SECTOR OVERVIEW 1 Introduction: Banking sector The Indian Banking industry governed by the Banking Regulation Act of India, 1949, falling into two broad classifications, non-scheduled banks and scheduled banks. Within the commercial banks there are nationalized banks, the State Bank of India and its group banks, regional rural banks and private sector banks (the old/ new domestic and foreign). With the economic growth picking up pace and the investment cycle on the way to recovery, the banking sector has witnessed a transformation in its vital role of intermediating between the demand and supply of funds.
The revived credit off take (both from the food and non food segments) and structural reforms have paved the way for a change in the dynamics of the sector itself. Besides gearing up for the compliance with Basel accord, the sector is also looking forward to consolidation and investments on the FDI front. Public sector banks have undergone much restructuring alongside technology implementation. NPAs have been written off against treasury gains in the last few years.
Retail lending (especially mortgage financing) has been grabbing a major share of the market in the last 3 years. With better penetration in the semi urban and rural areas the banks garnered a higher proportion of low cost deposits thereby economizing on the cost of funds. 2 Apart from streamlining their processes through technology initiatives such as ATMs, telephone banking, online banking and web based products, banks have also resorted to cross selling of financial products such as credit cards, mutual funds and insurance policies to augment their fee based income.
RBI’s soft interest rate policy has helped increase the liquidity in the market, and banks have been liquidating their gilt portfolios partially to free resources for lending. Credit off take is expected to be reasonably good both on retail and corporate sides. Following the advice of the government banks have increased lending to agricultural sector, while ensuring good quality lending by informed customer analysis. Currently the banking sector in the country is strongly fragmented and hence with further policy changes taking place in the sector, consolidation is likely to take place at a faster rate.
However this is subject to the removal of the ceiling on voting rights will ensure that private sector and foreign banks will be in a much better position to carry out acquisitions in the banking sector. A hike in FDI capital limits in the sector would further go a long way in the process of consolidation. In terms of credit growth, going forward, India’s core sector is witnessing a revival of sorts. The manufacturing sector has shown significant improvement in FY05.
Hence as corporate growth picks up lending too is likely to see an uptick. Retail credit off-take is expected to remain strong going forward with the housing finance industry, the main contributor to credit off-take from this segment, expected to grow between 20%-25% in the next 3-4 years. 3 Indian banks have to be encouraged to expand fast, both through organic growth and through consolidation, in order to fuel the growth of large firms and to strengthen their risk assessment systems, for catering to the requirements of smaller firms.
Various policy measures are in process to help this transition along. However, when we look at the global scenario, only 22 Indian banks figure in the list of top 1000 banks and there are only 5 Indian banks in the list of top 500 banks. The biggest Indian bank, State Bank of India, has a market capitalization of under US$ 10 billion compared to the market capitalization of US$ 243 billion of Citigroup. Indian banking sector has a long way to go before we can say that Indian banks are relatively significant players.
Having said that, there are sufficient reasons to believe that the Indian Banking sector is poised for tremendous growth and with proper policy framework in place, it would be very soon, matching their global counterparts on most of the relevant banking indicators/ parameters (except size for some time to come). 4 INDIAN BANKING SYSTEM 5 Indian Banking System: For the past three decades India’s banking system has several outstanding achievements to its credit. The government’s regular policy for Indian bank since 1969 has paid rich dividends with the nationalization of 14 major private banks of India.
The first bank in India, though conservative, was established in 1786. From 1786 till today, the journey of Indian Banking System can be segregated into three distinct phases. They are as mentioned below: • • Early phase from 1786 to 1969 of Indian Banks Nationalisation of Indian Banks and up to 1991 prior to Indian banking sector Reforms. New phase of Indian Banking System with the advent of Indian Financial & Banking Sector Reforms after 1991. • Phase I During the first phase the growth was very slow and banks also experienced periodic failures between 1913 and 1948.
There were approximately 1100 banks, mostly small. To streamline the functioning and activities of commercial banks, the Government of 6 India came up with The Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act No. 23 of 1965). Reserve Bank of India was vested with extensive powers for the supervision of banking in India as the Central Banking Authority. Phase II The following are the steps taken by the Government of India to Regulate Banking Institutions in the Country: • • • • • • • • 949: Enactment of Banking Regulation Act. 1955: Nationalisation of State Bank of India. 1959: Nationalisation of SBI subsidiaries. 1961: Insurance cover extended to deposits. 1969: Nationalisation of 14 major banks. 1971: Creation of credit guarantee corporation. 1975: Creation of regional rural banks. 1980: Nationalisation of seven banks with deposits over 200 crore. Phase III In 1991, under the chairmanship of M Narasimham, a committee was set up by his name which worked for the liberalisation of banking practices. The country is flooded with foreign banks and their ATM stations.
Efforts are being put to give a satisfactory service to customers. Phone banking and net banking is introduced. The entire 7 system became more convenient and swift. Time is given more importance than money. Current Scenario: The Indian Banking industry has been undergoing rapid changes reflecting a number of underlying changes. Liberalization and deregulation witnessed in the Indian markets in the 1990s have resulted in a spurt in banking activity in India. Significant advances in communication have enabled banks to expand their reach, both in terms of geography covered as well as new products introduced.
With increased competition in wholesale banking due to the entry of foreign banks and new private sector banks, the sector has witnessed a squeeze in margins. This has led to banks increasing their focus on retail banking so as to obtain access to low cost funds and to expand into relatively untapped, potential growth areas. Banks and financial institutions are thus continuously exploring new avenues for increasing their footprint and safeguarding their margins. Competition from multinational banks and entry of new private sector banks has rewritten the rules of the retail lending business in India.
