ASSIGNMENT ON

CURRENT CHALLENGES AND ISSUES IN

INDIAN BANKING

Submitted by

RAJA PAVAN KUMAR J

09AC31

INTRODUCTION
 The growing role of the financial sector in allocation of resources has significant potential
advantages for the efficiency with which our economy functions. Consequently, the adverse
consequences of malfunction of the financial system are likely to be more severe than they used to
be in the past. Hence, all our efforts today are focused at ensuring greater financial stability. Given
the significance of the Indian banking system, one cannot afford to underplay the importance of a
robust and resilient banking system.

The enhanced role of the banking sector in the Indian economy, the increasing levels of
deregulation along with the increasing levels of competition have facilitated globalisation of the
India banking system and placed numerous demands on banks. Operating in this demanding
environment has exposed banks to various challenges. The last decade has witnessed major changes
in the financial sector - new banks, new financial institutions, new instruments, new windows, and
new opportunities - and, along with all this, new challenges. While deregulation has opened up new
vistas for banks to augment revenues, it has entailed greater competition and consequently greater
risks. Demand for new products, particularly derivatives, has required banks to diversify their
product mix and also effect rapid changes in their processes and operations in order to remain
competitive in the globalised environment.

A healthy banking system is essential for any economy striving to achieve good growth
and yet remain stable in an increasingly global business environment. The Indian banking system,
with one of the largest banking networks in the world, has witnessed a series of reforms over the
past few years like the deregulation of interest rates, dilution of the government stake in public
sector banks (PSBs), and the increased participation of private sector banks. The growth of the retail
financial services sector has been a key development on the market front. Indian banks (both public
and private) have not only been keen to tap the domestic market but also to compete in the global
market place. New foreign banks have been equally keen to gain a foothold in the Indian market.

The momentum in credit growth has been maintained during 2005-06 due to two factors:
The corporate sector has stepped up its demand for credit to fund its expansion plans; there has also
been a growth in retail banking. However, even as the opportunities increase, there are some issues
and challenges that Indian banks will have to contend with if they are to emerge successful in the
medium to long term. This report discusses these issues and challenges -- both intrinsic and external,
such as,

1. Globalisation
2. Basel II implementation
3. Interest rate risk
4. Interest rates and non-performing assets(NPA’s)
5. Competition in retail banking
6. The urge to merge
7. Capital efficiency
8. Enhancing corporate governance
9. Compliance with international accounting standards
10. In closing
11. Outsourcing risks
12. Application of advanced technology
 13. Capacity building

Globalisation – a challenge as well as an opportunity

The benefits of globalisation have been well documented and are being increasingly
recognised. Globalisation of domestic banks has also been facilitated by tremendous advancement
in information and communications technology. Globalisation has thrown up lot of opportunities but
accompanied by concomitant risks. There is a growing realisation that the ability of countries to
conduct business across national borders and the ability to cope with the possible downside risks
would depend, inter-alia, on the soundness of the financial system and the strength of the individual
participants. Adoption of appropriate prudential, regulatory, supervisory, and technological
framework on par with international best practices enables strengthening of the domestic banking
system, which would help in fortifying it against the risks that might arise out of globalisation. In
India, we had strengthened the banking sector to face the pressures that may arise out of
globalisation by adopting the banking sector reforms in a calibrated manner, which followed the
twin governing principles of non-disruptive progress and consultative process1.

Global challenges in banking

A few broad challenges faced by the Indian banks in the following areas, viz., enhancement
of customer service; application of technology; implementation of Basel II; improvement of risk
management systems; implementation of new accounting standards; enhancement of transparency
& disclosures; and compliance with KYC aspects. If we were to identify a few global challenges which
banks face today. An overview of the global challenges would include the following: Basel II
implementation; enhancing corporate governance; alignment of regulatory and accounting
requirements; outsourcing risks; and application of advanced technology.

