A STUDY ON THE COST AND PROFITABILITY OF BANKS IN INDIA.

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Bachelor of Commerce Ba !" # $ I %&ra ce S ! &t r ' (2%12)13* Su"!#tt d "+ D,NISH -HIRO. D/0,SH H.R. COLLEGE OF COMMERCE & ECONOMICS 123, D.W. Road, Churchgat , Mu!"a# $ 4%% %2%.

A STUDY ON THE COST AND PROFITABILITY OF BANKS IN INDIA.

Bachelor of Commerce Ba !" # $ I %&ra ce S ! &t r ' I1 -art#a2 Fu23#22! 1t o3 th r 4u#r ! 1t& For th ,5ard o3 D gr o3 0ach 2or o3 Co!! rc $ 0a16#1g & I1&ura1c Su"!#tt d "+ MS. D,NISH -HIRO. D/0,SH Ro22 No.14 H.R. COLLEGE OF COMMERCE & ECONOMICS 123, D.W. Road, Churchgat , Mu!"a# $ 4%% %2%.

DECLARATION

I Miss DANISH PHIROZ DUBASH the stu%ent of B.Com.- Banking & Insurance Semester V 2! 12 - 2!13" here,y %ec#are that I ha-e com$#ete% the 'ro&ect on ' Stud( o) the Co*t ')d H.R. COLLEGE OF COMMERCE & ECONOMICS +ro,"ta!"-t( O, .a)/* ") I)d"a0 123, D.W. Road, Churchgate, Mu !a" # $%% %2%. *+terna# *+aminer The information su,mitte% is true an% origina# to the ,est of my kno.#e%ge. This is to certify that Shri / Miss DANISH PHIROZ DUBASH of B.Com.Banking & Insurance Semester V 2!12 - 2!13 " has successfu##y com$#ete%Signature the $ro&ect on &' Stud( o) the Co*t ')d +ro,"ta!"-t( O, .a)/* ") I)d"a0 un%er the gui%ance of 'rof. Meena (esai. (/0IS1 '1I234 (5B/S1 2o## 0o. 16 Course Co-or%inator 'rinci$a#

CERTIFICATE

'ro&ect )ui%e / Interna# *+aminer

'C1NOWLEDGEMEN2

I would like to express my gratitude to the professor in charge and my guide +ro,. Mee)a De*a" for her extensive support and guidance and also for providing the relevant information.

I would like to thank our head +ro, Hee)a 2ha//ar for providing us with the opportunity of such a unique learning experience.

E3EC42I5E S4MM'R6.
The term 'profit' is an accounting concept which shows the excess of income over expenditure viewed during a specified period of time. Profit is the main reason for the continued existence of every commercial organisation. On the other hand, the term profita ility is a relative measure where profit is expressed as a ratio, generally as a percentage. Profita ility depicts the relationship of the a solute amount of profit with various other factors. Profita ility is the most important and relia le indicator as it gives a road indicator of the a ility of a ank to raise its income level. Profita ility of anks is affected y a num er of factors. !ome of these are endogenous, some are exogenous. "hanges in policies made y #$I are exogenous to the system. These include changes in monetary policy, changes in quantitative credit control like changes in cash reserve ratio, statutory liquidity ratio, manipulation of ank rates, qualitative credit controls like selective credit control measures, credit deposit ratio, region% wise guidelines on lending to priority sector, changes in interest rates on deposits and advances, levy of tax on interest income etc. &arious other factors like careful control of expenditure, timely recovery of loans are endogenous. In practice executives define profits in anks as the difference etween total earnings from all earning assets and total expenditure on managing entire assetlia ilities portfolio. In case of anks, the main source of income is interest earned and discount on ills discounted. !ince anks accept various types of deposits from people so interest paid to customer is an important expenditure of the anks. The difference etween interest earned and interest paid is known as spread and is a goodindicator of ank's efficiency. 'sta lishment expenses covering salaries, provident fund, allowances, onus and so on, form another important component of expenditure.Profit is the very reason for the continued existence of every commercial organisation.The rate of profita ility and volume of profits are

therefore rightfully considered as indicators of efficiency in the deployment of resources of anks.

INDE3
Ser"aNo.

2o7"c
Introduction to the Banking Sector Classification Of Banking Industry Need of Banks. Regulations for Indian Banks. Need For Cost And Profitabilty Of Banks. Cost And Profitabilty In Banks Assets & Liabilties of Banks. efor!s on Banking Syste!"s Li#uidity & Profitabilty . Perfor!ance and Profitability of Indian Banks in the Post Liberali$ation Period. Cost %eter!ining Factors. FAC&O S AFF'C&IN( &)' P OFI&ABILI&* OF BAN+S . FAC&O S %'&' ,ININ( &)' LI-.I%I&* OF BAN+S . Li#uidity isk ,anage!ent Assess!ent of Li#uidity ,anage!ent in Banks. %ata 'n/elo0!ent Analysis for Asses!ent of Costs and Profitabilty. ising Interest ates & Bank"s Profit

+age No.

)%(*

+ . * , / 0 ) (1 (( (+ (. (* (,

(,%((/%+. +*%+/ +0%+) .1%.+ .. .*%., .-%./ .0%*1 *(%*+ *.%**/%*0 *)%,( ,+%-1

Ser/ice Charges1 ,a2or Costs of the Banks in India ANAL*SIS OF FINANCIAL S&A&','N&S OF BAN+S 1 P OFI&3 P OFI&ABILI&* AN% B 'A+ '4'N L'4'L

((/ (0

Challeneges before ,ange!ents of Banks. Articles relating to Cost and Profitability of Banks. Bibliogra0hy & eferences.

-(%-+ -.%/1 /(

I)troduct"o) to the .a)/")g Sector ") INDI'.

2 ank is a financial institution that provides anking and other financial services to their customers. 2 ank is generally understood as an institution which provides fundamental anking services such as accepting deposits and providing loans. There are also non anking institutions that provide certain anking services without meeting the legal definition of a ank. $anks are a su set of the financial services industry. 2 anking system also referred as a system provided y the ank which offers cash management services for customers, reporting the transactions of their accounts and portfolios, through out the day. The anking system in India, should not only e hassle free ut it should e a le to meet the new challenges posed y the technology and any other external and internal factors. 3or the past three decades, India4s anking system has several outstanding achievements to its credit. The $anks are the main participants of the financial system in India. The $anking sector offers several facilities and opportunities to their customers. 2ll the anks safeguards the money and valua les and provide loans, credit, and payment services, such as checking accounts, money orders, and cashier4s cheques. The anks also offer investment and insurance products. 2s a variety of models for cooperation and integration among finance industries have emerged, some of the traditional distinctions etween anks, insurance companies, and securities firms have diminished. In spite of these changes, anks continue to maintain and perform their primary role5accepting deposits and lending funds from these deposits.
1!

C-a**","cat"o) o, .a)/")g I)du*tr( ") I)d"a

Indian anking industry has een divided into two parts, organi6ed and unorgani6ed sectors. The organi6ed sector consists of #eserve $ank of India, "ommercial $anks and "o%operative $anks, and !peciali6ed 3inancial Institutions 7I8$I, I"I"I, I3" etc9. The former two have since ecome full fledged $anks.The unorgani6ed sector, which is not homogeneous, is largely made up of money lenders and indigenous ankers. 2n outline of the Indian $anking structure may e presented as follows:% (. #eserve anks of India. +. Indian !cheduled "ommercial $anks. a9 !tate $ank of India and its associate anks. 9 Twenty nationali6ed anks. c9 #egional rural anks. d9 Other scheduled commercial anks. .. 3oreign $anks *. ;on%scheduled anks. ,. "o%operative anks.

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Need o, the .a)/*.

$efore the esta lishment of anks, the financial activities were handled y money lenders and individuals. 2t that time the interest rates were very high. 2gain there were no security of pu lic savings and no uniformity regarding loans. !o as to overcome such pro lems the organi6ed anking sector was esta lished, which was fully regulated y the government. The organi6ed anking sector works within the financial system to provide loans, accept deposits and provide other services to their customers. The following functions of the ank explain the need of the ank and its importance: < To provide the security to the savings of customers. < To control the supply of money and credit < To encourage pu lic confidence in the working of the financial system, increase savings speedily and efficiently. < To avoid focus of financial powers in the hands of a few individuals and institutions. < To set equal norms and conditions 7i.e. rate of interest, period of lending etc9 to all types of customers.

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Regu-at"o)* ,or I)d"a) !a)/*

"urrently in most =urisdictions commercial anks are regulated y government entities and require a special ank license to operate. >sually the definition of the usiness of anking for the purposes of regulation is extended to include acceptance of deposits, even if they are not repaya le to the customer's order5although money lending, y itself, is generally not included in the definition. >nlike most other regulated industries, the regulator is typically also a participant in the market, i.e. a government%owned 7central9 ank. "entral anks also typically have a monopoly on the usiness of issuing anknotes. ?owever, in some countries this is not the case. In >@, for example, the 3inancial !ervices 2uthority licenses anks, and some commercial anks 7such as the $ank of !cotland9 issue their own anknotes in addition to those issued y the $ank of 'ngland, the >@ government's central ank. !ome types of financial institutions, such as uilding societies and credit unions, may e partly or wholly exempted from ank license requirements, and therefore regulated under separate rules. The requirements for the issue of a ank license vary etween =urisdictions ut typically include: < Ainimum capital B Ainimum capital ratio < '3it and Proper' requirements for the ank's controllers, owners, directors, andCor senior officers

13

< 2pproval of the ank's usiness plan as eing sufficiently prudent and plausi le. I)d"a) Schedu-ed Co erc"a- .a)/*

The commercial anking structure in India consists of scheduled commercial anks, and unscheduled anks. Scheduled Banks: !cheduled $anks in India constitute those anks which have een included in the second schedule of #$I act ().*. #$I in turn includes only those anks in this schedule which satisfy the criteria laid down vide section *+7-a9 of the 2ct. D!cheduled anks in IndiaE means the !tate $ank of India constituted under the !tate $ank of India 2ct, (),, 7+. of (),,9, a su sidiary ank as defined in the s !tate $ank of India 7su sidiary anks9 2ct, (),) 7.0 of (),)9, a corresponding new ank constituted under section . of the $anking companies 72cquisition and Transfer of >ndertakings9 2ct, ()01 7*1 of ()019, or any other ank eing a ank included in the !econd !chedule to the #eserve ank of India 2ct, ().* 7+ of ().*9, ut does not include a co%operative ankE. 3or the purpose of assessment of performance of anks, the #eserve $ank of India categories those anks as pu lic sector anks, old private sector anks, new private sector anks and foreign anks, i.e. private sector, pu lic sector, and foreign anks come under the um rella of scheduled commercial anks.

