An Overview of India's Banking Sector
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A bank is a financial institution whose primary activity is to act as a payment agent for customers, to borrow and to lend money.
‘BANK' the name is derived from the italian word ‘banco', which means ‘desk/bench'.
The history of banks pave their way back to 3rd millenium B.C. They were probably the religious places where they started off. Then they developed gradually over years and currently it has taken a very complex shape.
There are certain financial institutions whicu provide banking services but do not have the banking license,they are called NBFCs.
There are various types of banks on the basis of activities and on the basis of ownership and above all is the central bank which is the last resort for all commercial banks in the country.
Banks ought to get license for their working as a bank and there are regulations regarding the capital requirements and their reserves.
The current scenario of banking industry is bad due to the net interest margin getting thinner because of incresed inflation and resultant hike in repo rates.
MEANING AND DEFINITION
The definition of a bank varies from country to country.
Under English law, a bank is defined as a person who carries on the business of banking, which is specified as
- conducting current accounts for his customers
- paying cheques drawn on him, and
- collecting cheques for his customers.
A Bank can be defined as :
A bank is an institution that acts as an agent that provides financial services and that holds a banking license granted by bank regulatory authorities for carrying out the most fundamental banking services.
There are also financial institutions that provide certain banking services without meeting the legal definition of a bank, a so called non-banking financial company. Banks are a subset of the financial services industry.Banks are a sub set of the financial services industry.
Bank can be more clearly understood by the activities it perform:
- Accepting deposits and granting loans to customers.
- It also acts as credit intermediary- borrow and lend back-to-back on their own account as middle men.
- It also act as a collection agent, participate in inter-bank clearing and settlement systems.
- Issuer of money, in the form of banknotes and current accounts subject to cheque or payment at the customer's order.
In other words can be said that, Banker includes a body of persons, whether incorporated or not, who carry on the business of banking.
‘BANK', the name is derived from the italian word ‘banco' , which means ‘desk/bench' , used during the Renaissance by Florentines bankers , who used to make their transactions above a desk covered by a green tablecloth. In fact, the word traces its origins back to the Ancient Roman Empire, where moneylenders would set up their stalls in the middle of enclosed courtyards called ‘macella' on a long bench called a ‘bancu' , from which the words banco and bank are derived.
The first banks were probably the religious temples of the ancient world, and were probably established sometime during the 3rd millennium B.C. Banks probably predated the invention of money. Deposits initially consisted of grain and later other goods including cattle, agricultural implements, and eventually precious metals such as gold.There are some extant records of loans from the 18th century B.C. in Babylon that were made by temple priests monks to merchants.
Ancient Greece holds further evidence of banking. There is evidence too of credit, whereby in return for a payment from a client, a moneylender in one Greek port would write a credit note for the client who could "cash" the note in another city.
In the late third century B.C., the barren Aegean island of Delos, known for its magnificent harbor and famous temple of Apollo, became a prominent banking center.
Ancient Rome perfected the administrative aspect of banking and saw greater regulation of financial institutions and financial practices. Charging interest on loans and paying interest on deposits became more highly developed and competitive.
The first modern bank was founded in Italy in Genoa in 1406, its name was Banco di San Giorgio (Bank of St. George).
HISTORY OF BANKING IN INDIA:
Banking in India originated in the first decade of 18th century with The General Bank of India coming into existence in 1786. This was followed by Bank of Hindustan. Both these banks are now defunct. The oldest bank in existence in India is the State Bank of India being established as "The Bank of Bengal" in Calcutta in June 1806.
The first fully Indian owned bank was the Allahabad Bank, which was established in 1865.
By the 1900s, the market expanded with the establishment of banks such as Punjab National Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of which were founded under private ownership. The Reserve Bank of India formally took on the responsibility of regulating the Indian banking sector from 1935. After India's independence in 1947, the Reserve Bank was nationalized and given broader powers.
At the end of late-18th century, there were hardly any banks in India in the modern sense of the term. Subsequently, banking in India remained the exclusive domain of Europeans for next several decades until the beginning of the 20th century. At the beginning of the 20th century, Indian economy was passing through a relative period of stability. Around five decades have elapsed since the India's First war of Independence, at that time there were very small banks operated by Indians, and most of them were owned and operated by particular communities. The banking in India was controlled and dominated by the presidency banks, namely, the Bank of Bombay, the Bank of Bengal, and the Bank of Madras - which later on merged to form the Imperial Bank of India, and Imperial Bank of India, upon India's independence, was renamed the State Bank of India. There was potential for many new banks as the economy was growing. many Indians came forward to set up banks, and many banks were set up at that time, a number of which have survived to the present such as Bank of India and Corporation Bank, Indian Bank, Bank of Baroda, and Canara Bank.
During the Wars
The period during the First World War (1914-1918) through the end of the Second World War (1939-1945), and two years thereafter until the independence of India were challenging for the Indian banking. The years of the First World War were turbulent, and it took toll of many banks which simply collapsed despite the Indian economy gaining indirect boost due to war-related economic activities. At least 94 banks in India failed during the years 1913 to 1918.