Basel II implementation

Basel II implementation is widely acknowledged as a significant challenge faced by both

banks and the regulators internationally. It is true that Basel II implementation may be seen as a
compliance challenge. While it may be so for some banks, venture to mention that Basel II
implementation has another dimension which offers considerable opportunities to banks. To
highlight two opportunities those are offered to banks, viz., refinement of risk management systems;
and improvement in capital efficiency

Comprehensive risk management: Under Basel I banks were focused on credit and market
risks. Basel II has brought into focus a larger number of risks requiring banks to focus on a larger
canvas. Besides the increase in the number of risks, banks are now beginning to focus on their inter-
linkages with a view to achieve a more comprehensive risk management framework. Basel II
implementation, therefore, is being increasingly seen as a medium through which banks constantly
endeavour to upgrade the risk management systems to address the changing environment. Further,
in the initial stages, banks were managing each risk in isolation. It is no longer adequate to manage
each risk independently. Enterprises worldwide are, therefore, now putting in place an integrated
framework for risk management which is proactive, systematic and spans across the entire
organisation. Banks in India are also moving from the individual silo system to an enterprise wide
risk management system. While the first milestone would be risk integration across the entity, banks
are also aware of the desirability of risk aggregation across the group both in the specific risk areas
as also across the risks. Banks would, therefore, be required to allocate significant resources towards
this endeavour.

Interest rate risk

Interest rate risk can be defined as exposure of bank's net interest income to adverse movements in
interest rates. A bank's balance sheet consists mainly of rupee assets and liabilities. Any movement
in domestic interest rate is the main source of interest rate risk.

Over the last few years the treasury departments of banks have been responsible for a substantial
part of profits made by banks. Between July 1997 and Oct 2003, as interest rates fell, the yield on 10-
year government bonds (a barometer for domestic interest rates) fell, from 13 per cent to 4.9 per
cent. With yields falling the banks made huge profits on their bond portfolios.

Now as yields go up (with the rise in inflation, bond yields go up and bond prices fall as the debt
market starts factoring a possible interest rate hike), the banks will have to set aside funds to mark
to market their investment.

This will make it difficult to show huge profits from treasury operations. This concern becomes much
stronger because a substantial percentage of bank deposits remain invested in government bonds.

Banking in the recent years had been reduced to a trading operation in government securities.
Recent months have shown a rise in the bond yields has led to the profit from treasury operations
falling. The latest quarterly reports of banks clearly show several banks making losses on their
treasury operations. If the rise in yields continues the banks might end up posting huge losses on
their trading books. Given these facts, banks will have to look at alternative sources of investment.

Interest rates and non-performing assets

The best indicator of the health of the banking industry in a country is its level of NPAs. Given this
fact, Indian banks seem to be better placed than they were in the past. A few banks have even
managed to reduce their net NPAs to less than one percent (before the merger of Global Trust Bank
into Oriental Bank of Commerce, OBC was a zero NPA bank). But as the bond yields start to rise the
chances are the net NPAs will also start to go up. This will happen because the banks have been
making huge provisions against the money they made on their bond portfolios in a scenario where
bond yields were falling.

Reduced NPAs generally gives the impression that banks have strengthened their credit appraisal
processes over the years. This does not seem to be the case. With increasing bond yields, treasury
income will come down and if the banks wish to make large provisions, the money will have to come
from their interest income, and this in turn, shall bring down the profitability of banks.
Competition in retail banking

The entry of new generation private sector banks has changed the entire scenario.
Earlier the household savings went into banks and the banks then lent out money to corporate. Now
they need to sell banking. The retail segment, which was earlier ignored, is now the most important
of the lot, with the banks jumping over one another to give out loans. The consumer has never been
so lucky with so many banks offering so many products to choose from. With supply far exceeding
demand it has been a race to the bottom, with the banks undercutting one another. A lot of foreign
banks have already burnt their fingers in the retail game and have now decided to get out of a few
retail segments completely.

The nimble footed new generation private sector banks have taken a lead on this front and the
public sector banks are trying to play catch up.

The PSBs have been losing business to the private sector banks in this segment. PSBs need to figure
out the means to generate profitable business from this segment in the days to come.

The urge to merge

In the recent past there has been a lot of talk about Indian Banks lacking in scale and size. The State
Bank of India is the only bank from India to make it to the list of Top 100 banks, globally. Most of the
PSBs are either looking to pick up a smaller bank or waiting to be picked up by a larger bank.