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 Regional Rural Bank: The government of India set up #egional #ural $anks 7##$s9 on Octo er +, ()/, . The anks provide credit to the weaker sections of the rural areas, particularly the small and marginal farmers, agricultural la ourers, and small enterpreneurs. Initially, five ##$s were set up on Octo er +, ()/, which was sponsored y !yndicate $ank, !tate $ank of India, Pun=a ;ational $ank, >nited "ommercial $ank and >nited $ank of India. The total authori6ed capital was fixed at #s. ( "rore which has since een raised to #s. , "rores. There are several concessions en=oyed y the ##$s y #eserve $ank of India such as lower interest rates and refinancing facilities from ;2$2#8 like lower cash ratio, lower statutory liquidity ratio, lower rate of interest on loans taken from sponsoring anks, managerial and staff assistance from the sponsoring ank and reim ursement of the expenses on staff training. The ##$s are under the control of N'.'RD. ;2$2#8 has the responsi ility of laying down the policies for the ##$s, to oversee their operations, provide refinance facilities, to monitor their performance and to attend their pro lems. Unscheduled Banks: D>nscheduled $ank in IndiaE means a anking company as defined in clause 7c9 of section , of the $anking #egulation 2ct, ()*) 7(1 of ()*)9, which is not a scheduled ankE. There are several types of anks, which differ in the num er of services they provide and the clientele 7"ustomers9 they serve. 2lthough some of the differences etween these types of anks have lessened as they have egun to expand the range of products and services they offer, there are still key distinguishing traits. These anks are as follows:
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 Commercial banks, which dominate this industry, offer a full range of services for individuals, usinesses, and governments. These anks come in a wide range of si6es, from large glo al anks to regional and community anks. Global banks are involved in international lending and foreign currency trading, in addition to the more typical anking services. Regional banks have numerous ranches and automated teller machine 72TA9 locations throughout a multi%state area that provide anking services to individuals. $anks have ecome more oriented toward marketing and sales. 2s a result, employees need to know a out all types of products and services offered y anks. Community banks are ased locally and offer more personal attention, which many individuals and small usinesses prefer. In recent years, online anks5which provide all services entirely over the Internet5have entered the market, with some success. ?owever, many traditional anks have also expanded to offer online anking, and some formerly Internet%only anks are opting to open ranches. Sa ings banks and savings and loan associations, sometimes called thrift institutions, are the second largest group of depository institutions. They were first esta lished as community% ased institutions to finance mortgages for people to uy homes and still cater mostly to the savings and lending needs of individuals.

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 Credit unions are another kind of depository institution. Aost credit unions are formed y people with a common ond, such as those who work for the same company or elong to the same la our union or church. Aem ers pool their savings and, when they need money, they may orrow from the credit union, often at a lower interest rate than that demanded y other financial institutions.

Need ,or Co*t

a)age e)t & +ro,"ta!"-"t( ") .a)/*.

$anks earn profit when its usiness costs and expenses are less than its revenues through its services and investments. 2ny usiness for that matter survives only if it earns profits. 2lthough $anking is considered as a loodline of economy of a nation, to provide a reasona le return for the a ove%cited huge capital expenditures and to remain servicing any economy, profita ility of the anks is a must. To remain profita le, 'efficient B effective cost management' of its entire operations is the need of the day for the anking sector. $esides this asic need of earning profit for survival, contrary to other usiness activities, the anks are uniquely positioned to face many constraints to earn even normal profits for its services. The following are some of the ottlenecks the anks have to circumvent to earn profits. (. The worlds over most of the $anks are predominantly regulated y respective Fovernments to serve their national o =ectives like food production, rural development, health, education etc. $anks lend their orrowed funds to other orrowers with needs spread across different time periods. !ince anks rely on orrowed money, they need to raise resources in a matching manner to avoid the risk of asset%lia ility mismatch. 2t the systemic level often anks face small gaps in their
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matching maturity profiles of their resources due to frequent change in regulatory provisions. +. $anking usiness involves greater risk than many other usinesses owing to its nature of commodity of transactions%money. .. The increased range and complexity of ank operations calls for !ophisticated risk management systems and techniques, planning tools and processes that demands additional capital. *. $usiness expansion and implementation of $asel%II accord are forcing $anks to shore up capital resources. ,.$urgeoning ;P2s in the ooks of $anks drain the precious resources of the $anks y way of prudential provisioning for ad assets that is the anks chief scourge. -. "ustomer driven competitive environment% "ustomers are less loyal and demand immaculate service delivery. /. "ompetition from post offices and non% ank technology companies due to onset of e%commerce with extensive intermediation. 0. Frowing interest rates strain the interest spreads. ). 'conomies of scale to support new products and services.

1:

Co*t & +ro,"ta!"-"t( ") .a)/*.

2ccording to a "redit #ating and Information !ervices of India 7"risil9 study, Gower operating expenses including rationalisation of employee costs have improved the profita ility of anks, contrary to the popular perception that only trading profits helped the anking sector shore up their ottomlines. The reduction in operating expenses was achieved through large%scale voluntary retirement schemes implemented y pu lic sector anks. !ince this reduction in operating expenses seems sustaina le, it promises a righter future for the anking sector. 2lthough the non%interest income of anks did increase y 1..H during this period, it was more than offset y a 1.+(H increase in provisions and an identical decline in spreads. "ompared to the relatively volatile treasury income, the reduction in operating expenses imparts a greater level of comfort in terms of the anking sector's a ility to sustain its profita ility in the future. The anking sector4s overall profita ility as measured y the return on average assets 7#o229 has improved to 1.0* per cent in +11(%1+ from 1.,. per cent in +111%1(. 2n analysis of the incremental change in the various profita ility components shows that: I In +11(%1+, the sector4s non%interest income rose y .+ asis points 7 ps9 over the previous year, primarily due to an increase in treasury profits. On
1;

the other hand, the net interest income or interest spread declined y +( ps in the same period. This was in line with the declining interest rate regime and increasing competition in the sector. 2t the same time, provision and contingency charges rose y +( ps. Together, the two more than offset the incremental contri ution from the non%interest income. I Operating expenses, however, declined significantly y *( ps in +11(%1+ over +111%1( and this ena led the anking sector to report an overall increase in profita ility y .( ps. The reduction in operating expenses can e attri uted to the large%scale voluntary retirement schemes 7&#!9 eing implemented across all pu lic sector anks as well as other cost%cutting measures. 2 closer analysis of the different anking groups 7pu lic sector anks, old private sector anks, new private sector anks and foreign anks9 also shows that the reduction in operating expenses was only experienced y the pu lic sector and foreign anks. 3or private sector anks, the profita ility improvement was mainly ecause of the increase in treasury income and not due to any material reduction in operating expenses. $ut since pu lic sector and foreign anks account for over 01 per cent of the total assets of all scheduled commercial anks, a reduction in their core operating expenses contri utes significantly in improving the profita ility of the entire Indian anking sector. "risil elieves that the anking sector is now reaping the enefits of rationalising its employee costs and undertaking other cost%reduction initiatives, which is a welcome sign in terms of the anks4 financial performance. "risil, however, pointed out that anks4 a ility to repeat and sustain such efforts would e critical in maintaining their profita ility, given the increasing pressure on interest spreads and rising provisioning levels.

2!

SO4RCES OF .'N10S INCOME

2 ank is a usiness organisation engaged in the usiness of orrowing and lending money. 2 ank can earn income only if it orrows at a lower rate and lends at a higher rate. The difference etween the two rates will represent the costs incurred y the ank and the proJt. $ank also provides a num er of services to its customers for which it charges commission.