Slow growth in corporate lending, pressure on corporate spreads due to competition and concerns over asset quality have induced public sector banks to follow the private sector banks in placing emphasis on growth through expansion of retail portfolio. The Indian retail lending market is relatively unexplored with the percapita usage of retail product offerings such as housing finance, 8 credit cards, auto loans, consumer finance, etc. lower as compared to Asian peers. Also the relative size of the Indian market, backed by factors such s a growing population of bankable households, low penetration rate for retail finance products and the increased propensity of the urban populace to take credit, offers scope for expansion. In retail financing most of the players are trying to enter or consolidate their housing finance segment, as housing loans market is perhaps the least risky segment in the financial sector. Housing finance companies (HFCs) generally target the retail borrower where the nature of the loan ensures that defaults are few and far between. The relatively small size of a housing loan also ensures the risk is well spread out.
Moreover pursuance to the government’s policy to provide shelter to a large number of people and concessions provided in the Finance Act to boost housing and housing finance activities indicates great future potential for this segment. The industry is currently in a transition phase. On the one hand, the PSBs, which are the mainstay of the Indian Banking system, are in the process of shedding their flab in terms of excessive manpower, excessive non Performing Assets (NPA’s) and excessive governmental equity, while on the other hand the private sector banks are consolidating themselves through mergers and acquisitions.
Public Sector banks that imbibe new concepts in banking, turn tech savvy, leaner and meaner post VRS and obtain more autonomy by keeping governmental stake to the minimum can succeed in 9 effectively taking on the private sector banks by virtue of their sheer size. Weaker PSU banks are unlikely to survive in the long run. Consequently, they are likely to be either acquired by stronger players or will be forced to look out for other strategies to infuse greater capital. The private players however cannot match the PSBs great reach, great size and access to low cost deposits.
Therefore one of the means for them to combat the PSBs has been through the merger and acquisition (M) route. Over the last two years, the industry has witnessed several such instances. For instance, HDFC Bank’s merger with Times Bank; ICICI Bank’s acquisition of ITC Classic, Anagram Finance and Bank of Madura. Centurion Bank, Indusland Bank, Bank of Punjab, Vysya Bank are said to be on the lookout. The UTI bank- Global Trust Bank merger however opened a Pandora’s box and brought about the realization that all was not well in the functioning of many of the private sector banks.
In the near term, the low interest rate scenario is likely to affect the spreads of majors. This is likely to result in a greater focus on better asset-liability management procedures. Consequently, only banks that strive hard to increase their share of fee-based revenues are likely to do better in the future. Commercial banking structure The commercial banking structure in India consists of: • • Scheduled Commercial Banks in India Unscheduled Banks in India 10 Scheduled Banks in India constitute those banks which have been included in the Second Schedule of Reserve Bank of India(RBI) Act, 1934.
RBI in turn includes only those banks in this schedule which satisfy the criteria laid down vide section 42 (6) (a) of the Act. “Non-scheduled bank in India” means a banking company as defined in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949), which is not a scheduled bank”. As on September 2005, there were about 269 commercial banks. Of the 269 commercial banks, 265 were scheduled commercial banks and 4 were non scheduled commercial banks. As on September 2005, there were 68,246 offices in India out of which around 46. 74% were in rural areas, 22. 62% were in semi-urban areas, 17% in urban areas and 13. 4% in metropolitan cities. Growth of Indian Banking Sector Banks Public Sector Private Sector Foreign 2001-02 968749 169439 64511 2002-03 1079167 207173 69110 2003-04 1229463 252336 79141 2004-05 1435853 312645 86505 11 Deposits 1600000 1400000 1200000 1000000 800000 600000 400000 200000 0 2001-02 2002-03 2003-04 2004-05 crores yr Public Sector Private Sector Foreign Banks Public Sector Private Sector Foreign 2001-02 117253 20817 12960 2002-03 128464 31846 11999 2003-04 137587 31814 12819 2004-05 144344 32463 13034 Net Income 160000 140000 120000 100000 80000 60000 40000 20000 0 2001-02 2002-03 2003-04 2004-05 rores yr Public Sector Private Sector Foreign 12 Banks Public Sector Private Sector Foreign 2001-02 480680 118430 48632 2002-03 548436 138949 52018 2003-04 633036 161083 59822 2004-05 854671 220337 75318 Advances 1000000 800000 crore 600000 400000 200000 0 2001-02 2002-03 2003-04 2004-05 yr Public Sector Private Sector Foreign Banks Public Sector Private Sector Foreign 2001-02 8302 1779 1492 2002-03 12296 2958 1817 2003-04 16547 4162 2110 2004-05 15477 3564 1982 13 C Net Profit 20000 15000 crore 10000 5000 0 2001-02 2002-03 yr Public Sector Banks Public Sector Private Sector Foreign 2001-02 1. 2 3. 97 8. 18 Private Sector 2003-04 2. 47 5. 1 9. 81 Foreign 2004-05 3. 06 5. 77 9. 4 2003-04 2004-05 2002-03 2. 15 4. 44 10. 34 14 Business / Employee 12 10 8 6 4 2 0 crore 2001-02 2002-03 yr Public Sector 2003-04 2004-05 Private Sector Foreign Financial and Banking Sector Reforms The Banking System: Almost 80% of the business is still controlled by Public Sector Banks (PSBs). PSBs are still dominating the commercial banking system. Shares of the leading PSBs are already listed on the stock exchanges. The RBI has given licenses to new private sector banks as part of the liberalisation process.