The central government also seems to be game about the issue and is seen to be encouraging PSBs
to merge or acquire other banks. Global evidence seems to suggest that even though there is great
enthusiasm when companies merge or get acquired, majority of the mergers/acquisitions do not
really work.

So in the zeal to merge with or acquire another bank the PSBs should not let their common sense
take a back seat. Before a merger is carried out cultural issues should be looked into. A bank based
primarily out of North India might want to acquire a bank based primarily out of South India to
increase its geographical presence but their cultures might be very different. So the integration
process might become very difficult. Technological compatibility is another issue that needs to be
looked into in details before any merger or acquisition is carried out.

The banks must not just merge because everybody around them is merging. As Keynes wrote,
"Worldly wisdom teaches us that it's better for reputation to fail conventionally than succeed
unconventionally". Banks should avoid falling into this trap.

Capital efficiency

Basel II prescriptions have ushered in a transition from the traditional regulatory

measure of capital adequacy to an evaluation of whether a bank has found the most efficient use of
its capital to support its business i.e., a transition from capital adequacy to capital efficiency. In this
transition, how effectively capital is used will determine return on equity and a consequent
enhancement of shareholder value. In effect, banks may adopt a more dynamic approach to use of
capital, in which capital will flow quickly to its most efficient use. This revised efficiency approach is
expected to guide the return-on-equity strategy and influence banks’ business plans. With the
extension of capital charge for market risks to the AFS portfolio this year and the coming into force
of Basel II norms in March 2007, banks would need to shore up the capital levels not only for
complying with these requirements but also for supporting the balance sheet growth. With a view to
enhancing the options available to banks for augmenting their capital levels, the Reserve Bank has
recently permitted banks to issue new capital instruments, including perpetual instruments. A
notable feature of these instruments is that these are designed to help banks in not only managing
their capital effectively but also efficiently.

Enhancing corporate governance

The issues related to corporate governance have continued to attract considerable

national and international attention in light of a number of high-profile breakdowns in corporate
governance. This becomes all the more relevant for banks since they not only accept and deploy
large amount of uncollateralized public funds in fiduciary capacity, but also leverage such funds
through credit creation. Banks are also important participants in the payment and settlement
systems. In view of the above, legal prescriptions for ownership and governance of banks in Banking
Regulation Act, 1949 have been supplemented by regulatory prescriptions issued by RBI from time
to time.

In view of the importance of the banking system for financial stability, sound corporate
governance is not only relevant at the level of the individual bank, but is also a critical ingredient at
the system level. Effective risk management systems determine the health of the financial system
and its ability to survive economic shocks. To a large extent, many risk management failures reflect a
breakdown in corporate governance which arise due to poor management of conflicts of interest,
inadequate understanding of key banking risks, and poor Board oversight of the mechanisms for risk
management and internal audit. Corporate governance is, therefore, the foundation for effective risk
managements in banks and thus the foundation for a sound financial system. Therefore, the choices
which banks make when they establish their risk management and corporate governance systems
have important ramifications for financial stability. These systems can affect how the institution
functions and how others perceive it in the marketplace.

A good “governance culture” is crucial for financial stability but since it is an ‘intangible’,
rules may not be able to capture its essence effectively. Therefore, banks may have to cultivate a
good governance culture building in appropriate checks and balances in their operations. There are
four important forms of oversight that should be included in the organisational structure of any bank
in order to ensure appropriate checks and balances: (1) oversight by the board of directors or
supervisory board; (2) oversight by individuals not involved in the day-to-day running of the various
business areas; (3) direct line supervision of different business areas; and (4) independent risk
management, compliance and audit functions. In addition, it is important that key personnel are fit
and proper for their jobs. Although some ownership structures might have the potential to alter the
strategies and objectives of a bank, these banks will also face many of the same risks associated with
weak corporate governance. Consequently, the general principles of sound corporate governance
should also be applied to all banks irrespective of their unique ownership structures4.

