Domestic banks continued to manage growth with resilience during 2010-11 with ample reserves
of capital and liquidity, improved performance in profitability and asset quality. With high growth
potential of the Indian economy and favourable demographics, banks have immense opportunities to
further expand their business both with traditional and innovative products and through financial
inclusion using technology enabled sustainable business models. However, the prevailing interest rate
environment and slowing growth in the near-term amidst somewhat skewed exposures to interest
sensitive sectors will require adept management of such exposures going forward. Further, it will be
challenging for banks to raise additional capital and liquidity to support higher growth and to comply
with Basel III stipulations. This would require banks to use innovative and attractive market based
funding channels, especially when capital continues to remain expensive and the Government support
may be constrained by fiscal considerations. The challenge to converge with the International Financial
Reporting System would require banks to upgrade infrastructure including information technology and
human resources. Given the focus on inclusive growth, banks are also expected to renew efforts to broaden
the scope of financial inclusion and use viable business models to achieve their targets. Finally, sustained
pursuit of forward looking strategies aimed at mitigating risks, diversifying revenue sources, containing
asset-liability mismatches, providing effective response to changing global market environment and
improving customer relationships should strengthen the overall growth of the banking sector in the
medium term.
1. Introduction
1.1 The banking sector in India emerged
largely unscathed from the global financial crisis
of 2007-08, but faced a slowdown in the
momentum of growth due to the weakening of
trade, finance and confidence channels.
However, post crisis, the economic growth in
most emerging market economies (EMEs)
including India recovered, while growth remains
anemic in advanced economies. Instability of
sovereign debt markets in the Euro zone,
political turmoil in the Middle East and North
African (MENA) region, calamities in Japan,
sovereign debt downgrade of the United States
in August this year and the persistently elevated
levels of commodity prices have together led to
an accentuation of downside risks to global
growth. While these risks are expected to recede
gradually over time, the long-term sustainability of higher growth in India will depend crucially
on the ability of the banking sector to mobilise
the savings and meet the credit needs of the
growing economy through innovative financial
instruments and services that foster financial
inclusion and provide efficient and transparent
delivery of credit.
1.2 Despite the challenging headwinds from
domestic and international developments, the
performance of Indian banks remained robust
during 2010-11. The resilience of the banking
sector was marked by improvement in the
capital base, asset quality and profitability. The
profitability of scheduled commercial banks
(SCBs) improved both in terms of return on
assets (RoA) and return on equity (RoE).
Simultaneously, both gross and net NPA ratios
declined in comparison with the previous year.
Since the Indian financial system is bank dominated, banks’ ability to withstand stress is
critical to overall financial stability. A series of
stress tests conducted by the Reserve Bank in
respect of credit, liquidity and interest rate risks
showed that banks remained reasonably
resilient. However, under extreme shocks, some
banks could face moderate liquidity problems
and their profitability could be affected.
1.3 A detailed description of perspectives on
global developments is covered in Chapter II on
Global Banking Developments. Against this
background, some relevant perspectives about
the Indian banking sector are outlined.
2. Forces Shaping the Environment
Are Indian banks adequately prepared for
migration to Basel III regime?
1.4 Commercial banks in India have already
adopted standardised approaches under Basel
II. It is time for larger banks to seriously consider
upgrading their systems and migrating to
advanced approaches. Adoption of advanced
approaches requires simultaneous use of the
underlying processes in the day-to-day risk
management of banks. In the background of the
recent global regulatory developments, a
question often discussed is whether the Indian
banks are prepared for Basel III. The building
blocks of Basel III are by now quite well known:
higher and better quality capital; an
internationally harmonised leverage ratio to
constrain excessive risk taking; capital buffers
which would be built up in good times so that
they can be drawn down in times of stress;
minimum global liquidity standards; and
stronger standards for supervision, public
disclosure and risk management. Quick
assessments show that at the aggregate level
Indian banks will not have any problem in
adjusting to the new capital rules both in terms
of quantum and quality. Indian banks are
comfortably placed in terms of compliance with
the new capital rules.
1.5 One point to note though is that the
comparative position is at the aggregate level; a
few individual banks may fall short of the Basel
III norms and will have to augment their capital.
