and information needs. Adoption of the advanced approaches will require adoption of superior technology and information systems which aid the banks in better data collection, support high quality data and provide scope for detailed technical analysis which are essential for the advanced approaches. Hence, banks aiming at maintaining lower capital by adopting the advanced approaches would also have to be prepared to meet the higher information needs. While migration to the advanced approaches will basically be a business decision, there are few things which may perhaps influence those decisions:

Implementation of advanced approaches under Basel II will not be mandatory for small banks which are undertaking traditional banking business and have a regional or limited presence. Implementation of advanced approaches under Basel II should not be considered as fashionable and implementation of elementary approaches should not be considered as inferior. Any decision to migrate to the advanced approaches should be a well deliberated, conscious decision of the banks Board, after taking into account, not only their capacity to compute the capital requirement under those approaches but also their capacities to sustain the banks risk profile and the consequent capital levels under various scenarios, especially stress scenarios. The preconditions for migration to the advanced approaches would include (a) well established, efficient and independent risk management framework; (b) supported by well established, efficient IT and MIS infrastructure; (c) cost benefit analysis of adoption of advanced approaches; (d) availability of appropriate skills

41

and capacity to retain / attract such skills at all points in time; and (e) a well established, effective and independent internal control mechanism for supplementing the risk management systems Introduction of Advanced Approaches of Basel II Framework in India Draft Time Schedule: Please refer to our circular DBOD.No.BP.BC.90/20.06.001/2006-07 dated April 27, 2007 on the New Capital Adequacy Framework in terms of which the foreign banks operating in India and the Indian banks having operational presence outside India have migrated to the simpler approaches available under the Basel II Framework since March 31, 2008. Other commercial banks are required to migrate to these approaches from March 31, 2009. Thus, the Standardized Approach for credit risk, Basic Indicator Approach for operational risk and the Standardized Duration Approach for market risk (as slightly amended under Basel II framework) has been implemented for the banks in India. Having regard to the necessary up-gradation of risk management framework as also capital efficiency likely to accrue to the banks by adoption of the advanced approaches envisaged under the Basel II Framework and the emerging international trend in this regard, it is considered desirable to lay down a timeframe for implementation of the advanced approaches in India. This would enable the banks to plan and prepare for their migration to the advanced approaches for credit risk and operational risk, as also for the Internal Models Approach (IMA) for market risk. Keeping in view the likely lead time that may be needed by the banks for creating the requisite technological and the risk management infrastructure, including the required databases, the MIS and the skill up-gradation, etc., it is proposed to lay down the following time schedule for implementation of the advanced approaches for the regulatory capital measurement: S. Approach No. The earliest date ofLikely date of making applicationapproval by the by banks to theRBI RBI a. Internal Models Approach (IMA) forApril 1, 2010 March 31, 2011 Market Risk b. The Standardized Approach (TSA) forApril 1, 2010 September 30, Operational Risk 2010 c. Advanced Measurement ApproachApril 1, 2011 March 31, 2013

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(AMA) for Operational Risk d. Internal Ratings-Based (IRB)April 1, 2012 Approaches for Credit Risk (Foundation- as well as Advanced IRB)

March 31, 2014

The banks are advised to undertake an internal assessment of their preparedness for migration to advanced approaches, in the light of the criteria envisaged in the Basel II document, as per the aforesaid time schedule, and take a decision, with the approval of their Boards, whether they would like to migrate to any of the advanced approaches. The banks deciding to migrate to the advanced approaches may approach us for necessary approvals, in due course, as per the stipulated time schedule. It may please be noted that the banks, at their discretion, would have the option of adopting the advanced approaches for one or more of the risk categories, as per their preparedness, while continuing with the simpler approaches for other risk categories, and it would not be necessary to adopt the advanced approaches for all the risk categories simultaneously. However, the banks should invariably obtain prior approval of the RBI for adopting any of the advanced approaches.