Compliance with international accounting standards

One of the prime international standards considered relevant for ensuring a safe and sound
banking system is the ‘Core Principles for Effective Banking Supervision’ issued by the Basel
Committee on Banking Supervision (BCBS). Accounting standards are now a part of the set of twelve
standards that have been identified by the Financial Stability Forum as conducive to a robust
financial infrastructure. Financial reporting and prudential supervision have slightly different
perspectives. While the former is oriented towards capturing the historical position, the latter has a
forward looking element particularly with reference to measurement of impairment and capital. An
important challenge, therefore, is to ensure that accounting standards and prudential frameworks
are mutually consistent. While working towards achieving this consistency between the two sets of
standards, it is essential for the regulators to be in a position to address any implications that the
changes in accounting standards may have for the safety and soundness of banks.

Derivative activity in banks in India has been increasing at a brisk pace. While the risk
management framework for derivative trading, which is a relatively new area for Indian banks
(particularly more in respect of structured products), is an essential pre-requisite, the absence of
clear accounting guidelines in this area is matter of significant concern. It is widely accepted that as
the volume of transactions increases, which is happening in the Indian banking system, the need to
upgrade the accounting framework needs no emphasis. The World Bank’s ROSC on Accounting and
Auditing in India has commented on the absence of an accounting standard which deals with
recognition, measurement, presentation and disclosures pertaining to financial instruments. The
Accounting Standards Board of the Institute of Chartered Accountants of India (ICAI) is considering
issue of Accounting Standards on the above aspects pertaining to financial Instruments. These will
be the Indian parallel to International Financial Reporting Standard 7, International Accounting
Standards 32 and 39. The proposed Accounting Standards will be of considerable significance for
financial entities and could therefore have implications for the financial sector. The formal
introduction of these Accounting Standards by the ICAI is likely to take some time in view of the
processes involved. In the meanwhile, the Reserve Bank is considering the need for banks and
financial entities adopting the broad underlying principles of IAS 39. Since this is likely to give rise to
some regulatory / prudential issues all relevant aspects are being comprehensively examined. The
proposals in this regard would, as is normal, be discussed with the market participants before
introduction. Adoption and implementation of these principles are likely to pose a great challenge to
both the banks and the Reserve Bank.

In closing

Over the last few years, the falling interest rates, gave banks very little incentive to lend to projects,
as the return did not compensate them for the risk involved. This led to the banks getting into the
retail segment big time. It also led to a lot of banks playing it safe and putting in most of the deposits
they collected into government bonds. Now with the bond party over and the bond yields starting to
go up, the banks will have to concentrate on their core function of lending.

The banking sector in India needs to tackle these challenges successfully to keep growing and
strengthen the Indian financial system.

Furthermore, the interference of the central government with the functioning of PSBs should stop. A
fresh autonomy package for public sector banks is in offing. The package seeks to provide a high
degree of freedom to PSBs on operational matters. This seems to be the right way to go for PSBs.

The growth of the banking sector will be one of the most important inputs that shall go into making
sure that India progresses and becomes a global economic super power.

Outsourcing risks

Banks are increasingly using outsourcing for achieving strategic aims leading to either
rationalisation of operational costs or tapping specialist expertise which is not available internally.
'Outsourcing' may be defined as a bank's use of a third party, including an affiliated entity within a
corporate group, to perform activities on a continuing basis that would normally be undertaken by
the bank itself. Typically outsourced financial services include applications processing (loan
origination, credit card), document processing, investment management, marketing and research,
supervision of loans, data processing and back office related activities etc.

Outsourcing might give rise to several risks including, strategic risk, reputation risk,
compliance risk, operational risk, exit strategy risk, counterparty risk, country risk, access risk,
concentration risk and systemic risk. The failure of a service provider to provide a specified service,
ensure security/ confidentiality, and comply with legal and regulatory requirements can lead to
financial losses/ reputational risk for the bank and could also lead to systemic risks for the entire
banking system in a country. It would therefore be imperative for the bank outsourcing its activities
to ensure effective management of these risks.

It is in this background that RBI has issued draft guidelines on outsourcing, which is intended
to provide direction and guidance to banks to effectively manage risks arising from such outsourcing
activities. The underlying principles for any outsourcing arrangement by a bank are that such
arrangements should neither diminish the bank’s ability to fulfill its obligations to its customers and
the RBI nor impede effective supervision by RBI. Outsourcing banks, therefore, should take steps to
ensure that the service provider employs the same high standard of care in performing the services
as would be employed by the banks if the activities were conducted within the banks and not
outsourced. Accordingly, banks are not expected to outsource any activity that would result in their
internal control, business conduct, or reputation being compromised or weakened.