There will be challenges of upgrading risk
management systems and meeting the credit
needs of a rapidly growing economy even while
adjusting to a more demanding regulatory
regime. In addition to countercyclical capital
buffers, Basel III also envisages countercyclical
provisions.
1.6 In India, banks have a stock of floating
provisions which the Reserve Bank has not
permitted to be used, except under a situation
of systemic stress. While the floating provisions
may serve the purpose of countercyclical
provision, a framework is necessary for allowing
its use. As an interim measure, the Reserve
Bank has been trying to develop a methodology
based on the Spanish dynamic provisioning
system. This, however, has not been easy given
the lack of required data and analytics with the
banks. Migration to Basel III requires a high level
of liquidity to be maintained through a pool of
liquid assets. The definition of liquid assets is
very stringent including the requirement that
they should be freely available.
Are the Indian banks geared up for
transition to the International Financial
Reporting System (IFRS)?
1.7 Converging to global accounting
standards, i.e., IFRS facilitates comparability
between enterprises operating in different
jurisdictions. Convergence would help to reduce
both the cost of capital and cost of compliance
for industry. Training, education and skill
development are cornerstones of a successful
IFRS implementation. All the stakeholders
including investors, accountants, auditors,
customers, software and hardware vendors,
rating agencies, analysts, audit committees,
actuaries, valuation experts and other
specialists will need to develop an understanding of IFRS provisions to varying degrees and what
they need to do. It is not only the accounting
issues but how to address the non-accounting
issues that will determine how successfully
banks make a transition to IFRS. Additionally,
banks will need to upgrade their infrastructure,
including IT and human resources to face the
complexities and challenges of IFRS. Some major
technical issues arising for Indian banks
during the convergence process are the
differences between the IFRS and current
regulatory guidelines, in particular, those within
the ambit of International Accounting Standard
(IAS) 39 replacement project relating to
classification and measurement of financial
assets and liabilities.
Interconnectedness in the banking sector
and vulnerability of financial system
1.8 Post-crisis, macro-prudential policy has
emerged as an important tool for addressing
systemic risk, highlighting its time and the cross
sectional dimensions. While the time dimension
refers to pro-cyclical elements that give rise to
the evolution of aggregate risk over time, the
cross section dimension is concerned with
distribution of risks which can be exacerbated
owing to the interconnectedness in the financial
system. Financial interconnectedness as a part
of macro-financial surveillance is the key issue
in discussions on prudential regulation policies
as it can magnify idiosyncratic shocks across
the financial system. To put in place an effective
system of macro-prudential surveillance of the
financial system, the Reserve Bank has started
using network analysis techniques to model
inter-bank exposures. The analysis revealed that
the banking sector in India is deeply connected.
Further, the contagion analysis made on the
basis of network analysis underlined that
interconnectedness in the banking sector gives
rise to vulnerability of financial system in the
event of failure of one or more banks depending
on the degree of interaction. The contagion
impact is relatively contained due to regulatory
limits on interbank exposures. However, the impact may be more significant if other entities
like other banks, NBFCs, and mutual funds are
included for analysis.
Current and emerging environment offers
sound business opportunities to the banks
1.9 The emerging economic environment
provides a number of opportunities for the
Indian banking sector. Factors like expected
positive economic performance, strong savings
growth spurred by the favourable demographic
dividend, emphasis on expansion of physical
infrastructure and the extent of financial
exclusion to be bridged will ensure growth of
the banking sector in medium term. To exploit
emerging opportunities and to benefit from their
strengths, Indian banks need to be globally
competitive. From a strategic perspective,
competitiveness can be achieved by balancing
factors such as scale, scope, prudence and
knowledge.
3. Strategic and Operational Responses
Migration of financial conglomerates in
India to holding company structure
1.10 At present, most of the financial groups in
India are led by banks and organised under the
Bank Subsidiary model. This model puts
the onus on the parent bank for corporate
governance, performance and capital
requirement of subsidiaries. Besides, the parent
carries very substantial reputational risk. The
Working Group on ‘Introduction of Holding
Company structure in India for banks’ has
recommended migration of major financial
conglomerates to the holding company structure
to address these limitations to some extent. The
main challenges in implementing the
recommendations include, formulating a new
law governing functioning of financial holding
companies, providing right incentives to the
existing financial conglomerates through
appropriate tax treatment and resolution
of strategic and public policy issues by the
Government in the case of public sector banks.