The partition of India in 1947 had adversely impacted the economies of Punjab and West Bengal, and banking activities had remained paralyzed for months.
- In 1948, the Reserve Bank of India, India's central banking authority, was nationalized, and it became an institution owned by the Government of India.
- In 1949, the Banking Regulation Act was enacted which empowered the Reserve Bank of India (RBI) "to regulate, control, and inspect the banks in India."
- The Banking Regulation Act also provided that no new bank or branch of an existing bank may be opened without a licence from the RBI, and no two banks could have common directors.
By the 1960s, the Indian banking industry has become an important tool to facilitate the development of the Indian economy.
Indira Gandhi, the-then Prime Minister of India expressed the intention of the GOI in the annual conference to nationalised the 14 largest commercial banks with effect from the midnight of July 19, 1969. A second dose of nationalisation of 6 more commercial banks followed in 1980. The stated reason for the nationalisation was to give the government more control of credit delivery. With the second dose of nationalisation, the GOI controlled around 91% of the banking business of India.
After this, until the 1990s, the nationalised banks grew at a pace of around 4%, closer to the average growth rate of the Indian economy.
In the early 1990s the then Narsimha Rao government embarked on a policy of liberalisation and gave licences to a small number of private banks.
This move, along with the rapid growth in the economy of India, kickstarted the banking sector in India, which has seen rapid growth with strong contribution from all the three sectors of banks, namely, government banks, private banks and foreign banks.
The next stage for the Indian banking has been setup with the proposed relaxation in the norms for Foreign Direct Investment, where all Foreign Investors in banks may be given voting rights which could exceed the present cap of 10%,at present it has gone up to 49% with some restrictions.
Currently, India has 88 scheduled commercial banks (SCBs) - 28 public sector banks (that is with the Government of India holding a stake), 29 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 31 foreign banks. They have a combined network of over 53,000 branches and 17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75 percent of total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5% respectively.
The Indian Banking industry is one of the most robustly developed banking system in the world comprising 28 PSU banks, 33 private banks and 35 foreign banks. Together these are known as scheduled commercial banks (SCBs). Apart form the SCBs, there exists 133 regional rural banks (RRBs) and four local area banks, 1853 urban co-operative banks and 109924 rural co-operative banks. The government of India nationalised 14 banks in 1969 and another six in 1980. Privatisation in the sector was allowed in 1993. ICICI Bank and HDFC Bank were the first to thrive thereafter. PSU major Sate bank of India is one of the 100 largest banks in the world.
The size of India's financial and banking sector is quite low when compared to other countries.
Banking is the only sector influencing all components of the GDP in one way or the other. It is the only sector that can help you capitalise on all the three key themes of the India growth story — consumption, investment and foreign trade. It drives acts as a source of funds for the infrastructure sector (construction, basic materials like cement & metals and engineering). It promotes consumption through its complex machanisms for the FMCG, auto, pharma and the real estate sector.
From a Banking and Financial Services perspective, India is an under penetrated market. The total credit as a percentage of GDP is 53% as compared to 80% in case of Japan, 83% incase of Korea.China and Malaysia have the highest credit penetration of 108% and 109% respectively. Retail credit penetration is a measly 13% in India much lower than 61% in Malaysia and 41% & 23% in case of Korea and Japan. Also, India is under-insured when it comes to life and non-life insurance (penetration of just 4% in case of life insurance and 1% in case of non life insurance).
TYPES OF BANKS
§ ON THE BASIS OF ACTIVITIES:
Banks' activities can be divided into:
- Retail banking, dealing directly with individuals and small businesses.
- Business banking, providing services to mid-market business.
- Corporate banking, directed at large business entities.
- Private banking, providing wealth management services to High Net Worth Individuals and families.
- Investment banking, relating to activities on the financial markets
Most banks are profit-making, private enterprises. However, some are owned by government, or are non-profits.
Central banks are normally government owned banks: charged with quasi-regulatory responsibilities, e.g. supervising commercial banks. They generally provide liquidity to the banking system and act as Lender of last resort in event of a crisis.
ON THE BASIS OF OWNERSHIP:
Banks as classified on ownership basis can be categorised into:
- Public banks,owned and managed by government.
- Private banks,owned and managed by private enterpreneurs.
- Foreign banks,owned and managed by foreign institutions.
Commercial banks can have two meanings:
- Commercial bank is the term used for a normal bank to distinguish it from an investment bank.
- Commercial bank can also refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses, as opposed to normal individual members of the public (retail banking).
Commercial bank is engaged in the following activities:
- processing of payments by way of telegraphic transfer, EFTPOS, internet banking or other means
- issuing bank drafts and bank cheques
- accepting money on term deposit
- lending money by way of overdraft, installment loan or otherwise
- providing documentary and standby letter of credit, guarantees, performance bonds, securities underwriting commitments and other forms of off balance sheet exposures
- safekeeping of documents and other items in safe deposit boxes
- currency exchange
- sale, distribution or brokerage, with or without advice, of insurance, unit trusts and similar financial products as a “financial supermarket”
Types of loans granted by commercial banks
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral (i.e., security) for the loan.