The RBI has also been granting licenses to industrial houses. Many banks are successfully running in the retail and consumer segments but are yet to deliver services to industrial finance, retail trade, small business and agricultural finance. The PSBs will play an important role in the industry due to its number 15 of branches and foreign banks facing the constraint of limited number of branches. Deregulation of Banking System: Prudential norms were introduced for income recognition, asset classification, provisioning for delinquent loans and for capital adequacy.
In order to reach the stipulated capital adequacy norms, substantial capital were provided by the Government to PSBs. Government pre-emption of banks’ resources through statutory liquidity ratio (SLR) and cash reserve ratio (CRR) brought down in steps. Interest rates on the deposits and lending sides almost entirely were deregulated. New private sector banks allowed promoting and encouraging competition. PSBs were encouraged to approach the public for raising resources. Recovery of debts due to banks and the Financial Institutions Act, 1993 was passed, and special recovery tribunals set up to facilitate quicker recovery of loan arrears.
Bank lending norms liberalised and a loan system to ensure better control over credit introduced. Banks asked to set up asset liability management (ALM) systems. RBI guidelines issued for risk management systems in banks encompassing credit, market and operational risks. 16 A credit information bureau being established to identify bad risks. Derivative products such as forward rate agreements (FRAs) and interest rate swaps (IRSs) introduced. Porters Five Force Model: An analysis of Indian Banking System. SUPPLIER POWER -High During periods of tight liquidity.
Trade unions in public sector banks can be anti reforms. Depositors may invest elsewhere if interest rates fall. There are large numbers of banks and rise in investment avenues like Mutual Funds, Tax-free bonds, Equity market etc. 17 THREAT OF SUBSTITUTES: High BARRIERS TO Licensing requirement. Investment in technology In the lending side of the business, and branch network. banks are seeing competition rise Banks are fearful of being squeezed out of the payments business, especially since it is a good source of fee-based revenue.
Another trend that poses a threat is companies offering other financial services. What would it take for an insurance company to start offering mortgage and loan service? from unconventional companies e. g. car companies are offering 0% financing, why would anyone want to get a car loan from the bank and pay 5-10% interest? ENTRY There are public sector banks, private sector and foreign banks along with non banking finance companies competing in similar business lines. BUYER POWER High switching costs For good creditworthy borrowers bargaining power is high due to the availability of large number of banks.
It is high due to high competition and growing avenues of raising funds like Commercial Papers etc. DEGREE OF RIVALRY: High There is intense competition due to the large number of players in the market. There are 296 Commercial banks operating in India. Banks attempt to lure clients away from competitor banks by offering lower financing, preferred rates, and investment services. The banking sector is in a race to see who can offer the better and faster services, but this also causes banks to experience a lower ROA. They then have an incentive to take- on high risk projects. 18
BENCHMARKINGINDIAN BANKING INUSTRY Benchmarking the Indian Banking Industry: In an increasingly integrated world, disruptions anywhere may have repercussions for the banking system. Weak and unsound financial system may also find it difficult to compete in the global marketplace. It is, therefore, important from the financial stability perspective that banks are sound by international standards. Significant strengthening 19 of prudential supervision coupled with wide-ranging measures undertaken by the Government and the Reserve Bank has significantly improved the health of the banking sector.
After initiation of reforms in the early 1990s, financial performance, especially of PSBs, has improved markedly. Several balance sheet and profitability indicators suggest that the Indian banking sector now compares well with the global benchmarks. Funding Volatility Ratio The funding volatility ratio (FVR), an important aspect of banks’ balance sheet, measures the extent to which banks rely on volatile liabilities to finance their assets. The smaller the ratio, the better the bank’s liquidity profile. Accordingly, it is preferable to have FVR=0 (whereby volatile liabilities are either exactly or more than fully covered y liquid assets). Bank group Public Sector Private Sector Foreign Banks Scheduled Commercial 2002-03 -0. 25 -0. 27 -0. 25 -0. 25 2003-04 -0. 23 -0. 23 -0. 18 -0. 25 2004-05 -0. 19 -0. 15 -0. 11 -0. 17 Global range for 1998: [-0. 71 to 0. 11] Return on Assets Bank group Public Sector Private Sector 2004 1. 1 0. 9 2005 0. 9 0. 8 20 Foreign Banks Scheduled Commercial Emerging Markets Argentina Brazil Mexico Korea Developed Markets South Africa US UK Japan Canada Australia Global range for 2004: [-1. 2 to 6. 2] 1. 7 1. 1 1. 3 0. 9 -0. 3 1. 8 1. 5 0. 9 1 2 1. 2 1. 4 0. 6 0. 1 0. 8 1. 1 1. 3 0. 8 0. 3 0. 8 1. The return on total assets (RoA) of banks, defined as the ratio of net profit to total assets, is one of the most widely employed measure of profitability. A bank performing on sound commercial lines is expected to exhibit a healthy RoA. Globally, the RoA of the banking sector for 2004 ranged between -1. 2 per cent and 6. 2 per cent . The RoA of SCBs in India for 2004-05 was 0. 9 per cent. The ratio was highest for foreign banks, followed by new private sector banks. The RoA of public sector banks was close to the industry level within the country and the international benchmark. Net Interest Margin: 1 The net interest margin (NIM) of a bank reflects the efficiency of its intermediation process, a lower margin being indicative of higher efficiency. Most countries in developed and even several emerging economies have NIM of around 2 per cent of total assets. Globally, net interest margin for the banking sector generally varies markedly. In the Indian context, among bank-groups, NIM of new private sector banks was the lowest in 2004-05, while it was slightly higher for old private sector banks. The ratio in the case of public sector banks was close to 3 per cent. Foreign banks had the highest NIM.