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CURRENT STATE OF THE INDIAN BANKING SECTOR

Even as the banking sector elsewhere in the world went through a tumult, the Indian public sector banks stood the test of time and emerged unscathed. So much so that nationalization, a term that was scorned once upon a time, has become the new mantra of salvation. Crisis is a great equalizer. Till few months back, there was a lot of noise that only few large Indian banks will survive post April 1, 2009 following banking liberalization era when foreign banks will have same freedom as domestic banks in respect of opening branches, acquisition of banks, and such others. The whole Indian banking landscape was supposed to change. But, with the sub prime crisis in the US which led to the process of de-leveraging of assets, the entire banking scenario in the world has changed. Nationalization seems to be the new buzz word, which otherwise was unheard of in developed economies, which are now ready to embrace it. A case in point is that of Freddie Mac and Fannie Mae which was taken over by US government, and more recently the talk of stress test for banks which will test banks qualification for nationalization. The financial sector, which remained in the centre of a whirlwind that engulfed the entire economy, has changed the perception of Indian banks. Public sector banks (PSBs), which were out of the limelight for the last couple of years, are back with a vengeance. They have outperformed their private counterparts in almost every performance matrix for the quarter ended December 2008. Therefore, it is not surprising that in the recently announced top 500 global financial brands by Brand Finance in association with UKs

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The Banker magazine, there were 13 new entrants from India all of them were public sector banks. Apart from this, there has been a remarkable shift in perception of India Inc about banks. In the last quarter alone, leading Indian IT companies have shifted around Ra 1400 crore from private banks to public sector banks. Till now, Indian banks have not suffered any major casualty and have demonstrated good growth amid the upheaval faced by the banks in US and Europe. Lets see whether they will continue to perform and what are the areas which can act as Achilles heels for Indian banks.

Income When banks around the world, especially in the developed world, are struggling to survive and many have already gone bankrupt or have been taken over by some other bank or government, Indian banks not only survived but showed spectacular performance both Y-o-Y basis as well as Q-o-Q basis. Starting from total income of the banks, which increased by 35 per cent in FY 08-09, the momentum was maintained even in the third quarter of FY 08-09.when banks continued to show their strong growth and increased by 33 per cent Y-o-Y. The best performance was demonstrated by Axis Bank which increased by 65.5 per cent. Coming to profits, at a time when banks developed markets are posting highest ever losses in their existence, the Indian banks have matched the growth in their profit to income, and profits grew by 35 per cent last year and 33 per cent this Y-o-Y basis. Lakshmi Vilas Bank was the best perform, increasing its profit this quarter by a whopping 400 per cent. Apart from interest income, which the primary source of income for the banks, they derive income from non-interest sources like fees, treasury operations, and such others. Interest income earned by the banks, has increased by 28 per cent CAGR between FY 06-FY 08, and was major contributor to top line with more than 83 per cent contribution. This spectacular increase in interest income can be explained by 26.67 per cent in the same period. Even a hike in PLRs (Prime Lending Rates) by the banks helped to boost their interest income. Non-interest income, which mainly comprises commission, exchange and brokerage (CEB), fee income business clients and government agencies etc, have increased by 25 per cent CAGR between FY 06-FY 08. Top five in Profit Growth Q3 FY 09 (Q-o-Q) Bank Name Net Profit (Cr) Growth

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Dec-08 Allahabad Bank Central Bank of India State Bank of India Lakshmi Vilas Bank 369.47 353.26 182.59 19.10

Sep-08 41.68 96.15 54.17 6.92 113.83

Dec-07 365.05 201.01 70.91 3.82 82.82

QoQ (%) 786.40 267.40 237.10 176.00 129.20

State Bank of Travancore 260.86

Top five in Income Growth Q3 FY 09 (Q-o-Q)

Bank Name

Net Profit (Crore) Dec-08 Sep-08 2697.25 2545.05 531.62 Dec-07 2077.24 1802.34 437.69

Growth QoQ (%) 20.40 17.30 16.70 15.80 15.70

IDBI Bank Axis Bank ING Vysya Bank State Bank of India Bank of Baroda Assets:

3247.30 2984.77 620.21

18030.34 15566.50 12666.81 4108.00 3550.98 3002.19

It is primarily the balance sheet which drives the income for banks, and in last four years banks have grown their total assets by 21 per cent CAGR. It was primarily driven by the aggressiveness of private banks who managed to grow their assets faster than public sector banks. They grew by 30 per cent CAGR compared to 19 per cent achieved by PSBs. For example, Yes Bank, which had assets of little over Rs 1250 crores in FY05, has grown more than thirteen times in the last four years and stood at Rs 17000 crore in FY08.