This is also an important source of income. The followings are the various sources of a ank4s proJt: (. Interest on Goans: The main function of a commercial ank is to orrow money for the purpose of lending at a higher rate of interest. $ank grants various types of loans to the industrialists and traders. The yields from loans constitute the ma=or portion of the income of a ank. The anks grant loans generally for short periods. $ut now the anks also advance call loans which can e called at a very short notice. !uch loans are grantedto share rokers and other anks. These assets are highly liquid ecause they can e called at any time. Aoreover, they are source of income to the ank. +. Interest on Investments: $anks also invest an important portion of their resources in government and other Jrst class industrial securities. The interest and dividend received from time to time on these investments is a source of income for the anks. $ank also earn some income when the market prices of these securities rise.
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.. 8iscounts: "ommercial anks invest a part of their funds in ills of exchange y discounting them. $anks discount oth foreign and inland ills of exchange, or in other words, they purchase the ills at discount and receive the full amount at the date of maturity. 3or instance, if a ill of #s. (111 is discounted for #s. )/,, the ank earns a discount of #s. +, ecause ank pays #s. )/, today, ut will get #s. (111 on the due date. 8iscount, as a matter of fact, is the interest on the amount paid for the remaining period of the ill. The rate of discount on ills of exchange is slightly lower than the interest rate charged on loans and advances ecause ills are considered to e highly liquid assets. *. "ommission, $rokerage, etc.: $anks perform numerous services to their customers and charge commission, etc., for such services. $anks collect cheques, rents, dividends, etc., accepts ills of exchange, issue drafts and letters of credit and collect pensions and salaries on ehalf of their customers. They pay insurance premiums, rents, taxes etc., on ehalf of their customers. 3or all these services anks charge their commission. They also earn locker rents for providing safety vaults to their customers. #ecently the anks have also started underwriting the shares and de entures issued y the =oint stock companies for which they receive underwriting commission. "ommercial anks also deal in foreign exchange. They sell demand drafts, issue letters of credit and help remittance of funds in foreign countries. They also act as rokers in foreign exchange. $anks earn income out of these operations. IN5ES2MEN2 +OLIC6 OF .'N1S The Jnancial position of a commercial ank is reKected in its alance sheet. The alance sheet is a statement of the assets and lia ilities of the ank. The assets of the ank are distri uted in accordance with certain guiding principles. These principles underline the investment policy of the ank. They are discussed elow: 1. L"8u"d"t(9 In the context of the alance sheet of a ank the term liquidity has two interpretations. 3irst, it refers to the a ility of the ank to honour
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the claims of the depositors. !econd, it connotes the a ility of the ank to convert its non%cash assets into cash easily and without loss. It is a well known fact that a ank deals in funds elonging to the pu lic. ?ence, the ank should always e on its guard in handling these funds. The ank should always have enough cash to meet the demands of the depositors. In fact, the success of a ank depends to a considera le extent upon the degree of conJdence it can instill in the minds of its depositors. If the depositors lose conJdence in the integrity of their ank, the very existence of the ank will e at stake. !o, the ank should always e prepared to meet the claims of the depositors y having enough cash. 2mong the various items on the assets side of the alance sheet, cash on hand represents the most liquid asset. ;ext comes cash with other anks and the central ank. The order of liquidity goes on descending. Giquidity also means the a ility of the ank to convert its non%cash assets into cash easily and without loss. The ank cannot have all its assets in the form of cash ecause each is an idle asset which does not fetch any return to the ank. !o some of the assets of the ank, money at call and short notice, ills discounted, etc. could e made liquid easily and without loss. 2. +ro:ta!"-"t(: 2 commercial ank y deJnition, is a proJt hunting institution. The ank has to earn proJt to earn income to pay salaries to the staff, interest to the depositors, dividend to the shareholders and to meet the day%to%day expenditure. !ince cash is the least proJta le asset to the ank, there is no point in keeping all the assets in the form of cash on hand. The ank has got to earn income. ?ence, some of the items on the assets side are proJt yielding assets. They include money at call and short notice, ills discounted, investments, loans and advances, etc. Goans and advances, though the least liquid asset, constitute the most proJta le asset to the ank. Auch of the income of the ank accrues y way of interest charged on loans and advances. $ut, the ank has to e highly discreet while advancing loans. 3. Sa,et( or Secur"t(9 2part from liquidity and proJta ility, the ank should look to the principle of safety of its funds also for its smooth working. Lhile
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advancing loans, it is necessary that the ank should consider the three M"4 s of credit character, capacity and the collateral of the orrower. The ank cannot afford to invest its funds recklessly without considering the principle of safety. The loans and investments made y the ank should e adequately secured. 3or this purpose, the ank should always insist on security of the orrower. Of late, somehow or other the anks have not een paying adequate importance to safety, particularly in India. $. D";er*"t(9 The ank should invest its funds in such a way as to secure for itself an adequate and permanent return. 2nd while investing its funds, the ank should not keep all its eggs in the same asket. 8iversiJcation of investment is necessary to avoid the dangerous consequences of investing in one or two channels. If the ank invest its funds in different types of securities or makes loans and advances to different o =ectives and enterprises, it shall ensure for itself a regular Kow of income. <. Sa-ea!"-"t( o, Secur"t"e*9 3urther, the ank should invest its funds in such types of securities as can e easily marketed at a time of emergency. The ank cannot afford to invest its funds in very long term securities or those securities which are unsalea le. It is necessary for the ank to invest its funds in government or in Jrst class securities or in de entures of reputed Jrms. It should also advance loans against stocks which can e easily sold. -. Sta!"-"t( ") the 5a-ue o, I);e*t e)t*9 The ank should invest its funds in those stocks and securities the prices of which are more or less sta le. The ank cannot afford to invest its funds in securities, the prices of which are su =ect to frequent Kuctuations. =. +r")c"7-e* o, 2a>?E>e 7t"o) o, I);e*t e)t*9 3inally, the investment policy of a ank should e ased on the principle of tax exemption of investments. The ank should invest in those government securities which are exempted from income and other taxes. This will help the ank to increase its proJts. Of late, there has een a controversy regarding the relative importance of the various principles inKuencing the investment

26

policy of a ank particularly etween liquidity and proJta ility. It is interesting to examine this controversy. The ank should have adequate cash to meet the claims of the depositors. It is true that a successful anking usiness calls for installing conJdence in the minds of the depositors. $ut, it should e noted that accepting deposits is not the only function of a ank. Aoreover, the ank cannot afford to forget the fact that it has to earn income to pay salaries to the staff, interest to the depositors, dividend to the shareholders and meet the day%to%day expenditure. If the ank keeps all its resources in liquid form, it will not e a le to earn even a rupee. $ut proJta ility is a must for the ank. Though cash on hand is the most liquid asset, it is the least proJta le asset as well. "ash is an idle asset. ?ence, the anker cannot concentrate on liquidity only. If the ank attaches importance to proJta ility only, it would e equally disastrous to the very survival of a ank. It is true that a ank needs income to meet its expenditure and pay returns to the depositors and shareholders. The ank cannot undermine the interests of the depositors. If the ank lends out all its funds it will e left with no cash at all to meet the claims of the depositors. It should e noted that the ank should have cash to honour the o ligations of the depositors. Otherwise, there will e a Mrun4 on the ank. 2 run on the ank would e suicidal to the very existence of the ank. Goans and advances, though the most proJta le asset, constitute the least liquid asset. It follows from the a ove that the choice is etween liquidity and proJta ility. The constant tug of war etween liquidity and proJta ility is the feature of the assets side. 2ccording to "rowther, liquidity and proJta ility are opposing or conKicting considerations. The secret of successful anking lies in striking a alance etween the two.

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'**et* & L"a!"-t"e* o, .a)/*.

2ccording to "rowther, the assets side of the alance sheet is more complicated and interesting. 2ssets are the claims of the ank on others. In the distri ution of its assets, the ank is governed y certain well deJned principles. These principles constitute the principles of the investment policy of the ank or the principles underlying the distri ution of the assets of the ank. The most important guiding principles of the distri ution of assets of the ank are liquidity, proJta ility and safety or security. In fact, the various items on the assets side are distri uted according to the descending order of liquidity and the ascending order of proJta ility. 1. Ca*h9 ?ere we can distinguish cash on hand from cash with central ank and other anks cash on hand refers to cash in the vaults of the ank. It constitutes the most liquid asset which can e immediately used to meet the o ligations of the depositors. "ash on hand is called the Jrst line of defence to the ank. In addition to cash on hand, the ank also keeps some money with the central ank or other commercial anks. This represents the second line of defence to the ank. 2. Mo)e( at Ca-- a)d Short Not"ce9 Aoney at call and short notice includes loans to the rokers in the stock market, dealers in the discount market and to other anks. These loans could e quickly converted into cash and without loss, as and when the ank requires. 2t the same time, this item yields income to the ank. The signiJcance of money at call and short notice is that it is used y the anks to effect desira le ad=ustments in

28

the alance sheet. This process is called MLindow 8ressing4. This item constitutes the Mthird line of defence4 to the ank. 3. ."--* D"*cou)ted9 The commercial anks invest in short term ills consisting of ills of exchange and treasury ills which are self%liquidating in character. These short term ills are highly negotia le and they satisfy the twin o =ectives of liquidity and proJta ility. If a commercial ank requires additional funds, it can easily rediscount the ills in the ill market and it can also rediscount the ills with the central ank. $. ."--* ,or Co--ect"o)9 2s mentioned earlier, this item appears on oth sides of the alance sheet. <. I);e*t e)t*: This item includes the total amount of the proJt yielding assets of the ank. The ank invests a part of its funds in government and non%government securities. @. Loa)* a)d 'd;a)ce*9 Goans and advances constitute the most proJta le asset to the ank. The very survival of the ank depends upon the extent of income it can earn y advancing loans. $ut, this item is the least liquid asset as well. The ank earns quite a si6ea le interest from the loans and advances it gives to the private individuals and commercial Jrms.

L"a!"-"t"e*
Gia ilities are those items on account of which the ank is lia le to pay others. They denote other4s claims on the ank. ;ow we have to analyse the various items on the lia ilities side. 1. Ca7"ta-9 The ank has to raise capital efore commencing its usiness. 2uthorised capital is the maximum capital upto which the ank is empowered to raise capital y the Aemorandum of 2ssociation. Fenerally, the entire authorised capital is not raised from the pu lic. That part of authorised capital which is issued in the form of shares for pu lic su scription is called the issued capital. !u scri ed capital represents that part of issued capital which is actually su scri ed y the pu lic. 3inally, paid%up capital is that part of the su scri ed capital which the su scri ers are actually called upon to pay.
29

2. Re*er;e Fu)d9 #eserve fund is the accumulated undistri uted proJts of the ank. The ank maintains reserve fund to tide over any crisis. $ut, it elongs to the shareholders and hence a lia ility on the ank. In India, the commercial ank is required y law to transfer +1 per cent of its annual proJts to the #eserve fund. 3. De7o*"t*9 The deposits of the pu lic like demand deposits, savings deposits and Jxed deposits constitute an important item on the lia ilities side of the alance sheet. The success of any anking usiness depends to a large extent upon the degree of conJdence it can instill in the minds of the depositors. The ank can never afford to forget the claims of the depositors. ?ence, the ank should always have enough cash to honour the o ligations of the depositors. $. .orroA")g* ,ro Other .a)/*9 >nder this head, the ank shows those loans it has taken from other anks. The ank takes loans from other anks, especially the central ank, in certain extraordinary circumstances. <. ."--* +a(a!-e9 These include the unpaid ank drafts and telegraphic transfers issued y the ank. These drafts and telegraphic transfers are paid to the holders thereof y the ank4s ranches, agents and correspondents who are reim ursed y the ank. @. 'cce7ta)ce* a)d E)dor*e e)t*9 This item appears as a contra item on oth the sides of the alance sheet. It represents the lia ility of the ank in respect of ills accepted or endorsed on ehalf of its customers and also letters of credit issued and guarantees given on their ehalf. 3or rendering this service, a commission is charged and the customers to whom this service is extended are lia le to the ank for full payment of the ills. ?ence, this item is shown on oth sides of the alance sheet. =. Co)t")ge)t L"a!"-"t"e*9 "ontingent lia ilities comprise of those lia ilities which are not known in advance and are unforeseea le. 'very ank makes some provision for contingent lia ilities.

2:

B. +ro:t a)d Lo** 'ccou)t: The proJt earned y the ank in the course of the year is shown under this head. !ince the proJt is paya le to the shareholders it represents a lia ility on the ank. C. ."--* ,or Co--ect"o): This item also appears on oth the sides of the alance sheet. It consists of drafts and hundies drawn y sellers of goods on their customers and are sent to the ank for collection, against delivery documents like railway receipt, ill of lading, etc., attached thereto. 2ll such ills in hand at the date of the alance sheet are shown on oth the sides of the alance sheet ecause they form an asset of the ank, since the ank will receive payment in due course, it is also a lia ility ecause the ank will have to account for them to its customers.