Bank group Public Sector Private Sector Foreign Banks Scheduled Commercial Global range: [1. 2 to 11. 6] 2002-03 2. 9 1. 9 3. 4 2. 8 2003-04 2. 9 2. 2 3. 6 2. 9 2004-05 3 2. 3 3. 3 2. 9 Average over the period 1995-99. Non-Performing Loans (NPLs) Ratio: A common measure of banks’ asset quality is the ratio of gross nonperforming advances to gross advances. Banks with adequate credit risk management practices are expected to have lower nonperforming loans. Globally, non-performing loan ratio varies widely from a low of 0. 3 per cent to 3. 0 per cent in developed economies to over 10. 0 per cent in several Latin American economies.
Consequent upon several measures undertaken, as 22 part of financial sector reforms, non-performing loans ratio of Indian banks declined steadily over the years. The ratio of NPLs to total loans of SCBs, which was at a high of 15. 7 per cent at end-March 1997, declined steadily to 5. 2 per cent by end-March 2005 banks exhibit wide variations in the provisioning to NPLs ratio from less than 10 per cent to over 200 per cent. However, emerging markets with a high quantum of NPL tend to have higher provisions. The provisioning to NPLs ratio by Indian banks was around 60 per cent at end-March 2005, which was within the global range.
Bank group Public Sector Private Sector Old Pvt. Sector New Pvt. Sector Foreign Banks Scheduled Commercial Emerging Markets Argentina Brazil Mexico Korea South Africa Developed Markets US UK Japan Canada 1. 1 2. 5 5. 2 1. 2 0. 8 2. 2 2. 9 0. 7 18. 6 3. 9 2. 5 1. 7 1. 8 1. 8 2. 4 17. 1 7. 6 5 4. 6 7. 2 6 3. 6 2. 8 5. 2 2004 7. 8 2005 5. 7 23 Australia 0. 4 0. 3 Global range for 2004: [0. 3 to 30. 0] Capital Adequacy Ratio: The capital to risk weighted assets ratio (CRAR) is the most widely employed measure of soundness of a bank. The CRAR of the bank reflects its ability to withstand shocks in the event of adverse developments.
The global range for capital adequacy ratio lies between 8. 8 per cent and 37. 1 per cent. In the Indian context, banks have improved their capital adequacy ratio. The overall capital adequacy ratio of SCBs at endMarch 2005 was 12. 8 per cent as against the regulatory requirement of 9 per cent, which itself is higher than the Basel norm of 8 per cent. The capital adequacy ratio was broadly comparable with the global range. Most banks, including the systematically important, satisfy the regulatory capital adequacy requirements. The CRAR of 78 banks out of 88 was above 10 per cent.
Only two banks had capital adequacy ratio below the regulatory minimum. However, their share in total banking sector assets was less than 0. 5 per cent. 24 Bank group Public Sector Private Sector Old Pvt. Sector New Pvt. Sector Foreign Banks Scheduled Commercial Emerging Markets Argentina Brazil Mexico Korea South Africa Developed Markets US UK Japan Canada Australia 2004 13. 2 2005 12. 9 13. 7 10. 2 15 12. 9 12. 5 11. 8 14. 1 12. 8 11. 2 18. 2 14. 1 11. 3 13. 3 11. 6 13. 7 12. 9 13 12. 4 11. 1 13. 4 10. 1 13. 2 12. 3 11. 6 13. 3 10. 5 25 Global range for 2004: [8. 8 to 37. 1] 26 Global Competitiveness of Indian Banks 27
Indian banks fare well against global peers: Some performance indicators But there’s an interesting twist to the story. Despite being small in terms of capital base and assets, Indian banks are way ahead of their global counterparts when it comes to return on assets, a parameter which denotes efficiency. Except for Bank of America and Citigroup, not too many of the global giants can match Indian banks in terms of ROA. Last year, Bank of America’s ROA was 1. 91 per cent, while that of Citigroup’s was 1. 63 per cent. Andhra Bank’s ROA was not far behind at 1. 59 per cent. In fact, its ROA was the highest among all Asian banks.