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It was the advances for the bank which increased faster than deposits. Advances increased by 30 per cent CAGR compared to 20 per cent increase in deposits since 2004. This resulted in the lowering of investments by Scheduled Commercial Banks (SCBs) in SLR instruments. It continuously decreased in the last couple of years before starting to rise in October 2008. Currently, it is more than 27.1 per cent of NDTL (Net Demand and Time Liability) for SCBs, against the required limit of 24 per cent. Therefore, bankers are accused of not lending more and are charged of lazy banking. But bankers enunciate they are using the excess reserves for taking short-term loans under repo window, as excess SLR investment allows them to take short-term loans. It is estimated that percentage point cut in SLR releases approximately Rs 40,000 crores into the system. This is even apparent from the latest third quarter review of RBI holding Rs 121792 crore, as on December 19, 2008 which , otherwise, would have been used for lending. The other reason for the bank not lending much is the fall in key policy rates. As many banks, especially PSBs having large investments in government securities, tend to benefit once the rate get reduced. The boost for the credit growth will come from the huge capex planed by India Inc. According to the CMIE, Rs. 300000 crore worth of projects are likely to be completed in FY09. Therefore the credit growth can be seen in the coming time. Quality of Assets: The party seems to come to end abruptly for banks after few years of high growth when quality of assets improved along with the increase in top-line and bottom-line. Standard assets in the banks improved from 97.3 % in FY07 to 97.6 % in FY08. One of the reasons for improvement in the asset quality is boom in economy leading to better cash flow for the corporate. Moreover there is positive correlation between credit growth and asset quality. NPAs of PSBs decreased from 4.3% to 1.1% and for private sector banks it reduced from 3.6% to .9% between FY04 to FY08.Composition of NPAs of PSBs-00 to 08 is shown in the table

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But, the total landscape has changed with slowdown in economy, scarcity of easy and cheaper money, demand destruction and flaccid personal incomes- all signaling the tough road ahead for banks. KEY RATES AND RATIOS (As on 29-03-2009) Policy Rates Bank rate 6.0% Repo rate- 5.0% Reverse Repo rate- 3.5% Reserve Ratios CRR: 5.00% SLR: 24.00% Lending/ Deposit Rates

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PLR- 12.75% to 13.25% Savings bank rate- 3.5% Deposit rate- 7.50%-9.60%

HERES WHY INDIAN BANKS ARE SAFE

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Net Profit

Capital

Return on Assets 50

FROM THE FIRST GRAPHICAL REPRESENTATION: Going by the fiscal 2008 data, none of the Indian banks, big or small, can fail. This fiscal, beginning April, the situation has changed slightly for certain banks as their non51

performing assets, or NPAs, are going up as consumers have started defaulting on their payment obligations with the rise in interest rates. Their exposure to some of the troubled global banks that have either gone under or are staying afloat with government support have also come to the surface. But that is minuscule and will not make any significant dent in their balance sheets. The best way of judging a banks health is looking at the most critical parameters such as capital adequacy ratio, asset quality and earnings, which define their ability to pay service depositors. On all these parameters, Indian banks more than meet the accepted norms. Net Worth: State Bank of India has the highest net worthcapital and reservesamong all Indian banks, followed by ICICI Bank. Each has about four times the net worth of the third biggest bank in this category, Punjab National Bank. Overall, seven banks have more than Rs10,000 crore net worth. Net NPAs: Most Indian banks have less than 1% NPA. The average NPA of all banks operating in India (including foreign banks) is 1%. So, no worry on the quality of assets, as of now. Capital Adequacy Ratio: Among the big Indian banks, ICICI Bank has the highest capital adequacy ratio, or CAR 13.97% against the regulatory requirement of 9%. Four banks have a higher CAR than ICICI Bank, but they are relatively smaller banks. Overall, 30 banks have more than 12% CAR. Not a single bank has less than 9% CAR. Under the norms, for every Rs100 worth of assets, banks need Rs9 worth of capital. The higher capital base shows they are less leveraged and, hence, strong.