2;

Re,or * o) .a)/")g S(*te 0* L"8u"d"t( & +ro,"ta!"-t( .

The li erali6ation of the Indian anking system dates ack to the ())1s when the government egan to implement the recommendations of the ;arasimham "ommittee 7())+, ())/9. The principal features of the steps taken to li erali6e and reform the system include: (. Increase in competition via more li eral rules for the entry of new domestic andforeign anks, raising the num er of anks from /1 to over )1 y Aarch +11*. #ecent consolidation in the industry has reduced the num er of total num er of anks to 01 with num er of foreign anks declining from a peak of *1 to +) and private anks shrinking to +/ y end Aarch +11/. !ince ())., twelve new private sector anks were set up ut some of them have already either merged with other P!$s or private anks or have gone out of usiness. !oreign direct in estment in "ri ate sector banks is allo#ed u" to $%&. +. Infusion of Fovernment capital in P!$s followed y In=ection of private equity. P!$s are allowed to increase the share of private capital upto *)H of which '(& can be foreign e)uity. 2s a result, the share of wholly
3!

Fovernment%owned pu lic sector anks in total system assets fell from )1H in ())( to (1H in +11* .. 8eregulation on interest rates except for certain specific classes such as savings deposit accounts, ;#I deposits, small loans up to #s. + lakh, and exports credits. *. "uts in Statutory *i)uidity Re)uirements +S*R, and Cash Reser e Re)uirements +CRR, to reduce "re-em"tion of ank lending and lower financial repression. ,. #eduction in credit controls to *1H from 01H of total credit. -. Introduction of a roader definition of priority sector lending. /. Incentives to increase consumer loans including long term home mortgages. 0. Implementation of micro%prudential measures including $asle% ased capital adequacy requirements, income recognition, asset classification and provisioning norms for loans, exposure norms and accounting norms. ). 'mphasis on performance, transparency and accounta ility.

31

+er,or a)ce a)d +ro,"ta!"-"t( o, I)d"a) .a)/* ") the +o*t L"!era-"Dat"o) +er"od.
Lhile inputs and outputs are easily identified in most usinesses, that is hardly the case in anking. 2t the heart is the question of whether deposits are input or output. 2 typical financial intermediation role for anks involves the use of deposits together with physical inputs of land, la or and capital to make loans and earn interest income. $anks also recogni6e the importance of generating non%interest income as an anti%dote to the varia ility in interest income. This approach suggests that we should treat the number of bank branches. total o"erating e/"enses and de"osits as in"uts and loans +ad ances, and non-interest income as out"uts . In this formulation, deposits are not coveted as an independent outputN instead they are treated only as a conduit to generating loans. In most anking systems, ank investments 7in addition to loans9 are also considered as a legitimate output. $ut such investments in India are mostly in government securities which are often thought of as reflections of Dla6yE anking. 2ccording to this line of thinking, higher investments simply imply that anks are not pushing loans adequately. In view of this, we do not use investments as anks4 output. $ut the treatment of deposits as an input is far from a universally accepted framework. Indeed. de"osit generation is thought of as a legitimate
32

ob0ecti e of banking by many analysts. The promotion of anking in India was partly motivated y the desire to inculcate anking ha its among the masses and generate deposits. ?ence, state%owned * anks were encouraged to expand ranch networks everywhere, including rural areas. 'qually relevant is the o servation that 1"eo"le demand de"osits for the ser ices of recordkee"ing and safe-kee"ing. and that these ser ices render deposits as outputs of anking activity.E 7!rivastava, ()))9. Thus, it is not unreasona le to specify deposits as an output that is produced together with loans and non%interest income using physical inputs such as the num er of ank ranches and operating expenses. 2'.LE 1 $ranches 7 H Total9
.a)/* State? 1CC=H 2@.C 2%%$ 2<.= @.2C B.3 2.= %.3 2%%= 2$.@ @2.$ B.1 $.$ %.<
'2MS EF 2ota-G

8eposits 7H Total9 2dvances 7H Total9

2%%= 1CC= 23.< <%.$ <.1 31.= <2.< =.2 2.= @.% 2%%$ 2%%= 2<.= $B @.B 13.1 @.< 2$.3 $B.$ $.= 1@.2 @.$

2%%=H 1CC= 2%%$ H 23.B 3@.< <.C 3%.2 3.< 2B.2 <B.@ @.$ 2.% $.B 2=.@ <%.= =.%

oA)ed Nat"o)a-"Ded @<.% +r";ate?O-d +r";ate?NeA Fore"g) =.= @.2 %.1

1%1.1 1<.3 $.< <.@

I'nd Aarch Partly in response to these measures and partly as a result of the economy4s improved performance, the Indian anking sector4s characteristics have changed and its health has improved. Old and new private anks have increased their market share in terms of num er of ranches and 2TAs as well as share in deposits and loans at the expense
33

of state%owned and nationali6ed anks 7Ta le (9. !ince ())/, net interest margins have declined in every segment of the anking system save nationali6ed anks and profit margins with and without taxes have improved acrossthe% oard save new private anks upto +11* ut private anks4 net interest margins and profits started improving from +11, and outstripped overall industry margins. 2ll in all, industry%wide net interest and profit margins peaked in +11* and have not recovered from their downward spiral to date.

36

COS2 DE2ERMINING F'C2ORS.

#ole of equity capital has ecome more significant since the adoption of $asel 2ccords I and II y all anks in India under guidance from the #eserve $ank of India. >nder $asel 2ccord II, all anks have achieved risk weighted capital adequacy ratio of (1H y +11- or so. The number of branches is a ery im"ortant factor in providing anking products and services, especially in a country like India where a ma=ority of a ank4s customers are likely to have only limited a ility to travel. 2n extensive ank ranch network should cut the shoe%leather costs of anking and allow a ank to generate more de"osits and more loans #ith the same le el of o"erating e/"enses. In recent years, anks have een moving towards automation and computeri6ation of operations, adding 2TAs across the country and encouraging their customers to use internet anking. 2s a result of transition to automation and com"uteri2ation as well as 2TAs and internet anking, o7erat")g co*t* are -"/e-( to dec-")e while fixed costs increase ut we would still expect an overall improvement in ank efficiency and profita ility.

37

F'C2ORS 'FFEC2ING 2HE +ROFI2'.ILI26 OF .'N1S .

56 A!ount of 7orking Funds 1 3unds deployed y a ank in profita le assets are the working funds of the ank. Profita ility of a usiness is directly proportionate to the amount of working funds dePloyed y the ank. 86 Cost of Funds 1 "ost of funds are the expenses incurred on o taining funds from various sources in the form of share capital, reserves, deposits, and orrowings. Thus, it generally refers to interest expenses. *o#er the cost of funds. higher the "rofitability. 96 *ield on Funds 1 The funds raised y the ank through various sources are deployed in various assets. These assets yield income in the form of interest. So. higher the interest. greater the "rofitability. :6 S0read 1 !pread is defined as the d",,ere)ce !etAee) the ")tere*t rece";ed E")tere*t ")co e G a)d the ")tere*t 7a"d E")tere*t e>7e)*e G.
38

?igher spread indicates more efficient financial intermediation and higher net income. 3hus. higher s"read leads to higher "rofitability.

;6 O0erating Costs 1 Operating costs are the expenses incurred in the functioning of the ank 'xcluding cost of funds, all other expenses are operating costs. *o#er o"erating costs gi e rise to greater "rofitability of the banks. <6 isk Cost 1

This cost is associated to the pro a le annual loss on assets. They include provisions made towards ad de ts and dou tful de ts. *o#er risk costs increase the "rofitability of banks. =6 Non > interest inco!e 1 It is the income derived from non O financial assets and services It includes commission B rokerage on rencittance facility, rent of locker facility, fees for underwriting and financial guarantees, etc. 3his income adds to the "rofitability of banks. ?6 Le/el of &echnology 1 >se of upgraded technology normally leads to decline in the operating costs of anks. 3his im"ro es the "rofitability of banks. @6 Le/el of Non > 0erfor!ing assets ANPAs61 The profita ility of a ank is inversely related to the level of ;P2s. ?ence, over the years, the ;P2s of commercial anks have greatly declined.
39

5B6 Le/el of co!0etition 1 Increase in competition generally leads to higher operating costs. This leads to lower profita ility.

F'C2ORS DE2ERMINING 2HE LII4IDI26 OF .'N1S .

1G S&A&.&O * '-.I ','N&S 1 The extent of liquid reserves held y anks depends on the statutory requirements of the "entral $ank 7i.e. the #$I9 2ccording to #$I, commercial anks have to maintain a certain "##7cash #eserve #atio 9 and !G# 7statutory liquid ratio9 4igher CRR and S*R result in lo#er li)uidity.

86 Banking )abits of the Peo0le 1 The nature of the economy has an impact on the anking ha its of the people. In developing countries, cheque transactions are confined to usiness. Individuals depend more on cash transactions ?ence, the need for li)uidity is com"arati ely higher.

96 ,onetary &ransactions 1 The num er and magnitude of monetary transactions determine the liquidity of anks. 4igher monetary transaction leads to higher li)uidity.

3:

:6 Nature of ,oney ,arket 1 In case of fully developed money markets, anks uy and sell securities easily. 3herefore. li)uidity re)uirement is lo#er. ;6 Structure of Banking Syste! 1 $ranch anking system requires lower liquidity since cash reserves can e centrali6ed in the head office. Unit Banking System re)uires higher degree of li)uidity.

<6 Nu!ber and Si$e of %e0osits 1 The num er and si6ed of deposits influence the liquidity of anks. Increase in the number 5 si2e of de"osits #ill re)uire higher li)uidity. =6 Nature of %e0osits 1 8eposits trade with the anks are of various types like time deposits, demand deposits, short O term deposits, etc. larger demand deposits Cshort O term deposits need higher liquidity.

?6 Li#uidity Policies of other Banks 1 &arious anks may function in the same area !o, liquidity policies of other anks also have an impact on the liquidity of a ank to uild goodwill among depositors.