Introducing innovative financial products as
an efficient way to manage risks
1.11 Introducing innovative financial products
is an efficient way to manage risks involved in
the banking business. From this point of view,
the decision to introduce credit default swaps
(CDS) with effect from October 24, 2011 is a
welcome development. However, given their
complex nature, CDS shall be permitted on
listed corporate bonds, unlisted but rated bonds
of infrastructure companies and unlisted/
unrated bonds issued by the Special Purpose
Vehicles (SPVs) set up by infrastructure
companies as reference obligations, and the
reference entities shall be single legal resident
entities. The guidelines also require market
participants to build robust and appropriate risk
management systems. Newer skill sets for
managing newer areas and unfamiliar elements
of risks would continue to pose questions even
to the most advanced banks. The
implementation of innovative financial products
requires diligent assessment of counterparty
and related risks. Banks will have to adopt an
approach to re-evaluate their risk management
acumen in a manner that calls for higher levels
of transparency, structural integrity and
operational control. While expanding market is
a matter of survival, a further challenge for the
banks would be to ring-fence their operations
by establishing a sound risk management
system that is not only protective but also
inclusive and acts as a business enabler.
Management of asset quality
1.12 While gross NPAs, in percentage terms,
have declined steadily from 15.70 per cent at
end March 1997 to 2.25 per cent at end March
2011, this does not fully reveal the underlying
realities and some trends are a matter of
concern, which could put pressure on asset
quality of banks in future. Aggressive lending
during the high credit growth phase followed
by the crisis resulted in slippage with gross NPA
ratio steadily rising from 1.81 per cent at end March 2008 to 2.21 per cent at end March 2010,
followed by a slight moderation to 2.01 per cent
in 2011. The concern is that the recoveries have
not kept pace with slippages since 2007-08.
Rising interest rates and substantial amount of
restructuring done during the crisis period, if
not done with due care, are likely to put further
pressure on asset quality of banks. Further,
asset quality of banks needs to be closely
watched in the changing interest rate
environment as the sticky loan portfolio of small
and medium enterprises might rise. Therefore,
there is a need for banks to step up efforts to
resolve their existing NPAs and tighten their
credit risk management systems.
Robust business continuity management and
disaster recovery
1.13 The extensive use of technology systems
in transaction processing and settlement in
retail as well as inter-institution and interbank
markets requires adequate availability and
capacity to handle the increasing load on these
systems for smooth functioning of financial
markets and banking industry in India. Data
centres managed by the Reserve Bank, and
Indian Financial Network (INFINET), the
communication backbone for the financial sector
managed by the Institute for Development and
Research in Banking Technology (IDRBT),
continued to provide robust support during the
year. Software changes were made in Real Time
Gross Settlement (RTGS) and Public Debt Office-
Negotiated Dealing System (PDO-NDS)
applications to enhance performance and
introduce new functionalities. The next
generation RTGS with advanced technology and
new functionalities is also in the pipeline, which
would have features such as advanced liquidity
management facility, extensible markup
language based messaging system conforming
to ISO 2002, and real time information and
transaction monitoring and control system.
Periodic drills were conducted to get feedback
and assurance on the effectiveness of the Business Continuity management and Disaster
Recovery (BCP-DR) arrangements for shared
infrastructure and Payment and Settlement
Systems. A quarterly report on the BCP-DR and
Vulnerability Analysis and Penetration Testing
(VAPT) exercise conducted by commercial banks
at their end was also obtained and significant
points emerging out of the same are included in
the inputs for analysis and suitable incorporation
in the periodical Financial Stability Report.
4. Challenges
Need for further improving the efficiency
parameters of the Indian Banks
1.14 The Indian banking sector has recorded
an impressive improvement in productivity over
the last 15 years; many of the productivity/
efficiency indicators have moved closer to the
global levels. There has been a particularly
discernible improvement in banks’ operating
efficiency in recent years owing to technology
up-gradation and staff restructuring. However,
to sustain high and inclusive growth, there is a
need to raise the level of domestic savings and
channel those savings into investment. This
implies that banks need to offer attractive
interest rates to depositors and reduce the
lending rates charged on borrowers - in other
words, reduce the net interest margin (NIM). The
NIM of the Indian banking system is higher than
that in some of the other emerging market
economies even after accounting for mandated
social sector obligations such as priority sector
lending and credit support for the Government’s
anti-poverty initiatives.