FROM THE SECOND DIAGRAMATIC REPRESENTATION: Net profits:

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State Bank posted the highest net profit, Rs6,729 crore, last year, followed by ICICI Bank, with Rs4,158 crore. Two more banks, Punjab National Bank and Bank of India, posted net profits of more than Rs2,000 crore last year. Higher net profits enabled them shore up their net worth and strengthened their ability to cushion any shock. Capital: Kolkata-based United Bank of India, one of the two unlisted public sector banks, has the maximum equity base, followed by ICICI Bank, the countrys second largest lender. The only other Indian bank that has more than Rs1,000 crore capital is Central Bank of India. Return on Assets: Twenty-seven banks showed at least 1% return on assests (RoA) last fiscal and five of them, including some relatively smaller players, had more than 1.5% RoA. By looking at these aspects in totality, it seems like that our banking systems growth will sustain. But one cant deny the fact that if US goes through the bad patch, then entire world suffer as we are coupled with them. This means the implication of the negative development throughout the world will hamper system and ultimately the growth will erode by some or other way. Lets see what happen..

CONCLUSION

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We have seen that Indian Banking System has experienced many ups and downs in its entire life. This has certainly helped it to get stronger and muscular. It is obvious to say that our Banking sector is the nerve system of the Indian economy as the majority chunk of contribution to the GDP (Gross Domestic Product) comes from the banking only. Whereas Due to the financial carnage happened in US, the road towards the growth doesnt seem that easy, as it was before a year or two. The reason would be the interdependence within the countries. But on the optimistic side, regular interruption of RBI has helped the entire financial system decently. Initially it was looking like being conservative but the steps taken by RBI, has paid us decorously and we can expect the same in the future. While from the steady growth point of view, I must say that the innovations and development plays a key role in the financial sector. So lets be optimistic and see what lies in the future for our banking system.

ABBRAVIATIONS
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ARC - Annual Report Card ADR - American depository Receipt BPLR - Benchmark Prime Lending Rates BIA - Basic Indicator Approach CAAP - Capital Adequacy Assessment Process CAGR - Compounded Annual Growth Ration CAR - Capital Adequacy Ratio CEB - Corporate Executive Board CMIE - Centre For Managing Indian Economy CRAR - Capital To Risk- Weighted- Asset Ratio CRR - Cash Reserve Ratio CSO - Central Statistical Organization EME - Emerging Market Economies ECD - Exchange Control Department FDI FII - Foreign Direct Investment - Foreign Institutional Investor

FIPB - Foreign Investment Promotion Board GDR - Global Depository Receipt IIP LAF - Index of Industrial Production - Liquidity Adjustment Factor - London Inter-bank Offer Rate - Mumbai Inter-bank Offer Rate

LIBOR MIBOR

MSS - Market Stabilization Scheme NPA - Non Performing Assets NRI - Non Residential Indian NTDL - Net Demand and Time Liability OMO - Open Market Operations PLR RBI - Prime Lending Rates - Reserve Bank of India 55 Q-o-Q- Quarter on quarter

RBS - Risk Based Supervision RoA SA SLR SSI WPI - Return on Assets. - Standardized Approach - Statutory Liquidity ratio - Small Scale Industries - Wholesale Price Index RRB - Regional Rural Banks SCB - Scheduled Commercial Banks SPNS - Shared Payment Network Systems VRS - Voluntary Retirement Scheme Y-o-Y - Year on year

REFERENCES

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www.rbi.org.in

Introduction to banking by Vijayaragavan Iyengar

Dalal Street Investment Journal dated Mar 2 to Mar 15, 2009 Indian Banking System, the changing scene by ICFAI university www.livemint.com www.google.com

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