3;

L"8u"d"t( R"*/ Ma)age e)t

What "* L"8u"d"t( R"*/ 9 Giquidity risk is the potential ina ility to meet the lia ilities as they ecome due. It arises when the anks are una le to generate cash to cope with a decline in deposits or increase in assets. It originates from the mismatches in the maturity pattern of assets and lia ilities. I 7orta)ce o, L"8u"d"t( R"*/ 9 Aeasuring and managing liquidity needs are vital for effective operation of commercial anks. $y assuring a ank4s a ility to meet its lia ilities as they ecome due, liquidity management can reduce the pro a ility of an adverse situation developing. L"8u"d"t( R"*/ Ma)age e)t 2nalysis of liquidity risk involves the measurement of not only the liquidity position of the ank on an ongoing asis ut also examining how funding requirements are likely to e affected under crisis scenarios. ;et funding requirements are determined y analy6ing the ank4s future cash flows ased on assumptions of the future ehavior of assets and lia ilities that are classified into specified time uckets and then calculating the cumulative net flows over the time frame for liquidity assessment. 3uture cash flows are to e analysed under Dwhat ifE scenarios so as to assess any significant positive C negative liquidity swings that could occur on a day%to%day asis and under ank specific and general market crisis scenarios. 3actors to e taken into consideration while determining liquidity of the ank4s future stock of assets and lia ilities include:

their potential marketa ility, the extent to which maturing assets Clia ility will e renewed, the acquisition of new assets C lia ility and the normal growth in asset C lia ility accounts.
6!

3actors affecting the liquidity of assets and lia ilities of the bank cannot al#ays be forecast #ith "recision . ?ence they need to e reviewed frequently to determine their continuing validity, especially given the rapidity of change in financial markets. The liquidity risk in anks manifest in different dimensions: +a, !unding Risk 6 need to replace net outflows due to unanticipated withdrawalCnon%renewal of deposits 7wholesale and retail9N +b, 3ime Risk O need to compensate for non%receipt of expected inflows of funds, i.e. performing assets turning into non%performing assetsN and 7c, Call Risk O due to crystallisation of contingent lia ilities and una le to undertake profita le usiness opportunities when desira le.

Mea*ure e)t o, L"8u"d"t(9

Giquidity measurement is quite a difficult task and can e measured through stock or cash flow approaches. The key ratios, adopted across the anking system are Goans to Total 2ssets, Goans to "ore 8eposits, Garge Gia ilities 7minus9 Temporary Investments to 'arning 2ssets 7minus9 Temporary Investments, Purchased 3unds to Total 2ssets, Goan GossesC;et Goans, ?owever, the ratios do not reveal the intrinsic liquidity profile of Indian anks which are operating generally in an illiquid market. 'xperiences show that assets commonly considered as liquid like Fovernment securities, other money marketinstruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches. 3or measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool.

The following prudential limits are considered y $anks to put in place to avoid liquidity crisis:% 7i9 "ap on inter% ank orrowings, especially call orrowingsN
61

7ii9 Purchased funds vis%P%vis liquid assetsN 7iii9 "ore deposits vis%P%vis "ore 2ssets i.e. "ash #eserve #atio, !tatutory Giquidity #atio and GoansN 7iv9 8uration of lia ilities and investment portfolioN 7v9 Aaximum "umulative Outflows across all time andsN 7vi9 "ommitment #atio O track the total commitments given to corporates C anks and other financial institutions to limit the off% alance sheet exposureN 7vii9 !wapped 3unds #atio, i.e. extent of Indian #upees raised out of foreign currency sources.

62

'**e** e)t o, L"8u"d"t( Ma)age e)t ") .a)/*.

%e/elo0ing a Structure for ,anaging Li#uidity 'ach ank should have an agreed strategy for the day%to%day management of liquidity. This strategy should e communicated throughout the organisation. 2 ank4s oard of directors should a""ro e the strategy and significant policies related to the management of liquidity. The oard should also ensure that senior management takes the steps necessary to monitor and control liquidity risk. The board should be informed regularly of the liquidity situation of the ank and immediately if there are any material changes in the ank4s current or prospective liquidity position. 'ach ank should have a management structure in "lace to e/ecute effecti ely the li)uidity strategy . This structure should include the ongoing involvement of mem ers of senior management. !enior management must ensure that liquidity is effectively managed, and that appropriate policies and procedures are esta lished to control and limit liquidity risk. $anks should set and regularly review limits on the si6e of their liquidity positions over particular time hori6ons. 2 ank must ha e ade)uate information systems for measuring. monitoring. controlling and re"orting li)uidity risk. #eports should e provided on a timely asis to the ank4s oard of directors, senior management and other appropriate personnel. ,easuring and ,onitoring Net Funding e#uire!ents 'ach ank should esta lish a process for the ongoing measurement and monitoring of net funding requirements. 2 ank should analyse liquidity utilising a variety of Dwhat ifE scenarios. 2 ank should review frequently the assumptions utilised in managing liquidity to determine that they continue to e valid. ,anaging ,arket Access
63

'ach ank should periodically review its efforts to esta lish and maintain relationships with lia ility holders, to maintain the diversification of lia ilities, and aim to ensure its capacity to sell assets.

Contingency Planning 2 ank should have contingency plans in place that address the strategy for handling liquidity crises and include procedures for making up cash flow shortfalls in emergency situations. Foreign Currency Li#uidity ,anage!ent 'ach ank should have a measurement, monitoring and control system for its liquidity positions in the ma=or currencies in which it is active. In addition to assessing its aggregate foreign currency liquidity needs and the accepta le mismatch in com ination with its domestic currency commitments, a ank should also undertake separate analysis of its strategy for each currency individually. !u =ect to the analysis undertaken according to Principle (1, a ank should, where appropriate, set and regularly review limits on the si6e of its cash flow mismatches over particular time hori6ons for foreign currencies in aggregate and for each significant individual currency in which the ank operates. Internal Controls for Li#uidity isk ,anage!ent 'ach ank must have an adequate system of internal controls over its liquidity risk management process. 2 fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or enhancements to internal controls are made. The results of such reviews should e availa le to supervisory authorities. ole of Public %isclosure in I!0ro/ing Li#uidity 'ach ank should have in place a mechanism for ensuring that there is an adequate level of disclosure of information a out the ank in order to manage pu lic perception of the organisation and its soundness.

66

Data E);e-o7 e)t ')a-(*"* ,or '**e* e)t o, Co*t* a)d +ro,"ta!"-t(.
8ata 'nvelopment 2nalysis 78'29, developed y "harnes, "ooper and #hodes 7()/09, uses principles of linear programming to examine how a particular decisionmaking unit 78A>9 O like a ank in our exercise O operates relative to other 8A>s in the sample. 'fficiency is defined y the ratio of output to input. This is straight forward when there is only one output and one input. $ut the task ecomes complex where multi"le of out"uts and in"uts are involved. 8'2 gets around this pro lem y constructing an efficiency frontier from weighted outputs 7virtual output9 and weighted inputs 7virtual input9. 8A>s on the frontier are assigned an efficiency score of 7 while those inside receive scores of etween 2ero and one. The further a#ay a bank is from the frontier. the lo#er its efficiency score. Lhile inputs and outputs are easily identified in most industries, it is not so in the anking industry. The 8'2 studies of ank efficiency have typically used either the intermediation approach or the production approach in selecting outputs and inputs. The former considers banks as ntermediaries that use de"osits together #ith other in"uts such as labor and ca"ital to "roduce out"uts like loans. ?ence, the intermediation approach views
67

deposits as an input. In the "roduction a""roach. however, anks are thought of as ser ice "ro iders and de"osits are considered as an out"ut . Thus, the production approach postulates that anks produce deposits, and loans using la or and capital as inputs. In using the two approaches, we also consider non%interest income earned y each anks as a distinct output in view of the emphasis anks themselves place on it as a sta le source of income. 2s our su sequent quantitative analysis shows, whether deposits are treated as an input or an output does not appear to make any difference to the efficiency scores of various anks. 2 few 8'2% ased studies of efficiency in the Indian anking system have appeared in recent years. They have used a variety of specifications for inputs and outputs as evident from the Ta le elow.

'uthorE*G
$hattacharyya 2. ".2.@. Govell B P. !ahay !aha B #avisankar

I)7ut*
Interest 'xpense, Operating 'xpense ;o. of $ranches, ;o. of 'mployees, ;on% esta lishment

Out7ut*
2dvances, 8eposits Investments

+er"od
()0-%)(

2dvances, 8eposits, Investments, !pread, Total Income, Interest Income

())(%)+ ())*%),

'sta lishment B B ;on%interest

68

'xpenditures @etkar B ;oulas "apital, ;o. 'mployees 8eposits

Investments 2dvances

()).

'uthorE*G
@etkar, ;oulas B 2garwal

I)7ut*
"apital ;o. of 'mployees 8eposits Operating

Out7ut*

+er"od

Investments2dvances ())1%()),

#ammohan B

Investments, Goans B ())+%+111 ;on%interest Income Investments, Performing Goans , 'quity ;on%interest Income ())/%+11.

#ay "osts, 8eposits 8as 2. 2. ;ag B $orrowed !. #ay 3unds, ;o. of 'mployees, 3ixed 2ssets,

Inputs vary from purely financial such as interest and non%interest expenses to purely physical like num er of ranches and employees. Outputs are either income related -- interest and non-interest income or "roduct8ser ice related 6 loans. in estments and non-interest income . 8eposits appear as inputs or outputs depending upon whether the authors work with the intermediation or production interpretation of anking usiness. The efficiency scores are found to be relati ely sensiti e to the s"ecification in terms of in"uts and out"uts, which makes it difficult to reach generali6ed conclusions on how ank efficiencies stack up y ownership.

69

In a few studies that use a large num er of inputs, not surprisingly many more anks are found to e on the efficiency frontier 78as, ;ag and #ay9. In earlier papers @etkar etc. used de"osits as #ell as "hysical in"uts such as num er of full time employees as a proxy for la or and num er of ranches as a proxy for capital, and loans and investments as outputs. The efficiency scores of most domestic anks were found to e quite low in that specification of inputs and outputs. On reflection, we conclude that this was due to a shift away from anks4 traditional intermediation function of mo ili6ing deposits and making loans. The financial market reforms of the ())1s increased competition for anks from non% ank intermediaries in the capital markets. "ompanies were increasingly a le to o tain financing via equity issuance, which reduced their captivity to ank lending. $anks recogni6ed this and over time started focusing on earning non%interest income.