A mortgage loan is a very common type of debt instrument, used to purchase real estate. Under this arrangement, the money is used to purchase property. Commercial banks, however, are given security - a lien on the title to the house - until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.
Unsecured loans are monetary loans that are not secured against the borrowers assets (i.e., no collateral is involved). These may be available from financial institutions under many different guises or marketing packages:
- credit card debt,
- personal loans,
- bank overdrafts
- credit facilities or lines of credit
- corporate bonds
Retail banking refers to banking in which banks undergo transactions directly with consumers, rather than corporations or other banks.
Services offered include: savings and checking accounts, mortgages, personal loans, debit cards, credit cards, and so forth.
Investment banks are financial intermediaries that perform a variety of services. This includes underwriting, acting as an intermediary between an issuer of securities and the investing public, facilitating mergers and other corporate reorganizations, and also acting as a broker for institutional clients. In other words can be said that, Investment banks help companies and governments raise money by issuing and selling securities in the capital markets (both equity and debt), as well as providing advice on transactions such as mergers and acquisitions
Types of investment banks
- Investment banks "underwrite" (guarantee the sale of) stock and bond issues, trade for their own accounts, make markets, and advise corporations on capital markets activities such as mergers and acquisitions.
- Merchant banks were traditionally banks which engaged in trade financing. The modern definition, however, refers to banks which provide capital to firms in the form of shares rather than loans. Unlike venture capital firms, they tend not to invest in new companies.
Private banking is a term for banking, investment and other financial services provided by banks to private individuals disposing of sizable assets. The term "private" refers to the customer service being rendered on a more personal basis than in mass-market retail banking, usually via dedicated bank advisers. Personalized financial and banking services that are traditionally offered to a bank's rich,high net worth individuals (HNWIs).
Banks, which are incorporated, owned and regulated by government.
Private banks are banks that are not incorporated. A non-incorporated bank is owned by either an individual or a general partner(s) with limited partner(s). In any such case, the creditors can look to both the "entirety of the bank's assets" as well as the entirety of the sole-proprietor's/general-partners' assets. "Private banks" and "private banking" can also refer to non-government owned banks in general, in contrast to government-owned (or nationalized) banks.
NON-BANKING FINANCIAL CORPORATION
Non-bank financial companies (NBFCs) are financial institutions that provide banking services without meeting the legal definition of a bank, i.e. one that does not hold a banking license. Operations are, regardless of this, still exercised under bank regulation. However this depends on the jurisdiction, as in some jurisdictions, such as New Zealand, any company can do the business of banking, and there are no banking licences issued.
NBFCs are doing functions akin to that of banks, however there are a few differences:
(i) A NBFC cannot accept demand deposits;
(ii) it is not a part of the payment and settlement system and as such cannot issue cheques to its customers; and
(iii) deposit insurance facility of DICGC is not available for NBFC depositors unlike in case of banks.
It is mandatory that every NBFC should be registered with RBI to commence or carry on any business of non-banking financial institution as defined in clause (a) of Section 45 I of the RBI Act, 1934.However, to obviate dual regulation, certain category of NBFCs which are regulated by other regulators are exempted from the requirement of registration with RBI viz. Venture Capital Fund/Merchant Banking companies/Stock broking companies registered with SEBI, Insurance Company holding a valid Certificate of Registration issued by IRDA, or Housing Finance Companies regulated by National Housing Bank.
All NBFCs are not entitled to accept public deposits. Only those NBFCs holding a valid Certificate of Registration with authorization to accept Public Deposits can accept/hold public deposits. The NBFCs accepting public deposits should have minimum stipulated Net Owned Fund and comply with the Directions issued by the Bank.
There is ceiling on acceptance of Public Deposits. A NBFC maintaining required NOF/CRAR and complying with the prudential norms could accept public deposits as follows:
Category of NBFC
Ceiling on public deposits
AFCs maintaining CRAR of 15% without credit rating.
AFCs with CRAR of 12% and having minimum investment grade credit rating.
1.5 times of NOF or Rs.10crore whichever is less.
4 times of NOF
LC/IC with CRAR of 15% and having minimum investment grade credit rating.
1.5 times of NOF
AFC-Asset financing Company
If a NBFC defaults in repayment of deposit, the depositor can approach Company Law Board or Consumer Forum or file a civil suit to recover the deposits
Some other types of banks:
An advising bank (also known as a notifying bank) advises a beneficiary (exporter) that a letter of credit (L/C) opened by an issuing bank for an applicant (importer) is available and informs the beneficiary about the terms and conditions of the L/C. The advising bank is not necessarily responsible for the payment of the credit which it advises the beneficiary of.