1.15 By far the most important task is to further
improve operating efficiency on top of what has
already been achieved by optimising operating
costs, i.e., non-interest expenses including
wages and salaries, transaction costs and
provisioning expenses. This will enable banks
to lower lending rates while preserving their
profitability. If pursued effectively, financial inclusion will provide banks access to sizeable
low cost funds as also opportunities for lending
in the small volume segment. The latter should
be possible since the Reserve Bank has
deregulated the interest rate that can be charged
on small value loans. To gainfully pursue
financial inclusion, banks will need to constantly
reinvent their business models and design
products and services demanded by a growing
economy with rapid structural transformation.
Challenges to further strengthening
inclusive growth
1.16 The banking sector is a key driver of
inclusive growth. There are supply side and
demand side factors driving inclusive growth.
Banks and other financial services players
largely are expected to mitigate the supply side
processes that prevent poor and disadvantaged
social groups from gaining access to the financial
system. Banks were advised to ensure close
and continuous monitoring of Business
Correspondents (BCs). They were also advised
to focus, in future, on opening of some form of
low cost brick and mortar branches between the
base branch and BC locations. Further, banks
were required to make efforts to increase the
number of transactions in no-frill accounts.
There should be seamless integration of the
financial inclusion server with their internal core
banking solution (CBS) systems and in the case
of end-to-end solution, there should be a clear
demarcation of the technology related activities
and BC related activities of their service
providers. However, banks must bear in mind
that apart from the supply side factors, demand
side factors, such as lower income and /or asset
holdings also have a significant bearing on
inclusive growth.
1.17 Banks also need to take into account
various behavioural and motivational attributes
of potential consumers for a financial inclusion
strategy to succeed. Today, access to financial
products is constrained by several factors, which include: lack of awareness about the financial
products, unaffordable products, high
transaction costs, and products which are not
convenient, inflexible, not customised and of low
quality. A major challenge of the next decade is
financing the millions in the unorganised sector,
self-employed in the micro and small business
sector, the small and marginal farmers as also
rural share-croppers in the agricultural sector.
Other challenges include financing affordable
housing and education needs of low income
households.
Need for effective corporate governance in
banks
1.18 Banks are different from other corporates
in important respects and that makes corporate
governance of banks not only different but also
more critical. Banks facilitate economic growth,
are the conduits of monetary policy transmission
and constitute the economy’s payment and
settlement system. By the very nature of their
business, banks are highly leveraged. They
accept large amounts of uncollateralised public
funds as deposits in a fiduciary capacity and
further leverage those funds through credit
creation. Banks are interconnected in diverse,
complex and opaque ways underscoring their
‘contagion’ potential. If a corporate fails, the
fallout can be restricted to the stakeholders. If
a bank fails, the impact can spread rapidly
through to other banks with potentially serious
consequences for the entire financial system and
the macro economy. While regulation has a role
to play in ensuring robust corporate standards
in banks, the point to recognise is that effective
regulation is a necessary, but not a sufficient
condition for good corporate governance. In this
context, the relevant issues pertaining to
corporate governance of banks in India are bank
ownership, accountability, transparency, ethics,
compensation, splitting the posts of chairman
and CEO of banks and corporate governance
under financial holding company structure,
which should engage adequate attention.
Need to review laws governing the Indian
banking sector
1.19 The extant statutory arrangement is
complex with different laws governing different
segments of the banking industry. The
nationalised banks are governed by the Banking
Companies (Acquisition and Transfer of
Undertaking) Acts of 1970 and 1980. State Bank
of India and its subsidiaries are governed by
their respective statutes. Private sector banks
come under the purview of the Companies Act,
1956 and the Banking Regulation Act, 1949.
Foreign banks which have registered their
documents with the registrar under Section 592
of the Companies Act are also banking
companies under the Banking Regulation Act.
Certain provisions of the Banking Regulation Act
have been made applicable to public sector
banks. Similarly, some provisions of the RBI Act
too are applicable to nationalised banks, SBI
and its subsidiaries, private sector banks and
foreign banks. Notwithstanding this wide array
of legislations of varying vintage, the statutory
arrangement has served the system well by
helping maintain an orderly banking system.