6:

R"*")g I)tere*t Rate* & .a)/0* +ro,"t

The #eserve $ank of India 7#$I9 today cautioned rising interest rate and high cost of funds could hurt the profita ility of the anking sector. QFoing ahead, with hardening interest rates and the imminent increase in cost of funds, the credit growth is expected to slow down, which could adversely affect the profita ility,Q the #$I said in 3inancial !ta ility #eport released today.

The hike in savings account interest rate, amortisations of pension lia ilities and potentially enhanced provisioning requirements for ;P2s may also impact profita ility, it said. The report noted that anks' profita ility improved, uoyed y increased net interest income 7;II9 though non%interest income remained stagnant. 2n increase in ;II facilitated growth of around +1H in aggregate net profit of the anking system, even with an almost stagnant non%interest income and increase in risk provisions, it said. Interest income increased y (0.-H over /.,H last year and interest expense increased y (1.(H as against *.1H last year, it said. There was improvement of .*.)H in the ;II of the anks during +1(1%(( despite little change in non%interest income, increase of *)H in risk provisions and +*H increase in operating expenses. The growth in interest income y (0.-H was, however, not in tandem with the growth in loans and advances which grew y ++.-H during +1(1%((, it said.
6;

?owever, it said, the pu lic sector anks registered a lower growth in profits O mainly due to reduction in trading profits, increase in provisions towards staff expenses 7including those for pension lia ilities9 and towards impaired assets. >nder stress conditions ased on ;P2 shocks, it said, the profita ility of the anks was seen to e affected significantly though the capital adequacy position appeared to e reasona ly resilient. The study indicates that some anks may face extreme liquidity constraints, under severe stress scenario. Overall, the results of the macro% stress tests using different scenarios, suggested that the anking sector would e a le to withstand macroeconomic shocks though the prevailing inflation and interest rate situation is expected to have an adverse effect on the asset quality of anks, it said

7!

Ser;"ce Charge*9 MaJor Co*t* o, the .a)/* ") I)d"a

In ())), the practice of Indian $anks' 2ssociation 7I$29 fixing the enchmark service charges on ehalf of the mem er anks was discontinued and the decision to prescri e the service charges was left to the discretion of the $oards of individual anks. $anks were then advised that they should ensure that the charges were reasona le and not out of line with the average cost of providing the services and that the customers with low volume of activities were not penali6ed. It was expected that, with time, market pressure would force the anks to price their services competitively ensuring services at a fair price. ?owever, the #eserve $ank continued to receive representations from the pu lic regarding >nreasona le and nontransparent service charges. The plethora of complaints received indicated that the issue of fairness in fixing the service charges y the anks needed to e examined. 2ccordingly, in order to ensure fair practices in anking services, in terms of the 2nnual Policy !tatement +11-%1/, #eserve $ank constituted a Lorking Froup having in it a nominee of the I$2 and a representative of customers to formulate a scheme for ensuring reasona leness of ank charges, and to incorporate the same in the 3air Practices "ode, the compliance of which would e monitored y the $anking "odes and !tandards $oard of India 7$"!$I9. AA6Nature of transactions1 a. $anking services that are ordinarily availed y individuals in the middle and lower segments will e the first parameter. These will comprise services related to depositCloan accounts, remittance services and collection services.
71

. Lhen the a ove transactions occur in different delivery channels, for the purpose ofpricing, they may e treated on separate footing.

AB6 4alue of transactions1 Gow value of transactions with customersCpu lic upto the ceiling as given elow will e the second Parameter: i. #emittances up to #s. (1,111C% in each instance. ii. "ollections elow #s. (1,111C% in each instance. 73oreign exchange transactions valued upto >! R ,11C%9. 2s per extant #$I instructions the anks4 service charges should not e out of line with the average costs of providing the services. .a*"c Ser;"ce*. There are +/ asic service charges that should e taken into account while analy6ing the service charges. These are Ser ice relating to de"osit accounts ( "heque ook facility + Issue of Pass $ook 7or !tatement9 C Issue of $alance "ertificate . Issue of duplicate pass ook or statement * 2TA cards , 8e it cards 7electronic cheque9 - !top Payment / $alance enquiry
72

0 2ccount closure )I "heque #eturn % Inward 7cheque received for payment9 (1I !ignature verification

Relating to *oan 9ccounts ((I ;o dues certificate Remittance !acilities +Ru"ee or foreign e/change 9 (+ (. (* (, ((/ (0 8emand 8raft O Issue 8emand 8raft O "ancellation 8emand 8raft O#evalidation 8emand 8raft O 8uplicate issuance Payment Order O Issue Payment Order% "ancellation Payment Order O #evalidation

() Payment Order%8uplicate issuance +1I Telegraphic Transfer O Issue +(I ++I +.I Telegraphic Transfer O"ancellation Telegraphic Transfer% 8uplicate issuance Payment y 'lectronic "learing !ervices 7'"!9

+*I Transfer y ;ational 'lectronic 3und Transfer 7;'3T9 and 'lectronic 3unds Transfer 7'3T9. Collection facilities +,I "ollection of Gocal "heques
73

+-I +/I

"ollection of Outstation "heques "heque #eturn%Outward 7cheque deposited for collection9

'N'L6SIS OF FIN'NCI'L S2'2EMEN2S OF .'N1S 9 +ROFI2, +ROFI2'.ILI26 'ND .RE'1 E5EN LE5EL
The anks, acting as financial intermediaries, mo ili6e savings of the society and supplement their resources through orrowings for providing credit to the needy sectors. They have to pay interest on their deposits and orrowings. They have to pay salaries to their staff and incur other overhead expenses in the course of their usiness operations. They are also required to make provisions for any potential erosion in their assets. 2fter all this, they may have to pay a reasona le divided to their shareholders. The anks will, therefore, have to earn profit. Only a profit earning ank inspires confidence in its customers. FAC&O S AFF'C&IN( P OFI&ABILI&* Lhile profit is excess of income over expenditure during any accounting period, profita ility is a relative term expressed as a percentage to average working funds. The following five important factors determine the profita ility of a ank. i9 2mount of working funds deployed ii9 "ost of funds iii9 Sield on funds

76

iv9 $urden Aanagement cost, and v9 #isk cost

i67orking funds
Lorking 3unds are the funds deployed y a ank in its usiness. The amount of working funds so deployed is usually arrived at y su tracting the aggregate amount of contra items from the total lia ilities of the alance sheet. ?owever, for analy6ing the profita ility, the alance sheet showing alance ased on weeklyCmonthly average should prepared. $ased on this alance sheet, the average working funds should e ascertained y netting the total of contra items from the total of the alance sheet.

ii6Cost of funds
The sources of funds for a ank comprise share capital and reserves 7owned funds9, deposits, orrowings and other lia ilities. These are riefly discussed in the following paragraphs. a,Share ca"ital and reser es O !hare capital is contri uted y the shareholders in case of "$s and ##$s and y the mem ers in "ooperative anks for the usiness of the ank and may, therefore, e treated as cost free for the purpose of profita ility. ?owever, for a more stringent and conservative analysis of profita ility, the dividend paid y a ank may e taken as cost of owned funds. b,Reser es eing past profits retained in the usiness are cost free. Provisions and credit alance in the profit and loss account which are not in the nature of outside lia ilities may e equated with the reserves first, share capital and further from deposits for the purpose of profita ility analysis.

77

ILL4S2R'2ION9 If the share capital of a ank is #s.,1,11 lakh out of the total owned funds of #s./,.11 lakh, and if the ank had declared a dividend of (,H on its share capital. The average cost of owned funds can e calculated as under:

2mount of dividend 2verage cost of owned funds T %%%%%%%%%%%%%%%%%%%%%%% U 2verage owned funds /,,1,111 T %%%%%%%%%%%%%%%%%%%%%%%% U (11 /,,11,111 T (1H (11

It may e o served from the a ove that although the ank had declared a dividend of (,H the cost of its owned funds works out to only (1H due to the uild up cost free reserves. c,:e"osits O The anks pay different rates of interest depending upon the nature and term of the deposit. The cost of deposits, therefore, depends upon the deposit%mix of the ank. Le have to find out the average cost of these deposits for comparing with the average yield on funds deployed. The average cost of deposits is worked out per #s.(11C% of deposits as in the following example: If the amount of interest paid and paya le on the deposits of #s.+11.11 lakhs is #s.(*,++,-11C%the average cost of deposits is worked out as follows: Interest paidCpaya le 72s per P B G 2Cc9 T %%%%%%%%%%%%%%%%%%%%%%%% U 2verage deposits
78

(11

(*,++,-11 T %%%%%%%%%%%%%%%%%%%%%%%% U +11,11,111 K =.113F d,Borro#ings O These may e y way of orrowings from higher financing agencies, inter ank orrowings or refinance from #$I, ;2$2#8, !I8$I, I8$I, ;?$ etc. The average cost of orrowings and the weighted average cost of each type of orrowing have to e worked out as in the case of deposits. e,Other liabilities O The other lia ilities include ills pauya le, drafts paya le, etc. and represents cost free funds. f,9 erage cost of funds O The average cost of funds for the ank can e worked out as under : Total interestCdividend paid 7as per P B G 2Cc.9 2verage cost of funds 7k9T %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% 2verage working funds U (11 (11

iii6%e0loy!ent of funds and yield on funds The funds mo ili6ed y a ank through different sources are utili6ed for O a. "ompliance with the statutory requirements relating to "## and !G#N . investments in non%!G# avenueN c. granting loans and advancesN and d. deploying in other assets such as land B uildings, furniture and fixtures, etc.
79

Ca*h o) ha)d O 2s cash on hand yields no returns, anks should maintain only minimum cash alance required for day to day usiness. This will also reduce the security risk for the ank. .a-a)ce ") Curre)t 'ccou)t O 2mount kept in "2 with other ank and if no interest is paid incomeCyield on this alance will e nil. !ome of the sponsor anks pay interest on "2 alance with them to their sponsor ##$s. Interest received on such I);e*t e)t* O Investments, for the purposes of profita ility analysis, include all deposits with anks including current account alance, and other investments in Fovernment and other securities, shares and de entures, etc. The anks have to maintain these investments for the purposes of "## and C or !G#. The return on these investments comprises interest and divided actually received. 2s in the case of lia ilities, the average yield on investment and the weighted average yield on each type of investment have to e worked out to select the optimum investmentsmix.

