Perspectives on the Indian Banking Sector

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 nearterm 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.

Q: Are the Indian banks geared up for transition to the International Financial Reporting System (IFRS)?
A: 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 nonaccounting 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

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.

Migration of financial conglomerates in India to holding company structure

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.

Current and emerging environment offers sound business opportunities to the banks
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.

Management of asset quality by banks

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 endMarch 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.

Challenges Need for further improving the efficiency parameters of the Indian Banks
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 Governments anti-poverty initiatives. 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. 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

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. 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

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 economys 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.

Can the Indian banks aim to become global in stature?

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 Indias 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.

Global Banking Developments

The year 2010, and 2011 so far, has been a difficult period for the global banking system, with challenges arising from the global financial system as well as the emerging fiscal and economic growth scenarios across countries. The Global Financial Stability Report in September 2011 has cautioned that for the first time since October 2008, the risks to global financial stability have increased, signaling a partial reversal in the progress made over the past three years. Banking systems in advanced economies have continued to be on uncertain grounds on account of a lacklustre economic revival and increasing sovereign credit strains. The US, despite riding on the QE2 wave, has witnessed its economic recovery losing steam and has experienced a downgrading of its sovereign. The US banking system, which showed signs of improvement in credit growth and profitability in 2010, now faces a serious question about whether this revival in the banking system would continue in the near future. The banking system in the Euro zone, as a whole, stands vulnerable to mounting credit, market and funding risks as a result of severe deterioration in public finances in certain European countries. Further, many of these banks require recapitalisation to cushion them from the risk of sovereign defaults. In the UK too, banking system continues to be beleaguered by high leverage and weak asset quality. In major emerging economies, credit growth has been at relatively high levels and is being regarded as a cause of concern given the growing inflationary pressures and increasing capital inflows. Further, concerns are also being expressed about the credit growth laying foundations for a weak asset quality in the years to come. On the positive side, both advanced and emerging economies, individually, and multilaterally, have moved forward towards strengthening macro-prudential oversight of their banking systems. While it is important to keep up efforts towards strengthening the banking system from within, it is also equally important to develop effective solutions for containing fiscal and economic risks, which at the present juncture, threaten the stability of the global banking system from without. All such solutions need to be designed keeping in mind the larger interests of the global economy.