Needless to say, each of the statutes was crafted
in a setting reflecting the needs and concerns
of the time. Almost all the statutes have had to
be amended from time to time to reflect changes
in circumstances and context. There is a strong
case for reviewing all the various legislations and
recasting them for a number of reasons. There
is also a need to iron out inconsistencies between
the primary laws governing the banking sector
and other laws applicable to the banking sector.
The decision of the Government to set up a
Financial Sector Legislative Reforms
Commission “to rewrite and clean up the
financial sector laws to bring them in line with
the requirements of the sector” is very timely
and very vital. It is important, however, to
recognise that changes in policy or in the
regulatory architecture cannot be the remit of a
Legislative Reforms Commission. Rather, they
should be debated and decided upon as a prelude to the work of the Commission so that
the Commission has a clear mandate on the
policy directions.
Can the Indian banks aim to become global
in stature?
1.20 Of late, there is a debate on whether the
Indian banks should aim to become global? In
this context, there is a need to view the related
costs and benefits analytically and also view this
as an aspiration consistent with India’s growing
international profile. Two specific questions that
need clarity in this context are: (i) can Indian
banks aspire to achieve global size? and (ii)
should Indian banks aspire to attain global size?
On the first question, it is unlikely that any of
the Indian banks will come in the top ten of the
global league even after reasonable
consolidation. On the next question, those who
argue that banks must go global contend that
the issue is not so much the size of our banks
in global rankings but of Indian banks having a
strong enough global presence. The main
argument is that the increasing global size and
influence of Indian corporates warrant a
corresponding increase in the global footprint
of Indian banks. The opposing view is that Indian
banks should look inwards rather than
outwards, focus their efforts on financial
deepening at home rather than aspiring to global
size. It is possible to take a middle path and
argue that looking outwards towards increased
global presence and looking inwards towards
deeper financial penetration are not mutually
exclusive; it should be possible to aim for both.
In the wake of the global financial crisis, there
has definitely been a pause to the rapid
expansion overseas of our banks.
Notwithstanding the risks involved, it will be
opportune for some of the larger banks to be
looking out for opportunities for consolidation.
The surmise, therefore, is that Indian banks
should increase their global presence. In the
rapidly changing global financial landscape, it
is imperative for the Indian banks to think global
but act local.
Costs and risks in using technology to
change the face of banking
1.21 Technology adoption has changed the face
of banking in India. Wide spread technology
deployment in the banking business has also
brought to the fore some new issues and
challenges. These can be broadly divided into
two categories - costs and risks. Costs, in terms
of increasing expenditure on IT deployment and
risks that are resulting from reliance on IT
systems without necessary safeguards. Cost
aspects can be addressed by synergising IT
deployment objectives with the broader,
strategic business objectives to ensure adequate
operational and management controls over
purchase as well as maintenance of appropriate
technology solutions. The second aspect relating
to IT risks is a very critical issue. With the
increased use of IT, there are attendant risks
posed to the banks as well as their customers
in terms of monetary loss, data theft, breach of
privacy and banks need to be extremely
cognizant of such risks. Another significant
aspect of banking business is regulatory and
supervisory compliance. With the growth and
globalisation of markets in general and in the
aftermath of recent crisis in particular, number
of such compliance requirements is increasing.
Basel II and III implementation brings in huge
challenges. Banks have adopted technology, but
the benefit of technology has not fully percolated
in terms of cost, speed and convenience.
Empowering customers with technology-driven
benefits is a big challenge.
Emerging trends in payment systems and
related challenges
1.22 The smooth functioning of the market
infrastructure for enabling payment and
settlement systems is essential for market and
financial stability, as also for economic efficiency,
and for the smooth functioning of financial
markets. The financial sector and the payment
and settlement system infrastructure have to
be subservient to the real sector. The evolving payment systems scenario offers new challenges
and opportunities to all segments of this
industry. To leverage on the opportunities
provided by new products, the system
providers/banks need to ensure that the
challenges are adequately addressed. It also has
to be ensured that the products cover all
segments of the population and provide an
incentive to adopt these products. The
regulatory process will support all orderly
development of new systems and processes,
within the legal mandate. The important issues
in this context are how banks can provide costeffective,
safe, and speedier and hassle free
payment and settlement products and solutions.