Community development banks (CDBs) are banks designed to serve residents and spur economic development in low- to moderate-income (LMI) geographical areas. When CDBs provide retail banking services, they usually target customers from "financially underserved" demographics.
a custodian bank, or simply custodian, refers to a financial institution responsible for safeguarding a firm's or individual's financial assets. The role of a custodian in such a case would be the following: to hold in safekeeping assets such as equities and bonds, arrange settlement of any purchases and sales of such securities, collect information on and income from such assets, provide information on the underlying companies and provide regular reporting on all their activities to their clients
A depository bank is a bank organized in the United States which provides all the stock transfer and agency services in connection with a depository receipt program. This function includes arranging for a custodian to accept deposits of ordinary shares, issuing the negotiable receipts which back up the shares, maintaining the register of holders to reflect all transfers and exchanges, and distributing dividends.
Islamic banking refers to a system of banking or banking activity that is consistent with Islamic law (Sharia) principles and guided by Islamic economics. In particular, Islamic law prohibits the collection and payment of interest.In addition, Islamic law prohibits investing in businesses that are considered unlawful.
A mutual savings bank is a financial institution chartered through a state or federal government to provide a safe place for individuals to save and to invest those savings in mortgages, loans, stocks, Bonds and other securities.
An offshore bank is a bank located outside the country of residence of the depositor, typically in a low tax jurisdiction that provides financial and legal advantages.
Banking Industry Strucure in India
A central bank, reserve bank, or monetary authority is the entity responsible for the monetary policy of a country. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a "bailout" lender of last resort to the banking sector during times of financial crisis. ).
It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.
The oldest central bank in the world is the Riksbank in Sweden, which was opened in 1668 with help from Dutch businessmen. This was followed in 1694 by the Bank of England, created by Scottish businessman William Paterson in the City of London at the request of the English government to help pay for a war.
Activities and responsibilities
Functions of a central bank
- implementation of monetary policy
- controls the nation's entire money supply
- the Government's banker and the bankers' bank ("Lender of Last Resort")
- manages the country's foreign exchange and gold reserves and the Government's stock register;
- regulation and supervision of the banking industry:
- setting the official interest rate - used to manage both inflation and the country's exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms
Central banks implement a country's chosen monetary policy. At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency, currency board or a currency union.
Many central banks are "banks" in the sense that they hold assets (foreign exchange, gold, and other financial assets) and liabilities.
Central banks generally earn money by issuing currency notes and "selling" them to the public for interest-bearing assets, such as government bonds.
Interest rate interventions:
Typically a central bank controls certain types of short-term interest rates. These influence the stock- and bond markets as well as mortgage and other interest rates.
The main monetary policy instruments available to central banks are:
- open market operation
- bank reserve requirement
- interest rate policy
- credit policy
capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules.
Open Market Operations:
Through open market operations, a central bank influences the money supply in an economy directly. Each time it buys securities, exchanging money for the security, it raises the money supply. Conversely, selling of securities lowers the money supply. Buying of securities thus amounts to printing new money while lowering supply of the specific security.
Another significant power that central banks hold is the ability to establish reserve requirements for other banks. By requiring that a percentage of liabilities be held as cash or deposited with the central bank (or other agency), limits are set on the money supply.
Interest Rate Policy:
By far the most visible and obvious power of many modern central banks is to influence market interest rates. The mechanism to move the market towards a 'target rate' is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing and selling bonds.
All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor. Capital requirements may be considered more effective than deposit/reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.
Currently in most jurisdictions commercial banks are regulated by government entities and require a special bank licence to operate. Unlike most other regulated industries, the regulator is typically also a participant in the market, i.e. government owned bank (a central bank). The requirements for the issue of a bank licence vary between jurisdictions but typically incude:
- Minimum capital
- Minimum capital ratio
- 'Fit and Proper' requirements for the bank's controllers, owners, directors, and/or senior officers
- Approval of the bank's business plan as being sufficiently prudent and plausible.
- A branch, banking centre or financial centre is a retail location where a bank or financial institution offers a wide array of face-to-face service to its customers
- Telephone banking
- Online banking
liquidity risk -the risk that many depositors will request withdrawals beyond available funds
credit risk -the risk that those who owe money to the bank will not repay
interest rate risk- the risk that the bank will become unprofitable if rising interest rates force it to pay relatively more on its deposits than it receives on its loans.
A bank generates a profit from the differential between the level of interest it pays for deposits and other sources of funds, and the level of interest it charges in its lending activities. This difference is referred to as the spread between the cost of funds and the loan interest rate.
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines.
The objectives of bank regulation, and the emphasis are:
- Prudential -- to reduce the level of risk bank creditors are exposed to
- Systemic risk reduction -- to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures
- Avoid Misuse of Banks -- to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime
- To protect banking confidentiality
- Credit allocation -- to direct credit to favoured sectors .
General Principles of Bank Regulation
Banking regulations can vary widely across nations and jurisdictions. Thes are some of the general principles of bank regulation throughout the world
Requirements are imposed on banks in order to promote the objectives of the regulator. The most important minimum requirement in banking regulation is minimum capital ratios.
Banks are required to be issued with a bank licence by the regulator in order to carry on business as a bank, and the regulator supervises licenced banks for compliance with the requirements and responds to breaches of the requirements through obtaining undertakings, giving directions, imposing penalties or revoking the bank's licence.