Loa)* a)d ad;a)ce* # The loans and advances port%folio provides the most profita le avenue for deployment of funds y a ank. The weighted average yield on advances of (11 is worked out as follows :

Interest received on advances 7as per PBG 2Cc.9 2verage yield on advances T %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% U (11

2verage advances 7including ;P2s9

7:

Other a**et* O The ank should limit its investments in land and uildings, furniture and fixtures, etc. only to the extent required for its usiness as they do not either earn any return or earn comparatively low returns.

i/6Other factorsC
Le have so far discussed the average cost of funds and average yield on funds. The profita ility, however, ultimately depends upon the overhead costs, risk cost and the miscellaneous income. These are discussed riefly hereunder: 2ra)*act"o) co*t* EO7erat")g co*tG O These are also called management costs and include all costs other than cost of funds and provisions. Thus, they consist of staff cost, i.e., salaries and other payments such as onus, gratuity, etc. made to staff 7s9 and overheads such as expenses on stationery and printing, postages, rents, depreciation on assets, etc. 7o9. Transaction costs should e computed as a percentage of working funds as under: Total transaction costs Transaction costs 7sVo9 T %%%%%%%%%%%%%%%%%%%%%%%%% U (11 2verage working funds R"*/ co*t O The risk cost is worked out to estimate the likely annual loss on assets as a ratio of #s.(11C% of average funds deployed. Provisions made towards ad and dou tful de ts, loss assets should e included under risk cost. The risk cost can e qualified as : Total of provisions made in P B G 2Cc. towards ;P2, etc. #isk cost 7pc9 T %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% U (11

7;

2verage working funds In order to ensure a realistic pro=ection of the risk cost anks should systematically estimate ad and dou tful assets each year. "alculation of risk cost can e made on the asis of asset classification and provisioning norms. No)?")tere*t ")co e O This is the income derived from non%financial assets and services and includes commission and rokerage on remittance facilities, G"s, guarantees, underwriting contracts etc., locker rentals and other service charges. ?owever, items of non%recurring nature such as profit from sale of non% anking assets, when significant should not e included. 3or the purpose of profita ility analysis, noninterest income also is to e worked out per #s.(11 of working funds as follows: Total non%interest income ;on%interest income 7n9 T %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% U (11 2verage working funds F")a)c"a- arg") O Wust as a trading or manufacturing organi6ation arrives at its gross profit to assess its trading or manufacturing activities, anks also ascertain their gross profit. This is also called Q!preadQ and is computed as a difference etween weighted average yield on assets and weighted average cost of funds.

.urde) O The total non%interest expenses representing the transactions costs will generally e more than miscellaneous income. The difference etween the two is called urden, as while making a cost plus pricing of loans this difference has to e loaded onto the rate of interest. The concept of urden also illustrates the importance of non%interest or service income of the ank. 2 high level of noninterest income can not only recover the entire operating cost, it can ena le a ank to pay high level of compensation to its employees, as in the case of foreign anks. If the non%

8!

interest income of ank is high enough to leave surplus after paying for operating cost, the same can recover a part of the interest cost as well. This means a negative loading in a cost plus pricing scenario. !uch strategy is surely highly aggressive and may even prove to e unnecessarily risky.

2oo-* o, F")a)c"a- ')a-(*"* ") .a)/*.

There are some widely popular tools of financial analysis. !ome of these are discussed hereunder:% 2re)d a)a-(*"* This is done through comparison of two or more successive alance%sheets and profit and loss accounts, and studying the changes in the various components of assets and lia ilities and income and expenditure. .rea/ E;e) Le;e- .u*")e** E.ELG This is the level of usiness 7in terms of working funds9 at which the total income of the ank is =ust adequate to meet all its costs. It is calculated as follows: 7Transaction costs V #isk costs9 %;on%interest income $'G T %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% U (11 ;et Aargin In case the present level of working funds is more than $'G, the ank would e in profit and the actual profit can e arrived at as follows: Profit T 72ctual working funds O $'G working funds9 U ;et margin

81

The amount of dividend taken to calculate the average cost of funds, has to e added to the a ove figure to arrive at the net profit shown in the profit and loss account. !ometimes reak%even level is calculated in relation to core usiness, that is, without considering non%interest income. 3or this $'G is arrived at y dividing the total operating costs y financial margin 7or net interest margin9.

Cha--e)ge* !e,ore Ma)age e)t* o, .a)/*.

(. $anks need to retain their existing customers and widen their ase developing a retail strategy and geographical capa ilities to focus on the customer satisfaction, improve product sales and delivery qualitatively adhering to regulatory frame work. +. $anks have to develop an effective strategy and management tools to ensure cost effective straight through processing and seamless end%to%end usiness processing y leveraging technology for real time performance management capa ilities ena ling link etween actual usiness performance and usiness plans. ..2fter the recent melt down of the western economies like >!2 which saw some of the iggest and supposedly DsafestE names in international anking like $ear !terns, Gehman $rothers, Aerrill Gynch and ?$O! on oth sides of 2tlantic keel over, the confidence level of investing pu lic in anking is at low e . It's reported that /* anks in >!2 were closed their shutters this year alone till !eptem er +11). Therefore earning legitimate profits in a transparent and fair manner managing inherent risk factors for
82

ultimate survival is a ig challenge. *. The range of anking products is ever changing with lesser and lesser marginsN ut cost of infrastructure and operating costs are growing exponentially. ,. 8eveloping new revenue streams and pricing competitively. It is easier said than done. It all again depends upon the level of organi6ational maturity, management skills, resource strength and usiness plans of each ank to evolve their own cost management and profit making strategies carefully prioriti6ing each step of their activity. 2 study conducted y the &irginia $ankers association and researchers from &irginia "ommonwealth >niversity examining the relationship etween ank financial performance and the emphasis on operational practices touted as critical success factors. This survey gets importance for the reason that -* $anks were analy6ed with an average usiness existence of -+ years to their credit 7+) percent had een in usiness for at least (11 years9. Aore than )1H of the response came from the highest level of $ank Aanagement, President, "'O, "3O or "OO. The results are clear. In the current economic environment, one clear critical success factor for $anks is a strong emphasis on expense management throughout the $anks. 2lthough other critical success factors% such as quality, dependa ility, relationship uilding and convenience% are always worthy of attention, an emphasis on controlling expenses trumped all other factors.

83

RECEN2 'R2ICLES REL'2ING 2O COS2 & +ROFI2'.IL26 OF .'N1S.

Bank "rofitability set to fall- Goura Gu"ta +Aanager, 3inancial sector ratings, "#I!IG,
?igher salaries, declining spreads and lower fee incomes will ensure this. Aacroeconomic headwinds in +11-%1/ and +11/%10 have resulted in su stantial fluctuations in anks' profita ility. #ising interest rates in +11-% 1/ and the first half of +110%1) raised anks' overall cost of orrowingsN as yields on advances and investments did not keep pace, anks' profita ility suffered. Aoreover, the #$I's use of reserve ratios, statutory liquidity ratio and cash reserve ratio as monetary policy tools affected anks' profita ility: ;o interest is paid on "## alances, and the interest yield on !G# securities is far lower than the yields on advances. $y the time the #$I relaxed reserve requirements in Octo er +110, reducing "## and !G# to , per cent and +* per cent respectively %% from ) per cent and +, per cent %% the effect on anks' profita ility was already apparent. 3or these reasons, after +11*%1,, when anks' net profita ility margin peaked at (.-. per cent, their core profita ility has een on a declining trendN y +11/%10, it had reached (.*1 per cent. "#I!IG elieves that anks' core profita ility remained under stress in +110%1), with the system ;PA estimated to have reduced to (.+- per centN a further drop to (.() per cent is pro=ected for +11)%(1.
86

R"*")g Co*t O, De7o*"t* For .a)/* The hardening of interest rates, acting in com ination with a steady increase in "## etween +11*%1, and +11/%10 resulted in an across%the% oard increase in anks' overall cost of resources. 3urther, strong credit growth, and a shift in the deposit%mix towards expensive term%deposits, added to the pressure on anks' "o$. The Indian anking system experienced credit growth averaging +0 per cent annually etween +11+%1. and +11-%1/. To fund credit growth, anks started vying for ig%ticket term%deposits. In addition, the tenure of term deposits started shrinking. $ecause interest rates were increasing, anks were forced to re%price deposits at renewal. Pricing pressure and a paucity of retail deposits compelled anks to offer higher interest rates on retail term%deposits. The dou le impact of usiness%led upward pressure on cost of deposits, and tighter monetary policies, saw anks' cost of deposits rise to -.( per cent in +11/%10, from ,.( per cent in +11-%1/. "#I!IG estimates that the cost of deposits has further increased y a out ,1 asis points 7 psN (11 ps equals ( percentage point9 in +110%1), to around -.- per cent. 6"e-d* Fa"- to +-a( Catch?47 #$I's liquidity%tightening measures, especially the increase in "##, left no option for anks ut to increase prime lending rates. $etween +11,%1- and +11/%10, anks increased their PG#s y (,1 to +11 ps, causing yields on advances to increase to 0.,- per cent in +11/%10 from /.)+ per cent in +11-%1/. 2lthough yields did increase to some extent, they did not keep pace with the sharp increase in "o$. $anks also suffered ecause of the negative carry on !G# portfolios, as term%deposit rates rose faster than yields on incremental !G# portfolios 7yield on (1%year government securities moved in the range of /.*0%0..+ per cent during +11/%109. The com ined effect of increasing "o$, negative carry on !G# portfolios, and 6ero interest on "##, was to severely constrain anks' spreads. The system average interest spread declined y .+ ps, to +..( per cent in +11/%10, from +.-. per cent in +11-%1/.

87

"#I!IG estimates that the yield on advances has increased y -. ps in +110%1), driven y higher yields on corporate and retail advances, ut overall interest yields are estimated to have increased y only *) ps, ecause of the raking effect of !G# and "##. "#I!IG estimates that interest spreads declined to +.++ per cent in +110%1).