Some concerns related to financial stability
1.23 Despite the fragility of the global macrofinancial
environment, the macroeconomic
fundamentals for India have remained robust.
Further, since December 2010, the financial
markets remained stress-free and the forecast
of the values of the Financial Stress Indicator
pointed out that they were likely to remain stable
in the near term. Some emerging trends that
may be of immediate concern in respect of
financial stability are, (i) the possibility of
spillovers from increasing financialisation of
commodities to financial markets, (ii) interest
rate differentials vis-à-vis advanced economies,
which could propel foreign funding by Indian
corporates leading to currency mismatches, (iii)
rollover risks of maturity of Foreign Currency
Convertible Bonds (FCCBs) requiring
refinancing at higher interest rates, and (iv)
disproportionate growth in bank credit to four
specific sectors, viz., real estate, infrastructure,
NBFCs and retail credit coupled with persistent
asset-liability mismatches, reliance on borrowed
funds and enhanced requirement of provisioning
for NPAs. Stress tests suggest that the banking
sector remains fairly well capitalised and
resilient to asset quality shocks and other
plausible adverse changes in macroeconomic
scenario. Issues pertaining to regulatory gaps remaining in the NBFC sector that impinge on
financial stability are being addressed by
enhancing the scope of the regulatory perimeter
while vulnerabilities in the liquidity risk
management systems of domestic central
counterparties are being weighed in terms of
new mechanisms for bail-outs.
5. The Way Forward
1.24 While the opportunities to grow further are
on increase, banks do have to contend with new
challenges as they move forward. The recent
deregulation of savings bank deposit interest
rates announced on October 25, 2011 may
initially lead to some competition, as banks with
low share of savings deposits may like to garner
a larger share of such deposits. However, this
process may not be disruptive. The provisioning
in lieu of pension liabilities and slippages in
incrementally high growth loan portfolios in
sensitive sectors such as retail and real estate
sectors may impact profitability. A specific area
of concern that has come to the fore is the
concentrated and high pace of lending to the
infrastructure sector by the public sector banks
(PSBs), raising the apprehensions of increasing
delinquencies in the future. As mentioned
earlier, banks also face challenges in respect of
demanding needs of supporting growth through
financial inclusion and efficient credit
intermediation through technology and product
innovation.
1.25 It is important to recognise that with
further globalisation, consolidation, deregulation
and diversification of the financial system, the
banking business is set to become more complex
and riskier. Issues like complex risk
management, appropriate liquidity management
and enhancing skill development are some
challenges already visible in the Indian context.
The interface between banks and financial
markets has undergone a fundamental shift in
the recent times. The banks have become
intricately linked to financial markets and hence
more vulnerable to financial markets stress.
While technological advancements in IT have led
to discernible improvement in the efficiency of
banking services, banks have not gained in
terms of efficiency partly because of lack of
business process re-engineering. The challenge
is to leverage technology optimally to balance
growth, efficiency and risk management
objectives.
Medium term outlook
1.26 To take full advantage of the opportunities
while addressing the new challenges, the
process of institutional strengthening assumes
critical importance. Banks need to build on four
principles, viz., efficiency, stability, transparency
and inclusion. The three balancing acts that the
banking sector development strategy needs to
perform are: between the drivers of banking
sector growth and the requirements of the larger
growth and development agenda; between the
benefits and risks of greater global integration;
and between the advantages of scale and the compulsions of diversity. As articulated earlier,
expected economic performance, robust savings,
policy thrust to expand infrastructure and
further strengthening of financial inclusion are
expected to ensure robust growth of the banking
sector in medium term.
1.27 In the long term, however, the most
significant task of the Indian banking sector is
to ensure that banking products and services
are made available to every individual in the
country efficiently to achieve total financial
inclusion. Going forward, filling the void called
‘financial exclusion’ is the critical responsibility
of banks. Despite all the challenges and issues
to be addressed, the banking sector in India can
look forward to enormous opportunities in their
quest for long term growth. The banking sector
needs to focus on growth through inclusion,
innovation and diversification while complying
with domestic regulations and internalising
international best practices.
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