The regulator requires banks to publicly disclose financial and other information, and depositors and other creditors are able to use this information to assess the level of risk and to make investment decisions. As a result of this, the bank is subject to market discipline and the regulator can also use market-pricing information as an indicator of the bank's financial health.
Instruments and Requirements of Bank Regulation
The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted. The capital ratio is the percentage of a bank's capital to its risk-weighted assets.
The reserve requirement sets the minimum reserves each bank must hold to demand deposits and banknotes. The purpose of minimum reserve ratios is liquidity rather than safety.
Corporate governance requirements are intented to encourage the bank to be well managed and also to achieve certain objectives as to maintain it as a body corporate, maintaining minimum number of members and organisational structure etc.
Financial Reporting, Disclosure and Prospectus Requirements
Banks may be required to:
- Prepare annual financial statements according to a financial reporting standard, have them audited, and to register or publish them .
- Prepare more frequent financial disclosures.
- Have directors of the bank attest to the accuracy of such financial disclosures.
- Prepare and have registered prospectuses detailing the terms of securities it issues.
Credit Rating Requirement
Banks may be required to obtain and maintain a current credit rating from an approved credit rating agency, and to disclose it to investors and prospective investors. Also, banks may be required to maintain a minimum credit rating.
Large Exposures Restrictions
Banks may be restricted from having imprudently large exposures to individual counterparties or groups of connected counterparties.
Related Party Exposure Restrictions
Banks may be restricted from incurring exposures to related parties such as the bank's parent company or directors.
The Bank for International Settlements (or BIS) is an international organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." The BIS carries out its work through subcommittees, the secretariats it hosts, and through its annual General Meeting of all members.
It also provides banking services, but only to central banks, or to international organizations like itself. Based in Basel, Switzerland, the BIS was established by the Hague agreements of 1930. The BIS' main role is in setting capital adequacy requirements.
The BIS sets "requirements on two categories of capital, Tier 1 capital and Total capital. Tier 1 capital is the book value of its stock plus retained earnings. Tier 2 capital is loan-loss reserves plus subordinated debt
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It consists primarily of shareholders' equity but may also include preferred stock that is irredeemable and non-cumulative and retained earnings.
Capital in this sense is related to, but different from, the accounting concept of shareholder's equity. Both tier 1 and tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord.
The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's Central Bank).
Tier 2 capital
Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliable form of financial capital, from a regulator's point of view. The forms of banking capital were largely standardised in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord.
Basel I is the term which refers to a round of deliberations by central bankers from around the world, and in 1988, the Basel Committee This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992 and it primarily focused on credit risk.
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.
Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.
The final version aims at:
- Ensuring that capital allocation is more risk sensitive;
- Separating operational risk from credit risk, and quantifying both;
- Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage
Basel II uses a "three pillars" concept -
(1) minimum capital requirements (addressing risk),
(2) supervisory review and
(3) market discipline - to promote greater stability in the financial system.
The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.
The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. Other risks are not considered fully quantifiable at this stage.
The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach".
For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or STA, and advanced measurement approach or AMA.
For market risk the preferred approach is VaR (value at risk).
The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.
The third pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying structural models, and the complexities of public policy and existing regulation. Banks' senior management will determine corporate strategy, as well as the country in which to base a particular type of business, based in part on how Basel II is ultimately interpreted by various countries' legislatures and regulators.
Economic reforms in 1991
India was a latecomer to economic reforms, embarking on the process in earnest only in 1991, in the wake of an exceptionally severe balance of payments crisis. The need for a policy shift had become evident much earlier, as many countries in East Asia achieved high growth and poverty reduction through policies, which emphasized greater export orientation and encouragement of the private sector. India took some steps in this direction in the 1980s, but it was not until 1991 that the government signaled a systemic shift to a more open economy with greater reliance upon market forces, a larger role for the private sector including foreign investment, and a restructuring of the role of government.
India's economic performance in the post-reforms period has many positive features. The average growth rate in the ten year period from 1992-93 to 2001-02 was around 6.0 percent, slightly better than the annual average of 5.7 percent in the 1980s, but it can be argued that the 1980s growth was unsustainable, fuelled by a buildup of external debt which culminated in the crisis of 1991.
Banking Sector Reforms in 1991 in India
India's reform program included wide-ranging reforms in the banking system and the capital markets relatively early in the process with reforms in insurance introduced at a later stage.
Banking sector reforms included:
(a) Measures for liberalization, like dismantling the complex system of interest rate controls, eliminating prior approval of the Reserve Bank of India for large loans, and reducing the statutory requirements to invest in government securities.
(b) Measures designed to increase financial soundness, like introducing capital adequacy requirements and other prudential norms for banks and strengthening banking supervision.
(c) Measures for increasing competition like more liberal licensing of private banks and freer expansion by foreign banks.
These steps have produced some positive outcomes. These steps can be detailed as:
- 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 was 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 were allowed to promote and encourage 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.
- A credit information bureau being established to identify bad risks. Derivative products such as forward rate agreements (FRAs) and interest rate swaps (IRSs) were introduced.