Application of advanced technology

Technology is a key driver in the banking industry, which creates new business models and
processes, and also revolutionises distribution channels. Banks which have made inadequate
investment in technology have consequently faced an erosion of their market shares. The
beneficiaries are those banks which have invested in technology. Adoption of technology also
enhances the quality of risk management systems in banks. Recognising the benefits of modernising
their technology infrastructure banks are taking the right initiatives. While doing so, banks have four
options to choose from: they can build a new system themselves, or buy best of the modules, or buy
a comprehensive solution, or outsource. In this context banks need to clearly define their core
competencies to be sure that they are investing in areas that will distinguish them from other
market players, and give them a competitive advantage6. A further challenge which banks face in
this regard is to ensure that they derive maximum advantage from their investments in technology
and avoid wasteful expenditure which might arise on account of uncoordinated and piecemeal
adoption of technology; adoption of inappropriate/ inconsistent technology and adoption of
obsolete technology.

Capacity building

As dictated by the changing environment, banks need to focus on appropriate capacity

building measures to equip their staff to handle advanced risk management systems and supervisors
also need to equally equip themselves with appropriate skills to have effective supervision of banks
adopting those systems. In the likelihood of a high level of attrition in the system, banks need to
focus on motivating their skilled staff and retaining them. Skill requirements would be significantly
higher for banks planning to migrate to the advanced approaches under Basel II. Capacity building
gains greater relevance in these banks, so as to equip themselves to take advantage of the incentives
offered under the advanced approaches.

A relevant point in this regard is that capacity building should be across the institution and
not confined to any particular level or any particular area. The demand for better skills can be met
either from within or from outside. It would perhaps be worthwhile to first glean through the
existing resources to identify misplaced or hidden or forgotten resources and re-position them to
boost the bank’s efforts to capitalise on available skills. This does not undermine the benefits that a
bank may derive by meeting their requirements from the market, but is only intended to prioritise
the process.

Strategic options with banks to cope with the challenges

Leading players in the industry have embarked on a series of strategic and tactical initiatives to
sustain leadership. The major initiatives include:

 Investing in state of the art technology as the back bone to ensure reliable service delivery.
 Leveraging the branch network and sales structure to mobilize low cost current and savings
deposits.
 Making aggressive forays in the retail advances segment of home and personal loans.
 Implementing organization wide initiatives involving people, process and technology to
reduce the fixed costs and cost per transaction.
  Focusing on fee based income to compensate for squeezed spread, (e.g. CMS, trade
services).
 Innovating Products to capture customer ‘mind share’ to begin with and later the wallet
share.
 Improving the asset quality as per Base II norms

Conclusion

The global challenges which banks face are not confined only to the global banks. These
aspects are also highly relevant for banks which are part of a globalised banking system. Further,
overcoming these challenges by the other banks is expected to not only stand them in good stead
during difficult times but also augurs well for the banking system to which they belong and will also
equip them to launch themselves as a global bank.

REFERENCES:

1. Dr. Y.V. Reddy on Banking Sector Reforms in India An Overview at the Institute of Bankers of
Pakistan, Karachi, Pakistan, May 18, 2005

2. Dr. Alan Bollard, Corporate governance in the financial sector, Christchurch, New Zealand, 7
April 2003.

3. Mark W. Olson, Business Trends and Management Challenges for the Banking Industry,
Annual Economic Outlook Conference, Middle Tennessee State University, Murfreesboro,
Tennessee, 16 September 2005

4. Enhancing corporate governance for banking organisations, Consultative document issued

by BCBS, July 2005.

5. Malcolm D Knight, Banking and insurance regulation and supervision: Greater convergence,
common challenges, Madrid, 22-23 September 2004

6. UBS AG, The Bank for Banks Industry Challenges. August 2004

7. Ms. K.J.Udeshi, Financial System Stability and Basel II - Way Forward, Sri Lanka, August
2005.