Among other Indian banks, Oriental Bank of Commerce’s ROA was 1. 41 per cent, HDFC Bank’s 1. 29 per cent, ICICI Bank and Allahabad Bank’s 1. 20 per cent, Punjab National Bank’s 1. 12 per cent and Canara Bank’s 1. 01 per cent. Last year, SBI’s ROA was 0. 94 per cent. Among the top four Chinese banks only China Construction Bank had an ROA of 1. 29 per cent. The other three bank’s ROA varied between 0. 05 and 0. 81 per cent. Among the top 10 global giants, JP Morgan 28 Chase, Credit Agricole, Mitsubishi Tokyo, Mizo Financial and BNP Paribas had an ROA of less than 1 per cent. Vital Statistics (Source: Mckinsey RBI Report)
Another indicator of the banking industry’s health and efficiency is its non-performing assets. On this count too, Indian banks are way ahead of their Chinese counterparts and on par with the global giants. So obviously, a group of efficient Indian bankers is spending its time and energy in running tiny banks. On this count alone, they should start thinking of consolidation. If the industry pushes for mergers among regional players, then five of the public sector banks in the western region – Bank of India, Bank of Baroda, Union Bank, Bank of Maharashtra and Dena Bank – will collectively own assets worth $76 billion and capital $3. billion. On this basis, the merged entity could 29 be Asia’s 21st largest bank. Globally, it will be ranked 138. It may not be easy to merge all regional banks because of practical issues such as duplication of branches and common customers, banks should begin drafting a blue print for consolidation if they want to build scale and compete with the so-called predators when the sector opens up in 2009. The gross NPA to advances ratio for the sector declined from 16% in FY97 to 5% in FY05. Although this was above the range of 0. % to 3% for the developed economies, it was well below the average of 10% for several Latin American economies. In fact, Indian banks fare much better in this respect than their Chinese counterparts (having average NPA levels of 15% to 20%). Actually, the Indian banking sector compares well with the global benchmarks, thanks to prudential supervision and the measures undertaken by the Reserve Bank of India and the Government. In its report on Trends and Progresses of Banking in India 2004-05, the RBI has compared the Indian scheduled commercial banks (SCBs) to banks in other countries on various financial and soundness indicators.
These parameters include funding volatility ratio, return on assets, net interest margin, costincome ratio, non – performing loans ratio and capital adequacy ratio. The return on total assets (ROA) of banks, defined as ratio of net profit to total assets, was 0. 9 per cent for SCBs in India in 2004-05, as compared to the global ROA of between -1. 2 per cent and 6. 2 per cent, said the RBI in its report. The ROA was the highest for foreign 30 banks at 1. 3 per cent, followed by new private sector banks at 1. 1 per cent. For public sector banks, it was 0. 9 per cent.
ROA is one of the most widely employed measures of profitability. With regard to funding volatility ratio (FVR), which measures the extent to which banks rely on volatile liabilities to finance their assets, the ratio for various bank groups was in the range of -0. 11 to – 0. 23 per cent. This compares favorably with the global range, which was in the range of -0. 71 and 0. 11 per cent, the ratio being primarily negative for most countries. Most countries in developed and even several emerging economies have net interest margin (NIM) of around 2 per cent of total assets.
In India, the NIM for scheduled commercial banks was 2. 9 per cent in 2004-05, with the new private banks having the lowest NIM in 2004-05, at 2. 2 per cent. The cost-income ratio CIR for Indian banks was 0. 5 per cent, with the global range being 0. 46 to 0. 68 per cent. The ratio of non-performing loans (NPL) to total assets vary from 0. 3 per cent to 3 per cent in developed economies to over 10 per cent in several Latin America economies, said the report. In the case of Indian banks, the NPL has declined to 5. 2 percent by endMarch 2005. Provisioning to NPLs ratio was 60. per cent for Indian banks, which was within the global range. Globally, the provisioning ratio varies from less than 10 per cent to over 200 per cent. Indian banks have improved their capital adequacy ratio (CAR) or the capital to risk weighted assets ratio. The global range for CAR lies between 8. 8 per cent and 37. 1 per cent. For Indian banks, it is 12. 8 per cent, which is higher than the regulatory requirement of 9 per cent. Globally the capital to assets ratio varies between 2. 7 per cent and 20. 2 per cent. For Indian banks it is 6. 3 per cent. 31
Consolidation in Banking Industry With 27 public sector banks, 31 private banks and 29 foreign banks, a consolidation exercise in the banking industry cannot be kept in cold storage. Due to diversified operations and varying credit profiles of banks, merger and consolidation would serve as a risk mitigation or risk sharing mechanism, besides increasing the potential for growth. Owing to greater scale and size, consolidation can help save intermediation cost and improve efficiency 32 Cost comparison within Indian Banking Industry Avenues need to be explored for raising capital to meet international Basel II norms.
According to a FICCI survey, a majority of banks face an incremental capital requirement of 1-2% or more (Exhibit 2). It is estimated that the banking system will need an additional capital infusion of around USD 9 million by March 2010. Experts in the Indian Banking industry have long been contemplating on the consolidation leading to 6-7 major players in the market. What India needs is a roadmap for managed consolidation. Banks need to find ways for voluntary mergers so that the shareholder value is maximized for both the entities.
Government is also planning to kick-off consolidation in the sector by lining up a series of merger and acquisition proposals for the public sector banks. 33 Globalization of Operations Of the many Asia Pacific countries, China, Taiwan, South Korea and India will continue to influence the development of the Asian markets. India has a huge potential to become major growth market for traditional banking, investment banking and securities growth given its rapidly growing economy and banking industry. According to Moody’s Investor Services data, Indian lenders have posted highest ROE of 20. 8% (system average of 3 years) by Indonesia (20. 19%) and New Zealand (18. 83%). As a result, leading international and regional banks are interested to establish their presence in India. 34 Whereas 29 foreign banks have 255 branches in India (Source: RBI’s annual report), Indian banks have managed to open only 110 branches abroad. This clearly indicates a one sided flow which needs to be changed for Indian banking sector to have a visibility in the global markets. Another issue is that of uniform regulation, which implies convergence of regulation for Indian and foreign banks in the commonly exploited affairs.