- Another aspect of the financial sector reforms in India is the consolidation of existing institutions, which is especially applicable to the commercial banks. In India the banks are in huge quantity. First, there is no need for 27 PSBs with branches all over India. A number of them can be merged.
The most important achievements in the banking sector after reforms of 1991 can be summed up as:
- 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 liberalization 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 of branches and foreign banks facing the constraint of limited number of branches. Hence, in order to achieve an efficient banking system, the onus is on the Government to encourage the PSBs to run on professional lines.
Banking Sector Reforms 1999-2000
The Reserve Bank continued to play a major role in the development of financial markets and improvement of credit delivery systems. In order to provide greater flexibility, the Reserve Bank has attempted to move gradually towards provision of a daily liquidity adjustment facility in the Indian money markets. The Interim Liquidity Adjustment Facility (ILAF) introduced in April 1999 was replaced in June 2000 by a full fledged liquidity adjustment facility in which liquidity would be injected through reverse repo auctions and liquidity would be sucked out through repo auctions.
The Reserve Bank undertook several measures to further facilitate the deregulation and flexibility in interest rates.
First, the Reserve Bank allowed banks the freedom to prescribe different prime lending rates (PLRs) for different maturities. Banks were accorded the freedom to charge interest rates without reference to the PLR in case of certain specified loans. Banks may also offer fixed rate term-loans in conformity with the ALM guidelines.
Secondly,scheduled commercial banks (excluding regional rural banks), PDs and all-India financial institutions were allowed to undertake forward rate agreements (FRAs)/interest rate swaps (IRS) for hedging and market making.
Thirdly, the Reserve Bank allowed the interest rates that are implied in the foreign forward exchange market to be used as an additional benchmark to price rupee interest rate derivatives and facilitate integration between money and foreign exchange markets.
The Reserve Bank advised banks and FIs in April 2000 to make necessary in-house arrangements for transmittal of the appropriate information to the Central Information Bureau.
Important measures on strengthening the health of banks included:
(i) Assigning of risk weight of 2.5% to cover market risk in respect of investments in securities, and
(ii) Lowering of the exposure ceiling in respect of an individual borrower from 25 per cent of the bank's capital fund to 20%, effective April 1, 2000.
The Reserve Bank persevered with the on-going process of strengthening prudential accounting norms with the objective of improving the financial soundness of banks by reducing the stock of NPAs by encouraging the banks to go in for compromise settlements in a transparent manner.
The Reserve Bank advised banks in February 1999 to put in place an ALM system. The Reserve Bank also released ALM system guidelines in January 2000 for all-India term-lending and refinancing institutions. As per the guidelines, banks and such institutions were required to prepare statements on liquidity gaps and interest rate sensitivity at specified periodic intervals.
The Reserve Bank issued detailed guidelines for risk management systems and banks would put in place loan policies, approved by their boards of directors, covering the methodologies for measurement, monitoring and control of credit risk.
As a move towards greater transparency, banks were directed to disclose the following additional information in the 'Notes to Accounts' in the balance sheets from the accounting year ended March 31, 2000:
a. Maturity pattern of loans and advances, investment securities, deposits and borrowings,
b. Foreign currency assets and liabilities,
c. Movements in NPAs and
d. Lending to sensitive sectors as defined by the Reserve Bank from time to time.
The Reserve Bank had set up a Working Group (Chairman: Shri M. S. Verma) to suggest measures for the revival of weak PSBs in February 1999.The Working Group, in its report submitted in October 1999, suggested that an analysis of the performance based on a combination of seven parameters covering three major areas of
1. Solvency (capital adequacy ratio and coverage ratio),
2. Earnings capacity (return on assets and net interest margin) and
3. Profitability (operating profit to average working funds, cost to income and staff cost to net interest income plus all other income).
CONSOLIDATION IN BANKING SECTOR
"Consolidation alone will give banks the muscle, size and scale to act like world-class banks. We have to think global and act local and seek new markets, new classes of borrowers. It is heartening to note that the Indian Banks' Association is working out a strategy for consolidation among banks."
It is inevitable! In the Indian banking scenario, consolidation is the next step for evolution.
A look at the international scene suggests that, size does matter. To put things in perspective; State Bank of India is three times the size of Bank of America (BoA). SBI is reaching 90 to 100 million customers while BoA has 30 million customers.
But if you look at assets, BoA has more than a trillion dollar of assets as against SBI's asset size of Rs 4,000 billion. That gives BoA the muscle to cut costs and amplify earnings.
In this scenario, if banks are to be made more effective, efficient and comparable with their counterparts functioning abroad, they would need to be more capitalized, automated and technology oriented, even while strengthening their internal operations and systems.
Bank Consolidation assumes significance from the point of view of making Indian banking strong and sound apart from its growth and development to become sustainable
Benefits Of Consolidation
- As competition heats up, many banks having bigger size, will command more in the market. A bigger bank would have more staff strength, greater geographical reach, more financial resources, more delegated power and less operational and transactional costs due to economies of scale. A bigger financial conglomeration can easily withstand external assaults more effectively.