Fee?I)co e GroAth to Moderate !ince +11.%1*, anks have reported strong growth in fee revenues, a trend primarily led y private anks' focus on retail credit, distri ution of third% party products such as insurance and mutual funds, and provision of wealth management services. 2fter +11*%1,, pu lic sector anks also focused increasingly on fee%income generation as the contri ution from treasury operations declined. !ustained growth in retail credit 7where anks charge up%front processing fees9, and uoyant capital markets, ena led the anking sector to increase the proportion of fee% ased income 7as a percentage of average funds deployed9 to (.(* per cent in +11/%10, from ( per cent in +11,%1-. "#I!IG expects the contri ution of fee% ased income to anks' total income to reduce to around (.1) per cent in +110%1), and further to (.1, per cent in +11)%(1, on account of the slowdown in retail credit growth, and weaker distri ution income ecause of sluggish capital market conditions. O7e> 4)-"/e-( to Reduce Aost pu lic sector anks have sought to rein in their operating expenditure 7Opex9 y investing su stantially in the implementation of core anking solutions which will allow anks to reduce their operating expenses over the medium%term % ecause of greater operational integration and real%time processing of transactions. ?owever, pu lic sector anks' operating expenses may increase over the next (0 months, on account of wage revisions due from ;ovem er +11/. Core 7ro,"ta!"-"t( to dec-")e

88

;)uities: $etween +11,%1- and +11/%10, anks recorded a significant growth in profits on sale of investments on account of uoyant equity markets. ?owever, equity prices have declined sharply since Wanuary +110. "#I!IG elieves that equity prices will remain su dued over the near% to medium%term, and that anks are unlikely to ook the levels of PO!I that they en=oyed etween +11,%1- and +11/%10. :ebt: In the past, anks also ooked huge gains on their large ond portfolios when yields were falling. ?owever, anks had to provide for mark%to%market losses in +11/%10 and the first quarter of +110%1) as yields increased. 2 sharp fall in yields on government securities during the third quarter of +110%1), after the repo rate cuts y #$I, helped Indian anks register a high level of income from PO!I on de t. "#I!IG, however, elieves that these treasury gains were driven y short% term swings in interest rates, which were the result of several macro% economic and demand%supply factors. The su sequent increase in the interest rates during the fourth quarter of +110%1) could negate the enefit of treasury gains ooked in the previous quarter, and significantly affect profits for +110%1). The economic slowdown, declining spreads, and lower fee%income, are expected to result in weakening profita ility for Indian anks over the next two years. "#I!IG expects the system average ;PA to reduce to (.() per cent in +11)%(1, from (.*1 per cent in +11/%10. $anks' profits will also e affected y lower PO!I, and higher provisioning costs.

89

<alini Bhu"ta 5 9bhi0it *ele: 3he hidden truth to =SB "rofitability State-o#ned banks may be sitting on a "o#der-keg of inade)uately "ro isioned loans. <alini Bhu"ta 5 9bhi0it *ele 8 <umbai Se" (>. '(7'. ((:%$ IS3 The anking sector4s Wune quarter earnings DpleasantlyE surprised the market. The country4s largest lender, !tate $ank of India 7!$I9, has seen its net profit grow (./ per cent in the quarter, which has helped push up the profita ility of the enchmark indices. On the ack of such a stellar performance, the ank has een trying to convince analysts to give its shares a etter rating, since its profita ility puts it in league with companies like Oil and ;atural Fas "orporation, #eliance Industries and Tata "onsultancy !ervices. The !treet, however, is in no hurry to re%rate either !$I or the larger universe of pu lic sector anks 7P!$s9, even though shares of these anks are availa le at throwaway prices. This is not surprising ecause state% owned anks have seen a pile%up of ad loans at a faster pace, compared to their private sector peers. 3or P!$s, the fresh inflow of non%performing loans 7;PGs9 in the quarter, also known as slippages, has sharply moved up in the opening quarter of 3S(.. 3or instance, !$I4s slippage ratio or share of impaired assets in X( has more than dou led to *.,) per cent.

This sharp deterioration in asset quality of P!$s implies two things. 3irst, the accretion of ad de t and loan restructuring signal financial stress. !econd, the sharp rise in ad de t calls for a review of the lending process
8:

of state%owned anks, considering the orrower profile of private sector anks is no different and yet their non%performing assets are lower. @otak Institutional 'quities says it is intrigued y the low levels of ;PGs of certain private anks versus the high levels of restructured loans and ;PGs of state%owned anks. The rokerage notes that the loan profile of oth is not very different. Lhat makes the situation worrisome for state%owned anks is the inadequate provisioning for these ad loans. In +11), the #eserve $ank of India 7#$I9 had made it mandatory for anks to put aside #s /1 for every #s (11 that had ecome an ;PG. Gast 2pril, the central ank unexpectedly relaxed the norms on this provisioning coverage ratio 7P"#9, under which anks were not required to maintain a P"# of /1 per cent for ad loans after !eptem er +1(1. The consequence of this relaxation is visi le in the earnings of P!$s this fiscal. !$I4s P"# is down from -0 per cent in X*3S(+ to -* per cent in X(. ?ad !$I provided adequately for its ad loans, its profits would have een lower. $#I"! !ecurities says while the profita ility of the sector seems reasona le, it4s de ata le if one ad=usts for higher provisioning. 2nish Tawakley of $arclays explains: DThe alance sheets of P!$s have een deteriorating. If the P"#s had een maintained, the reported profits would have een lower. ?owever, a liquidity crisis is not imminent here. !ince most of the anking system is government%owned, depositors don4t get concerned a out the safety of their deposits.E 3or the top (1 P!$s, the average P"# has come down to ,1.-* per cent from ,..-. per cent year%on%year. In contrast, the large private sector anks have a P"# of 01 per cent. 2ccording to analyst estimates, incremental provisioning 7for the fresh accretion of ad loans every quarter9 has come down sharply from the prudential /1 per cent levels for many P!$s. Investors and analysts elieve that these anks are only deferring pain. 'mkay Flo al4s analysis shows that the P"# of (1 P!$s has come down to ,1.-* per cent from ,..-. per cent compared to last year. !$I4s Aanaging 8irector and "hief 3inancial Officer 8iwakar Fupta says: DThe first priority is to ensure that the alance sheet is ro ust and we will improve the P"#.E

8;

+RO5ISION'L +ROFI2S .a)/ Net 'dJu*ted +ro;"*"o) I)cre e)ta*-"77age* +'2 ER* co;erage 7ro;"*"o)")g ") Gro** croreG rat"o co;erage I1F(13 N+' ") ") rat"o EFG ER* ") I1F613 I1F613 I1F(13 ") I1F613H croreG EFG 2ndhra .-+ -)( -1..0 ++.// +./ $ank $ank of 000 (,(). -1.0*/./( +.India "anara //, 0*1 --.,. ,-./) +.1 $ank "orp $ank ./1 ,(1 -(.1+ *-.0(./ Pun=a ;ational (,+*(,1*1 -+.0( 0-.,* ... $ank >nion $ank ,(+ (,(/1 ,).11 ./.., ..0 of India !tate $ank .,/,+ /,,-+ -*.+) .-.)1 ,.1 of India I Incremental provisioning ratio is calculated y emkay4s analysts !ource: 'mkay Flo al

9!

'ven as most P!$s are confident that the trend in asset quality deterioration will reverse soon, this optimism is questiona le. The trend in asset quality deterioration suggests that currently medium and small corporations are stressed. In the Wune quarter, !$I4s reported net slippages were to the tune of #s /,,11 crore, of which #s .,*11 crore has come from medium and small companies. This is expected to spread to large corporate and retail orrowers in the coming quarters. $ad loans have increased to )., per cent of gross assets for P!$s in the Wune quarter, while it has held steady for private anks at ..+ per cent of gross advances, explains $#I"! !ecurities. Fiven that P!$s account for /1 per cent of the anking sector, the sharp pile%up in ad de ts is not good news. Over the last few quarters, oth restructured assets and fresh slippages have een high. In the fourth quarter of 3S(+, slippages for the (1 P!$s stood at #s (+,-.( crore, and loans worth #s ./,*., crore were restructured. In the first quarter of 3S(., the value of restructured loans is down to #s ++,(1, crore ut slippages have dou led to #s ++,)+- crore. 2lthough anks could improve their P"#, it could come at the cost of lower net profit. It will hit the capital adequacy at a time when they are preparing for the roll%out of $asel III norms, for which the #$I governor has indicated the government will need to infuse #s )1,111 crore over the next six years. Pra hakar said setting aside higher amounts 7as provisions9 will impact the ottom line and capital adequacy. #aising extra capital in the current market situation then ecomes a challenge. Foing y the nature of companies headed for corporate de t restructuring, analysts elieve that P!$s will have to write off at least +1 per cent of their restructured portfolio. Gate last year, a consortium of +, lenders agreed to restructure the #s (-,111%crore de t of FTG Froup. !imilarly, +/ lenders have agreed to recast the #s .,.11%crore de t of ?industan "onstruction "ompany. !ays one analyst, knock%offs will e high for these anks a few quarters down the line. 2nish 8amania, co%head equities at 'mkay Flo al, says: D2sset quality woes will haunt P!> anks, there y increasing credit cost requirement and eventually lowering return on assets. If slippages stay elevated, then revenue visi ility will e lower and net interest income will decline.E Lith growth slowing and interest rates high, companies are finding it increasingly difficult to service loans. The quarterly num ers of anks show
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that corporate orrowers are either defaulting on payments or seeking easier repayment terms along with lower interest rates. ;ot only has the fresh accretion of ad loans increased ut the queue of companies outside the corporate de t restructuring 7"8#9 cell has grown longer. 2ccording to an analysis y 'mkay Flo al, over 3S1) and X(3S(., the "8# cell has cumulatively restructured .1) cases amounting to #s (-1,111 crore. 'ither way, anks have to take a hit on their ooks.

.I.LIOGR'+H6 & REFERENCES. Book eferences I)d"a) Ma)age e)t Stud"e* Lour)a-9+ro,"ta!"-"t( ')a-(*"* o, +u!-"c Sector .a)/* ") I)d"a? Nar")der 1aur a)d Reetu 1a7oor Co "ttee* a)d Co "**"o)* ") I)d"a, 1C$=?=39 1C=1?=3 2he +er,or a)ce o, I)d"a) .a)/* Dur")g F")a)c"a- L"!era-"Dat"o) .( +et(a 1oe;a .roo/* .a)/")g Sector Re,or * ") I)d"a a)d +er,or a)ce E;a-uat"o) o, Co erc"a- .a)/* $y 8e aprosanna ;andy Online eferences1

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