However, as banks compete for globalization, it might get difficult to propagate social sector and government policy signals through them. An indication of the same can be seen from a shrinking size of bank credit from 17. 3% of net bank credit in 1999-2000 to 7% in 2003-04. Given that in 2009 the banking sector will be completely opened up, domestic banks may be 35 in a weak position if mergers and consolidations do not conclude effectively. 36 BUDGET IMPACTS 37 Budget & Banking Sector: Budget Measures: • Autonomy to RBI to implement reforms in banking sector. • Amendment of the Banking Regulation Act. Allow banking companies to issue preference shares to boost their Tier-I capital. • Introduce provisions to enable the consolidated supervision of banks and their subsidiaries by RBI. • Increase bank lending to agricultural sector by 30% and PSU banks to increase number of agricultural borrowers by 5 m. • Remove the lower and upper bounds to the statutory liquidity ratio (SLR) and removal of the limits on the cash reserve ratio (CRR) to provide flexibility to RBI to prescribe prudential norms • Enable RBI to lend or borrow securities by way of repo, reverse repo or otherwise. 0. 1% banking transaction tax to be imposed on cash withdrawals above Rs. 10,000 on a single day. • Removal of benefits available to depositors (Section 80-L) Budget Impact: • Higher autonomy to RBI will enable the apex bank to vary the CRR and SLR limits as per the liquidity requirements of banks (in consonance with the credit growth) and this in turn, will facilitate more flexible conduct of monetary policy. Also, enabling RBI to lend or borrow securities by way of repo or reverse repo will enhance trading of government securities. 8 • The proposal to amend the Banking Regulation Act does not specify the intended modifications to be brought in the act. However, the same may consider the enhancement of FDI limits and higher voting rights cap. • Allowing banking companies to issue preference shares will enable them to infuse more Tier I capital and thereby help them comply with Basel requirements • Mandation on PSU banks to hike their agricultural lending may resurface the problem of NPAs for these banks. Banks are also likely to be the beneficiaries of higher infrastructure lending by way of routing their funds through the ‘Infrastructure financing SPV’ for eligible and appraised projects. While this would provide an impetus to core advances of banks, the quality of such advances is likely to be better. In this light, there is relatively less NPA risk. • The 0. 1% banking transaction tax will discourage cash transactions. • The removal of benefits to individuals with respect to Section 80-L i. e. deduction to a limit on interest on bank deposits could impact deposit growth.
Key Positives: • Guidelines on bank mergers: The RBI’s guideline on bank mergers cleared the persisting ambiguity regarding the route that banks need to follow for their inorganic growth. • Liberalisation of ECB norms: The government also liberalised ECB norms to permit financial sector entities engaged in 39 infrastructure funding to raise ECBs. This enabled banks and financial institutions, which were earlier not permitted to raise such funds, explore this route for raising cheaper funds in the overseas markets. •
Restriction of voting rights: In another move to narrow down the impact of foreign entities on management of domestic banks, the government in its new norms for ADR/GDR issues has specified that the voting rights of ADR/GDR holders will be restricted to 10% (which is as per RBI norms). • Credit classification: To accelerate the initiatives for credit efficiency of banking entities post Basel II (FY07 onwards), the RBI has suggested that banks will need to classify loans above Rs. 50 m as ‘non-retail exposure’ and exercise credit rating on the same through their internal rating mechanism. Ceiling on dividends: The RBI has raised the ceiling on the dividends that commercial banks are permitted to pay to 40% of a bank’s net profits, from the earlier 33. 3%. The caveat, however, is that banks can now pay dividends if their NPAs are less than 7% of their total advances and they have had a capital adequacy ratio (CAR) of at least 9% for three consecutive years. As not meeting any of the said guidelines makes a bank ineligible for dividend payment, it ensure that bank sustain a healthy asset book in the longer term. •
Hybrid capital: In an attempt to relieve banks of their capital crunch, the RBI has allowed them to raise perpetual bonds and other hybrid capital securities to shore up their capital. Significantly, FII and NRI investment limits in these securities have 40 been fixed at 49%, compared to 20% foreign equity holding allowed in PSU banks. Key Negatives: • Increase in risk weightage: The National Housing Bank (NHB) has further tightened norms for housing finance companies (HFC) in the wake of the risk foreseen due to high asset prices. The NHB has increased the risk weightage for loans to the commercial real estate sector from 100% to 125%.
Also, investments in mortgagebacked-securities (MBS) will attract risk weightage of 125%. The decision comes close on the heels of the NHB increasing the risk weightage on home loans from 50% to 75%. This will lead to contraction in CAR. • Refusal to dilute stake in PSU banks: The government has refused to dilute its stake in PSU banks below 51% thus choking the headroom available to these banks for raining equity capital. • Higher provision for standard assets: The RBI has increased the provisioning requirement on standard assets from 0. 25% to 0. 4%, thus increasing the provisioning liability for banks. Interest rate dampener: The interest rate movement in the short term is likely to be with an upward bias as is evident from the RBI’s dual 25 basis points rise in repo and reverse repo rates. A corresponding rise in deposit rates, not commensurate with rise in yields, may pressurise the margins. • Impediments in Sectoral reforms: Opposition from Left and resultant cautious approach from the North Block in terms of 41 approving merger of PSU banks may hamper their growth prospects in the medium term (NIMs) for the sector Sector Outlook: The budget has been a mixed one for the banking sector.