- Mergers and acquisitions can help banks with complimentary expertise to boost up their combined talents as well as on presenting a vastly improved performance. For instance, a foreign bank with proven merit in treasury operations when merged with a bank with investible surpluses could generate substantial profits.
- The geographical and regional spread would get widened when banks with different strongholds merge. Based on the principles of synergy, the business volume and geographical reach of consolidated entity automatically increases by many folds.
- Similarly, the market image and brand name of the consolidated entity will always likely to get a boost in comparison to the individual banks. This will lead to a better market image, which in turn translates to better performance expectations by the investors and the analysts, thus finally leading to better valuations in the market. We know, that better market valuations mean better shareholder returns leading to an even better market image. Thus, a reinforcing vicious cycle would set in.
- The larger size, greater geographical penetration and enhanced market image and other synergic factors would inevitably increase the bargaining power of the new bank. In a competitive world where the battle is fierce, a better bargaining power position is always an invaluable asset.
- The business in near future is unlikely to remain localized but bound to go global. In view of the saturating environment at domestic front, banks will have to venture overseas without any hesitation. Initial foray into overseas markets are always made through strategic alliances and joint ventures. A merged entity with bigger market size, greater geographical spread, sound financial position, good image, greater resistance etc. would necessarily be successful in the overseas. All these virtues also help in acquiring tenders and bids.
- The consolidated entity can serve the end user i.e. the customer in a better way through providing single window service by offering a variety of services like conventional banking, merchant banking, mutual funds, insurance etc. under one umbrella leading to innovation and origin of new hybrid products and services like banc assurance.
- Risk Associated With Consolidation
There are several risks associated with consolidation and few of them are as follows: -
- When two banks merge into one then there is an inevitable increase in the size of the organization. Big size may not always be better. The size may get too widely and go beyond the control of the management. The increased size may become a drug rather than an asset.
- Consolidation does not lead to instant results and there is an incubation period before the results arrive. Mergers and acquisitions are sometimes followed by losses and tough intervening periods before the eventual profits pour in. Patience, forbearance and resilience are required in ample measure to make any merger a success story. All may not be up to the plan, which explains why there are high rate of failures in mergers.
- Consolidation mainly comes due to the decision taken at the top. It is a top-heavy decision and willingness of the rank and file of both entities may not be forthcoming. This leads to problems of industrial relations, deprivation, depression and demotivation among the employees. Such a work force can never churn out good results. Therefore, personal management at the highest order with humane touch alone can pave the way.
- The structure, systems and the procedures followed in two banks may be vastly different, for example, a PSU bank or an old generation bank and that of a technologically superior foreign bank. The erstwhile structures, systems and procedures may not be conducive in the new milieu. A thorough overhauling and systems analysis has to be done to assimilate both the organizations. This is a time consuming process and requires lot of cautions approaches to reduce the frictions.
- There is a problem of valuation associated with all mergers. The shareholder of existing entities has to be given new shares. Till now a foolproof valuation system for transfer and compensation is yet to emerge.
What are merger possibilities? Ideally, the State Bank of India should merge its seven associate banks with itself. This is the right time for State Bank to demonstrate its ability to extract value from its investments in associate banks. That can be done either by merging the associate banks with itself or even selling a few of them.
For instance, if State Bank is not willing to merge State Bank of Mysore or State Bank of Indore with itself, it must sell them to Industrial Development Bank of India or any other bank or institution that is willing to buy them.
If the government really wants to create a champion in the financial sector, the merged entity can additionally gobble up one of the three big Indian banks -Punjab National Bank, Canara Bank or Bank of Baroda.
If State Bank of India chairman A K Purwar is not willing to think big, the Life Insurance Corporation of India can play a major role as far as consolidation goes. It holds a 26.7 per cent stake in the Mangalore-based Corporation Bank.
While the State Bank and LIC could be big participants in the M&A game, so too could IDBI. IDBI Chairman M. Damodaran has already made public his ambition to become No 2 in the Indian banking universe by swallowing up one or more nationalized banks.
FARM LOAN WAIVER
The Finance Minister has acted Santa Clause and announced debt waiver and relief for small and marginal farmers. The banks may be on the tenterhooks but the ‘Indian farmer' is rejoicing. Marginal farmer are defined as cultivating agricultural land up to 1 hectare. A small farmer is defined as cultivating between 1 hectare and 2 hectares. They will get full debt waiver of their short-term crop loans as well as all the overdue installments on the investment credit. The other farmers, those owning over 2 hectares, will get one time settlement relief.
Agricultural loans given by scheduled commercial banks, regional rural banks and cooperative credit institutions up to March 31, 2007 and over-due as of December 31 that year will be covered under the waiver scheme to address the problem of indebtedness of farmers.
The move will cost the government a total of Rs 60,000 crore - the waiver costing Rs 50,000 cr and a 25 per cent discount on the one time waiver to cost Rs 10,000 crore.
The loan waiver scheme will benefit three crore small and medium farmers and cover loans worth Rs 50,000 crore in total - that is 4 per cent of the total loans of commercial banks One crore other farmers will benefit to the tune of Rs 10,000 crore in the waiver.
According to industry sources, the banks have reasons to be happy, as there was an implicit hint that they would get reimbursed accordingly. In that scenario, the move will help the banks to get rid of bad debt.
The farm loan wavier impact on PSU banks really depends on the government, since they have offered to compensate Rs 60,000 crore to the banks over the next three years. But the government hasn't given any clarity as to how they are going to compensate these banks. It will act as a positive in the short-term as banks would be able to write-back provisions and also help pre-empted potential NPAs. The modalities of compensation to banks are not clear, but reports suggest that it could be a combination of bonds and cash to compensate for the waiver.
If it is cash then the banks will get it over a period of three-years, which is slightly tardy, but it would not impact the banks in anyway.
And if it is bonds then it depends on whether these bonds have an SLR status. If it is SLR status then it's good for banks, since it is as good as money for banks and also if the bonds classify for tier-two capital then that also will free up a lot of cash for banks.
So if any of these modes are followed, it will bepositive for banks in the short-term. In the long run, it could increase the risk of defaults by farmers hence making lending to the agriculture sector riskier. But it depends on what is going to be the clear mode and unless the government clarifies on that account, it would be really difficult to say what kind of impact will there be on PSU banks.
BANKING SECTOR - INVESTMENT CASE
Close proximity to GDP
India is highly under banked with approximately 50% of adults having a bank account. But the rising income levels together with increasing standard of living will lead to more opening up of bank accounts. The Banking sector is a very close proximity to GDP. In the last 5 years, advances have grown 3 times real GDP growth and advances have grown 2.5 times real GDP growth. With India expected to clock GDP growth rate of around 8%, the banking industry will continue to get the required push.
Advances growth to GDP growth
Deposit growth to GDP growth
The asset quality of banks has reduced substantially over the last few years. The gross NPAs have come down significantly from 7% in 2003-04 to 3% in 2006-07 and net NPAs have fallen to 3% and 1% during the corresponding periods. Also, the Indian banks do not have exposure to the U.S subprime related losses. Also, it may be noted that the market share of foreign banks in total Indian banking asset is one of the lowest.
Bank credit -well diversified among sectors
The NIMs have remained stable at ~3% since 1993 irrespective of the large interest rate movements that have happened. The improving operating efficiencies and increase in the other income component over that last few years has resulted in the ROE and ROA improving.
Though the secular growth story of the banking industry remains firm, the current high interest rate, high inflation scenario has worked against the banking sector. Given below are some factors:
v Rising Inflation and interest rates
Rising inflation has played spoilsport and dampened expectations of benign interest rate scenario in India, which was widely believed by most in the industry. After the CRR hike, the belief that the firm interest rate scenario is here to stay for some more time. Nevertheless, the outlook for margins is that of caution, especially for public sector banks.
Inflation rates are rising
The rise in inflation due to indirect cost increases post the fuel price hike. Money supply, deposit and non-food credit growth continues to be way above the RBI's target zone, and hence further tightening policy action with double-digit inflation (likely to persist in the near term) cannot be ruled out.
Interest rates are rising
RBI hiking the key rates is pushing up rates
The RBI hiked repo rates to curb higher inflationary expectations. This will be a triple whammy for the banking system because
(a) Credit growth will slow down
(b) CRR hike will take a toll on margins
(c) Bond yields will move up, which means treasury losses will also mount
- Lower credit growth
Credit growth has slowed down from over 30% last year to about 22% as on March 28 - below RBI's expectations of 24-25% in FY08. If rates remain at higher levels or rise marginally, it could further pull down the country's economic growth rate and also, the credit growth. In other words, it will be negative, especially for public sector banks, which derive a major part of their interest income from corporate loans. For private banks, a slowdown in retail credit offtake will hurt, as they have a higher exposure to retail loans.
- NIM under pressure due to high deposit rates and not so high lending rates
Net interest margin will be under pressure primarily due to high inflation, which has caused RBI to hike the key rates (repo rates). Now if the key rates are high banks will have to increase their lending rates to a certain limit and they also cannot decrease the deposit rates, hence thinning the interest margin. The increase in interest rates would now harden in the system, with banks having to increase their deposit and lending rates.
- Slowdown in other income
While banks could be hit in their core business, the other risk, which is looming large, is the potential slowdown in their other income growth. For public sector banks, the major source of other income is in the form of treasury profits in bonds market and distribution of third party products like mutual funds and insurance. Banks, which had collected huge money in anticipation of pick-up in credit growth, had parked their money in investments.
With rising inflation, yields on government securities have also been moving up for the past few weeks. Thus, there could be some mark-to-market hit on their portfolio. Also, with stock markets in a bad shape, the flow of new business pertaining to distribution of mutual funds and insurance products could be impacted. Private sector banks are at a bigger risk to slowdown in other income as they were enjoying high valuations due to the strong support from other income growth.
The anticipated hit on account of forex derivative losses will not only pose them to greater risk in terms of fulfilling the obligations, but will also affect their future prospects of getting derivatives business. Also, with equity markets in doldrums, expect some impact of this on income of banks.
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