While there is increased flexibility, the move to boost agriculture advances is likely to have a much larger impact on PSU majors. While we expect the credit growth to remain robust (though slower than 21% in the recent past), not all banks will be able to reap the benefits from such sector trends. Enhanced lending to agriculture and priority sectors (including infrastructure lending) will require banks to exercise more caution on the NPA front. Amendments to Banking Regulation Act may however, fulfill the key objectives of competition, consolidation and convergence as highlighted in the budget speech. 42
Credit Policy & Regulatory Policy 43 Credit Policy 2006-07 The Annual Policy Statement 2006-07 surprised the market by not changing any of the interest rates. It is a masterly summary of money, bond and forex markets as well as the risk profile of the economy and the banking system. In the annual policy unveiled on 18 April 2006, the RBI governor, Yaga Venugopal Reddy, cautiously sought to maintain the growth momentum by keeping the policy rates and reserve ratios stable. The central bank has however indicated the possibility of rate hikes later in the event of an upturn in inflation due to pass-through of international oil prices.
The policy concentrated more on quality of credit off take. Mr. Reddy expressed his concern over loan bubble and has packaged the measures in a way that are politically acceptable. Reserve Bank of India has called for a slowdown in lending to sensitive sectors such as real estate and capital markets. RBI wants to ensure that banks have the necessary cushion to absorb a possible correction in the real estate market. Monetary & Credit creation 44 Money supply (M3) increased by 20. 4 % (Rs. 4, 58,456 crores) in 2005-06 as compared with 12. 1 % (Rs. , 42,260 crores), net of conversion, in the previous year. The year-on-year increase in nonfood bank credit during 2005-06 (over April 1, 2005) was 30. 8 % (Rs. 3, 42,493 crores) on top of 27. 5 % (Rs. 2, 21,602 crores), net of conversion, a year ago. Substantial increases were observed in credit flow to industries like food processing, iron and steel, cotton textiles, vehicles, chemicals, gems and jewellery and construction. credit growth outpaced deposit growth by a substantial margin. The aggregate deposits of SCBs increased by 22. 8 % (Rs. , 87,471 crores) during 2005-06 as against an increase of 12. 8 % (Rs. 1, 92,269 crores), net of conversion, in the previous year. The expansion in M3 is projected to be around 15% for 2006-07. While this indicative projection is consistent with the projected GDP growth and inflation. The growth in aggregate deposits is projected to be around Rs. 3, 30,000 crores in 2006-07. Non-food bank credit including investments in bonds/debentures/shares of public sector undertakings and private corporate sector and commercial paper (CP) is expected to increase by around 20 % from a growth of above 30 % presently.
Liquidity Position RBI in its annual policy kept key policy rates unchanged this would keep the liquidity condition in the market conducive for the growth of the industry. Liquidity as reflected in outstanding under the Liquidity Adjustment Facility (LAF), the Market Stabilization Scheme (MSS) 45 and surplus cash balances of the Central Government taken together increased marginally from an average of Rs. 1, 14,192 crores in March 2005 to Rs. 1, 15,258 crores in October 2005. The IMD redemption at end-December, 2005 accounted for about Rs. 32, 000 crores of this decline of Rs. 40, 924 crores.
During the year, the financial markets shifted from surplus mode to deficit in terms of LAF. On a net basis, the average daily LAF reverse repo absorption was Rs. 22, 481 crores and Rs. 25, 409 crores in the first and the second quarters, respectively, but declined to Rs. 7, 825 crores in the third quarter, and finally shifted into average daily repo injection of Rs. 11, 686 crores during the last quarter. Pressures on market liquidity warranted appropriate monetary operations to avoid wide fluctuations in market rates and to ensure reasonable stability in financial markets consistent with the monetary policy stance.
The outstanding balances under MSS increased from Rs. 65, 481 crores at end-March 2005 to a peak of Rs. 80, 585 crores in early September and thereafter declined by Rs. 51, 585 crores to Rs. 29, 000 crores by end-March 2006 reflecting the unwinding of MSS balances. During January-March 2006, Rs. 17, 578 crores was released through unwinding of MSS securities. Financial markets remained generally stable during 2005-06 although interest rates firmed up in all segments and the uncollateralized overnight call market experienced persistent tightness during the last quarter of the year.
A noteworthy and desirable development during the year was the substantial shift of money market activity from the uncollateralized call money segment to the collateralized market repo 46 and collateralized borrowing and lending obligations (CBLO) markets. The share of the uncollateralized call market in the total overnight market transactions declined from 48. 5% in April 2005 to 26. 7% in March2006. The call money rate moved up from an average of 5. 12% in October 2005 to 6. 58% in Mar06. The overnight CBLO and market repo rates also rose from 5. 01% and 4. 8%, respectively, in October 2005 to 6. 22% and 6. 17% in March 2006. In the Government securities market, the primary market yields of 91day and 364-day Treasury Bills (T-Bills) increased from 5. 12% and 5. 60 % at end-April 2005 to 6. 11% and 6. 42%, respectively, at endMarch 2006. The 182-day T-Bill yield moved up from 5. 29% to 6. 61 % during this period. The yield on Government securities with 1-year residual maturity in the secondary market increased from 5. 77 % as at end-April 2005 to 6. 52 % at end-March 2006 but subsequently declined to 6. 29 % as on April 13, 2006.
The yield on Government securities with 10-year residual maturity increased from 7. 35 % at end-April 2005 to 7. 52 % at end-March 2006 and further to 7. 55 % as on April 13. Consequently, the yield spread between 10-year and 1year Government securities came down from 158 basis points in April 2005 to 100 basis points in March 2006 but increased to 126 basis points on April 13, 2006. Monetary Measures and Regulatory Policies Bank Rate 47 Bank Rate is the rate at which RBI allows finance to commercial banks. Any change in bank rate is a signal to the banks to revise deposit rates as well as Prime Lending Rate (PLR).
In Annual Monetary Policy for the year 2006-07, RBI has decided to maintain Bank rate at its present level of 6%. Reverse Repo rate The reverse repo rate is the rate at which banks park their short-term excess liquidity with the RBI. In its Annual Credit Policy for FY07 the Reserve Bank of India has decided to keep reverse repo rate unchanged at 5. 5% under its liquidity adjustment facility (LAF) due to tight liquidity conditions. The spread between the reverse repo rate and the repo rate has also been kept same at 100 basis points. Accordingly, the fixed repo rate under LAF will also be kept unchanged at 6. 0% Cash Reserve Ratio Banks are required to maintain certain %age of demand and time liabilities in the form of cash reserves or by way of current account with the Reserve Bank of India (RBI), this is known as Cash reserve ratio, the objective of it is to ensure the safety and liquidity of the deposits with the banks. Reserve bank of India has decided to keep CRR at 5%. While the Reserve Bank continues to pursue its mediumterm objective of reducing the CRR to the statutory minimum level of 3. 0%, on a review of the current liquidity situation, it is felt desirable to keep the present level of CRR at 5. 0% unchanged. 48
Interest Rate Policy The interest rate on savings bank deposits is regulated by the RBI, has also been kept unchanged at prescribed rate of 3. 5% per annum. Currently RBI considers it appropriate to maintain the status quo while it recognizes that deregulation of this interest rate is essential for product innovation and price discovery in the long run. • RBI has increased Interest rates on non-resident (external) rupee deposits for one to three years maturity by 25 basis points to 1% above LIBOR/SWAP rates for US dollar of corresponding maturity with immediate effect. This has made NRE Rupee Deposits more attractive for the investors.
This will help in bringing more foreign inflows to the country. RBI has increased the export credit interest rate by 25 basis points to LIBOR plus 1% with immediate effect. Going forward, foreign currency, pre-shipment and post-shipment credit will become dearer for the exporters. 49 BASEL II – NORMS 50 BASEL- II: The New Basel Capital Accord, often referred to as the Basel II Accord or simply Basel II, was approved by the Basel Committee on Banking Supervision of Bank for International Settlements in June 2004 and suggests that banks and supervisors implement it by beginning 2007, providing a transition time of 30 months.
It is estimated that the Accord would be implemented in over 100 countries, including India. Basel II takes a three-pillar approach to regulatory capital measurement and capital standards: Pillar 1 (minimum capital requirements); Pillar 2 (supervisory oversight); and Pillar 3 (market discipline and disclosures). Basel II Accord: 51 Pillar 1 Specifies new standards for minimum capital requirements, along with the methodology for assigning risk weights on the basis of credit risk and market risk; also specifies capital requirement for operational risk.
Pillar 2 Enlarges the role of banking supervisors and gives power to them to review the banks’ risk management systems. Pillar 3 Defines the standards and requirements for higher disclosure by banks on capital adequacy, asset quality and other risk management processes. Approach of the Reserve Bank of India to Basel II Accord The Reserve Bank of India (RBI) has asked banks to move in the direction of implementing the Basel II norms, and in the process identify the areas that need strengthening. The RBI aims to reach the global best standards in a phased manner, taking a consultative approach rather than a directive one.
The RBI has set up a steering committee to suggest migration methodology to Basel II. Based on recommendations of the Steering Committee, in February 2005, RBI has proposed the “Draft Guidelines for Implementing New Capital Adequacy Framework” covering the capital adequacy guidelines of the Basel II accord. RBI expects banks to adopt the Standardised Approach for the measurement of Credit Risk and the Basic Indicator Approach for the assessment of Operational Risk. Over time, when adequate risk management skills have developed, 52 ome banks may be allowed to migrate to the Internal Ratings Based approach for credit risk measurement. Standardised approach as suggested by RBI may not significantly alter Credit Risk measurement for Indian banks In the Standardised approach proposed by Basel II Accord, credit risk is measured on the basis of the risk ratings assigned by external credit assessment institutions. This approach is different from the one under Basel I in the sense that the earlier norms had a “one size fits all” approach, i. e. 100% risk weight for all corporate exposures.
Thus, the risk weighted corporate assets measured using the standardised approach of Basel II would get lower risk weights as compared with 100% risk weights under Basel II. Basel II gives a free hand to national regulators (in India’s case, the RBI) to specify different risk weights for retail exposures, in case they think that to be more appropriate. To facilitate a move towards Basel II, the RBI has also come out with an indicative mapping of domestic corporate long term loans and bond credit ratings against corporate ratings by international agencies.
Going by this mapping, the impact of the lower risk weights assigned to higher rated corporates would not be significant for the loans & advances portfolio of banks, as these portfolios mainly have unrated entities, which under the new draft guidelines continue to have a risk weight of 100%. However, given the investments into higher rated corporates in the bonds and debentures portfolio, the risk weighted corporate assets measured using the standardised approach may get marginally lower risk 53 weights as compared with the 100% risk weights assigned under Basel I.
For retail exposures—which banks in India are increasing focusing on for asset growth—RBI has proposed a lower 75% risk weights (in line with the Basel II norms) against the currently applicable risk weights of 125% and 100% for personal/credit card loans, and other retail loans respectively. For mortgage loans secured by residential property and occupied by the borrower, Basel II specifies a risk weight of 35%, which is significantly lower than the RBI’s draft prescription of 75% (if margins are 25% or more) and 100% (if margins
